**SECURITIES
        AND EXCHANGE COMMISSION**
 **Washington,
        D.C. 20549**
  **FORM
          10-Q**
 
 **x** **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF**
 **THE
          SECURITIES EXCHANGE ACT OF 1934**
 **For
          the quarterly period ended September 30, 2005**
 
 ** ̈** **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
          ACT
          OF 1934**
 **For
          the Transition Period from _____to _____**
 **Commission
        File No.** **0-25020**
 **HERITAGE
        OAKS BANCORP**
 **(Exact
        name of registrant as specified in charter)**
 **STATE
        OF CALIFORNIA**
 **(State
        or other jurisdiction of incorporation or organization)**
 **77-0388249**
 **(I.R.S.
        Employer Identification Code)**
 
 **545
        12th STREET, PASO ROBLES, CA 93446**
 **(Address
        of principal office)**
 **(805)
        239-5200**
 **(Registrant's
        telephone number, including area code)**
 
 **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 ninety (90) days.**
 **YES** **x** **NO** ** ̈**
  **Indicate
        by check mark whether the registrant is an accelerated filer (as defined
        in
        Exchange Act Rule 12b-2).**
 **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 October 6, 2005 there were approximately 4,146,936 shares outstanding
        of the
        Registrant’s common stock.**
 
  •
            PAGE • 1
•
   **TABLE
        OF CONTENTS**
  PagePart
                    1. Financial Information
                3Item
                    1.
                Consolidated
                    Financial Statements (Unaudited)
                3Consolidated
                    Balance Sheets
                3Consolidated
                    Statements of Income
                4Consolidated
                    Statements of Comprehensive Income
                5Consolidated
                    Statements of Stockholders’ Equity
                6Consolidated
                    Statements of Cash Flows
                7Notes
                    to Consolidated Financial Statements
                8Item
                    2.
                Management’s
                    Discussion and Analysis of Financial Condition and Results of
                    Operations
                14Item
                    3.
                Quantitative
                    and Qualitative Disclosure about Market Risk
                32Item
                    4.
                Controls
                    and Procedures
                33Part
                    2. Other Information
                34Item
                    1.
                Legal
                    Proceedings
                34Item
                    2.
                Changes
                    in Securities, Use of Proceeds and Issuer Purchases of Equity
                    Securities
                34Item
                    3.
                Defaults
                    Upon Senior Securities
                34Item
                    4.
                Submission
                    of Matters to a Vote of Security Holders
                34Item
                    5.
                Other
                    Information
                34Item
                    6.
                Exhibits
                34Signatures
                
                35Exhibits
                
                36
 
  •
            PAGE • 2
•
 
 PART
        1.
        FINANCIAL INFORMATION
 Item
        1.
        Financial Statements
  **HERITAGE
        OAKS BANCORP**
 **CONSOLIDATED
        BALANCE SHEETS**
 (in
        thousands)
 
 **30-Sep-05**
              
              **31-Dec-04**ASSETS
              
              **Un-audited**
              
              **(1)**Cash
                  and due from banks
              
              $
              23,033
              
              $
              13,092Federal
                  funds sold
              
              
              53,035
              
              
              5,775Money
                  market funds
              
              
              -
              
              
              3,000Total
                  cash and cash equivalents
              
              
              76,068
              
              
              21,867Interest
                  bearing deposits other banks
              
              
              298
              
              
              498Securities
                  Available for sale
              
              
              46,462
              
              
              57,394Federal
                  Home Loan Bank Stock, at cost
              
              
              1,864
              
              
              1,809Loans
                  Held For Sale
              
              
              7,694
              
              
              2,253Loans,
                  net
              
              
              366,158
              
              
              334,964Property,
                  premises and equipment, net
              
              
              10,730
              
              
              10,383Cash
                  surrender value life insurance
              
              
              7,635
              
              
              7,130Deferred
                  Tax Assets
              
              
              2,121
              
              
              1,918Goodwill
              
              
              4,865
              
              
              4,865Core
                  Deposit Intangible
              
              
              1,590
              
              
              2,021Other
                  assets
              
              
              2,884
              
              
              2,910TOTAL
                  ASSETS
              
              $
              528,369
              
              $
              448,012LIABILITIES
                  AND STOCKHOLDERS' EQUITYLIABILITIESDeposits:Demand,
                  non-interest bearing
              
              $
              206,965
              
              $
              143,455Savings,
                  NOW, and money market deposits
              
              
              167,827
              
              
              166,015Time
                  deposits of $100 or more
              
              
              18,098
              
              
              18,034Time
                  deposits under $100
              
              
              50,879
              
              
              42,937Total
                  deposits
              
              
              443,769
              
              
              370,441FHLB
                  advances and other borrowed money
              
              
              28,000
              
              
              28,500Securities
                  Sold under Agreement to Repurchase
              
              
              2,057
              
              
              766Notes
                  Payable
              
              
              -
              
              
              -Junior
                  subordinated debentures
              
              
              8,248
              
              
              8,248Other
                  liabilities
              
              
              3,423
              
              
              2,807Total
                  liabilities
              
              
              485,497
              
              
              410,762COMMITMENTS
                  AND CONTINGENCIES
              
              
              -Stockholders'
                  equityCommon
                  stock, no par value; 20,000,000 shares authorized; issued and outstanding
                  4,146,936 and 4,102,987 for September 30, 2005 and December 31,
                  2004,
                  respectively.
              
              
              28,925
              
              
              24,050Retained
                  earnings
              
              
              13,944
              
              
              13,053Accumulated
                  other comprehensive income
              
              
              3
              
              
              147Total
                  stockholders' equity
              
              
              42,872
              
              
              37,250TOTAL
                  LIABILITIES & STOCKHOLDERS' EQUITY
              
              $
              528,369
              
              $
              448,012
 
 (1)
        These
        numbers have been derived from the audited financial statements.
  See
        notes
        to consolidated financial statements
  •
            PAGE • 3
•
  **HERITAGE
        OAKS BANCORP**
 **CONSOLIDATED
        STATEMENTS OF INCOME**
 (in
                    thousands except per share date)
  **For
                        the three months**
                      **ended
                        September 30,**
                    
                    **For
                        the nine months**
                      **ended
                        September 30,****2005**
                    
                    **2004**
                    
                    **2005**
                    
                    **2004****(Unaudited)**
                    
                    **(Unaudited)**
                    
                    **(Unaudited)**
                    
                    **(Unaudited)**Interest
                        Income:Interest
                        and fees on loans
                    
                    $
                    7,179
                    
                    $
                    5,136
                    
                    $
                    19,794
                    
                    $
                    15,002Investment
                        securities
                    
                    
                    489
                    
                    
                    627
                    
                    
                    1,586
                    
                    
                    1,779Federal
                        funds sold and commercial paper
                    
                    
                    270
                    
                    
                    74
                    
                    
                    440
                    
                    
                    228Interest
                        Bearing Deposits
                    
                    
                    2
                    
                    
                    11
                    
                    
                    7
                    
                    
                    16Total
                        interest income
                    
                    
                    7,940
                    
                    
                    5,848
                    
                    
                    21,827
                    
                    
                    17,025Interest
                        Expense:Now
                        accounts
                    
                    
                    25
                    
                    
                    10
                    
                    
                    67
                    
                    
                    21MMDA
                        accounts
                    
                    
                    442
                    
                    
                    137
                    
                    
                    983
                    
                    
                    386Savings
                        accounts
                    
                    
                    29
                    
                    
                    21
                    
                    
                    71
                    
                    
                    68Time
                        deposits of $100 or more
                    
                    
                    103
                    
                    
                    61
                    
                    
                    276
                    
                    
                    180Other
                        time deposits
                    
                    
                    350
                    
                    
                    197
                    
                    
                    856
                    
                    
                    655Other
                        borrowed funds
                    
                    
                    398
                    
                    
                    371
                    
                    
                    1,201
                    
                    
                    1,211Total
                        interest expense
                    
                    
                    1,347
                    
                    
                    797
                    
                    
                    3,454
                    
                    
                    2,521Net
                        Interest Income Before Provision for Possible Loan Losses
                    
                    
                    6,593
                    
                    
                    5,051
                    
                    
                    18,373
                    
                    
                    14,504Provision
                        for loan losses
                    
                    
                    170
                    
                    
                    75
                    
                    
                    530
                    
                    
                    280Net
                        interest income after provision for loan losses
                    
                    
                    6,423
                    
                    
                    4,976
                    
                    
                    17,843
                    
                    
                    14,224Non-interest
                        Income:Service
                        charges on deposit accounts
                    
                    
                    655
                    
                    
                    546
                    
                    
                    1,825
                    
                    
                    1,644Gain
                        of Sale of Securities
                    
                    
                    -
                    
                    
                    -
                    
                    
                    
                    
                    
                    28Other
                        income
                    
                    
                    734
                    
                    
                    525
                    
                    
                    1,962
                    
                    
                    1,621Total
                        Non-interest Income
                    
                    
                    1,389
                    
                    
                    1,071
                    
                    
                    3,787
                    
                    
                    3,293Non-interest
                        Expense:Salaries
                        and employee benefits
                    
                    
                    2,532
                    
                    
                    2,068
                    
                    
                    7,188
                    
                    
                    6,242Occupancy
                        and equipment
                    
                    
                    600
                    
                    
                    644
                    
                    
                    1,853
                    
                    
                    1,907Other
                        expenses
                    
                    
                    1,743
                    
                    
                    1,412
                    
                    
                    4,820
                    
                    
                    4,210Total
                        Noninterest Expenses
                    
                    
                    4,875
                    
                    
                    4,124
                    
                    
                    13,861
                    
                    
                    12,359Income
                        before provision for income taxes
                    
                    
                    2,937
                    
                    
                    1,923
                    
                    
                    7,769
                    
                    
                    5,158Provision
                        for applicable income taxes
                    
                    
                    1,132
                    
                    
                    730
                    
                    
                    2,940
                    
                    
                    1,927Net
                        Income
                    
                    $
                    1,805
                    
                    $
                    1,193
                    
                    $
                    4,829
                    
                    $
                    3,231Earnings
                        per share: (See note #4)Basic
                    
                    $
                    0.44
                    
                    $
                    0.30
                    
                    $
                    1.18
                    
                    $
                    0.81Fully
                        Diluted
                    
                    $
                    0.42
                    
                    $
                    0.28
                    
                    $
                    1.11
                    
                    $
                    0.76
 See
          notes
          to consolidated financial statements
   •
            PAGE • 4
•
  
 **HERITAGE
        OAKS BANCORP**
 **Consolidated
        Statements of Comprehensive Income**
 (Unaudited,
        in thousands)
 
 **Three
                    Month Period**
                
                **Nine
                    Month Period****Ended
                    September 30,**
                
                **Ended
                    September 30,****2005**
                
                **2004**
                
                **2005**
                
                **2004****Net
                    Income**
                
                $
                1,805
                
                $
                1,193
                
                $
                4,829
                
                $
                3,231**Other
                    Comprehensive Income Before Taxes:**Unrealized
                    gains (losses) on securities available for sale:Unrealized
                    holding gains (losses) arising during period
                
                
                (291
                )
                
                1,074
                
                
                (240
                )
                
                363Reclassification
                    adjustments for (gains) included in net income
                
                
                -
                
                
                -
                
                
                -
                
                
                (28
                )Other
                    comprehensive income (loss), before taxes
                
                
                (291
                )
                
                1,074
                
                
                (240
                )
                
                335Income
                    tax expense (benefit) related to unrealized gain in comprehensive
                    income
                
                
                118
                
                
                (428
                )
                
                96
                
                
                (145
                )Income
                    tax expense (benefit) related to realized gain in comprehensive
                    income
                
                
                -
                
                
                -
                
                
                -
                
                
                11**Other
                    Comprehensive Income (Loss), Net of Taxes**
                
                
                (173
                )
                
                646
                
                
                (144
                )
                
                201**Comprehensive
                    Income**
                
                $
                1,632
                
                $
                1,839
                
                $
                4,685
                
                $
                3,432
 
 See
          notes
          to consolidated financial statements
 
 
 
 
  •
            PAGE • 5
•
  
 **HERITAGE
        OAKS BANCORP**
 **CONSOLIDATED
        STATEMENTS OF STOCKHOLDERS' EQUITY**
 **September
        30, 2005 and September 30, 2004**
 **(Unaudited)**
 (in
        thousands except shares outstanding)
 
 **Accumulated****Other**
                
                **Total****Shares**
                
                **Common**
                
                **Retained**
                
                **Comprehensive**
                
                **Stockholders'**(in
                    thousands)
                
                **Outstanding**
                
                **Stock**
                
                **Earnings**
                
                **Income**
                
                **Equity****Balance
                    January 1, 2005**
                
                
                3,817,943
                
                $
                24,050
                
                $
                13,053
                
                $
                147
                
                $
                37,250Exercise
                    of Stock Options
                
                
                133,980
                
                
                945
                
                
                
                
                
                
                
                
                945Stock
                    dividend - 5%
                
                
                195,013
                
                
                3,930
                
                
                (3,930
                )
                
                
                
                
                0Cash
                    paid to Shareholders' in Lieu of fractional shares on 5% Stock
                    Dividend
                
                
                
                
                
                
                
                
                (8
                )
                
                
                
                
                (8
                )Comprehensive
                    IncomeNet
                    Income
                
                
                
                
                
                
                
                
                4,829
                
                
                
                
                
                4,829Unrealized
                    Security Holding Gains (net of $96 tax )
                
                
                
                
                
                
                
                
                
                
                
                (144
                )
                
                (144
                )Total
                    other comprehensive Income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                4,685**Balance
                    September 30, 2005**
                
                
                **4,146,936**
                
                **$**
                **28,925**
                
                **$**
                **13,944**
                
                **$**
                **3**
                
                **$**
                **42,872**
 
 **Accumulated****Other**
                
                **Total****Shares**
                
                **Common**
                
                **Retained**
                
                **Comprehensive**
                
                **Stockholders'**(in
                    thousands)
                
                **Outstanding**
                
                **Stock**
                
                **Earnings**
                
                **Income**
                
                **Equity****Balance
                    January 1, 2004**
                
                
                3,604,497
                
                $
                20,649
                
                $
                11,541
                
                $
                98
                
                $
                32,288Exercise
                    of Stock Options
                
                
                31,172
                
                
                187
                
                
                
                
                
                
                
                
                1875%
                    Stock Dividend to be distributed
                
                
                180,301
                
                
                3,065
                
                
                (3,065
                )
                
                
                
                
                0April
                    23, 2004Cash
                    Paid in lieu of fractional shares
                
                
                
                
                
                
                
                
                (6
                )
                
                
                
                
                (6
                )Comprehensive
                    IncomeNet
                    Income
                
                
                
                
                
                
                
                
                3,231
                
                
                
                
                
                3,231Unrealized
                    Security Holding Losses (net of $145 tax )
                
                
                
                
                
                
                
                
                
                
                
                218
                
                
                218Less
                    reclasification adjustment for gain (net of ($11) tax)
                
                
                
                
                
                
                
                
                
                
                
                (17
                )
                
                (17
                )Total
                    other comprehensive Income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                3,432**Balance
                    September 30, 2004**
                
                
                **3,815,970**
                
                **$**
                **23,901**
                
                **$**
                **11,701**
                
                **$**
                **299**
                
                **$**
                **35,901**
 See
        notes
        to consolidated financial statements
 
 
 
  •
            PAGE • 6
•
  
 **HERITAGE
        OAKS BANCORP**
 **CONSOLIDATED
        STATEMENTS OF CASHFLOWS**
 **Periods
        ended September 30**
 (in
        thousands)
 
 2005
                
                2004(Unaudited)
                
                (Unaudited)**Cash
                    Flows from Operating Activities**Net
                    income
                
                $
                4,829
                
                $
                3,231Adjustments
                    to reconcile net income to net cash provided by operating
                    activitiesNet
                    cash provided by operating activitiesDepreciation
                    and amortization
                
                
                688
                
                
                709Provision
                    for possible loan losses
                
                
                530
                
                
                280Provision
                    for possible unfunded loan losses
                
                
                (10
                )
                
                25Realized
                      loss on sales of available-for-sale securities, net
                
                
                0
                
                
                (28
                )Amortization
                      of premiums/discounts on investment securities, net
                
                
                170
                
                
                307FHLB
                    Stock dividends
                
                
                (55
                )
                
                (55
                )Amortization
                    of intangible assets
                
                
                431
                
                
                316(Increase)/decrease
                    in loans held for sale
                
                
                (5,441
                )
                
                1,913Net
                    increase in cash surrender value of life insurance
                
                
                (205
                )
                
                (206
                )(Increase)
                    Decrease in other assets
                
                
                (73
                )
                
                1Increase
                    (Decrease) in other liabilities
                
                
                626
                
                
                (32
                )**NET
                    CASH PROVIDED BY/(USED IN) OPERATING ACTIVITIES**
                
                
                1,490
                
                
                6,461**Cash
                    Flows From Investing Activities**Purchase
                    of securities available-for-sale
                
                
                (1,393
                )
                
                (1,455
                )Purchase
                    of mortgage backed securities available-for-sale
                
                
                0
                
                
                (17,295
                )Proceeds
                    from sales of securities available-for-sale
                
                
                0
                
                
                1,534Proceeds
                    from principal reductions and maturities of securities
                    available-for-sale
                
                
                850
                
                
                1,315Proceeds
                    from principal reductions and maturities of mortgage backed securities
                    available-for-sale
                
                
                11,065
                
                
                11,060Net
                    Change in interest bearing deposits with other banks
                
                
                200
                
                
                (4,100
                )Proceeds
                    from Sale of FHLB stock
                
                
                0
                
                
                435Purchase
                    of life insurance policies
                
                
                (300
                )
                
                0Increase
                    in loans, net
                
                
                (31,746
                )
                
                (35,117
                )ALLL
                    Recoveries
                
                
                22
                
                
                2Proceeds
                    from disposal of property
                
                
                617
                
                
                0Purchase
                    of property, premises and equipment, net
                
                
                (1,660
                )
                
                (737
                )**NET
                    CASH USED IN INVESTING ACTIVITIES**
                
                
                (22,345
                )
                
                (44,358
                )**Cash
                    Flows From Financing Activities**Increase
                    in deposits, net
                
                $
                73,328
                
                $
                18,434Net
                    increase/(decrease) in other borrowings
                
                
                791
                
                
                (3,394
                )Proceeds
                    from exercise of stock options
                
                
                945
                
                
                187Cash
                    paid in lieu of fractional shares
                
                
                (8
                )
                
                (6
                )**NET
                    CASH PROVIDED BY FINANCING ACTIVITIES**
                
                
                75,056
                
                
                15,221**Net
                    Increase/(Decrease) in Cash and Cash Equivalents**
                
                
                54,201
                
                
                (22,676
                )**Cash
                    and Cash Equivalents**,
                    Beginning of year
                
                
                21,867
                
                
                77,114**Cash
                    and Cash Equivalents**,
                    End of period
                
                $
                76,068
                
                $
                54,438**Supplemental
                    Disclosures of Cash Flow Information**Interest
                    paid
                
                $
                3,456
                
                $
                2,277Income
                    taxes paid
                
                $
                3,132
                
                $
                1,775
  See
          notes
          to consolidated financial statements
 
  •
            PAGE • 7
•
   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 2004 Annual Report on Form 10-KSB.
 
 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 Trust I is an unconsolidated subsidiary formed solely
        for
        the purpose of issuing trust preferred securities. Operating results for
        the
        three and nine months ended September 30, 2005 are not necessarily indicative
        of
        the results that may be expected for the year ending December 31, 2005. Certain
        amounts in the consolidated financial statements for the year ended December
        31,
        2004 and the three and nine month period ended September 30, 2004 may have
        been
        reclassified to conform to the presentation of the consolidated financial
        statement in 2005.
 
 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: debit and
        equity 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.
  •
            PAGE • 8
•
 
 The
        amortized cost and fair values of investment securities available for sale
        at
        September 30, 2005 and December 31, 2004:
 
 (in
                  thousands)September
                  30, 2005
              
              
              
              Gross
              
              GrossAmortized
              
              Unrealized
              
              Unrealized
              
              FairCost
              
              Gains
              
              Losses
              
              ValueObligations
                  of U.S. government agencies and corporations
              
              $
              1,330
              
              $
              -
              
              $
              (26
              )
              $
              1,304Mortgage-backed
                  securities
              
              
              31,316
              
              
              29
              
              
              (400
              )
              
              30,945Obligations
                  of State and Political Subdivisions
              
              
              13,804
              
              
              431
              
              
              (31
              )
              
              14,204Other
                  Securities
              
              
              9
              
              
              -
              
              
              -
              
              
              9Total
              
              $
              46,459
              
              $
              460
              
              $
              (457
              )
              $
              46,462December
                  31, 2004
              
              
              
              
              
              Gross
              
              
              Gross(in
                  thousands)
              
              
              Amortized
              
              
              Unrealized
              
              
              Unrealized
              
              
              FairCost
              
              
              Gains
              
              
              Losses
              
              
              ValueObligations
                  of U.S. government agencies and corporations
              
              $
              1,868
              
              $
              5
              
              $
              (30
              )
              $
              1,843Mortgage-backed
                  securities
              
              
              42,622
              
              
              181
              
              
              (239
              )
              
              42,564Obligations
                  of State and Political Subdivisions
              
              
              12,651
              
              
              413
              
              
              (86
              )
              
              12,978Other
                  Securities
              
              
              9
              
              
              -
              
              
              -
              
              
              9Total
              
              $
              57,150
              
              $
              599
              
              $
              (355
              )
              $
              57,394
 
 Note
        3.  LOANS
        AND
        ALLOWANCE FOR LOAN LOSSES
  Major
          classifications of loans were:
 
 September
                    30,
                
                December
                    31,(in
                    thousands)
                
                2005
                
                2004Commercial,
                    financial, and agricultural
                
                $
                65,492
                
                $
                49,584Real
                    estate-construction
                
                
                76,202
                
                
                66,833Commercial
                    real estate
                
                
                224,171
                
                
                217,473Installment
                    loans to individuals
                
                
                5,410
                
                
                5,538All
                    other loans (including overdrafts)
                
                
                304
                
                
                265371,579
                
                
                339,693Less
                    - deferred loan fees, net
                
                
                (1,662
                )
                
                (1,482
                )Less
                    - reserve for possible loan losses
                
                
                (3,759
                )
                
                (3,247
                )Total
                    loans
                
                $
                366,158
                
                $
                334,964Loans
                    Held For Sale
                
                $
                7,694
                
                $
                2,253
 Concentration
          of Credit Risk
  At
        September 30, 2005, over $300 million of the Bank’s loan portfolio was
        collateralized by various forms of real estate. 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 project type. While Management believes that the collateral
        presently securing this portfolio is adequate, there can be no assurances
        that
        significant deterioration in the California real estate market would not
        expose
        the Bank to significantly greater credit risk.
  •
            PAGE • 9
•
  At
        September 30, 2005, the Bank was contingently liable for letters of credit
        accommodations made to its customers totaling approximately $17 million and
        un-disbursed loan commitments in the approximate amount of $152 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.
 
 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 allowance for loan losses
        is
        composed of allocations for specific loans and a historical portion for all
        other loans.
  An
        analysis of the changes in the reserve for possible loan losses is as
        follows:
 
 (in
                  thousands)
              
              September
                  30,
              
              December
                  31,2005
              
              2004Balance
                  at beginning of year
              
              $
              3,247
              
              $
              3,070Additions
                  charged to operating expense
              
              
              530
              
              
              410Loans
                  charged off
              
              
              (40
              )
              
              (236
              )Recoveries
                  of loans previously charged off
              
              
              22
              
              
              3Balance
                  at end of year
              
              $
              3,759
              
              $
              3,247
 
  The
        Bank
        recognized 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 loss 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 collectability of the
        loans
        in its portfolio by incorporating feedback provided by internal loan staff,
        an
        independent loan review function, and information provided by examinations
        performed by regulatory agencies. The Bank makes monthly evaluations as to
        the
        adequacy of the allowance for loan losses.
 
 The
        analysis of the allowance for loan losses is comprised of three components:
        specific credit allocation; general portfolio allocation; and subjectively
        by
        determined allocation. Effective January 1, 1995, the Bank adopted SFAS No.114,
        Accounting by Creditors for Impairment of a Loan (SFAS 114), 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 Statement 114 is based
        on
        discounted cash flows using the loan’s initial effect interest rate or the fair
        value of the collateral for certain collateral dependent loans. The general
        portfolio allocation 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.
  •
            PAGE •
            10 •
  The
        allowance for loan losses is based on estimates, and ultimate losses will
        vary
        from current estimates. These estimates are reviewed monthly, 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 possible loan losses
        for the
        three and nine months ended September 30, 2005 is consistent with prior periods.
 
 The
        allowance for loan losses as a percentage of total net loans was 1.03% as
        of
        September 30, 2005 and 0.97% as of December 31, 2004. Management believes
        that
        the allowance for credit losses at September 30, 2005 is prudent and warranted,
        based on information currently available.
  Note
        4.  EARNINGS
        PER SHARE
 
 Basic
        earnings per share are based on the weighted average number of shares
        outstanding before any dilution from common stock equivalents. Diluted earnings
        per share reflects the potential dilution that could occur if securities
        or
        other contracts to issue common stock were exercised or converted into common
        stock or resulted in the issuance of common stock that then shares in the
        earnings of the entity.
 
 On
        March
        25, 2005, the Company’s Board of Directors declared a 5% stock dividend. The
        record date for the stock dividend was April 8, 2005 and the pay date was
        April
        22, 2005.
 
 Share
        information has been retroactively adjusted for such 5% stock
        dividend.
 
 The
        following table shows the number of shares used to calculate and the earnings
        per share for the three and nine months ending September 30, 2005 and
        2004:
 
 EPS
              
              EPSFor
                  the Three Months Ending:
              
              For
                  the Nine Months Ending:30-Sep-05
              
              30-Sep-04
              
              30-Sep-05
              
              30-Sep-04Net
                  Income
              
              $
              1,804,918
              
              $
              1,193,646
              
              $
              4,828,627
              
              $
              3,231,240Basic
              
              $
              0.44
              
              $
              0.30
              
              $
              1.18
              
              $
              0.81Diluted
              
              $
              0.42
              
              $
              0.28
              
              $
              1.11
              
              $
              0.76Shares:Basic
              
              
              4,124,030
              
              
              3,999,395
              
              
              4,098,162
              
              
              3,989,084Diluted
              
              
              4,332,785
              
              
              4,273,470
              
              
              4,343,320
              
              
              4,278,425
   •
            PAGE •
            11 •
  The
        following table illustrates the effect on net income and earnings per share
        if
        the Company had applied the fair value recognition provision of SFAS 123,
        Accounting for Stock Based Compensation, to stock based employee
        compensation:
 
 Three
                  Months Ended
              
              Nine
                  Months Ended30-Sep-05
              
              30-Sep-04
              
              30-Sep-05
              
              30-Sep-04Net
                  income:As
                  reported
              
              $
              1,804,918
              
              $
              1,193,646
              
              $
              4,828,627
              
              $
              3,231,240Stock-based
                  compensation using the intrinsic value method
              
              
              -
              
              
              -
              
              
              -
              
              
              -Stock-based
                  compensation that would have been reported using the fair value
                  method of
                  SFAS 123
              
              
              (6,607
              )
              
              (7,551
              )
              
              (77,541
              )
              
              (52,727
              )Pro
                  forma net income
              
              $
              1,798,311
              
              $
              1,186,095
              
              $
              4,751,086
              
              $
              3,178,513Weighted
                  Average Shares Outstanding - Basic
              
              
              4,124,030
              
              
              3,999,395
              
              
              4,098,162
              
              
              3,989,084Weighted
                  Average Shares Outstanding - Diluted
              
              
              4,332,785
              
              
              4,273,470
              
              
              4,343,320
              
              
              4,278,425Basic
                  Earnings per shareAs
                  reported
              
              $
              0.44
              
              $
              0.30
              
              $
              1.18
              
              $
              0.81Pro
                  forma
              
              $
              0.44
              
              $
              0.30
              
              $
              1.16
              
              $
              0.80Earnings
                  per share - assuming dilutionAs
                  reported
              
              $
              0.42
              
              $
              0.28
              
              $
              1.11
              
              $
              0.76Pro
                  forma
              
              $
              0.42
              
              $
              0.28
              
              $
              1.09
              
              $
              0.74
 
 Note
        5.  RECENT
        ACCOUNTING PRONOUNCEMENTS
  In
        March
        2004, the Financial Accounting Standards Board (FASB) issued an exposure
        draft
        entitled "Share-Based Payment, an Amendment of FASB Statements No. 123 and
        95."
        This proposed statement would eliminate the ability to account for stock-based
        compensation using APB 25 and require such transactions be recognized as
        compensation expense in the income statement based on their fair values at
        the
        date of grant. Companies transitioning to fair value based accounting for
        stock-based compensation will be required to use the "modified prospective"
        method whereby companies must recognize equity compensation cost from the
        beginning of the year in which the recognition provisions are first applied
        as
        if the fair value method had been used to account for all equity compensation
        awards granted, modified, or settled in fiscal years beginning after December
        31, 1994. As proposed, this statement would have been effective for the
        Corporation on January 1, 2005. In December 2004, the FASB issued SFAS No.
        123
        (revised 2004). *“Share-Based
        Payment”* ,
        which
        is a revision of SFAS No. 123, *“Accounting
        for Stock-Based Compensation”* .
        SFAS
        No. 123(R) supersedes APB Opinion No. 25, *“Accounting
        for Stock Issued to Employees”* and
        amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS
        No.
        123(R) is similar to the approach described in SFAS No. 123. However, SFAS
        No.
        123(R) requires all share-based payments to employees, including grants of
        employee stock options, to be recognized in the income statement based on
        their
        fair values. Pro forma disclosure is no longer an alternative. On April 15,
        2005, the SEC extended the compliance deadline for SFAS 123(R) to the first
        interim or annual report for a Company’s first fiscal year beginning on or after
        June 15, 2005. The Company has not determined if the adoption of this standard
        will have a material impact on its financial statements.
  •
            PAGE •
            12 •
  In
        January 2003, the FASB issued the Emerging Information Task Force Issue 03-1, *The
        Meaning of Other-Than-Temporary Impairment and Its Application to Certain
        Investors* (“EITF
        03-1”), and in March 2004, FASB issued an update. EITF 03-1 addresses the
        meaning of other-than-temporary impairment and its application to certain
        debt
        and equity securities. EITF 03-1 aids in the determination of impairment
        of an
        investment and gives guidance as to the measurement of impairment loss and
        the
        recognition and disclosures of other-than-temporary investments. EITF 03-1
        also
        provides a model to determine other-than-temporary impairment using
        evidence-based judgment about the recovery of the fair value up to the cost
        of
        the investment by considering the severity and duration of the impairment
        in
        relation to the forecasted recovery of the fair value. In July 2005, FASB
        adopted the recommendation of its staff to nullify key parts of Emerging
        Issues
        Task Force (“EITF”) Issue 03-1. The staff’s recommendations were to nullify the
        guidance on the determination of whether an investment is impaired as set
        forth
        in paragraphs 10-18 of Issue 03-1 and not to provide additional guidance
        on the
        meaning of other-than-temporary impairment. Instead, the staff recommends
        entities recognize other-than-temporary impairments by applying
        existing accounting literature such as paragraph 16 of SFAS 115.
 
 Under
        FASB Interpretation (FIN) No. 46, *“Consolidation
        of Variable Interest Entities, an interpretation of ARB No.
        51,”* the
        Company is not allowed to consolidate Heritage Oaks Capital Trust I 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 new 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 1 capital, subject to certain new limitations which
        will
        not become effective until March 31, 2009 and which, in any event, are not
        expected to affect the treatment of the Company's Junior Subordinated Debentures
        as Tier 1 capital for regulatory purposes. At September 30, 2005, the Company
        has included the net junior subordinated debt in its Tier 1 Capital for
        regulatory capital purposes.
 
 Note
        6.  RECLASSIFICATIONS
 
 Certain
        amounts in the 2004 financial statements have been reclassified to conform
        to
        the 2005 presentation.
  •
            PAGE •
            13 •
   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: 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, 2004 10-KSB, ITEM 1. Description of
        Business-Factors that May Affect Future Results of Operations.) 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.**
 
 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 for the periods ending September 30, 2005 and 2004. 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"), an 11 branch bank
        serving San Luis Obispo and northern Santa Barbara Counties. In 1994, the
        Company acquired all of the outstanding common stock of the Bank in a holding
        company formation transaction.
 
 In
        April
        2002, the Company formed Heritage Oaks Capital Trust I (the “Trust”). The Trust
        is a statutory business trust formed under the laws of the State of Delaware.
        The Trust is a wholly-owned, non-financial, non-consolidated subsidiary of
        the
        Company.
 
 On
        October 31, 2003, the Company acquired Hacienda Bank and on June 28, 2004,
        Hacienda Bank was merged with and into the Bank.
 
 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-KSB (Annual Report), Form 10-Q
        (Quarterly Report), Form 8-K (Report of Unscheduled Material Events), 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
  •
            PAGE •
            14 •
  
 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.
 
 Executive
        Summary and Recent Developments
 
 The
        table
        below provides selected financial data that highlights the Company’s quarterly
        performance results:
 
 **SELECTED
                  FINANCIAL DATA****For
                  the Quarter Ended,**
 
 Dec-03
              
              Mar-04
              
              Jun-04
              
              Sep-04
              
              Dec-04
              
              Mar-05
              
              Jun-05
              
              Sep-05Return
                  on Average Assets
              
              
              0.99
              %
              
              0.82
              %
              
              1.02
              %
              
              1.06
              %
              
              1.18
              %
              
              1.24
              %
              
              1.37
              %
              
              1.44
              %Return
                  on Average Equity
              
              
              13.59
              %
              
              10.60
              %
              
              13.62
              %
              
              13.62
              %
              
              14.77
              %
              
              14.74
              %
              
              15.94
              %
              
              17.03
              %Average
                  Equity to Average Assets
              
              
              6.76
              %
              
              7.69
              %
              
              7.58
              %
              
              7.78
              %
              
              6.76
              %
              
              8.40
              %
              
              8.60
              %
              
              8.47
              %Net
                  Interest Margin
              
              
              4.85
              %
              
              4.71
              %
              
              4.87
              %
              
              5.15
              %
              
              5.40
              %
              
              5.55
              %
              
              5.68
              %
              
              5.80
              %Efficiency
                  Ratio*
              
              
              68.94
              %
              
              72.65
              %
              
              68.55
              %
              
              67.36
              %
              
              67.64
              %
              
              64.14
              %
              
              62.66
              %
              
              61.08
              %Average
                  Loans to Average Deposits
              
              
              81.74
              %
              
              80.10
              %
              
              80.63
              %
              
              80.88
              %
              
              85.65
              %
              
              92.82
              %
              
              91.91
              %
              
              89.60
              %Net
                  Income
              
              $
              975
              
              $
              876
              
              $
              1,162
              
              $
              1,193
              
              $
              1,353
              
              $
              1,417
              
              $
              1,606
              
              $
              1,805Earnings
                  Per Share:Basic
              
              $
              0.26
              
              $
              0.22
              
              $
              0.29
              
              $
              0.30
              
              $
              0.33
              
              $
              0.35
              
              $
              0.39
              
              $
              0.44Diluted
              
              $
              0.24
              
              $
              0.20
              
              $
              0.27
              
              $
              0.28
              
              $
              0.31
              
              $
              0.33
              
              $
              0.37
              
              $
              0.42Outstanding
                  Shares:Basic
              
              
              3,743,258
              
              
              3,980,382
              
              
              3,987,768
              
              
              3,999,395
              
              
              4,007,309
              
              
              4,053,900
              
              
              4,111,714
              
              
              4,124,030Diluted
              
              
              4,033,538
              
              
              4,282,901
              
              
              4,272,027
              
              
              4,273,470
              
              
              4,306,783
              
              
              4,305,622
              
              
              4,349,899
              
              
              4,332,785
 
 
 *
        The
        efficiency ratio is defined as total non-interest expense as a percent of
        the
        combined net interest income plus non-interest income.
 
 In
        the
        culmination of many years of effort to gain a greater presence in Santa Maria,
        the Company acquired Hacienda Bank of Santa Maria on October 31, 2003.
        Management viewed Santa Maria as an area within the Company’s primary service
        area that presented good opportunities for growth of the Bank’s business. The
        acquisition was accretive to earnings in the third quarter of 2004, one quarter
        ahead of management’s initial expectation.
 
 In
        1999,
        the Company implemented a Corporate Culture Survey that allows employees
        to
        respond anonymously to nearly 100 questions regarding communication, training,
        management effectiveness and many other pertinent areas. This survey is
        conducted annually during the fourth quarter. The results of the survey provide
        senior management and the Board fo Directors with information that assists
        in
        future endeavors to address areas where there is an opportunity to improve.
        During the past five years, the overall “rating” has shown measured improvement.
        Senior management and the Board of Directors consider this to be one of the
        most
        important achievements for the Company.
  •
            PAGE •
            15 •
   The
        Company continues to focus on increased market share in each city within
        its
        primary market area. Measured calling programs for both lending and operational
        staff have been implemented utilizing, among other resources, a Customer
        Relationship Management (CRM) system. While competition remains robust in
        the
        Central Coast with numerous independent banks headquartered in the area and
        the
        presence of the major financial institutions, the Company believes that its
        unique corporate culture will ultimately be its best tool to accomplish its
        market share goals. According to deposit market share data compiled by the
        FDIC,
        from June 1998 to June 2005, the Company’s market share in San Luis Obispo
        County grew from 5.9% to 7.9%. This growth represented a move from the eighth
        position among seventeen commercial banks and thrifts to fourth among fifteen
        commercial banks and thrifts. The Compound Annual Growth Rate (CAGR) for
        the
        Company over a ten year period (June 1995 through June 2005) was 18.2% compared
        to a CAGR of 7.5% for total deposits in San Luis Obispo County.
 
 In
        July
        2003, the Bank purchased a property immediately adjacent to its Headquarters
        facility. Construction is under way on approximately 20 thousand square feet
        of
        office space to house all administrative functions of the Company. Completion
        of
        the project is anticipated to be late in the first quarter of 2006.
 
 On
        September 27, 2004, the Company commenced trading under the symbol HEOP on
        the
        Nasdaq Capital Market.
 
 In
        early
        October 2004, the Bank began the process of converting the previous Hacienda
        Bank computer systems and changing the name from Hacienda Bank, a Division
        of
        Heritage Oaks Bank to Heritage Oaks Bank. The computer conversion took place
        on
        March 4, 2005. At that same time, the Bank relocated its original branch
        office
        in Santa Maria to one of the acquired branch locations. These two branch
        offices
        were located within one mile of one another. The Bank is in the process of
        sub-leasing the vacated facility. The underlying lease expires in October
        2008.
 
 In
        July
        2005, the Company finalized a sale/leaseback of the Atascadero Branch Office
        real property. The property was sold to a non affiliated party for the appraised
        value. A five year lease with four five year options to renew was executed
        and
        became effective July 15, 2005. The triple net lease cost of $1.43 per square
        foot is consistent with market rates and the appraisal. The gain on sale
        of the
        property of approximately $283 thousand will be amortized over a period of
        five
        years and is not considered to be material to the net income of the Company.
 
 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. Management believes that the Company’s primary market area consists
        of the following four distinct areas. The following also outlines some of
        the
        characteristics that define these market areas:
 
 1.
              Northern
                  San Luis Obispo County - Paso Robles and
                  Atascadero
 -
              A
                  small town environment with transitioning culture and diversifying
                  industry
 -
              A
                  pocket of relatively affordable housing in some of California’s least
                  densely populated coastal
                  communities
 -
              Halfway
                  between San Francisco and Los Angeles on US Highway 101 and the
                  main
                  Highway 46 corridor to the coast from growing Fresno and Bakersfield
                  in
                  California’s central valley
 
 2.
              San
                  Luis Obispo
 -
              Home
                  to California State Polytechnic University, a nationally acclaimed
                  member
                  of the California State University
                  system
 -
              A
                  robust market with a highly attractive mix of culture, country
                  and
                  coast
 -
              A
                  dynamic environment of growth and cultural
                  evolution
  •
            PAGE •
            16 •
  
 
 3.
              Cambria,
                  San Simeon, Morro Bay, Pismo and Arroyo
                  Grande
 -
              Some
                  of the finest, most underdeveloped and accessible coastline in
                  California
 -
              At
                  the terminus of Highway 46 from California’s central valley, these
                  enclaves have attracted residential investment by many living in
                  Fresno,
                  Bakersfield and other communities
 -
              All
                  the ingredients are intact for further economic transition and
                  development
 
 4.
              Northern
                  Santa Barbara County - Santa Maria and Orcutt
 -
              Combination
                  of family communities, resort destinations and agricultural
                  zones
 -
              Largest
                  developable coastal area in the
                  region
 -
              Santa
                  Maria is the largest city in the Central Coast
                  region
 
 The
        population of San Luis Obispo County and the City of Santa Maria (in Northern
        Santa Barbara County) totaled 258 thousand and 85 thousand, respectively,
        according to recent economic data provided by local county and title company
        sources. 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. 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. Principally due to the diversity of the various industries in the
        Company’s service area, the area, while not immune from economic fluctuations,
        does tend to enjoy a more stable level of economic activity than many other
        areas of California.
 
 Critical
        Accounting Policies
 
 The
        Company’s significant accounting policies are set forth in the 2004 Annual
        Report, Note 1 of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, which was
        filed on Form 10-KSB.
 
 The
        following is a brief description of the Company’s current accounting policies
        involving significant management valuation judgments.
 
 Allowance
        for Loan and Lease Losses
 
 The
        Company considers its policy regarding the allowance for loan losses to be
        its
        most critical accounting policy, because it requires management's most
        subjective and complex judgments. In addition, changes in economic conditions
        can have a significant impact on the allowance for loan losses and therefore
        the
        provision for loan losses and results of operations. The Company has developed
        appropriate policies and procedures for assessing the adequacy of the allowance
        for loan losses, recognizing that this process requires a number of assumptions
        and estimates with respect to its loan portfolio. The Company's assessments
        may
        be impacted in future periods by changes in economic conditions, the impact
        of
        regulatory examinations, and the discovery of information with respect to
        borrowers, which is not known to management at the time of the issuance of
        the
        consolidated financial statements.
 
 The
        allowance for loan and lease losses represents management’s best estimate of
        losses inherent in the existing loan portfolio. The allowance for loan and
        lease
        losses is increased by the provision for loan and lease losses charged to
        expense and reduced by loans charged-off, net of recoveries. The allowance
        for
        loan and lease losses is determined based on management’s assessment of several
        factors: reviews and evaluation of individual loans, changes in the nature
        and
        volume of the loan portfolio, current economic conditions and the related
        impact
        on specific borrowers and industry groups, historical loan loss experiences
        and
        the level of classified and nonperforming loans.
 
 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.
  •
            PAGE •
            17 •
  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 and lease losses and the associated provision for loan and lease losses.
 
 Securities
        Available for Sale
  The
        fair
        value of most securities that are designated available for sale are based
        on
        quoted market prices. If quoted market prices are not available, fair values
        are
        extrapolated from the quoted prices of similar instruments.
 
 Goodwill
        and Other Intangible Assets
  As
        discussed in the 2004 Annual Report, Note 6 of the NOTES TO CONSOLIDATED
        FINANCIAL STATEMENTS, we assess goodwill and other intangible assets each
        year
        for impairment. The Company determined that there was no impairment at December
        31, 2004.
 
 RESULTS
        OF OPERATIONS
 
 Earnings
        Overview
 
 The
        Company reported net income for the three months ended September 30, 2005
        of
        $1.8 million compared to $1.2 million during the same period in 2004. This
        represents an increase of 51%. Basic earnings per share for the three months
        ended September 30, 2005 and September 30, 2004, were $0.44 and $0.30,
        respectively. Diluted earnings per share for the three months ended September
        30, 2005 and September 30, 2004, were $0.42 and $0.28, respectively.
 
 The
        Company reported net income for the nine months ended September 30, 2005
        of $4.8
        million compared to $3.2 million during the same period in 2004. This represents
        an increase of 49%. Basic earnings per share for the nine months ended September
        30, 2005 and September 30, 2004, were $1.18 and $0.81, respectively. Diluted
        earnings per share for the nine months ended September 30, 2005 and September
        30, 2004, were $1.11 and $0.76, respectively.
 
 Net
        Interest Income and Interest 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
        table
        below sets forth changes for the three and nine months ended September 30,
        2005
        compared to the same period in 2004 in regard to volume and rate associated
        with
        interest earning assets and interest bearing deposits.
  •
            PAGE •
            18 •
 Analysis
                    of Changes in Net Interest Income (in thousands)Three
                    months ended
                
                Nine
                    months endedSeptember
                    30. 2005 over 2004
                
                September
                    30. 2005 over 2004Volume
                
                Rate
                
                Total
                
                Volume
                
                Rate
                
                TotalInterest
                    income:Loans
                    (1)
                
                $
                1,258
                
                $
                785
                
                $
                2,043
                
                $
                3,259
                
                $
                1,533
                
                $
                4,792Investment
                    securities taxable
                
                
                (146
                )
                
                (15
                )
                
                (161
                )
                
                (257
                )
                
                4
                
                
                (253
                )Investment
                    securities non-taxable (2):
                
                
                24
                
                
                (1
                )
                
                23
                
                
                67
                
                
                (7
                )
                
                60Taxable
                    equivalent adjustment (2):
                
                
                12
                
                
                (1
                )
                
                12
                
                
                35
                
                
                (4
                )
                
                31Interest
                    bearing deposits
                
                
                (24
                )
                
                15
                
                
                (9
                )
                
                (5
                )
                
                (4
                )
                
                (9
                )Federal
                    funds sold
                
                
                49
                
                
                147
                
                
                196
                
                
                (45
                )
                
                257
                
                
                212Net
                    increase (decrease)
                
                
                1,175
                
                
                929
                
                
                2,104
                
                
                3,055
                
                
                1,778
                
                
                4,833Interest
                    expense:Savings,
                    now, money market
                
                
                13
                
                
                315
                
                
                328
                
                
                36
                
                
                610
                
                
                646Time
                    deposits
                
                
                (20
                )
                
                215
                
                
                195
                
                
                (97
                )
                
                394
                
                
                297Other
                    borrowings
                
                
                (9
                )
                
                (7
                )
                
                (16
                )
                
                (4
                )
                
                (109
                )
                
                (113
                )Long
                    term borrowings
                
                
                -
                
                
                43
                
                
                43
                
                
                -
                
                
                103
                
                
                103Net
                    increase (decrease)
                
                
                (16
                )
                
                566
                
                
                550
                
                
                (65
                )
                
                998
                
                
                933Total
                    net increase (decrease)
                
                $
                1,190
                
                $
                363
                
                $
                1,554
                
                $
                3,121
                
                $
                779
                
                $
                3,900
 
 (1)
          Loan
          fees of $347 and $272 for the three months ending September 30, 2005 and
          2004 ,
          respectively, and loan fees of $1,033 and $735 for the nine months ending
          September 30, 2005 and 2004, respectively been included in the interest
          income
          computation.
 (2)
          Adjusted to a fully taxable equivalent basis using a tax rate of
          34%.
 Note
          A:
          Average balances of all categories in each period were included in the
          volume
          computations.
 Note
          B:
          Average yield rates in each period were used in rate computations. Change
          attributable to both volume and
          rate
          have been allocated in proportion to the relationship between their absolute
          dollar amounts.
 The
        tables below sets forth changes for the three and nine months ending September
        30, 2005 compared to the same periods in 2004 for average interest earning
        assets and their respective average yields.
 
 
 (dollars
                  in thousands)
              
              Average
                  Balance
                for
                  the three months ending
                September
                  30,
              
              $
              
              %
              
              Average
                  Yield
                for
                  the three months ending
                September
                  30,Interest
                  Earning Assets:
              
              2005
              
              2004
              
              Variance
              
              Variance
              
              2005
              
              2004
              
              VarianceInterest
                  Bearing Deposits
              
              $
              396
              
              $
              3,381
              
              $
              (2,985
              )
              
              -88.29
              %
              
              2.00
              %
              
              1.29
              %
              
              0.71
              %Investment
                  securities taxable
              
              
              36,457
              
              
              52,041
              
              
              (15,584
              )
              
              -29.95
              %
              
              3.71
              %
              
              3.83
              %
              
              -0.12
              %Investment
                  securities non-taxable
              
              
              13,684
              
              
              11,465
              
              
              2,219
              
              
              19.35
              %
              
              4.29
              %
              
              4.33
              %
              
              -0.04
              %Federal
                  funds sold
              
              
              31,250
              
              
              21,002
              
              
              10,248
              
              
              48.80
              %
              
              3.43
              %
              
              1.40
              %
              
              2.03
              %Loans
                  (1) (2)
              
              
              373,200
              
              
              304,555
              
              
              68,645
              
              
              22.54
              %
              
              7.63
              %
              
              6.69
              %
              
              0.94
              %Total
                  interest earning assets
              
              $
              454,987
              
              $
              392,444
              
              $
              62,543
              
              
              15.94
              %
              
              6.92
              %
              
              5.91
              %
              
              1.01
              %
 
 (dollars
                  in thousands)
              
              Average
                  Balance
                for
                  the nine months ending
                September
                  30,
              
              $
              
              %
              
              Average
                  Yield
                for
                  the nine months ending
                September
                  30,Interest
                  Earning Assets:
              
              2005
              
              2004
              
              Variance
              
              Variance
              
              2005
              
              2004
              
              VarianceInterest
                  Bearing Deposits
              
              $
              943
              
              $
              1,514
              
              $
              (571
              )
              
              -37.71
              %
              
              0.99
              %
              
              1.41
              %
              
              -0.42
              %Investment
                  securities taxable
              
              
              40,461
              
              
              49,373
              
              
              (8,912
              )
              
              -18.05
              %
              
              3.82
              %
              
              3.81
              %
              
              0.01
              %Investment
                  securities non-taxable
              
              
              13,265
              
              
              11,206
              
              
              2,059
              
              
              18.37
              %
              
              4.34
              %
              
              4.43
              %
              
              -0.09
              %Federal
                  funds sold
              
              
              18,606
              
              
              27,614
              
              
              (9,008
              )
              
              -32.62
              %
              
              3.16
              %
              
              1.10
              %
              
              2.06
              %Loans
                  (1) (2)
              
              
              358,233
              
              
              297,545
              
              
              60,688
              
              
              20.40
              %
              
              7.39
              %
              
              6.74
              %
              
              0.65
              %Total
                  interest earning assets
              
              $
              431,508
              
              $
              387,252
              
              $
              44,256
              
              
              11.43
              %
              
              6.76
              %
              
              5.88
              %
              
              0.88
              %
 
 (1)
              Nonaccrual
                  loans have been included in total
                  loans.
 (2)
              Loan
                  fees of $347 and $272 for the three months ending September 30,
                  2005 and
                  2004 , respectively, and loan fees of $1,033 and $735 for the nine
                  months
                  ending September 30, 2005 and 2004, respectively been included
                  in the
                  interest income computation.
 
  •
            PAGE •
            19 •
  
 The
        Company has been able to increase the loan portfolio with continued market
        penetration by a team of seasoned loan officers who are compensated for
        production. Additions to the loan portfolio for both the three and nine months
        ending September 30, 2005 were achieved under the Company’s established Loan
        Policy. For
        the
        three month and nine months ending September 30, 2005 compared to the same
        period in 2004, the average yield on loans improved by 94 and 65 basis points,
        respectively. This has been primarily due to action by the Federal Reserve
        Bank
        of raising rates by 200 basis points from September 2004 through September
        30
        2005. See “Item 3. Quantitative and Qualitative Disclosure about Market Risk”
        for further discussion.
 
 For
        the
        nine months ended September 30, 2005 compared to the same period in 2004,
        other
        than loans and the tax-exempt portion of the investment portfolio the average
        balances for all categories of interest earning assets decreased and provided
        funds for the robust loan demand. The Company can significantly increase
        its
        holdings of tax-exempt securities before triggering an Alternative Minimum
        Tax
        issue. The Company has increased this particular portfolio by approximately
        18.4% in the past year. For the three months ended September 30, 2005, the
        average balance in Fed Funds Sold increased by 48.8% due primarily to higher
        demand deposit balances, particularly attributable to deposit accounts
        management considers volatile. The average rate earned on Fed Funds Sold
        also
        increased by 203 basis points. The combined volume and rate influences on
        Fed
        Funds Sold increased interest income for these assets by $196,000.
 
 The
        tables below sets forth changes for the three and nine months ending September
        30, 2005 compared to the same periods in 2004 for average interest bearing
        liabilities and their respective average rates paid.
 
 (dollars
                  in thousands)
              
              Average
                  Balance
                for
                  the three months ending
                September
                  30,
              
              $
              
              %
              
              Average
                  Rate
                for
                  the three months ending
                September
                  30,Interest
                  bearing liabilities:
              
              2005
              
              2004
              
              Variance
              
              Variance
              
              2005
              
              2004
              
              VarianceSavings/NOW/money
                  market
              
              $
              168,734
              
              $
              157,111
              
              $
              11,623
              
              
              7.40
              %
              
              1.17
              %
              
              0.42
              %
              
              0.75
              %Time
                  deposits
              
              
              63,050
              
              
              68,926
              
              
              (5,876
              )
              
              -8.53
              %
              
              2.85
              %
              
              1.49
              %
              
              1.36
              %Other
                  borrowings
              
              
              29,251
              
              
              30,266
              
              
              (1,015
              )
              
              -3.35
              %
              
              3.36
              %
              
              3.46
              %
              
              -0.10
              %FF
                  Purchased
              
              
              -
              
              
              -
              
              
              -
              
              
              100.00
              %
              
              0.00
              %
              
              0.00
              %
              
              0.00
              %Long
                  Term Debt
              
              
              8,248
              
              
              8,248
              
              
              -
              
              
              0.00
              %
              
              7.22
              %
              
              5.15
              %
              
              2.07
              %Total
                  interest-bearing liabilities
              
              $
              269,283
              
              $
              264,551
              
              $
              4,732
              
              
              1.79
              %
              
              1.98
              %
              
              1.20
              %
              
              0.78
              %
 
 (dollars
                  in thousands)
              
              Average
                  Balance
                for
                  the nine months ending
                September
                  30,
              
              $
              
              %
              
              Average
                  Rate
                for
                  the nine months ending
                September
                  30,Interest
                  bearing liabilities:
              
              2005
              
              2004
              
              Variance
              
              Variance
              
              2005
              
              2004
              
              VarianceSavings/NOW/money
                  market
              
              $
              166,131
              
              $
              155,275
              
              $
              10,856
              
              
              6.99
              %
              
              0.90
              %
              
              0.41
              %
              
              0.49
              %Time
                  deposits
              
              
              61,372
              
              
              71,710
              
              
              (10,338
              )
              
              -14.42
              %
              
              2.47
              %
              
              1.56
              %
              
              0.91
              %Other
                  borrowings
              
              
              31,439
              
              
              31,762
              
              
              (323
              )
              
              -1.02
              %
              
              3.31
              %
              
              3.78
              %
              
              -0.47
              %FF
                  Purchased
              
              
              193
              
              
              -
              
              
              193
              
              
              100.00
              %
              
              3.46
              %
              
              0.00
              %
              
              3.46
              %Long
                  Term Debt
              
              
              8,248
              
              
              8,248
              
              
              -
              
              
              0.00
              %
              
              6.76
              %
              
              5.09
              %
              
              1.67
              %Total
                  interest-bearing liabilities
              
              $
              267,383
              
              $
              266,995
              
              $
              388
              
              
              0.15
              %
              
              1.73
              %
              
              1.26
              %
              
              0.47
              %
  The
        Company continues to enjoy a low cost of funds, specifically in regard to
        interest bearing deposits. The ability to attract low cost deposits is part
        of
        the Company’s marketing plans that have been in place for numerous years. While
        this remains Management’s main objective, in February 2005 the company
        implemented a Time Deposit/Money Market promotion to run for a period of
        approximately 60 days. This was done to provide appropriate liquidity for
        current and anticipated loan funding. This has resulted in an increase in
        deposit costs.
  •
            PAGE •
            20 •
  
 
 From
        September 2004 through September 2005, the Federal Reserve Bank increased
        rates
        by a total of 200 basis points. Due to the asset sensitive nature of the
        Company’s balance sheet, these increases, coupled with the Company’s substantial
        volume of non-interest bearing deposits and low average rates on interest
        bearing deposits, are the primary factors for the increase in net interest
        margin.
 
 For
        the
        three months ending September 30, 2005 compared to the same period in 2004,
        the
        Company was able to increase the Net Interest Margin as the result of an
        increase of 101 basis points in average yield on average interest earning
        assets
        from 5.91% to 6.92% while the average yield on average interest earning
        liabilities increased by only 78 basis points from 1.20% to 1.98%.
 
 **AVERAGE
                    BALANCE SHEET INFORMATION**
  (dollars
                    in thousands)
                
                For
                    the three months ending September 30,
                
                For
                    the nine months ending September 30,2005
                
                
                
                
                
                2004
                
                
                
                
                
                2005
                
                
                
                
                
                2004Avg.
                
                Yield/
                
                Amt.
                
                Avg.
                
                Yield/
                
                Amt.
                
                Avg.
                
                Yield/
                
                Amt.
                
                Avg.
                
                Yield/
                
                Amt.Interest
                    Earning Assets:
                
                Balance
                
                Rate
                
                Interest
                
                Balance
                
                Rate
                
                Interest
                
                Balance
                
                Rate
                
                Interest
                
                Balance
                
                Rate
                
                InterestInterest
                    bearing deposits
                
                $
                396
                
                
                2.00
                %
                $
                2
                
                $
                3,381
                
                
                1.29
                %
                $
                11
                
                $
                943
                
                
                0.99
                %
                $
                7
                
                $
                1,514
                
                
                1.41
                %
                $
                16Investment
                    securities taxable
                
                
                36,457
                
                
                3.71
                %
                
                341
                
                
                52,041
                
                
                3.83
                %
                
                502
                
                
                40,461
                
                
                3.82
                %
                
                1,155
                
                
                49,373
                
                
                3.81
                %
                
                1,408Investment
                    securities non-taxable
                
                
                13,684
                
                
                4.29
                %
                
                148
                
                
                11,465
                
                
                4.33
                %
                
                125
                
                
                13,265
                
                
                4.34
                %
                
                431
                
                
                11,206
                
                
                4.43
                %
                
                371Federal
                    funds sold
                
                
                31,250
                
                
                3.43
                %
                
                270
                
                
                21,002
                
                
                1.40
                %
                
                74
                
                
                18,606
                
                
                3.16
                %
                
                440
                
                
                27,614
                
                
                1.10
                %
                
                228Loans
                    (1) (2)
                
                
                373,200
                
                
                7.63
                %
                
                7,179
                
                
                304,555
                
                
                6.69
                %
                
                5,136
                
                
                358,233
                
                
                7.39
                %
                
                19,794
                
                
                297,545
                
                
                6.74
                %
                
                15,002Total
                    interest earning assets
                
                
                454,987
                
                
                6.92
                %
                
                7,940
                
                
                392,444
                
                
                5.91
                %
                
                5,848
                
                
                431,508
                
                
                6.76
                %
                
                21,827
                
                
                387,252
                
                
                5.88
                %
                
                17,025Allowance
                    for possible loan losses
                
                
                (3,664
                )
                
                
                
                
                
                
                
                (3,148
                )
                
                
                
                
                
                
                
                (3,491
                )
                
                
                
                
                
                
                
                (3,150
                )Other
                    assets
                
                
                48,876
                
                
                
                
                
                
                
                
                61,492
                
                
                
                
                
                
                
                
                47,988
                
                
                
                
                
                
                
                
                60,168TOTAL
                    ASSETS
                
                $
                500,199
                
                
                
                
                
                
                
                $
                450,788
                
                
                
                
                
                
                
                $
                476,005
                
                
                
                
                
                
                
                $
                444,270Interest
                    -bearing liabilities:Savings/NOW/money
                    market
                
                
                168,734
                
                
                1.17
                %
                
                496
                
                
                157,111
                
                
                0.42
                %
                
                168
                
                
                166,131
                
                
                0.90
                %
                
                1,121
                
                
                155,275
                
                
                0.41
                %
                
                475Time
                    deposits
                
                
                63,050
                
                
                2.85
                %
                
                453
                
                
                68,926
                
                
                1.49
                %
                
                258
                
                
                61,372
                
                
                2.47
                %
                
                1,132
                
                
                71,710
                
                
                1.56
                %
                
                835Other
                    borrowings
                
                
                29,251
                
                
                3.36
                %
                
                248
                
                
                30,266
                
                
                3.46
                %
                
                264
                
                
                31,439
                
                
                3.31
                %
                
                779
                
                
                31,762
                
                
                3.78
                %
                
                897FF
                    Purchased
                
                
                -
                
                
                0.00
                %
                
                -
                
                
                0
                
                
                0.00
                %
                
                -
                
                
                193
                
                
                3.46
                %
                
                5
                
                
                -
                
                
                0.00
                %
                
                -Long
                    Term Debt
                
                
                8,248
                
                
                7.22
                %
                
                150
                
                
                8,248
                
                
                5.15
                %
                
                107
                
                
                8,248
                
                
                6.76
                %
                
                417
                
                
                8,248
                
                
                5.09
                %
                
                314Total
                    interest-bearing liabilities
                
                
                269,283
                
                
                1.98
                %
                
                1,347
                
                
                264,551
                
                
                1.20
                %
                $
                797
                
                
                267,383
                
                
                1.73
                %
                
                3,454
                
                
                266,995
                
                
                1.26
                %
                
                2,521Demand
                    deposits
                
                
                184,756
                
                
                
                
                
                
                
                
                148,579
                
                
                
                
                
                
                
                
                164,940
                
                
                
                
                
                
                
                
                140,879Other
                    liabilities
                
                
                3,774
                
                
                
                
                
                
                
                
                2,609
                
                
                
                
                
                
                
                
                3,286
                
                
                
                
                
                
                
                
                2,418Stockholders'
                    equityCommon
                    stock
                
                
                28,909
                
                
                
                
                
                
                
                
                23,879
                
                
                
                
                
                
                
                
                27,717
                
                
                
                
                
                
                
                
                22,792Retained
                    earnings
                
                
                13,414
                
                
                
                
                
                
                
                
                11,298
                
                
                
                
                
                
                
                
                12,609
                
                
                
                
                
                
                
                
                11,185Valuation
                    Allowance Investments
                
                
                63
                
                
                
                
                
                
                
                
                (128
                )
                
                
                
                
                
                
                
                70
                
                
                
                
                
                
                
                
                1Total
                    stockholders' equity
                
                
                42,386
                
                
                
                
                
                
                
                
                35,049
                
                
                
                
                
                
                
                
                40,396
                
                
                
                
                
                
                
                
                33,978TOTAL
                      LIABILITIES AND STOCKHOLDERS' EQUITY
                
                $
                500,199
                
                
                
                
                
                
                
                $
                450,788
                
                
                
                
                
                
                
                $
                476,005
                
                
                
                
                
                
                
                $
                444,270Net
                    Interest Income
                
                
                
                
                
                
                
                $
                6,593
                
                
                
                
                
                
                
                $
                5,051
                
                
                
                
                
                
                
                $
                18,373
                
                
                
                
                
                
                
                $
                14,504Net
                    Interest Margin (3)
                
                
                
                
                
                5.80
                %
                
                
                
                
                
                
                
                5.15
                %
                
                
                
                
                
                
                
                5.68
                %
                
                
                
                
                
                
                
                4.99
                %
 
 (1)
              Nonaccrual
                  loans have been included in total
                  loans.
 (2)
              Loan
                  fees of $347 and $272 for the three months ending September 30,
                  2005 and
                  2004 , respectively, and loan fees of $1,033 and $735 for the nine
                  months
                  ending September 30, 2005 and 2004, respectively been included
                  in the
                  interest income computation.
 (3)
              Net
                  interest income has been calculated by dividing the net interest
                  income by
                  total average earning assets.
 
  •
            PAGE •
            21 •
  
 Non-Interest
        Income
 
 The
        tables below set forth changes for the three and nine months ending September
        30, 2005 compared to the same period in 2004 for non-interest income excluding
        Gain on Sale of Securities.
  Non-Interest
                      Income ComponentsFor
                      Three Months EndedSeptember
                      30,(dollars
                      in thousands)
                  
                  2005
                  
                  2004
                  
                  $
                      Variance
                  
                  %
                      VarianceService
                      Charges on Deposit Accounts
                  
                  $
                  655
                  
                  $
                  546
                  
                  $
                  109
                  
                  
                  20.0
                  %ATM/Debit
                      Card Transaction/Interchange Fees
                  
                  
                  170
                  
                  
                  150
                  
                  
                  20
                  
                  
                  13.3
                  %Bancard
                  
                  
                  34
                  
                  
                  28
                  
                  
                  6
                  
                  
                  21.4
                  %Mortgage
                      Origination Fees
                  
                  
                  296
                  
                  
                  151
                  
                  
                  145
                  
                  
                  96.0
                  %Earnings
                      on Cash Surrender Value Life Ins
                  
                  
                  88
                  
                  
                  78
                  
                  
                  10
                  
                  
                  12.8
                  %Other
                  
                  
                  146
                  
                  
                  118
                  
                  
                  28
                  
                  
                  23.7
                  %Total
                  
                  $
                  1,389
                  
                  $
                  1,071
                  
                  $
                  318
                  
                  
                  29.7
                  %
  For
                      Nine Months EndedSeptember
                      30,(dollars
                      in thousands)
                  
                  2005
                  
                  2004
                  
                  $
                      Variance
                  
                  %
                      VarianceService
                      Charges on Deposit Accounts
                  
                  $
                  1,825
                  
                  $
                  1,644
                  
                  $
                  181
                  
                  
                  11.0
                  %ATM/Debit
                      Card Transaction/Interchange Fees
                  
                  
                  464
                  
                  
                  428
                  
                  
                  36
                  
                  
                  8.4
                  %Bancard
                  
                  
                  105
                  
                  
                  86
                  
                  
                  19
                  
                  
                  22.1
                  %Mortgage
                      Origination Fees
                  
                  
                  719
                  
                  
                  528
                  
                  
                  191
                  
                  
                  36.2
                  %Earnings
                      on Cash Surrender Value Life Ins
                  
                  
                  239
                  
                  
                  238
                  
                  
                  1
                  
                  
                  0.4
                  %Other
                  
                  
                  435
                  
                  
                  341
                  
                  
                  94
                  
                  
                  27.6
                  %Total
                  
                  $
                  3,787
                  
                  $
                  3,265
                  
                  $
                  522
                  
                  
                  16.0
                  %
 
 Mortgage
        origination fee income remains strong as we continue to experience favorable
        long term rates in the current flat yield curve environment. Service charges
        on
        deposit accounts have improved due primarily to the growth of transactional
        deposit accounts. For the three months ended September 30, 2005 compared
        to the
        same period in 2004, Mortgage Origination Fees increased due to an increased
        volume of new mortgage loan fundings which were primarily attributable to
        a
        favorable interest rate environment and higher residential real estate
        prices.
  •
            PAGE •
            22 •
   Non-Interest
        Expenses
 
 The
        tables below set forth changes for the three and nine months ending September
        30, 2005 compared to the same period in 2004 for non-interest expense.
 
 Non-Interest
                  Expense ComponentsFor
                  Three Months EndedSeptember
                  30,(dollars
                  in thousands)
              
              2005
              
              2004
              
              $
                  Variance
              
              %
                  VarianceSalaries
                  and Employee Benefits
              
              $
              2,532
              
              $
              2,068
              
              $
              464
              
              
              22.4
              %Occupany
                  and Equipment
              
              
              600
              
              
              644
              
              
              (44
              )
              
              -6.8
              %Data
                  Processing
              
              
              561
              
              
              511
              
              
              50
              
              
              9.8
              %Advertising
                  and promotional
              
              
              175
              
              
              143
              
              
              32
              
              
              22.4
              %Regulatory
                  fees
              
              
              27
              
              
              25
              
              
              2
              
              
              8.0
              %Other
                  professional fees and outside services
              
              
              156
              
              
              163
              
              
              (7
              )
              
              -4.3
              %Legal
                  fees and other litigation expense
              
              
              22
              
              
              24
              
              
              (2
              )
              
              -8.3
              %Loan
                  Department Costs
              
              
              45
              
              
              52
              
              
              (7
              )
              
              -13.5
              %Stationery
                  and supplies
              
              
              72
              
              
              103
              
              
              (31
              )
              
              -30.1
              %Director
                  fees
              
              
              70
              
              
              46
              
              
              24
              
              
              52.2
              %Core
                  Deposit Intangible Amortization
              
              
              143
              
              
              105
              
              
              38
              
              
              36.2
              %Other
              
              
              472
              
              
              240
              
              
              232
              
              
              96.7
              %Total
              
              $
              4,875
              
              $
              4,124
              
              $
              751
              
              
              18.2
              %
 
 For
                  Nine Months EndedSeptember
                  30,(dollars
                  in thousands)
              
              2005
              
              2004
              
              $
                  Variance
              
              %
                  VarianceSalaries
                  and Employee Benefits
              
              $
              7,188
              
              $
              6,242
              
              $
              946
              
              
              15.2
              %Occupany
                  and Equipment
              
              
              1,853
              
              
              1,907
              
              
              (54
              )
              
              -2.8
              %Data
                  Processing
              
              
              1,678
              
              
              1,478
              
              
              200
              
              
              13.5
              %Advertising
                  and promotional
              
              
              438
              
              
              435
              
              
              3
              
              
              0.7
              %Regulatory
                  fees
              
              
              77
              
              
              88
              
              
              (11
              )
              
              -12.5
              %Other
                  professional fees and outside services
              
              
              399
              
              
              432
              
              
              (33
              )
              
              -7.6
              %Legal
                  fees and other litigation expense
              
              
              80
              
              
              71
              
              
              9
              
              
              12.7
              %Loan
                  Department Costs
              
              
              116
              
              
              130
              
              
              (14
              )
              
              -10.8
              %Stationery
                  and supplies
              
              
              238
              
              
              289
              
              
              (51
              )
              
              -17.6
              %Director
                  fees
              
              
              175
              
              
              161
              
              
              14
              
              
              8.7
              %Core
                  Deposit Intangible Amortization
              
              
              430
              
              
              316
              
              
              114
              
              
              36.1
              %Other
              
              
              1,189
              
              
              810
              
              
              379
              
              
              46.8
              %Total
              
              $
              13,861
              
              $
              12,359
              
              $
              1,502
              
              
              12.2
              %
  Salary/Related
        Expense
  Salaries
        and employee related expense incurred the greatest dollar increase of any
        non-interest expense category for the three and nine months ending September
        30,
        2005 and 2004. For the nine months ending September 30, 2005, approximately
        $442
        thousand or 47% of the increase is due to the increased bonus accrual as
        the
        result of the record earnings for the first three quarters of 2005.
        Approximately $337 thousand or 36% of the increase is due to salary.
 
 Data
        Processing Expense
  For
        the
        three months ending September 30, 2005 compared to the same period in 2004,
        there was approximately a $102 thousand increase in Escrow Accounting costs
        related to three long-time deposit customers of the Bank and a $52 thousand
        decrease in all other categories of data processing expense. For the nine
        months
        ending September 30, 2005 compared to the same period in 2004, there was
        approximately a $255 thousand increase in Escrow Accounting costs related
        to
        three long-time deposit customers of the Bank and a $55 thousand decrease
        in all
        other categories of data processing expense.
  •
            PAGE •
            23 •
  
 Provision
        for Income Taxes
 
 The
        provision for income taxes was 38.5% and 38.0% of net pre-tax income for
        the
        three months ending September 30 2005, and 2004, respectively. The provision
        for
        income taxes was 37.8% and 37.4% of net pre-tax income for the nine months
        ending September 30 2005, and 2004, respectively.
 
 FINANCIAL
        CONDITION ANALYSIS
 
 Total
        assets of the Company were $448.0 million at December 31, 2004 compared to
        $528.3 million at September 30, 2005. This represents an increase of $80.3
        million or approximately 18%.
 
 Loans
 
 The
        table
        below sets forth changes from December 31, 2004 to September 30, 2005 for
        the
        composition of the loan portfolio.
 
 Major
                  classifications of loans were:September
                  30,
              
              December
                  30,2005
              
              2004
              
              $
                  Variance
              
              %
                  Variance(dollars
                  in thousands)Commercial,
                  financial, and agricultural
              
              $
              65,492
              
              $
              49,584
              
              
              15,908
              
              
              32.08
              %Real
                  estate-construction
              
              
              76,202
              
              
              66,833
              
              
              9,369
              
              
              14.02
              %Commercial
                  Real Estate
              
              
              224,171
              
              
              217,473
              
              
              6,698
              
              
              3.08
              %Installment
                  loans to individuals
              
              
              5,410
              
              
              5,538
              
              
              (128
              )
              
              -2.31
              %All
                  other loans (including overdrafts)
              
              
              304
              
              
              265
              
              
              39
              
              
              14.72
              %371,579
              
              
              339,693
              
              
              31,886
              
              
              9.39
              %Less
                  - deferred loan fees, net
              
              
              (1,662
              )
              
              (1,482
              )
              
              (180
              )
              
              12.15
              %Less
                  - reserve for possible loan losses
              
              
              (3,759
              )
              
              (3,247
              )
              
              (512
              )
              
              15.77
              %Total
                  loans
              
              $
              366,158
              
              $
              334,964
              
              
              31,194
              
              
              9.31
              %Loans
                  Held For Sale
              
              $
              7,694
              
              $
              2,253
              
              
              5,441
              
              
              241.50
              %
  Gross
        loans grew by almost 10% in the first nine months of 2005 with most of the
        growth in the second quarter. During the first quarter of 2005, there were
        numerous construction projects that were completed resulting in either 1)
        the
        sale of the properties and pay-downs on the outstanding loans or 2) conversion
        to mini-perm commercial real estate loans. In addition, commercial real estate
        loans experienced some early pay-off activity during the first quarter. During
        the second quarter numerous new loans were made on commercial properties,
        for
        acquisition of residential development properties and for residential and
        commercial construction. During the third quarter a total of $42 million
        in new
        loans were made; however, many were construction loans and credit lines with
        limited funding. This, combined with payoffs, resulted in loan growth of
        $5.0
        million during the third quarter.
 
 The
        increase in commercial, financial and agricultural loans is attributed primarily
        to draws on existing and new lines of credit.
 
 The
        increase in real estate-construction loans can be attributed to several new
        large construction projects and funding of existing construction projects
        during
        the period. New loans include a hotel for $6.3 million, a strip center for
        $2.2
        million, an office building for $3.3 million, a residential development for
        $3.3
        million, retail/office building for $1.4 million, additions to a strip center
        for $2.2 million, a restaurant/wine shop for $1.7 million, a retail/office
        building for $4.2 million, a motel addition for $4.3 million, a commercial
        building for $9.5 million, a condo project for $3.4 million, a retail/warehouse
        building for $4.4 million, residential developments for $1.7 million and
        for
        $1.8 million, a gas station for $1 million and numerous other smaller projects.
        Construction loans are typically granted for a one year period and then,
        with
        income properties, are amortized over not more than 25 years with 10 to 15
        year
        maturities.
  •
            PAGE •
            24 •
  
 The
        Bank
        presently has a concentration of loans in construction/land in the amount
        of
        $72.5 million with an additional $48.4 million undisbursed. Combined this
        represents 265% of the Bank’s Total Risk Based capital. At September 30, 2005
        there were 89 construction loans with outstanding balances and remaining
        commitments of approximately $53.5 million and $48.4 million, respectively.
        The
        hotel loan for $6.3 million, mentioned above, was the single largest loan
        in the
        Company’s portfolio at September 30, 2005. At September 30, 2005, there were 52
        land loans with balances of approximately $19.0 million. The single largest
        land
        loan accounts for approximately $3.3 million of the total and is for a single
        family home tract development. The construction/land loans are spread throughout
        the Company’s market area and have consistently performed in a satisfactory
        manner.
 
 The
        increase in commercial real estate loans is attributed to several of the
        construction loans moving into amortizing loans and to new commercial property
        loans including an office/warehouse building for $2.1 million, a hotel for
        $4.3
        million, commercial building for $2.2 million, several new property loans
        to one
        client for $3.7 million, a strip center for $4.9 million, a bowling alley
        for
        $1.5 million and a commercial warehouse for $2.7 million.
 
 Hotel
        loans are presently considered to be a concentration with $44.3 million in
        loans
        and an additional $6.7 million in undisbursed commitments. Hotel loans are
        up
        $7.7 million from 2004 year end and now represent 111.32% of the Bank’s Total
        Risk Based capital. At September 30, 2005, there were 28 hotel loans. The
        single
        largest loan with a balance of approximately $4.3 million was made to an
        upscale
        resort hotel located in Avila Beach, California. The hotel loans are also
        made
        to clients throughout the Company’s market. These loans have also typically paid
        as agreed. The Bank had one out of area hotel participation loan that was
        in
        default. This loan, in the original amount of $1.0 million, was paid down
        by
        $900 thousand in April 2004 and the remaining $95 thousand charged off. A
        small
        recovery of $1 thousand was received with no further payment expected.
 
 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. The
        primary purpose of the bond issue was to refinance existing debt and provide
        funds for the expansion of an assisted living facility in San Luis Obispo.
        Approximately $6.6 million of the funds have been deposited with the Bank
        with
        $4.0 million remaining. These funds are being used for capital improvements
        to
        the assisted living facility. The letter of credit will expire in September
        2007.
 
 Construction
        loan demand for both single family and commercial real estate was strong
        during
        2004 and has continued during 2005. Area home prices continue to increase
        however they remain considerably lower than the metropolitan areas to our
        North
        and South. Low mortgage rates and a multitude of financing options (interest
        only mortgages, 40 year loans, etc.) have kept many in the market. The continued
        availability of land for subdivision use also continues to drive the
        market.
 
 Business
        properties are also in demand with low vacancies and favorable loan rates.
        Commercial property values and rental rates increased substantially during
        2004.
        Investors, many seeking exchange properties, continue to seek properties
        in our
        market area. The Bank has and expects to experience continued growth in
        commercial real estate loans during 2005.
 
 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
        that the Bank funds them. Settlement from the correspondents is typically
        within
        30 to 45 days.
 
 At
        September 30, 2005, the Bank had no foreign loans outstanding. The Bank did
        not
        have any concentrations of loans except as disclosed above.
 
 The
        Bank’s management is responsible for monitoring loan performance that 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 requires regular
        review as well as an internal loan classification process. 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, loan grades
        and the outside loan review are reviewed regularly by the Bank’s Board of
        Directors.
  •
            PAGE •
            25 •
  
 The
        Bank’s provision for loan losses was $170 thousand for the third quarter of
        2005, compared to $75 thousand for the same period 2004.  The
        provision amount is based on the Bank’s monthly allowance for loan losses
        calculation including current plans for recovery collection.
 
 The
        Bank
        has a non-accrual policy that requires a loan greater than 90 days past due
        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
        uncollected interest accrued is reversed from earnings. Once on non-accrual
        status, interest on a loan is only recognized on a cash basis. Payments that
        are
        received may also be applied to reduce the principal balance. 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 property is recognized by a
        charge
        to the reserve for loan losses. When the property is held for sale after
        foreclosure, it is subject to a periodic appraisal. If the appraisal indicates
        that the property will sell for less than its recorded value, the Bank
        recognizes the loss by a charge to non-interest expense.
 
 Loans
        on
        non-accrual status totaled $0.9 million and $0.5 million at December 31,
        2004
        and September 30, 2005, respectively. Typically, these loans have adequate
        collateral protection and/or personal guaranties to provide a source of
        repayment to the Bank. Most of the loans on non-accrual are related to several
        commercial loans that are being addressed by specific workout plans at this
        time. Interest income that would have been recognized on non-accrual loans
        if
        they had performed in accordance with the terms of the loans was approximately
        $126 thousand and $80 thousand  for
        the
        period ended December 31, 2004 and September 30, 2005,
        respectively.
 
 Non-performing
        loans include non-accrual loans, restructured loans and accruing loans that
        are
        90 days or more delinquent. Non-performing loans totaled $0.9 million at
        December 31, 2004 and $0.5 million at September 30, 2005. There were no loans
        past due 90 days or more and still accruing interest at September 30, 2005.
  Non-performing
        loans were 0.20% and 0.09% of total assets as of December 31, 2004 and September
        30, 2005, respectively. The allowance for loan loss to non-performing loans
        was
        3.6x and 7.9x at December 31, 2004 and September 30, 2005, respectively.
 
 Total
        Cash and Due from Banks
 
 Total
        cash and due from banks were $13.1 million and $23.0 million at December
        31,
        2004 and September 30, 2005, respectively. This line item will vary depending
        on
        cash letters from the previous night and actual cash on hand in the branches.
 
 Investment
        Securities and Other Earning Assets
 
 Other
        earning assets are comprised of Federal Home Loan Bank, Federal Funds sold
        (funds lent 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 sets forth changes from December 31, 2004 to September 30, 2005 for
        the
        composition of other earning assets. Interest bearing deposits with other
        financial institutions decreased by $3.2 million primarily due to the return
        of
        funds which were previously placed in a short term (14 days) pool of money
        market accounts. Fed Funds Sold have increased due to: 1) the return of the
        $3
        million in money market accounts, 2) 20% deposit growth, including $41.7
        million
        net increase in two volatile deposit relationships and, 3) a 19% decrease
        in the
        Investment Portfolio.
  •
            PAGE •
            26 •
  
 
 **COMPOSITION
        OF OTHER EARNING ASSETS**
 
 
 September
                  30,
              
              December
                  31,2005
              
              2004
              
              $
                  Variance
              
              %
                  Variance(dollars
                  in thousands)Federal
                  Home Loan Bank, and other stock
              
              $
              1,864
              
              $
              1,809
              
              $
              55
              
              
              3.04
              %Available-for-Sale
                  Investments
              
              
              46,462
              
              
              57,394
              
              $
              (10,932
              )
              
              -19.05
              %Federal
                  Funds Sold
              
              
              53,035
              
              
              5,775
              
              $
              47,260
              
              
              818.35
              %Interest
                  Bearing Deposits
              
              
              298
              
              
              3,498
              
              
              (3,200
              )
              
              -91.48
              %Total
                  Other Earning Assets
              
              $
              101,659
              
              $
              68,476
              
              $
              33,183
              
              
              48.46
              %
 
  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 boards 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. As of December 31, 2004, net unrealized gains in the portfolio were
        $147 thousand compared to a net unrealized gain of $3 thousand at September
        30,
        2005. This change in market value was driven by the flattening of the yield
        curve with lower long term rates even though the FRB continued increasing
        rates
        on short term investments. The portfolio decreased in size due to principle
        reductions on Mortgage Backed Securities.
 
 At
        September 30, 2005, available-for-sale securities in the portfolio included
        obligations of state and political subdivisions, obligations of US government
        agencies and corporations and mortgaged backed securities issued by various
        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.
 
 Deposits
        and Borrowed Funds
 
 The
        table
        below sets forth changes from December 31, 2004 to September 30, 2005 for
        the
        composition of deposit categories.
  •
            PAGE •
            27 •
  
 September
                  30,
              
              December
                  31,
              
              
              
              
              
              %
                  of Total(in
                  thousands)
              
              2005
              
              2004
              
              $
                  Variance
              
              %
                  Variance
              
              DepositsDeposits:Demand,
                  non-interest bearing
              
              $
              206,965
              
              $
              143,455
              
              
              63,510
              
              
              44.27
              %
              
              47
              %Interest
                  bearing demand
              
              
              52,595
              
              
              60,256
              
              
              (7,661
              )
              
              -12.71
              %
              
              12
              %Savings
              
              
              33,170
              
              
              36,232
              
              
              (3,062
              )
              
              -8.45
              %
              
              7
              %Money
                  market
              
              
              82,062
              
              
              69,527
              
              
              12,535
              
              
              18.03
              %
              
              18
              %Time
                  deposits of $100 or more
              
              
              18,098
              
              
              18,034
              
              
              64
              
              
              0.35
              %
              
              4
              %Time
                  deposits under $100
              
              
              50,879
              
              
              42,937
              
              
              7,942
              
              
              18.50
              %
              
              11
              %Total
                  deposits
              
              $
              443,769
              
              $
              370,441
              
              $
              73,328
              
              
              19.79
              %
              
              100
              %
 
 
 The
        Company has been able to increase deposits due to a well planned marketing
        strategy and incentive based compensation that has been in place for several
        years. Like all good strategies, this one is fluid and is subject to the
        changing dynamics within the Company’s balance sheet and staffing along with
        changes in its primary market area. Friendly competition between the branch
        offices to increase deposit totals has been in place for two years. The branch
        offices are all given goals for each deposit category type and results are
        measured monthly. Lending and Operational staff work together to meet or
        beat
        their goals. This program has generated a significant amount of pride for
        the
        entire staff and resulted in growth for the Company.
 
 For
        the
        Company, at September 30, 2005, non-interest bearing demand deposits provide
        46.6% of total deposits compared to 38.7% at December 31, 2004. At December
        31,
        2004 and September 30, 2005, the Bank had three and two deposit relationships,
        respectively, that it considers to be volatile. The smallest of the three
        deposit relationships that accounted for approximately 1% of total deposits
        at
        December 31, 2005 closed during the second quarter of 2005. The current volatile
        deposits are held by two, long time customers of the Bank that engage in
        mortgage related activities. The volatile nature of these relationships was
        evidenced by a net increase of $41.7 million in these account balances from
        December 31, 2004 to September 30, 2005. As a percentage of total deposits,
        these accounts represented 13.6% at December 31, 2004 compared to 20.7% at
        September 30, 2005. These volatile account relationships are included in
        the
        volatile liability dependency report that the Bank produces on a monthly
        basis.
        Typically, a material increase in balances held by these three customers
        is
        reflected in Federal Funds Sold and is recognized by Management to potentially
        be short term in nature. Therefore, any material increase in these balances
        is
        not considered to be a funding source for any form of long-term investment.
        Management and the Board of Directors of the Bank are keenly aware that as
        the
        mortgage market conditions change, these relationships will be impacted.
 
 Core
        deposits (time deposits less than $100 thousand, demand, and savings) gathered
        in the local communities served by the Company continue to be the primary
        source
        of funds for loans and investments. Core deposits of $425.7 million represented
        95.9% of total deposits at September 30, 2005. The Company does not purchase
        funds through deposit brokers.
 
 In
        October 2003, the Company executed a Promissory Note with Pacific Coast Bankers
        Bank (PCBB) for a revolving line of credit in the amount of $3.5 million.
        As
        discussed in the paragraph below, at September 30, 2005, the Company had
        a zero
        balance outstanding on this loan. The note was obtained to assist with the
        cash
        and capital needs for the acquisition of Hacienda. 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
        September 30, 2005, the interest rate on the note was 6.75% and is variable
        and
        moves with prime. Under the terms of the agreement, the Company will not
        incur
        any additional debt over $2 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.
 
 One
        of
        the benefits of merging Hacienda Bank with and into the Bank on June 28,
        2004
        was the enhanced capital position of the resultant bank. On July 22, 2004,
        the
        Bank’s Board of Directors declared a dividend of $3.5 million to the Company to
        enable the Company to pay the PCBB line of credit down to zero. This was
        done on
        July 23, 2004. The line of credit in the amount of $3.5 million is still
        available to the Company until October 2005. The Company is currently in
        the
        process of renewing the revolving line of credit for an additional two years.
  •
            PAGE •
            28 •
  
 
 The
        Bank
        has established borrowing lines with the Federal Home Loan Bank (FHLB). At
        September 30, 2005, the Bank had borrowings with the FHLB of $28 million
        collateralized by loans. The borrowing consists of the following:
 
 a)
        $10
        million in borrowing maturing in July 2006 with a term of 1 year at a variable
        rate of interest indexed to 3 month LIBOR. The initial rate was
        3.61%.
 b)
        $18
        million in borrowing with a term of 6 months and a fixed rate of 3.35% matures
        on October 25, 2005.
 
 On
        September 17, 2004, the Bank issued a Letter of Credit in the amount of
        approximately $11.7 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.
 
 At
        September 30, 2005, the Bank has a remaining borrowing capacity with existing
        collateral of approximately $63.2 million and $14.9 million secured by loans
        and
        securities, respectively.
 
 The
        Bank
        utilizes securities sold under repurchase agreements as a source of funds.
        The
        Bank had $766 thousand in securities sold under repurchase agreements at
        December 31, 2004 compared to $2.1 million at September 30, 2005.
 
 Capital
 
 The
        Company's total stockholders equity was $37.2 million at December 31, 2004
        compared to $42.9 million at September 30, 2005. The increase in capital
        was due
        to net income of $4,829,000, stock options exercised in the amount of $945
        thousand, $8 thousand cash paid in lieu of fractional shares for the April
        22,
        2005 distribution of the 5% stock dividend, and a decrease in accumulated
        other
        comprehensive income of $144 thousand.
 
 On
        March
        25, 2005 the Board of Directors of the Company announced a 5% stock dividend
        to
        shareholders of record on April 8, 2005 that was distributed on April 22,
        2005.
        The Consolidated Statements of Stockholders’ Equity found under “Item 1.
        Financial Statements” in this document reflect the 5% stock dividend.
 
 On
        April
        10, 2002, the Company issued $8,248,000 of Floating Rate Junior Subordinated
        Deferrable Interest Debentures (the “debt securities”) to Heritage Oaks Capital
        Trust I, a statutory trust created under the laws of the State of Delaware.
        These debt securities are subordinated to effectively all borrowings of the
        Company and are due and payable on April 22, 2032. Interest is payable
        semi-annually on these debt securities at 6-Month LIBOR plus 3.7% for an
        effective rate of 7.11375% as of September 30, 2005. The debt securities
        can be
        called at any time commencing on April 22, 2007, at par. The debt securities
        can
        also be redeemed at par if certain events occur that impact the tax treatment,
        regulatory treatment or the capital treatment of the issuance. The Company
        also
        purchased a 3% minority interest totaling $248 thousand in Heritage Oaks
        Capital
        Trust I. The balance of the equity of Heritage Oaks Capital Trust I is comprised
        of mandatorily redeemable preferred securities and is included in other
        assets.
 
 If
        the
        Company elects to defer interest payments pursuant to terms of the agreement,
        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.
   •
            PAGE •
            29 •
  
 The
        Company used the proceeds from the sale of the securities for general corporate
        purposes, including the repayment of outstanding indebtedness of $1.9 million
        on
        April 11, 2002 and capital contributions to the Bank for future
        growth.
 
 Under
        FASB Interpretation (FIN) No. 46, *“Consolidation
        of Variable Interest Entities, an interpretation of ARB No.
        51,”* the
        Company is not allowed to consolidate Heritage Oaks Capital Trust I 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 new 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 1 capital, subject to certain new limitations which
        will
        not become effective until March 31, 2009 and which, in any event, are not
        expected to affect the treatment of the Company's Junior Subordinated Debentures
        as Tier 1 capital for regulatory purposes. At September 30, 2005, the Company
        has included the net junior subordinated debt in its Tier 1 Capital for
        regulatory capital purposes.
 
 Management
        believes that organic growth in 2005 for the Company can be accomplished
        without
        further borrowing for capital or cash flow purposes. At September 30, 2005,
        the
        Company had sufficient cash to service the $8.2 million in junior subordinated
        debenture interest payments for approximately ten quarters without dividends
        from subsidiaries. The Bank’s capacity to provide cash to the Company, while
        remaining “well-capitalized”, was $2.4 million at September 30, 2005.
 
 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 12 different countries
        around
        the world. The standards essentially take into account the fact 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.
 
 Summarized
        below are the Company’s and the Bank’s capital ratios at September 30, 2005.
 Regulatory
                    StandardAdequately
                
                Well
                
                Heritage
                    Oaks
                
                Heritage
                    OaksCapitalized
                
                Capitalized
                
                Bancorp
                
                BankLeverage
                    Ratio
                
                
                4.00%
                
                
                5.00%
                
                
                8.78%
                
                
                8.53%Tier
                    One Risk Based Captial Ratio
                
                
                4.00%
                
                
                6.00%
                
                
                10.09%
                
                
                9.65%Total
                    Risk Based Captial Ratio
                
                
                8.00%
                
                
                10.00%
                
                
                10.99%
                
                
                10.55%
 
  •
            PAGE •
            30 •
  
 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 Bank customers serve as the
        primary source of liquidity. The Bank has credit arrangements with correspondent
        banks that serve as a secondary liquidity source in the amount of $13.5 million.
        At September 30, 2005, the Bank had no borrowings against credit arrangements
        with these correspondent banks. The Bank is a member of the FHLB and has
        a
        collateralized borrowing capacity remaining of approximately $78.1 million.
 
 The
        Bank
        manages liquidity by maintaining a majority of the investment portfolio in
        federal funds sold and other liquid investments. At December 31, 2004, the
        ratio
        of liquid assets not pledged for collateral and other purposes to deposits
        and
        other liabilities was 12.7% compared to 22.5% at September 30, 2005. The
        ratio
        of net loans to deposits, another key liquidity ratio, was 90.4% at December
        31,
        2004 compared to 82.5% at September 30, 2005.
 
 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 debt and
        upward pressure on operating expenses. The effect of inflation during the
        three-year period ended September 30, 2005 has been significant to the Company’s
        financial position and results of operations in regard to fluctuation in
        interest rates creating in the decreasing rate environment a narrowing of
        the
        net interest margin and in the increasing rate environment for the past four
        quarters, a widening of the net interest margin. However, inflation has not
        been
        a factor in the customer’s ability to repay debt or in upward pressure on
        operation expenses.
 
 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
        financial instruments consisting of commitments to extend credit, commercial
        letter of credit, and standby letter of credit. Such financial instruments
        are
        recorded in the financial statement when they are funded or related fees
        are
        incurred or received. For a fuller discussion of these financial instruments,
        refer to Note 10 of the Company’s consolidated financial statements contained in
        Item 7 of Part II of the Company’s December 31, 2004 10-KSB.
 
 In
        the
        ordinary course of business, the Bank is a party to various operating leases.
        For a fuller discussion of these financial instruments, refer to Note 5 of
        the
        Company’s consolidated financial statements contained in Item 7 of Part II of
        the Company’s December 31, 2004 10-KSB.
 
 In
        connection with the $8.2 million in debt securities discussed in “Capital,” the
        Company issued the full and unconditional payment guarantee of certain accrued
        distributions.
  •
            PAGE •
            31 •
  
 Item
        3.  Quantitative
        and Qualitative Disclosure about Market Risk
 
 As
        a
        financial institution, the Company’s primary component of market risk is
        interest rate volatility. Fluctuations in interest rates will ultimately
        impact
        both the level of interest income and interest expense recorded on a large
        portion of the Company’s assets and liabilities, and the market value of all
        interest earning assets and interest bearing liabilities, other than those
        which
        possess a short term to maturity. Virtually all of the Company’s interest
        earning assets and interest bearing liabilities are located at the banking
        subsidiary level. Thus, virtually all of the Company’s interest rate risk
        exposure lies at the banking subsidiary level other than $8.2 million in
        subordinated debentures issued by the Company’s subsidiary grantor trust. As a
        result, all significant interest rate risk procedures are performed at the
        banking subsidiary level. The subsidiary bank’s real estate loan portfolio,
        concentrated primarily within Northern Santa Barbara County and San Luis
        Obispo
        County, 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 sensitivity. Based
        on the results of this model, management believes the Bank’s balance sheet is
“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 this movement
        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. The results for the Company’s September 30, 2005 balances
        indicate that the net interest income at risk over a one year time horizon
        for a
        1%, 2% and 3% rate increase and 1% rate decrease are within the Company’s policy
        guidelines for such changes.
  
  •
            PAGE •
            32 •
  (dollars
                    in Thousands)
                
                Shock
                    Rate Scenarios-100bp
                
                Base
                
                +100bp
                
                +200bp
                
                +300bpNet
                    Interest Income (NII)
                
                $
                24,174
                
                $
                25,804
                
                $
                27,621
                
                $
                29,557
                
                $
                31,517$
                    Change from Base
                
                $
                (1,630
                )
                $
                -
                
                $
                1,817
                
                $
                3,752
                
                $
                5,713%
                    Change from Base
                
                
                -6.32
                %
                
                0.00
                %
                
                7.04
                %
                
                14.54
                %
                
                22.14
                %
 It
        is
        important to note that the above table is a summary of several forecasts
        and
        actual results may vary. The forecasts are based on estimates and assumptions
        of
        management that may turn out to be different and may change over time. Factors
        affecting these estimates and assumptions include, but are not limited to
        1)
        competitor behavior, 2) economic conditions both locally and nationally,
        3)
        actions taken by the Federal Reserve Board, 4) customer behavior and 5)
        management’s responses. Changes that vary significantly from the assumptions and
        estimates may have significant effects on the Company’s net interest income,
        therefore, the results of this analysis should not be relied upon as indicative
        of actual future results.
 
 The
        following tables show Management’s estimates of how the loan portfolio is broken
        out between variable-daily, variable at various time lines, fixed rate loans
        and
        estimates of re-pricing opportunities for the entire loan portfolio.
  (dollars
        in Thousands)
 %
                      ofGross
                      Loans
                  
                  Balance
                  
                  TotalVariable-Daily
                  
                  $
                  152,671
                  
                  
                  41
                  %Variable
                      >Daily < 3 months
                  
                  
                  8,330
                  
                  
                  2
                  %Variable
                      > 3 months
                  
                  
                  145,321
                  
                  
                  39
                  %Fixed
                  
                  
                  65,257
                  
                  
                  18
                  %Total
                      Gross Loans
                  
                  $
                  371,579
                  
                  
                  100
                  %
  Gross
                      Loans
                  
                  %
                      ofRe-Pricing
                  
                  Balance
                  
                  Total<
                      1 Year
                  
                  $
                  240,982
                  
                  
                  65
                  %1-3
                      Years
                  
                  
                  77,948
                  
                  
                  21
                  %3-5
                      Years
                  
                  
                  39,795
                  
                  
                  11
                  %>
                      5 Years
                  
                  
                  12,854
                  
                  
                  3
                  %$
                  371,579
                  
                  
                  100
                  %
  The
        table
        above identifies approximately 41% of the loan portfolio that will re-price
        immediately in a changing rate environment.
 
 Item
        4.  Controls
        and Procedures
 
 Evaluation
        of Disclosure Controls and Procedures
  •
            PAGE •
            33 •
  
 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 Rule 13a-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.
 
 There
        was
        no change in the Company’s internal controls over financial reporting during the
        quarter ended September 30, 2005 that has materially affected, or is reasonably
        likely to materially affect, the Company’s internal controls over financial
        reporting.
 
 In
        designing and evaluating disclosure controls and procedures, the Company’s
        management recognized that any controls and procedures, no matter how well
        designed and operated, can provide only reasonable, not absolute, assurances
        of
        achieving the desired control objectives and management necessarily was required
        to apply its judgment in evaluating the cost-benefit relationship of possible
        controls and procedures.
 
 PART
        2.
        OTHER INFORMATION
 
 Item
        1.  Legal
        Proceedings
 The
        Company is not a party to any material legal proceeding.
 
 Item
        2.  Changes
        in Securities, Use of Proceeds and Issuer Purchases of Equity
        Securities
 N/A
 
 Item
        3.  Defaults
        Upon Senior Securities
 N/A
 
 Item
        4.  Submission
        of Matters to a Vote of Security Holders
 N/A
 
 Item
        5.  Other
        Information
 N/A
 
 Item
        6.  Exhibits
 (a)Exhibits :
 
 Exhibit
                (10.42)
              Atascadero
                  Branch Lease entered into on July 15, 2005, filed with the SEC
                  in the
                  Company’s 10-Q for the quarter ended September 30,
                  2005
 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
 
 
 
  •
            PAGE •
            34 •
  
 
 
 SIGNATURES
 
 Pursuant
        to the requirements of the Securities Exchange Act of 1934, the registrant
        has
        duly caused this report to be signed on its behalf by the undersigned thereunto
        duly authorized.
 
 HERITAGE
        OAKS BANCORP
 
 DATE:
        October 19, 2005
  /s/ Lawrence
                  P. WardLawrence
                    P. Ward
                  President
                  Chief
                    Executive Officer
   /s/ Margaret
                    A. TorresMargaret
                      A. Torres
                    Chief
                      Financial Officer
                    Executive
                      Vice President
 •
            PAGE •
            35 •
  
 EXHIBIT
        INDEX
 Exhibit
                  (10.42)
                Atascadero
                    Branch Lease entered into on July 15, 2005, filed with the SEC
                    in the
                    Company’s 10-Q for the quarter ended September 30,
                    2005
 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
 •
            PAGE •
            36 •