**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, 2006**





**o
      TRANSITION REPORT
      PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934**


**For
      the Transition Period from _____** **to _____**





**Commission
      File 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
      o**




**Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer or is a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (check
      one.)**





**Large
      Accelerated filer o Accelerated
      filer o
      Non-accelerated filer x**




**Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Act). Yes o 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 11, 2006 there were approximately 6,356,021 shares outstanding of
      the
      Registrant’s common stock.**










**TABLE
      OF CONTENTS**




Part
                  1. Financial Information
              3Item
                  1. Consolidated Financial Statements (Un-audited)
              3Consolidated
                  Balance Sheets
              3Consolidated
                  Statements of Operations
              4Consolidated
                  Statements of Other Comprehensive Income
              5Consolidated
                  Statement of Changes in Stockholders’ Equity
              6Consolidated
                  Statements of Cash Flows
              7Notes
                  to Consolidated Financial Statements
              8Item
                  2. Management’s Discussion and Analysis ofFinancial
                  Condition and Results of Operations
              16Item
                  3. Quantitative and Qualitative Disclosure about Market
                  Risk
              35Item
                  4. Controls and Procedures
              37Part
                  2. Other Information
              37Item
                  1. Legal Proceedings
              37Item
                  1. A. Risk Factors
              37Item
                  2. Unregistered Sales of Equity Securities and Use of
                  Proceeds
              37Item
                  3. Defaults Upon Senior Securities
              38Item
                  4. Submission of Matters to a Vote of Security Holders
              38Item
                  5. Other Information
              38Item
                  6.Exhibits
              38Signatures
              39CertificationsExhibits
              40




2







PART
      1.
      FINANCIAL INFORMATION


Item
      1.
      Financial Statements




**HERITAGE
        OAKS BANCORP**
 **CONSOLIDATED
        BALANCE SHEETS**
  **(in
                  thousands)**
              
              **September
                  30,**
              
              **December
                  31,****2006**
              
              **2005****ASSETS**
              
              
              **(Unaudited**)****
              
              
              **(1**)****Cash
                  and due from banks
              
              $
              17,972
              
              $
              18,279Federal
                  funds sold
              
              
              14,195
              
              
              26,280Total
                  cash and cash equivalents
              
              
              32,167
              
              
              44,559Interest
                  bearing deposits other banks
              
              
              318
              
              
              298Securities
                  Available for sale
              
              
              40,294
              
              
              44,402Federal
                  Home Loan Bank Stock, at cost
              
              
              1,955
              
              
              1,885Loans
                  Held For Sale
              
              
              2,069
              
              
              3,392Loans,
                  net
              
              
              419,314
              
              
              362,635Property,
                  premises and equipment, net
              
              
              14,801
              
              
              11,905Cash
                  surrender value life insurance
              
              
              9,344
              
              
              7,706Deferred
                  Tax Assets
              
              
              2,515
              
              
              2,358Goodwill
              
              
              4,864
              
              
              4,865Core
                  Deposit Intangible
              
              
              1,223
              
              
              1,448Other
                  assets
              
              
              3,517
              
              
              3,048**TOTAL
                  ASSETS**
              
              **$**
              **532,381**
              
              **$**
              **488,501****LIABILITIES**Deposits:Demand,
                  non-interest bearing
              
              $
              157,180
              
              $
              164,014Savings,
                  NOW, and money market deposits
              
              
              152,033
              
              
              170,106Time
                  deposits of $100 or more
              
              
              31,782
              
              
              17,414Time
                  deposits under $100
              
              
              89,277
              
              
              66,263Total
                  deposits
              
              
              430,272
              
              
              417,797FHLB
                  advances and other borrowed money
              
              
              40,000
              
              
              10,000Securities
                  Sold under Agreement to Repurchase
              
              
              1,219
              
              
              3,847Junior
                  subordinated debentures
              
              
              8,248
              
              
              8,248Other
                  liabilities
              
              
              4,215
              
              
              3,764Total
                  liabilities
              
              
              483,954
              
              
              443,656**STOCKHOLDERS'
                  EQUITY**Common
                  stock, no par value;20,000,000
                  shares authorized; issued and outstanding6,356,021
                  and 6,231,982 as of September 30, 2006and
                  December 31, 2005, respectively.
              
              
              29,648
              
              
              29,255Retained
                  earnings
              
              
              18,668
              
              
              15,748Accumulated
                  other comprehensive income/(loss)
              
              
              111
              
              
              (158
              )Total
                  stockholders' equity
              
              
              48,427
              
              
              44,845**TOTAL
                  LIABILITIES & STOCKHOLDERS' EQUITY**
              
              **$**
              **532,381**
              
              **$**
              **488,501**
 (1)
          These
          numbers have been derived from the audited financial statements.
  See
          notes
          to condensed consolidated financial statements
  3





**HERITAGE
        OAKS BANCORP**
 **CONSOLIDATED
        STATEMENTS OF INCOME**
  (in
        thousands except per share date)


**For
                  the three months**
              
              **For
                  the nine months****ended
                  September 30,**
              
              **ended
                  September 30,****2006**
              
              **2005**
              
              **2006**
              
              **2005****(Unaudited)**
              
              **(Unaudited)**
              
              **(Unaudited)**
              
              **(Unaudited)**Interest
                  Income:Interest
                  and fees on loans
              
              
              
              $
              8,968
              
              $
              7,179
              
              $
              24,475
              
              $
              19,794Investment
                  securities
              
              
              
              
              467
              
              
              489
              
              
              1,446
              
              
              1,586Federal
                  funds sold and commercial paper
              
              
              
              
              131
              
              
              270
              
              
              513
              
              
              440Time
                  certificates of deposit
              
              
              
              
              2
              
              
              2
              
              
              6
              
              
              7Total
                  interest income
              
              
              
              
              9,568
              
              
              7,940
              
              
              26,440
              
              
              21,827Interest
                  Expense:Now
                  accounts
              
              
              
              
              22
              
              
              25
              
              
              66
              
              
              67MMDA
                  accounts
              
              
              
              
              567
              
              
              442
              
              
              1,687
              
              
              983Savings
                  accounts
              
              
              
              
              25
              
              
              29
              
              
              78
              
              
              71Time
                  deposits of $100 or more
              
              
              
              
              172
              
              
              103
              
              
              428
              
              
              276Other
                  time deposits
              
              
              
              
              1,132
              
              
              350
              
              
              2,671
              
              
              856Other
                  borrowed funds
              
              
              
              
              628
              
              
              398
              
              
              1,406
              
              
              1,201Total
                  interest expense
              
              
              
              
              2,546
              
              
              1,347
              
              
              6,336
              
              
              3,454Net
                  Interest Income Before Prov. for Possible Loan
                Losses
              
              
              
              
              7,022
              
              
              6,593
              
              
              20,104
              
              
              18,373Provision
                  for loan losses
              
              
              
              
              180
              
              
              170
              
              
              480
              
              
              530Net
                  interest income after provision for loan losses
              
              
              
              
              6,842
              
              
              6,423
              
              
              19,624
              
              
              17,843Non-interest
                  Income:Service
                  charges on deposit accounts
              
              
              
              
              644
              
              
              655
              
              
              1,826
              
              
              1,825Other
                  income
              
              
              
              
              578
              
              
              734
              
              
              1,826
              
              
              1,962Total
                  Non-interest Income
              
              
              
              
              1,222
              
              
              1,389
              
              
              3,652
              
              
              3,787Non-interest
                  Expense:Salaries
                  and employee benefits
              
              
              
              
              2,965
              
              
              2,532
              
              
              8,534
              
              
              7,188Occupancy
                  and equipment
              
              
              
              
              633
              
              
              600
              
              
              1,901
              
              
              1,853Other
                  expenses
              
              
              
              
              1,786
              
              
              1,743
              
              
              4,982
              
              
              4,820Total
                  Noninterest Expenses
              
              
              
              
              5,384
              
              
              4,875
              
              
              15,417
              
              
              13,861Income
                  before provision for income taxes
              
              
              
              
              2,680
              
              
              2,937
              
              
              7,859
              
              
              7,769Provision
                  for applicable income taxes
              
              
              
              
              947
              
              
              1,132
              
              
              2,846
              
              
              2,940Net
                  Income
              
              
              
              $
              1,733
              
              $
              1,805
              
              $
              5,013
              
              $
              4,829Earnings
                  per share: (See note #4)Basic
              
              
              
              $
              0.27
              
              $
              0.29
              
              $
              0.79
              
              $
              0.79Fully
                  Diluted
              
              
              
              $
              0.26
              
              $
              0.28
              
              $
              0.76
              
              $
              0.74
  See
          notes
          to condensed consolidated financial statements
  4


**HERITAGE
        OAKS BANCORP** Consolidated Statements of Comprehensive
          Income
  **(Unaudited,
                  in thousands)**
              
              **Three
                  Month Period**
              
              **Nine
                  Month Period****Ended
                  September 30,**
              
              **Ended
                  September 30,****2006**
              
              **2005**
              
              **2006**
              
              **2005****Net
                  Income**
              
              $
              1,733
              
              $
              1,805
              
              $
              5,013
              
              $
              4,829**Other
                  Comprehensive Income (Loss) Before Taxes:**Unrealized
                  gains (losses) on securities available for sale:Unrealized
                  holding gains (losses) arising during period
              
              
              (1,043
              )
              
              (291
              )
              
              448
              
              
              (240
              )Reclassification
                  adjustments for (gains) included in net income
              
              
              -
              
              
              -
              
              
              -
              
              
              -Other
                  comprehensive income (loss), before taxes
              
              
              (1,043
              )
              
              (291
              )
              
              448
              
              
              (240
              )Income
                  tax expense (benefit) related to items in comprehensive
                  income
              
              
              418
              
              
              118
              
              
              (179
              )
              
              96Income
                  tax expense (benefit) related to realized gain in comprehensive
                  income
              
              
              -
              
              
              -
              
              
              -
              
              
              -**Other
                  Comprehensive Income (Loss), Net of Taxes**
              
              
              (625
              )
              
              (173
              )
              
              269
              
              
              (144
              )**Comprehensive
                  Income**
              
              $
              1,108
              
              $
              1,632
              
              $
              5,282
              
              $
              4,685
  See
          notes
          to condensed consolidated financial statements
  5





**HERITAGE
        OAKS BANCORP** CONSOLIDATED STATEMENTS OF STOCKHOLDERS'
          EQUITY


**September
        30, 2006 and September 30, 2005**
 **(Unaudited)**
 (
        in
        thousands except shares outstanding)
  **Accumulated****Other**
              
              **Total****Shares**
              
              **Common**
              
              **Retained**
              
              **Comprehensive**
              
              **Stockholders'****Outstanding**
              
              **Stock**
              
              **Earnings**
              
              **Income/(Loss)**
              
              **Equity****Balance
                  January 1, 2006**
              
              
              6,231,982
              
              $
              29,255
              
              $
              15,748
              
              $
              (158
              )
              $
              44,845Exercise
                  of Stock Options
                  (including
                    $160 tax benefit from exercise of
                    stock options)
              
              
              72,989
              
              
              559
              
              
              
              
              
              
              
              
              559Cash
                  Dividend of $.25 per share paid May 19,
                2006
              
              
              
              
              
              
              
              
              (1,585
              )
              
              
              
              
              (1,585
              )Cash
                  Dividend of $.08 per share paid August 25,
                2006
              
              
              
              
              
              
              
              
              (508
              )
              
              
              
              
              (508
              )Stock-based
                  compensation expense
              
              
              
              
              
              83
              
              
              
              
              
              
              
              
              83Issuance
                  of Restricted Stock Awards
              
              
              66,050Stock
                  Repurchased
              
              
              (15,000
              )
              
              (249
              )
              
              
              
              
              
              
              
              (249
              )Comprehensive
                  IncomeNet
                  Income
              
              
              
              
              
              
              
              
              5,013
              
              
              
              
              
              5,013Unrealized
                  security holding gains (net of $179
                tax)
              
              
              
              
              
              
              
              
              
              
              
              269
              
              
              269Total
                  other comprehensive Income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              5,282**Balance
                  September 30, 2006**
              
              
              **6,356,021**
              
              **$**
              **29,648**
              
              **$**
              **18,668**
              
              **$**
              **111**
              
              **$**
              **48,427****Other**
              
              
              **Total****Shares**
              
              
              **Common**
              
              
              **Retained**
              
              
              **Comprehensive**
              
              
              **Stockholders'****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 offractional
                  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**


See
        notes
        to condensed consolidated financial statements





6


**HERITAGE
        OAKS BANCORP**
 **CONSOLIDATED
        STATEMENTS OF CASHFLOWS**


**(in
        thousands)**
  **Periods
                  ended September 30,****2006**
              
              **2005****(Unaudited)**
              
              **(Unaudited)****Cash
                  Flows from Operating Activities**Net
                  income
              
              $
              5,013
              
              $
              4,829Adjustments
                  to reconcile net income tonet
                  cash provided by operating activitiesNet
                  cash provided by operating activitiesDepreciation
                  and amortization
              
              
              690
              
              
              688Provision
                  for possible loan losses
              
              
              480
              
              
              530Provision
                  for possible unfunded loan commitment
              
              
              -
              
              
              (10
              )Amortization
                  of premiums/discounts onInvestment
                  securities, net
              
              
              (3
              )
              
              170FHLB
                  stock dividends received
              
              
              (70
              )
              
              (55
              )Amortization
                  of intangible assets
              
              
              225
              
              
              431Stock
                  based compensation expense
              
              
              83
              
              
              -(Increase)
                  in loans held for sale
              
              
              1,323
              
              
              (5,441
              )Net
                  increase in cash surrender value of life insurance
              
              
              (252
              )
              
              (205
              )(Increase)
                  in other assets
              
              
              (805
              )
              
              (73
              )Excess
                  tax benefit related to stock based compensation expense
              
              
              -
              
              
              -Increase
                  in other liabilities
              
              
              452
              
              
              626**NET
                  CASH PROVIDED BY/(USED IN) OPERATING ACTIVITIES**
              
              
              7,136
              
              
              1,490**Cash
                  Flows From Investing Activities**Net
                  Change in time deposits
              
              
              (20
              )
              
              200Purchase
                  of securities available-for-sale
              
              
              (1,190
              )
              
              (1,393
              )Maturity/Call
                  AFS securities
              
              
              -
              
              
              850Proceeds
                  from principal reductions and maturitiesof
                  mortgage backed securities available-for-sale
              
              
              5,749
              
              
              11,065Purchase
                  of life insurance policies
              
              
              (1,386
              )
              
              (300
              )Increase
                  in loans, net
              
              
              (57,180
              )
              
              (31,746
              )Net
                  ALLL Recoveries
              
              
              21
              
              
              22Proceeds
                  from disposal of property
              
              
              -
              
              
              617Purchase
                  of property, premises and equipment, net
              
              
              (3,586
              )
              
              (1,660
              )**NET
                  CASH USED IN INVESTING ACTIVITIES**
              
              
              (57,592
              )
              
              (22,345
              )**Cash
                  Flows From Financing Activities**Increase
                  in deposits, net
              
              $
              12,475
              
              $
              73,328Increase
                  in FHLB borrowing
              
              
              30,000
              
              
              (500
              )Increase/(Decrease)
                  in Repurchase agreements
              
              
              (2,628
              )
              
              1,291Proceeds
                  from exercise of stock options
              
              
              270
              
              
              945Excess
                  tax benefit related to stock based compensation
              
              
              289
              
              
              -Repurchase
                  of stock
              
              
              (249
              )
              
              -Cash
                  Dividend paid
              
              
              (2,093
              )
              
              -Cash
                  paid in lieu of fractional shares
              
              
              -
              
              
              (8
              )**NET
                  CASH PROVIDED BY FINANCING ACTIVITIES**
              
              
              38,064
              
              
              75,056**Net
                  Increase in Cash and Cash Equivalents**
              
              
              (12,392
              )
              
              54,201**Cash
                  and Cash Equivalents**, Beginning of year
              
              
              44,559
              
              
              21,867**Cash
                  and Cash Equivalents**, End of period
              
              $
              32,167
              
              $
              76,068**Supplemental
                  Disclosures of Cash Flow Information**Interest
                  paid
              
              $
              5,939
              
              $
              3,456Income
                  taxes paid
              
              $
              2,290
              
              $
              3,132


See
        notes
        to condensed consolidated financial statements
  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 2005 Annual Report on Form 10-K.





The
      condensed consolidated financial statements include the accounts of the Company
      and its wholly-owned financial subsidiary, Heritage Oaks Bank (the “Bank”). All
      significant inter-company balances and transactions have been eliminated.
      Heritage Oaks Capital 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, 2006 are not necessarily indicative
      of
      the results that may be expected for the year ending December 31, 2006. Certain
      amounts in the consolidated financial statements for the year ended December
      31,
      2005 and the three and nine month period ended September 30, 2005 may have
      been
      reclassified to conform to the presentation of the consolidated financial
      statement in 2006.





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.




8




The
        amortized cost and fair values of investment securities available for sale
        at
        September 30, 2006 and December
        31, 2005:
  **(in
                  thousands)**
              
              
              
              **Gross**
              
              **Gross****Amortized**
              
              **Unrealized**
              
              **Unrealized**
              
              **Fair****Balance
                  September 30, 2006**
              
              **Cost**
              
              **Gains**
              
              **Losses**
              
              **Value**Obligations
                  of U.S. government agencies and
                corporations
              
              $
              759
              
              $
              -
              
              $
              (8
              )
              $
              751Mortgage-backed
                  securities
              
              
              23,243
              
              
              10
              
              
              (461
              )
              
              22,792Obligations
                  of State and Political Subdivisions
              
              
              16,100
              
              
              670
              
              
              (28
              )
              
              16,742Other
                  Securities
              
              
              9
              
              
              -
              
              
              -
              
              
              9**TOTAL**
              
              **$**
              **40,111**
              
              **$**
              **680**
              
              **$**
              **(497**
              **)**
              **$**
              **40,294****Gross**
              
              
              **Gross****Amortized**
              
              
              **Unrealized**
              
              
              **Unrealized**
              
              
              **Fair****As
                  of December 31, 2005**
              
              
              **Cost**
              
              
              **Gains**
              
              
              **Losses**
              
              
              **Value**Obligations
                  of U.S. government agencies and
                corporations
              
              $
              826
              
              $
              -
              
              $
              (20
              )
              $
              806Mortgage-backed
                  securities
              
              
              28,795
              
              
              13
              
              
              (518
              )
              
              28,290Obligations
                  of State and Political Subdivisions
              
              
              15,036
              
              
              364
              
              
              (103
              )
              
              15,297Other
                  Securities
              
              
              9
              
              
              -
              
              
              -
              
              
              9**TOTAL**
              
              **$**
              **44,666**
              
              **$**
              **377**
              
              **$**
              **(641**
              **)**
              **$**
              **44,402**


Note
      3.  LOANS
      AND
      ALLOWANCE FOR LOAN LOSSES





Major
        classifications of loans were:
  **September
                  30,**
              
              **December
                  31,****(in
                  thousands)**
              
              **2006**
              
              **2005**Commercial,
                  financial, and agricultural
              
              $
              75,627
              
              $
              60,050Real
                  estate-construction/land
              
              
              101,665
              
              
              76,981Real
                  estate - other
              
              
              229,070
              
              
              210,690Home
                  equity lines of credit
              
              
              11,777
              
              
              14,398Installment
                  loans to individuals
              
              
              5,660
              
              
              5,620All
                  other loans (including overdrafts)
              
              
              867
              
              
              394424,666
              
              
              368,133Less
                  - deferred loan fees, net
              
              
              (1,489
              )
              
              (1,617
              )Less
                  - reserve for possible loan losses
              
              
              (3,863
              )
              
              (3,881
              )Total
                  loans
              
              
              419,314
              
              
              362,635Loans
                  Held For Sale
              
              $
              2,069
              
              $
              3,392




Concentration
      of Credit Risk




At
      September 30, 2006, approximately $342.5 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.




9




At
      September 30, 2006, the Bank was contingently liable for letters of credit
      accommodations made to its customers totaling approximately $20.1 million and
      un-disbursed loan commitments in the approximate amount of $160 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,****2006**
              
              **2005**Balance
                  at beginning of year
              
              $
              3,881
              
              $
              3,247Additions
                  charged to operating expense
              
              
              480
              
              
              710Loans
                  charged off
              
              
              (519
              )
              
              (100
              )Recoveries
                  of loans previously charged off
              
              
              21
              
              
              24Balance
                  at end of year
              
              $
              3,863
              
              $
              3,881





The
      Bank
      recognizes that credit losses will be experienced and the risk of loss will
      vary
      with, among other things, general economic conditions; the type of loan being
      made; the creditworthiness of the borrower over the term of the loan and in
      the
      case of a collateralized loan, the quality of the collateral for such loan.
      The
      allowance for loan 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 ability to collect 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.





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, 2006 is consistent with prior periods.





10




The
      allowance for loan losses as a percentage of total net loans was .92% as of
      September 30, 2006 and 1.07% as of December 31, 2005. Management believes that
      the allowance for credit losses at September 30, 2006 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. In addition, on October 21, 2005, the Board of Directors declared
      a 3
      for 2 stock split payable on December 2, 2005 to stockholders of record on
      November 10, 2005. Share information has been retroactively adjusted for the
      stock split and dividend.





On
      April
      21, 2006 the Board of Directors declared a special $0.25 per share cash dividend
      that was paid on May 19, 2006 to shareholders of record on May 8, 2006.





On
      July
      21, 2006, the Board of Directors declared a quarterly cash dividend of $.08
      to
      be paid on August 25, 2006 to shareholders of record on August 11, 2006. In
      addition, the Board of Directors adopted a resolution authorizing the repurchase
      of up to 40,000 shares of Company stock. Purchases are to be made, as conditions
      warrant, from time to time in the open market. The duration of the program
      is
      one year and the timing of purchases will depend on market conditions. During
      the three months ending September 30, 2006, 15,000 shares of the Company’s stock
      was repurchased.





On
      October 20, 2006, the Board of Directors declared a quarterly cash dividend
      of
      $.08 to be paid on November 17, 2006 to shareholders of record on November
      3,
      2006. In addition, the Board of Directors adopted a resolution to increase
      the
      number of shares to 100,000 for the repurchase plan that was adopted in July
      2006. Purchases are to be made, as conditions warrant, from time to time in
      the
      open market. The duration of the program is one year and the timing of purchases
      will depend on market conditions.





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, 2006 and
      2005:




**For
                  the Three Months Ending**
              
              **For
                  the Nine Months Ending****September
                  30,**
              
              **September
                  30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**Net
                  Income
              
              $
              1,733,149
              
              $
              1,804,918
              
              $
              5,012,872
              
              $
              4,828,627Basic
              
              $
              0.27
              
              $
              0.29
              
              $
              0.79
              
              $
              0.79Diluted
              
              $
              0.26
              
              $
              0.28
              
              $
              0.76
              
              $
              0.74Shares:Basic
              
              
              6,350,727
              
              
              6,186,045
              
              
              6,326,743
              
              
              6,147,243Diluted
              
              
              6,594,626
              
              
              6,499,178
              
              
              6,594,800
              
              
              6,514,980




11





Note
      5.  RECENT
      ACCOUNTING PRONOUNCEMENTS





In
      July
      2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation
      No. 48, *Accounting
      for Uncertainty in Income Taxes—an interpretation of FASB Statement No.
      109* (FIN 48)
      which clarifies the accounting and disclosure for uncertainty in tax positions,
      as defined. FIN 48 seeks to reduce the diversity in practice associated with
      certain aspects of the recognition and measurement related to accounting for
      income taxes. This interpretation is effective for fiscal years beginning after
      December 15, 2006. The Company has not yet determined the impact this
      interpretation will have on our results from operations or financial position.





SHARE-BASED
      PAYMENT: Effective January 1, 2006, we adopted the fair value recognition
      provisions of statement of Financial Accounting Standards (SFAS) No. 123
      (revised 2004), "Share-Based Payment" (SFAS No.123(R)), using the modified
      prospective transition method and, therefore, have not restated results for
      prior periods. Under this transition method, stock-based compensation expense
      for the nine months ending September 30, 2006 included compensation expense
      for
      all stock-based compensation awards granted prior to, but not yet vested as
      of
      January 1, 2006, based on the grant date fair value estimated in accordance
      with
      the original provision of SFAS No. 123, "Accounting for Stock-Based
      Compensation" ("SFAS No.123"). Stock-based compensation expense for all
      stock-based compensation awards granted after January 1, 2006 is based on the
      grant-date fair value estimated in accordance with the provisions of SFAS
      No.123(R). The Company recognizes these compensation costs on a straight-line
      basis over the requisite service period of the award. Prior to the January
      1,
      2006 adoption of SFAS No.123(R), the Company recognized stock-based compensation
      expense in accordance with Accounting Principles Board (APB) Opinion No. 25,
      "Accounting for Stock Issued to Employees" (APB No. 25). In March 2005, the
      Securities and Exchange Commission (the SEC) issued Staff Accounting Bulletin
      No. 107 (SAB No. 107) regarding the SEC's interpretation of SFAS No.123(R)
      and
      the valuation of share-based payments for public companies. The Company has
      applied the provisions of SAB No. 107 in its adoption of SFAS No. 123(R). See
      Note 6 to the Un-audited Consolidated Financial Statements for a further
      discussion on stock-based compensation.





ACCOUNTING
      FOR CERTAIN HYBRID FINANCIAL INSTRUMENTS: In February 2006, the FASB issued
      SFAS
      No. 155, "Accounting for Certain Hybrid Financial Instruments - an amendment
      of
      FASB Statements No. 133 and 140." SFAS No. 155 simplifies accounting for certain
      hybrid instruments currently governed by SFAS No. 133, "Accounting for
      Derivative Instruments and Hedging Activities," by allowing fair value
      re-measurement of hybrid instruments that contain an embedded derivative that
      otherwise would require bifurcation. SFAS No. 155 also eliminates the guidance
      in SFAS No.133 Implementation Issue No. D1, "Application of Statement 133 to
      Beneficial Interests in Securitized Financial Assets," which provides such
      beneficial interests are not subject to SFAS No.133. SFAS No. 155 amends SFAS
      No. 140, "Accounting for Transfers and Servicing of Financial Assets and
      Extinguishments of Liabilities - a Replacement of FASB Statement No. 125,"
      by
      eliminating the restriction on passive derivative instruments that a qualifying
      special-purpose entity may hold. This statement is effective for financial
      instruments acquired or issued after the beginning of the Company’s fiscal year
      2007. The Company does not expect the adoption of this statement to have a
      material impact on the Company’s financial condition, results of operations or
      cash flows.





ACCOUNTING
      FOR SERVICING OF FINANCIAL ASSETS: In March 2006, the Financial Accounting
      Standards Board (FASB) issued SFAS No. 156, "Accounting for Servicing of
      Financial Assets- an amendment of FASB Statement No. 140." SFAS No.156 requires
      an entity to recognize a servicing asset or servicing liability each time it
      undertakes an obligation to service a financial asset by entering into a
      servicing contract in specific situations. Additionally, the servicing asset
      or
      servicing liability shall be initially measured at fair value; however, an
      entity may elect the "amortization method" or "fair value method" for subsequent
      balance sheet reporting periods. SFAS No.156 is effective as of an entity's
      first fiscal year beginning after September 15, 2006. Early adoption is
      permitted as of the beginning of an entity's fiscal year, provided the entity
      has not yet issued financial statements, including interim financial statements,
      for any period of that fiscal year. The Company does not expect the adoption
      of
      this statement to have a material impact on its financial condition, results
      of
      operations or cash flows.





In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      No. 157, *Fair
      Value Measurements* (FAS
      157). FAS 157 enhances existing guidance for measuring assets and liabilities
      using fair value. Prior to the issuance of FAS 157, guidance for applying fair
      value was incorporated in several accounting pronouncements. FAS 157 provides
      a
      single definition of fair value, together with a framework for measuring it,
      and
      requires additional disclosure about the use of fair value to measure assets
      and
      liabilities. FAS 157 also emphasizes that fair value is a market-based
      measurement, not an entity-specific measurement, and sets out a fair value
      hierarchy with the highest priority being quoted prices in active markets.
      Under
      FAS 157, fair value measurements are disclosed by level within that hierarchy.
      While FAS 157 does not add any new fair value measurements, it does change
      current practice. Changes to practice include: (1) a requirement for an
      entity to include its own credit standing in the measurement of its liabilities;
      (2) a modification of the transaction price presumption; (3) a
      prohibition on the use of block discounts when valuing large blocks of
      securities for broker-dealers and investment companies; and (4) a
      requirement to adjust the value of restricted stock for the effect of the
      restriction even if the restriction lapses within one year. FAS 157 is effective
      for financial statements issued for fiscal years beginning after
      November 15, 2007, and interim periods within those fiscal years. The
      Company has not determined the impact of adopting FAS 157 on its financial
      statements.





12




In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      No. 158, *Employers’
      Accounting for Defined Benefit Pension and Other Postretirement Plans (an
      amendment of FASB Statements No. 87, 88, 106, and 132R)* (FAS
      158), requires an employer to: (a) Recognize in its statement of financial
      position an asset for a plan’s over funded status or a liability for a plan’s
      under funded status; (b) measure a plan’s assets and its obligations that
      determine its funded status as of the end of the employer’s fiscal year (with
      limited exceptions); and (c) recognize changes in the funded status of a
      defined benefit postretirement plan in the year in which the changes occur.
      Those changes will be reported in comprehensive income of a business entity
      and
      in changes in net assets of a not-for-profit organization. The requirement
      by
      FAS 158 to recognize the funded status of a benefit plan and the disclosure
      requirements of FAS 158 are effective as of the end of the fiscal year ending
      after December 15, 2006 for entities with publicly traded equity
      securities. The requirement to measure plan assets and benefit obligations
      as of
      the date of the employer’s fiscal year-end statement of financial position is
      effective for fiscal years ending after December 15, 2008. The Company does
      not expect the adoption of FAS 158 to have a material effect on the financial
      position of the company at December 31, 2006.




Note
      6.
      Stock-Based Compensation





As
      of
      September 30, 2006, the Company had three stock-based employee compensation
      plans, which are more fully described in Note 14 of the Consolidated Financial
      Statements in the Company's Annual Report on Form 10-K for the year ended
      December 31, 2005. These plans include two stock option plans and the 2005
      Equity Based Compensation Plan.





Effective
      January 1, 2006, the Company adopted the fair value recognition provisions
      of
      SFAS No. 123(R), using the modified prospective transition method and,
      therefore, have not restated results for prior periods. Under this transition
      method, stock-based compensation expense for the first nine months of 2006
      included compensation expense for all stock-based compensation awards granted
      prior to, but that remained unvested as of, January 1, 2006. Compensation
      expense was based on the grant date fair value estimated in accordance with
      the
      original provision of SFAS No. 123.





Prior
      to
      January 1, 2006, the Company accounted for stock-based compensation under the
      recognition, measurement and pro forma disclosure provisions of APB No. 25,
      the
      original provisions of SFAS No. 123, and SFAS No. 148, "Accounting for
      Stock-Based Compensation-Transition and Disclosure" (SFAS 148). No stock-based
      compensation expense was reflected in net income as all options are required
      by
      the plan to be granted with an exercise price equal to the estimated fair value
      of the underlying common stock on the date of grant.





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





As
      a
      result of the Company’s January 1, 2006, adoption of SFAS No.123(R), the impact
      to the Consolidated Financial Statements for the nine months ended September
      30,
      2006 on income before income taxes and on net income were reductions of $83
      thousand and $50 thousand, respectively. The cumulative effect of the change
      in
      accounting was $83 thousand before income taxes and $50 thousand, after income
      taxes. The change had no impact on basic and $.0076 on diluted earnings per
      share for the three months ended September 30, 2006. In addition, prior to
      the
      adoption of SFAS No. 123(R), the Company presented the tax benefit of stock
      option exercises as operating cash flows, upon the adoption of SFAS No. 123(R),
      tax benefits resulting from tax deductions in excess of the compensation cost
      recognized for those options are classified as financing cash
      flows.




13




PRO
      FORMA
      INFORMATION UNDER SFAS NO. 123





Pro
      forma
      information regarding the effect on the net income and basic and diluted income
      per share for the three and nine months ended September 30, 2005, had the
      Company applied the fair value recognition provisions of SFAS No. 123, are
      as
      follows:




For
                  the Three
              
              For
                  the NineMonths
                  Ended
              
              Months
                  Ended30-Sep-05
              
              30-Sep-05Net
                  income:As
                  reported
              
              $
              1,804,918
              
              $
              4,828,627Stock-based
                  compensation using the intrinsic value method
              
              
              -
              
              
              -Stock-based
                  compensation that would have been reportedusing
                  the fair value method of SFAS 123
              
              
              (6,607
              )
              
              (77,541
              )Pro
                  forma net income
              
              $
              1,798,311
              
              $
              4,751,086Weighted
                  Average Shares Outstanding - Basic
              
              
              6,186,045
              
              
              6,147,243Weighted
                  Average Shares Outstanding - Diluted
              
              
              6,499,178
              
              
              6,514,980Basic
                  Earnings per shareAs
                  reported
              
              $
              0.29
              
              $
              0.79Pro
                  forma
              
              $
              0.29
              
              $
              0.77Earnings
                  per share - assuming dilutionAs
                  reported
              
              $
              0.28
              
              $
              0.74Pro
                  forma
              
              $
              0.28
              
              $
              0.73





The
      stock-based compensation expense recognized in the condensed consolidated
      statement of operations for the nine months ended September 30, 2006 is based
      on
      awards ultimately expected to vest, and accordingly has been adjusted by the
      amount of estimated forfeitures. SFAS No. 123(R) requires forfeitures to be
      estimated at the time of grant and revised, if necessary, in subsequent periods
      if actual forfeitures differ from those estimates. Forfeitures were estimated
      based partially on historical experience.





The
      aggregate intrinsic value in the table below represents the total pretax
      intrinsic value (the difference between the Company’s closing stock price on the
      last trading day of the third quarter of 2006 (September 30, 2006) and the
      exercise price, multiplied by the number of in-the-money options that would
      have
      been received by the option holders had all option holders exercised their
      options on September 30, 2006, this amount changes based on the fair market
      value of the Company's stock. Total intrinsic value of options exercised for
      the
      three and nine months ended September 30, 2006 was $330 thousand and $1,033
      thousand, respectively. Total fair value of options vested and expensed was
      $50
      thousand, net of tax, for the nine months ended September 30, 2006. No options
      were granted during the nine months ended September 30, 2006 and there were
      11,250 options issued during the same period in 2005.





14




**Average****Weighted**
                
                **Remaining**
                
                **Total****Average**
                
                **Contractual**
                
                **Intrinsic****Number
                    of**
                
                **Exercise**
                
                **Term**
                
                **Value****Shares**
                
                **Price**
                
                **(in
                    years)**
                
                **(in
                    000's)**Options
                    outstanding, January 1, 2006
                
                
                525,915
                
                $
                5.19Granted
                
                
                -
                
                
                -Exercised
                
                
                (72,989
                )
                
                3.66Forfeited
                
                
                (3
                )
                
                4.35Options
                    outstanding, September 30, 2006
                
                
                452,923
                
                $
                5.43
                
                
                3.9
                
                $
                4,924Exercisable
                    at September 30, 2006
                
                
                383,837
                
                $
                4.49
                
                
                3.7
                
                $
                4,534





As
      of
      September 30, 2006, there was $256,012 of total unrecognized compensation cost
      related to non-vested share-based compensation arrangements. That cost is
      expected to be recognized over a weighted-average period of 4.4
      years.





The
      following table summarizes information about stock options outstanding at
      September 30, 2006:




**Weighted****Average**
              
              **Weighted**
              
              
              
              **Weighted****Range
                  of**
              
              **Number**
              
              **Remaining**
              
              **Average**
              
              **Number**
              
              **Average****Exercise**
              
              **of
                  shares**
              
              **Contractual**
              
              **Exercise**
              
              **of
                  shares**
              
              **Exercise****Prices**
              
              **Outstanding**
              
              **Life
                  (years)**
              
              **Price**
              
              **Exercisable**
              
              **Price**$2.56
                  to $5.74
              
              
              326,376
              
              
              2.67
              
              $
              3.67
              
              
              326,376
              
              $
              3.67$5.75
                  to $10.27
              
              
              37,047
              
              
              5.95
              
              
              6.94
              
              
              25,140
              
              
              6.70$10.28
                  to $13.84
              
              
              89,500
              
              
              7.60
              
              
              11.22
              
              
              32,321
              
              
              11.02**Totals**
              
              
              **452,923**
              
              
              **3.91**
              
              **$**
              **5.43**
              
              
              **383,837**
              
              **$**
              **4.49**





The
      fair
      value of each stock option was estimated on the date of grant using the
      Black-Scholes option-pricing model with the weighed average assumptions included
      on the table above, under the header "Stock Based Option Valuation and Expense
      Information under SFAS No.123(R)".





The
      Company grants restricted share awards periodically for the benefit of
      employees. These restricted shares generally “cliff vest” after five years of
      issuance. Recipients of restricted shares have the right to vote all shares
      subject to such grant, and receive all dividends with respect to such shares,
      whether or not the shares have vested. Recipients do not pay any cash
      consideration for the shares. The Company records compensation expense relating
      to restricted share awards. For the three and nine months ended September 30,
      2006, the Company recorded compensation of $32 thousand and $101 thousand,
      net
      of tax, respectively.




Note
      7.  Reclassifications





Certain
      amounts in the 2005 financial statements have been reclassified to conform
      to
      the 2006 presentation.




15




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, 2005 10-K, ITEM 1A. Risk Factors.) The
      Company disclaims any obligation to update any such factors or to publicly
      announce the results of any revisions to any of the forward-looking statements
      contained herein to reflect future events or developments.**





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, 2006 and 2005. 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
      October 2006, the Company formed Heritage Oaks Capital Trust II (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.





Other
      than holding the shares of the Bank, the Company conducts no significant
      activities, although it is authorized, with the prior approval of the Board
      of
      Governors of the Federal Reserve System (the "Federal Reserve Board"), the
      Company's principal regulator, to engage in a variety of activities which are
      deemed closely related to the business of banking. The Company has also caused
      to be incorporated a subsidiary, CCMS Systems, Inc. which is currently inactive
      and has not been capitalized. The Company has no present plans to activate
      the
      proposed subsidiary.





Where
      You
      Can Find More Information





Under
      the
      Securities Exchange Act of 1934 Sections 13 and 15(d), periodic and current
      reports must be filed with the SEC. The Company electronically files the
      following reports with the SEC: Form 10-K (Annual Report), Form 10-Q (Quarterly
      Report), Form 8-K (Current Report), and Form DEF 14A (Proxy Statement). The
      Company may file additional forms. The SEC maintains an Internet site,
      www.sec.gov, in which all forms filed electronically may be accessed.
      Additionally, all forms filed with the SEC and additional shareholder
      information is available free of charge on the Company’s website:
      www.heritageoaksbancorp.com





The
      Company posts these reports to its website as soon as reasonably practicable
      after filing them with the SEC. None of the information on or hyperlinked from
      the Company’s website is incorporated into this Quarterly Report on Form
      10-Q.




16




Executive
      Summary and Recent Developments





On
      October 27, 2006, the Company issued $8,248,000 of Floating Rate Junior
      Subordinated Deferrable Interest Debentures (the “debt securities”) to Heritage
      Oaks Capital Trust II, 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 January 1, 2037. Interest is payable
      quarterly on these debt securities at 3-Month LIBOR plus 1.72% for an effective
      rate of 7.10% as of September 30, 2006. The debt securities can be called at
      any
      time commencing on January 1, 2012, at par. The Company also purchased a 3%
      minority interest totaling $248 thousand in Heritage Oaks Capital Trust II.
      The
      balance of the equity of Heritage Oaks Capital Trust II is comprised of
      mandatorily redeemable preferred securities and is included in other
      assets.





The
      Company intends to use the proceeds of the sale of the Trust Preferred
      Securities for general corporate purposes which may include investment in the
      Bank, acquisitions, investments, payment of dividends and repurchased of our
      outstanding common stock.





On
      October 20, 2006, the Board of Directors declared a quarterly cash dividend
      of
      $.08 to be paid on November 17, 2006 to shareholders of record on November
      3,
      2006. In addition, the Board of Directors adopted a resolution to increase
      the
      number of shares to 100,000 for the repurchase plan that was adopted in July
      2006. Purchases are to be made, as conditions warrant, from time to time in
      the
      open market. The duration of the program is one year and the timing of purchases
      will depend on market conditions. During the three months ending September
      30,
      2006, 15,000 shares of the Company’s stock were repurchased.





On
      July
      21, 2006, the Board of Directors declared a quarterly cash dividend of $.08
      to
      be paid on August 25, 2006 to shareholders of record on August 11, 2006. In
      addition, the Board of Directors adopted a resolution authorizing the repurchase
      of up to 40,000 shares of Company stock. Purchases are to be made, as conditions
      warrant, from time to time in the open market. The duration of the program
      is
      one year and the timing of purchases will depend on market conditions.





On
      April
      21, 2006 the Company declared a $0.25 per share special cash dividend that
      paid
      on May 19, 2006 to shareholders of record on May 8, 2006. The special dividend
      was declared in lieu of recent annual stock dividends the Company has declared.




In
      July
      2003, the Bank purchased a property immediately adjacent to its Headquarters
      facility. Construction was completed in May 2006 on the approximate 20 thousand
      square feet of office space. This facility houses all administrative functions
      of the Company and has enabled the Company to vacate two leased facilities.




17


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


**Selected
        Financial Data**
 **For
        the Quarter Ended,**
  Sep-06
              
              Jun-06
              
              Mar-06
              
              Dec-05
              
              Sep-05
              
              Jun-05
              
              Mar-05
              
              Dec-04Return
                  on
                Average
                  Assets
              
              
              1.35
              %
              
              1.37
              %
              
              1.33
              %
              
              1.47
              %
              
              1.44
              %
              
              1.37
              %
              
              1.24
              %
              
              1.18
              %Return
                  on
                Average
                  Equity
              
              
              14.54
              %
              
              14.33
              %
              
              13.92
              %
              
              16.38
              %
              
              17.03
              %
              
              15.94
              %
              
              14.74
              %
              
              14.77
              %Average
                  Equity to
                Average
                  Assets
              
              
              9.25
              %
              
              9.59
              %
              
              9.58
              %
              
              8.97
              %
              
              8.47
              %
              
              8.60
              %
              
              8.40
              %
              
              6.76
              %Net
                  Interest
                Margin
              
              
              6.07
              %
              
              6.04
              %
              
              5.90
              %
              
              6.06
              %
              
              5.80
              %
              
              5.68
              %
              
              5.55
              %
              
              5.40
              %Efficiency
                  Ratio*
              
              
              65.31
              %
              
              64.34
              %
              
              65.02
              %
              
              60.65
              %
              
              61.08
              %
              
              62.66
              %
              
              64.14
              %
              
              67.64
              %Average
                  Loans to
                Average
                  Deposits
              
              
              97.15
              %
              
              94.37
              %
              
              90.15
              %
              
              89.84
              %
              
              89.60
              %
              
              91.91
              %
              
              92.82
              %
              
              85.65
              %Net
                  Income
              
              $
              1,733
              
              $
              1,673
              
              $
              1,606
              
              $
              1,808
              
              $
              1,805
              
              $
              1,606
              
              $
              1,417
              
              $
              1,353Earnings
                  Per
                Share:Basic
              
              $
              0.27
              
              $
              0.26
              
              $
              0.26
              
              $
              0.29
              
              $
              0.29
              
              $
              0.26
              
              $
              0.23
              
              $
              0.23Diluted
              
              $
              0.26
              
              $
              0.25
              
              $
              0.24
              
              $
              0.27
              
              $
              0.28
              
              $
              0.25
              
              $
              0.22
              
              $
              0.21Outstanding
                Shares:Basic
              
              
              6,350,727
              
              
              6,337,712
              
              
              6,283,890
              
              
              6,223,500
              
              
              6,186,045
              
              
              6,167,571
              
              
              6,080,805
              
              
              6,010,964Diluted
              
              
              6,594,626
              
              
              6,670,942
              
              
              6,643,432
              
              
              6,592,000
              
              
              6,499,178
              
              
              6,524,849
              
              
              6,458,433
              
              
              6,460,174







*
      The
      efficiency ratio is defined as total non-interest expense as a percent of the
      combined net interest income plus non-interest income.





The
      Company’s earnings are highly influenced by changes in short term interest
      rates. The nature of the Company’s balance sheet can be summarily described as
      of short duration and asset sensitive. The balance sheet is of short duration
      because a large percentage of its interest sensitive assets and liabilities
      re-price immediately with changes in the Federal Funds and Prime interest rates.
      The Company is asset sensitive, primarily due to its large volume of
      non-interest bearing demand deposit accounts which effectively never re-price.
      Therefore, an upward movement in short term interest rates will generally result
      in higher net interest margin and, conversely, a reduction in short term
      interest rates will result in reduced net interest margin.





Historically,
      the largest and most variable source of income for the Company is net interest
      income. The results of operations for the three and nine months ended September
      30, 2006 and September 30, 2005 reflect the impact of increases in short term
      rates as well as growth in the volume of both interest earning assets and
      interest bearing liabilities during these periods.





Local
      Economy





The
      economy in the Company’s service area is based primarily on agriculture,
      tourism, light industry, oil and retail trade. Services supporting these
      industries have also developed in the areas of medical, financial and
      educational services. The population of San Luis Obispo County and the City
      of
      Santa Maria (in Northern Santa Barbara County) in 2005 **** totaled
      approximately 260,000 and 90,000, respectively, according to 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. The Central Coast’s
      leading agricultural industry is the production of high quality wine grapes
      and
      production of premium quality wines. Vineyards in production have grown
      significantly over the past several years throughout the Company’s service area.
      Access to numerous recreational activities, including lakes, mountains and
      beaches, provide a relatively stable tourist industry from many areas including
      the Los Angeles/Orange County basin, the San Francisco Bay area and the San
      Joaquin Valley. 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.





18




Critical
      Accounting Policies





The
      Company’s significant accounting policies are set forth in the 2005 Annual
      Report, Note 1 of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, which was
      filed on Form 10-K.





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





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.




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.





See
      Note
      3 to the Consolidated Financial Statements for further discussion on Allowance
      for Loan 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 2005 Annual Report, Note 6 of the NOTES TO CONSOLIDATED
      FINANCIAL STATEMENTS, we assess goodwill and other intangible assets each year
      for impairment. This assessment involves estimating cash flows for future
      periods. If the future cash flows were materially less than the recorded
      goodwill and other intangible assets balances, the Company would be required
      to
      take a charge against earnings to write down the assets to the lower value.
      The
      Company determined that there was no impairment at December 31,
      2005.




19




RESULTS
      OF OPERATIONS





Earnings
      Overview





The
      Company reported net income for the three months ended September 30, 2006 of
      $1.7 million compared to $1.8 million during the same period in 2005. This
      represents a decrease of 4%. Basic earnings per share for the three months
      ended
      September 30, 2006 and September 30, 2005, were $0.27 and $0.29, respectively.
      Diluted earnings per share for the three months ended September 30, 2006 and
      September 30, 2005, were $0.26 and $0.28, respectively.





The
      Company reported net income for the nine months ended September 30, 2006 of
      $5.0
      million compared to $4.8 million during the same period in 2005. This represents
      an increase of 4%. Basic earnings per share for the both the nine months ended
      September 30, 2006 and September 30, 2005, were $0.79. Diluted earnings per
      share for the nine months ended September 30, 2006 and September 30, 2005,
      were
      $0.76 and $0.74, respectively.





Year-to-date,
      non-interest expense increased to $15.4 million, compared to $13.9 million
      in
      the same period a year ago. At the end of 2005 the Company began a branding
      initiative which included an extensive assessment, both internally and
      externally of all bank delivery channels. Recommended actions were incorporated
      into a comprehensive Marketing Strategic Plan which is currently in process
      of
      implementation. The increase in non-interest expense has been primarily the
      result of expenses related to the branding project, the addition of staff
      including the EVP / Human Resources and EVP/Product Delivery and full service
      branch expansion within the bank’s existing footprint in the town of Templeton.
      The Company has invested significant resources in these new initiatives
      throughout 2006 in an effort to improve our service delivery and image and
      expect to continue the investment with the expectation of returns on these
      investments adding to shareholder value this year.





As
      a
      result of the increase in expenses, the efficiency ratio was 65.31% for the
      third quarter of 2006 compared to 61.08% for the same period in 2005. On a
      linked quarter basis, the efficiency ratio was 65.02% and 64.34% for the first
      and second quarter of 2006, respectively. The efficiency ratio measures
      non-interest expenses as a percent of revenues.





While
      earnings increased year over year for the nine months ended 2006 compared to
      the
      same period in 2005, earnings performance compared to quarter three and four
      in
      2005 has been impacted by the above noted strategic issues that have been
      implemented by the Company. These new initiatives are designed to improve future
      profitability through enhanced customer relationship management, service
      delivery and branding.




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.




20





The
        table
        below sets forth changes for the three and nine months ended September 30,
        2006
        compared to the same period in 2005 in regard to volume and rate associated
        with
        interest earning assets and interest bearing deposits.




Analysis
      of Changes in Net Interest Income (in thousands)




**Three
                  months ended**
              
              **Nine
                  months ended****September
                  30. 2006 over 2005**
              
              **September
                  30. 2006 over 2005**Volume
              
              Rate
              
              Total
              
              Volume
              
              Rate
              
              TotalInterest
                  income:Loans
                  (1)
              
              $
              746
              
              $
              1,043
              
              $
              1,789
              
              $
              1,711
              
              $
              2,970
              
              $
              4,681Investment
                  securities taxable
              
              
              (129
              )
              
              73
              
              
              (56
              )
              
              (426
              )
              
              176
              
              
              (250
              )Investment
                  securities non-taxable (2):
              
              
              44
              
              
              1
              
              
              45
              
              
              144
              
              
              (2
              )
              
              142Taxable
                  equivalent adjustment (2):
              
              
              (15
              )
              
              (0
              )
              
              (16
              )
              
              (49
              )
              
              1
              
              
              (49
              )Interest-bearing
                  deposits
              
              
              (0
              )
              
              5
              
              
              5
              
              
              (1
              )
              
              16
              
              
              15Federal
                  funds sold
              
              
              (554
              )
              
              415
              
              
              (139
              )
              
              (59
              )
              
              132
              
              
              73Net
                  increase (decrease)
              
              
              91
              
              
              1,537
              
              
              1,628
              
              
              1,319
              
              
              3,294
              
              
              4,613Interest
                  expense:Savings,
                  now, money market
              
              
              (37
              )
              
              155
              
              
              118
              
              
              (17
              )
              
              727
              
              
              710Time
                  deposits
              
              
              536
              
              
              315
              
              
              851
              
              
              980
              
              
              987
              
              
              1,967Other
                  borrowings
              
              
              33
              
              
              158
              
              
              191
              
              
              (92
              )
              
              172
              
              
              80Long
                  term borrowings
              
              
              -
              
              
              39
              
              
              39
              
              
              -
              
              
              125
              
              
              125Net
                  increase (decrease)
              
              
              532
              
              
              667
              
              
              1,199
              
              
              871
              
              
              2,011
              
              
              2,882Total
                  net increase (decrease)
              
              $
              (441
              )
              $
              870
              
              $
              429
              
              $
              448
              
              $
              1,283
              
              $
              1,731




(1)
        Loan
        fees of $303 and $347 for the three months ending September 30, 2006 and
        2005 ,
        respectively, and loan fees of $960 and $1,033 for the nine months ending
        September 30, 2006 and 2005, 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.
  21
 The
          table
          below sets forth the average balance sheet information, interest income
          and
          expense, average yields and rates and net interest income and margin for
          the
          three and nine months ended September 30, 2006 and September 30, 2005.
          The
          average balance of non-accruing loans has been included in loan totals.


**AVERAGE
        BALANCE SHEET INFORMATION**


**(dollars
                  in thousands)**
              
              **For
                  the three months ending September 30,**
              
              **For
                  the nine months ending September 30,****2006**
              
              
              
              
              
              **2005**
              
              
              
              
              
              **2006**
              
              
              
              
              
              **2005****Avg.**
              
              **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**
              
              **Interest**Investments
                  with other banks
              
              $
              318
              
              
              8.81
              %
              $
              7
              
              **$**
              **396**
              
              
              **2.02**
              **%**
              **$**
              **2**
              
              $
              314
              
              
              9.32
              %
              $
              22
              
              **$**
              **943**
              
              
              **0.99**
              **%**
              **$**
              **7**Investment
                  securities taxable
              
              
              26,366
              
              
              4.32
              %
              
              285
              
              
              **36,457**
              
              
              **3.74**
              **%**
              
              **341**
              
              
              28,161
              
              
              4.27
              %
              
              905
              
              
              **40,461**
              
              
              **3.80**
              **%**
              
              **1,155**Investment
                  securities non-taxable
              
              
              16,467
              
              
              4.30
              %
              
              177
              
              
              **13,684**
              
              
              **4.33**
              **%**
              
              **148**
              
              
              16,209
              
              
              4.31
              %
              
              525
              
              
              **13,265**
              
              
              **4.32**
              **%**
              
              **431**Federal
                  funds sold
              
              
              9,966
              
              
              5.26
              %
              
              131
              
              
              **31,250**
              
              
              **3.46**
              **%**
              
              **270**
              
              
              14,217
              
              
              4.80
              %
              
              513
              
              
              **18,606**
              
              
              **3.15**
              **%**
              
              **440**Loans
                  (1) (2)
              
              
              409,897
              
              
              8.75
              %
              
              8,968
              
              
              **373,200**
              
              
              **7.69**
              **%**
              
              **7,179**
              
              
              387,627
              
              
              8.40
              %
              
              24,475
              
              
              **358,233**
              
              
              **7.35**
              **%**
              
              **19,794**Total
                  interest earning assets
              
              
              463,014
              
              
              8.27
              %
              
              9,568
              
              
              **454,987**
              
              
              **6.98**
              **%**
              
              **7,940**
              
              
              446,528
              
              
              7.88
              %
              
              26,440
              
              
              **431,508**
              
              
              **6.73**
              **%**
              
              **21,827**Allowance
                  for possible loan losses
              
              
              (3,767
              )
              
              
              
              
              
              
              
              **(3,664**
              **)**
              
              
              
              
              
              
              
              (3,928
              )
              
              
              
              
              
              
              
              **(3,491**
              **)**Other
                  assets
              
              
              56,073
              
              
              
              
              
              
              
              
              **48,876**
              
              
              
              
              
              
              
              
              52,319
              
              
              
              
              
              
              
              
              **47,988**TOTAL
                  ASSETS
              
              $
              515,320
              
              
              
              
              
              
              
              **$**
              **500,199**
              
              
              
              
              
              
              
              $
              494,919
              
              
              
              
              
              
              
              **$**
              **476,005**Interest
                  -bearing liabilities:Savings/NOW/money
                  market
              
              
              154,539
              
              
              1.59
              %
              
              614
              
              
              **168,734**
              
              
              **1.18**
              **%**
              
              **496**
              
              
              163,506
              
              
              1.49
              %
              
              1,831
              
              
              **166,131**
              
              
              **0.90**
              **%**
              
              **1,121**Time
                  deposits
              
              
              119,162
              
              
              4.38
              %
              
              1,304
              
              
              **63,050**
              
              
              **2.87**
              **%**
              
              **453**
              
              
              101,354
              
              
              4.07
              %
              
              3,099
              
              
              **61,372**
              
              
              **2.45**
              **%**
              
              **1,132**Other
                  borrowings
              
              
              32,195
              
              
              5.33
              %
              
              429
              
              
              **29,251**
              
              
              **3.39**
              **%**
              
              **248**
              
              
              22,577
              
              
              5.01
              %
              
              851
              
              
              **31,439**
              
              
              **3.30**
              **%**
              
              **779**FF
                  Purchased
              
              
              652
              
              
              6.13
              %
              
              10
              
              
              **-**
              
              
              **0.00**
              **%**
              
              **-**
              
              
              305
              
              
              5.67
              %
              
              13
              
              
              **193**
              
              
              **3.45**
              **%**
              
              **5**Long
                  Term Debt
              
              
              8,248
              
              
              9.17
              %
              
              189
              
              
              **8,248**
              
              
              **7.27**
              **%**
              
              **150**
              
              
              8,248
              
              
              8.74
              %
              
              542
              
              
              **8,248**
              
              
              **6.72**
              **%**
              
              **417**Total
                  interest-bearing liabilities
              
              
              314,796
              
              
              3.24
              %
              
              2,546
              
              
              **269,283**
              
              
              **2.00**
              **%**
              
              **1,347**
              
              
              295,990
              
              
              2.85
              %
              
              6,336
              
              
              **267,383**
              
              
              **1.72**
              **%**
              
              **3,454**Demand
                  deposits
              
              
              148,215
              
              
              
              
              
              
              
              
              **184,756**
              
              
              
              
              
              
              
              
              147,908
              
              
              
              
              
              
              
              
              **164,940**Other
                  liabilities
              
              
              4,646
              
              
              
              
              
              
              
              
              **3,774**
              
              
              
              
              
              
              
              
              4,178
              
              
              
              
              
              
              
              
              **3,286**Stockholders'
                  equityCommon
                  stock
              
              
              29,589
              
              
              
              
              
              
              
              
              **28,909**
              
              
              
              
              
              
              
              
              29,506
              
              
              
              
              
              
              
              
              **27,717**Retained
                  earnings
              
              
              18,336
              
              
              
              
              
              
              
              
              **13,414**
              
              
              
              
              
              
              
              
              17,562
              
              
              
              
              
              
              
              
              **12,609**Valuation
                  Allowance Investments
              
              
              (262
              )
              
              
              
              
              
              
              
              **63**
              
              
              
              
              
              
              
              
              (225
              )
              
              
              
              
              
              
              
              **70**Total
                  stockholders' equity
              
              
              47,663
              
              
              
              
              
              
              
              
              **42,386**
              
              
              
              
              
              
              
              
              46,843
              
              
              
              
              
              
              
              
              **40,396**TOTAL
                  LIABILITIES AND STOCKHOLDERS'EQUITY
              
              $
              515,320
              
              
              
              
              
              
              
              **$**
              **500,199**
              
              
              
              
              
              
              
              $
              494,919
              
              
              
              
              
              
              
              **$**
              **476,005**Net
                  Interest Income
              
              
              
              
              
              
              
              $
              7,022
              
              
              
              
              
              
              
              **$**
              **6,593**
              
              
              
              
              
              
              
              $
              20,104
              
              
              
              
              
              
              
              **$**
              **18,373**Net
                  Interest Margin (3)
              
              
              
              
              
              6.07
              %
              
              
              
              
              
              
              
              **5.80**
              **%**
              
              
              
              
              
              
              
              **6.00**
              **%**
              
              
              
              
              
              
              
              **5.68**
              **%**




**(1)
        **Nonaccrual
        loans have been included in total loans.****
  **(2)
          **Loan
          fees of $303 and $347 for the three months ending September 30, 2006 and
          2005,
          respectively, and loan fees of $960 **and
          $1,033 for the nine months ending September 30, 2006 and 2005, 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.**
  22
 The
            tables below set forth changes for the three and nine months ending September
            30, 2006 compared to the same periods in 2005 for average interest earning
            assets and their respective average yields.
  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, 2006 were achieved under the Company’s established Loan
          Policy.





For
      the
      three and nine months ending September 30, 2006 compared to the same period
      in
      2005, the average yield on loans improved by 106 and 105 basis points,
      respectively. This has been primarily due to action by the Federal Reserve
      Bank
      of raising rates by 225 basis points from June 2005 through September 2006.
      See
“Item 3. Quantitative and Qualitative Disclosure about Market Risk” for further
      discussion.





The
      tax-exempt portion of the investment portfolio also increased as the Company
      selectively purchased securities available in the marketplace. The Company
      has
      significant ability to increase its holdings of tax-exempt securities before
      becoming subject to the Alternative Minimum Tax. The taxable investment
      portfolio gained in average yield due to extension of average life as the result
      of rising rates. Taxable investment securities decreased due to regular
      principal reductions on Mortgage Backed Securities (MBS).


Average
                      Balance
                  
                  
                  
                  
                  
                  Average
                      Yieldfor
                      the three months ending
                  
                  
                  
                  
                  
                  for
                      the three months ending(dollars
                      in thousands)
                  
                  September
                      30,
                  
                  $
                  
                  %
                  
                  September
                      30,Interest
                      Earning Assets:
                  
                  2006
                  
                  2005
                  
                  Variance
                  
                  Variance
                  
                  2006
                  
                  2005
                  
                  VarianceTime
                      deposits with other banks
                  
                  $
                  318
                  
                  $
                  396
                  
                  $
                  (78
                  )
                  
                  -19.70
                  %
                  
                  8.81
                  %
                  
                  2.02
                  %
                  
                  6.79
                  %Investment
                      securities taxable
                  
                  
                  26,366
                  
                  
                  36,457
                  
                  
                  (10,091
                  )
                  
                  -27.68
                  %
                  
                  4.32
                  %
                  
                  3.74
                  %
                  
                  0.58
                  %Investment
                      securities non-taxable
                  
                  
                  16,467
                  
                  
                  13,684
                  
                  
                  2,783
                  
                  
                  20.34
                  %
                  
                  4.30
                  %
                  
                  4.33
                  %
                  
                  -0.03
                  %Federal
                      funds sold
                  
                  
                  9,966
                  
                  
                  31,250
                  
                  
                  (21,284
                  )
                  
                  -68.11
                  %
                  
                  5.26
                  %
                  
                  3.46
                  %
                  
                  1.80
                  %Loans
                      (1) (2)
                  
                  
                  409,897
                  
                  
                  373,200
                  
                  
                  36,697
                  
                  
                  9.83
                  %
                  
                  8.75
                  %
                  
                  7.69
                  %
                  
                  1.06
                  %Total
                      interest earning assets
                  
                  $
                  463,014
                  
                  $
                  454,987
                  
                  $
                  8,027
                  
                  
                  1.76
                  %
                  
                  8.27
                  %
                  
                  6.98
                  %
                  
                  1.29
                  %
  Average
                      Balance
                  
                  
                  
                  
                  
                  Average
                      Yieldfor
                      the nine months ending
                  
                  
                  
                  
                  
                  for
                      the nine months ending(dollars
                      in thousands)
                  
                  September
                      30,
                  
                  $
                  
                  %
                  
                  September
                      30,Interest
                      Earning Assets:
                  
                  2006
                  
                  2005
                  
                  Variance
                  
                  Variance
                  
                  2006
                  
                  2005
                  
                  VarianceTime
                      deposits with other banks
                  
                  $
                  314
                  
                  $
                  943
                  
                  $
                  (629
                  )
                  
                  -66.70
                  %
                  
                  9.32
                  %
                  
                  0.99
                  %
                  
                  8.33
                  %Investment
                      securities taxable
                  
                  
                  28,161
                  
                  
                  40,461
                  
                  
                  (12,300
                  )
                  
                  -30.40
                  %
                  
                  4.27
                  %
                  
                  3.80
                  %
                  
                  0.48
                  %Investment
                      securities non-taxable
                  
                  
                  16,209
                  
                  
                  13,265
                  
                  
                  2,944
                  
                  
                  22.19
                  %
                  
                  4.31
                  %
                  
                  4.32
                  %
                  
                  -0.01
                  %Federal
                      funds sold
                  
                  
                  14,217
                  
                  
                  18,606
                  
                  
                  (4,389
                  )
                  
                  -23.59
                  %
                  
                  4.80
                  %
                  
                  3.15
                  %
                  
                  1.65
                  %Loans
                      (1) (2)
                  
                  
                  387,627
                  
                  
                  358,233
                  
                  
                  29,394
                  
                  
                  8.21
                  %
                  
                  8.40
                  %
                  
                  7.35
                  %
                  
                  1.05
                  %Total
                      interest earning assets
                  
                  $
                  446,528
                  
                  $
                  431,508
                  
                  $
                  15,020
                  
                  
                  3.48
                  %
                  
                  7.88
                  %
                  
                  6.73
                  %
                  
                  1.15
                  %


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




**(2)
        **Loan
        fees of $303 and $347 for the three months ending September 30, 2006 and
        2005,
        respectively, and loan fees of $960 **and
        $1,033 for the nine months ending September 30, 2006 and 2005, respectively
        been
        included in the interest income
        computation.******




From
      June
      2004 through September 2006, the Federal Reserve Bank increased rates by a
      total
      of 425 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.




23




The
      tables below sets forth changes for the three and nine months ending September
      30, 2006 compared to the same periods in 2005 for average interest bearing
      liabilities and their respective average rates paid.


Average
                  Balance
              
              
              
              
              
              Average
                  Ratefor
                  the three months ending
              
              
              
              
              
              for
                  the three months ending(dollars
                  in thousands)
              
              September
                  30,
              
              $
              
              %
              
              September
                  30,Interest
                  bearing liabilities:
              
              2006
              
              2005
              
              Variance
              
              Variance
              
              2006
              
              2005
              
              VarianceSavings/NOW/money
                  market
              
              $
              154,539
              
              $
              168,734
              
              $
              (14,195
              )
              
              -8.41
              %
              
              1.59
              %
              
              1.18
              %
              
              0.41
              %Time
                  deposits
              
              
              119,162
              
              
              63,050
              
              
              56,112
              
              
              89.00
              %
              
              4.38
              %
              
              2.87
              %
              
              1.51
              %Other
                  borrowings
              
              
              32,195
              
              
              29,251
              
              
              2,944
              
              
              10.06
              %
              
              5.33
              %
              
              3.39
              %
              
              1.94
              %FF
                  Purchased
              
              
              652
              
              
              -
              
              
              652
              
              
              100.00
              %
              
              6.13
              %
              
              0.00
              %
              
              6.13
              %Long
                  Term Debt
              
              
              8,248
              
              
              8,248
              
              
              -
              
              
              0.00
              %
              
              9.17
              %
              
              7.27
              %
              
              1.89
              %Total
                  interest-bearing liabilities
              
              $
              314,796
              
              $
              269,283
              
              $
              45,513
              
              
              16.90
              %
              
              3.24
              %
              
              2.00
              %
              
              1.24
              %
  Average
                  Balance
              
              
              
              
              
              Average
                  Ratefor
                  the nine months ending
              
              
              
              
              
              for
                  the nine months ending(dollars
                  in thousands)
              
              September
                  30,
              
              $
              
              %
              
              September
                  30,Interest
                  bearing liabilities:
              
              2006
              
              2005
              
              Variance
              
              Variance
              
              2006
              
              2005
              
              VarianceSavings/NOW/money
                  market
              
              $
              163,506
              
              $
              166,131
              
              $
              (2,625
              )
              
              -1.58
              %
              
              1.49
              %
              
              0.90
              %
              
              0.59
              %Time
                  deposits
              
              
              101,354
              
              
              61,372
              
              
              39,982
              
              
              65.15
              %
              
              4.07
              %
              
              2.45
              %
              
              1.62
              %Other
                  borrowings
              
              
              22,577
              
              
              31,439
              
              
              (8,862
              )
              
              -28.19
              %
              
              5.01
              %
              
              3.30
              %
              
              1.71
              %FF
                  Purchased
              
              
              305
              
              
              193
              
              
              112
              
              
              58.03
              %
              
              5.67
              %
              
              3.45
              %
              
              2.22
              %Long
                  Term Debt
              
              
              8,248
              
              
              8,248
              
              
              -
              
              
              0.00
              %
              
              8.74
              %
              
              6.72
              %
              
              2.02
              %Total
                  interest-bearing liabilities
              
              $
              295,990
              
              $
              267,383
              
              $
              28,607
              
              
              10.70
              %
              
              2.85
              %
              
              1.72
              %
              
              1.13
              %


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 2005, due to intensified competition, the Company implemented
      a
      Time Deposit/Money Market promotion that continues today. This has resulted
      in
      an increase in interest bearing deposits as well as an increase in deposit
      costs.




For
      the
      three months ending September 30, 2006 compared to the same period in 2005,
      the
      Company’s average yield on average interest earnings assets and average yield on
      average interest bearing liabilities increased by 128 basis points and 123
      basis
      points, respectively. For the nine months ending September 30, 2006 compared
      to
      the same period in 2005, the Company’s average yield on average interest
      earnings assets and average yield on average interest bearing liabilities
      increased by 115 basis points and 113 basis points, respectively.





The
      Company’s net interest margin improved as a result of the larger balances of
      interest earning assets as compared to interest bearing liabilities during
      both
      periods. This result is primarily driven by the presence of non-interest bearing
      deposits that also fund earning assets.




24




Non-Interest
      Income





The
      tables below set forth changes for the three and nine months ending September
      30, 2006 compared to the same period in 2005 for non-interest income.


Non-Interest
                  Income Components**For
                  Three Months Ended****September
                  30,**(dollars
                  in thousands)
              
              **2006**
              
              **2005**
              
              **$
                  Variance**
              
              **%
                  Variance**Service
                  Charges on Deposit Accounts
              
              $
              644
              
              $
              655
              
              $
              (11
              )
              
              -1.7
              %ATM/Debit
                  Card Transaction/Interchange Fees
              
              
              183
              
              
              170
              
              
              13
              
              
              7.6
              %Bancard
              
              
              35
              
              
              34
              
              
              1
              
              
              2.9
              %Mortgage
                  Origination Fees
              
              
              110
              
              
              296
              
              
              (186
              )
              
              -62.8
              %Earnings
                  on Cash Surrender Value Life Ins
              
              
              113
              
              
              88
              
              
              25
              
              
              28.4
              %Other
              
              
              137
              
              
              146
              
              
              (9
              )
              
              -6.2
              %Total
              
              $
              1,222
              
              $
              1,389
              
              $
              (167
              )
              
              -12.0
              %
  **For
                  Nine Months Ended****September
                  30,**(dollars
                  in thousands)
              
              **2006**
              
              **2005**
              
              **$
                  Variance**
              
              **%
                  Variance**Service
                  Charges on Deposit Accounts
              
              $
              1,826
              
              $
              1,825
              
              $
              1
              
              
              0.1
              %ATM/Debit
                  Card Transaction/Interchange Fees
              
              
              542
              
              
              464
              
              
              78
              
              
              16.8
              %Bancard
              
              
              89
              
              
              105
              
              
              (16
              )
              
              -15.2
              %Mortgage
                  Origination Fees
              
              
              410
              
              
              719
              
              
              (309
              )
              
              -43.0
              %Earnings
                  on Cash Surrender Value Life Ins
              
              
              289
              
              
              239
              
              
              50
              
              
              20.9
              %Other
              
              
              496
              
              
              435
              
              
              61
              
              
              14.0
              %Total
              
              $
              3,652
              
              $
              3,787
              
              $
              (135
              )
              
              -3.6
              %




For
      both
      the three months ending September 30, 2006 as compared to the same period in
      2005, non-interest income excluding Mortgage Origination Fees has remained
      relatively flat. The Company has experienced a modest increase in the electronic
      activity category of ATM/Debit Card Transaction/Interchange Fees due to the
      continuing migration of consumers to paperless transactions.





For
      both
      the three and nine months ended September 30, 2006 compared to the same period
      in 2005, Mortgage Origination Fees have been negatively impacted by reduced
      mortgage volumes as the result of a slowdown in both purchase and refinance
      activity. Home sales have slowed with builders beginning to offer additional
      buyer incentives and lower prices. The area still remains desirable with prices
      considerably lower than the major metropolitan areas to the Company’s North and
      South. Reasonable mortgage rates and financing options such as interest only
      mortgages and 40 year loans have kept many in the market. The table below
      illustrates the decline in activity in both number of loans and dollars.


**Mortgage
                  Origination Activity**($
                  in 000's)For
                  the 3 months
              
              
              
              For
                  the 9 monthsending
                  September 30,
              
              
              
              ending
                  September 30,2006
              
              2005
              
              Variance
              
              
              
              2006
              
              2005
              
              Variance$
                  Volume
              
              $
              18,185
              
              $
              33,612
              
              
              -46
              %
              
              $Volume
              
              $
              48,916
              
              $
              75,538
              
              
              -35
              %#
                  Loans
              
              
              31
              
              
              66
              
              
              -53
              %
              
              #
                  Loans
              
              
              147
              
              
              224
              
              
              -34
              %




25




Non-Interest
      Expenses





The
      tables below set forth changes for the three and nine months ending September
      30, 2006 compared to the same period in 2005 for non-interest expense.




Non-Interest
                  Expense Components**For
                  Three Months Ended****September
                  30,**(dollars
                  in thousands)
              
              **2006**
              
              **2005**
              
              **$
                  Variance**
              
              **%
                  Variance**Salaries
                  and Employee Benefits
              
              $
              2,965
              
              $
              2,532
              
              $
              433
              
              
              17.1
              %Occupany
                  and Equipment
              
              
              633
              
              
              600
              
              
              33
              
              
              5.5
              %Data
                  Processing
              
              
              517
              
              
              561
              
              
              (44
              )
              
              -7.8
              %Advertising
                  and promotional
              
              
              278
              
              
              175
              
              
              103
              
              
              58.9
              %Regulatory
                  fees
              
              
              28
              
              
              27
              
              
              1
              
              
              3.7
              %Other
                  professional fees and outside services
              
              
              286
              
              
              156
              
              
              130
              
              
              83.3
              %Legal
                  fees and other litigation expense
              
              
              30
              
              
              22
              
              
              8
              
              
              36.4
              %Loan
                  Department Costs
              
              
              30
              
              
              45
              
              
              (15
              )
              
              -33.3
              %Stationery
                  and supplies
              
              
              84
              
              
              72
              
              
              12
              
              
              16.7
              %Director
                  fees
              
              
              69
              
              
              70
              
              
              (1
              )
              
              -1.4
              %Core
                  Deposit Intangible Amortization
              
              
              75
              
              
              143
              
              
              (68
              )
              
              -47.6
              %Other
              
              
              389
              
              
              472
              
              
              (83
              )
              
              -17.6
              %Total
              
              $
              5,384
              
              $
              4,875
              
              $
              509
              
              
              10.4
              %
  **For
                  Nine Months Ended****September
                  30,**(dollars
                  in thousands)
              
              **2006**
              
              **2005**
              
              **$
                  Variance**
              
              **%
                  Variance**Salaries
                  and Employee Benefits
              
              $
              8,534
              
              $
              7,188
              
              $
              1,346
              
              
              18.7
              %Occupany
                  and Equipment
              
              
              1,901
              
              
              1,853
              
              
              48
              
              
              2.6
              %Data
                  Processing
              
              
              1,579
              
              
              1,678
              
              
              (99
              )
              
              -5.9
              %Advertising
                  and promotional
              
              
              632
              
              
              438
              
              
              194
              
              
              44.3
              %Regulatory
                  fees
              
              
              85
              
              
              77
              
              
              8
              
              
              10.4
              %Other
                  professional fees and outside services
              
              
              694
              
              
              399
              
              
              295
              
              
              73.9
              %Legal
                  fees and other litigation expense
              
              
              90
              
              
              80
              
              
              10
              
              
              12.5
              %Loan
                  Department Costs
              
              
              112
              
              
              116
              
              
              (4
              )
              
              -3.4
              %Stationery
                  and supplies
              
              
              221
              
              
              238
              
              
              (17
              )
              
              -7.1
              %Director
                  fees
              
              
              217
              
              
              175
              
              
              42
              
              
              24.0
              %Core
                  Deposit Intangible Amortization
              
              
              225
              
              
              430
              
              
              (205
              )
              
              -47.7
              %Other
              
              
              1,127
              
              
              1,189
              
              
              (62
              )
              
              -5.2
              %Total
              
              $
              15,417
              
              $
              13,861
              
              $
              1,556
              
              
              11.2
              %




Salary
      and Employee Benefits




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,
      2006 and 2005. The increase was primarily a result of increased expenses related
      to the addition of staff to enhance relationship management and the expansion
      of
      a full service branch within the bank’s existing footprint in the town of
      Templeton. The Bank hired the four Templeton staff members in April and May
      to
      allow time for intense training. In addition, the Bank instituted two new
      executive positions, one in Human Resources and one in Marketing. The HR
      position was filled in June 2006. The Marketing executive began the oversight
      of
      the branding initiatives in late 2005. Both executives are seasoned
      professionals in the banking industry.





Other
      Professional Fees and Outside Services




Other
      professional fees and outside services expenses increased for the quarter as
      a
      result of increases in a number of sub-categories including executive search
      expenses, consulting fees, audit fees, compliance and insurance costs. As
      competition within the primary market area has intensified, the Company has
      found it necessary to use the service of executive search firms when looking
      to
      either replace or add staff. In addition to this, during the second quarter
      of
      2006, the Company engaged a consulting firm to assist with compensation programs
      including base salary and bonus program assessment.




26





Advertising
      and Promotional




The
      increase in advertising and promotional expenses was primarily a result of
      increases in professional fees related to the new marketing initiatives designed
      to enhance customer relationship management, service delivery and
      branding.





Provision
      for Income Taxes





The
      provision for income taxes was 35.3% and 38.5% of net pre-tax income for the
      three months ending September 30, 2006, and 2005, respectively. The provision
      for income taxes was 36.2% and 37.8% of net pre-tax income for the nine months
      ending September 30 2006, and 2005, respectively.





FINANCIAL
      CONDITION ANALYSIS





Total
      assets of the Company were $488.5 million at December 31, 2005 compared to
      $532.4 million at September 30, 2006. This represents an increase of $43.9
      million or approximately 9%.





Loans





The
      table
      below sets forth changes from December 31, 2005 to September 30, 2006 for the
      composition of the loan portfolio.




Major
                  classifications of loans were:**September
                  30,**
              
              **December
                  30,****2006**
              
              **2005**
              
              **$
                  Variance**
              
              **%
                  Variance****(in
                  thousands)**Commercial,
                  financial, and agricultural
              
              $
              75,627
              
              $
              60,050
              
              
              15,577
              
              
              25.94
              %Real
                  estate-construction/land
              
              
              101,665
              
              
              76,981
              
              
              24,684
              
              
              32.07
              %Real
                  estate - other
              
              
              229,070
              
              
              210,690
              
              
              18,380
              
              
              8.72
              %Home
                  equity lines of credit
              
              
              11,777
              
              
              14,398
              
              
              (2,621
              )
              
              -18.20
              %Installment
                  loans to individuals
              
              
              5,660
              
              
              5,620
              
              
              40
              
              
              0.71
              %All
                  other loans (including overdrafts)
              
              
              867
              
              
              394
              
              
              473
              
              
              120.05
              %424,666
              
              
              368,133
              
              
              56,533
              
              
              15.36
              %Less
                  - deferred loan fees, net
              
              
              (1,489
              )
              
              (1,617
              )
              
              128
              
              
              -7.92
              %Less
                  - reserve for possible loan losses
              
              
              (3,863
              )
              
              (3,881
              )
              
              18
              
              
              -0.46
              %Total
                  loans
              
              
              419,314
              
              
              362,635
              
              
              56,679
              
              
              15.63
              %Loans
                  Held For Sale
              
              $
              2,069
              
              $
              3,392
              
              
              (1,323
              )
              
              -39.00
              %





The
      increase in commercial, financial and agricultural loans is attributed primarily
      to a $2.3 million new line of credit to a winery, a $5 million line of credit
      to
      a financial services company, an $8 million line of credit to a title company
      that is collateralized by marketable securities, a $1.9 million agriculture
      property loan, $3.4 million to acquire 3 restaurants and several other new
      $.5
      to $1 million business credit lines to medical groups, contractors and others.





The
      increase in real estate-construction and land loans can be attributed to several
      large new construction projects and the funding of existing construction
      projects. New loans include a strip center for $4.0 million, a $6.7 million
      medical office complex, an office complex for $1.7 million, an office building
      for $1.2 million, a $1.2 million hotel site land loan, a spec residence for
      $1.6
      million, an apartment construction loan increase of $1.8 million, a meat
      processing facility for $1.2 million, a 4 home development for $2.2 million,
      a
      spec residence for $1.2 million, 4 loans on land for tract development of $2.4,
      $1.3, $1.2 & $1.2 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.




27





The
      increase in real estate-mortgage loans is attributed to several new loans
      including a hotel for $5.4 million, a theatre complex for $7.3 million,
      restaurant properties for $2.6 million, a medical office for $1 million, a
      gas
      station for $2 million, an auto dealership for $1.2 million, a RV park for
      $1.2
      million, an office building for $1.0 million and several smaller real estate
      loans. During the period, numerous loans were also refinanced and paid off
      through out of area lenders and mortgage brokers.





The
      Bank
      presently has a concentration of loans in construction/land in the amount of
      $101.7 million which represents 188% of the Bank’s Total Risk Based capital. Of
      this, 57% are owner occupied thus the concentration is 131% net of owner
      occupied. Un-disbursed commitments total $48.6 million which combined with
      disbursed represent 278.6% of the Bank’s Total Risk based Capital with 86% owner
      occupied. At September 30, 2006 there were 85 construction loans with
      outstanding balances and remaining commitments of approximately $76.6 million
      and $48.6 million, respectively. The single largest construction loan, an office
      complex in San Luis Obispo, has a commitment amount of approximately $10.7
      million with a balance of approximately $3.9 million at September 30, 2006.
      A
      portion of the project has been sold with a $5.1 million principal reduction.
      At
      September 30, 2006, there were 61 land loans with balances of approximately
      $25.0 million. The single largest land loan accounts for approximately $1.6
      million of the total and is for a mixed use development. While these loans
      may
      be considered somewhat riskier than certain other real estate loans, the
      construction/land loans are spread throughout the Company’s market area and have
      consistently performed in a satisfactory manner.





Single
      family residence construction loans represent 15.48% of the total construction
      and land loan commitments. Land loans account for 17.61%, tract for .22%,
      multiple family income properties for 11.04%, owner occupied commercial for
      31.06% and non-owner occupied commercial properties for 24.60%.





Hotel
      loans disbursed are not considered to be a concentration with balances of $41.9
      million which represents 78% of the Bank’s Total Risk Based Capital. However,
      there are several hotel construction loans that increase total outstanding
      to
      $58.6 million and total commitments to $62.4 million which represents a
      concentration at 115.54% of the Bank’s Total Risk Based Capital. At September
      30, 2006, there were 34 motel loans. The single largest loan has a commitment
      of
      approximately $6.3 million, was made to a nationally known chain and is located
      in Paso Robles, California. The hotel loans are also made to clients throughout
      the Company’s markets. These loans have also typically paid as agreed.





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 were deposited with the Bank with $.8
      million remaining at September 30, 2006. These funds are being used for capital
      improvements to the assisted living facility. The project is complete and
      lease-up is under way. The letter of credit will expire in September
      2007.





Construction
      loan demand for both single family and commercial real estate moderated during
      the first quarter of 2006 and then increased during the second and third
      quarters. Increased interest rates and construction costs impacted commercial
      real estate activity. Home sales have slowed with builders beginning to offer
      additional buyer incentives and lower prices. The area still remains desirable
      with prices considerably lower than the major metropolitan areas to the
      Company’s North and South. Reasonable mortgage rates and financing options such
      as interest only mortgages and 40 year loans have kept many in the market.
      The
      continued availability of land for subdivision use also continued to drive
      the
      market in the North San Luis Obispo County and Santa Maria markets. Builders
      are
      moving to the more rural communities in order to construct more affordable
      homes.





Business
      properties are also in demand with low vacancies and competitive but increasing
      loan rates. Commercial property values and rental rates increased substantially
      during 2005 and have slowed somewhat thus far in 2006. Investors, many seeking
      exchange properties, continue to seek properties in the Company’s market area.
      Capitalization rates have steadily decreased with increased demand.
      Capitalization rate (the rate at which a stream of future cash flows is
      discounted to find the present value) ranges over the last three years are:
      2003- 7.0% to 8.0%, 2004- 6.5% to 7.5% and 2005- 5.5% to 6.5%. Commercial
      properties typically require larger down payments in order to satisfy bank
      debt
      coverage requirements. The Bank expects to experience continued growth in
      commercial real estate loans during 2006. Interest rate margins are expected
      to
      decrease somewhat do to competitive pressures and increasing cost of
      funds.





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, 2006, the Bank had no foreign loans outstanding. The Bank did
      not
      have any concentrations of loans except as disclosed above.




28





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.





The
      Bank’s provision for loan losses was $180 thousand for the three months ended
      September 30, 2006 compared to $170 thousand for the same period in
      2005.  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 nine 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.





During
      the second quarter of 2006, the Bank recognized a $500,000 write down on a
      single account receivable loan. The bank has identified this as not indicative
      of a deterioration of overall loan quality. Management believes that the
      allowance for credit losses at September 30, 2006 is adequate based on
      information currently available.





Loans
      on
      non-accrual status totaled $54 thousand and $183 thousand at December 31, 2005
      and September 30, 2006, respectively. Typically, these loans have adequate
      collateral protection and/or personal guaranties to provide a source of
      repayment to the Bank. Loans on non-accrual consist of six loans most of which
      are related to 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 $87 thousand and $47 thousand  for
      the
      period ended December 31, 2005 and September 30, 2006,
      respectively.





Non-performing
      loans include non-accrual loans, restructured loans and accruing loans that
      are
      90 days or more delinquent. Non-performing loans totaled $52 thousand at
      December 31, 2005 and $183 thousand at September 30, 2006. There were no loans
      past due 90 days or more and still accruing interest at September 30, 2006.




Non-performing
      loans were 0.01% and 0.04% of total assets as of December 31, 2005 and September
      30, 2006, respectively. The allowance for loan loss to non-performing loans
      was
      74.3x and 21.2x at December 31, 2005 and September 30, 2006, respectively.





Total
      Cash and Due from Banks





Total
      cash and due from banks were $18.3 million and $18.0 million at December 31,
      2005 and September 30, 2006, 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.




29




The
      table
      below sets forth changes from December 31, 2005 to September 30, 2006 for the
      composition of other earning assets. Investments available-for-sale decreased
      due to cash flow on Mortgage Backed Securities (MBS) and Collateralized Mortgage
      Obligations (CMO). Overnight liquidity in the form of Federal Funds Sold
      decreased due to loan demand outpacing deposit growth.


**COMPOSITION
                  OF OTHER EARNING ASSETS****September
                  30,**
              
              **December
                  31,****2006**
              
              **2005**
              
              **$
                  Variance**
              
              **%
                  Variance****(in
                  thousands)**Federal
                  Home Loan Bank, and other stock
              
              $
              1,955
              
              $
              1,885
              
              $
              70
              
              
              3.71
              %Available-for-Sale
                  Investments
              
              
              40,294
              
              
              44,402
              
              $
              (4,108
              )
              
              -9.25
              %Federal
                  Funds Sold
              
              
              14,195
              
              
              26,280
              
              $
              (12,085
              )
              
              -45.99
              %Interest
                  Bearing Deposits other fin inst.
              
              
              318
              
              
              298
              
              
              20
              
              
              6.71
              %Total
                  Other Earning Assets
              
              $
              56,762
              
              $
              72,865
              
              $
              (16,103
              )
              
              -22.10
              %





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, 2005, net unrealized losses in the portfolio were
      $158 thousand compared to a net unrealized gain of $183 thousand at September
      30, 2006. This change in market value was driven by the slope of the yield
      curve
      becoming more inverted with long term rates, the 30-Year T-Bill as much as
      26bp
      lower than the 6 month T-Bill at September 30, 2006. The portfolio decreased
      in
      size due to principle reductions on MBS and CMOs.





At
      September 30, 2006, 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.




30




Deposits
      and Borrowed Funds





The
      table
      below sets forth changes from December 31, 2005 to September 30, 2006 for the
      composition of deposit categories.




**%
                  of Total****September
                  30,**
              
              **December
                  31,**
              
              
              
              
              
              **Deposits****(in
                  thousands)**
              
              **2006**
              
              **2005**
              
              **$
                  Variance**
              
              **%
                  Variance**
              
              **30-Sep-06**Deposits:Demand,
                  non-interest bearing
              
              $
              157,180
              
              $
              164,014
              
              
              (6,834
              )
              
              -4.17
              %
              
              36.5
              %Interest
                  bearing demand
              
              
              46,100
              
              
              50,598
              
              
              (4,498
              )
              
              -8.89
              %
              
              10.7
              %Savings
              
              
              24,755
              
              
              29,386
              
              
              (4,631
              )
              
              -15.76
              %
              
              5.8
              %Money
                  market
              
              
              81,178
              
              
              90,122
              
              
              (8,944
              )
              
              -9.92
              %
              
              18.9
              %Time
                  deposits of $100 or more
              
              
              31,782
              
              
              17,414
              
              
              14,368
              
              
              82.51
              %
              
              7.4
              %Time
                  deposits under $100
              
              
              89,277
              
              
              66,263
              
              
              23,014
              
              
              34.73
              %
              
              20.7
              %Total
                  deposits
              
              $
              430,272
              
              $
              417,797
              
              $
              12,475
              
              
              2.99
              %
              
              100
              %





Acquisition
      of core, low cost deposits has become the single biggest challenge facing the
      Company. Still, 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. A shift to higher balances in
      time deposits is the result of fierce competition for deposits coupled with
      funding requirements for loans.





For
      the
      Company, at September 30, 2006, non-interest bearing demand deposits provide
      37%
      of total deposits compared to 39% at December 31, 2005. At December 31, 2005
      and
      September 30, 2006, the Bank had three deposit relationships that it considers
      to be volatile. These deposits are held by three customers of the Bank that
      engage in mortgage related activities. As a percentage of total deposits, these
      accounts represented 12.5% or $52.2 million at December 31, 2005 compared to
      10.1% or $43.6 million at September 30, 2006. 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 $398.5 million represented
      92.6% of total deposits at September 30, 2006. The Company does not purchase
      funds through deposit brokers.





In
      October 2005, the Company renewed a Promissory Note with Pacific Coast Bankers
      Bank (PCBB) for a revolving line of credit in the amount of $3.5 million. At
      September 30, 2006, the Company had a zero balance outstanding on this note.
      The
      Company pledged 646,598 shares (51%) of the Bank’s stock as collateral for the
      loan. The note is revolving in nature for the first two years. The terms of
      the
      note call for quarterly interest only payments for the first two years with
      subsequent principal and interest payments for eight years on a fully amortized
      basis. At September 30, 2006, the interest rate on the note was 8.25% 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.




31




The
      Bank
      has established borrowing lines with the Federal Home Loan Bank (FHLB). At
      September 30, 2006, the Bank had borrowings with the FHLB of $40.0 million
      collateralized by loans. The table below sets forth the various
      advances:




**Amount**
              
              **Interest**
              
              **Maturity****Borrowed**
              
              **Rate**
              
              **Variable/Fixed**
              
              **Date**$
                  10,000
              
              
              5.39
              
              
              Variable-
                  Daily
              
              
              28-Sep-07$
                  10,000
              
              
              5.44
              
              
              Fixed
              
              
              26-Feb-07$
                  10,000
              
              
              5.50
              
              
              Fixed
              
              
              25-Jul-07$
                  10,000
              
              
              5.28
              
              
              Fixed
              
              
              24-Nov-06




At
      maturity, Management will assess balance sheet needs and determine how much
      if
      any and at what term it will borrow from the FHLB.





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, 2006, the Bank has a remaining borrowing capacity with existing
      collateral of approximately $57.6 million and $9.7 million secured by loans
      and
      securities, respectively.





The
      Bank
      utilizes securities sold under repurchase agreements as a source of funds.
      The
      Bank had $3.8 million in securities sold under repurchase agreements at December
      31, 2005 compared to $1.2 million at September 30, 2006.





Capital





The
      Company's total stockholders equity was $44.8 million at December 31, 2005
      compared to $48.4 million at September 30, 2006. The increase in capital was
      due
      to net income of $5.0 million, stock options exercised in the amount of $559
      thousand, the capital impact of stock options expense of $83 thousand, $2.1
      million paid for a cash dividend, $249 thousand paid to repurchase the Company’s
      stock and an increase in accumulated other comprehensive income of $269
      thousand.




On
      October 20, 2006, the Board of Directors declared a quarterly cash dividend
      of
      $.08 to be paid on November 17, 2006 to shareholders of record on November
      3,
      2006. In addition, the Board of Directors adopted a resolution to increase
      the
      number of shares to 100,000 for the repurchase plan that was adopted in July
      2006. Purchases are to be made, as conditions warrant, from time to time in
      the
      open market. The duration of the program is one year and the timing of purchases
      will depend on market conditions. During the three months ending September
      30,
      2006, 15,000 shares of the Company’s stock was repurchased.





On
      July
      21, 2006, the Board of Directors declared a quarterly cash dividend of $.08
      to
      be paid on August 25, 2006 to shareholders of record on August 11, 2006. In
      addition, the Board of Directors adopted a resolution authorizing the repurchase
      of up to 40,000 shares of Company stock. Purchases are to be made, as conditions
      warrant, from time to time in the open market. The duration of the program
      is
      one year and the timing of purchases will depend on market conditions. Under
      this program, during the third quarter of 2006, the Company purchased 15,000
      shares at an average price of $16.56 per share.





On
      April
      21, 2006 the Company declared a $0.25 per share special cash dividend to be
      paid
      on May 19, 2006 to shareholders of record on May 8, 2006. The special dividend
      was declared in lieu of recent annual stock dividends the Company has declared.





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.
      On October 21, 2005, the Board of Directors declared a 50% stock split payable
      on December 2, 2005 to stockholders of record on November 10, 2005. The
      Consolidated Statements of Stockholders’ Equity found under “Item 1. Financial
      Statements” in this document reflects the 5% stock dividend and the 50% stock
      split.




32




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 8.99% as of September 30, 2006. 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.




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, 2006, the Company
      has included the net junior subordinated debt in its Tier1 Capital for
      regulatory capital purposes.





At
      September 30, 2006, the Company had sufficient cash to service the existing
      $8.2
      million in junior subordinated debenture interest payments for approximately
      two
      quarters without dividends from subsidiaries. The Bank’s capacity to provide
      cash to the Company, while remaining “well-capitalized”, was $5.4 million at
      September 30, 2006.





It
      is
      widely known in the banking and investment community that pricing on these
      debt
      securities has changed dramatically since the Company issued $8 million in
      2002.
      As the market’s appetite for these debt securities grew from 2002 through 2005,
      pricing eased as well as costs associated with the transactions. With the
      opportunity to call the existing debt securities in April 2007 and given the
      fact that pricing has been tightening since late 2005 due to the significant
      amount of debt securities that are becoming callable, the Company has determined
      that early in the fourth quarter of 2006, it will issue an additional $8 million
      in debt securities. The cost of the debt, net of income generated on the
      proceeds is estimated to have less than a $.01 impact to EPS for the remainder
      of 2006. It is anticipated that the cost for the newly issued debt securities
      will be approximately 200bp less than those issued in 2002. Management will
      review whether to use these proceeds to eliminate or reduce the existing debt
      securities in April 2007. Costs in the amount of $282 thousand that were
      associated with the original issuance were amortized to the call date of April
      2007 thereby eliminating any write-down if the securities are called. The cost
      associated with the potential new issue of debt securities is anticipated to
      be
      less than $15 thousand. To this end, on October 27, 2006, the Company issued
      $8,248,000 of Floating Rate Junior Subordinated Deferrable Interest Debentures
      (the “debt securities”) to Heritage Oaks Capital Trust II, 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 January 1, 2037. Interest is payable quarterly on these debt
      securities at 3-Month LIBOR plus 1.72% for an effective rate of 7.10% as of
      September 30, 2006. The debt securities can be called at any time commencing
      on
      January 1, 2012, at par. The Company also purchased a 3% minority interest
      totaling $248 thousand in Heritage Oaks Capital Trust II. The balance of the
      equity of Heritage Oaks Capital Trust II is comprised of mandatorily redeemable
      preferred securities and is included in other assets.





The
      Company intends to use the proceeds of the sale of the Trust Preferred
      Securities for general corporate purposes which may include investment in the
      Bank, acquisitions, investments, payment of dividends and repurchased of our
      outstanding common stock.




33





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, 2006.




Regulatory
                  StandardAdequately
              
              Well
              
              Heritage
                  Oaks
              
              Heritage
                  OaksCapitalized
              
              Capitalized
              
              Bancorp
              
              BankLeverage
                  Ratio
              
              
              4.00
              %
              
              5.00
              %
              
              9.86
              %
              
              9.94
              %Tier
                  One Risk Based Captial Ratio
              
              
              4.00
              %
              
              6.00
              %
              
              10.35
              %
              
              10.27
              %Total
                  Risk Based Captial Ratio
              
              
              8.00
              %
              
              10.00
              %
              
              11.18
              %
              
              11.10
              %




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 $13.4 million.
      At September 30, 2006, 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 $67 million.





The
      Bank
      manages liquidity by maintaining a majority of the investment portfolio in
      federal funds sold and other liquid investments. At September 30, 2006, the
      ratio of liquid assets not pledged for collateral and other purposes to deposits
      and other liabilities was 11.6% compared to 16.1% at December 31, 2005. The
      ratio of net loans to deposits, another key liquidity ratio, was 97.5% at
      September 30, 2006 compared to 86.8% at December 31, 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
      four-year period ended September 30, 2006 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 two
      years, a widening of the net interest margin. However, inflation has not been
      a
      factor in the customer’s ability to repay debt.




34




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, 2005 10-K.





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, 2005 10-K.





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.





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.




35




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. Management believes the results for the Company’s September 30,
      2006 balances indicate that the net interest income at risk over a one year
      time
      horizon for a 1% and 2% rate increase and decrease is acceptable at this
      time.




(dollars
      in thousands)




**Shock
                  Rate Scenarios****-200bp**
              
              **-100bp**
              
              **Base**
              
              **+100bp**
              
              **+200bp****Net
                  Interest****Income
                  (NII)**
              
              $
              24,954
              
              $
              26,053
              
              $
              27,221
              
              $
              28,239
              
              $
              29,264**$
                  Change from Base**
              
              $
              (2,267
              )
              $
              (1,168
              )
              $
              -
              
              $
              1,018
              
              $
              2,043**%
                  Change from Base**
              
              
              -8.33
              %
              
              -4.29
              %
              
              0.00
              %
              
              3.74
              %
              
              7.50
              %




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)




**%
                  of****Loans**
              
              **Balance**
              
              **Total**Variable-Daily
              
              $
              182,855
              
              
              43
              %Variable
                  Other than Daily
              
              
              192,068
              
              
              45
              %Fixed
              
              
              49,743
              
              
              12
              %Total
                  Gross Loans
              
              $
              424,666
              
              
              100
              %




**Total
                  Gross Loans**
              
              **%
                  of****Re-Pricing**
              
              **Balance**
              
              **Total**<
                  1 Year
              
              $
              260,095
              
              
              61
              %1-3
                  Years
              
              
              98,298
              
              
              23
              %3-5
                  Years
              
              
              51,716
              
              
              12
              %>
                  5 Years
              
              
              14,557
              
              
              4
              %$
              424,666
              
              
              100
              %




The
      table
      above identifies approximately 43% of the loan portfolio that will re-price
      immediately in a changing rate environment.




36




Item
      4.  Controls
      and Procedures





Evaluation
      of Disclosure Controls and Procedures





As
      of the
      end of the period covered by this report, the Company carried out an evaluation,
      under the supervision and with the participation of its management, including
      the Company’s Chief Executive Officer and Chief Financial Officer, of the
      effectiveness of the design and operation of the Company’s disclosure controls
      and procedures pursuant to Exchange Act 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, 2006 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
      1A.Risk Factors




During
      the period covered by this report there were no material changes from risk
      factors as previously disclosed in the Company’s December 31, 2005 10k in
      response to Item A
      to Part
      I of Form 10k.





Item
      2.  Changes
      in Securities, Use of Proceeds and Issuer Purchases of Equity
      Securities





**Unregistered
      Sale of Equity Securities**





None





**Purchases
      of Equity Securities**





On
      July
      21, 2006, the Company adopted a one year stock repurchase program in the initial
      amount of 40,000 shares. In October 2006, the Company approved an increase
      in
      the stock repurchase program to a total of 100,000 shares. Under the publicly
      announced stock repurchase program, the Company has been acquiring our common
      stock shares in the open market from time to time.




37




The
      table
      below summarizes our monthly repurchases and redemptions of our common equity
      securities during the three months ended September 30, 2006.




Total
                  Number of Sharesthat
                  may yet beTotal
                  Number
              
              Average
              
              Purchased
                  Under theof
                  Shares
              
              Price
                  Paid
              
              Publicly
                  AnnouncedPeriod
              
              Purchased
              
              Per
                  Share
              
              PlanJuly
                  1 - 31, 2006
              
              
              N/A
              
              
              N/A
              
              
              40,000August
                  1 - 31, 2006
              
              
              15,000
              
              $
              16.56
              
              
              25,000September
                  1 - 30, 2006
              
              
              -
              
              $
              -
              
              
              25,000Total
              
              
              15,000
              
              $
              16.56
              
              
              85,000
              (1)





1)
              Includeds
                  the additional 60,000 shares added to the repurchase plan in October
                  2006.


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
      (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




38




SIGNATURES





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





HERITAGE
      OAKS BANCORP




DATE:
      November 3, 2006




/s/
                Lawrence P. WardLawrence
              P. Ward
              President
              Chief
                Executive Officer


/s/
                Margaret A. TorresMargaret
              A. Torres
              Chief
                Financial Officer
              Executive
                Vice President


39





EXHIBIT
      INDEX





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




40