**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**


**FORM
      10-Q**







x
            QUARTERLY
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30,
                2008.





OR





 ̈
            TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934 FOR THE TRANSITION PERIOD FROM _______ to
                _______.





**COMMISSION
      FILE NUMBER: 000-25020**





**HERITAGE
      OAKS BANCORP**


(Exact
      name of registrant as specified in charter)




**STATE
                OF CALIFORNIA**
            
            ******77-0388249**(State
                or other jurisdiction of
              incorporation
                or organization)
            
            (I.R.S.
                Employer Identification No.)





**545
      12th STREET, PASO ROBLES, CA 93446**


(Address
      of principal office) (Zip Code)





**(805)
      369-5200**


(Registrant's
      telephone number, including area code)





**Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding twelve (12) months (or for such shorter period that the registrant
      was
      required to file such reports), and (2) has been subject to such filing
      requirements for the past ninety (90) days.**





**YES** **x** **NO** ** ̈**





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





**Large
      Accelerated filer** ** ̈** **Accelerated
      filer** **x** **Non-accelerated
      filer** ** ̈** **Smaller
      Reporting Company** ** ̈**





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





**YES** ** ̈** **NO** **x**





**Indicate
      the number of shares outstanding of each of the issuer's classes of common
      stock, as of the latest practicable date: As of July 29, 2008 there were
      approximately 7,709,600 shares outstanding of the Registrant’s common stock.**













**Heritage
      Oaks Bancorp and Subsidiaries**


**Table
      of Contents**





**Part
                1. Financial Information**
            3**Item
                1. Consolidated Financial Statements (Un-audited, except for Balance
                Sheet
                as of 12/31/2007)**
            3Consolidated
                Balance Sheets
            4Consolidated
                Statements of Income
            5Consolidated
                Statements of Stockholders’ Equity
            6Consolidated
                Statements of Comprehensive Income
            7Consolidated
                Statements of Cash Flows
            8**Notes
                to Consolidated Financial Statements**
            9Note
                1 – Consolidated Financial Statements
            9Note
                2 – Investment Securities
            10Note
                3 – Loans and the Allowance for Loan Losses
            11Note
                4 – Earnings Per Share
            12Note
                5 – Recent Accounting Pronouncements
            13Note
                6 – Share Based Compensation
            15Note
                7 – Fair Value of Financial Instruments
            17Note
                8 – Goodwill
            19Note
                9 – Reclassifications
            19**Item
                2. Management’s Discussion and Analysis of Financial Condition and Results
                of Operations**
            20The
                Company
            20Where
                You Can Find More Information
            20Earnings
                and Financial Condition Overview
            21Recent
                Developments
            22Stock
                Repurchases and Dividends
            23Selected
                Financial Data
            24Local
                Economy
            24Critical
                Accounting Policies
            24Results
                of Operations
            26Net
                Interest Income and Margin
            26Non-Interest
                Income
            31Non-Interest
                Expenses
            32Financial
                Condition Analysis
            34Loans
            34Non-Performing
                Assets
            38Total
                Cash and Due From Banks
            39Investment
                Securities and Other Earning Assets
            39Deposits
                and Borrowed Funds
            41Capital
            42Liquidity
            45Inflation
            45Off-Balance
                Sheet Arrangements
            46**Item
                3. Quantitative and Qualitative Disclosure about Market
                Risk**
            46**Item
                4. Controls and Procedures**
            48**Part
                2. Other Information**
            48**Item
                1. Legal Proceedings**
            48**Item
                1.A. Risk Factors**
            48**Item
                2. Unregistered Sales of Equity Securities and Use of
                Proceeds**
            48**Item
                3. Defaults Upon Senior Securities**
            49**Item
                4. Submission of Matters to a Vote of Security
                Holders**
            49**Item
                5. Other Information**
            49**Item
                6. Exhibits**
            50**Signatures**
            51**Certifications****Exhibits**




-
            2
            -





**Part
      1. Financial Information**





**Item
      1. Consolidated Financial Statements**





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





-
            3
            -




**HERITAGE
      OAKS BANCORP**


**CONSOLIDATED
      BALANCE SHEETS**


*(dollar
      amounts in thousands)*





**(Unaudited)**
            
            **(1)****June 30,**
            
            **December 31,****2008**
            
            **2007****Assets**Cash
                and due from banks
            
            $
            27,346
            
            $
            23,254Federal
                funds sold
            
            
            15,660
            
            
            23,165Total
                cash and cash equivalents
            
            
            43,006
            
            
            46,419Interest
                bearing deposits with other banks
            
            
            131
            
            
            330Securities
                available for sale
            
            
            57,064
            
            
            47,556Federal
                Home Loan Bank stock, at cost
            
            
            5,401
            
            
            3,045Loans
                held for sale
            
            
            1,246
            
            
            902Loans,
                net (2)
            
            
            649,928
            
            
            605,342Property,
                premises and equipment, net
            
            
            6,524
            
            
            6,390Bank
                owned life insurance
            
            
            10,527
            
            
            9,923Deferred
                tax assets
            
            
            5,799
            
            
            5,290Goodwill
            
            
            11,541
            
            
            10,911Core
                deposit intangible
            
            
            4,121
            
            
            4,551Other
                real estate owned
            
            
            197
            
            
            -Other
                assets
            
            
            4,600
            
            
            4,895**Total
                assets**
            
            $
            800,085
            
            $
            745,554**Liabilities**Demand,
                non-interest bearing
            
            $
            168,589
            
            $
            153,684Savings,
                NOW, and money market deposits
            
            
            293,799
            
            
            317,911Time
                deposits of $100 or more
            
            
            79,756
            
            
            75,966Time
                deposits under $100
            
            
            92,374
            
            
            97,247Total
                deposits
            
            
            634,518
            
            
            644,808FHLB
                advances and other borrowed money
            
            
            71,500
            
            
            8,000Securities
                sold under agreement to repurchase
            
            
            2,718
            
            
            1,936Junior
                subordinated debentures
            
            
            13,403
            
            
            13,403Other
                liabilities
            
            
            7,074
            
            
            7,957Total
                liabilities
            
            
            729,213
            
            
            676,104Commitments
                and contingencies
            
            
            -
            
            
            -**Stockholders'
                Equity**Common
                stock, no par value; 20,000,000 shares authorized; issued and outstanding
                7,709,929 and 7,683,829 as of June 30, 2008 and December 31, 2007,
                respectively.
            
            
            48,456
            
            
            43,996Additional
                paid in capital
            
            
            839
            
            
            672Retained
                earnings
            
            
            22,140
            
            
            24,598Accumulated
                other comprehensive income
            
            
            (563
            )
            
            184Total
                stockholders' equity
            
            
            70,872
            
            
            69,450**Total
                liabilities and stockholders' equity**
            
            $
            800,085
            
            $
            745,554





(1)
            These
                numbers have been derived from the audited financial
                statements.


(2)
            Loans
                net of deferred fees of $1,756 and $1,732 and allowance for loan
                losses of
                $8,128 and $6,143 at June 30, 2008 and December 31, 2007,
                respectively.





See
      notes
      to condensed consolidated financial statements.





-
            4
            -




**HERITAGE
      OAKS BANCORP**


**CONSOLIDATED
      STATEMENTS OF INCOME (UNAUDITED)**


*(dollar
      amounts in thousands except per share data)*





**For the three months**
            
            **For the six months****ended June 30,**
            
            **ended June 30,****2008**
            
            **2007**
            
            **2008**
            
            **2007****Interest
                Income:**Interest
                and fees on loans
            
            $
            11,732
            
            $
            10,214
            
            $
            23,823
            
            $
            20,029Investment
                securities
            
            
            794
            
            
            437
            
            
            1,450
            
            
            885Federal
                funds sold and commercial paper
            
            
            45
            
            
            162
            
            
            112
            
            
            193Time
                certificates of deposit
            
            
            3
            
            
            10
            
            
            6
            
            
            18Total
                interest income
            
            
            12,574
            
            
            10,823
            
            
            25,391
            
            
            21,125**Interest
                Expense:**Now
                accounts
            
            
            162
            
            
            43
            
            
            255
            
            
            71MMDA
                accounts
            
            
            823
            
            
            946
            
            
            2,105
            
            
            1,613Savings
                accounts
            
            
            35
            
            
            23
            
            
            166
            
            
            47Time
                deposits of $100 or more
            
            
            525
            
            
            301
            
            
            1,205
            
            
            510Other
                time deposits
            
            
            674
            
            
            1,276
            
            
            1,574
            
            
            2,488Other
                borrowed funds
            
            
            766
            
            
            976
            
            
            1,377
            
            
            2,105Total
                interest expense
            
            
            2,985
            
            
            3,565
            
            
            6,682
            
            
            6,834Net
                interest income before provision for possible loan losses
            
            
            9,589
            
            
            7,258
            
            
            18,709
            
            
            14,291Provision
                for loan losses
            
            
            2,775
            
            
            170
            
            
            3,015
            
            
            310Net
                interest income after provision for loan losses
            
            
            6,814
            
            
            7,088
            
            
            15,694
            
            
            13,981**Non-Interest
                Income:**Service
                charges on deposit accounts
            
            
            837
            
            
            686
            
            
            1,609
            
            
            1,299Other
                income
            
            
            882
            
            
            705
            
            
            1,549
            
            
            1,324Gain
                on sale of investment securities
            
            
            37
            
            
            -
            
            
            37
            
            
            -Total
                non-interest income
            
            
            1,756
            
            
            1,391
            
            
            3,195
            
            
            2,623**Non-Interest
                Expense:**Salaries
                and employee benefits
            
            
            4,021
            
            
            3,194
            
            
            8,246
            
            
            6,444Occupancy
                and equipment
            
            
            1,129
            
            
            706
            
            
            2,268
            
            
            1,421Other
                expenses
            
            
            2,348
            
            
            1,663
            
            
            4,604
            
            
            3,391Total
                non-interest expenses
            
            
            7,498
            
            
            5,563
            
            
            15,118
            
            
            11,256Income
                before provision for income taxes
            
            
            1,072
            
            
            2,916
            
            
            3,771
            
            
            5,348Provision
                for applicable income taxes
            
            
            381
            
            
            1,116
            
            
            1,405
            
            
            2,037Net
                income
            
            $
            691
            
            $
            1,800
            
            $
            2,366
            
            $
            3,311**Earnings
                Per Share:**Basic
            
            $
            0.09
            
            $
            0.27
            
            $
            0.31
            
            $
            0.49Fully
                diluted
            
            $
            0.09
            
            $
            0.26
            
            $
            0.30
            
            $
            0.47




See
      notes
      to condensed consolidated financial statements.




-
            5
            -




**HERITAGE
      OAKS BANCORP**


**CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS' EQUITY (UNAUDITED)**


**June
      30, 2008 and 2007**


*(amounts
      in thousands except shares outstanding)*





**Accumulated****Common Stock**
            
            **Additional**
            
            
            
            
            
            **Other**
            
            **Total****Number of**
            
            
            
            **Paid-In**
            
            **Comprehensive**
            
            **Retained**
            
            **Comprehensive**
            
            **Stockholders'****Shares**
            
            **Amount**
            
            **Capital**
            
            **Income**
            
            **Earnings**
            
            **Income**
            
            **Equity****Balance, December
                31, 2007**
            
            
            7,317,932
            
            $
            43,996
            
            $
            672
            
            
            
            
            $
            24,598
            
            $
            184
            
            $
            69,450Exercise
                of stock options (including $88 excess tax benefit from exercise
                of stock
                options)
            
            
            31,228
            
            
            228
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            2285%
                Stock Dividend distributed May 16, 2008
            
            
            366,344
            
            
            4,232
            
            
            
            
            
            
            
            
            (4,232
            )
            
            
            
            
            -Cash
                paid in lieu of fractional shares
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (5
            )
            
            
            
            
            (5
            )Cash
                dividend - $0.08 per share paid on February 15, 2008
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (587
            )
            
            
            
            
            (587
            )Share-based
                compensation expense
            
            
            
            
            
            
            
            
            167
            
            
            
            
            
            
            
            
            
            
            
            167Issuance
                of restricted stock awards
            
            
            1,000
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -Retirement
                of restricted share awards
            
            
            (6,575
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -Comprehensive
                income:Net
                income
            
            
            
            
            
            
            
            
            
            
            $
            2,366
            
            
            2,366
            
            
            
            
            
            2,366Unrealized
                security holding losses (net of $537 tax benefit)
            
            
            
            
            
            
            
            
            
            
            
            (769
            )
            
            
            
            
            (769
            )
            
            (769
            )Realized
                gains on sale of securities (net of $15 tax)
            
            
            
            
            
            
            
            
            
            
            
            22
            
            
            
            
            
            22
            
            
            22Total
                comprehensive income
            
            
            
            
            
            
            
            
            
            
            $
            1,619**Balance,
                June 30, 2008**
            
            
            7,709,929
            
            $
            48,456
            
            $
            839
            
            
            
            
            $
            22,140
            
            $
            (563
            )
            $
            70,872**Balance,
                December 31, 2006**
            
            
            6,345,639
            
            $
            29,247
            
            $
            336
            
            
            
            
            $
            19,809
            
            $
            80
            
            $
            49,472Exercise
                of stock options (including $440 excess tax benefit from exercise
                of stock
                options)
            
            
            129,764
            
            
            825
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            825Cash
                dividend - $0.08 per share paid on February 16, 2007
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (510
            )
            
            
            
            
            (510
            )Cash
                dividend - $0.08 per share paid on May 18, 2007
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (514
            )
            
            
            
            
            (514
            )Share-based
                compensation expense
            
            
            
            
            
            
            
            
            184
            
            
            
            
            
            
            
            
            
            
            
            184Issuance
                of restricted stock awards
            
            
            1,000
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            -Comprehensive
                income:Net
                income
            
            
            
            
            
            
            
            
            
            
            $
            3,311
            
            
            3,311
            
            
            
            
            
            3,311Unrealized
                security holding losses (net of $164 tax benefit)
            
            
            
            
            
            
            
            
            
            
            
            (247
            )
            
            
            
            
            (247
            )
            
            (247
            )Total
                comprehensive income
            
            
            
            
            
            
            
            
            
            
            $
            3,064**Balance,
                June 30, 2007**
            
            
            6,476,403
            
            $
            30,072
            
            $
            520
            
            
            
            
            $
            22,096
            
            $
            (167
            )
            $
            52,521





See
      notes
      to condensed consolidated financial statements.




-
            6
            -




**HERITAGE
      OAKS BANCORP**


**CONSOLIDATED
      STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)**


*(dollar
      amounts in thousands)*





**For the three months**
            
            **For the six months****ended June 30,**
            
            **ended June 30,****2008**
            
            **2007**
            
            **2008**
            
            **2007****Net
                Income**
            
            $
            691
            
            $
            1,800
            
            $
            2,366
            
            $
            3,311**Other
                comprehensive income / (loss) before taxes:**Unrealized
                losses on securities available for sale arising during the
                period
            
            
            (1,611
            )
            
            (488
            )
            
            (1,307
            )
            
            (411
            )Realized
                gains on sale of availavle for sale securities during the
                period
            
            
            37
            
            
            -
            
            
            37
            
            
            -Total
                other comprehensive (loss) before taxes
            
            
            (1,574
            )
            
            (488
            )
            
            (1,270
            )
            
            (411
            )Unrealized
                income tax benefit related to items in comprehensive
                (loss)
            
            
            663
            
            
            195
            
            
            538
            
            
            164Income
                tax related to the sale of available for sale securities
            
            
            (15
            )
            
            -
            
            
            (15
            )
            
            -**Total
                other comprehensive (loss), net of taxes**
            
            
            (926
            )
            
            (293
            )
            
            (747
            )
            
            (247
            )**Comprehensive
                (loss) / income**
            
            $
            (235
            )
            $
            1,507
            
            $
            1,619
            
            $
            3,064




See
      notes
      to condensed consolidated financial statements.




-
          7
          -


**HERITAGE
      OAKS BANCORP**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS (UNAUDITED)**


*(dollar
      amounts in thousands)*





**For
                the six month periods****ended
                June 30,****2008**
            
            **2007****Cash
                flows from operating activities:**Net
                income
            
            $
            2,366
            
            $
            3,311Adjustments
                to reconcile net income to net cash provided by operating
                activities:Depreciation
                and amortization
            
            
            537
            
            
            509Provision
                for possible loan losses
            
            
            3,015
            
            
            310Amortization
                of premiums/discounts on investment securities, net
            
            
            (66
            )
            
            (41
            )Federal
                Home Loan Bank stock dividends received
            
            
            (84
            )
            
            (64
            )Amortization
                of intangible assets
            
            
            430
            
            
            177Gain
                on sale of available-for-sale securities
            
            
            (37
            )
            
            -Share-based
                compensation expense
            
            
            167
            
            
            184(Increase)
                in loans held for sale
            
            
            (344
            )
            
            (1,565
            )Net
                (increase) in bank owned life insurance
            
            
            (204
            )
            
            (186
            )Decrease/(increase)
                in deferred tax asset
            
            
            14
            
            
            (2,078
            )Increase/(decrease)
                in other assets
            
            
            (483
            )
            
            582(Decrease)/increase
                in other liabilities
            
            
            (795
            )
            
            1,741Excess
                tax benefit related to share-based compensation expense
            
            
            (88
            )
            
            (440
            )**NET
                CASH PROVIDED IN OPERATING ACTIVITIES**
            
            
            4,428
            
            
            2,440**Cash
                flows from investing activities:**Purchase
                of available-for-sale securities
            
            
            (18,417
            )
            
            -Proceeds
                from principal reductions and maturities of available-for-sale mortgage
                backed securities
            
            
            5,193
            
            
            2,057Maturities
                and calls of available-for-sale securities
            
            
            1,012
            
            
            -Sale
                of available-for-sale-securities
            
            
            1,537
            
            
            -Maturities
                of time deposits with other banks
            
            
            199
            
            
            -Purchase
                of Federal Home Loan Bank stock
            
            
            (2,272
            )
            
            (705
            )Purchase
                of bank owned life insurance policies
            
            
            (400
            )
            
            -(Increase)
                in loans, net
            
            
            (47,673
            )
            
            (15,082
            )Allowance
                for loan and lease loss recoveries
            
            
            72
            
            
            149Purchase
                of property, premises and equipment, net
            
            
            (720
            )
            
            (386
            )Proceeds
                from sale of property, premises and equipment
            
            
            -
            
            
            12,810**NET
                CASH (USED) IN INVESTING ACTIVITIES**
            
            
            (61,469
            )
            
            (1,157
            )**Cash
                flows from financing activities:**(Decrease)/increase
                in deposits, net
            
            
            (10,290
            )
            
            68,586Increases
                in Federal Home Loan Bank borrowing
            
            
            240,000
            
            
            55,000Paydowns
                in Federal Home Loan Bank borrowing
            
            
            (176,500
            )
            
            (75,000
            )Increase/(decrease)
                in repurchase agreements
            
            
            782
            
            
            (6
            )Decrease
                in junior subordinated debentures
            
            
            -
            
            
            (8,248
            )Excess
                tax benefit related to share-based compensation expense
            
            
            88
            
            
            440Proceeds
                from exercise of stock options
            
            
            140
            
            
            385Cash
                paid in lieu of fractional shares
            
            
            (5
            )
            
            -Cash
                dividends paid
            
            
            (587
            )
            
            (1,024
            )**NET
                CASH PROVIDED BY FINANCING ACTIVITIES**
            
            
            53,628
            
            
            40,133Net
                (decrease)/increase in cash and cash equivalents
            
            
            (3,413
            )
            
            41,416Cash
                and cash equivalents, beginning of period
            
            
            46,419
            
            
            23,034**CASH
                AND CASH EQUIVALENTS, END OF PERIOD**
            
            $
            43,006
            
            $
            64,450**Supplemental
                disclosures of cash flow information:**Interest
                paid
            
            $
            6,819
            
            $
            7,000Income
                taxes paid
            
            $
            1,405
            
            $
            2,030Transfer
                of loans to other real estate owned
            
            $
            197
            
            $
            -





See
      notes
      to condensed consolidated financial statements.




-
          8
          -




**Heritage
      Oaks Bancorp and Subsidiaries**


**Notes
      To Consolidated Financial Statements (Un-audited)**


**June
      30, 2008**





**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 2007 annual report filed on Form 10-K.





The
      condensed consolidated financial statements include the accounts of the Company
      and its wholly-owned financial subsidiary, Heritage Oaks Bank (“the Bank”). All
      significant inter-company balances and transactions have been eliminated.
      Heritage Oaks Capital Trusts II and III are unconsolidated subsidiaries formed
      solely for the purpose of issuing trust preferred securities. Operating results
      for the three and six months ended June 30, 2008 are not necessarily indicative
      of the results that may be expected for the year ending December 31, 2008.
      Certain amounts in the consolidated financial statements for the year ended
      December 31, 2007 and for the three and six months ended June 30, 2007 may
      have
      been reclassified to conform to the presentation of the consolidated financial
      statements in 2008.





On
      October 12, 2007 the Company acquired Business First National Bank (“Business
      First”). Business First was merged with and into Heritage Oaks Bank, a wholly
      owned subsidiary of the Company. The consideration paid for Business First
      was
      approximately $19.5 million, consisting of approximately 75% common stock and
      25% cash. Business First shareholders received 0.5758 shares of Heritage Oaks
      Bancorp common stock for each share of Business First they owned and $3.44
      per
      share in cash. Upon the acquisition of Business First, the Company issued
      850,213 shares of Heritage Oaks Bancorp common stock and approximately $5.1
      million in cash to the former shareholders of Business First. Upon the date
      of
      the acquisition, the Company added approximately $160.5 million in assets and
      approximately $133.4 million in deposits. The financial position, results of
      operations and cash flows of the Company as of and for the three and six month
      periods ended June 30, 2008 reflect the acquisition of Business
      First.





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.




-
          9
          -





**Note
      2. Investment Securities**





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





The
      following table sets forth the amortized cost and fair values of investment
      securities available for sale at June 30, 2008 and December 31,
      2007:





*(dollars
                in thousands)*
            
            
            
            **Gross**
            
            **Gross****Amortized**
            
            **Unrealized**
            
            **Unrealized**
            
            **Fair****As
                of June 30, 2008**
            
            **Cost**
            
            **Gains**
            
            **Losses**
            
            **Value**Obligations
                of U.S. government agencies and corporations
            
            $
            1,170
            
            $
            2
            
            $
            (1
            )
            $
            1,171Mortgage-backed
                securities
            
            
            39,743
            
            
            39
            
            
            (1,005
            )
            
            38,777Obligations
                of state and political subdivisions
            
            
            16,999
            
            
            223
            
            
            (215
            )
            
            17,007Other
                securities
            
            
            109
            
            
            -
            
            
            -
            
            
            109Total
            
            $
            58,021
            
            $
            264
            
            $
            (1,221
            )
            $
            57,064





**Gross**
            
            **Gross****Amortized**
            
            **Unrealized**
            
            **Unrealized**
            
            **Fair****As
                of December 31, 2007**
            
            **Cost**
            
            **Gains**
            
            **Losses**
            
            **Value**Obligations
                of U.S. government agencies and corporations
            
            $
            3,674
            
            $
            12
            
            $
            (6
            )
            $
            3,680Mortgage-backed
                securities
            
            
            26,793
            
            
            71
            
            
            (206
            )
            
            26,658Obligations
                of state and political subdivisions
            
            
            16,667
            
            
            478
            
            
            (36
            )
            
            17,109Other
                securities
            
            
            109
            
            
            -
            
            
            -
            
            
            109Total
            
            $
            47,243
            
            $
            561
            
            $
            (248
            )
            $
            47,556





At
      June
      30, 2008, the fair value of the securities portfolio was approximately $57.1
      million. This, when compared to the $47.6 million reported at December 31,
      2007,
      represents an increase of approximately $9.5 million. The change in the fair
      value of the portfolio can be attributed in large part to purchases of
      securities in the amount of $18.4 million, proceeds from principal reductions
      of
      mortgage-backed securities in the amount of $5.2 million, and sales and
      maturities totaling $2.5 million. During the quarter ended June 30, 2008, the
      Bank recognized a gain of approximately $37 thousand related to the sale of
      securities previously mentioned. At June 30, 2008, the securities portfolio
      had
      a net unrealized loss of approximately $1.0 million or $563 thousand, net of
      tax. This, when compared to the net unrealized gain of approximately $313
      thousand or $184 thousand, net of tax the portfolio had at December 31, 2007,
      represents a decline in market value of approximately $1.3 million or $747
      thousand, net of tax. The year to date decline in market value of the securities
      portfolio can be attributed in large part to a rise in market interest rates
      during the second quarter of 2008, as well as a continued concerns surrounding
      mortgage related securities.




-
          10
          -




**Note
      3. Loans and the Allowance for Loan Losses**





The
      following table provides a summary of outstanding loan balances as of June
      30,
      2008 compared to December 31, 2007:





**June 30,**
            
            **December 31,***(dollars
                in thousands)*
            
            **2008**
            
            **2007****Real
                Estate Secured:**Multi-family
                residential
            
            $
            14,457
            
            $
            12,779Residential
                1 to 4 family
            
            
            26,466
            
            
            24,326Home
                equity lines of credit
            
            
            19,220
            
            
            17,470Commercial
            
            
            268,612
            
            
            274,266Farmland
            
            
            10,652
            
            
            11,557**Commercial:**Commercial
                and industrial
            
            
            154,456
            
            
            133,981Agriculture
            
            
            12,747
            
            
            11,367Other
            
            
            814
            
            
            732**Construction:**Single
                family residential
            
            
            9,708
            
            
            10,239Single
                family residential - Spec.
            
            
            16,565
            
            
            18,718Tract
            
            
            2,317
            
            
            1,664Multi-family
            
            
            9,482
            
            
            9,054Hospitality
            
            
            21,401
            
            
            16,784Commercial
            
            
            27,565
            
            
            30,677Land
            
            
            55,555
            
            
            31,064Installment
                loans to individuals
            
            
            7,792
            
            
            7,977All
                other loans (including overdrafts)
            
            
            2,003
            
            
            562Total
                loans, gross
            
            
            659,812
            
            
            613,217Deferred
                loan fees
            
            
            1,756
            
            
            1,732Reserve
                for possible loan losses
            
            
            8,128
            
            
            6,143Total
                loans, net
            
            $
            649,928
            
            $
            605,342Loans
                held for sale
            
            $
            1,246
            
            $
            902





*Concentration
      of Credit Risk*





At
      June
      30, 2008, approximately $482.7 million or 73.2% of the Bank’s loan portfolio was
      collateralized by various forms of real estate, this represents an increase
      of
      approximately $24.1 million when compared to the $458.6 million or 74.8%
      reported at December 31, 2007. 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. At June 30, 2008, the Bank was contingently
      liable for letters of credit accommodations made to its customers totaling
      approximately $17.9 million and un-disbursed loan commitments in the approximate
      amount of $173.1 million. The Bank makes commitments to extend credit in the
      normal course of business to meet the financing needs of its customers.
      Commitments to extend credit are agreements to lend to a customer as long as
      there is no violation of any condition established in the contract. Commitments
      generally have fixed expiration dates or other termination clauses and may
      require payment of a fee. Since many of the commitments are expected to expire
      without being drawn upon, the total outstanding commitment amount does not
      necessarily represent future cash requirements. Standby letters of credit
      written are conditional commitments issued by the Bank to guarantee the
      performance of a customer to a third party. The credit risk involved in issuing
      letters of credit is essentially the same as those involved in extending loan
      facilities to customers. The Bank 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.




-
          11
          -




An
      analysis of the changes in the allowance for possible loan losses for the
      periods indicated below is as follows:





**For the three months ended**
            
            **For the six months ended**
            
            **For the year ended***(dollars
                in thousands)*
            
            **June 30, 2008**
            
            **June 30, 2007**
            
            **June 30, 2008**
            
            **June 30, 2007**
            
            **December 31, 2007**Balance
                at beginning of period
            
            $
            6,305
            
            $
            4,312
            
            $
            6,143
            
            $
            4,081
            
            $
            4,081Credit
                from purchase of Business First National Bank
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            1,381Additions
                charged to operating expense
            
            
            2,775
            
            
            170
            
            
            3,015
            
            
            310
            
            
            660Loans
                charged off
            
            
            (1,024
            )
            
            (19
            )
            
            (1,102
            )
            
            (20
            )
            
            (249
            )Recoveries
                of loans previously charged off
            
            
            72
            
            
            57
            
            
            72
            
            
            149
            
            
            270Balance
                at end of period
            
            $
            8,128
            
            $
            4,520
            
            $
            8,128
            
            $
            4,520
            
            $
            6,143





For
      the
      three and six month periods ended June 30, 2008, the Company had net charge-offs
      of approximately $952 thousand and $1.0 million, respectively. During the same
      periods ended in 2007, the Company had a net recoveries of loans previously
      charged off in the approximate amounts of $38 thousand and $129 thousand,
      respectively. During the second quarter of 2008, the Bank wrote down the value
      of certain non-performing loans in the approximate amount of $1.0 million.
      For a
      more detailed discussion concerning the loans the Bank has placed on non-accrual
      status, see “Non Performing Assets” under Item 2. Management’s Discussion and
      Analysis of Financial Condition and Results of Operations in this Form
      10-Q.





The
      Bank
      recognizes that credit losses will be experienced and the risk of loss will
      vary
      with, among other things, general economic conditions; the type of loan being
      made; the creditworthiness of the borrower over the term of the loan and in
      the
      case of a collateralized loan, the quality of the collateral for such loan.
      The
      allowance for loan losses represents the Bank’s estimate of the allowance
      necessary to provide for probable incurred losses in the portfolio. In making
      this determination, the Bank analyzes the ultimate ability to collect the loans
      in its portfolio based on: the quality of credits in the portfolio given the
      Bank’s loan grading system and feedback provided by internal loan staff,
      information provided from examinations performed by regulatory agencies, and
      information provided from an independent loan review function. Additionally,
      the
      allowance consists of allocations made for specific loans and is determined,
      in
      part, by certain other qualitative measures. 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. The Bank accounts for problem loans in accordance with
      Statement of Financial Accounting Standards (“SFAS”) No. 114, “ *Accounting
      by Creditors for Impairment of a Loan,”* as
      amended by SFAS No. 118, *“Accounting
      by Creditors for Impairment of a Loan - Income Recognition and
      Disclosures.”* These
      pronouncements provide that when it is probable that a creditor will be unable
      to collect all amounts due in accordance with the terms of the loan that such
      loan is deemed impaired. Impaired loans are accounted for differently in that
      the amount of the impairment is measured and reflected in the records of the
      creditor. The allowance for loan losses related to loans that are identified
      for
      evaluation in accordance with SFAS No. 114 is based on discounted cash flows
      using the loan’s initial effective interest rate or the fair value of the
      collateral for certain collateral dependent loans. The general portfolio
      allocation 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 six months ended June 30, 2008 is consistent with prior periods.
      The
      allowance for loan losses as a percentage of total gross loans was 1.23% and
      1.00% at June 30, 2008 and December 31, 2007, respectively. Management believes
      that the allowance for loan losses as of June 30, 2008 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 would then share in
      the
      earnings of the entity.




-
          12
          -




The
      following table sets forth the number of shares used in the calculation of
      both
      basic and diluted earnings per share for the three and six months ended June
      30,
      2008 and 2007:





**For the three months ending**
            
            **For the six months ending****June 30,**
            
            **June 30,***(dollars
                in thousands except per share data)*
            
            **2008**
            
            **2007**
            
            **2008**
            
            **2007****Net
                Income**
            
            $
            691
            
            $
            1,800
            
            $
            2,366
            
            $
            3,311Basic
            
            $
            0.09
            
            $
            0.27
            
            $
            0.31
            
            $
            0.49Diluted
            
            $
            0.09
            
            $
            0.26
            
            $
            0.30
            
            $
            0.47**Shares:**Basic
            
            
            7,705,174
            
            
            6,754,321
            
            
            7,699,860
            
            
            6,728,840Diluted
            
            
            7,830,390
            
            
            7,027,090
            
            
            7,841,144
            
            
            7,018,270





On
      October 12, 2007, the Company issued 850,213 shares of common stock to the
      former shareholders of Business First National Bank in connection with its
      acquisition. Additionally, on April 24, 2008, the Company’s Board of Directors
      declared a 5% stock dividend to be paid on May 16, 2008. As a result of this
      dividend, the Company issued 366,344 shares of its common stock to holders
      of
      record on May 2, 2008. The basic and diluted shares presented in the table
      above
      for the three and six months ended June 30, 2008 fully reflect the shares issued
      in connection with the acquisition of Business First National Bank as well
      as
      the stock dividend paid in May 2008. Additionally, earnings per share for all
      prior periods have been adjusted to fully reflect the May 2008 stock
      dividend.




**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 and provides that the tax effects from an uncertain
      tax position be recognized in the financial statements only if, based on its
      merits, the position is more likely than not to be sustained in audit by the
      taxing authorities. This interpretation is effective for fiscal years beginning
      after December 15, 2006. Effective January 1, 2007, the Company adopted FIN
      48.  Management believes that all tax positions taken as of June 30, 2008
      are highly certain and, accordingly, no accounting adjustments have been made
      to
      the financial statements.





In
      September 2006, the FASB issued SFAS No. 157, “ *Fair
      Value Measurements.”* SFAS No.
      157 enhances existing guidance for measuring assets and liabilities using fair
      value. Prior to the issuance of SFAS No. 157, guidance for applying fair value
      was incorporated in several accounting pronouncements. SFAS No. 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. SFAS No. 157 also emphasizes that fair value is a market-based
      measurement, not an entity-specific measurement, and sets forth a fair value
      hierarchy with the highest priority being quoted prices in active markets.
      Under
      SFAS No. 157, fair value measurements are disclosed by level within that
      hierarchy. While SFAS No. 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. SFAS No. 157
      is
      effective for financial statements issued for fiscal years beginning after
      November 15, 2007, and interim periods within those fiscal years. Effective
      January 1, 2008, the Company adopted SFAS No. 157. The adoption of this standard
      has not had a material impact on the Company’s financial position, results of
      operations or cash flows.





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




In
      February 2007, the FASB issued SFAS No. 159, *“Establishing
      the Fair Value Option for Financial Assets and Liabilities.”* The FASB
      has issued SFAS No. 159 to permit all entities to choose to elect, at specified
      election dates, to measure eligible financial instruments at fair value. An
      entity shall report unrealized gains and losses on items for which the fair
      value option has been elected in earnings at each subsequent reporting date,
      and
      recognize upfront costs and fees related to those items in earnings as incurred
      and not deferred. SFAS No. 159 applies to fiscal years beginning after November
      15, 2007, with early adoption permitted for an entity that has also elected
      to
      apply the provisions of SFAS No. 157, Fair Value Measurements. An entity is
      prohibited from retrospectively applying SFAS No. 159, unless it chooses early
      adoption. SFAS No. 159 also applies to eligible items existing at November
      15,
      2007 (or early adoption date). The Company adopted SFAS No. 159 on January
      1,
      2008 and chose not to measure certain eligible financial instruments at their
      fair values and as a result the adoption of SFAS No. 159 did not have a material
      impact on its financial position, results of operations or cash
      flows.




-
          13
          -




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





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




In
      February 2008, the FASB issued FASB Staff Position (“FSP”) FAS 157-1,
“ *Application
      of FASB Statement No. 157 and Other Accounting Pronouncements That Address
      Fair
      Value Measurements for Purposes of Lease Classification or Measurement Under
      Statement 13* ,”
and
      FSP FAS 157-2, “ *Effective
      Date of FASB Statement No. 157.* ”
FSP
      FAS
      157-1 removes leasing from the scope of SFAS No. 157, “ *Fair
      Value Measurements.* ”
FSP
      FAS
      157-2 delays the effective date of SFAS No. 157 from 2008 to 2009 for all
      non-financial assets and non-financial liabilities, except those that are
      recognized or disclosed at fair value in the financial statements on a recurring
      basis (at least annually). The Company does not expect the implementation of
      FSP
      157-1 to have a material impact on its financial position, results of
      operations, or cash flows. Additionally, in accordance with FSP 157-2 the
      Company will delay the application of SFAS No. 157 for non-financial assets
      and
      non-financial liabilities until January 1, 2009 and does not expect the
      application to have a material impact on the Company’s financial position,
      results of operations, or cash flows.





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





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




-
          14
          -




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




**Note
      6. Share-Based Compensation**





As
      of
      June 30, 2008, the Company had two share-based employee compensation plans,
      which are more fully described in Note 14 of the Consolidated Financial
      Statements in the Company's Annual Report filed on Form 10-K for the year ended
      December 31, 2007. These plans include the “1997 Stock Option Plan” and the
“2005 Equity Based Compensation Plan.”





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





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





The
      share-based compensation expense recognized in the condensed consolidated
      statements of income for the three and six month periods ended June 30, 2008
      and
      2007 is based on awards ultimately expected to vest, and accordingly has been
      adjusted by the amount of estimated forfeitures. SFAS No. 123(R) requires
      forfeitures to be estimated at the time of grant and revised, if necessary,
      in
      subsequent periods if actual forfeitures differ from those estimates.
      Forfeitures were estimated based partially on historical
      experience.





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





**For the three months ended**
            
            **For the six months ended****June 30,**
            
            **June 30,***(dollars
                in thousands except per share data)*
            
            **2008**
            
            **2007**
            
            **2008**
            
            **2007****Share-based
                compensation expense:**Stock
                option expense
            
            $
            52
            
            $
            28
            
            $
            101
            
            $
            56Restricted
                stock expense
            
            
            3
            
            
            64
            
            
            66
            
            
            127Total
                share-based compensation expense
            
            $
            55
            
            $
            92
            
            $
            167
            
            $
            183Total
                share-based compensation expense, net of tax
            
            $
            40
            
            $
            63
            
            $
            114
            
            $
            126Diluted
                shares outstanding
            
            
            7,830,390
            
            
            7,027,090
            
            
            7,841,144
            
            
            7,018,270Impact
                on diluted earnings per share
            
            $
            0.005
            
            $
            0.009
            
            $
            0.015
            
            $
            0.018**Unrecognized
                compensation expense:**Stock
                option expense
            
            $
            367
            
            $
            171Restricted
                stock expense
            
            
            604
            
            
            921Total
                unrecognized share-based compensation expense
            
            $
            971
            
            $
            1,092Total
                unrecognized share-based compensation expense, net of tax
            
            $
            597
            
            $
            699





At
      June
      30, 2008, there was a total of $367 thousand of unrecognized compensation
      expense related to non-vested stock option awards. That expense is expected
      to
      be recognized over a weighted-average period of 1.8 years.





-
          15
          -





The
      Company grants restricted share awards periodically for the benefit of
      employees. These restricted shares generally “cliff vest” after five years of
      issuance. Recipients of restricted shares have the right to vote all shares
      subject to such grant, and receive all dividends with respect to such shares,
      whether or not the shares have vested. Recipients do not pay any cash
      consideration for the shares. The total unrecognized compensation expense
      related to restricted share awards at June 30, 2008 was $604 thousand. That
      expense is expected to be recognized over the next 2.7 years.





The
      aggregate intrinsic value in the table below represents the total pretax
      intrinsic value (the difference between the Company’s closing stock price on the
      last trading day of the second quarter of 2008 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 June
      30,
      2008). The aggregate pretax intrinsic value is subject to change based on the
      fair market value of the Company's stock. The aggregate intrinsic value of
      options exercised for the three and six month periods ended June 30, 2008 and
      2007 was $72 thousand and $214 thousand and $249 thousand and $1.1 million,
      respectively.





The
      following table provides a summary of the aggregate intrinsic value of options
      outstanding and exercisable as well as options granted, exercised, and forfeited
      during the year-to-date period ended June 30, 2008 and 2007:





**Average****Weighted**
            
            **Remaining**
            
            **Total****Average**
            
            **Contractual**
            
            **Intrinsic****Number of**
            
            **Exercise**
            
            **Term**
            
            **Value****Shares**
            
            **Price**
            
            **(in years)**
            
            **(in 000's)**Options
                outstanding, January 1, 2008
            
            
            463,160
            
            $
            8.36Granted
            
            
            26,250
            
            
            11.48Exercised
            
            
            (32,090
            )
            
            4.37Forfeited
            
            
            (4,437
            )
            
            6.58Expired
            
            
            (2
            )
            
            4.42Options
                outstanding, June 30, 2008
            
            
            452,881
            
            $
            8.84
            
            
            4.41
            
            $
            906Exercisable
                at June 30, 2008
            
            
            362,146
            
            $
            7.78
            
            
            3.37
            
            $
            904Options
                outstanding, January 1, 2007
            
            
            458,395
            
            $
            5.16Granted
            
            
            -
            
            
            -Exercised
            
            
            (136,252
            )
            
            2.82Forfeited
            
            
            (1,047
            )
            
            10.23Options
                outstanding, June 30, 2007
            
            
            321,096
            
            $
            6.14
            
            
            4.24
            
            $
            3,545Exercisable
                at June 30, 2007
            
            
            277,230
            
            $
            5.42
            
            
            3.82
            
            $
            3,257





During
      the first quarter of 2008, 26,250 options were granted to members of the
      Company’s Board of Directors excluding the one inside Director. The following
      table presents the assumptions used in the calculation of the weighted average
      fair value of those options on the date of grant using the Black-Scholes options
      pricing model:




**February****2008**Expected
                volatility
            
            
            35.07
            %Expected
                term (years)
            
            
            10Dividend
                yield
            
            
            2.66
            %Risk
                free rate
            
            
            3.62
            %Weighted-average
                grant date fair value
            
            $
            3.93




-
          16
          -




**Note
      7. Fair Value of Financial Instruments**





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





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





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





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





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





*Fair
      Value Measurements*





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





·
            ***Securities***





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





·
            ***Loans
                Held For Sale***





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





·
            ***Impaired
                Loans***





A
      loan is
      considered impaired when it is probable that payment of interest and principal
      will not be made in accordance with the contractual terms of the loan agreement.
      Impairment is measured based on the fair value of the underlying collateral
      or
      the discounted expected future cash flows. The Company measures impairment
      on
      all non-accrual loans for which it has established specific reserves as part
      of
      the specific allocated allowance component of the allowance for loan losses.
      As
      such, the Company records impaired loans as non-recurring Level 2 when the
      fair
      value of the underlying collateral is based on an observable market price or
      current appraised value. When current market prices are not available or the
      Company determines that the fair value of the underlying collateral is further
      impaired below appraised values, the Company records impaired loans as
      non-recurring Level 3. At June 30, 2008, substantially all of the Company’s
      impaired loans were evaluated based on the fair value of their underlying
      collateral based upon the most recent appraisal available to
      Management.





-
          17
          -




·
            ***Other
                Real Estate Owned and Foreclosed
                Collateral***





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





The
      following table provides a summary of the financial instruments the Company
      measures at fair value on a recurring basis as of June 30, 2008:





**Fair Value Measurments Using****Assets At***(dollars
                in thousands)*
            
            **Level 1**
            
            **Level 2**
            
            **Level 3**
            
            **Fair Value****Assets:**Available
                for sale investment securities
            
            $
            -
            
            $
            56,352
            
            $
            712
            
            $
            57,064Total
                assets measured on a recurring basis
            
            $
            -
            
            $
            56,352
            
            $
            712
            
            $
            57,064





The
      following table provides a summary of the changes in balance sheet carrying
      values associated with Level 3 financial instruments during the six months
      ended
      June 30, 2008:





**Available For****Sale Investment***(dollars
                in thousands)*
            
            **Securities**Beginning
                balance
            
            $
            739Total
                gains or losses
                (realized/unrealized)**(1)**:Included
                in earnings
            
            
            -Included
                in other comprehensive income
            
            
            (27
            )Purchases
            
            
            -Transfers
                in and/or out of Level 3
            
            
            -Ending
                balance
            
            $
            712





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





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





The
      following table provides a summary of the financial instruments the Company
      measures at fair value on a non-recurring basis as of June 30,
      2008:





**Fair Value Measurments Using****Assets At***(dollars
                in thousands)*
            
            **Level 1**
            
            **Level 2**
            
            **Level 3**
            
            **Fair Value****Assets:**Impaired
                loans
            
            $
            -
            
            $
            13,507
            
            $
            -
            
            $
            13,507Loans
                held for sale
            
            
            -
            
            
            1,246
            
            
            -
            
            
            1,246Other
                real estate owned
            
            
            -
            
            
            197
            
            
            -
            
            
            197Other
                assets(1)
            
            
            -
            
            
            30
            
            
            -
            
            
            30Total
                assets measured on a non-recurring basis
            
            $
            -
            
            $
            14,980
            
            $
            -
            
            $
            14,980





**(1)** Other
      assets represent foreclosed collateral carried at fair value.




-
          18
          -




In
      addition to the assets presented in the table above, the Company uses fair
      value
      measurements on a non-recurring basis in its assessment of assets classified
      as
      Goodwill. These assets are recorded at fair value initially and assessed for
      impairment periodically thereafter. During the fiscal year ended December 31,
      2007, the carrying amount of goodwill assets were compared to their fair value.
      No change in carrying amount resulted in accordance with the provisions of
      SFAS
      No. 142, *“Goodwill
      and Other Intangible Assets* . *”* Additionally, the Company has certain other loans that are measured at fair
      value on a non-recurring basis such as loans that were acquired in the
      acquisition of Business First National Bank.





**Note
      8. Goodwill**





As
      of
      June 30, 2008, the balance of good will was approximately $11.5 million. This,
      when compared to the $10.9 million the Company reported at December 31, 2007,
      represents an increase of approximately $0.6 million. The increase in the
      balance of goodwill can be attributed exclusively to expenses the Company
      incurred and capitalized, directly related to the acquisition of Business First
      National Bank.




**Note
      9. Reclassifications**





Certain
      amounts in the 2007 financial statements have been reclassified to conform
      to
      the 2008 presentation.




**Forward
      Looking Statements**





**Certain
      statements contained in this Quarterly Report on Form 10-Q (“Quarterly Report”),
      including, without limitation, statements containing the words “believes”,
“anticipates”, “intends”, “expects”, and words of similar impact, constitute
“forward-looking statements” within the meaning of Section 27A of the Securities
      Act of 1933 and Section 21E of the Securities and Exchange Act of 1934. Such
      forward-looking statements involve known and unknown risks, uncertainties and
      other factors that may cause the actual results, performance or achievements
      of
      the Company to be materially different from any future results, performance
      or
      achievements expressed or implied by such forward-looking statements. Such
      factors include, among others, the following: the recent fluctuations in U.S.
      markets resulting, in part, from problems related to sub-prime lending, the
      recent downturn in the California real-estate market, general economic and
      business conditions in those areas in which the Company operates, demographic
      changes, competition, fluctuations in interest rates, changes in business
      strategy or development plans, changes in governmental regulation, credit
      quality, the availability of capital to fund the expansion of the Company’s
      business, as well as economic, political and global changes arising from the
      war
      on terrorism (Refer to the Company’s December 31, 2007 10K, 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.**




-
          19
          -




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





The
      following is an analysis of the results of operations and financial condition
      of
      the Company as of and for the three and six month periods ending June 30, 2008
      and 2007. The analysis should be read in connection with the consolidated
      financial statements and notes thereto appearing elsewhere in this
      report.





*The
      Company*





Heritage
      Oaks Bancorp (the "Company") is a California corporation organized in 1994
      to
      act as a holding company of Heritage Oaks Bank ("Bank"), a 15 branch bank
      serving San Luis Obispo and Santa Barbara Counties. In 1994, the Company
      acquired all of the outstanding common stock of the Bank in a holding company
      formation transaction.





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





In
      September 2007, the Company formed Heritage Oaks Capital Trust III (the
“Trust”). The Trust is a statutory business trust formed under the laws of the
      State of Delaware. The Trust is a wholly-owned, non-financial, non-consolidated
      subsidiary of the Company.





On
      October 12, 2007, the Company acquired Business First National Bank (“Business
      First”). Business First was merged with and into Heritage Oaks Bank, a wholly
      owned subsidiary of the Company. In connection with the acquisition, two
      additional branches were added to the Bank’s network. For additional information
      regarding this acquisition, please see Note 1 to the consolidated financial
      statements filed on this Form 10-Q as well as Note 22 to the consolidated
      financial statements of the Company’s 2007 annual report, which was filed on
      Form 10-K.





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





*Where
      You Can Find More Information*





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





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





-
          20
          -


**Executive
      Summary and Recent Developments**





*Earnings
      and Financial Condition Overview*





For
      the
      three and six months ended June 30, 2008, the Company earned $0.7 million and
      $2.4 million, respectively. This represents declines of 61.6% and 28.5% for
      the
      three and six months ended June 30, 2008 when compared to the same periods
      ended
      a year earlier. During the second quarter of 2008, the Company made additions
      to
      the allowance for loan losses in the approximate amount of $2.8 million. The
      Company felt it necessary to make additions to the allowance, given the weakened
      economic environment, and changes in the trend of delinquent loans. The
      Company’s analysis of the allowance for loan losses indicates that as of June
      30, 2008, the allowance was sufficient to cover potential credit losses inherent
      in the loan portfolio. With respect to earnings per share, the Company earned
      $0.09 and $0.30 per diluted share for the quarter and year to date periods
      ended
      June 30, 2008. When compared to the same periods ended a year earlier, diluted
      earnings per share declined approximately 65.5% and 36.0%, respectively. The
      year over year decline in diluted earnings per share can be attributed in part
      to shares the Company issued during the fourth quarter of 2007 in connection
      with the acquisition of Business First. For additional information related
      to
      the Company’s 2007 acquisition of Business First, see Note 1 to the consolidated
      financial statements filed on this Form 10-Q as well as Note 22 to the
      consolidated financial statements of the Company’s 2007 annual report filed on
      Form 10-K. Additionally, when viewing data as of and for the periods ended
      June
      30, 2008, it is important to consider that Business First was acquired on
      October 12, 2007. Therefore, the Company’s financial position and results of
      operations will not reflect the acquisition as of and for the periods ended
      June
      30, 2007.





The
      following provides financial highlights as of and for the three and six months
      ended June 30, 2008:





·
            Total
                interest income increased approximately $1.8 million and $4.3 million
                or
                16.2% and 20.2% when compared to the same three and six month periods
                ended a year earlier. This can be attributed to higher loan balances
                in
                connection with the acquisition of Business First as well as organic
                loan
                growth. At June 30, 2008 gross loan balances were approximately $199.0
                million higher than a year ago. The Bank obtained approximately $120.8
                million in new loan balances upon the acquisition of Business
                First.





·
            Interest
                expense declined approximately $0.6 million and $0.2 million or 16.3%
                and
                2.2% when compared to the same three and six month periods ended
                a year
                earlier. The declines in interest expense can be attributed in large
                part
                to the dramatic declines seen in the overnight Fed Funds rate during
                the
                first six months of 2008, leading Management to significantly re-price
                its
                deposits.





·
            Net
                interest income increased approximately $2.3 million or 32.1% and
                $4.4
                million or 30.9% when compared to the same three and six month periods
                ended a year earlier. The increase in net interest income is attributable
                in large part to the items mentioned
                above.





·
            Non-interest
                income increased approximately $0.4 million or 26.2% and $0.6 million
                or
                21.8% when compared to the same three and six month periods ended
                a year
                earlier. The quarter and year to date increases are largely attributable
                to increased service charges on deposit accounts stemming from the
                additional deposit relationships the Bank obtained from promotional
                activities during 2007 as well as the acquisition of Business First.
                Additionally, during the second quarter, the Bank recognized income
                in the
                approximate amount of $0.3 million related to the Visa, Inc. initial
                public offering.





·
            Non-interest
                expenses increased approximately $1.9 million or 34.8% and $3.9 million
                or
                34.3% from the same three and six month periods ended a year earlier.
                The
                increases in this category can be attributable in large part to higher
                salaries and employee benefits stemming from branch expansion and
                additional staff from the acquisition of Business First. Additionally,
                higher occupancy and equipment expenses contributed to the increase
                within
                this category as a result of branch expansion and the Business First
                acquisition.





·
            The
                acquisition of Business First accounted for the addition of nearly
                $160.5
                million in assets along with approximately $13.8 million in equity
                over
                that which was reported at June 30, 2007. It is because of these
                additional balances in addition to the additional loan loss provision
                the
                Bank booked during the second quarter of 2008, that return on average
                assets for the three and six months ended June 30, 2008 was 0.35%
                and
                0.62%, respectively compared to 1.25% and 1.17% for the same periods
                ended
                a year earlier. Return on average equity was 3.84% and 6.66% for
                the three
                and six months ended June 30, 2008 compared to 13.84% and 12.99%
                for the
                same periods ended a year earlier.





·
            The
                Company’s net interest margin for the three and six months ended June 30,
                2008 was 5.28% and 5.31%, respectively. This, when compared to the
                5.56%
                and 5.61% the Company reported for the same periods ended a year
                earlier,
                represents declines of approximately 28 and 30 basis points, respectively.
                The Company was able to mitigate margin compression by aggressively
                re-pricing its deposits and borrowings during the declining rate
                environment.




-
          21
          -




·
            For
                the three and six months ended June 30, 2008 the Company’s operating
                efficiency ratio was 66.31% and 69.14%, respectively. This, when
                compared
                to the 64.32% and 66.55% the Company reported for the same periods
                ended a
                year earlier, represents increases of approximately 199 and 259 basis
                points, respectively. The increases in the efficiency ratio can be
                attributed in large part to the increases in non-interest expenses
                previously mentioned.





At
      June
      30, 2008, total assets were $800.1 million. This represents an increase of
      approximately $54.5 million or 7.3% when compared to the $745.6 million reported
      at December 31, 2007.





·
            Net
                loan balances were $649.9 million at June 30, 2008. This, when compared
                to
                the $605.3 million reported at the end of 2007, represents an increase
                of
                approximately $44.6 million or
                7.4%.





·
            Total
                deposit balances were $634.5 million at June 30, 2008, which represents
                a
                decline of approximately $10.3 million or 1.6% from the $644.8 million
                reported at December 31, 2007. The year to date decline in deposit
                balances can be attributable in large part to the dramatic decline
                in
                interest rates seen during the first half of 2008. As the Bank moved
                to
                match the declines in the overnight Fed Funds rate made by the Federal
                Open Market Committee (“FOMC”), we experienced declines in deposit
                balances, particularly with respect to non-core promotional deposit
                products and money market balances. See also “Deposits” under Item 2.
                Management’s Discussion and Analysis of Financial Condition and Results of
                Operations on this Form 10-Q for additional information related to
                deposits.





·
            Federal
                Home Loan Bank and other borrowings were $71.5 million at June 30,
                2008.
                When compared to the $8.0 million reported at the end of 2007, this
                represents an increase of approximately $63.5 million. The large
                increase
                in wholesale borrowing is attributed in large part to the strategy
                by
                Management to replace higher cost non-core deposits with lower cost
                FHLB
                borrowing.





·
            At
                June 30, 2008, the allowance for loan losses was $8.1 million. As
                a
                percentage of total gross and non-performing loan balances, the allowance
                for loan losses was 1.23% and 60.18%, respectively. For the three
                and six
                month periods ended June 30, 2008, provision for loan losses was
                approximately $2.8 million and $3.0 million, respectively. When compared
                to the same periods ended a year earlier, this represents increases
                of
                approximately $2.6 million and $2.7 million, respectively. The increased
                provision of loan losses can be attributed in part to weakened economic
                conditions, increases in the balance of non-performing loans, as
                well as
                loans the Bank charged off during the second quarter of
                2008.





·
            As
                of June 30, 2008, the balance of loans placed on non-accrual status
                was
                approximately $13.4 million. This represents an increase of approximately
                $13.1 million from that reported at December 31, 2007. During the
                quarter,
                the Bank also moved to foreclose on real-estate securing a loan previously
                placed on non-accrual. The value of this property was recorded at
                $197
                thousand as of June 30, 2008. See also “Non Performing Assets” under Item
                2. Management’s Discussion and Analysis of Financial Condition and Results
                of Operations on this Form 10-Q for additional information related
                to
                non-performing assets.





*Recent
      Developments*





On
      October 12, 2007, the Company acquired Business First National Bank (“Business
      First”). Business First was merged with and into Heritage Oaks Bank, a wholly
      owned subsidiary of Heritage Oaks Bancorp. The consideration paid for Business
      First was approximately $19.5 million, consisting of approximately 75% common
      stock and 25% cash. Business First shareholders received 0.5758 shares of
      Heritage Oaks Bancorp common stock for each share of Business First they owned
      and $3.44 per share in cash. Upon the acquisition, the Company issued 850,213
      shares of common stock and $5.1 million in cash to the former shareholders
      of
      Business First. For additional information regarding the acquisition of Business
      First, see Note 1 to the consolidated financial statements filed on this Form
      10-Q as well as Note 22 to the consolidated financial statements of the
      Company’s 2007 annual report filed on Form 10-K.





On
      September 20, 2007, the Company issued $5.2 million in Junior Subordinated
      Debt
      Securities (the “Debt Securities”) to Heritage Oaks Capital Trust III, a
      statutory trust created under the laws of the State of Delaware. The Debt
      Securities are subordinated to effectively all borrowings of the Company and
      are
      due and payable in September 2037. Interest is payable quarterly on these
      securities based on the five year SWAP rate (a rate that may be converted to
      a
      floating rate at a later date) plus 2.00% for an effective rate of 6.888%.
      Interest on the Debt Securities is fixed for five years and at the end of such
      time will convert to a floating rate of the five year SWAP rate plus 2.00%.
      The
      Company has the right under the Indenture to defer payment of interest on the
      Debt Securities at any time for a period not to exceed twenty consecutive
      quarterly periods (each an “Extension Period”) provided that no Extension Period
      may extend beyond the maturity of the Debt Securities. In the event the Company
      exercises the right to defer payment of interest on the Debt Securities, it
      may
      not declare or pay any dividends on its common stock. The Company presently
      has
      no intention to defer interest payments on the Debt Securities, and it considers
      the likelihood of such a deferral to be remote. The securities can be called
      at
      any time commencing on December 15, 2012, at par. The Company also purchased
      a
      3.1% minority interest totaling $155 thousand in Heritage Oaks Capital Trust
      III. The balance of the equity of Heritage Oaks Capital Trust III is comprised
      of mandatorily redeemable preferred securities and is included in other assets.
      The company used the proceeds from the sale of the securities to assist in
      the
      acquisition in Business First, for general corporate purposes, and for capital
      contributions to the Bank for future growth.




-
          22
          -




On
      May
      11, 2007 the Company entered into a material definitive agreement to sell four
      of the Bank’s properties to First States Group, L.P. (“First States”) in a
      sale/leaseback transaction for $12.8 million. In connection with the sale,
      the
      Bank entered into four separate lease agreements with First States Investors,
      LLC to lease back three branches and one administrative facility under which
      the
      Bank will continue to utilize the properties for the normal course of business.
      Each of the four leases contain an annual rent escalation clause equal to the
      lower of CPI-U (Consumer Price Index for all Urban Consumers) or 2.5 percent,
      commencing in the second year of the lease term. Each of the four leases provide
      for an initial term of 15 years with the option to renew for two 10 year terms.
      As of June 30, 2008, the Bank makes monthly payments in the aggregate amount
      of
      $75 thousand to lease these facilities.





In
      connection with the sale of the properties mentioned, the Bank will recognize
      a
      gain of approximately $3.4 million. This gain will be recognized over a fifteen
      year period in accordance with SFAS No. 13 *“Accounting
      For Leases.”* For the
      three and six months ended June 30, 2008, the Bank recognized a gain of
      approximately $57 thousand or $33 thousand net of tax and $114 thousand or
      $67
      thousand net of tax, respectively. This gain was recorded as an offset to rental
      expense for the period mentioned. In addition to deferring the gain on sale,
      the
      Bank recorded an income tax liability and a deferred tax asset in the
      approximate amounts of $1.4 million, directly related to the deferred gain
      on
      sale.





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





*Stock
      Repurchases and Dividends*





On
      July
      18, 2007, the Board of Directors authorized a one year extension of the stock
      repurchase program that was adopted in July 2006. Under the one year extension
      the Company may repurchase up to 100,000 shares of its common stock. As of
      June
      30, 2008, the Company repurchased 53,500 shares of its common stock under the
      current plan. No repurchases were made during the first six months of
      2008.





On
      April
      24, 2008, the Board of Directors declared a 5% stock divided to be paid on
      May
      16, 2008 to shareholders of record on May 2, 2008. This stock dividend
      represents a change in the form of dividend payment to the Company’s
      shareholders away from cash dividends in order to retain the Company’s capital
      for future growth.





On
      January 24, 2008, the Board of Directors declared a quarterly cash dividend
      of
      $0.08 per share to be paid on February 15, 2008 to shareholders of record on
      February 1, 2008.





On
      October 17, 2007, the Board of Directors declared a quarterly cash dividend
      of
      $0.08 per share to be paid on November 16, 2007 to shareholders of record on
      November 2, 2007.





On
      July
      18, 2007, the Board of Directors declared a quarterly cash dividend of $0.08
      per
      share to be paid on August 17, 2007 to shareholders of record on August 3,
      2007.





On
      April
      20, 2007, the Board of Directors declared a quarterly cash dividend of $0.08
      per
      share to be paid on May 18, 2007 to shareholders of record on May 4, 2007.




On
      January 19, 2007, the Board of Directors declared a quarterly cash dividend
      of
      $0.08 per share to be paid on February 16, 2007 to shareholders of record on
      February 2, 2007.





-
          23
          -


*Selected
      Financial Data*





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


**For
                  the quarters ended***(dollars
                  in thousands except share data)*
              
              **06/30/08**
              
              **03/31/08**
              
              **12/31/07**
              
              **09/30/07**
              
              **06/30/07**
              
              **03/31/07**
              
              **12/31/06**
              
              **09/30/06**Return
                  on average assets
              
              
              0.35
              %
              
              0.91
              %
              
              1.11
              %
              
              1.12
              %
              
              1.25
              %
              
              1.10
              %
              
              1.24
              %
              
              1.33
              %Return
                  on average equity
              
              
              3.84
              %
              
              9.55
              %
              
              11.65
              %
              
              12.09
              %
              
              13.84
              %
              
              12.10
              %
              
              13.64
              %
              
              14.43
              %Average
                  equity to average assets
              
              
              9.14
              %
              
              9.48
              %
              
              9.49
              %
              
              9.27
              %
              
              9.02
              %
              
              9.07
              %
              
              9.11
              %
              
              9.25
              %Net
                  interest margin
              
              
              5.28
              %
              
              5.33
              %
              
              5.33
              %
              
              5.44
              %
              
              5.56
              %
              
              5.66
              %
              
              5.77
              %
              
              6.02
              %Efficiency
                  ratio*
              
              
              66.31
              %
              
              72.17
              %
              
              67.26
              %
              
              66.89
              %
              
              64.32
              %
              
              68.89
              %
              
              67.12
              %
              
              65.31
              %Average
                  loans to average deposits
              
              
              109.26
              %
              
              103.64
              %
              
              96.40
              %
              
              95.79
              %
              
              103.52
              %
              
              108.23
              %
              
              105.03
              %
              
              97.15
              %Net
                  Income
              
              $
              691
              
              $
              1,675
              
              $
              1,978
              
              $
              1,628
              
              $
              1,800
              
              $
              1,510
              
              $
              1,649
              
              $
              1,733Earnings
                  Per Share:Basic
              
              $
              0.09
              
              $
              0.22
              
              $
              0.26
              
              $
              0.24
              
              $
              0.27
              
              $
              0.23
              
              $
              0.25
              
              $
              0.26Diluted
              
              $
              0.09
              
              $
              0.21
              
              $
              0.25
              
              $
              0.23
              
              $
              0.26
              
              $
              0.22
              
              $
              0.24
              
              $
              0.25Outstanding
                  Shares:Basic
              
              
              7,705,174
              
              
              7,694,546
              
              
              7,682,730
              
              
              6,796,286
              
              
              6,754,321
              
              
              6,703,358
              
              
              6,673,239
              
              
              6,668,263Diluted
              
              
              7,830,390
              
              
              7,851,831
              
              
              7,887,206
              
              
              7,013,070
              
              
              7,027,090
              
              
              6,936,239
              
              
              6,928,273
              
              
              6,924,357




*
      The
      efficiency ratio is defined as total non-interest expense as a percent of the
      combined net interest income plus non-interest income, exclusive of gains and
      losses on the sale of investment securities.





*Local
      Economy*





The
      economy in the Company’s service area is based primarily on agriculture,
      tourism, light industry, oil and retail trade. Services supporting these
      industries have also developed in the areas of medical, financial and
      educational services. The population of San Luis Obispo County, the City of
      Santa Maria (in Northern Santa Barbara County) and the City of Santa Barbara
      totaled approximately 260,000 and 92,000 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, has historically experienced a more stable level of
      economic activity when compared to many other areas of California.





*Critical
      Accounting Policies*





The
      Company’s significant accounting policies are set forth in the 2007 Annual
      Report, Note 1 of the consolidated financial statements, which was filed on
      Form
      10-K.





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





·
            ***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.




-
          24
          -




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 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 also Note 3 to the consolidated financial statements for further discussion
      on Allowance for Loan Losses.





·
            ***Securities
                Available for Sale***





The
      fair
      values of most securities that are designated available for sale are based
      on
      quoted market prices. If quoted market prices are not available, fair values
      are
      extrapolated from the quoted prices of similar instruments.





·
            ***Goodwill
                and Other Intangible Assets***





As
      discussed in the 2007 Annual Report, Note 1 of the consolidated financial
      statements, which was filed on Form 10-K, we assess goodwill and other
      intangible assets each year for impairment. This assessment involves a “carrying
      amount comparison” that compares the fair value of the reporting unit to its
      carrying value (stated shareholders’ equity, including goodwill). If the
      carrying value of a reporting unit materially exceeds its fair value, 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, 2007.





-
          25
          -


**Results
      of Operations**





The
      Company’s earnings are highly influenced by changes in short term interest
      rates. The nature of the Company’s balance sheet can be summarily described as
      of short duration and asset sensitive. The balance sheet is of short duration
      because a large percentage of its interest sensitive assets and liabilities
      re-price immediately with changes in Federal Funds and Prime interest rates.
      This was evidenced during the first six months of 2008, as the FOMC cut the
      overnight Fed Funds rate by 225 basis points. The result was sequential declines
      in interest income and interest expense in the first and second quarters of
      2008
      from that reported for the three months ended December 31, 2007. The Company
      has
      historically been 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. However, during
      2007
      and the first half of 2008, the Bank engaged in promotional activities designed
      to attract lower cost core deposits. As a result of these promotions, the
      balance of floating rate money market accounts increased dramatically. This
      proved to be beneficial during the first and second quarters of 2008, as the
      Bank had the ability to re-price those funds in conjunction with the moves
      in
      interest rates made by the FOMC. The ability to rapidly re-price significant
      portions of the balance sheet allowed for a relatively stable net interest
      margin. For the three and six months ended June 30, 2008 the Bank’s net interest
      margin was 5.28% and 5.31%, respectively. This, when compared to the 5.33%
      reported for the first quarter of 2008 and fourth quarter of 2007, represents
      minimal declines of 5 and 2 basis points, respectively. Given that interest
      rates are considerably lower on a year over year basis, the net interest margin
      contracted approximately 28 and 30 basis points when compared to the same three
      and six month periods ended June 30 th a year
      earlier.





Historically,
      the largest and most variable source of income for the Company is net interest
      income. The results of operations for the three and six months ended June 30,
      2008 and 2007 reflect the impact of a rising rate environment that covered
      the
      majority of 2004 through the third quarter of 2007 as well as a dramatic decline
      in interest rates from the fourth quarter of 2007 through April of
      2008.





*Net
      Interest Income and Interest Margin*





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





The
      volume and rate variances table below sets forth the dollar difference in
      interest earned and paid for each major category of interest-earning assets
      and
      interest-bearing liabilities for the three and six month periods ended June
      30,
      2008 over the same period ended in 2007, and the amount of such change
      attributable to changes in average balances (volume) or changes in average
      yields and rates.


**For the three months ended**
              
              **For the six months ended****June 30, 2008 over 2007**
              
              **June 30, 2008 over 2007***(dollars
                  in thousands)*
              
              **Volume**
              
              **Rate**
              
              **Total**
              
              **Volume**
              
              **Rate**
              
              **Total****Interest
                  Income:**Loans
                  (1)
              
              $
              2,722
              
              $
              (1,204
              )
              $
              1,518
              
              $
              5,996
              
              $
              (2,202
              )
              $
              3,794Investment
                  securities taxable
              
              
              293
              
              
              49
              
              
              342
              
              
              465
              
              
              73
              
              
              538Investment
                  securities non-taxable (2)
              
              
              13
              
              
              (2
              )
              
              11
              
              
              21
              
              
              -
              
              
              21Taxable
                  equivalent adjustment (2)
              
              
              (5
              )
              
              1
              
              
              (4
              )
              
              (7
              )
              
              -
              
              
              (7
              )Interest-bearing
                  deposits
              
              
              -
              
              
              1
              
              
              1
              
              
              -
              
              
              1
              
              
              1Federal
                  funds sold
              
              
              (39
              )
              
              (78
              )
              
              (117
              )
              
              23
              
              
              (104
              )
              
              (81
              )Net
                  increase (decrease)
              
              
              2,984
              
              
              (1,233
              )
              
              1,751
              
              
              6,498
              
              
              (2,232
              )
              
              4,266**Interest
                  Expense:**Savings,
                  now, money market
              
              
              20
              
              
              (12
              )
              
              8
              
              
              1,030
              
              
              (235
              )
              
              795Time
                  deposits
              
              
              289
              
              
              (667
              )
              
              (378
              )
              
              1,122
              
              
              (1,341
              )
              
              (219
              )Other
                  borrowings
              
              
              (1,004
              )
              
              805
              
              
              (199
              )
              
              582
              
              
              (1,189
              )
              
              (607
              )Long
                  term borrowings
              
              
              (108
              )
              
              97
              
              
              (11
              )
              
              2
              
              
              (123
              )
              
              (121
              )Net
                  increase (decrease)
              
              
              (803
              )
              
              223
              
              
              (580
              )
              
              2,736
              
              
              (2,888
              )
              
              (152
              )Total
                  net increase (decrease)
              
              $
              3,787
              
              $
              (1,456
              )
              $
              2,331
              
              $
              3,762
              
              $
              656
              
              $
              4,418




(1)
            Loan
                fees of $369 and $353 for the three months ending June 30, 2008 and
                2007,
                respectively and $724 and $641 for the six months ending June 30,
                2008 and
                2007, respectively have been included in interest income
                computation.


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





-
          26
          -





The
      tables below set forth average balance sheet information, interest income and
      expense, average yields and rates and net interest income and margin for the
      three and six month periods ended June 30, 2008 and 2007. The average balance
      of
      non-accruing loans has been included in loan totals.





**For
                the three months ending**
            
            **For
                the three months ending****June
                30, 2008**
            
            **June
                30, 2007****Yield/**
            
            **Income/**
            
            
            
            **Yield/**
            
            **Income/***(dollars
                in thousands)*
            
            **Balance**
            
            **Rate
                (4)**
            
            **Expense**
            
            **Balance**
            
            **Rate
                (4)**
            
            **Expense****Interest
                Earning Assets:**Investments
                with other banks
            
            $
            281
            
            
            4.29
            %
            $
            3
            
            $
            318
            
            
            2.52
            %
            $
            2Investment
                securities taxable
            
            
            46,594
            
            
            5.26
            %
            
            609
            
            
            23,636
            
            
            4.53
            %
            
            267Investment
                securities non-taxable
            
            
            17,423
            
            
            4.27
            %
            
            185
            
            
            16,621
            
            
            4.30
            %
            
            178Federal
                funds sold
            
            
            9,249
            
            
            1.96
            %
            
            45
            
            
            13,198
            
            
            4.92
            %
            
            162Loans
                (1) (2)
            
            
            656,917
            
            
            7.18
            %
            
            11,732
            
            
            469,719
            
            
            8.72
            %
            
            10,214Total
                interest earning assets
            
            
            730,464
            
            
            6.92
            %
            
            12,574
            
            
            523,492
            
            
            8.29
            %
            
            10,823Allowance
                for possible loan losses
            
            
            (6,475
            )
            
            
            
            
            
            
            
            (4,417
            )Other
                assets
            
            
            67,083
            
            
            
            
            
            
            
            
            59,619Total
                assets
            
            $
            791,072
            
            
            
            
            
            
            
            $
            578,694**Interest
                Bearing Liabilities:**Savings/NOW/money
                market
            
            
            295,713
            
            
            1.39
            %
            
            1,020
            
            
            181,654
            
            
            2.23
            %
            
            1,012Time
                deposits
            
            
            152,628
            
            
            3.16
            %
            
            1,199
            
            
            133,377
            
            
            4.74
            %
            
            1,577Other
                borrowings
            
            
            92,825
            
            
            2.45
            %
            
            565
            
            
            55,607
            
            
            5.55
            %
            
            769Federal
                funds purchased
            
            
            3,439
            
            
            2.46
            %
            
            21
            
            
            1,130
            
            
            5.68
            %
            
            16Long-term
                debt
            
            
            13,403
            
            
            5.40
            %
            
            180
            
            
            10,242
            
            
            7.48
            %
            
            191Total
                interest-bearing liabilities
            
            
            558,008
            
            
            2.15
            %
            
            2,985
            
            
            382,010
            
            
            3.74
            %
            
            3,565Demand
                deposits
            
            
            152,927
            
            
            
            
            
            
            
            
            138,696Other
                liabilities
            
            
            7,856
            
            
            
            
            
            
            
            
            5,818Total
                liabilities
            
            
            718,791
            
            
            
            
            
            
            
            
            526,524**Stockholders'
                Equity:**Common
                stock
            
            
            46,291
            
            
            
            
            
            
            
            
            29,833Additional
                paid in capital
            
            
            824
            
            
            
            
            
            
            
            
            467Retained
                earnings
            
            
            25,129
            
            
            
            
            
            
            
            
            21,801Valuation
                allowance investments
            
            
            37
            
            
            
            
            
            
            
            
            69Total
                stockholders' equity
            
            
            72,281
            
            
            
            
            
            
            
            
            52,170Total
                liabilities and stockholders' equity
            
            $
            791,072
            
            
            
            
            
            
            
            $
            578,694Net
                interest income
            
            
            
            
            
            
            
            $
            9,589
            
            
            
            
            
            
            
            $
            7,258Net
                interest margin (3)
            
            
            
            
            
            5.28
            %
            
            
            
            
            
            
            
            5.56
            %





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


(2)
            Loan
                fees of $369 and $353 for the three months ending June 30, 2008 and
                2007,
                respectively have been included in interest income
                computation.


(3)
            Net
                interest margin has been calculated by dividing the net interest
                income by
                total average earning assets.


(4)
            Yield/Rate
                is annualized using actual number of days in
                period.





-
          27
          -


**For the six months ending**
            
            **For the six months ending****June 30, 2008**
            
            **June 30, 2007****Yield/**
            
            **Income/**
            
            
            
            **Yield/**
            
            **Income/***(dollars
                in thousands)*
            
            **Balance**
            
            **Rate
                (4)**
            
            **Expense**
            
            **Balance**
            
            **Rate
                (4)**
            
            **Expense****Interest
                Earning Assets:**Investments
                with other banks
            
            $
            306
            
            
            3.94
            %
            $
            6
            
            $
            318
            
            
            3.17
            %
            $
            5Investment
                securities taxable
            
            
            42,370
            
            
            5.13
            %
            
            1,081
            
            
            23,924
            
            
            4.58
            %
            
            543Investment
                securities non-taxable
            
            
            17,273
            
            
            4.30
            %
            
            369
            
            
            16,636
            
            
            4.30
            %
            
            355Federal
                funds sold
            
            
            8,631
            
            
            2.61
            %
            
            112
            
            
            7,834
            
            
            4.97
            %
            
            193Loans
                (1) (2)
            
            
            640,449
            
            
            7.48
            %
            
            23,823
            
            
            465,297
            
            
            8.68
            %
            
            20,029Total
                interest earning assets
            
            
            709,029
            
            
            7.20
            %
            
            25,391
            
            
            514,009
            
            
            8.29
            %
            
            21,125Allowance
                for possible loan losses
            
            
            (6,339
            )
            
            
            
            
            
            
            
            (4,299
            )Other
                assets
            
            
            64,924
            
            
            
            
            
            
            
            
            58,630Total
                assets
            
            $
            767,614
            
            
            
            
            
            
            
            $
            568,340**Interest
                Bearing Liabilities:**Savings/NOW/money
                market
            
            
            299,808
            
            
            1.69
            %
            
            2,526
            
            
            170,263
            
            
            2.05
            %
            
            1,731Time
                deposits
            
            
            153,334
            
            
            3.64
            %
            
            2,779
            
            
            129,695
            
            
            4.66
            %
            
            2,998Other
                borrowings
            
            
            69,250
            
            
            2.67
            %
            
            918
            
            
            56,420
            
            
            5.44
            %
            
            1,521Federal
                funds purchased
            
            
            3,824
            
            
            2.94
            %
            
            56
            
            
            2,123
            
            
            5.70
            %
            
            60Long-term
                debt
            
            
            13,403
            
            
            6.05
            %
            
            403
            
            
            13,352
            
            
            7.91
            %
            
            524Total
                interest-bearing liabilities
            
            
            539,619
            
            
            2.49
            %
            
            6,682
            
            
            371,853
            
            
            3.71
            %
            
            6,834Demand
                deposits
            
            
            148,518
            
            
            
            
            
            
            
            
            139,878Other
                liabilities
            
            
            8,051
            
            
            
            
            
            
            
            
            5,218Total
                liabilities
            
            
            696,188
            
            
            
            
            
            
            
            
            516,949**Stockholders'
                Equity:**Common
                stock
            
            
            45,164
            
            
            
            
            
            
            
            
            29,587Additional
                paid in capital
            
            
            768
            
            
            
            
            
            
            
            
            419Retained
                earnings
            
            
            25,416
            
            
            
            
            
            
            
            
            21,316Valuation
                allowance investments
            
            
            78
            
            
            
            
            
            
            
            
            69Total
                stockholders' equity
            
            
            71,426
            
            
            
            
            
            
            
            
            51,391Total
                liabilities and stockholders' equity
            
            $
            767,614
            
            
            
            
            
            
            
            $
            568,340Net
                interest income
            
            
            
            
            
            
            
            $
            18,709
            
            
            
            
            
            
            
            $
            14,291Net
                interest margin (3)
            
            
            
            
            
            5.31
            %
            
            
            
            
            
            
            
            5.61
            %


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


(2)
            Loan
                fees of $724 and $641 for the six months ending June 30, 2008 and
                2007,
                respectively have been included in interest income
                computation.


(3)
            Net
                interest margin has been calculated by dividing the net interest
                income by
                total average earning assets.


(4)
            Yield/Rate
                is annualized using actual number of days in
                period.





-
          28
          -





The
      tables below set forth changes in average interest earning assets and their
      respective yields for the three and six month periods ending June 30, 2008
      compared to the same periods ended in 2007.


**Average Balance**
              
              
              
              **Average Yield****for the three months ending**
              
              
              
              **for the three months ending****June 30,**
              
              **Variance**
              
              **June 30,***(dollars
                  in thousands)*
              
              **2008**
              
              **2007**
              
              **dollar**
              
              **percentage**
              
              **2008**
              
              **2007**
              
              **Variance**Time
                  deposits with other banks
              
              $
              281
              
              $
              318
              
              $
              (37
              )
              
              -11.64
              %
              
              4.29
              %
              
              2.52
              %
              
              1.77
              %Investment
                  securities taxable
              
              
              46,594
              
              
              23,636
              
              
              22,958
              
              
              97.13
              %
              
              5.26
              %
              
              4.53
              %
              
              0.73
              %Investment
                  securities non-taxable
              
              
              17,423
              
              
              16,621
              
              
              802
              
              
              4.83
              %
              
              4.27
              %
              
              4.30
              %
              
              -0.03
              %Federal
                  funds sold
              
              
              9,249
              
              
              13,198
              
              
              (3,949
              )
              
              -29.92
              %
              
              1.96
              %
              
              4.92
              %
              
              -2.96
              %Loans
                  (1) (2)
              
              
              656,917
              
              
              469,719
              
              
              187,198
              
              
              39.85
              %
              
              7.18
              %
              
              8.72
              %
              
              -1.54
              %Total
                  interest earning assets
              
              $
              730,464
              
              $
              523,492
              
              $
              206,972
              
              
              39.54
              %
              
              6.92
              %
              
              8.29
              %
              
              -1.37
              %




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


(2)
            Loan
                fees of $369 and $353 for the three months ending June 30, 2008 and
                2007,
                respectively have been included in the interest income
                computation.




**Average Balance**
            
            
            
            **Average Yield****for the six months ending**
            
            
            
            **for the six months ending****June 30,**
            
            **Variance**
            
            **June 30,***(dollars
                in thousands)*
            
            **2008**
            
            **2007**
            
            **dollar**
            
            **percentage**
            
            **2008**
            
            **2007**
            
            **Variance**Time
                deposits with other banks
            
            $
            306
            
            $
            318
            
            $
            (12
            )
            
            -3.77
            %
            
            3.94
            %
            
            3.17
            %
            
            0.77
            %Investment
                securities taxable
            
            
            42,370
            
            
            23,924
            
            
            18,446
            
            
            77.10
            %
            
            5.13
            %
            
            4.58
            %
            
            0.55
            %Investment
                securities non-taxable
            
            
            17,273
            
            
            16,636
            
            
            637
            
            
            3.83
            %
            
            4.30
            %
            
            4.30
            %
            
            0.00
            %Federal
                funds sold
            
            
            8,631
            
            
            7,834
            
            
            797
            
            
            10.17
            %
            
            2.61
            %
            
            4.97
            %
            
            -2.36
            %Loans
                (1) (2)
            
            
            640,449
            
            
            465,297
            
            
            175,152
            
            
            37.64
            %
            
            7.48
            %
            
            8.68
            %
            
            -1.20
            %Total
                interest earning assets
            
            $
            709,029
            
            $
            514,009
            
            $
            195,020
            
            
            37.94
            %
            
            7.20
            %
            
            8.29
            %
            
            -1.09
            %




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


(2)
            Loan
                fees of $724 and $641 for the six months ending June 30, 2008 and
                2007,
                respectively have been included in the interest income
                computation.





As
      of
      June 30, 2008, total earning assets were approximately $207.0 million higher
      than when reported a year earlier. The primary factor for the increase in
      interest earning assets can be attributed to the acquisition of Business First,
      organic loan growth, and the purchase of approximately $18.4 million in
      investment securities during the first six months of 2008. At June 30, 2008,
      Business First accounted for approximately $167.5 million and $158.7 million
      of
      the quarter and year to date increases in interest earning assets. Additionally,
      the Company continues to increase the loan portfolio organically with continued
      market penetration by a team of seasoned loan officers. Additions to the loan
      portfolio for the three and six months ending June 30, 2008 were achieved under
      the Company’s established loan policy.





For
      the
      three and six month periods ended June 30, 2008, the average yield on loans
      was
      7.18% and 7.48%, respectively. This represents declines of 154 and 120 basis
      points from the 8.72% and 8.68% reported for the same periods ended a year
      earlier. As conditions in the credit markets and specifically the financial
      services industry have worsened over the last nine months, the FOMC has moved
      to
      cut the overnight Fed Funds rate in aggregate by 325 basis points since late
      in
      the third quarter of 2007. This has had a direct impact in the average yield
      of
      the loan portfolio, as corresponding declines in the Prime rate have brought
      yields in the portfolio down. The decline in the average yield of the loan
      portfolio is the primary contributory factor in the year over declines in the
      yield on earning assets. For the three and six month periods ended June 30,
      2008, the yield on earning assets declined approximately 137 and 109 basis
      points, respectively when compared to the same periods ended a year ago.





Also
      contributing to the decline in the yield on earning assets were declines in
      the
      yield on federal funds sold of approximately 296 and 236 basis points for the
      three and six months ended June 30, 2008. The declines in the yield earned
      on
      federal funds sold are a direct result of the moves made by the FOMC since
      late
      in the third quarter to cut the overnight Fed Funds rate.





As
      evidenced in the tables above, the yield on taxable investment securities
      increased approximately 73 and 55 basis points for the three and six month
      periods ended June 30, 2008 when compared to the same periods ended a year
      earlier. During the first six months of 2008, the Bank purchased approximately
      $18.2 million in mortgage backed securities with yields somewhat higher than
      other securities in the portfolio, contributing significantly to the rise in
      yield of the portfolio overall. See also “Item 3. Quantitative and Qualitative
      Disclosure About Market Risk” for additional discussion.




-
          29
          -


The
      tables below set forth changes in average interest bearing liabilities and
      their
      respective rates for the three and six month periods ending June 30, 2008
      compared to the same periods ended in 2007.


**Average Balance**
              
              
              
              
              
              **Average Rate****for the three months ending**
              
              
              
              
              
              **for the three months ending****June 30,**
              
              **Variance**
              
              **June 30,***(dollars
                  in thousands)*
              
              **2008**
              
              **2007**
              
              **dollar**
              
              **percentage**
              
              **2008**
              
              **2007**
              
              **Variance**Savings/NOW/money
                  market
              
              $
              295,713
              
              $
              181,654
              
              $
              114,059
              
              
              62.79
              %
              
              1.39
              %
              
              2.23
              %
              
              -0.84
              %Time
                  deposits
              
              
              152,628
              
              
              133,377
              
              
              19,251
              
              
              14.43
              %
              
              3.16
              %
              
              4.74
              %
              
              -1.58
              %Other
                  borrowings
              
              
              92,825
              
              
              55,607
              
              
              37,218
              
              
              66.93
              %
              
              2.45
              %
              
              5.55
              %
              
              -3.10
              %Federal
                  funds purchased
              
              
              3,439
              
              
              1,130
              
              
              2,309
              
              
              204.34
              %
              
              2.46
              %
              
              5.68
              %
              
              -3.22
              %Long
                  term debt
              
              
              13,403
              
              
              10,242
              
              
              3,161
              
              
              30.86
              %
              
              5.40
              %
              
              7.48
              %
              
              -2.08
              %Total
                  interest-bearing liabilities
              
              $
              558,008
              
              $
              382,010
              
              $
              175,998
              
              
              46.07
              %
              
              2.15
              %
              
              3.74
              %
              
              -1.59
              %


**Average Balance**
              
              
              
              
              
              **Average Rate****for the six months ending**
              
              
              
              
              
              **for the six months ending****June 30,**
              
              **Variance**
              
              **June 30,***(dollars
                  in thousands)*
              
              **2008**
              
              **2007**
              
              **dollar**
              
              **percentage**
              
              **2008**
              
              **2007**
              
              **Variance**Savings/NOW/money
                  market
              
              $
              299,808
              
              $
              170,263
              
              $
              129,545
              
              
              76.09
              %
              
              1.69
              %
              
              2.05
              %
              
              -0.36
              %Time
                  deposits
              
              
              153,334
              
              
              129,695
              
              
              23,639
              
              
              18.23
              %
              
              3.64
              %
              
              4.66
              %
              
              -1.02
              %Other
                  borrowings
              
              
              69,250
              
              
              56,420
              
              
              12,830
              
              
              22.74
              %
              
              2.67
              %
              
              5.44
              %
              
              -2.77
              %Federal
                  funds purchased
              
              
              3,824
              
              
              2,123
              
              
              1,701
              
              
              80.12
              %
              
              2.94
              %
              
              5.70
              %
              
              -2.76
              %Long
                  term debt
              
              
              13,403
              
              
              13,352
              
              
              51
              
              
              0.38
              %
              
              6.05
              %
              
              7.91
              %
              
              -1.86
              %Total
                  interest-bearing liabilities
              
              $
              539,619
              
              $
              371,853
              
              $
              167,766
              
              
              45.12
              %
              
              2.49
              %
              
              3.71
              %
              
              -1.22
              %




At
      June
      30, 2008 the balance of average interest bearing liabilities was approximately
      $176.0 million and $167.8 million higher than that reported for the same three
      and six month periods ended a year earlier. The primary factor contributing
      to
      the increase was the acquisition of Business First as well as promotions the
      Bank engaged in during the majority of 2007 and early 2008 designed to attract
      lower cost core deposits. This is evidenced by the $114.1 million or 62.8%
      and
      $129.5 million or 76.1% increases in Savings, NOW and Money Market account
      balances for the three and six month periods ended June 30, 2008 when compared
      to the same periods ended a year earlier. The quarter and year to date increases
      in interest bearing deposit balances, of approximately $75.8 million and $72.2
      million can be attributed to core deposit balances the Bank obtained in the
      acquisition of Business First.





The
      average balance of floating rate deposits represented approximately 66.0% and
      57.7% and 66.2% and 56.8% of total interest bearing deposit accounts for the
      three and six month periods ended June 30, 2008 and 2007 respectively. The
      increase in floating rate deposit balances allowed the Bank to re-price its
      interest bearing deposits more rapidly in conjunction with the moves in the
      over
      night Fed Funds made by the FOMC during the first six months of 2008. The
      ability to rapidly re-price these funds was a contributing factor in stabilizing
      the net interest margin at 5.28% and 5.31% for the three and six months ended
      June 30, 2008 when compared to the 5.33% reported for the three month periods
      ended March 31, 2008 and December 31, 2007. The declines in the average rates
      paid on interest bearing liabilities for the three and six month periods ended
      June 30, 2008 when compared to the same periods ended a year earlier can be
      attributed almost exclusively to the 325 basis point decline in the overnight
      Fed Funds rate since late in the third quarter of 2007.




-
          30
          -




*Non-Interest
      Income*





The
      tables below set forth changes in non-interest income for the three and six
      month periods ended June 30, 2008 compared to the same periods ended in 2007.





**For the three months ended****June 30,**
            
            **Variance***(dollars in thousands)*
            
            **2008**
            
            **2007**
            
            **dollar**
            
            **percentage**Service
                charges on deposit accounts
            
            $
            837
            
            $
            684
            
            $
            153
            
            
            22.4
            %ATM/Debit
                Card transaction/interchange fees
            
            
            218
            
            
            201
            
            
            17
            
            
            8.5
            %Bancard
            
            
            70
            
            
            59
            
            
            11
            
            
            18.6
            %Mortgage
                origination fees
            
            
            83
            
            
            110
            
            
            (27
            )
            
            -24.5
            %Earnings
                on bank owned life insurance
            
            
            119
            
            
            107
            
            
            12
            
            
            11.2
            %Gain
                on sale of investment securities
            
            
            37
            
            
            -
            
            
            37
            
            
            0.0
            %Other
            
            
            392
            
            
            230
            
            
            162
            
            
            70.4
            %Total
                non-interest income
            
            $
            1,756
            
            $
            1,391
            
            $
            365
            
            
            26.2
            %








**For the six months ended****June 30,**
            
            **Variance***(dollars in thousands)*
            
            **2008**
            
            **2007**
            
            **dollar**
            
            **percentage**Service
                charges on deposit accounts
            
            $
            1,609
            
            $
            1,295
            
            $
            314
            
            
            24.2
            %ATM/Debit
                Card transaction/interchange fees
            
            
            413
            
            
            378
            
            
            35
            
            
            9.3
            %Bancard
            
            
            113
            
            
            117
            
            
            (4
            )
            
            -3.4
            %Mortgage
                origination fees
            
            
            249
            
            
            259
            
            
            (10
            )
            
            -3.9
            %Earnings
                on bank owned life insurance
            
            
            231
            
            
            213
            
            
            18
            
            
            8.5
            %Gain
                on sale of investment securities
            
            
            37
            
            
            -
            
            
            37
            
            
            0.0
            %Other
            
            
            543
            
            
            361
            
            
            182
            
            
            50.4
            %Total
                non-interest income
            
            $
            3,195
            
            $
            2,623
            
            $
            572
            
            
            21.8
            %




Non-interest
      income increased approximately $365 thousand or 26.2% and $572 thousand or
      21.8%
      for the three and six month periods ended June 30, 2008 when compared to the
      same periods ended a year earlier. As evidenced in the tables above, one of
      the
      primary factors behind the overall increase in non-interest income can be
      attributed to higher service charges on deposit accounts. Of the quarter and
      year to date increases in this category, approximately $94 thousand and $229
      thousand can be attributed to the acquisition of Business First. The additional
      deposit relationships obtained resulting from the promotional activities the
      Bank engaged in during the majority of 2007 and early 2008 have also contributed
      to the year over year increase within this category.





The
      primary factor behind the year over year increase in debit card interchange
      income can be attributed to the acquisition of Business First, the additional
      accounts the Bank added over the prior year related to promotional activities,
      and a stronger emphasis being placed on customer debit card usage.





Other
      non-interest income for the three and six months ended June 30, 2008 increased
      approximately $162 thousand and $182 thousand, respectively. The primary factor
      behind the year over year increases in this category can be attributed to
      proceeds the Bank received from the Visa, Inc. initial public offering in the
      approximate amount of $272 thousand.





Mortgage
      origination fee income was approximately $27 thousand and $10 thousand lower
      for
      the three and six months ended June 30, 2008, when compared to the same periods
      ended a year earlier. Origination volumes declined during the second quarter
      of
      2008, as concerns over the values of real-estate, a rise in interest rates
      when
      compared to the first quarter, and buyers being less eager to purchase homes
      led
      to weaker volumes. However, the decline in interest rates on a year over year
      basis has contributed to the number of home owners seeking to re-finance. This
      was evidenced in the first quarter of 2008, contributing greatly to the minimal
      decline in volumes the Bank saw on a year to date basis when compared to a
      year
      ago. Additionally, since the fourth quarter of 2007, the Bank has moved to
      strengthen the origination team with additional high quality, seasoned
      professionals. Management believes these additions will help to strengthen
      the
      Bank’s position to become one of the preferred originators within its current
      market footprint.




-
          31
          -




The
      table
      below illustrates the change in the number and total dollar volume of mortgage
      loans originated during the three and six months ended June 30, 2008 when
      compared to the same periods ended in 2007.





**For the three months ended June 30,***(dollars in thousands)*
            
            **2008**
            
            **2007**
            
            **Variance**Dollar
                volume
            
            $
            12,973
            
            $
            14,477
            
            
            -10.4
            %Number
                of loans
            
            
            38
            
            
            43
            
            
            -11.6
            %





**For the six months ended June 30,***(dollars in thousands)*
            
            **2008**
            
            **2007**
            
            **Variance**Dollar
                volume
            
            $
            29,377
            
            $
            29,620
            
            
            -0.8
            %Number
                of loans
            
            
            83
            
            
            84
            
            
            -1.2
            %





*Non-Interest
      Expenses*





The
      tables below set forth changes in non-interest expenses for the three and six
      month periods ended June 30, 2008 compared to the same periods ended in
      2007.





**For the three months ended****June 30,**
            
            **Variance***(dollars in thousands)*
            
            **2008**
            
            **2007**
            
            **dollar**
            
            **percentage**Salaries
                and employee benefits
            
            $
            4,021
            
            $
            3,194
            
            $
            827
            
            
            25.9
            %Occupancy
                and equipment
            
            
            1,129
            
            
            706
            
            
            423
            
            
            59.9
            %Data
                processing
            
            
            672
            
            
            571
            
            
            101
            
            
            17.7
            %Advertising
                and promotional
            
            
            235
            
            
            213
            
            
            22
            
            
            10.3
            %Regulatory
                fees
            
            
            117
            
            
            28
            
            
            89
            
            
            317.9
            %Other
                professional fees and outside services
            
            
            311
            
            
            281
            
            
            30
            
            
            10.7
            %Legal
                fees and other litigation expense
            
            
            26
            
            
            18
            
            
            8
            
            
            44.4
            %Loan
                department costs
            
            
            39
            
            
            28
            
            
            11
            
            
            39.3
            %Stationery
                and supplies
            
            
            105
            
            
            78
            
            
            27
            
            
            34.6
            %Director
                fees
            
            
            80
            
            
            77
            
            
            3
            
            
            3.9
            %Core
                deposit intangible amortization
            
            
            215
            
            
            88
            
            
            127
            
            
            144.3
            %Other
            
            
            548
            
            
            281
            
            
            267
            
            
            95.0
            %Total
                non-interest expense
            
            $
            7,498
            
            $
            5,563
            
            $
            1,935
            
            
            34.8
            %








**For the six months ended****June 30,**
            
            **Variance***(dollars in thousands)*
            
            **2008**
            
            **2007**
            
            **dollar**
            
            **percentage**Salaries
                and employee benefits
            
            $
            8,247
            
            $
            6,444
            
            $
            1,803
            
            
            28.0
            %Occupany
                and equipment
            
            
            2,268
            
            
            1,421
            
            
            847
            
            
            59.6
            %Data
                processing
            
            
            1,326
            
            
            1,105
            
            
            221
            
            
            20.0
            %Advertising
                and promotional
            
            
            481
            
            
            427
            
            
            54
            
            
            12.6
            %Regulatory
                fees
            
            
            225
            
            
            55
            
            
            170
            
            
            309.1
            %Other
                professional fees and outside services
            
            
            597
            
            
            625
            
            
            (28
            )
            
            -4.5
            %Legal
                fees and other litigation expense
            
            
            63
            
            
            46
            
            
            17
            
            
            37.0
            %Loan
                department costs
            
            
            71
            
            
            70
            
            
            1
            
            
            1.4
            %Stationery
                and supplies
            
            
            224
            
            
            172
            
            
            52
            
            
            30.2
            %Director
                fees
            
            
            158
            
            
            147
            
            
            11
            
            
            7.5
            %Core
                deposit intangible amortization
            
            
            430
            
            
            177
            
            
            253
            
            
            142.9
            %Other
            
            
            1,028
            
            
            567
            
            
            461
            
            
            81.3
            %Total
                non-interest expense
            
            $
            15,118
            
            $
            11,256
            
            $
            3,862
            
            
            34.3
            %




-
          32
          -




·
            ***Salary
                and Employee Benefits***





Salaries
      and employee related expense incurred the greatest dollar increase of any
      non-interest expense category for the three and six months ended June 30, 2008
      when compared to the same periods ended in 2007. The primary factor driving
      the
      increase within this category can be attributed to the acquisition of Business
      First. Of the quarter and year to date increases within this category,
      approximately $507 thousand and $1,128 thousand can be attributed to acquired
      staff costs. Additionally, the Bank opened a new full service branch in the
      town
      of San Miguel, which has also contributed to the increase within this
      category.





·
            ***Occupancy
                and Equipment***





Expenses
      related to occupancy and equipment increased significantly for the three and
      six
      months ended June 30, 2008 when compared to the same periods ended a year
      earlier. Late in the second quarter of 2007, the Bank sold four of its
      properties in a sale-leaseback transaction. While this contributed significantly
      to the year over year increase in occupancy and equipment expenses, the Bank
      benefited to the extent that approximately $12.8 million in additional liquidity
      was available for investment in earning assets. Additionally, the addition
      of
      two branches related to the acquisition of Business First contributed to the
      increase with this category. For the three and six months ended June 30, 2008
      the additional expense incurred within this category attributable to Business
      First was approximately $201 thousand and $415 thousand, respectively.
      Additionally, the opening of a new branch in the town of San Miguel, as
      previously mentioned, also contributed to the quarter and year to date increases
      within this category.





·
            ***Data
                Processing***





Expenses
      within this category increased approximately $101 thousand and $221 thousand
      for
      the three and six month periods ended June 30, 2008 when compared to the same
      period ended a year earlier. The primary factor behind the increase within
      this
      category can be attributed to higher transaction processing volumes related
      to
      the acquisition of Business First. Also, the additional deposit relationships
      the Bank obtained over the last year have also contributed to the increase
      within this category.





·
            ***Regulatory
                Fees***





For
      the
      three and six months ended June 30, 2008 regulatory fees increased approximately
      $89 thousand and $170 thousand, respectively. During 2007 the Bank received
      a
      one-time assessment credit under the Federal Deposit Insurance Reform Act of
      2005 to recognize its past contributions to the insurance fund. It is the
      absence of this one-time credit during the three and six months ended June
      30,
      2008 that contributed substantially to the year over year increases within
      this
      category.





·
            ***Core
                Deposit Intangible (“CDI”)
                Amortization***





Upon
      the
      acquisition of Business First the Company booked CDI in the approximate amount
      of $3.8 million. The remaining balance of this intangible will be amortized
      over
      a six year period. For the three and six months ended June 30, 2008 CDI
      amortization was approximately $127 thousand and $253 thousand higher than
      that
      reported for the same periods ended in 2007. Of the quarter and year to date
      increases approximately $119 thousand and $239 thousand can be attributed to
      the
      acquisition of Business First.





·
            ***Provision
                for Income Taxes***





For
      the
      three and six month periods ended June 30, 2008, the provision for income taxes
      was 35.5% and 37.3% of pre tax income. For the same periods ended a year
      earlier, the provision for income taxes was 38.3% and 38.1% of pre tax
      income.




-
          33
          -




**Financial
      Condition Analysis**





At
      June
      30, 2008 total assets were $800.1 million compared to $745.6 million at December
      31, 2007. This represents an increase of $54.5 million or approximately 7.3%.
      During the first six months of 2008, the Bank saw gross loan growth in the
      approximate amount of $46.6 million. The majority of the increase in loan
      balances can be attributed to increases in the commercial and industrial and
      land segments of the portfolio.





The
      Bank
      also saw declines in deposit balances during the first six months of 2008 and
      consequently lower balances of Federal Funds sold and higher balances of Federal
      Home Loan Bank borrowing. The large decline in the overnight Fed Funds rate
      during the first quarter prompted the Bank to reduce the rate paid on its
      interest bearing deposits and as a result total deposit balances declined
      approximately $10.3 million or 1.6% from the balance reported at December 31,
      2007. During the second quarter of 2008, the Bank purchased approximately $30.0
      million in brokered deposits in an effort to rely less on Federal Home Loan
      Bank
      borrowing. Net of brokered deposits, total deposits declined approximately
      $40.3
      million from that reported at December 31, 2007. For the quarter, total
      deposits, net of brokered, increased approximately $14.1 million.




*Loans*





At
      June
      30, 2008, total gross loan balances were $659.8 million. This represents an
      increase of approximately $46.6 million or 7.6% from the balance reported at
      December 31, 2007. As previously mentioned, the primary factor behind the year
      to date increase in total gross loans can be attributed to higher commercial
      and
      industrial and land loan balances in the approximate amount of $45.0 million.





The
      table
      below sets forth changes from December 31, 2007 to June 30, 2008 for the
      composition of the loan portfolio:




**June 30,**
            
            **December 31,**
            
            **Variance***(dollars in thousands)*
            
            **2008**
            
            **2007**
            
            **dollar**
            
            **percentage****Real
                Estate Secured:**Multi-family
                residential
            
            $
            14,457
            
            $
            12,779
            
            $
            1,678
            
            
            13.13
            %Residential
                1 to 4 family
            
            
            26,466
            
            
            24,326
            
            
            2,140
            
            
            8.80
            %Home
                equity lines of credit
            
            
            19,220
            
            
            17,470
            
            
            1,750
            
            
            10.02
            %Commercial
            
            
            268,612
            
            
            274,266
            
            
            (5,654
            )
            
            -2.06
            %Farmland
            
            
            10,652
            
            
            11,557
            
            
            (905
            )
            
            -7.83
            %**Commercial:**Commercial
                and industrial
            
            
            154,456
            
            
            133,981
            
            
            20,475
            
            
            15.28
            %Agriculture
            
            
            12,747
            
            
            11,367
            
            
            1,380
            
            
            12.14
            %Other
            
            
            814
            
            
            732
            
            
            82
            
            
            11.20
            %**Construction:**Single
                family residential
            
            
            9,708
            
            
            10,239
            
            
            (531
            )
            
            -5.19
            %Single
                family residential - Spec.
            
            
            16,565
            
            
            18,718
            
            
            (2,153
            )
            
            -11.50
            %Tract
            
            
            2,317
            
            
            1,664
            
            
            653
            
            
            39.24
            %Multi-family
            
            
            9,482
            
            
            9,054
            
            
            428
            
            
            4.73
            %Hospitality
            
            
            21,401
            
            
            16,784
            
            
            4,617
            
            
            27.51
            %Commercial
            
            
            27,565
            
            
            30,677
            
            
            (3,112
            )
            
            -10.14
            %Land
            
            
            55,555
            
            
            31,064
            
            
            24,491
            
            
            78.84
            %Installment
                loans to individuals
            
            
            7,792
            
            
            7,977
            
            
            (185
            )
            
            -2.32
            %All
                other loans (including overdrafts)
            
            
            2,003
            
            
            562
            
            
            1,441
            
            
            256.41
            %Total
                loans, gross
            
            
            659,812
            
            
            613,217
            
            
            46,595
            
            
            7.60
            %Deferred
                loan fees
            
            
            1,756
            
            
            1,732
            
            
            24
            
            
            1.39
            %Reserve
                for possible loan losses
            
            
            8,128
            
            
            6,143
            
            
            1,985
            
            
            32.31
            %Total
                loans, net
            
            $
            649,928
            
            $
            605,342
            
            $
            44,586
            
            
            7.37
            %Loans
                held for sale
            
            $
            1,246
            
            $
            902
            
            $
            344
            
            
            38.14
            %




-
          34
          -




·
            ***Real-Estate
                Secured***





Real-Estate
      secured loan balances declined approximately $1.0 million from that reported
      at
      December 31, 2007. Contributing to the overall decline were lower commercial
      real-estate balances. This is primarily the result of several large loan
      pay-downs during the second quarter totaling approximately $7.7 million.
      Additionally, several other loans in amounts less than $1.0 million were also
      paid down during the quarter. Mitigating the decline, were the funding of
      several new loans in amounts between $0.5 million and $1.0 million during the
      quarter.





Hotel
      loans disbursed are not considered a concentration with balances of
      approximately $50.5 million, representing 75.6% of the Bank’s Tier I capital.
      However, there are several hotel construction and land loans that increase
      total
      outstanding balances to $75.7 million as well as un-disbursed commitments of
      approximately $16.8 million, which in aggregate represent a concentration at
      138.6% of the Bank’s Tier I capital. These loans are made to clients throughout
      our market area and have historically performed in a satisfactory
      manner.





As
      of
      June 30, 2008, approximately $139.2 million or 40.9% of real-estate secured
      loans are considered owner occupied.





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





·
            ***Commercial***





Loans
      within this category increased $21.9 million or 15.0% from the year ended
      December 31, 2007. Increases in commercial and industrial loan balances in
      the
      approximate amount $20.5 million are the primary factor behind the increase
      within this category. During the first six months of 2008, the Bank funded
      thirteen new loans in excess of $1.0 million within this category with an
      aggregate balance of approximately $26.4 million, with the majority of these
      fundings taking place during the second quarter.  Additionally,
      many other smaller loans with balances of $0.5 million or less were made during
      the first six months of the year. New loans within this category were made
      to
      medical groups, contractors, hotel operators, farmers and others within the
      Bank’s primary market area. At June 30, 2008, the aggregate balance of loans
      within this category was approximately $168.0 million, representing 251.8%
      of
      the Bank’s Tier I Capital. Additionally, approximately $1.0 million of
      commercial loans were SBA guaranteed at June 30, 2008.





·
            ***Construction***





At
      June
      30, 2008, construction loan balances were approximately $87.0 million or $0.1
      million less than that reported at December 31, 2007. During the second quarter,
      loan pay-downs out paced new fundings as the Bank has become very selective
      in
      the loans it originates within this category. During the first six months of
      the
      year the Bank funded approximately $5.1 million of new loans within this
      category and at the same time saw several sizable pay-offs in the aggregate
      amount of $6.6 million. At June 30, 2008, total construction balances
      represented 130.5% of the Bank’s Tier I Capital. Un-disbursed commitments within
      this category totaled approximately $49.2 million and when combined with
      disbursed represent 204.3% of the Bank’s Tier I Capital. As of June 30, 2008,
      approximately $22.3 million or 25.6% of the construction portfolio is considered
      owner occupied. Construction loans are typically granted for a one year period
      and then, with income properties, are amortized over a period not more than
      30
      years with 10 to 15 year maturities.





During
      the second quarter of 2008, the Bank placed approximately $9.2 million in single
      family spec construction loans on non-accrual status. The Bank also charged-off
      approximately $206 thousand in construction balances. For a more detailed
      discussion related to the loans the Bank has placed on non-accrual status,
      please see “Non Performing Assets” under Item 2. Management’s Discussion and
      Analysis of Financial Condition and Results of Operations on this Form 10-Q.
      The
      Bank continues to closely monitor this segment of the loan portfolio for
      additional signs of deterioration and has devoted additional resources to this
      effort.




-
          35
          -




·
            ***Land***





At
      June
      30, 2008 the balance of loans within this category was approximately $55.6
      million. When compared to the $31.1 million reported at December 31, 2007,
      land
      balances increased approximately $24.5 million. The year to date increase within
      this category can be attributed in large part to the funding of six loans in
      excess of $1.0 million with an aggregate balance of $18.1 million. Two of the
      largest new loans made within this category consist of loans for residential
      tract developments in the aggregate amount of $13.4 million. These projects
      are
      located in the California Central Valley in Kern County. One project is approved
      for 314 single family lots. This project, located in Bakersfield, California,
      has also been approved for approximately 8.6 acres of commercial development
      and
      13.5 acres for recreational purposes. The project was funded in the first
      quarter of 2008 and has an approximate loan to value of 50.0%, based on an
      appraisal conducted earlier in the year. The borrower is in the process of
      grading the project site and anticipates cash flow will be obtained in this
      process from the excavation of rock at the site that will later be sold. The
      Bank anticipates the cash flow obtained from the grading/excavation of the
      site
      will be used to pay-down the loan and that the borrower will begin to see cash
      flow from the project early in the third quarter. At June 30, 2008, the balance
      of this loan was approximately $10.6 million, with approximately $1.6 million
      un-disbursed. The second project, located in McFarland, California, consists
      of
      17 finished homes, 38 finished lots and is the only new housing development
      in
      its area. The purpose of the project is to provide affordable housing to a
      market that generally consists of renters. This loan funded in March 2008 at
      approximately $4.1 million and has subsequently been paid down by approximately
      $1.4 million from proceeds of sold homes. The borrower is actively marketing
      the
      remaining finished homes and sales continue to occur at a rate of two homes
      per
      month. Currently there are four homes under contract to be sold within the
      third
      quarter of 2008. The Bank anticipates the additional sale of these homes to
      further reduce the outstanding balance of this loan. Although the Bank continues
      to closely monitor both of these particular loans, the borrowers have continued
      to perform under the contractual terms of their respective loan agreements.
      At
      June 30, 2008, land balances combined with un-disbursed commitments totaled
      approximately $61.1 million or 91.6% of the Bank’s Tier I Capital. Additionally,
      as of June 30, 2008, approximately $10.8 million or 19.4% of the land portfolio
      was considered owner occupied.





·
            ***Installment***





At
      June
      30, 2008, the balance of installment loans was approximately $7.8 million.
      This,
      when compared to the $8.0 million reported at December 31, 2007, represents
      a
      decline of approximately $0.2 million. Installment loans include revolving
      credit plans, consumer loans, Money Plus loans, as well as credit card balances
      obtained in the acquisition of Business First.





·
            ***Loans
                Held For Sale***





Loans
      held for sale consist of mortgage originations that have already been sold
      pursuant to correspondent mortgage loan agreements. There is no interest rate
      risk associated with these loans as the commitments are in place at the time
      the
      Bank funds them. Settlement from the correspondents is typically within 30
      to 45
      days. At June 30, 2008 and December 31, 2007 mortgage correspondent loans (loans
      held for sale) totaled approximately $1.2 million and $0.9 million,
      respectively.





·
            ***Foreign
                Loans***





At
      June
      30, 2008, the Bank had no foreign loans outstanding.





·
            ***Summary
                of Market Condition***





The
      local
      residential real-estate market came under significant pressure during 2007
      and
      continues to remain under pressure thus far in 2008. The market was negatively
      impacted by rising interest rates during the majority of 2007, negative
      sentiment surrounding market values of real-estate, an over supply of newly
      constructed homes and inflationary pressures. As more and more home owners
      began
      to see interest rate resets on adjustable rate mortgages, the number of
      non-performing loans and defaults began to rise in the industry as a whole.
      This
      trend has continued thus far in 2008. These factors eventually led to the
      tightening of credit and further downturn in real-estate markets. Sales of
      single family homes have significantly fallen year over year in the Company’s
      market area and California as a whole, with recent indications showing price
      declines of close to 20%. The Bank continues to employ stringent lending
      standards and remains very selective with regard to any additional real-estate
      construction and land loans it chooses to originate in an effort to effectively
      manage risk in this difficult credit environment. Along with other segments
      in
      the real-estate environment, commercial real-estate prices in the Company’s
      market area have experienced some pressure during 2008, though not to the extent
      of the residential real-estate market. During 2007 the demand for business
      and
      professional properties in the Company’s market area remained relatively strong,
      with low vacancies, competitive loan rates, and many investors seeking exchange
      properties. This helped to provide some insulation against a significant
      downturn in prices as well as the volume of sales. Demand for these properties
      have experienced little to moderate pressure thus far in 2008, and vacancy
      rates, in some of the Company’s market areas, appear to be increasing with
      respect to retail and office segments. Capitalization rates, the rate at which
      a
      stream of cash flows are discounted to find their present value, for the last
      three years were as follows: 5.5% to 6.5% in 2005, 5.0% to 6.5% in 2006, and
      6.0% to 7.0% in 2007.





Although,
      the Company’s market footprint has historically enjoyed a more stable level of
      economic growth, we are not completely immune from the effects of a
      slowdown on a state or national level. As the availability of credit
      significantly diminished and the effects of inflation as well as interest rate
      resets on mortgages placed more pressure on borrowers throughout the U.S.
      economy, the ability of consumers to satisfy outstanding obligations to the
      financial sector has begun to languish. We believe that within certain areas
      of
      our local economy these more macro level concerns have started to become more
      evident, specifically with respect to real-estate development in the single
      family residential market. This has no doubt had an impact on the level of
      and
      type of loans the Bank has placed on non accrual during the first six months
      of
      2008. However, the desirability of the Company’s market footprint and diversity
      of the loan portfolio, we believe will continue to provide some insulation
      against a significant slowdown in growth relative to many other areas within
      California. Additionally, the Company has devoted considerable resources to
      the
      monitoring of credits within the loan portfolio in order to take any appropriate
      steps when and if necessary to mitigate any material adverse impact the slowing
      of the single family residential and commercial real-estate markets may have
      on
      the Bank overall.




-
          36
          -




The
      following table provides a break-down of the Bank’s construction, land, and
      real-estate secured loan portfolios as of June 30, 2008:





**June 30, 2008**
            
            
            
            **Percent of**
            
            
            
            **Single****Undisbursed**
            
            **Total Bank**
            
            **Percent**
            
            **Bank's Tier 1**
            
            **Number**
            
            **Largest***(dollars in thousands)*
            
            **Balance**
            
            **Commitment**
            
            **Exposure**
            
            **Composition**
            
            **Capital**
            
            **of Loans**
            
            **Loan****Construction:**Single
                family residential
            
            $
            9,708
            
            $
            7,560
            
            $
            17,268
            
            
            12.7
            %
            
            25.9
            %
            
            25
            
            $
            1,396Single
                family residential - Spec.
            
            
            16,565
            
            
            7,046
            
            
            23,611
            
            
            17.3
            %
            
            35.4
            %
            
            15
            
            
            2,551Tract
            
            
            2,317
            
            
            455
            
            
            2,772
            
            
            2.0
            %
            
            4.2
            %
            
            5
            
            
            539Multi-family
            
            
            9,482
            
            
            9,867
            
            
            19,349
            
            
            14.2
            %
            
            29.0
            %
            
            7
            
            
            3,650Commercial
            
            
            27,565
            
            
            7,798
            
            
            35,363
            
            
            26.0
            %
            
            53.0
            %
            
            30
            
            
            4,000Hospitality
            
            
            21,401
            
            
            16,468
            
            
            37,869
            
            
            27.8
            %
            
            56.8
            %
            
            5
            
            
            10,891**Total
                construction**
            
            **$**
            **87,038**
            
            **$**
            **49,194**
            
            **$**
            **136,232**
            
            
            **100.0**
            **%**
            
            **204.3**
            **%**
            
            **87**
            
            **$**
            **23,027****Land:**Single
                family residential
            
            $
            8,896
            
            $
            -
            
            $
            8,896
            
            
            14.6
            %
            
            13.3
            %
            
            24
            
            $
            1,400Single
                family residential - Spec.
            
            
            1,073
            
            
            240
            
            
            1,313
            
            
            2.1
            %
            
            2.0
            %
            
            6
            
            
            400Tract
            
            
            31,408
            
            
            5,059
            
            
            36,467
            
            
            59.7
            %
            
            54.7
            %
            
            10
            
            
            10,609Multi-family
            
            
            1,393
            
            
            69
            
            
            1,462
            
            
            2.4
            %
            
            2.2
            %
            
            3
            
            
            675Commercial
            
            
            8,978
            
            
            174
            
            
            9,152
            
            
            15.0
            %
            
            13.7
            %
            
            18
            
            
            1,500Hospitality
            
            
            3,807
            
            
            -
            
            
            3,807
            
            
            6.2
            %
            
            5.7
            %
            
            3
            
            
            2,340**Total
                land**
            
            **$**
            **55,555**
            
            **$**
            **5,542**
            
            **$**
            **61,097**
            
            
            **100.0**
            **%**
            
            **91.6**
            **%**
            
            **64**
            
            **$**
            **16,924****Real-Estate
                Secured:**Retail
            
            $
            41,088
            
            $
            1,569
            
            $
            42,657
            
            
            11.4
            %
            
            63.9
            %
            
            64
            
            $
            3,323Professional
            
            
            72,069
            
            
            2,425
            
            
            74,494
            
            
            20.1
            %
            
            111.7
            %
            
            107
            
            
            8,597Hospitality
            
            
            50,450
            
            
            362
            
            
            50,812
            
            
            13.7
            %
            
            76.2
            %
            
            40
            
            
            5,251Multi-family
            
            
            14,457
            
            
            1,029
            
            
            15,486
            
            
            4.2
            %
            
            23.2
            %
            
            19
            
            
            4,809Home
                equity lines of credit
            
            
            19,220
            
            
            21,995
            
            
            41,215
            
            
            11.1
            %
            
            61.8
            %
            
            266
            
            
            865Residential
                1 to 4 family
            
            
            26,466
            
            
            1,365
            
            
            27,831
            
            
            7.5
            %
            
            41.7
            %
            
            87
            
            
            2,769Farmland
            
            
            10,652
            
            
            645
            
            
            11,297
            
            
            3.0
            %
            
            16.9
            %
            
            26
            
            
            1,937Healthcare
                / medical
            
            
            16,785
            
            
            -
            
            
            16,785
            
            
            4.5
            %
            
            25.2
            %
            
            34
            
            
            2,176Restaurants
                / food establishments
            
            
            7,978
            
            
            94
            
            
            8,072
            
            
            2.2
            %
            
            12.1
            %
            
            15
            
            
            2,554Commercial
            
            
            67,123
            
            
            996
            
            
            68,119
            
            
            18.4
            %
            
            102.1
            %
            
            111
            
            
            4,750Other
            
            
            13,855
            
            
            594
            
            
            14,449
            
            
            3.9
            %
            
            21.7
            %
            
            29
            
            
            3,380**Total
                real-estate secured**
            
            **$**
            **340,143**
            
            **$**
            **31,074**
            
            **$**
            **371,217**
            
            
            **100.0**
            **%**
            
            **556.5**
            **%**
            
            **798**
            
            **$**
            **40,411**





The
      following table provides a break-down for some of the Bank’s largest segments of
      the loan portfolio: commercial real-estate secured, construction, and land
      by
      region as of June 30, 2008:





**Commercial****Real Estate****Geographic Distribution**
            
            **Secured**
            
            **Construction**
            
            **Land**Northern
                San Luis Obispo County
            
            
            28.1
            %
            
            41.8
            %
            
            23.5
            %Southern
                San Luis Obispo County
            
            
            16.5
            %
            
            15.2
            %
            
            19.9
            %Coastal
                Regions - San Luis Obispo County
            
            
            9.2
            %
            
            7.2
            %
            
            2.3
            %Northern
                Santa Barbara County
            
            
            21.1
            %
            
            12.8
            %
            
            2.9
            %Southern
                Santa Barbara County
            
            
            19.2
            %
            
            13.4
            %
            
            14.5
            %Other
            
            
            5.9
            %
            
            9.6
            %
            
            36.9
            %Totals
            
            
            100.0
            %
            
            100.0
            %
            
            100.0
            %




-
          37
          -




*Non
      Performing Assets*





The
      Bank’s Management is responsible for monitoring loan performance, which is done
      through various methods, including a review of loan delinquencies and personal
      knowledge of customers. Additionally, the Bank maintains both a “watch” list of
      loans that, for a variety of reasons, Management believes require regular review
      as well as an internal loan classification process. 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
      has a non-accrual policy that requires a loan greater than 90 days past due
      and/or is specifically determined to be impaired to be placed on non-accrual
      status unless such loan is well-collateralized and in the process of collection.
      When loans are placed on non-accrual status, all uncollected interest accrued
      is
      reversed from earnings. Once on non-accrual status, interest on a loan is only
      recognized on a cash basis and is generally not recognized on specific impaired
      loans unless the likelihood of further loss is remote. Interest payments
      received on such loans are applied as a reduction of the loan principal balance.
      Loans may be returned to accrual status if Management believes that all
      remaining principal and interest is fully collectible and there has been at
      least six months of sustained repayment performance since the loan was placed
      on
      non-accrual.





However,
      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.





Non-performing
      loans include non-accrual loans, restructured loans and accruing loans that
      are
      90 days or more delinquent. As of June 30, 2008, the Bank had one such loan
      with
      an approximate balance of $93 thousand that was 90 days past due and still
      accruing. Loans on non-accrual status totaled $13.4 million at June 30, 2008
      compared to $1.5 million at March 31, 2008 and $0.3 million at December 31,
      2007. In May 2008, the Company reported in an 8-K filing with the Securities
      and
      Exchange Commission, an increase in non-accrual loans of approximately $11.0
      million. All loans on non-accrual are carried at fair value pursuant to SFAS
      No.
      114. As of June 30, 2008, non-accruing loans consist of the
      following:





·
            Nine
                loans in the approximate amount of $10.4 million to three borrowers
                all
                representing single family spec construction loans located in various
                costal communities along the Central Coast of
                California.





·
            Five
                loans in the approximate amount of $2.3 million all secured by commercial
                real-estate and single family
                residences.





·
            Eight
                loans in the approximate amount of $0.7 million to five borrowers
                that are
                collateralized by various business assets and personal
                collateral.





Credit
      quality is consistently monitored and Management has implemented additional
      precautionary actions that include but are not limited to pro-actively
      identifying credit weaknesses earlier in the collection cycle, increasing the
      oversight frequency of watch list credits and devoting additional internal
      resources to monitoring those credits. During the second quarter of 2008, the
      Bank formed a “Special Assets” division to oversee all problem credits and to
      aid in the identification of any additional credits that exhibit signs of
      deterioration.





Interest
      income that would have been recognized on non-accruing loan balances if they
      had
      performed in accordance with the terms of the loans was approximately $276
      thousand and $65 thousand at June 30, 2008 and December 31, 2007,
      respectively.




During
      the second quarter of 2008, the Bank moved to foreclose on a commercial
      real-estate loan that was placed on non-accrual status during the first quarter.
      The value of the asset that was securing the loan was valued at approximately
      $197 thousand and is reflected in the Company’s financial statements as other
      real estate owned (“OREO”). No additional charge off was required at the time
      the asset moved into OREO. In addition, the Bank moved to foreclose on property
      securing an installment loan previously placed on non-accrual status during
      the
      first quarter. This loan had a balance of approximately $50 thousand of which
      $20 thousand was charged off at foreclosure. The value of this property is
      reflected in the Company’s financial statements under other assets. Subsequent
      to the closing of the quarter and the date of the financial statements filed
      on
      this Form 10-Q, the Bank received a cash offer to sell the foreclosed property
      in July and on July 21, 2008 the Bank closed on the sale and recorded a net
      recovery of approximately $15 thousand.




-
          38
          -




At
      June
      30, 2008, non-performing assets were approximately $13.7 million, or 1.71%
      of
      total assets. When compared to the $0.3 million or 0.05% of total assets
      reported at December 31, 2007, this represents an increase of approximately
      $13.4 million. As previously mentioned the increase in non performing assets
      can
      be attributed in large part to nine single family spec construction loans placed
      on non accrual during the second quarter of 2008.





At
      June
      30, 2008, the allowance for loan losses was approximately $8.1 million, or
      1.23%
      of total gross loans. This, when compared to the $6.1 million or 1.00% of total
      gross loans reported at December 31, 2007, represents an increase of
      approximately $2.0 million. The year to date change in the allowance can be
      attributed to net charge offs in the amount of $1.0 million as well as additions
      to the allowance in the amount of $3.0 million. During the second quarter of
      2008, the Bank wrote down the values of certain loans previously placed on
      non
      accrual status. This, in conjunction with the weakened economic environment,
      as
      well as the large year to date increase in non accrual balances, prompted the
      Bank to make substantial additions to the allowance during the second quarter
      of
      2008. As of June 30, 2008, Management believes that the allowance for loan
      losses is prudent and warranted, based on information currently
      available.





The
      following table provides a summary of non-performing assets at June 30, 2008
      compared to December 31, 2007 as well as key asset quality ratios:


**June 30,**
              
              **December 31,***(dollars in thousands)*
              
              **2008**
              
              **2007**Loans
                  delinquent 90 days or more and still accruing
              
              $
              93
              
              $
              -Non
                  Accruing Loans:Real-estate
                  secured
              
              
              1,564
              
              
              261Commercial
              
              
              1,236
              
              
              62Construction
              
              
              10,009
              
              
              -Land
              
              
              591
              
              
              -Installment
                  loans
              
              
              14
              
              
              15Total
                  non-accruing loans
              
              $
              13,414
              
              $
              338Other
                  real-estate owned
              
              $
              197
              
              $
              -Total
                  non-performing assets
              
              $
              13,704
              
              $
              338Ratio
                  of allowance for credit losses to total gross loans
              
              
              1.23
              %
              
              1.00
              %Ratio
                  of allowance for credit losses to total non-performing
                  loans
              
              
              60.18
              %
              
              1817
              %Ratio
                  of non-performing loans to total gross loans
              
              
              2.05
              %
              
              0.06
              %Ratio
                  of non-performing assets to total assets
              
              
              1.71
              %
              
              0.05
              %





*Total
      Cash and Cash Equivalents*





Total
      cash and due from banks was $43.0 million and $46.4 million at June 30, 2008
      and
      December 31, 2007, respectively. This line item will vary depending on cash
      letters from the previous night and actual cash on hand in the branches.
      Additionally, lower deposit balance during the first quarter of 2008 when
      compared to that reported at December 31, 2007 have contributed to fewer Federal
      Funds sold.




*Investment
      Securities and Other Earning Assets*





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




-
          39
          -




The
      table
      below sets forth the change in balances of other earning assets as of June
      30,
      2008 from that reported at December 31, 2007.




**June 30,**
            
            **December 31,**
            
            **Variance***(dollars in thousands)*
            
            **2008**
            
            **2007**
            
            **dollar**
            
            **percentage**Federal
                Home Loan Bank stock
            
            $
            5,401
            
            $
            3,045
            
            $
            2,356
            
            
            77.37
            %Available-for-sale
                securities
            
            
            57,064
            
            
            47,556
            
            
            9,508
            
            
            19.99
            %Federal
                funds sold
            
            
            15,660
            
            
            23,165
            
            
            (7,505
            )
            
            -32.40
            %Interest
                bearing deposits other financial institutions
            
            
            131
            
            
            330
            
            
            (199
            )
            
            -60.30
            %Total
                other earning assets
            
            $
            78,256
            
            $
            74,096
            
            $
            4,160
            
            
            5.61
            %





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





At
      June
      30, 2008, total other earning assets increased approximately $4.2 million from
      that reported at December 31, 2007, due primarily to increases in available
      for
      sale securities and Federal Home Loan Bank stock. The increase in the balance
      of
      Federal Home Loan Bank stock can be attributable to the year to date increases
      in Federal Home Loan Bank borrowing, resulting from lower deposit balances.
      The
      decline in the balance of Federal Funds sold can also be attributed to lower
      deposit balances, resulting in fewer excess funds available for overnight
      investment. Additionally, the amount of Federal Funds sold can vary widely
      on a
      daily basis depending on the cash position of the bank which is affected by
      numerous variables such as cash letters, incoming and outgoing wire activity,
      and loan funding needs.





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
      shareholders’ equity. At June 30, 2008, net unrealized losses in the portfolio
      were $957 thousand or $563 thousand, net of tax. This, when compared to the
      net
      unrealized gain of approximately $313 thousand or $184 thousand, net of tax
      the
      portfolio had at December 31, 2007, represents a decline in market value of
      approximately $1,270 thousand or $747 thousand, net of tax. The decline in
      the
      market value can be attributed in large part to continued concerns surrounding
      mortgage related securities as well as increases in market interest rates during
      the later part of the second quarter of 2008. In addition to changes in market
      values, the year to date change in the securities portfolio can be attributed
      to
      purchases in the amount $18.4 million, proceeds from principal reduction in
      mortgage-backed securities in the amount of $5.2 million, as well as sales
      and
      maturities totaling $2.5 million.





During
      the second quarter of 2008, the Bank sold two mortgage backed securities with
      total proceeds of approximately $1.5 million. In connection with this sale
      the
      Bank recognized a gain of approximately $37 thousand or $22 thousand net of
      tax.





During
      the third and fourth quarters of 2007, fixed income markets saw a significant
      re-pricing of credit risk, which caused the values of certain classes of fixed
      income instruments to fall, specifically those related to Collateralized Debt
      Obligations (“CDO”) and Mortgage-Backed Securities (“MBS”). Concerns surrounding
      these asset classes continued to overhang the market during the first half
      of
      2008 and the Bank’s securities portfolio was not completely immune to market
      fluctuations.





As
      part
      of the acquisition of Business First, the Bank acquired five whole loan CMO
      (“Collateralized Mortgage Obligation”) securities with a remaining principle
      balance of approximately $4.0 million and a net unrealized loss of approximately
      $150 thousand or $88 thousand net of tax. Additionally, the Bank purchased
      four
      additional whole loan CMOs in the approximate amount of $17.0 million in the
      first six months of 2008. Management performs extensive review of the underlying
      collateral for these securities, including but not limited to updates on: credit
      enhancements, loan-to-values, credit scores, delinquency rates and default
      rates. At June 30, 2008, the market value of these securities had a net
      unrealized loss of approximately $753 thousand or $443 thousand net of tax.





At
      June
      30, 2008, other than the nine whole loan CMOs discussed in the paragraph above,
      the remaining MBS and CMOs in the Bank’s investment portfolio were issued by:
      The Government National Mortgage Association (“Ginnie Mae”), The Federal
      National Mortgage Association (“Fannie Mae”), and The Federal Home Loan Mortgage
      Corporation (“Freddie Mac”). These securities carry the guarantee of the issuing
      agencies.





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




-
          40
          -


*Deposits
        and Borrowed Funds*
 
 The
        table
        below sets forth the change in the various categories of deposits from December
        31, 2007 to June 30, 2008:
 
 **% of Total****June 30,**
              
              **December 31,**
              
              **Variance**
              
              **Deposits***(dollars
                  in thousands)*
              
              **2008**
              
              **2007**
              
              **dollar**
              
              **percentage**
              
              **6/30/08**Non-interest
                  bearing demand
              
              $
              168,589
              
              $
              153,684
              
              $
              14,905
              
              
              9.70
              %
              
              26.6
              %Interest
                  bearing demand
              
              
              83,387
              
              
              69,558
              
              
              13,829
              
              
              19.88
              %
              
              13.1
              %Savings
              
              
              23,067
              
              
              41,599
              
              
              (18,532
              )
              
              -44.55
              %
              
              3.6
              %Money
                  market
              
              
              187,345
              
              
              206,754
              
              
              (19,409
              )
              
              -9.39
              %
              
              29.5
              %Time
                  deposits of $100 or more
              
              
              79,756
              
              
              75,966
              
              
              3,790
              
              
              4.99
              %
              
              12.6
              %Time
                  deposits under $100
              
              
              92,374
              
              
              97,247
              
              
              (4,873
              )
              
              -5.01
              %
              
              14.6
              %Total
                  deposits
              
              $
              634,518
              
              $
              644,808
              
              $
              (10,290
              )
              
              -1.60
              %
              
              100.0
              %
 
 Acquisition
        of core deposits has remained the single biggest challenge facing the Company.
        Still, the Company has been able to increase deposits on a year over year
        basis
        due to the acquisition of Business First, 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.
 
 At
        June
        30, 2008, total deposit balances were approximately $10.3 million lower than
        that reported at December 31, 2007. The moves by the FOMC during the first
        half
        of 2008 to cut the overnight Fed Funds rate by an aggregate 225 basis points
        has
        had a direct impact on the Bank’s total deposit balances. The Bank moved
        aggressively to lower rates paid on interest bearing accounts in response
        to the
        actions taken by the FOMC and as a result, we began to see some expected
        deposit
        run-off. In particular, deposit run-off was most evident in time deposit
        balances. Contributing to the year to date decline in time deposits was the
        call
        of approximately $10.7 million in higher cost brokered funds the Bank assumed
        upon the acquisition of Business First. However, during the second quarter
        of
        2008, the Bank purchased approximately $30.0 million in brokered deposits,
        which
        is fully reflected in the table above. The Bank purchased these funds in
        an
        effort to rely less on Federal Home Loan Bank borrowings and to maintain
        an
        appropriate mix of secondary funding. Net of brokered funds, total time deposit
        balances declined approximately $31.1 million during the first six months
        of
        2008 and increased approximately $10.3 million over that reported at March
        31,
        2008. Declines in savings and money market balances, resulting from the
        re-pricing of deposits, also contributed to the year to date decline in total
        deposit balances. Mitigating the decline in overall deposits were increases
        in
        non-interest and interest bearing demand balances. Increases in these categories
        can be attributed in part to increased balances of those deposits classified
        as
        public funds as well as promotions the Bank currently has in place to attract
        lower cost core deposits. Management has been keenly aware of the need for
        lower
        cost core deposits in order to rely less on secondary funding sources, but
        has
        chosen not to engage in irrational deposit pricing in an effort to not only
        maintain the net interest margin, but also to build a deposit base based
        on
        customer relationship.
 
 As
        of
        June 30, 2008, core deposit balances (demand, savings, and money market)
        represented 72.9% of total deposits compared to 73.1% of total deposits at
        December 31, 2007. Non-interest bearing demand accounts represent approximately
        26.6% of total deposits at June 30, 2008. Of this balance, approximately
        $22.7
        million consist of deposit relationships that the Bank considers to be volatile
        in nature. This when compared to the $15.7 million reported at December 31,
        2007, represents an increase of approximately $7.0 million. The customers
        that
        hold these deposits engage in mortgage related activities. These volatile
        account relationships are included in the volatile liability dependency report
        that the Bank produces on a monthly basis. Typically, a material change in
        balances held by these customers is reflected in the balance of 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 aware that as conditions in the mortgage market
        change, these relationships will be impacted. Additionally, the Bank closely
        monitors three additional deposit relationships that it also considers to
        be
        volatile. At June 30, 2008, the balances of these accounts were approximately
        $45.5 million. This when compared to the $42.6 million reported at December
        31,
        2007, represents an increase of approximately $2.9 million. At June 30, 2008,
        two of these accounts are classified as money market accounts with balances
        of
        approximately $28.9 million, while the other is classified as an interest
        bearing demand account with a balance of approximately $16.5 million and
        is
        considered public funds.
 
 Additionally,
        the Bank has a policy in place that permits the purchase of brokered funds
        as a
        secondary source for funding. This policy permits the Bank to purchase brokered
        funds in an amount not to exceed 10% of total assets. As previously mentioned,
        the Bank purchased approximately $30.0 million in brokered funds during the
        second quarter of 2008.
  -
            41
            -
  The
        following table provides a summary of the Federal Home Loan Bank (“FHLB”)
        borrowings the Bank had as of June 30, 2008:
 
 *(dollars
                  in thousands)***Amount**
              
              **Interest**
              
              **Maturity****Borrowed**
              
              **Rate**
              
              **Variable/Fixed**
              
              **Date**$
              22,500
              
              
              2.16
              %
              
              Fixed
              
              
              9/22/0810,000
              
              
              2.85
              %
              
              Fixed
              
              
              1/26/0910,000
              
              
              2.60
              %
              
              Fixed
              
              
              2/6/094,000
              
              
              4.93
              %
              
              Fixed
              
              
              2/27/0925,000
              
              
              2.57
              %
              
              Variable/Fixed
              
              
              6/22/09$
              71,500
              
              
              2.62
              %
 
 As
        evidenced in the table above, the balance of FHLB borrowing as of June 30,
        2008
        was $71.5 million. This represents an increase of approximately $63.5 million
        from the balance reported at December 31, 2007. The increase in FHLB borrowing
        is primarily attributable to the $10.3 million decline in deposit balances
        in
        addition to the $44.6 million increase in net loan balances the Bank saw
        during
        the first six months of 2008. Additionally, during the first quarter of 2008,
        the Bank borrowed $10.0 million from the FHLB and securitized that borrowing
        with securities it purchased in the approximate amount of $9.9 million.
        Management makes regular assessments of balance sheet needs to determine
        how
        much if any and at what term it will borrow from the FHLB.
 
 The
        Bank
        utilizes securities sold under repurchase agreements as a source of funds.
        The
        Bank had $2.7 million and $1.9 million in securities sold under agreements
        to
        repurchase at June 30, 2008 and December 31, 2007, respectively.
 
 In
        the
        fourth quarter of 2007, the Company renewed a promissory note with Pacific
        Coast
        Bankers Bank (“PCBB”) for a revolving line of credit in the amount of $3.5
        million. At June 30, 2008, the Company had no balance outstanding on this
        note.
        The Company pledged 646,598 shares (51.0%) 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 June 30, 2008 the interest rate on the note was 5.00% and is variable,
        moving with prime. Under the terms of the agreement, the Company will not
        incur
        any additional debt over $2.0 million exclusive of inter-company debt and
        existing debt without the prior written consent of PCBB. In addition, the
        Bank
        must be “well” capitalized on an on-going basis as defined by bank regulators.
 
 On
        September 17, 2004, the Bank issued a Letter of Credit in the amount of
        approximately $11.7 million to a customer in regard to a senior care facility.
        The Letter of Credit was issued pursuant to a Letter of Credit Reimbursement
        Agreement between the Bank and the FHLB. It is collateralized by a blanket
        lien
        with the FHLB that includes all qualifying loans on the Bank’s balance sheet.
        The letter of credit will expire in September 2009.
 
 *Capital*
 
 The
        Company's total stockholders’ equity was $70.9 million at June 30, 2008 compared
        to $69.5 million at December 31, 2007. The change in capital was due to net
        income of $2.4 million, stock options exercised in the amount of $228 thousand,
        the capital impact of year-to-date share-based compensation expense of $167
        thousand, $587 thousand paid year-to-date in cash dividends, cash paid in
        lieu
        of fractional shares issued in connection with a 5% stock dividend the Company
        paid to stockholders in May 2008, and a decline in accumulated other
        comprehensive income of $747 thousand.
  -
            42
            -
  ·
              ***Dividends***
 
 The
        following table provides a summary of dividends the Company has paid over
        the
        last two years:
 
 **Dividend****Amount**
              
              **Declaration**
              
              **Record**
              
              **Payable****Dividend
                  Type**
              
              **Per
                  Share**
              
              **Date**
              
              **Date**
              
              **Date**Stock
                  dividend
              
              
              5
              %
              
              4/24/2008
              
              
              5/2/2008
              
              
              5/16/2008Cash
                  dividend
              
              $
              0.08
              
              
              24-Jan-08
              
              
              1-Feb-08
              
              
              15-Feb-08Cash
                  dividend
              
              $
              0.08
              
              
              17-Oct-07
              
              
              2-Nov-07
              
              
              16-Nov-07Cash
                  dividend
              
              $
              0.08
              
              
              18-Jul-07
              
              
              3-Aug-07
              
              
              17-Aug-07Cash
                  dividend
              
              $
              0.08
              
              
              20-Apr-07
              
              
              4-May-07
              
              
              18-May-07Cash
                  dividend
              
              $
              0.08
              
              
              19-Jan-07
              
              
              2-Feb-07
              
              
              16-Feb-07Cash
                  dividend
              
              $
              0.08
              
              
              20-Oct-06
              
              
              3-Nov-06
              
              
              17-Nov-06Cash
                  dividend
              
              $
              0.08
              
              
              21-Jul-06
              
              
              11-Aug-06
              
              
              25-Aug-06
 
 As
        evidenced in the table above, on April 24, 2008, the Board of Directors declared
        a stock dividend in the amount of 5% to be paid on May 16, 2008 to shareholders
        of record on May 2, 2008. Shares and earnings per share for all prior periods
        have been adjusted to fully reflect the impact of the May 2008 stock dividend.
        The stock dividend represents a change in the form of dividend payment to
        the
        Company’s shareholders away from a cash dividend, which the Company has paid out
        over the past seven consecutive quarters. The Company had previously paid
        a
        stock dividend on an annual basis to shareholders for 10 consecutive years
        prior
        to switching to a cash dividend in 2006. At this time of economic uncertainty,
        the Board of Directors believes that retention of capital for future growth
        is
        in the best interest of the Company.
 
 ·
              ***Stock
                  Repurchases***
 
 On
        July
        21, 2006, the Board of Directors adopted a resolution authorizing the repurchase
        of up to 40,000 shares of the Company’s common stock. Purchases are to be made,
        as conditions warrant, from time to time in the open market or through privately
        negotiated transactions. The duration of the program is one year and the
        timing
        of purchases will depend on market conditions. Subsequently, on October 20,
        2006, the Board of Directors adopted a resolution to increase the number
        of
        shares available for repurchase under the current plan to 100,000. In July
        2007,
        the Board of Directors authorized a one year extension of this plan, which
        is
        set to expire in August 2008.
 
 As
        of
        June 30, 2008, the Company repurchased and retired approximately 53,500 shares
        of its common stock under the current plan at a weighted average price of
        $17.44. The Company made no repurchases of its common stock during the six
        month
        period ended June 30, 2008. Under the current plan, the Company has the
        authority to repurchase 46,500 shares through July 2008.
 
 ·
              ***Trust
                  Preferred Securities***
 
 On
        October 27, 2006 the Company issued $8.2 million of Floating Rate Junior
        Subordinated Debt Securities (“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. The Company intends to use the proceeds from the issuance of these
        securities for general corporate purposes, which may include capital
        contributions to the Bank, investments, payment of dividends, and repurchases
        of
        our common stock.
 
 On
        April
        23, 2007, the Company redeemed all of the Floating Rate Junior Subordinated
        Debt
        Securities it held associated with Heritage Oaks Capital Trust I, a wholly
        owned
        subsidiary of Heritage Oaks Bancorp. The redemption price was 100% of the
        principal amount redeemed plus accrued and unpaid interest as of the redemption
        date. The Company paid $0.4 million for the standard interest payment due
        April
        22, 2007, plus a payment of $8.2 million for the principal amount to be redeemed
        on that date. These amounts were funded from the Company’s general corporate
        reserves. As a result of the redemption of the securities associated with
        Heritage Oaks Capital Trust I, the Trust was dissolved on June 1,
        2007.
 
 On
        September 20, 2007, the Company issued $5.2 million of Junior Subordinated
        Deferrable Interest Debentures (the “debt securities”) to Heritage Oaks Capital
        Trust III, a statutory trust created under the laws of the State of Delaware.
        These debt securities are subordinated to effectively all borrowings of the
        Company. The Company used the proceeds from the sale of the securities to
        assist
        in the acquisition of Business First, for general corporate purposes, and
        for
        capital contributions to the Bank for future growth.
 
 At
        June
        30, 2008, the Company had $13.4 million in Junior Subordinated Deferrable
        Interest Debentures (the “debt securities”) issued and outstanding. These
        securities have been issued to Heritage Oaks Capital Trusts II and III. The
        debt
        securities are subordinated to effectively all borrowings of the Company
        and can
        be redeemed at par if certain events occur that impact the tax treatment,
        regulatory treatment or the capital treatment of the issuance. Upon the issuance
        of the debt securities, the Company purchased a 3.1% minority interest in
        both
        Heritage Oaks Capital Trusts II and III, totaling $248 thousand and $155
        thousand, respectively. The balance of the equity of Heritage Oaks Capital
        Trusts II and III is comprised of mandatory redeemable preferred securities
        and
        is included in other assets. Interest associated with the securities issued
        to
        Heritage Oaks Capital Trusts II and III is payable quarterly at 3-month LIBOR
        plus 1.71% variable rate and 6.888% fixed, respectively.
  -
            43
            -
  The
        following table provides a summary of the securities the Company has issued
        to
        Heritage Oaks Capital Trusts II and III as of June 30, 2008:
 
 **Amount**
              
              **Current**
              
              **Issue**
              
              **Scheduled**
              
              **Call***(dollars
                  in thousands)*
              
              **Issued**
              
              **Rate**
              
              **Date**
              
              **Maturity**
              
              **Date**
              
              **Rate
                  Type**Heritage
                  Oaks Capital Trust II
              
              $
              8,248
              
              
              4.42
              %
              
              27-Oct-06
              
              
              Aug-37
              
              
              Nov-11
              
              
              Varibale 3-month LIBOR + 1.71
              %Heritage
                  Oaks Capital Trust III
              
              
              5,155
              
              
              6.89
              %
              
              20-Sep-07
              
              
              Sep-37
              
              
              Dec-12
              
              
              5-year
                  Fixed SWAP + 2.00
              %Total
                  Issued
              
              $
              13,403
              
              
              5.37
              %
 
 The
        Company has the right under the indentures to defer interest payments for
        a
        period not to exceed twenty consecutive quarterly periods (each an “Extension
        Period”) provided that no extension period may extend beyond the maturity of the
        debt securities. If the Company elects to defer interest payments pursuant
        to
        terms of the agreements, then the Company may not (i) declare or pay any
        dividends or distributions on, or redeem, purchase, acquire or make a
        liquidation payment with respect to any of the Company’s capital stock, or (ii)
        make any payment of principal of or premium, if any, or interest on or repay,
        repurchase or redeem any debt securities of the Company that rank pari passu
        with or junior in interest to the Debt Securities, other than, among other
        items, a dividend in the form of stock, warrants, options or other rights
        in the
        same stock as that on which the dividend is being paid or ranks pari passu
        with
        or junior to such stock. The prohibition on payment of dividends and payments
        on
        pari passu or junior debt also applies in the case of an event of default
        under
        the agreements.
 
 Under
        FIN
        No. 46, *“Consolidation
        of Variable Interest Entities, an interpretation of ARB No.
        51,”* the
        Company is not allowed to consolidate Heritage Oaks Capital Trusts II and
        III
        into the Company’s financial statements. Prior to the issuance of FIN No. 46,
        Bank holding companies typically consolidated these entities. On February
        28,
        2005, the Federal Reserve Board issued a rule which provides that,
        notwithstanding the deconsolidation of such trusts, junior subordinated
        debentures, such as those issued by the Company, may continue to constitute
        up
        to 25% of a bank holding company's Tier I capital, subject to certain new
        limitations which will not become effective until March 31, 2009 and which,
        in
        any event, are not expected to affect the treatment of the Company's Junior
        Subordinated Debentures as Tier I capital for regulatory purposes. As of
        June
        30, 2008, the Company has included $13.0 million of the net junior subordinated
        debt in its Tier I Capital for regulatory capital purposes.
 
 At
        June
        30, 2008, the Company had sufficient cash to service the $13.4 million in
        junior
        subordinated debenture interest payments for approximately 2.5 years without
        dividends from subsidiaries. The Bank’s capacity to provide cash to the Company,
        while remaining “well-capitalized”, was approximately $4.0 million at June 30,
        2008.
 
 ·
              ***Regulatory
                  Capital Requirements***
 
 Capital
        ratios for commercial banks in the United States are generally calculated
        using
        three different formulas. These calculations are referred to as the “Leverage
        Ratio” and two “risk-based” calculations known as: “Tier One Risk Based Capital
        Ratio” and the “Total Risk Based Capital Ratio.” These standards were developed
        through joint efforts of banking authorities from different countries around
        the
        world. The standards essentially take into account that different types of
        assets have different levels of risk associated with them. Furthermore, they
        take into account the off-balance sheet exposures of banks when assessing
        capital adequacy.
 
 The
        Leverage Ratio calculation simply divides common stockholders’ equity (reduced
        by any goodwill a bank may have) by the total assets. In the Tier One Risk
        Based
        Capital Ratio, the numerator is the same as the leverage ratio, but the
        denominator is the total “risk-weighted assets.” Risk weighted assets are
        determined by segregating all the assets and off balance sheet exposures
        into
        different risk categories and weighting them by a percentage ranging from
        0%
        (lowest risk) to 100% (highest risk). The Total Risk Based Capital Ratio
        again
        uses “risk-weighted assets” in the denominator, but expands the numerator to
        include other capital items besides equity such as a limited amount of the
        loan
        loss reserve, long-term capital debt, preferred stock and other instruments.
  -
            44
            -
  The
        following table provides a Summary of the Company’s and the Bank’s regulatory
        capital ratios at June 30, 2008 and 2007:
 
 **Regulatory
                  Standard**
              
              **June
                  30, 2008**
              
              **June
                  30, 2007****Adequately**
              
              **Well**
              
              **Heritage Oaks**
              
              **Heritage Oaks**
              
              **Heritage Oaks**
              
              **Heritage Oaks****Capitalized**
              
              **Capitalized**
              
              **Bancorp**
              
              **Bank**
              
              **Bancorp**
              
              **Bank**Leverage
                  Ratio
              
              
              4.00
              %
              
              5.00
              %
              
              8.87
              %
              
              8.64
              %
              
              9.58
              %
              
              9.43
              %Tier
                  I Risk Based Captial Ratio
              
              
              4.00
              %
              
              6.00
              %
              
              9.66
              %
              
              9.38
              %
              
              10.64
              %
              
              10.48
              %Total
                  Risk Based Captial Ratio
              
              
              8.00
              %
              
              10.00
              %
              
              10.83
              %
              
              10.55
              %
              
              11.55
              %
              
              11.39
              %
 
 *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 and or other borrowed funds. 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. As of June 30, 2008 the Bank had no balance drawn against
        these credit arrangements. The Bank is also a member of the FHLB and as of
        June
        30, 2008 had approximately $71.5 million in outstanding borrowing from the
        FHLB.
 
 The
        following table provides a summary of the remaining borrowing capacity the
        Company has with various secondary liquidity sources as of June 30, 2008:
 
 *(dollars
                  in thousands)*
              
              **June
                  30, 2008**Federal
                  Home Loan Bank remaining borrowing capacity
              
              $
              84,421Correspondent
                  bank credit arrangements - Bank
              
              
              40,000Revolving
                  line of credit - Holding Company
              
              
              3,500Brokered
                  funds availability
              
              
              49,782Total
                  available secondary liquidity source
              
              $
              177,703
 
 As
        previously mentioned, the Company has a policy that permits the purchase
        of
        brokered funds in an amount not to exceed 10% of total assets. During the
        second
        quarter, the Bank called approximately $1.8 million in brokered funds that
        were
        assumed in the acquisition of Business First. Subsequently, the Bank purchased
        approximately $30.0 million in lower cost brokered funds. This was in an
        effort
        to rely less on FHLB borrowing as a source of funding.
 
 The
        Bank
        manages liquidity by maintaining an investment portfolio of federal funds
        sold
        and other liquid investments. At June 30, 2008, the ratio of liquid assets
        not
        pledged for collateral and other purposes to deposits and other liabilities
        was
        7.53% compared to 9.59% at December 31, 2007. The ratio of net loans to deposits
        was 102.4% at June 30, 2008 compared to 93.9% at December 31, 2007. Net of
        brokered deposits, the net loan to deposit ratio was 107.5% at June 30, 2008.
        The year to decline in deposit balances of $10.3 million and $40.3 million,
        net
        of brokered during the first six months of 2008 in addition to the $44.6
        million
        increase in net loan balances from December 31, 2007 contributed to the increase
        in the loan deposit ratio. The ratio of total gross loans to available funding
        sources, which takes into account all funding sources including those other
        than
        deposits such as FHLB advances and Fed Funds purchased, was 92.9% at June
        30,
        2008 compared to 80.6% at December 31, 2007.
 
 *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. Although, the Company’s market footprint
        has historically enjoyed a more stable level of economic growth, we are not
        completely immune to the effects of a slowdown on a state or national level.
        As
        the availability of credit significantly diminished and the effects of inflation
        as well as interest rate resets on mortgages placed more pressure on borrowers
        throughout the U.S. economy, the ability of consumers to satisfy outstanding
        obligations to the financial sector has begun to languish. We believe that
        within certain areas of our local economy these more macro level concerns
        have
        started to become more evident, specifically with respect to real-estate
        development in the single family residential market. This has no doubt had
        an
        impact on the level of and type of loans the Bank has placed on non accrual
        during the first six months of 2008.
  -
            45
            -
  *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 statements when they are funded or related fees
        are
        incurred or received. For a more detailed discussion of these financial
        instruments, refer to Note 10 of the Company’s Consolidated Financial Statements
        contained in Item 8 of Part II of the Company’s December 31, 2007
        10-K.
 
 In
        the
        ordinary course of business, the Bank is a party to various operating leases.
        For a more detailed discussion of these financial instruments, refer to Note
        10
        of the Company’s Consolidated Financial Statements contained in Item 8 of Part
        II of the Company’s December 31, 2007 10-K.
 
 In
        connection with the $13.4 million in debt securities discussed in “ *Capital* ,”
the
        Company issued the full and unconditional payment guarantee of certain accrued
        distributions.
 
 **Item
        3. Quantitative and Qualitative Disclosure about Market
        Risk**
 
 As
        a
        financial institution, the Company’s primary component of market risk is
        interest rate volatility. Fluctuations in interest rates will ultimately
        impact
        both the level of interest income and interest expense recorded on a large
        portion of the Company’s assets and liabilities, and the market value of all
        interest earning assets and interest bearing liabilities, other than those
        which
        possess a short term to maturity. Virtually all of the Company’s interest
        earning assets and interest bearing liabilities are located at the banking
        subsidiary level. Thus, virtually all of the Company’s interest rate risk
        exposure lies at the banking subsidiary level other than $13.4 million in
        subordinated debentures issued by the Company’s subsidiary grantor trusts. As a
        result, all significant interest rate risk procedures are performed at the
        banking subsidiary level. The subsidiary bank’s real estate loan portfolio,
        concentrated primarily within Santa Barbara and San Luis Obispo Counties,
        California, are subject to risks associated with the local economy.
  The
        fundamental objective of the Company’s management of its assets and liabilities
        is to maximize the Company’s economic value while maintaining adequate liquidity
        and an exposure to interest rate risk deemed by Management to be acceptable.
        Management believes an acceptable degree of exposure to interest rate risk
        results from the management of assets and liabilities through maturities,
        pricing and mix to attempt to neutralize the potential impact of changes
        in
        market interest rates. The Company’s profitability is dependent to a large
        extent upon its net interest income, which is the difference between its
        interest income on interest-earning assets, such as loans and investments,
        and
        its interest expense on interest-bearing liabilities, such as deposits and
        borrowings. The Company is subject to interest rate risk to the degree that
        its
        interest-earning assets re-price differently than its interest-bearing
        liabilities. The Company manages its mix of assets and liabilities with the
        goals of limiting its exposure to interest rate risk, ensuring adequate
        liquidity, and coordinating its sources and uses of funds.
  The
        Company seeks to control interest rate risk exposure in a manner that will
        allow
        for adequate levels of earnings and capital over a range of possible interest
        rate environments. The Company has adopted formal policies and practices
        to
        monitor and manage interest rate risk exposure.  Management believes
        historically it has effectively managed the effect of changes in interest
        rates
        on its operating results.  Management believes that it can continue to
        manage the short-term effect of interest rate changes under various interest
        rate scenarios.
  Management
        employs the use of an Asset and Liability Management software that is used
        to
        measure the Bank’s exposure to future changes in interest rates. This model
        measures the expected cash flows and re-pricing of each financial
        asset/liability separately in measuring the Bank’s interest 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.
  -
            46
            -
  The
        hypothetical impacts of sudden interest rate movements applied to the Company’s
        asset and liability balances are modeled monthly. The results of these models
        indicate how much of the Company’s net interest income is “at risk” from various
        rate changes over a one year horizon. This exercise is valuable in identifying
        risk exposures. Management believes the results for the Company’s June 30, 2008
        balances indicate that the net interest income at risk over a one year time
        horizon for a 1% and 2% rate increase and decrease is acceptable and within
        policy guidelines at this time.
 
 The
        results in the table below indicate the change in net interest income the
        Company would expect to see as of June 30, 2008, if interest rates were to
        change in the amounts set forth:
 
 **Rate
                  Shock Scenarios***(dollars
                  in thousands)*
              
              **-200bp**
              
              **-100bp**
              
              **Base**
              
              **+100bp**
              
              **+200bp**Net
                  interest income (NII)
              
              $
              35,453
              
              $
              37,063
              
              $
              38,588
              
              $
              40,336
              
              $
              42,520$
                  Change from base
              
              $
              (3,135
              )
              $
              (1,525
              )
              $
              -
              
              $
              1,748
              
              $
              3,932%
                  Change from base
              
              
              -8.12
              %
              
              -3.95
              %
              
              0.00
              %
              
              4.53
              %
              
              10.19
              %
 
 It
        is
        important to note that the above table is a summary of several forecasts
        and
        actual results may vary. The forecasts are based on estimates and assumptions
        of
        Management that may turn out to be different and may change over time. Factors
        affecting these estimates and assumptions include, but are not limited to
        1)
        competitor behavior, 2) economic conditions both locally and nationally,
        3)
        actions taken by the Federal Reserve Board, 4) customer behavior and 5)
        Management’s responses. Changes that vary significantly from the assumptions and
        estimates may have significant effects on the Company’s net interest income;
        therefore, the results of this analysis should not be relied upon as indicative
        of actual future results.
 
 The
        following tables show Management’s estimates of how the loan portfolio is broken
        out between variable-daily, variable at various time lines, fixed rate loans
        and
        estimates of re-pricing opportunities for the entire loan portfolio at June
        30,
        2008.
 
 *(dollars
                  in thousands)***Percent
                  of****Rate
                  Type**
              
              **Balance**
              
              **Total**Variable
                  - daily
              
              $
              298,086
              
              
              45.2
              %Variable
                  other than daily
              
              
              203,544
              
              
              30.8
              %Fixed
                  rate
              
              
              158,182
              
              
              24.0
              %Total
                  gross loans
              
              $
              659,812
              
              
              100.0
              %
 
 
 The
        table
        above identifies approximately 45.2% of the loan portfolio that will re-price
        immediately in a changing rate environment. At June 30, 2008, approximately
        $501.6 million or 76.0% of the Bank’s loan portfolio is variable and of this
        balance approximately $152.7 million are currently at their floor.
 
 *(dollars
                  in thousands)***Percent
                  of****Re-Pricing**
              
              **Balance**
              
              **Total**<
                  1 Year
              
              $
              397,374
              
              
              60.2
              %1-3
                  Years
              
              
              136,602
              
              
              20.7
              %3-5
                  Years
              
              
              70,749
              
              
              10.7
              %>
                  5 Years
              
              
              55,087
              
              
              8.4
              %Total
                  gross loans
              
              $
              659,812
              
              
              100.0
              %
 
 The
        table
        above indicates that as of June 30, 2008, approximately 60.2% of the Bank’s loan
        portfolio will re-price within one year.
  -
            47
            -
  **Item
        4. Controls and Procedures**
 
 *Evaluation
        of Disclosure Controls and Procedures*
 
 As
        of the
        end of the period covered by this report, the Company carried out an evaluation,
        under the supervision and with the participation of its management, including
        the Company’s Chief Executive Officer and Chief Financial Officer, of the
        effectiveness of the design and operation of the Company’s disclosure controls
        and procedures pursuant to Exchange Act Rules 13a-15 and 15d-15. Based upon
        that
        evaluation, the Chief Executive Officer and Chief Financial Officer concluded
        that the Company’s disclosure controls and procedures are effective to provide
        reasonable assurances that information required to be disclosed in the reports
        the Company files or submits under the Securities Exchange Act of 1934 is
        recorded, processed, summarized and reported within the time periods specified
        in the SEC’s rules and forms.
 
 *Changes
        in Internal Control Over Financial Reporting*
 
 There
        was
        no change in the Company’s internal controls over financial reporting during the
        quarter ended June 30, 2008 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, 2007 annual report
        filed on Form 10-K in response to Item A to Part I of Form 10-K.
 
 **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 Board of Directors adopted a resolution authorizing the repurchase
        of up to 40,000 shares of the Company’s common stock. Purchases are to be made,
        as conditions warrant, from time to time in the open market or through privately
        negotiated transactions. The duration of the program is one year and the
        timing
        of purchases will depend on market conditions. Subsequently, on October 20,
        2006, the Board of Directors adopted a resolution to increase the number
        of
        shares available for repurchase under the current plan to 100,000. In July
        2007,
        the Board of Directors authorized a one year extension of this plan, which
        is
        set to expire in July 2008.
 
 As
        of
        June 30, 2008, the Company repurchased and retired approximately 53,500 shares
        of its common stock under the current plan at a weighted average price of
        $17.44. The Company made no repurchases of its common stock during the six
        months ended June 30, 2008. Under the current plan, the Company has the
        authority to repurchase 46,500 shares through July 2008.
  -
            48
            -
  **Item
        3. Defaults upon Senior Securities**
 
 Not
        applicable.
 
 **Item
        4. Submission of Matters to a Vote of Security Holders**
 
 The
        following items were submitted to the security holders for approval at the
        Company’s annual meeting held on May 22, 2008:
 
 **1.**
              ***Election
                  of Directors.*******
 To
        elect
        eleven (11) persons to the Board of Directors of the Company to serve until
        the
        2008 Annual Meeting of Shareholders and until their successors are elected
        and
        have qualified. The following persons were elected on the following
        votes:
 
 **Directors**
              
              **Votes
                  For**
              
              **Votes
                  Withheld**
              
              **%
                  Votes For**Michael
                  J. Morris
              
              
              5,283,744
              
              
              531,198
              
              
              72.02
              %Don
                  Campbell
              
              
              5,275,852
              
              
              539,090
              
              
              71.92
              %Michael
                  Behrman
              
              
              5,681,822
              
              
              133,120
              
              
              77.45
              %Kenneth
                  Dewar
              
              
              5,279,744
              
              
              535,198
              
              
              71.97
              %Mark
                  C. Fugate
              
              
              5,685,716
              
              
              129,226
              
              
              77.50
              %Dolores
                  T. Lacey
              
              
              5,277,493
              
              
              537,449
              
              
              71.94
              %Merle
                  F. Miller
              
              
              5,275,021
              
              
              539,921
              
              
              71.90
              %Daniel
                  J. O'Hare
              
              
              5,283,544
              
              
              531,398
              
              
              72.02
              %Michael
                  E. Pfau
              
              
              5,069,213
              
              
              745,729
              
              
              69.10
              %Alexander
                  F. Simas
              
              
              5,283,321
              
              
              531,621
              
              
              72.02
              %Lawrence
                  P. Ward
              
              
              5,280,842
              
              
              534,100
              
              
              71.98
              %
 
 ***2.***
              ***Ratification
                  of Independent
                  Accountants.***
 To
        ratify
        the appointment of Vavrinek, Trine, Day & Co., LLP as the Company’s
        independent accountants for the 2008 fiscal year.
 
 **Votes
                  For**
              
              **Votes
                  Against**
              
              **Votes
                  Abstain**
              
              **%
                  Votes For****Ratification
                  of VTD**
              
              
              5,698,290
              
              
              95,416
              
              
              21,236
              
              
              77.67
              %
 
 **Item
        5. Other Information**
 
 Not
        applicable.
  -
            49
            -
  **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
  -
            50
            -
  **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:
        August 5, 2008
 
 /s/
                  Lawrence P. WardLawrence
                  P. WardPresidentChief
                  Executive Officer
 
 /s/
                  Margaret A. TorresMargaret
                  A. TorresExecutive
                  Vice PresidentChief
                  Financial Officer(Principal
                  Financial and Accounting
                  Officer)
  -
            51
            -