**UNITED
        STATES**
 **SECURITIES
        AND EXCHANGE COMMISSION**
 **WASHINGTON,
        D.C. 20549**
 
 **FORM
        10-Q**
 
 **x QUARTERLY
        REPORT
        PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**
 ****For
        the
        quarterly period ended September 30, 2008
 
 or
 
 **oTRANSITION
        REPORT
        PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**
 ****For
        the
        transition period from _______ to _______
 
 Commission
        File Number: 000-25020
 
 **HERITAGE
        OAKS BANCORP**
 (Exact
        name of registrant as specified in its charter)
 
 **California**
              **77-0388249**(State
                  or other jurisdiction of
                incorporation
                  or organization)
              (I.R.S.
                  Employer
                Identification
                  No.)
 
 **545
                  12th Street,****Paso
                  Robles, California**
              **93446**(Address
                  of principal offices)
              (Zip
                  Code)
 
 **(805)
        369-5200**
 (Registrant's
        telephone number, including area code)
 
 **Not
        Applicable**
 (Former
        name, former address and former fiscal year, if changed since last
        report)
 
 Indicate
        by check mark whether the registrant (1) has filed all reports required to
        be
        filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
        the
        preceding twelve (12) months (or for such shorter period that the registrant
        was
        required to file such reports), and (2) has been subject to such filing
        requirements for the past 90 days.
 
 YES
xNO
o
 
 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 oAccelerated
        filer xNon-accelerated filer oSmaller
        reporting company o
 
 Indicate
        by check mark whether the registrant is a shell company (as defined in Rule
        12b-2 of the Exchange Act).
 
 YES
oNO
x
 
 Indicate
        the number of shares outstanding of each of the issuer's classes of common
        stock, as of the latest practicable date: As of October 22, 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**Note
                  1 – Consolidated Financial Statements
              9Note
                  2 – Investment Securities
              10Note
                  3 – Loans and the Allowance for Loan Losses
              11Note
                  4 – Earnings Per Share
              13Note
                  5 – Recent Accounting Pronouncements
              13Note
                  6 – Share Based Compensation
              15Note
                  7 – Fair Value of Financial Instruments
              17Note
                  8 – Goodwill
              20Note
                  9 – Reclassifications
              20**Item
                  2. Management’s Discussion and Analysis of Financial Condition and Results
                  of Operations**
              21The
                  Company
              21Where
                  You Can Find More Information
              21Earnings
                  and Financial Condition Overview
              22Recent
                  Developments
              23Stock
                  Repurchases and Dividends
              24Selected
                  Financial Data
              25Local
                  Economy
              25Critical
                  Accounting Policies
              26Results
                  of Operations
              27Net
                  Interest Income and Margin
              27Non-Interest
                  Income
              32Non-Interest
                  Expenses
              33Financial
                  Condition Analysis
              35Loans
              35Non-Performing
                  Assets
              40Total
                  Cash and Cash Equivalents
              42Investment
                  Securities and Other Earning Assets
              42Deposits
                  and Borrowed Funds
              43Capital
              46Liquidity
              48Inflation
              49Off-Balance
                  Sheet Arrangements
              49**Item
                  3. Quantitative and Qualitative Disclosure about Market
                  Risk**
              49**Item
                  4. Controls and Procedures**
              51**Part
                  2. Other Information**
              51**Item
                  1. Legal Proceedings**
              51**Item
                  1.A. Risk Factors**
              51**Item
                  2. Unregistered Sales of Equity Securities and Use of
                  Proceeds**
              51**Item
                  3. Defaults Upon Senior Securities**
              52**Item
                  4. Submission of Matters to a Vote of Security
                  Holders**
              52**Item
                  5. Other Information**
              52**Item
                  6. Exhibits**
              53**Signatures**
              54**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)****September 30,**
              
              **December 31,****2008**
              
              **2007****Assets**Cash
                  and due from banks
              
              $
              18,914
              
              $
              23,254Federal
                  funds sold
              
              
              8,835
              
              
              23,165Total
                  cash and cash equivalents
              
              
              27,749
              
              
              46,419Interest
                  bearing deposits with other banks
              
              
              119
              
              
              330Securities
                  available for sale
              
              
              52,634
              
              
              47,556Federal
                  Home Loan Bank stock, at cost
              
              
              5,006
              
              
              3,045Loans
                  held for sale
              
              
              2,955
              
              
              902Loans,
                  net (2)
              
              
              654,403
              
              
              605,342Property,
                  premises and equipment, net
              
              
              6,769
              
              
              6,390Bank
                  owned life insurance
              
              
              10,631
              
              
              9,923Deferred
                  tax assets
              
              
              7,085
              
              
              5,290Goodwill
              
              
              11,541
              
              
              10,911Core
                  deposit intangible
              
              
              3,906
              
              
              4,551Other
                  real estate owned
              
              
              197
              
              
              -Other
                  assets
              
              
              4,940
              
              
              4,895**Total
                  assets**
              
              $
              787,935
              
              $
              745,554**Liabilities**Demand,
                  non-interest bearing
              
              $
              155,267
              
              $
              153,684Savings,
                  NOW, and money market deposits
              
              
              269,744
              
              
              317,911Time
                  deposits of $100 or more
              
              
              75,657
              
              
              75,966Time
                  deposits under $100
              
              
              88,583
              
              
              97,247Total
                  deposits
              
              
              589,251
              
              
              644,808Short
                  term FHLB borrowing
              
              
              96,500
              
              
              4,000Long
                  term FLHB borrowing
              
              
              10,000
              
              
              4,000Securities
                  sold under agreement to repurchase
              
              
              1,235
              
              
              1,936Junior
                  subordinated debentures
              
              
              13,403
              
              
              13,403Other
                  liabilities
              
              
              6,592
              
              
              7,957Total
                  liabilities
              
              
              716,981
              
              
              676,104Commitments
                  and contingencies
              
              
              -
              
              
              -**Stockholders'
                  Equity**Common
                  stock, no par value; 20,000,000 shares authorized; issued and outstanding
                  7,709,600 and 7,683,829 as of September 30, 2008 and December 31,
                  2007,
                  respectively.
              
              
              48,456
              
              
              43,996Additional
                  paid in capital
              
              
              947
              
              
              672Retained
                  earnings
              
              
              22,675
              
              
              24,598Accumulated
                  other comprehensive income
              
              
              (1,124
              )
              
              184Total
                  stockholders' equity
              
              
              70,954
              
              
              69,450**Total
                  liabilities and stockholders' equity**
              
              $
              787,935
              
              $
              745,554
 
 (1)
              These
                  numbers have been derived from the audited financial
                  statements.
 (2)
              Loans
                  net of deferred fees of $1,647 and $1,732 and allowance for loan
                  losses of
                  $10,350 and $6,143 atSeptember
                  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 nine months****ended September 30,**
              
              **ended September 30,****2008**
              
              **2007**
              
              **2008**
              
              **2007****Interest
                  Income:**Interest and fees on loans
              
              $
              11,731
              
              $
              10,058
              
              $
              35,554
              
              $
              30,087Investment securities
              
              
              786
              
              
              426
              
              
              2,236
              
              
              1,324Federal funds sold and commercial paper
              
              
              18
              
              
              385
              
              
              130
              
              
              577Time certificates of deposit
              
              
              1
              
              
              1
              
              
              7
              
              
              7Total interest income
              
              
              12,536
              
              
              10,870
              
              
              37,927
              
              
              31,995**Interest
                  Expense:**Now accounts
              
              
              88
              
              
              55
              
              
              343
              
              
              126MMDA accounts
              
              
              773
              
              
              1,216
              
              
              2,878
              
              
              2,830Savings accounts
              
              
              25
              
              
              21
              
              
              191
              
              
              69Time deposits of $100 or more
              
              
              620
              
              
              610
              
              
              1,825
              
              
              1,120Other time deposits
              
              
              702
              
              
              1,229
              
              
              2,276
              
              
              3,716Other borrowed funds
              
              
              803
              
              
              411
              
              
              2,180
              
              
              2,516Total interest expense
              
              
              3,011
              
              
              3,542
              
              
              9,693
              
              
              10,377Net
                  interest income before provision for possible loan losses
              
              
              9,525
              
              
              7,328
              
              
              28,234
              
              
              21,618Provision for loan losses
              
              
              3,200
              
              
              210
              
              
              6,215
              
              
              520Net
                  interest income after provision for loan losses
              
              
              6,325
              
              
              7,118
              
              
              22,019
              
              
              21,098**Non-Interest
                  Income:**Service charges on deposit accounts
              
              
              878
              
              
              645
              
              
              2,487
              
              
              1,944Other income
              
              
              635
              
              
              664
              
              
              2,184
              
              
              1,988Gain on sale of investment securities
              
              
              -
              
              
              -
              
              
              37
              
              
              -Total non-interest income
              
              
              1,513
              
              
              1,309
              
              
              4,708
              
              
              3,932**Non-Interest
                  Expense:**Salaries and employee benefits
              
              
              3,651
              
              
              3,238
              
              
              11,897
              
              
              9,681Occupancy and equipment
              
              
              1,076
              
              
              830
              
              
              3,344
              
              
              2,251Other expenses
              
              
              2,381
              
              
              1,709
              
              
              6,985
              
              
              5,101Total non-interest expenses
              
              
              7,108
              
              
              5,777
              
              
              22,226
              
              
              17,033Income
                  before provision for income taxes
              
              
              730
              
              
              2,650
              
              
              4,501
              
              
              7,997Provision for applicable income taxes
              
              
              196
              
              
              1,022
              
              
              1,601
              
              
              3,058Net
                  income
              
              $
              534
              
              $
              1,628
              
              $
              2,900
              
              $
              4,939**Earnings
                  Per Share:**Basic
              
              $
              0.07
              
              $
              0.24
              
              $
              0.38
              
              $
              0.73Fully diluted
              
              $
              0.07
              
              $
              0.23
              
              $
              0.37
              
              $
              0.70
 
 See
        notes
        to condensed consolidated financial statements.
  -
            5
            -
 
 **HERITAGE
        OAKS BANCORP**
 **CONSOLIDATED
        STATEMENTS OF STOCKHOLDERS' EQUITY (UNAUDITED)**
 **September
        30, 2008 and 2007**
 *(dollar
        amounts in thousands)*
 
 **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
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (586
              )
              
              
              
              
              (586
              )Share-based
                  compensation expense
              
              
              
              
              
              
              
              
              275
              
              
              
              
              
              
              
              
              
              
              
              275Issuance
                  of restricted stock awards
              
              
              1,000
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              -Retirement
                  of restricted share awards
              
              
              (6,904
              )
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              -Comprehensive
                  income:Net
                  income
              
              
              
              
              
              
              
              
              
              
              $
              2,900
              
              
              2,900
              
              
              
              
              
              2,900Unrealized
                  security holding losses (net of $537 tax benefit)
              
              
              
              
              
              
              
              
              
              
              
              (1,330
              )
              
              
              
              
              (1,330
              )
              
              (1,330
              )Realized
                  gains on sale of securities (net of $15 tax)
              
              
              
              
              
              
              
              
              
              
              
              22
              
              
              
              
              
              22
              
              
              22Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              $
              1,592**Balance,
                  September 30, 2008**
              
              
              7,709,600
              
              $
              48,456
              
              $
              947
              
              
              
              
              $
              22,675
              
              $
              (1,124
              )
              $
              70,954**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
              )Cash
                  dividend - $0.09 per share paid on August 17, 2007
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (519
              )
              
              
              
              
              (519
              )Share-based
                  compensation expense
              
              
              
              
              
              
              
              
              264
              
              
              
              
              
              
              
              
              
              
              
              264Issuance
                  of restricted stock awards
              
              
              1,500
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              -Retirement
                  of restricted share awards
              
              
              (1,250
              )
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              -Repurchases
                  of common stock
              
              
              (6,000
              )
              
              (96
              )
              
              
              
              
              
              
              
              
              
              
              
              
              
              (96
              )Comprehensive
                  income:Net
                  income
              
              
              
              
              
              
              
              
              
              
              $
              4,939
              
              
              4,939
              
              
              
              
              
              4,939Unrealized
                  security holding losses (net of $5 tax benefit)
              
              
              
              
              
              
              
              
              
              
              
              (11
              )
              
              
              
              
              (11
              )
              
              (11
              )Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              $
              4,928**Balance,
                  September 30, 2007**
              
              
              6,469,653
              
              $
              29,976
              
              $
              600
              
              
              
              
              $
              23,205
              
              $
              69
              
              $
              53,850
 ****
 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 nine months****ended September 30,**
              
              **ended September 30,****2008**
              
              **2007**
              
              **2008**
              
              **2007****Net
                  Income**
              
              $
              534
              
              $
              1,628
              
              $
              2,900
              
              $
              4,939**Other
                  comprehensive income / (loss) before taxes:**Unrealized
                  gains / (losses) on securities available for sale arising during
                  the
                  period
              
              
              (953
              )
              
              395
              
              
              (2,260
              )
              
              (16
              )Realized
                  gains on sale of available for sale securities during the
                  period
              
              
              -
              
              
              -
              
              
              37
              
              
              -Total
                  other comprehensive income / (loss) before taxes
              
              
              (953
              )
              
              395
              
              
              (2,223
              )
              
              (16
              )Unrealized
                  income tax benefit / (expense) related to items in comprehensive
                  income /
                  (loss)
              
              
              392
              
              
              (159
              )
              
              930
              
              
              5Income
                  tax related to the sale of available for sale securities
              
              
              -
              
              
              -
              
              
              (15
              )
              
              -**Total
                  other comprehensive income / (loss), net of taxes**
              
              
              (561
              )
              
              236
              
              
              (1,308
              )
              
              (11
              )**Comprehensive
                  income / (loss)**
              
              $
              (27
              )
              $
              1,864
              
              $
              1,592
              
              $
              4,928
 
 See
        notes
        to condensed consolidated financial statements.
  -
            7
            -
 
 **HERITAGE
        OAKS BANCORP**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS (UNAUDITED)**
 *(dollar
        amounts in thousands)*
 **  **  **  **  **  **  **
 **For
                  the nine month periods****ended
                  September 30,****2008**
              
              **2007****Cash
                  flows from operating activities:**Net
                  income
              
              $
              2,900
              
              $
              4,939Adjustments
                  to reconcile net income to net cash provided by operating
                  activities:Depreciation
                  and amortization
              
              
              803
              
              
              705Provision
                  for possible loan losses
              
              
              6,215
              
              
              520Amortization
                  of premiums / discounts on investment securities, net
              
              
              (105
              )
              
              (53
              )Amortization
                  of intangible assets
              
              
              645
              
              
              265Share-based
                  compensation expense
              
              
              275
              
              
              264Federal
                  Home Loan Bank stock dividends received
              
              
              (162
              )
              
              (103
              )Gain
                  on sale of available-for-sale securities
              
              
              (37
              )
              
              (3
              )(Increase)
                  / decrease in loans held for sale
              
              
              (2,053
              )
              
              862Net
                  (increase) in bank owned life insurance
              
              
              (308
              )
              
              (281
              )(Increase)
                  in deferred tax asset
              
              
              (880
              )
              
              (2,545
              )(Increase)
                  / decrease in other assets
              
              
              (823
              )
              
              85(Decrease)
                  / increase in other liabilities
              
              
              (1,277
              )
              
              773Excess
                  tax benefit related to share-based compensation expense
              
              
              (88
              )
              
              (440
              )**NET
                  CASH PROVIDED IN OPERATING ACTIVITIES**
              
              
              5,105
              
              
              4,988**Cash
                  flows from investing activities:**Maturities
                  of time deposits with other banks
              
              
              211
              
              
              (1,400
              )Purchase
                  of available-for-sale securities
              
              
              (18,417
              )
              
              (605
              )Sale
                  of available-for-sale-securities
              
              
              1,537
              
              
              -Maturities
                  and calls of available-for-sale securities
              
              
              2,186
              
              
              564Proceeds
                  from principal reductions and maturitiesof
                  available-for-sale mortgage backed securities
              
              
              7,535
              
              
              3,672Purchase
                  of Federal Home Loan Bank stock
              
              
              (1,799
              )
              
              -Sale
                  of Federal Home Loan Bank stock
              
              
              -
              
              
              282(Increase)
                  in loans, net
              
              
              (55,403
              )
              
              (30,364
              )Allowance
                  for loan and lease loss recoveries
              
              
              127
              
              
              155Purchase
                  of property, premises and equipment, net
              
              
              (1,231
              )
              
              (542
              )Proceeds
                  from sale of property, premises and equipment
              
              
              -
              
              
              12,810Purchase
                  of bank owned life insurance policies
              
              
              (400
              )
              
              -**NET
                  CASH (USED) IN INVESTING ACTIVITIES**
              
              
              (65,654
              )
              
              (15,428
              )**Cash
                  flows from financing activities:**(Decrease)
                  / increase in deposits, net
              
              
              (55,557
              )
              
              75,789Proceeds
                  from Federal Home Loan Bank borrowing
              
              
              330,000
              
              
              55,000Repayments
                  of Federal Home Loan Bank borrowing
              
              
              (231,500
              )
              
              (105,000
              )(Decrease)
                  / increase in repurchase agreements
              
              
              (701
              )
              
              100Decrease
                  in junior subordinated debentures
              
              
              -
              
              
              (3,093
              )Excess
                  tax benefit related to share-based compensation expense
              
              
              88
              
              
              440Repurchase
                  of common stock
              
              
              -
              
              
              (96
              )Proceeds
                  from exercise of stock options
              
              
              140
              
              
              385Cash
                  paid in lieu of fractional shares
              
              
              (5
              )
              
              -Cash
                  dividends paid
              
              
              (586
              )
              
              (1,543
              )**NET
                  CASH PROVIDED BY FINANCING ACTIVITIES**
              
              
              41,879
              
              
              21,982Net
                  (decrease) / increase in cash and cash equivalents
              
              
              (18,670
              )
              
              11,542Cash
                  and cash equivalents, beginning of period
              
              
              46,419
              
              
              23,034**CASH
                  AND CASH EQUIVALENTS, END OF PERIOD**
              
              $
              27,749
              
              $
              34,576**Supplemental
                  disclosures of cash flow information:**Interest
                  paid
              
              $
              9,927
              
              $
              10,518Income
                  taxes paid
              
              $
              2,405
              
              $
              4,980Transfer
                  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)**
 **September
        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 nine months ended September 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 nine months ended September
        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 nine
        month
        periods ended September 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 September 30, 2008 and December 31,
        2007:
 
 *(dollars
                  in thousands)*
              
              
              
              **Gross**
              
              **Gross****Amortized**
              
              **Unrealized**
              
              **Unrealized**
              
              **Fair****As
                  of September 30, 2008**
              
              **Cost**
              
              **Gains**
              
              **Losses**
              
              **Value**Obligations
                  of U.S. government agencies and corporations
              
              $
              151
              
              $
              -
              
              $
              (2
              )
              $
              149Mortgage-backed
                  securities
              
              
              37,305
              
              
              68
              
              
              (1,640
              )
              
              35,733Obligations
                  of state and political subdivisions
              
              
              16,979
              
              
              216
              
              
              (552
              )
              
              16,643Other
                  securities
              
              
              109
              
              
              -
              
              
              -
              
              
              109Total
              
              $
              54,544
              
              $
              284
              
              $
              (2,194
              )
              $
              52,634
  **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
        September 30, 2008, the fair value of the securities portfolio was approximately
        $52.6 million. This, when compared to the $47.6 million reported at December
        31,
        2007, represents an increase of approximately $5.0 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 $7.5 million, and sales, calls
        and
        maturities totaling $3.7 million. Additionally, during the second quarter,
        the
        Bank recognized a gain of approximately $37 thousand related to the sale
        of
        securities previously mentioned.
 
 At
        September 30, 2008, the securities portfolio had a net unrealized loss of
        approximately $1.9 million or $1.1 million, 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 $2.2 million or $1.3 million, net of tax. The year to date
        decline in market value of the securities portfolio can be attributed in
        large
        part to continued concerns surrounding mortgage related securities as well
        as
        concerns over certain segments of the credit markets as a whole.
 
 Management
        reviews the securities portfolio on a regular basis to identify investments
        that
        may be other than temporarily impaired. At September 30, 2008, Management
        does
        not believe that the current losses in the securities portfolio are other
        than
        temporary.
  -
            10
            -
  **Note
        3. Loans and the Allowance for Loan Losses**
 
 The
        following table provides a summary of outstanding loan balances as of September
        30, 2008 compared to December 31, 2007:
 
 **September 30,**
              
              **December 31,***(dollars
                  in thousands)*
              
              **2008**
              
              **2007****Real
                  Estate Secured**Multi-family
                  residential
              
              $
              13,997
              
              $
              12,779Residential
                  1 to 4 family
              
              
              29,031
              
              
              24,326Home
                  equity lines of credit
              
              
              22,247
              
              
              17,470Commercial
              
              
              281,269
              
              
              274,266Farmland
              
              
              10,630
              
              
              11,557**Commercial**Commercial
                  and industrial
              
              
              151,323
              
              
              133,981Agriculture
              
              
              13,059
              
              
              11,367Other
              
              
              662
              
              
              732**Construction**Single
                  family residential
              
              
              12,897
              
              
              10,239Single
                  family residential - Spec.
              
              
              17,469
              
              
              18,718Tract
              
              
              1,999
              
              
              1,664Multi-family
              
              
              7,803
              
              
              9,054Hospitality
              
              
              14,177
              
              
              16,784Commercial
              
              
              25,624
              
              
              30,677Land
              
              
              55,704
              
              
              31,064Installment
                  loans to individuals
              
              
              7,889
              
              
              7,977All
                  other loans (including overdrafts)
              
              
              620
              
              
              562Total
                  loans, gross
              
              
              666,400
              
              
              613,217Deferred
                  loan fees
              
              
              1,647
              
              
              1,732Reserve
                  for possible loan losses
              
              
              10,350
              
              
              6,143Total
                  loans, net
              
              $
              654,403
              
              $
              605,342Loans
                  held for sale
              
              $
              2,955
              
              $
              902
 
 *Concentration
        of Credit Risk*
 
 At
        September 30, 2008, approximately $492.8 million or 74.0% of the Bank’s loan
        portfolio was collateralized by various forms of real estate, this represents
        an
        increase of approximately $34.2 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 September 30, 2008, the Bank was
        contingently liable for letters of credit accommodations made to its customers
        totaling approximately $17.8 million and un-disbursed loan commitments in
        the
        approximate amount of $156.8 million. The Bank makes commitments to extend
        credit in the normal course of business to meet the financing needs of its
        customers. Commitments to extend credit are agreements to lend to a customer
        as
        long as there is no violation of any condition established in the contract.
        Commitments generally have fixed expiration dates or other termination clauses
        and may require payment of a fee. Since many of the commitments are expected
        to
        expire without being drawn upon, the total outstanding commitment amount
        does
        not necessarily represent future cash requirements. Standby letters of credit
        written are conditional commitments issued by the Bank to guarantee the
        performance of a customer to a third party. The credit risk involved in issuing
        letters of credit is essentially the same as those involved in extending
        loan
        facilities to customers. The Bank anticipates no losses as a result of such
        transactions. For detailed information on Concentration of Credit Risk, please
        refer to Financial Condition Analysis, Loans Section contained within this
        document.
  -
            11
            -
  *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.
 
 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 nine months ended**
              
              **Year ended****September 30,**
              
              **September 30,**
              
              **December 31,***(dollars in thousands)*
              
              **2008**
              
              **2007**
              
              **2008**
              
              **2007**
              
              **2007**Balance
                  at beginning of period
              
              $
              8,128
              
              $
              4,520
              
              $
              6,143
              
              $
              4,081
              
              $
              4,081Credit
                  from purchase of Business First National Bank
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,381Provision
                  for possible loan losses
              
              
              3,200
              
              
              210
              
              
              6,215
              
              
              520
              
              
              660Loans
                  charged off
              
              
              (1,033
              )
              
              (16
              )
              
              (2,135
              )
              
              (36
              )
              
              (249
              )Recoveries
                  of loans previously charged off
              
              
              55
              
              
              6
              
              
              127
              
              
              155
              
              
              270Balance
                  at end of period
              
              $
              10,350
              
              $
              4,720
              
              $
              10,350
              
              $
              4,720
              
              $
              6,143
 
 For
        the
        three and nine month periods ended September 30, 2008, the Company had net
        charge-offs of approximately $978 thousand and $2.0 million, respectively.
        During the same periods ended in 2007, the Company had a net charge off of
        approximately $10 thousand in the third quarter of 2007 and a net recovery
        of
        approximately $119 thousand for the first nine months of 2007. During the
        third
        quarter of 2008, the Bank wrote down the value of certain non-performing
        loans
        in the approximate amount of $1.0 million. This is in addition to loans the
        Bank
        wrote down during the first and second quarters totaling $1.1 million, bringing
        the total for year to date charge offs to $2.1 million. The majority of balances
        charged off during the first nine months of 2008 were within in the category
        of
        commercial real-estate, commercial and industrial, and construction single
        family - spec. 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 nine months ended September 30, 2008 is consistent with prior periods.
        The allowance for loan losses as a percentage of total gross loans was 1.55%
        and
        1.00% at September 30, 2008 and December 31, 2007, respectively. Management
        believes that the allowance for loan losses as of September 30, 2008 is prudent
        and warranted, based on information currently available.
  -
            12
            -
 
 **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.
 
 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 nine months ended
        September 30, 2008 and 2007:
 
 **For the three months ending**
              
              **For the nine months ending****September 30,**
              
              **September 30,***(dollars
                  in thousands except per share data)*
              
              **2008**
              
              **2007**
              
              **2008**
              
              **2007****Net
                  Income**
              
              $
              534
              
              $
              1,628
              
              $
              2,900
              
              $
              4,939Basic
              
              $
              0.07
              
              $
              0.24
              
              $
              0.38
              
              $
              0.73Diluted
              
              $
              0.07
              
              $
              0.23
              
              $
              0.37
              
              $
              0.70**Shares**Basic
              
              
              7,709,600
              
              
              6,796,286
              
              
              7,703,107
              
              
              6,751,322Diluted
              
              
              7,798,321
              
              
              7,013,070
              
              
              7,832,815
              
              
              7,013,986
 
 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 which was 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 nine months ended September 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 September 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.
  -
            13
            -
  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.
 
 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 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.
  -
            14
            -
  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.
 
 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.
 
 On
        October 10, 2008, the FASB issued Financial Accounting Standards Board Staff
        Position (“FSP”) FSP FAS 157-3, *“Determining
        the Fair Value of a Financial Asset When the Market for That Asset Is Not
        Active.”* The FSP
        clarifies the application of SFAS No. 157, *“Fair
        Value Measurements”* ,
        in a
        market that is not active and provides an example to illustrate key
        considerations in determining the fair value of a financial asset when the
        market for that financial asset is not active. The FSP is effective immediately,
        and includes prior periods for which financial statements have not been issued,
        and therefore the Company is subject to the provisions under the FSP effective
        September 30, 2008. The implementation of FSP FAS 157-3 did not affect the
        Company's fair value measurements as of September 30, 2008 .
 
 **Note
        6. Share-Based Compensation**
 
 As
        of
        September 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 nine month periods ended September
        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.
  -
            15
            -
 
 The
        following table provides a summary of the expenses the Company has recognized
        related to share-based compensation as well as the impact those expenses
        have
        had on diluted earnings per share for the periods indicated below:
 
 **For the three months ended**
              
              **For the nine months ended****September 30,**
              
              **September 30,***(dollars
                  in thousands except per share data)*
              
              **2008**
              
              **2007**
              
              **2008**
              
              **2007****Share-based
                  compensation expense**Stock
                  option expense
              
              $
              51
              
              $
              24
              
              $
              152
              
              $
              80Restricted
                  stock expense
              
              
              57
              
              
              56
              
              
              123
              
              
              184Total
                  share-based compensation expense
              
              $
              108
              
              $
              80
              
              $
              275
              
              $
              264Total
                  share-based compensation expense, net of tax
              
              $
              72
              
              $
              56
              
              $
              186
              
              $
              182Diluted
                  shares outstanding
              
              
              7,798,321
              
              
              7,013,070
              
              
              7,832,815
              
              
              7,013,986Impact
                  on diluted earnings per share
              
              $
              0.009
              
              $
              0.008
              
              $
              0.024
              
              $
              0.026**Unrecognized
                  compensation expense**Stock
                  option expense
              
              $
              315
              
              $
              147Restricted
                  stock expense
              
              
              547
              
              
              850Total
                  unrecognized share-based compensation expense
              
              $
              862
              
              $
              997Total
                  unrecognized share-based compensation expense, net of tax
              
              $
              525
              
              $
              635
 
 At
        September 30, 2008, there was a total of $315 thousand of unrecognized
        compensation expense related to non-vested stock option awards. That expense
        is
        expected to be recognized over a weighted-average period of 2
        years.
 
 The
        Company grants restricted share awards periodically for the benefit of
        employees. These restricted shares generally “cliff vest” after five years of
        issuance. Recipients of restricted shares have the right to vote all shares
        subject to such grant, and receive all dividends with respect to such shares,
        whether or not the shares have vested. Recipients do not pay any cash
        consideration for the shares. The total unrecognized compensation expense
        related to restricted share awards at September 30, 2008 was $547 thousand.
        That
        expense is expected to be recognized over the next 2.4 years.
 
 The
        aggregate intrinsic value in the table below represents the total pretax
        intrinsic value (the difference between the Company’s closing stock price on the
        last trading day of the third quarter of 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 September
        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 nine month periods ended September 30, 2008 and
        2007
        was $214 thousand and $1,070 thousand, respectively. There were no options
        exercised during the third quarters of 2008 and 2007.
  -
            16
            -
  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 September 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
              
              
              (7,910
              )
              
              8.20Expired
              
              
              (2
              )
              
              4.42Options
                  outstanding, September 30, 2008
              
              
              449,408
              
              $
              8.83
              
              
              4.15
              
              $
              622Exercisable
                  at September 30, 2008
              
              
              358,673
              
              $
              7.76
              
              
              3.10
              
              $
              622Options
                  outstanding, January 1, 2007
              
              
              436,567
              
              $
              5.43Granted
              
              
              -
              
              
              -Exercised
              
              
              (129,764
              )
              
              2.97Forfeited
              
              
              (997
              )
              
              10.77Options
                  outstanding, September 30, 2007
              
              
              305,806
              
              $
              6.46
              
              
              3.99
              
              $
              2,948Exercisable
                  at September 30, 2007
              
              
              264,029
              
              $
              5.71
              
              
              3.57
              
              $
              2,742
 
 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
 
 **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.
  -
            17
            -
 
 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 September 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.
 
 ·
              ***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.
  -
            18
            -
  The
        following table provides a summary of the financial instruments the Company
        measures at fair value on a recurring basis as of September 30,
        2008:
 
 **Fair Value Measurements Using****Assets At***(dollars in thousands)*
              
              **Level 1**
              
              **Level 2**
              
              **Level 3**
              
              **Fair Value****Assets:**Available
                  for sale investment securities
              
              $
              -
              
              $
              51,905
              
              $
              729
              
              $
              52,634Total
                  assets measured on a recurring basis
              
              $
              -
              
              $
              51,905
              
              $
              729
              
              $
              52,634
 
 The
        following table provides a summary of the changes in balance sheet carrying
        values associated with Level 3 financial instruments during the nine months
        ended September 30, 2008:
 
 **Available
                  For****Sale
                  Investment***(dollars
                  in thousands)*
              
              **Securities**Beginning
                  balance
              
              $
              712Total
                  gains or losses (realized / unrealized)**(1)**:Included
                  in earnings
              
              
              -Included
                  in other comprehensive income
              
              
              17Purchases
              
              
              -Transfers
                  in and/or out of Level 3
              
              
              -Non-trading
                  activity
              
              
              -Ending
                  balance
              
              $
              729
 
 **(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 September 30,
        2008:
 
 **Fair Value Measurements Using****Assets At***(dollars in thousands)*
              
              **Level 1**
              
              **Level 2**
              
              **Level 3**
              
              **Fair Value****Assets:**Impaired
                  loans
              
              $
              -
              
              $
              22,390
              
              $
              -
              
              $
              22,390Loans
                  held for sale
              
              
              -
              
              
              2,955
              
              
              -
              
              
              2,955Other
                  real estate owned
              
              
              -
              
              
              197
              
              
              -
              
              
              197Total
                  assets measured on a non-recurring basis
              
              $
              -
              
              $
              25,542
              
              $
              -
              
              $
              25,542
 
 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.
  -
            19
            -
  **Note
        8. Goodwill**
 
 As
        of
        September 30, 2008, the balance of goodwill 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 ongoing financial crisis
        in
        the United States, and the response of the federal and state government and
        our
        regulators thereto, general economic conditions and California’s energy crisis,
        the recent fluctuations in U.S. markets resulting, in part, from problems
        related to sub-prime lending, the recent downturn in the California real-estate
        market, general economic and business conditions in those areas in which
        the
        Company operates, demographic changes, competition, fluctuations in interest
        rates, changes in business strategy or development plans, changes in
        governmental regulation, credit quality, the availability of capital to fund
        the
        expansion of the Company’s business, as well as economic, political and global
        changes arising from the war on terrorism (Refer to the Company’s December 31,
        2007 10-K, ITEM 1A. Risk Factors). The Company disclaims any obligation to
        update any such factors or to publicly announce the results of any revisions
        to
        any of the forward-looking statements contained herein to reflect future
        events
        or developments.**
  -
            20
            -
  **Item
        2. Management’s Discussion and Analysis of Financial Condition and Results of
        Operations**
 
 The
        following is an analysis of the results of operations and financial condition
        of
        the Company as of and for the three and nine month periods ending September
        30,
        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.
  -
            21
            -
  **Executive
        Summary and Recent Developments**
 
 *Earnings
        and Financial Condition Overview*
 
 For
        the
        three and nine months ended September 30, 2008, the Company earned $0.5 million
        and $2.9 million, respectively. When compared to the same periods ended a
        year
        earlier, this represents declines of 67.2% and 41.3%, respectively. During
        the
        three and nine months ended September 30, 2008, the Company made provisions
        to
        the allowance for loan losses in the amounts of $3.2 million and $6.2 million,
        respectively. The Company felt it necessary to make additional provisions
        to the
        allowance, given the weakened economic environment, and increases in the
        trend
        of delinquent loans. The Company’s analysis of the allowance for loan losses
        indicates that as of September 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 $0.07 and $0.37 per diluted share for the quarter
        and year to date periods ended September 30, 2008. When compared to the same
        periods ended a year earlier, diluted earnings per share declined approximately
        69.6% and 47.1%, respectively. In addition to the declines in net income
        on a
        year over year basis, the year over year declines 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 September 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 September 30, 2007.
 
 The
        following provides financial highlights as of and for the three and nine
        months
        ended September 30, 2008:
 
 ·
              Total
                  interest income increased approximately $1.7 million and $5.9 million
                  or
                  15.3% and 18.5% when compared to the same three and nine 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 September 30, 2008 gross loan balances were approximately
                  $190.8 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 $0.5 million and $0.7 million or
                  15.0% and
                  6.6% when compared to the same three and nine 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 nine months of 2008, leading Management to significantly
                  re-price
                  its deposits. Additionally, declines in the cost of borrowing at
                  the
                  Federal Home Loan Bank (“FHLB”) have also contributed to the overall
                  decline in the cost of funding for the
                  Bank.
 
 ·
              Net
                  interest income increased approximately $2.2 million or 30.0% and
                  $6.6
                  million or 30.6% when compared to the same three and nine 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 $0.2 million or 15.6% and $0.8 million
                  or
                  19.7% when compared to the same three and nine 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 initial public
                  offering
                  of Visa, Inc. This additional income contributed largely to the
                  year to
                  date increase within this category.
 
 ·
              Non-interest
                  expenses increased approximately $1.3 million or 23.0% and $5.2
                  million or
                  30.5% from the same three and nine 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 September 30, 2007. It is because of
                  these
                  additional balances in addition to the additional loan loss provision
                  the
                  Bank booked during the three and nine months ended September 30,
                  2008,
                  that return on average assets for the quarter and year to date
                  periods was
                  0.27% and 0.50%, respectively compared to 1.12% and 1.16% for the
                  same
                  periods ended a year earlier. Return on average equity was 2.94%
                  and 5.41%
                  for the three and nine months ended September 30, 2008 compared
                  to 12.09%
                  and 12.68% for the same periods ended a year earlier.
  -
            22
            -
  ·
              The
                  Company’s net interest margin for the three and nine months ended
                  September 30, 2008 was 5.18% and 5.26%, respectively. This, when
                  compared
                  to the 5.44% and 5.53% the Company reported for the same periods
                  ended a
                  year earlier, represents declines of approximately 26 and 27 basis
                  points,
                  respectively. The margin was negatively impacted on a quarter and
                  year to
                  date basis when compared to a year ago due to a decline in the
                  yield of
                  the Company’s earning asset mix, resulting from the dramatic year over
                  year decline in the overnight Fed Funds rate. However, the Company
                  was
                  able to mitigate a substantial compression in the margin by aggressively
                  re-pricing its deposits and borrowings during the declining rate
                  environment.
 
 ·
              For
                  the three and nine months ended September 30, 2008 the Company’s operating
                  efficiency ratio was 64.40% and 67.55%, respectively. This, when
                  compared
                  to the 66.89% and 66.67% the Company reported for the same periods
                  ended a
                  year earlier, represents a decline of approximately 249 basis points
                  for
                  the quarter and an increase of approximately 88 basis points for
                  the year
                  to date period. The decline in the efficiency ratio for the quarter
                  when
                  compared to the same period ended a year earlier can be attributed
                  in part
                  to efficiencies the Company gained during the quarter related to
                  staffing.
 
 At
        September 30, 2008, total assets were $787.9 million. This represents an
        increase of approximately $42.3 million or 5.7% when compared to the $745.6
        million reported at December 31, 2007.
 
 ·
              Net
                  loan balances were $654.4 million at September 30, 2008. This,
                  when
                  compared to the $605.3 million reported at the end of 2007, represents
                  an
                  increase of approximately $49.1 million or 8.1%. See also “Loans” under
                  Item 2. Management’s Discussion and Analysis of Financial Condition and
                  Results of Operations on this Form 10-Q for a more detailed discussion
                  concerning the Bank’s loan
                  portfolio.
 
 ·
              Total
                  deposit balances were $589.3 million at September 30, 2008, which
                  represents a decline of approximately $55.6 million or 8.6% 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 nine months of 2008 and
                  to
                  Management’s strategy to protect the net interest margin through
                  aggressive re-pricing of interest bearing deposits. 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 borrowings were $106.5 million at September 30,
                  2008. When
                  compared to the $8.0 million reported at the end of 2007, this
                  represents
                  an increase of approximately $98.5 million. The large increase
                  in
                  wholesale borrowing can be attributed to Management’s deposit pricing
                  strategy to replace higher cost non-core deposits with lower cost
                  FHLB
                  borrowing in an effort to mitigate declines in the net interest
                  margin.
 
 ·
              At
                  September 30, 2008, the allowance for loan losses was $10.4 million.
                  As a
                  percentage of total gross and non-performing loan balances, the
                  allowance
                  for loan losses was 1.55% and 46.2%, respectively. For the three
                  and nine
                  month periods ended September 30, 2008, provision for loan losses
                  was
                  approximately $3.2 million and $6.2 million, respectively. When
                  compared
                  to the same periods ended a year earlier, this represents increases
                  of
                  approximately $3.0 million and $5.7 million, respectively. The
                  increased
                  provision for loan losses can be attributed in part to weakened
                  economic
                  conditions, increases in the trend in delinquent loans, as well
                  as loans
                  the Bank charged off during the first nine months of
                  2008.
 
 ·
              As
                  of September 30, 2008, the balance of loans placed on non-accrual
                  status
                  was approximately $22.4 million. This represents an increase of
                  approximately $22.1 million from that reported at December 31,
                  2007.
                  During the quarter, the Bank charged off approximately $1.0 million
                  in
                  loans and recovered approximately $55 thousand in loans previously
                  charged
                  off. At September 30, 2008 the balance of Other Real Estate Owned
                  (“OREO”)
                  remained unchanged from the second quarter at $197 thousand. 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.
  -
            23
            -
 
 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.
 
 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 September 30, 2008, the Bank makes monthly payments in the aggregate
        amount of $77 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 nine months ended September 30, 2008, the Bank recognized a gain
        of
        approximately $57 thousand or $33 thousand net of tax and $170 thousand or
        $100
        thousand net of tax, respectively. This gain was recorded as an offset to
        rental
        expense for the periods 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 at the time of the transaction, 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. The
        extension of the stock repurchase program expired in August of 2008 and was
        not
        renewed by the Company’s Board of Directors. The Company made no repurchases of
        its common stock during 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.
  -
            24
            -
  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.
 
 *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)*
              
              **09/30/08**
              
              **06/30/08**
              
              **03/31/08**
              
              **12/31/07**
              
              **09/30/07**
              
              **06/30/07**
              
              **03/31/07**
              
              **12/31/06**Return
                  on average assets
              
              
              0.27
              %
              
              0.35
              %
              
              0.91
              %
              
              1.11
              %
              
              1.12
              %
              
              1.25
              %
              
              1.10
              %
              
              1.24
              %Return
                  on average equity
              
              
              2.94
              %
              
              3.84
              %
              
              9.55
              %
              
              11.65
              %
              
              12.09
              %
              
              13.84
              %
              
              12.10
              %
              
              13.64
              %Average
                  equity to average assets
              
              
              9.16
              %
              
              9.14
              %
              
              9.48
              %
              
              9.49
              %
              
              9.27
              %
              
              9.02
              %
              
              9.07
              %
              
              9.11
              %Net
                  interest margin
              
              
              5.18
              %
              
              5.28
              %
              
              5.33
              %
              
              5.33
              %
              
              5.44
              %
              
              5.56
              %
              
              5.66
              %
              
              5.77
              %Efficiency
                  ratio*
              
              
              64.40
              %
              
              66.31
              %
              
              72.17
              %
              
              67.26
              %
              
              66.89
              %
              
              64.32
              %
              
              68.89
              %
              
              67.12
              %Average
                  loans to average deposits
              
              
              111.54
              %
              
              109.26
              %
              
              103.64
              %
              
              96.40
              %
              
              95.79
              %
              
              103.52
              %
              
              108.23
              %
              
              105.03
              %Net
                  Income
              
              $
              534
              
              $
              691
              
              $
              1,675
              
              $
              1,978
              
              $
              1,628
              
              $
              1,800
              
              $
              1,510
              
              $
              1,649Earnings
                  Per Share:Basic
              
              $
              0.07
              
              $
              0.09
              
              $
              0.22
              
              $
              0.26
              
              $
              0.24
              
              $
              0.27
              
              $
              0.23
              
              $
              0.25Diluted
              
              $
              0.07
              
              $
              0.09
              
              $
              0.21
              
              $
              0.25
              
              $
              0.23
              
              $
              0.26
              
              $
              0.22
              
              $
              0.24Outstanding
                  Shares:Basic
              
              
              7,709,600
              
              
              7,705,174
              
              
              7,694,546
              
              
              7,682,730
              
              
              6,796,286
              
              
              6,754,321
              
              
              6,703,358
              
              
              6,673,239Diluted
              
              
              7,798,321
              
              
              7,830,390
              
              
              7,851,831
              
              
              7,887,206
              
              
              7,013,070
              
              
              7,027,090
              
              
              6,936,239
              
              
              6,928,273
 *
        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, 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.
  -
            25
            -
  *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 and lease losses
        to be its most critical accounting policy, because it requires Management's
        most
        subjective and complex judgments. In addition, changes in economic conditions
        can have a significant impact on the allowance for loan losses and therefore
        the
        provision for loan losses and results of operations. The Company has developed
        appropriate policies and procedures for assessing the adequacy of the allowance
        for loan losses, recognizing that this process requires a number of assumptions
        and estimates with respect to its loan portfolio. The Company's assessments
        may
        be impacted in future periods by changes in economic conditions, the impact
        of
        regulatory examinations, and the discovery of information with respect to
        borrowers, which is not known to Management at the time of the issuance of
        the
        consolidated financial statements.
 
 The
        allowance for loan and lease losses represents Management’s best estimate of
        losses inherent in the existing loan portfolio. The allowance for loan and
        lease
        losses is increased by the provision for loan and lease losses charged to
        expense and reduced by loans charged-off, net of recoveries. The allowance
        for
        loan and lease losses is determined based on Management’s assessment of several
        factors: reviews and evaluation of individual loans, changes in the nature
        and
        volume of the loan portfolio, current economic conditions and the related
        impact
        on specific borrowers and industry groups, historical loan loss experiences
        and
        the level of classified and nonperforming loans.
 
 Loans
        are
        considered impaired if, based on current information and events, it is probable
        that we will be unable to collect the scheduled payments of principal or
        interest when due according to the contractual terms of the loan agreement.
        The
        measurement of impaired loans is generally based on the present value of
        expected future cash flows discounted at the historical effective interest
        rate
        stipulated in the loan agreement, except that all collateral-dependent loans
        are
        measured for impairment based on the fair value of the collateral. In measuring
        the fair value of the collateral, Management uses assumptions and methodologies
        consistent with those that would be utilized by unrelated third parties.
        Changes
        in the financial condition of individual borrowers, economic conditions,
        historical loss experience and the condition of the various markets 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.
  -
            26
            -
  **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 nine months of 2008, as the FOMC cut
        the
        overnight Fed Funds rate by 225 basis points. The result was sequential declines
        in net interest income in the first nine months 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
        nine
        months 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 and short term certificate accounts increased
        dramatically over those periods. Although some deposit run-off related to
        those
        funds was experienced during 2008, the Bank managed to retain the majority
        of
        those balances, which proved to be beneficial during the first and second
        quarters of 2008, as we 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 its liabilities allowed the Bank to mitigate declines in the net
        interest margin and net interest income during the first nine months of 2008.
        The net interest margin for the third quarter of 2008 was 5.18% and 5.26%
        for
        the first nine months of 2008. When compared to the 5.33% reported for the
        fourth quarter of 2007 and 5.47% reported for the year ended December 31,
        2007,
        this represents relatively minimal declines of 15 and 21 basis points,
        respectively. When comparing the net interest margin to that reported in
        the
        three and nine month periods ended a year earlier, the margin fell by
        approximately 26 and 27 basis points, respectively.
 
 Historically,
        the largest and most variable source of income for the Company is net interest
        income. The results of operations for the three and nine months ended September
        30, 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 the majority
        of 2008.
  *Net
        Interest Income and Margin*
 
 Net
        interest income, the primary component of the net earnings of a financial
        institution, refers to the difference between the interest paid on deposits
        and
        borrowings, and the interest earned on loans and investments. The net interest
        margin is the amount of net interest income expressed as a percentage of
        average
        earning assets. Factors considered in the analysis of net interest income
        are
        the composition and volume of earning assets and interest-bearing liabilities,
        the amount of non-interest bearing liabilities and non-accrual loans, and
        changes in market interest rates.
 
 The
        volume and rate variances table below sets forth the dollar difference in
        interest earned and paid for each major category of interest-earning assets
        and
        interest-bearing liabilities for the three and nine month periods ended
        September 30, 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 nine months ended****September 30, 2008 over 2007**
              
              **September 30, 2008 over 2007***(dollars
                  in thousands)*
              
              **Volume**
              
              **Rate**
              
              **Total**
              
              **Volume**
              
              **Rate**
              
              **Total****Interest
                  Income**Loans
                  (1)
              
              $
              2,904
              
              $
              (1,231
              )
              $
              1,673
              
              $
              8,907
              
              $
              (3,440
              )
              $
              5,467Investment
                  securities taxable
              
              
              291
              
              
              58
              
              
              349
              
              
              753
              
              
              134
              
              
              887Investment
                  securities non-taxable (2)
              
              
              17
              
              
              -
              
              
              17
              
              
              39
              
              
              (2
              )
              
              37Taxable
                  equivalent adjustment (2)
              
              
              (6
              )
              
              -
              
              
              (6
              )
              
              (13
              )
              
              1
              
              
              (12
              )Interest-bearing
                  deposits
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Federal
                  funds sold
              
              
              (221
              )
              
              (146
              )
              
              (367
              )
              
              (233
              )
              
              (214
              )
              
              (447
              )Net
                  increase (decrease)
              
              
              2,985
              
              
              (1,319
              )
              
              1,666
              
              
              9,453
              
              
              (3,521
              )
              
              5,932**Interest
                  Expense**Savings,
                  now, money market
              
              
              844
              
              
              (1,250
              )
              
              (406
              )
              
              766
              
              
              (379
              )
              
              387Time
                  deposits
              
              
              341
              
              
              (858
              )
              
              (517
              )
              
              1,179
              
              
              (1,914
              )
              
              (735
              )Other
                  borrowings
              
              
              420
              
              
              (52
              )
              
              368
              
              
              (1,562
              )
              
              1,324
              
              
              (238
              )Long
                  term borrowings
              
              
              45
              
              
              (21
              )
              
              24
              
              
              117
              
              
              (215
              )
              
              (98
              )Net
                  increase (decrease)
              
              
              1,650
              
              
              (2,181
              )
              
              (531
              )
              
              500
              
              
              (1,184
              )
              
              (684
              )Total
                  net increase (decrease)
              
              $
              1,335
              
              $
              862
              
              $
              2,197
              
              $
              8,953
              
              $
              (2,337
              )
              $
              6,616
 
 (1)
              Loan
                  fees of $285 and $232 for the three months ending September 30,
                  2008 and
                  2007, respectively and $1,008 and $873 for the nine months ending
                  September 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%.
  -
            27
            -
 
 The
        tables below set forth average balance sheet information, interest income
        and
        expense, average yields and rates and net interest income and margin for
        the
        three and nine month periods ended September 30, 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****September
                  30, 2008**
              
              **September
                  30, 2007****Yield/**
              
              **Income/**
              
              
              
              **Yield/**
              
              **Income/***(dollars
                  in thousands)*
              
              **Balance**
              ****
              **Rate
                  (4)**
              ****
              **Expense**
              ****
              **Balance**
              ****
              **Rate
                  (4)**
              ****
              **Expense****Interest
                Earning Assets**Investments
                  with other banks
              
              $
              128
              
              
              3.11
              %
              $
              1
              
              $
              481
              
              
              0.82
              %
              $
              1Investment
                  securities taxable
              
              
              43,221
              
              
              5.52
              %
              
              600
              
              
              21,649
              
              
              4.60
              %
              
              251Investment
                  securities non-taxable
              
              
              17,125
              
              
              4.32
              %
              
              186
              
              
              16,036
              
              
              4.33
              %
              
              175Federal
                  funds sold
              
              
              3,342
              
              
              2.14
              %
              
              18
              
              
              29,447
              
              
              5.19
              %
              
              385Loans
                  (1) (2)
              
              
              667,441
              
              
              6.99
              %
              
              11,731
              
              
              466,749
              
              
              8.55
              %
              
              10,058Total
                  interest earning assets
              
              
              731,257
              
              
              6.82
              %
              
              12,536
              
              
              534,362
              
              
              8.07
              %
              
              10,870Allowance
                  for possible loan losses
              
              
              (
                  8,664
              )
              
              
              
              
              
              
              
              (
                  4,600
              )Other
                  assets
              
              
              6
                  5,230
              
              
              
              
              
              
              
              
              46,858Total
                  assets
              
              $
              787,823
              
              
              
              
              
              
              
              $
              576,620**Interest
                  Bearing Liabilities**Savings/NOW/money
                  market
              
              
              273,281
              
              
              1.29
              %
              
              886
              
              
              206,186
              
              
              2.49
              %
              
              1,292Time
                  deposits
              
              
              169,518
              
              
              3.10
              %
              
              1,322
              
              
              147,659
              
              
              4.94
              %
              
              1,839Other
                  borrowings
              
              
              91,735
              
              
              2.57
              %
              
              593
              
              
              17,940
              
              
              5.55
              %
              
              251Federal
                  funds purchased
              
              
              4,583
              
              
              2.26
              %
              
              26
              
              
              -
              
              
              0.00
              %
              
              -Long-term
                  debt
              
              
              13,403
              
              
              5.46
              %
              
              184
              
              
              8,864
              
              
              7.16
              %
              
              160Total
                  interest-bearing liabilities
              
              
              552,520
              
              
              2.17
              %
              
              3,011
              
              
              380,649
              
              
              3.69
              %
              
              3,542Demand
                  deposits
              
              
              155,582
              
              
              
              
              
              
              
              
              133,432Other
                  liabilities
              
              
              7
                  ,585
              
              
              
              
              
              
              
              
              9
                  ,098Total
                  liabilities
              
              
              715,687
              
              
              
              
              
              
              
              
              523,179**Stockholders'
                Equity**Common
                  stock
              
              
              48,456
              
              
              
              
              
              
              
              
              30,042Additional
                  paid in capital
              
              
              882
              
              
              
              
              
              
              
              
              555Retained
                  earnings
              
              
              23,401
              
              
              
              
              
              
              
              
              22,958Valuation
                  allowance investments
              
              
              (603
              )
              
              
              
              
              
              
              
              (114
              )Total
                  stockholders' equity
              
              
              72,136
              
              
              
              
              
              
              
              
              53,441Total
                  liabilities and stockholders' equity
              
              $
              787,823
              
              
              
              
              
              
              
              $
              576,620Net
                  interest income
              
              
              
              
              
              
              
              $
              9,525
              
              
              
              
              
              
              
              $
              7,328Net
                  interest margin (3)
              
              
              
              
              
              5.18
              %
              
              
              
              
              
              
              
              5.44
              %
 
 (1)
              Nonaccrual
                  loans have been included in total
                  loans.
 (2)
              Loan
                  fees of $285 and $232 for the three months ending September 30,
                  2008 and
                  2007, respectivelyhave
                  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
              -
  **For the nine months ending**
              
              **For the nine months ending****September 30, 2008**
              
              **September 30, 2007****Yield/**
              
              **Income/**
              
              
              
              **Yield/**
              
              **Income/***(dollars
                  in thousands)*
              
              **Balance**
              
              **Rate (4)**
              
              **Expense**
              
              **Balance**
              
              **Rate (4)**
              
              **Expense****Interest
                  Earning Assets**Investments
                  with other banks
              
              $
              246
              
              
              3.80
              %
              $
              7
              
              $
              373
              
              
              2.51
              %
              $
              7Investment
                  securities taxable
              
              
              42,656
              
              
              5.26
              %
              
              1,681
              
              
              23,157
              
              
              4.58
              %
              
              794Investment
                  securities non-taxable
              
              
              17,223
              
              
              4.30
              %
              
              555
              
              
              16,434
              
              
              4.31
              %
              
              530Federal
                  funds sold
              
              
              6,855
              
              
              2.53
              %
              
              130
              
              
              15,117
              
              
              5.10
              %
              
              577Loans
                  (1) (2)
              
              
              649,511
              
              
              7.31
              %
              
              35,554
              
              
              468,007
              
              
              8.60
              %
              
              30,087Total
                  interest earning assets
              
              
              716,491
              
              
              7.07
              %
              
              37,927
              
              
              523,088
              
              
              8.18
              %
              
              31,995Allowance
                  for possible loan losses
              
              
              (7,120
              )
              
              
              
              
              
              
              
              (4,401
              )Other
                  assets
              
              
              65,028
              
              
              
              
              
              
              
              
              52,443Total
                  assets
              
              $
              774,399
              
              
              
              
              
              
              
              $
              571,130**Interest
                  Bearing Liabilities**Savings/NOW/money
                  market
              
              
              290,901
              
              
              1.57
              %
              
              3,412
              
              
              182,369
              
              
              2.22
              %
              
              3,025Time
                  deposits
              
              
              158,768
              
              
              3.45
              %
              
              4,101
              
              
              135,749
              
              
              4.76
              %
              
              4,836Other
                  borrowings
              
              
              76,800
              
              
              2.63
              %
              
              1,511
              
              
              43,453
              
              
              5.45
              %
              
              1,771Federal
                  funds purchased
              
              
              4,079
              
              
              2.69
              %
              
              82
              
              
              1,408
              
              
              5.70
              %
              
              60Long-term
                  debt
              
              
              13,403
              
              
              5.85
              %
              
              587
              
              
              11,839
              
              
              7.74
              %
              
              685Total
                  interest-bearing liabilities
              
              
              543,951
              
              
              2.38
              %
              
              9,693
              
              
              374,818
              
              
              3.70
              %
              
              10,377Demand
                  deposits
              
              
              150,890
              
              
              
              
              
              
              
              
              137,706Other
                  liabilities
              
              
              7,894
              
              
              
              
              
              
              
              
              6,525Total
                  liabilities
              
              
              702,735
              
              
              
              
              
              
              
              
              519,049**Stockholders'
                  Equity**Common
                  stock
              
              
              46,269
              
              
              
              
              
              
              
              
              29,740Additional
                  paid in capital
              
              
              806
              
              
              
              
              
              
              
              
              465Retained
                  earnings
              
              
              24,739
              
              
              
              
              
              
              
              
              21,869Valuation
                  allowance investments
              
              
              (150
              )
              
              
              
              
              
              
              
              7Total
                  stockholders' equity
              
              
              71,664
              
              
              
              
              
              
              
              
              52,081Total
                  liabilities and stockholders' equity
              
              $
              774,399
              
              
              
              
              
              
              
              $
              571,130Net
                  interest income
              
              
              
              
              
              
              
              $
              28,234
              
              
              
              
              
              
              
              $
              21,618Net
                  interest margin (3)
              
              
              
              
              
              5.26
              %
              
              
              
              
              
              
              
              5.53
              %
  (1)
              Nonaccrual
                  loans have been included in total
                  loans.
 (2)
              Loan
                  fees of $1,008 and $873 for the nine months ending September 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.
  -
            29
            -
  The
        tables below set forth changes in average interest earning assets and their
        respective yields for the three and nine month periods ending September 30,
        2008
        compared to the same periods ended in 2007.
  **Average Balance**
              
              
              
              
              
              **Average Yield****for the three months ending**
              
              
              
              
              
              **for the three months ending****September 30,**
              
              **Variance**
              
              **September 30,***(dollars
                  in thousands)*
              
              **2008**
              
              **2007**
              
              **dollar**
              
              **percentage**
              
              **2008**
              
              **2007**
              
              **Variance**Time
                  deposits with other banks
              
              $
              128
              
              $
              481
              
              $
              (353
              )
              
              -73.39
              %
              
              3.11
              %
              
              0.82
              %
              
              2.29
              %Investment
                  securities taxable
              
              
              43,221
              
              
              21,649
              
              
              21,572
              
              
              99.64
              %
              
              5.52
              %
              
              4.60
              %
              
              0.92
              %Investment
                  securities non-taxable
              
              
              17,125
              
              
              16,036
              
              
              1,089
              
              
              6.79
              %
              
              4.32
              %
              
              4.33
              %
              
              -0.01
              %Federal
                  funds sold
              
              
              3,342
              
              
              29,447
              
              
              (26,105
              )
              
              -88.65
              %
              
              2.14
              %
              
              5.19
              %
              
              -3.05
              %Loans
                  (1) (2)
              
              
              667,441
              
              
              466,749
              
              
              200,692
              
              
              43.00
              %
              
              6.99
              %
              
              8.55
              %
              
              -1.56
              %Total
                  interest earning assets
              
              $
              731,257
              
              $
              534,362
              
              $
              196,895
              
              
              36.85
              %
              
              6.82
              %
              
              8.07
              %
              
              -1.25
              %
  (1)
              Nonaccrual
                  loans have been included in total
                  loans.
 (2)
              Loan
                  fees of $285 and $232 for the three months ending September 30,
                  2008 and
                  2007, respectively have been included in the interest income
                  computation.
 
 **Average Balance**
              
              
              
              
              
              **Average Yield****for the nine months ending**
              
              
              
              
              
              **for the nine months ending****September 30,**
              
              **Variance**
              
              **September 30,***(dollars
                  in thousands)*
              
              **2008**
              
              **2007**
              
              **dollar**
              
              **percentage**
              
              **2008**
              
              **2007**
              
              **Variance**Time
                  deposits with other banks
              
              $
              246
              
              $
              373
              
              $
              (127
              )
              
              -34.05
              %
              
              3.80
              %
              
              2.51
              %
              
              1.29
              %Investment
                  securities taxable
              
              
              42,656
              
              
              23,157
              
              
              19,499
              
              
              84.20
              %
              
              5.26
              %
              
              4.58
              %
              
              0.68
              %Investment
                  securities non-taxable
              
              
              17,223
              
              
              16,434
              
              
              789
              
              
              4.80
              %
              
              4.30
              %
              
              4.31
              %
              
              -0.01
              %Federal
                  funds sold
              
              
              6,855
              
              
              15,117
              
              
              (8,262
              )
              
              -54.65
              %
              
              2.53
              %
              
              5.10
              %
              
              -2.57
              %Loans
                  (1) (2)
              
              
              649,511
              
              
              468,007
              
              
              181,504
              
              
              38.78
              %
              
              7.31
              %
              
              8.60
              %
              
              -1.29
              %Total
                  interest earning assets
              
              $
              716,491
              
              $
              523,088
              
              $
              193,403
              
              
              36.97
              %
              
              7.07
              %
              
              8.18
              %
              
              -1.11
              %
  (1)
                Nonaccrual
                    loans have been included in total
                    loans.
 (2)
              Loan
                  fees of $1,008 and $873 for the nine months ending September 30,
                  2008 and
                  2007, respectively have been included in the interest income
                  computation.
  As
        of
        September 30, 2008, total earning assets were approximately $196.9 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 September 30,
        2008, Business First accounted for approximately $176.1 million and $164.5
        million of the quarter and year to date increases in interest earning assets.
        Additionally, the Company increased the loan portfolio over the periods
        mentioned organically with continued market penetration by a team of seasoned
        loan officers.
 
 For
        the
        three and nine month periods ended September 30, 2008, the average yield
        on
        loans was 6.99% and 7.31%, respectively. This represents declines of 156
        and 129
        basis points from the 8.55% and 8.60% 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 twelve 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 on 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 nine month periods ended September
        30, 2008, the yield on earning assets declined approximately 125 and 111
        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 305 and 257 basis points for
        the
        three and nine months ended September 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 of 2007 to cut the overnight Fed Funds
        rate.
 
 As
        evidenced in the tables above, the yield on taxable investment securities
        increased approximately 92 and 68 basis points for the three and nine month
        periods ended September 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 AAA ratings and yields somewhat
        higher than other securities in the portfolio, contributing significantly
        to the
        rise in yield of the portfolio overall. Additionally, increases in pre-payments
        of principal associated with these investments have also contributed to higher
        yields. See also “Item 3. Quantitative and Qualitative Disclosure About Market
        Risk” as well as “Investment Securities and Other Earning Assets” for additional
        discussion.
  -
            30
            -
  The
        tables below set forth changes in average interest bearing liabilities and
        their
        respective rates for the three and nine month periods ending September 30,
        2008
        compared to the same periods ended in 2007.
  **Average Balance**
              
              
              
              
              
              **Average Rate****for the three months ending**
              
              
              
              
              
              **for the three months ending****September 30,**
              
              **Variance**
              
              **September 30,***(dollars
                  in thousands)*
              
              **2008**
              
              **2007**
              
              **dollar**
              
              **percentage**
              
              **2008**
              
              **2007**
              
              **Variance**Savings/NOW/money
                  market
              
              $
              273,281
              
              $
              206,186
              
              $
              67,095
              
              
              32.54
              %
              
              1.29
              %
              
              2.49
              %
              
              -1.20
              %Time
                  deposits
              
              
              169,518
              
              
              147,659
              
              
              21,859
              
              
              14.80
              %
              
              3.10
              %
              
              4.94
              %
              
              -1.84
              %Other
                  borrowings
              
              
              91,735
              
              
              17,940
              
              
              73,795
              
              
              411.34
              %
              
              2.57
              %
              
              5.55
              %
              
              -2.98
              %Federal
                  funds purchased
              
              
              4,583
              
              
              -
              
              
              4,583
              
              
              100.00
              %
              
              2.26
              %
              
              0.00
              %
              
              2.26
              %Long
                  term debt
              
              
              13,403
              
              
              8,864
              
              
              4,539
              
              
              51.21
              %
              
              5.46
              %
              
              7.16
              %
              
              -1.70
              %Total
                  interest-bearing liabilities
              
              $
              552,520
              
              $
              380,649
              
              $
              171,871
              
              
              45.15
              %
              
              2.17
              %
              
              3.69
              %
              
              -1.52
              %
 
 **Average Balance**
              
              
              
              
              
              **Average Rate****for the nine months ending**
              
              
              
              
              
              **for the nine months ending****September 30,**
              
              **Variance**
              
              **September 30,***(dollars
                  in thousands)*
              
              **2008**
              
              **2007**
              
              **dollar**
              
              **percentage**
              
              **2008**
              
              **2007**
              
              **Variance**Savings/NOW/money
                  market
              
              $
              290,901
              
              $
              182,369
              
              $
              108,532
              
              
              59.51
              %
              
              1.57
              %
              
              2.22
              %
              
              -0.65
              %Time
                  deposits
              
              
              158,768
              
              
              135,749
              
              
              23,019
              
              
              16.96
              %
              
              3.45
              %
              
              4.76
              %
              
              -1.31
              %Other
                  borrowings
              
              
              76,800
              
              
              43,453
              
              
              33,347
              
              
              76.74
              %
              
              2.63
              %
              
              5.45
              %
              
              -2.82
              %Federal
                  funds purchased
              
              
              4,079
              
              
              1,408
              
              
              2,671
              
              
              189.70
              %
              
              2.69
              %
              
              5.70
              %
              
              -3.01
              %Long
                  term debt
              
              
              13,403
              
              
              11,839
              
              
              1,564
              
              
              13.21
              %
              
              5.85
              %
              
              7.74
              %
              
              -1.89
              %Total
                  interest-bearing liabilities
              
              $
              543,951
              
              $
              374,818
              
              $
              169,133
              
              
              45.12
              %
              
              2.38
              %
              
              3.70
              %
              
              -1.32
              %
 
 At
        September 30, 2008 the balance of average interest bearing liabilities was
        approximately $171.9 million and $169.1 million higher than that reported
        for
        the same three and nine 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 2008 designed
        to
        attract lower cost core deposits. This is evidenced by the $67.1 million
        or
        32.5% and $108.5 million or 59.5% increases in Savings, NOW and Money Market
        account balances for the three and nine month periods ended September 30,
        2008
        when compared to the same periods ended a year earlier. Of the increases
        in
        Savings, NOW and Money Market accounts approximately $51.8 million and $55.8
        million are attributable to the acquisition of Business First as of September
        30, 2008.
 
 The
        average balance of floating rate deposits represented approximately 61.7%
        and
        58.3% and 64.7% and 57.3% of total interest bearing deposit accounts for
        the
        three and nine month periods ended September 30, 2008 and 2007, respectively.
        The relatively large percentage of floating rate deposit balances allowed
        the
        Bank to re-price its interest bearing deposits more rapidly in conjunction
        with
        the moves made by the FOMC during 2008 to lower the overnight Fed Funds rate.
        Additionally, throughout the majority of 2008, the Bank remained relatively
        short in duration with respect to time certificates and other borrowed funds,
        allowing the Bank to re-price other sources of funding in the event the
        overnight Fed Funds rate continued to decline. The ability to rapidly re-price
        these funds was the primary factor behind the quarter and year to date declines
        in the average rate paid on the Company’s interest bearing liabilities as well
        as the mitigation of the decline in the net interest margin. The net interest
        margin declined approximately 26 and 27 basis points during the three and
        nine
        months ended September 30, 2008 when compared to the same periods ended a
        year
        earlier. It has not been until recently that the Bank had begun to secure
        longer
        term funding in the form of time certificates and FHLB borrowing in order
        to
        take advantage of historically low funding rates and to ensure that the Bank
        has
        ample liquidity in the current economic environment.
  -
            31
            -
  *Non-Interest
        Income*
 
 The
        tables below set forth changes in non-interest income for the three and nine
        month periods ended September 30, 2008 compared to the same periods ended
        in
        2007.
 **For the three months ended****September 30,**
              
              **Variance***(dollars
                  in thousands)*
              
              **2008**
              
              **2007**
              
              **dollar**
              
              **percentage**Service
                  charges on deposit accounts
              
              $
              878
              
              $
              642
              
              $
              236
              
              
              36.8
              %ATM/Debit
                  Card transaction/interchange fees
              
              
              220
              
              
              194
              
              
              26
              
              
              13.4
              %Bancard
              
              
              69
              
              
              62
              
              
              7
              
              
              11.3
              %Mortgage
                  origination fees
              
              
              118
              
              
              119
              
              
              (1
              )
              
              -0.8
              %Earnings
                  on bank owned life insurance
              
              
              121
              
              
              109
              
              
              12
              
              
              11.0
              %Other
              
              
              107
              
              
              183
              
              
              (76
              )
              
              -41.5
              %Total
                  non-interest income
              
              $
              1,513
              
              $
              1,309
              
              $
              204
              
              
              15.6
              %
 
 **September
                  30,**
              
              **Variance***(dollars
                  in thousands)*
              
              **2008**
              
              **2007**
              
              **dollar**
              
              **percentage**Service
                  charges on deposit accounts
              
              $
              2,487
              
              $
              1,937
              
              $
              550
              
              
              28.4
              %ATM/Debit
                  Card transaction/interchange fees
              
              
              632
              
              
              572
              
              
              60
              
              
              10.5
              %Bancard
              
              
              183
              
              
              178
              
              
              5
              
              
              2.8
              %Mortgage
                  origination fees
              
              
              367
              
              
              378
              
              
              (11
              )
              
              -2.9
              %Earnings
                  on bank owned life insurance
              
              
              352
              
              
              322
              
              
              30
              
              
              9.3
              %Gain
                  on sale of investment securities
              
              
              37
              
              
              -
              
              
              37
              
              
              100.0
              %Other
              
              
              650
              
              
              545
              
              
              105
              
              
              19.3
              %Total
                  non-interest income
              
              $
              4,708
              
              $
              3,932
              
              $
              776
              
              
              19.7
              %
 
 Non-interest
        income increased approximately $204 thousand or 15.6% and $776 thousand or
        19.7%
        for the three and nine month periods ended September 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 $88 thousand and $317
        thousand can be attributed to the acquisition of Business First. The additional
        deposit relationships obtained resulting from promotional activities the
        Bank
        engaged in during the majority of 2007 and 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 months ended September 30, 2008 declined
        approximately $76 thousand when compared to the same period ended a year
        earlier. During the third quarter of 2007, the Bank recognized a gain of
        approximately $23 thousand from the sale of various SBA loans. The absence
        of
        this gain in the third quarter of 2008 contributed to the year over year
        decline
        within this category. For the first nine months of 2008, other non-interest
        income rose approximately $105 thousand from that reported for the first
        nine
        months of 2007. During the second quarter of 2008, the Bank recognized income
        in
        the amount of $272 thousand from proceeds it received in connection with
        the
        initial public offering of Visa, Inc. It is this additional income that has
        contributed substantially to the year to date increase within this
        category.
 
 Mortgage
        origination fee income was approximately $1 thousand and $11 thousand lower
        for
        the three and nine months ended September 30, 2008, when compared to the
        same
        periods ended a year earlier. While the number of loans originated declined
        slightly from the prior year, dollar volumes actually increased approximately
        $1.9 million and $1.6 million for the three and nine months ended September
        30,
        2008, when compared to the same period ended a year earlier. This can be
        attributed to a significant increase in the number of loan re-finances as
        homeowners moved to take advantage of lower interest rates during the first
        and
        third quarters of 2008. 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.
  -
            32
            -
  The
        table
        below illustrates the change in the number and total dollar volume of mortgage
        loans originated during the three and nine months ended September 30, 2008
        when
        compared to the same periods ended in 2007.
 
 **For the three months ended September 30,***(dollars
                  in thousands)*
              
              **2008**
              
              **2007**
              
              **Variance**Dollar
                  volume
              
              $
              14,710
              
              $
              12,835
              
              
              14.6
              %Number
                  of loans
              
              
              35
              
              
              37
              
              
              -5.4
              %**For the nine months ended September 30,***(dollars
                  in thousands)*
              
              
              **2008**
              
              
              **2007**
              
              
              **Variance**Dollar
                  volume
              
              $
              44,087
              
              $
              42,455
              
              
              3.8
              %Number
                  of loans
              
              
              118
              
              
              121
              
              
              -2.5
              %
 
 *Non-Interest
        Expenses*
 
 The
        tables below set forth changes in non-interest expenses for the three and
        nine
        month periods ended September 30, 2008 compared to the same periods ended
        in
        2007.
  **September
                  30,**
              
              **Variance***(dollars
                  in thousands)*
              
              **2008**
              
              **2007**
              
              **dollar**
              
              **percentage**Salaries
                  and employee benefits
              
              $
              3,651
              
              $
              3,238
              
              $
              413
              
              
              12.8
              %Occupancy
                  and equipment
              
              
              1,076
              
              
              830
              
              
              246
              
              
              29.6
              %Data
                  processing
              
              
              672
              
              
              529
              
              
              143
              
              
              27.0
              %Advertising
                  and promotional
              
              
              199
              
              
              165
              
              
              34
              
              
              20.6
              %Regulatory
                  fees
              
              
              116
              
              
              30
              
              
              86
              
              
              286.7
              %Other
                  professional fees and outside services
              
              
              261
              
              
              304
              
              
              (43
              )
              
              -14.1
              %Legal
                  fees and other litigation expense
              
              
              31
              
              
              31
              
              
              -
              
              
              -Loan
                  department costs
              
              
              68
              
              
              31
              
              
              37
              
              
              119.4
              %Stationery
                  and supplies
              
              
              99
              
              
              72
              
              
              27
              
              
              37.5
              %Director
                  fees
              
              
              80
              
              
              65
              
              
              15
              
              
              23.1
              %Core
                  deposit intangible amortization
              
              
              215
              
              
              88
              
              
              127
              
              
              144.3
              %Other
              
              
              640
              
              
              394
              
              
              246
              
              
              62.4
              %Total
                  non-interest expense
              
              $
              7,108
              
              $
              5,777
              
              $
              1,331
              
              
              23.0
              %**September
                  30,**
              
              
              **Variance***(dollars
                  in thousands)*
              
              
              **2008**
              
              
              **2007**
              
              
              **dollar**
              
              
              **percentage**Salaries
                  and employee benefits
              
              $
              11,897
              
              $
              9,682
              
              $
              2,215
              
              
              22.9
              %Occupancy
                  and equipment
              
              
              3,344
              
              
              2,251
              
              
              1,093
              
              
              48.6
              %Data
                  processing
              
              
              1,998
              
              
              1,634
              
              
              364
              
              
              22.3
              %Advertising
                  and promotional
              
              
              681
              
              
              592
              
              
              89
              
              
              15.0
              %Regulatory
                  fees
              
              
              340
              
              
              85
              
              
              255
              
              
              300.0
              %Other
                  professional fees and outside services
              
              
              858
              
              
              891
              
              
              (33
              )
              
              -3.7
              %Legal
                  fees and other litigation expense
              
              
              94
              
              
              77
              
              
              17
              
              
              22.1
              %Loan
                  department costs
              
              
              138
              
              
              102
              
              
              36
              
              
              35.3
              %Stationery
                  and supplies
              
              
              323
              
              
              244
              
              
              79
              
              
              32.4
              %Director
                  fees
              
              
              238
              
              
              212
              
              
              26
              
              
              12.3
              %Core
                  deposit intangible amortization
              
              
              646
              
              
              265
              
              
              381
              
              
              143.8
              %Other
              
              
              1,669
              
              
              998
              
              
              671
              
              
              67.2
              %Total
                  non-interest expense
              
              $
              22,226
              
              $
              17,033
              
              $
              5,193
              
              
              30.5
              %
 
 ·
              ***Salary
                  and Employee Benefits***
 
 Salaries
        and employee related expense incurred the greatest dollar increase of any
        non-interest expense category for the three and nine months ended September
        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 $475 thousand and $1,603 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.
  -
            33
            -
 
 ·
              ***Occupancy
                  and Equipment***
 
 Expenses
        related to occupancy and equipment increased significantly for the three
        and
        nine months ended September 30, 2008 when compared to the same periods ended
        a
        year earlier. The addition of two branches related to the acquisition of
        Business First contributed significantly to the increase within this category.
        For the three months ended September 30, 2008 the additional expense incurred
        within this category attributable to Business First was approximately $188
        thousand. For the nine months ended September 30, 2008, the additional expense
        incurred within this category attributable to Business First was approximately
        $603 thousand and approximately $234 thousand due to the impact of the sale
        leaseback of four Bank properties that was finalized in June 2007. 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 $143 thousand and $364 thousand
        for
        the three and nine month periods ended September 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 nine months ended September 30, 2008 regulatory fees increased
        approximately $86 thousand and $225 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 nine months ended September
        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 nine months ended September 30, 2008
        CDI
        amortization was approximately $127 thousand and $381 thousand higher than
        that
        reported for the same periods ended in 2007. Of the quarter and year to date
        increases approximately $119 thousand and $358 thousand can be attributed
        to the
        acquisition of Business First.
 
 ·
              ***Provision
                  for Income Taxes***
 
 For
        the
        three and nine month periods ended September 30, 2008, the provision for
        income
        taxes was 26.8% and 35.6% of pre tax income. For the same periods ended a
        year
        earlier, the provision for income taxes was 38.6% and 38.2% of pre tax income.
        The primary reason behind the quarter and year to date declines in the Company’s
        effective tax rate when compared to the same periods ended a year earlier
        is
        attributable to substantial increases in the provision for possible loan
        losses
        and the permanent difference associated with interest income the Company
        earned
        on municipal securities as well as income from holdings of bank owned life
        insurance becoming a larger percentage of overall taxable
        income.
  -
            34
            -
  **Financial
        Condition Analysis**
 
 At
        September 30, 2008 total assets were $787.9 million compared to $745.6 million
        at December 31, 2007. This represents an increase of $42.3 million or
        approximately 5.7%. During the first nine months of 2008, the Bank saw gross
        loan growth in the approximate amount of $53.2 million. The majority of the
        increase in loan balances can be attributed to increases in the commercial
        real-estate, commercial and industrial, and land segments of the portfolio
        during the first and second quarters of the year.
 
 The
        Bank
        saw declines in total deposit balances of approximately $55.6 million during
        the
        first nine months of 2008 and consequently lower balances of Federal Funds
        sold
        and higher balances of FHLB borrowing. The large decline in the over night
        Fed
        Funds rate thus far in 2008 prompted the Bank to reduce the rate paid on
        its
        interest bearing deposits and as a result total deposit balances, exclusive
        of
        brokered funds, declined approximately $63.3 million or 10.0% 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. As of September 30, 2008 the balance
        of brokered funds was approximately $20.2 million. See also “Deposits and
        Borrowed Funds” under Item 2. Management’s Discussion and Analysis of Financial
        Condition and Results of Operations for a more detailed discussion related
        to
        the Bank’s deposits and borrowings.
 
 *Loans*
 
 At
        September 30, 2008, total gross loan balances were $666.4 million. This
        represents an increase of approximately $53.2 million or 8.7% 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 real-estate, commercial and industrial and land loan balances
        in the approximate amount of $49.0 million. While the loan portfolio grew
        approximately $6.6 million during the third quarter, the majority of the
        year to
        date growth in the loan portfolio occurred during the first and second quarters
        of 2008.
 
 The
        table
        below sets forth changes from December 31, 2007 to September 30, 2008 for
        the
        composition of the loan portfolio:
 
 **September 30,**
              
              **December 31,**
              
              **Variance***(dollars
                  in thousands)*
              
              **2008**
              
              **2007**
              
              **dollar**
              
              **percentage****Real
                  Estate Secured**Multi-family
                  residential
              
              $
              13,997
              
              $
              12,779
              
              $
              1,218
              
              
              9.53
              %Residential
                  1 to 4 family
              
              
              29,031
              
              
              24,326
              
              
              4,705
              
              
              19.34
              %Home
                  equity line of credit
              
              
              22,247
              
              
              17,470
              
              
              4,777
              
              
              27.34
              %Commercial
              
              
              281,269
              
              
              274,266
              
              
              7,003
              
              
              2.55
              %Farmland
              
              
              10,630
              
              
              11,557
              
              
              (927
              )
              
              -8.02
              %**Commercial**Commercial
                  and industrial
              
              
              151,323
              
              
              133,981
              
              
              17,342
              
              
              12.94
              %Agriculture
              
              
              13,059
              
              
              11,367
              
              
              1,692
              
              
              14.89
              %Other
              
              
              662
              
              
              732
              
              
              (70
              )
              
              -9.56
              %**Construction**Single
                  family residential
              
              
              12,897
              
              
              10,239
              
              
              2,658
              
              
              25.96
              %Single
                  family residential - Spec.
              
              
              17,469
              
              
              18,718
              
              
              (1,249
              )
              
              -6.67
              %Tract
              
              
              1,999
              
              
              1,664
              
              
              335
              
              
              20.13
              %Multi-family
              
              
              7,803
              
              
              9,054
              
              
              (1,251
              )
              
              -13.82
              %Hospitality
              
              
              14,177
              
              
              16,784
              
              
              (2,607
              )
              
              -15.53
              %Commercial
              
              
              25,624
              
              
              30,677
              
              
              (5,053
              )
              
              -16.47
              %Land
              
              
              55,704
              
              
              31,064
              
              
              24,640
              
              
              79.32
              %Installment
                  loans to individuals
              
              
              7,889
              
              
              7,977
              
              
              (88
              )
              
              -1.10
              %All
                  other loans (including overdrafts)
              
              
              620
              
              
              562
              
              
              58
              
              
              10.32
              %Total
                  loans, gross
              
              
              666,400
              
              
              613,217
              
              
              53,183
              
              
              8.67
              %Deferred
                  loan fees
              
              
              1,647
              
              
              1,732
              
              
              (85
              )
              
              -4.91
              %Reserve
                  for possible loan losses
              
              
              10,350
              
              
              6,143
              
              
              4,207
              
              
              68.48
              %Total
                  loans, net
              
              $
              654,403
              
              $
              605,342
              
              $
              49,061
              
              
              8.10
              %Loans
                  held for sale
              
              $
              2,955
              
              $
              902
              
              $
              2,053
              
              
              227.61
              %
  -
            35
            -
  ***Real-Estate
        Secured***
 
 The
        following table provides a break-down of the real-estate secured segment
        of the
        Bank’s loan portfolio as of September 30, 2008:
 **September 30, 2008***(dollars
                    in thousands)*
                
                **Balance**
                
                **Undisbursed**Commitment
                
                **Total Bank**Exposure
                
                **Percent**Composition
                
                **Percent of**Bank's Tier 1Capital
                
                **Number**of
                    Loans
                
                **Single**LargestLoan**Real-Estate
                    Secured:**Retail
                
                $
                36,434
                
                $
                338
                
                $
                36,772
                
                
                9.5
                %
                
                54.3
                %
                
                54
                
                $
                3,320Professional
                
                
                71,308
                
                
                2,312
                
                
                73,620
                
                
                19.0
                %
                
                108.8
                %
                
                99
                
                
                8,875Hospitality
                
                
                59,311
                
                
                242
                
                
                59,553
                
                
                15.4
                %
                
                88.0
                %
                
                37
                
                
                10,851Multi-family
                
                
                13,997
                
                
                639
                
                
                14,636
                
                
                3.8
                %
                
                21.6
                %
                
                14
                
                
                5,837Home
                    equity lines of credit
                
                
                22,247
                
                
                22,474
                
                
                44,721
                
                
                11.6
                %
                
                66.1
                %
                
                279
                
                
                1,200Residential
                    1 to 4 family
                
                
                29,031
                
                
                1,004
                
                
                30,035
                
                
                7.8
                %
                
                44.4
                %
                
                70
                
                
                3,500Farmland
                
                
                10,630
                
                
                712
                
                
                11,342
                
                
                2.9
                %
                
                16.8
                %
                
                22
                
                
                2,000Healthcare
                    / medical
                
                
                16,417
                
                
                -
                
                
                16,417
                
                
                4.2
                %
                
                24.3
                %
                
                31
                
                
                2,170Restaurants
                    / food establishments
                
                
                6,522
                
                
                76
                
                
                6,598
                
                
                1.7
                %
                
                9.7
                %
                
                14
                
                
                2,600Commercial
                
                
                75,063
                
                
                1,006
                
                
                76,069
                
                
                19.7
                %
                
                112.4
                %
                
                114
                
                
                4,737Other
                
                
                16,214
                
                
                552
                
                
                16,766
                
                
                4.3
                %
                
                24.8
                %
                
                31
                
                
                2,100**Total
                    real-estate secured**
                
                **$**
                **357,174**
                
                **$**
                **29,355**
                
                **$**
                **386,529**
                
                
                **99.9**
                **%**
                
                **571.2**
                **%**
                
                **765**
                
                **$**
                **47,190**
  Real-Estate
        secured loan balances increased approximately $16.8 million from that reported
        at December 31, 2007. Contributing to the overall increase within this category
        were several large loans previously classified as construction moving into
        amortizing loans as well as organic loan growth. Of the year to date growth
        in
        the category of Residential 1-4 Family, approximately $3.5 million can be
        attributed to the origination of one, short term loan with an LTV of 33%
        in
        Santa Barbara during the third quarter of 2008. Additionally, there were
        several
        large HELOC disbursements made during the third quarter of 2008 in the aggregate
        amount of $2.3 million, contributing significantly to the year to date increase
        within this category. Commercial real-estate balances were approximately
        $7.0
        million higher that that reported at December 31, 2007. As mentioned, this
        is
        primarily the result of several large construction loans moving into amortizing
        balances during the third quarter as well as several new loans funded in
        the
        aggregate amount of $4.4 million. The increase within this category was somewhat
        tempered by several large pay-downs in the aggregate amount of $7.7 million
        that
        occurred during the second quarter as well as the participation of approximately
        $4.3 million in commercial real-estate loans during the third
        quarter.
 
 Hotel
        loans disbursed are not considered a concentration with balances of
        approximately $59.3 million, representing 87.6% of the Bank’s Tier I capital.
        However, there are several hotel construction and land loans that increase
        total
        outstanding balances to $77.3 million as well as un-disbursed commitments
        of
        approximately $13.3 million, which in aggregate represent a concentration
        at
        133.9% 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.
 
 At
        September 30, 2008, real-estate secured balances represented $357.2 million
        or
        53.6% of the loan portfolio and approximately 527.7% of the Bank’s Tier I
        capital. Of these balances, $156.3 million or 43.8% of the real-estate secured
        segment of the loan portfolio 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.
  -
            36
            -
  ***Commercial***
 
 The
        following table provides a break-down of the commercial and industrial segment
        of the Bank’s commercial loan portfolio as of September 30, 2008:
 
 **September 30, 2008***(dollars
                  in thousands)*
              
              **Balance**
              
              **Undisbursed**Commitment
              
              **Total Bank**Exposure
              
              **Percent**Composition
              
              **Percent of**Bank's Tier 1Capital
              
              **Number**of
                  Loans
              
              **Single**LargestLoanAgriculture
              
              $
              2,970
              
              $
              3,202
              
              $
              6,172
              
              
              2.5
              %
              
              9.1
              %
              
              26
              
              $
              2,000Oil
                  / gas & utilities
              
              
              858
              
              
              935
              
              
              1,793
              
              
              0.7
              %
              
              2.6
              %
              
              10
              
              
              750Construction
              
              
              19,542
              
              
              13,366
              
              
              32,908
              
              
              13.5
              %
              
              48.6
              %
              
              166
              
              
              2,750Manufacturing
              
              
              10,294
              
              
              8,707
              
              
              19,001
              
              
              7.8
              %
              
              28.1
              %
              
              108
              
              
              1,500Wholesale
                  and retail
              
              
              14,689
              
              
              7,954
              
              
              22,643
              
              
              9.3
              %
              
              33.5
              %
              
              130
              
              
              1,250Transportation
                  and warehousing
              
              
              2,775
              
              
              776
              
              
              3,551
              
              
              1.5
              %
              
              5.2
              %
              
              35
              
              
              526Media
                  and information services
              
              
              11,316
              
              
              1,522
              
              
              12,838
              
              
              5.3
              %
              
              19.0
              %
              
              23
              
              
              7,167Financial
                  services
              
              
              19,302
              
              
              6,679
              
              
              25,981
              
              
              10.6
              %
              
              38.4
              %
              
              48
              
              
              6,000Real-estate
                  / rental and leasing
              
              
              12,767
              
              
              14,679
              
              
              27,446
              
              
              11.3
              %
              
              40.6
              %
              
              96
              
              
              3,500Professional
                  services
              
              
              17,577
              
              
              11,719
              
              
              29,296
              
              
              12.0
              %
              
              43.3
              %
              
              144
              
              
              2,000Healthcare
                  / medical and social services
              
              
              14,208
              
              
              18,833
              
              
              33,041
              
              
              13.6
              %
              
              48.8
              %
              
              107
              
              
              11,355Restaurants
                  / food establishments
              
              
              17,089
              
              
              2,817
              
              
              19,906
              
              
              8.2
              %
              
              29.4
              %
              
              90
              
              
              1,320All
                  other
              
              
              7,936
              
              
              1,124
              
              
              9,060
              
              
              3.7
              %
              
              13.4
              %
              
              67
              
              
              2,530**Commercial
                  and industrial**
              
              **$**
              **151,323**
              
              **$**
              **92,313**
              
              **$**
              **243,636**
              
              
              **100.0**
              **%**
              
              **360.0**
              **%**
              
              **1,050**
              
              **$**
              **42,648**
 
 Loans
        within this category increased $19.0 million or 13.0% from the year ended
        December 31, 2007. Increases in commercial and industrial loan balances in
        the
        approximate amount $17.3 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. However, during the third quarter the Bank saw several
        large pay-downs in the aggregate amount of $5.1 million, with the majority
        of
        these pay-downs coming from one borrower. At September 30, 2008, the aggregate
        balance of loans within this category was approximately $165.0 million,
        representing 243.9% of the Bank’s Tier I Capital. Additionally, approximately
        $1.3 million of commercial loans were SBA guaranteed at September 30, 2008.
 
 During
        the quarter the Bank placed two commercial loans made to one borrower on
        non-accrual status and established a valuation allowance for these loans. At
        September 30, 2008, the balance of these loans was approximately $5.9 million.
        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 the loans the Bank has placed on
        non-accrual.
 
 ***Construction***
 
 The
        following table provides a break-down of the construction segment of the
        Bank’s
        loan portfolio as of September 30, 2008:
 
 **September 30, 2008***(dollars
                  in thousands)*
              
              **Balance**
              
              **Undisbursed**Commitment
              
              **Total Bank**Exposure
              
              **Percent**Composition
              
              **Percent of**Bank's Tier 1Capital
              
              **Number**of
                  Loans
              
              **Single**LargestLoan**Construction:**Single
                  family residential
              
              $
              12,897
              
              $
              12,586
              
              $
              25,483
              
              
              21.7
              %
              
              37.7
              %
              
              28
              
              $
              4,600Single
                  family residential - Spec.
              
              
              17,469
              
              
              2,011
              
              
              19,480
              
              
              16.6
              %
              
              28.8
              %
              
              13
              
              
              3,480Tract
              
              
              1,999
              
              
              901
              
              
              2,900
              
              
              2.5
              %
              
              4.3
              %
              
              9
              
              
              649Multi-family
              
              
              7,803
              
              
              2,855
              
              
              10,658
              
              
              9.1
              %
              
              15.7
              %
              
              6
              
              
              3,584Commercial
              
              
              25,624
              
              
              6,244
              
              
              31,868
              
              
              27.1
              %
              
              47.1
              %
              
              23
              
              
              4,250Hospitality
              
              
              14,177
              
              
              12,801
              
              
              26,978
              
              
              23.0
              %
              
              39.9
              %
              
              4
              
              
              7,853**Total
                  construction**
              
              **$**
              **79,969**
              
              **$**
              **37,398**
              
              **$**
              **117,367**
              
              
              **100.0**
              **%**
              
              **173.5**
              **%**
              
              **83**
              
              **$**
              **24,416**
 
 At
        September 30, 2008, construction loan balances were approximately $80.0 million
        or $7.2 million less than that reported at December 31, 2007. During the
        third
        quarter of 2008 several large loans previously classified as construction
        moved
        into amortizing balances under commercial real-estate. This contributed greatly
        to the year to date and quarter over quarter declines the Bank saw within
        this
        segment of the loan portfolio. During the second and third quarters, loan
        pay-downs kept pace with new fundings as the Bank has become very selective
        in
        the loans it originates within this category. At September 30, 2008, total
        construction balances represented 118.2% of the Bank’s Tier I Capital.
        Un-disbursed commitments within this category totaled approximately $37.4
        million and when combined with disbursed represent 173.5% of the Bank’s Tier I
        Capital. As of September 30, 2008, approximately $24.1 million or 30.2% of
        construction balances are 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.
  -
            37
            -
  During
        the first nine months of 2008, the Bank placed approximately $11.4 million
        in
        single family spec construction loans on non-accrual status. During the third
        quarter, the Bank also placed one loan in the amount of $2.5 million within
        the
        category of multi-family construction on non-accrual. 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 the construction segment of the loan portfolio
        for additional signs of deterioration and has devoted additional resources
        to
        this effort.
 
 ***Land***
 
 The
        following table provides a break-down of the land segment of the Bank’s loan
        portfolio as of September 30, 2008:
  **September 30, 2008***(dollars
                  in thousands)*
              
              **Balance**
              
              **Undisbursed**Commitment
              
              **Total Bank**Exposure
              
              **Percent**Composition
              
              **Percent of**Bank's Tier 1Capital
              
              **Number**of
                  Loans
              
              **Single**LargestLoan**Land:**Single
                  family residential
              
              $
              7,693
              
              $
              -
              
              $
              7,693
              
              
              12.8
              %
              
              11.4
              %
              
              25
              
              $
              1,200Single
                  family residential - Spec.
              
              
              1,938
              
              
              176
              
              
              2,114
              
              
              3.5
              %
              
              3.1
              %
              
              8
              
              
              618Tract
              
              
              31,709
              
              
              3,849
              
              
              35,558
              
              
              58.9
              %
              
              52.5
              %
              
              10
              
              
              12,208Multi-family
              
              
              1,628
              
              
              35
              
              
              1,663
              
              
              2.8
              %
              
              2.5
              %
              
              4
              
              
              675Commercial
              
              
              8,926
              
              
              297
              
              
              9,223
              
              
              15.3
              %
              
              13.6
              %
              
              16
              
              
              1,500Hospitality
              
              
              3,810
              
              
              270
              
              
              4,080
              
              
              6.7
              %
              
              6.0
              %
              
              4
              
              
              2,340**Total
                  land**
              
              **$**
              **55,704**
              
              **$**
              **4,627**
              
              **$**
              **60,331**
              
              
              **100.0**
              **%**
              
              **89.1**
              **%**
              
              **67**
              
              **$**
              **18,541**
 
 At
        September 30, 2008 the balance of loans within this category was approximately
        $55.7 million. When compared to the $31.1 million reported at December 31,
        2007,
        land balances increased approximately $24.6 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 loans within this category consist of loans for residential tract
        developments in the aggregate amount of $13.3 million. These projects are
        located in the California Central Valley in Kern County. One project is approved
        for 314 single family lots. This project has also been approved for
        approximately 8.6 acres of commercial development and 13.5 acres for
        recreational purposes. The project was funded in the first quarter of 2008
        and
        has an approximate loan to value of 50.0%, based on an appraisal conducted
        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 during
        the fourth quarter. At September 30, 2008, the balance of this loan was
        approximately $10.8 million, with approximately $1.4 million un-disbursed.
        The
        second project currently consists of 7 finished homes, 34 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 $1.6 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. The housing in this project also
        qualifies for the USDA Direct Loan program whereby individuals or families
        receive financial assistance directly from the Housing and Community Facilities
        Programs (HCFP) in the form of a home loan at an affordable interest rate.
 
 Kern
        County, somewhat outside of the Company’s market footprint, has a population of
        approximately 817,000 and depends on agriculture, oil, light industry,
        warehousing and distribution, and educational services to support its economy.
        This region of California’s Central Valley has experienced significant
        population growth over the last five years relative to other areas of the
        state,
        with annual percentage increases of 2.5% or more per year over the last five
        years. Affordable housing, relative to other metropolitan areas within
        California, has been a significant factor behind the growth in Kern County’s
        population. However, like many other areas within California, real-estate
        prices
        within the California Central Valley have fallen significantly, with recent
        indications showing year over year declines of approximately 30% and an
        approximate six month supply of unsold homes within Kern County, specifically.
        Management acknowledges that as economic conditions worsen across the state,
        the
        level of growth previously experienced within the California Central Valley
        will
        no doubt be negatively impacted.
  -
            38
            -
  The
        Bank
        does not typically make loans outside of its market footprint unless the
        potential for a long term relationship, including acquisition of additional
        deposits, exists. The Bank continues to closely monitor both relationships
        it
        has established with borrowers in the Central Valley for any signs of
        deterioration, given that they are out of our market area. As of September
        30,
        2008, these borrowers have continued to perform under the contractual terms
        of
        their respective loan agreements.
 
 At
        September 30, 2008, land balances represented 82.3% of the Bank’s Tier I capital
        and when combined with un-disbursed commitments represent approximately 89.1%
        of
        the Bank’s Tier I Capital. Additionally, as of September 30, 2008, approximately
        $9.6 million or 17.2% of the land portfolio was considered owner
        occupied.
 
 ***Installment***
 
 At
        September 30, 2008, the balance of installment loans was approximately $7.9
        million. This, when compared to the $8.0 million reported at December 31,
        2007,
        represents a decline of approximately $0.1 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 September 30, 2008 and December 31, 2007 mortgage correspondent
        loans
        (loans held for sale) totaled approximately $3.0 million and $0.9 million,
        respectively.
 
 ***Foreign
        Loans***
 
 At
        September 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. Additionally, as conditions
        in the
        credit markets worsened in 2008, financial institutions became more reluctant
        to
        extend new credit to borrowers, pushing the cost of certain types of credit
        higher in a rates down environment and contributing further to the decline
        in
        real-estate prices. As more and more home owners began to see interest rate
        resets on adjustable rate mortgages late in 2007 and into 2008, the number
        of
        non-performing loans and defaults rose significantly in the industry as a
        whole.
        This trend has continued thus far in 2008.
 
 Sales
        of
        single family homes have fallen significantly year over year in the Company’s
        market area and California as a whole, with recent indications showing price
        declines in the range of 30% to 40% statewide and 20% to 30% within the
        Company’s market area. Along with other segments in the real-estate sector,
        commercial real-estate prices in the Company’s market area have experienced some
        pressure during 2008 and the Company has begun to see a slight increase in
        vacancy rates in certain retail and office segments, though not to any
        considerable extent. 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. However, the Company realizes
        that any prolonged and significant downturn in the national and local economies
        may have an impact on the values of commercial real-estate within its market
        footprint as well as the borrowers to whom the Bank has extended such credit
        and
        thus continues to closely monitor the credits within this segment of the
        loan
        portfolio for potential signs of deterioration. Additionally, the Bank continues
        to employ stringent lending standards and remains very selective with regard
        to
        any additional commercial real-estate, real-estate construction and land
        loans
        it chooses to originate in an effort to effectively manage risk in this
        difficult credit environment.
 
 Although,
        the Company’s market footprint has historically enjoyed a more stable level of
        economic growth, we are not completely immune to the effects of a slowdown
        on a
        state or national level. As previously mentioned, with the availability of
        credit significantly diminished and the effects of inflation as well as interest
        rate resets on mortgages placing more pressure on borrowers throughout the
        U.S.
        economy, the ability of consumers to satisfy outstanding obligations to the
        financial sector, as a whole, has begun to languish. We believe that within
        certain areas of our local economy these more macro level concerns have started
        to become more evident, 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 and charged
        off
        during the first nine 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.
  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.
  -
            39
            -
 
 The
        following table provides a geographical break-down for some of the Bank’s
        largest segments of the loan portfolio: commercial real-estate secured,
        construction, and land as of September 30, 2008:
  **Commercial****Real Estate****Geographic
                  Distribution**
              
              **Secured**
              
              **Construction**
              
              **Land**Northern
                  San Luis Obispo County
              
              
              32.4
              %
              
              30.3
              %
              
              26.8
              %Southern
                  San Luis Obispo County
              
              
              16.8
              %
              
              12.9
              %
              
              12.7
              %Coastal
                  Regions - San Luis Obispo County
              
              
              7.3
              %
              
              16.1
              %
              
              3.7
              %Northern
                  Santa Barbara County
              
              
              19.7
              %
              
              12.3
              %
              
              8.7
              %Southern
                  Santa Barbara County
              
              
              18.0
              %
              
              14.0
              %
              
              7.2
              %Other
              
              
              5.8
              %
              
              14.4
              %
              
              40.9
              %Totals
              
              
              100.0
              %
              
              100.0
              %
              
              100.0
              %
 
 As
        evidenced in the table above, as of September 30, 2008, substantially all
        loans
        the Bank originated within the major categories of commercial real-estate,
        construction and land were made to borrowers within our current market
        footprint. The Majority of loans within the category of Land - Other were
        made
        to borrowers for projects located within the California Central Valley.
        Management closely monitors all loans made to borrowers outside of its market
        footprint and as of September 30, 2008 all such loans were performing as
        agreed.
  *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 collateral is recognized by
        a
        charge to the reserve for loan losses. When the collateral is held for sale
        after foreclosure, it is subject to a periodic appraisal. If the appraisal
        indicates that the collateral will sell for less than its recorded value,
        the
        Bank recognizes the loss by a charge to non-interest expense.
 
 Non-performing
        loans include non-accrual loans, restructured loans and accruing loans that
        are
        90 days or more delinquent. As of September 30, 2008, there were no loans
        90
        days past due and still accruing. Loans on non-accrual status totaled $22.4
        million at September 30, 2008 compared to $13.4 million at June 30, 2008
        and
        $0.3 million at December 31, 2007. During the third quarter of 2008, the
        Bank
        placed approximately $9.2 million in additional loans on non-accrual status.
        All
        loans on non-accrual are carried at fair value pursuant to SFAS No. 114 *“Accounting
        by Creditors for Impairment of a Loan.* ”
As
        of
        September 30, 2008, non-accruing loans consist of the following:
 
 ·
              Nine
                  loans in the approximate amount of $10.2 million to three borrowers
                  all
                  representing single family spec construction loans located in various
                  costal communities along the Central Coast of California. During
                  the third
                  quarter of 2008, the Bank charged off approximately $0.7 million
                  in
                  balances associated with these loans as the result of updated valuation
                  analyses. Most of the properties securing these loans are near
                  completion
                  and there has been some market
                  interest.
  -
            40
            -
 
 ·
              Five
                  loans in the approximate amount of $2.3 million all secured by
                  commercial
                  real-estate and single family residences. The borrowers continue
                  to work
                  with Management on these loans.
 
 ·
              Seven
                  loans in the approximate amount of $0.7 million to four borrowers
                  that are
                  collateralized by various business assets and personal collateral.
                  During
                  the third quarter, the Bank charged off one loan in the amount
                  of $12
                  thousand with a net loss of $6 thousand. Principal reductions in
                  the
                  aggregate amount of $30 thousand were received on the remaining
                  seven
                  loans. The borrowers continue to work with Management on these
                  loans.
 
 ·
              Seven
                  loans in the approximate amount of $0.9 million that are collateralized
                  by
                  various forms of business assets and personal collateral. One such
                  loan
                  contains an SBA guarantee in the amount of $0.3 million and is
                  in the
                  process of liquidation. The Bank has established a valuation allowance
                  in
                  the amount of $0.6 million on the remaining credits within this
                  group, all
                  of which are in the process of
                  collection.
 
 ·
              Three
                  loans to two borrowers in the approximate amount of $8.4 million
                  that are
                  secured by real-estate. One loan for $2.5 million is secured by
                  property
                  located in a coastal community of the central coast of California
                  and is
                  being carried at its analyzed fair value. The remaining two loans
                  are
                  secured by various commercial and farm properties within the Bank’s
                  primary market area. The Bank has established a valuation allowance
                  of
                  approximately $1.8 million for these
                  loans.
 
 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 $607
        thousand and $65 thousand at September 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”) as of September 30, 2008. No additional charge off
        was required at the time the asset moved into OREO. Additionally, in June
        2008
        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 Bank subsequently received and accepted a cash offer to
        sell
        the foreclosed property in July and as a result of that sale the Bank recorded
        a
        net recovery of approximately $15 thousand.
 
 At
        September 30, 2008, total non-performing assets were approximately $22.6
        million, or 2.87% 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 $22.3 million.
 
 At
        September 30, 2008, the allowance for loan losses was approximately $10.4
        million, or 1.55% 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 $4.3 million. The year to date change in the allowance
        can be attributed to net charge offs in the amount of $2.0 million as well
        as
        additions to the allowance in the amount of $6.2 million. During the second
        and
        third quarters 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 change in the trend of delinquent loans,
        prompted the Bank to make substantial additions to the allowance during the
        first nine months of 2008. As of September 30, 2008, Management believes
        that
        the allowance for loan losses is prudent and warranted, based on information
        currently available.
  -
            41
            -
  The
        following table provides a summary of non-performing assets at September
        30,
        2008 compared to December 31, 2007 as well as key asset quality
        ratios:
 
 **September 30,**
              
              **December 31,***(dollars
                  in thousands)*
              
              **2008**
              
              **2007**Loans
                  delinquent 90 days or more and still accruing
              
              $
              -
              
              $
              -Non
                  Accruing Loans:Real-estate
                  secured
              
              
              2,523
              
              
              261Commercial
              
              
              7,954
              
              
              62Construction
              
              
              11,311
              
              
              -Land
              
              
              590
              
              
              -Installment
                  loans
              
              
              12
              
              
              15Total
                  non-accruing loans
              
              $
              22,390
              
              $
              338Other
                  real-estate owned
              
              $
              197
              
              $
              -Total
                  non-performing assets
              
              $
              22,587
              
              $
              338Ratio
                  of allowance for credit losses to total gross loans
              
              
              1.55
              %
              
              1.00
              %Ratio
                  of allowance for credit losses to total non-performing
                  loans
              
              
              46.23
              %
              
              1817
              %Ratio
                  of non-performing loans to total gross loans
              
              
              3.36
              %
              
              0.06
              %Ratio
                  of non-performing assets to total assets
              
              
              2.87
              %
              
              0.05
              %
  *Total
        Cash and Cash Equivalents*
 
 Total
        cash and due from banks was $27.7 million and $46.4 million at September
        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 balances during the first nine months 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.
 
 The
        table
        below sets forth the change in balances of other earning assets as of September
        30, 2008 from that reported at December 31, 2007.
 
 **September 30,**
              
              **December 31,**
              
              **Variance***(dollars in thousands)*
              
              **2008**
              
              **2007**
              
              **dollar**
              
              **percentage**Federal
                  Home Loan Bank stock
              
              $
              5,006
              
              $
              3,045
              
              $
              1,961
              
              
              64.40
              %Available-for-sale
                  securities
              
              
              52,634
              
              
              47,556
              
              
              5,078
              
              
              10.68
              %Federal
                  funds sold
              
              
              8,835
              
              
              23,165
              
              
              (14,330
              )
              
              -61.86
              %Interest
                  bearing deposits other financial institutions
              
              
              119
              
              
              330
              
              
              (211
              )
              
              -63.94
              %Total
                  other earning assets
              
              $
              66,594
              
              $
              74,096
              
              $
              (7,502
              )
              
              -10.12
              %
 
 ·
              ***Federal
                  Home Loan Bank (“FHLB”)
                  Stock***
 
 As
        a
        member of the Federal Home Loan Bank of San Francisco, the Bank is required
        to
        hold a specified amount of FHLB capital stock based on the level of borrowings
        the Bank has obtained from the FHLB. As such, the amount of FHLB stock the
        Bank
        carries can vary from one period to another based on among other things the
        current liquidity needs of the Bank. At September 30, 2008, the Bank held
        approximately $5.0 million in FHLB stock, an increase of approximately $2.0
        million from that reported at December 31, 2007.
  -
            42
            -


·
              ***Available-for-Sale
                  Securities***
 
 The
        Company manages its securities portfolio to provide a source of both liquidity
        and earnings. The Bank has an asset/liability committee that develops current
        investment policies based upon its operating needs and market circumstance.
        The
        Bank’s investment policy is formally reviewed and approved annually by the board
        of directors. The asset/liability committee of the Bank is responsible for
        reporting and monitoring compliance with the investment policy. Reports are
        provided to the Bank’s board of directors on a regular basis.
 
 Securities
        available-for-sale are carried at fair value, with related unrealized net
        gains
        or losses, net of deferred income taxes, recorded as an adjustment to
        shareholders’ equity. At September 30, 2008, net unrealized losses in the
        portfolio were $1.9 million or $1.1 million, 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 $2.2 million or $1.3 million, net of tax. The decline in
        the
        market value can be attributed in large part to continued concerns surrounding
        mortgage related securities and the credit markets as a whole. In addition
        to
        changes in market values, the year to date change in the securities portfolio
        can be attributed to purchases in the amount of $18.4 million, proceeds from
        principal reduction in mortgage-backed securities in the amount of $7.5 million,
        as well as sales, calls and maturities totaling $3.7 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.
 
 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 $3.8 million and a net unrealized loss of approximately
        $192 thousand or $113 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 September 30, 2008, the market value of these securities had a
        net
        unrealized loss of approximately $1.4 million or $0.8 million, net of
        tax.
 
 At
        September 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.
 
 During
        the last twelve months, fixed income markets have seen a significant re-pricing
        of credit risk, which has 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 nine
        months of 2008 and the Bank’s securities portfolio was not completely immune to
        market fluctuations. Management reviews the securities portfolio on a regular
        basis to identify investments that may be other than temporarily impaired.
        At
        September 30, 2008, Management does not believe that the current losses in
        the
        securities portfolio are other than temporary.
 
 All
        fixed
        and adjustable rate mortgage pools contain a certain amount of risk related
        to
        the uncertainty of prepayments of the underlying mortgages. Interest rate
        changes have a direct impact upon prepayment rates. The Bank uses computer
        simulation models to test the average life, duration, market volatility and
        yield volatility of adjustable rate mortgage pools under various interest
        rate
        assumptions to monitor volatility. Stress tests are performed quarterly.
 
 ·
              ***Federal
                  Funds Sold***
 
 The
        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.
 
 *Deposits
        and Borrowed Funds*
 
 With
        recent uncertainty caused by an increase in bank failures, customers are
        more
        aware of FDIC insurance levels and in addition to the use of programs like
        CDARS, have been re-deploying deposits to ensure FDIC coverage. CDARS is
        an
        acronym for the Certificate of Deposit Account Registry Service, which enables
        depositors to have larger insured deposits above the FDIC stated maximums.
        While
        this has caused some funds to leave the bank, there is an increase in new
        money,
        as well. We are, however, noticing lower balances kept in most account types.
        We
        anticipate that this situation could experience a positive change with the
        very
        recently announced FDIC unlimited deposit account coverage on Demand Deposit
        Accounts and the increase from $100,000 to $250,000 for all types of
        accounts.
  -
            43
            -
 
 The
        table
        below sets forth the change in the various categories of deposits from December
        31, 2007 to September 30, 2008:
 
 **% of Total****September 30,**
              
              **December 31,**
              
              **Variance**
              
              **Deposits***(dollars in thousands)*
              
              **2008**
              
              **2007**
              
              **dollar**
              
              **percentage**
              
              **9/30/08**Non-interest
                  bearing demand
              
              $
              155,267
              
              $
              153,684
              
              $
              1,583
              
              
              1.03
              %
              
              26.4
              %Interest
                  bearing demand
              
              
              71,601
              
              
              69,558
              
              
              2,043
              
              
              2.94
              %
              
              12.2
              %Savings
              
              
              22,484
              
              
              41,599
              
              
              (19,115
              )
              
              -45.95
              %
              
              3.8
              %Money
                  market
              
              
              175,659
              
              
              206,754
              
              
              (31,095
              )
              
              -15.04
              %
              
              29.8
              %Time
                  deposits of $100 or more
              
              
              55,428
              
              
              63,445
              
              
              (8,017
              )
              
              -12.64
              %
              
              9.4
              %Time
                  deposits under $100
              
              
              88,583
              
              
              97,247
              
              
              (8,664
              )
              
              -8.91
              %
              
              15.0
              %Brokered
                  deposits
              
              
              20,229
              
              
              12,521
              
              
              7,708
              
              
              61.56
              %
              
              3.4
              %Total
                  deposits
              
              $
              589,251
              
              $
              644,808
              
              $
              (55,557
              )
              
              -8.62
              %
              
              100.0
              %
 
 The
        acquisition of core deposits has remained the single biggest challenge facing
        the Company and even more so in the current environment where many financial
        institutions are aggressively competing for sources of liquidity. During
        the
        first nine months of 2008, the Bank saw total deposit balances decline
        approximately $55.6 million. Exclusive of brokered funds, deposit balances
        declined approximately $63.3 million.
 
 The
        moves
        by the FOMC during the first nine months 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. Deposit run-off was
        most
        evident in money market balances with a year to decline of approximately
        $31.1
        million. Declines in time deposits also contributed greatly to the overall
        decline, with total time deposit balances, exclusive of brokered funds,
        approximately $16.7 million lower than that reported at December 31, 2007.
        The
        declines within these categories can be attributed in part to promotional
        deposit run-off in favor of somewhat irrational deposit pricing at other
        financial institutions in severe need of liquidity as well as declines in
        the
        balances of several large accounts the Bank monitors closely on a regular
        basis.
 
 During
        2007, the Bank engaged in promotional activities designed to attract lower
        cost
        core deposits in an effort to rely less on FHLB borrowings that were more
        expensive at the time. These promotions proved to be successful as the Bank
        saw
        a dramatic increase in floating rate money market and short-term time deposit
        balances, allowing for substantially all of the Bank’s borrowings to be paid
        down during 2007. Given the nature of the additional deposits gathered, in
        that
        they are of short duration and / or possess a floating rate, the Bank was
        able
        to immediately re-price the majority of these funds as the FOMC moved
        aggressively to lower interest rates during the first half of 2008. This,
        while
        allowing the Bank to mitigate declines in the net interest margin, has increased
        the level of deposit run-off the Bank has seen during the first nine months
        of
        2008.
 
 In
        an
        effort the stem the decline in deposit balances, rely less on FHLB borrowings
        and maintain an appropriate mix of secondary funding, the Bank purchased
        approximately $30.0 million in brokered funds during the second quarter of
        2008,
        of which approximately $10.0 million matured during the third quarter.
        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.
 
 Non-interest
        bearing demand accounts represented approximately 26.4% of total deposits
        at
        September 30, 2008. Of this balance, approximately $14.1 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
        a
        decline of approximately $1.6 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
        are
        impacted. Additionally, the Bank closely monitors several additional deposit
        relationships that it also considers to be volatile. At September 30, 2008,
        the
        balances of these accounts were approximately $22.8 million lower than the
        $52.7
        million reported at December 31, 2007. At September 30, 2008, two of these
        relationships were classified as money market with balances of approximately
        $21.5 million, while the other relationship is classified as an interest
        bearing
        demand with balances of approximately $8.4 million and is considered public
        funds.
  -
            44
            -
 
 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 of which approximately $10.0 million matured during the third
        quarter. At September 31, 2008, the balance of brokered funds was approximately
        $20.2 million or $7.7 million higher than that reported at December 31, 2007.
        The Bank also entered into an agreement with an entity that works on behalf
        of
        brokerages to sell excess un-invested funds to other financial institutions
        seeking additional liquidity. These funds are considered brokered money market
        funds whose balances are subject to change. The Bank’s policy states that such
        funds, including brokered funds, shall not exceed 10% of total assets. At
        September 30, 2008, the Bank did not carry a balance for funds classified
        as
        brokered money market.
 
 The
        following table provides a summary of the Federal Home Loan Bank (“FHLB”)
        borrowings the Bank had as of September 30, 2008:
 
 *(dollars
                  in thousands)*
 
 **Amount**
              
              **Interest**
              
              **Maturity****Borrowed**
              
              **Rate**
              
              **Variable/Fixed**
              
              **Date**$                         25,000
              
              
              2.57
              %
              
              Variable
              
              
              6/22/0932,500
              
              
              2.33
              %
              
              Variable
              
              
              Open15,000
              
              
              2.37
              %
              
              Fixed
              
              
              12/16/0810,000
              
              
              2.85
              %
              
              Fixed
              
              
              1/26/0910,000
              
              
              2.60
              %
              
              Fixed
              
              
              2/6/094,000
              
              
              4.93
              %
              
              Fixed
              
              
              2/27/0910,000
              
              
              2.89
              %
              
              Fixed
              
              
              9/16/10$                         106,500
              
              
              2.62
              %
 
 As
        evidenced in the table above, the balance of FHLB borrowing as of September
        30,
        2008 was $106.5 million. This represents an increase of approximately $98.5
        million from the balance reported at December 31, 2007. The increase in FHLB
        borrowing is primarily attributable to the $55.6 million decline in deposit
        balances in addition to the $53.2 million increase in gross loan balances
        the
        Bank saw during the first nine 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 the Bank’s need for liquidity
        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 $1.2 million and $1.9 million in securities sold under agreements
        to
        repurchase at September 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 September 30, 2008, the Company had no balance outstanding on
        this
        note. The Company pledged 646,598 shares (51%) of the Bank’s stock as collateral
        for the loan. The note is revolving in nature for the first two years. The
        terms
        of the note call for quarterly interest only payments for the first two years
        with subsequent principal and interest payments for eight years on a fully
        amortized basis. At September 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, which has since been reduced to $11.4 million,
        to a
        customer in regard to a senior care facility. The Letter of Credit was issued
        pursuant to a Letter of Credit Reimbursement Agreement between the Bank and
        the
        FHLB. It is collateralized by a blanket lien with the FHLB that includes
        all
        qualifying loans on the Bank’s balance sheet. The letter of credit will expire
        in September 2009.
  -
            45
            -
 
 *Capital*
 
 At
        September 30, 2008, the balance of stockholders’ equity was approximately $71.0
        million. This, when compared to the $69.5 million at December 31, 2007,
        represents an increase of approximately $1.5 million. The change in capital
        was
        due to net income of $2.9 million, stock options exercised in the amount
        of $228
        thousand, the capital impact of year-to-date share-based compensation expense
        in
        the amount of $275 thousand, $586 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 $1.3 million.
 
 ·
              ***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
              
              
              1/24/2008
              
              
              2/1/2008
              
              
              2/15/2008Cash
                  dividend
              
              $
              0.08
              
              
              10/17/2007
              
              
              11/2/2007
              
              
              11/16/2007Cash
                  dividend
              
              $
              0.08
              
              
              7/18/2007
              
              
              8/3/2007
              
              
              8/17/2007Cash
                  dividend
              
              $
              0.08
              
              
              4/20/2007
              
              
              5/4/2007
              
              
              5/18/2007Cash
                  dividend
              
              $
              0.08
              
              
              1/19/2007
              
              
              2/2/2007
              
              
              2/16/2007Cash
                  dividend
              
              $
              0.08
              
              
              10/20/2006
              
              
              11/3/2006
              
              
              11/17/2006Cash
                  dividend
              
              $
              0.08
              
              
              7/21/2006
              
              
              8/11/2006
              
              
              8/25/2006
 
 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 were to be made,
        as conditions warrant, from time to time in the open market or through privately
        negotiated transactions. The duration of the program was for one year and
        the
        timing of purchases was to 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 2006 plan to 100,000. In July 2007,
        the Board of Directors authorized a one year extension of this plan, which
        expired in August 2008.
 
 As
        of
        September 30, 2008, the Company repurchased and retired 53,500 shares of
        its
        common stock under the 2006 stock repurchase plan at a weighted average price
        of
        $17.44. The Company made no repurchases of its common stock during the nine
        month period ended September 30, 2008. As mentioned above, the Repurchase
        Plan
        expired in August 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 used the proceeds from the issuance of these securities
        for
        general corporate purposes, which included, but not limited: capital
        contributions to the Bank, investments, payment of dividends, and repurchases
        of
        our common stock.
 
 On
        April
        23, 2007, the Company redeemed all of the Floating Rate Junior Subordinated
        Debt
        Securities it held associated with Heritage Oaks Capital Trust I, a wholly
        owned
        subsidiary of Heritage Oaks Bancorp. The redemption price was 100% of the
        principal amount redeemed plus accrued and unpaid interest as of the redemption
        date. The Company paid $0.4 million for the standard interest payment due
        April
        22, 2007, plus a payment of $8.2 million for the principal amount to be redeemed
        on that date. These amounts were funded from the Company’s general corporate
        reserves. As a result of the redemption of the securities associated with
        Heritage Oaks Capital Trust I, the Trust was dissolved on June 1,
        2007.
  -
            46
            -
  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
        September 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.
 
 The
        following table provides a summary of the securities the Company has issued
        to
        Heritage Oaks Capital Trusts II and III as of September 30, 2008:
 **Amount**
                
                **Current**
                
                **Issue**
                
                **Scheduled**
                
                **Call***(dollars
                    in thousands)*
                
                **Issued**
                
                **Rate**
                
                **Date**
                
                **Maturity**
                
                **Date**
                
                **Rate
                    Type**Heritage
                    Oaks Capital Trust II
                
                $
                8,248
                
                
                4.51
                %
                
                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
                
                
                5.43
                %
 
 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
        September 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
        September 30, 2008, the Company had sufficient cash to service the $13.4
        million
        in junior subordinated debenture interest payments for approximately 2.3
        years
        without dividends from subsidiaries. The Bank’s capacity to provide cash to the
        Company, while remaining “well-capitalized”, was approximately $4.7 million at
        September 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.
  -
            47
            -
  The
        Leverage Ratio calculation simply divides common stockholders’ equity (reduced
        by any goodwill a bank may have) by the total assets. In the Tier One Risk
        Based
        Capital Ratio, the numerator is the same as the leverage ratio, but the
        denominator is the total “risk-weighted assets.” Risk weighted assets are
        determined by segregating all the assets and off balance sheet exposures
        into
        different risk categories and weighting them by a percentage ranging from
        0%
        (lowest risk) to 100% (highest risk). The Total Risk Based Capital Ratio
        again
        uses “risk-weighted assets” in the denominator, but expands the numerator to
        include other capital items besides equity such as a limited amount of the
        loan
        loss reserve, long-term capital debt, preferred stock and other instruments.
 
 The
        following table provides a Summary of the Company’s and the Bank’s regulatory
        capital ratios at September 30, 2008 and 2007:
 
 **Regulatory Standard**
              
              **September 30, 2008**
              
              **September 30, 2007****Adequately**
              
              **Well**
              
              **Heritage Oaks**
              
              **Heritage Oaks**
              
              **Heritage Oaks**
              
              **Heritage Oaks****Capitalized**
              
              **Capitalized**
              
              **Bancorp**
              
              **Bank**
              
              **Bancorp**
              
              **Bank**Leverage
                  Ratio
              
              
              4.00
              %
              
              5.00
              %
              
              9.01
              %
              
              8.78
              %
              
              10.69
              %
              
              9.80
              %Tier
                  I Risk Based Captial Ratio
              
              
              4.00
              %
              
              6.00
              %
              
              9.67
              %
              
              9.41
              %
              
              11.65
              %
              
              10.69
              %Total
                  Risk Based Captial Ratio
              
              
              8.00
              %
              
              10.00
              %
              
              10.92
              %
              
              10.66
              %
              
              12.58
              %
              
              11.62
              %
 
 *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, while sources such as
        the
        FHLB provide the Bank with the means to obtain additional liquidity in the
        absence of newly generated deposit relationships.
 
 The
        Bank
        has also established credit arrangements with correspondent banks that serve
        as
        a secondary liquidity source. As of September 30, 2008 the Bank had no balance
        drawn against these credit arrangements. As previously mentioned the Bank
        is
        also a member of the FHLB and as of September 30, 2008 had approximately
        $106.5
        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 September 30,
        2008:
 
 *(dollars
                  in thousands)*
              
              **September 30, 2008**Federal
                  Home Loan Bank remaining borrowing capacity
              
              $
              72,786Correspondent
                  bank credit arrangements - Bank
              
              
              40,000Revolving
                  line of credit - Holding Company
              
              
              3,500Brokered
                  funds availability
              
              
              58,565Total
                  available secondary liquidity source
              
              $
              174,851
 
 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 2008,
        the
        Bank called a total of approximately $12.5 million in higher cost brokered
        funds
        that were assumed in the acquisition of Business First. During the second
        quarter of 2008, the Bank purchased approximately $30.0 million in lower
        cost
        brokered funds, of which $10.0 million matured during the third quarter.
        The
        Bank purchased these funds in an effort to allow for increased borrowing
        availability at the FHLB. At September 30, 2008, the balance of brokered
        funds
        was $20.2 million.
 
 The
        Bank
        manages liquidity by maintaining an investment portfolio of federal funds
        sold
        and other liquid investments. At September 30, 2008, the Bank was within
        its
        internal guideline for liquidity and the ratio of liquid assets not pledged
        for
        collateral and other purposes to deposits and other liabilities was 5.75%
        compared to 9.59% at December 31, 2007. The ratio of net loans to deposits
        was
        111.1% at September 30, 2008 compared to 93.9% at December 31, 2007. Net
        of
        brokered deposits, the net loan to deposit ratio was 115.0% at September
        30,
        2008. The year to date decline in deposit balances of $55.6 million and $63.3
        million, net of brokered deposits during the first nine months of 2008 in
        addition to the $49.1 million increase in net loan balances from December
        31,
        2007 contributed to the increase in the loan to 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 95.6% at September 30, 2008 compared to 80.6% at
        December 31, 2007.
  -
            48
            -
  *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
        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 2008.
 
 *Off-Balance
        Sheet Arrangements*
 
 Off-balance
        sheet arrangements are any contractual arrangement to which an unconsolidated
        entity is a party, under which the Company has: (1) any obligation under
        a
        guarantee contract; (2) a retained or contingent interest in assets transferred
        to an unconsolidated entity or similar arrangement that serves as credit,
        liquidity or market risk support to that entity for such assets; (3) any
        obligation under certain derivative instruments; or (4) any obligation under
        a
        material variable interest held by the Company in an unconsolidated entity
        that
        provides financing, liquidity, market risk or credit risk support to the
        Company, or engages in leasing, hedging or research and development services
        with the Company.
 
 In
        the
        ordinary course of business, the Company has entered into off-balance sheet
        arrangements consisting of commitments to extend credit, commercial letters
        of
        credit, and standby letters of credit. Such financial instruments are recorded
        in the financial statements when they are funded or related fees are incurred
        or
        received. For a more detailed discussion of these financial instruments,
        refer
        to Note 10 of the Company’s Consolidated Financial Statements contained in Item
        8 of Part II of the Company’s December 31, 2007 Annual Report filed on Form
        10-K.
 
 In
        the
        ordinary course of business, the Bank is a party to various operating leases.
        For a more detailed discussion of these financial instruments, refer to Note
        10
        of the Company’s Consolidated Financial Statements contained in Item 8 of Part
        II of the Company’s December 31, 2007 Annual Report filed on Form
        10-K.
 
 In
        connection with the $13.4 million in debt securities discussed in “ *Capital* ,”
the
        Company issued the full and unconditional payment guarantee of certain accrued
        distributions.
 
 **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.
  -
            49
            -
  Management
        employs the use of an Asset and Liability Management software that is used
        to
        measure the Bank’s exposure to future changes in interest rates. This model
        measures the expected cash flows and re-pricing of each financial
        asset/liability separately in measuring the Bank’s interest rate sensitivity.
        Based on the results of this model, Management believes the Bank’s balance sheet
        is to a large extent “asset sensitive.” This means the Company expects (all
        other things being equal) to expand its net interest income if rates rise
        and
        expects it conversely to contract if rates fall.  The level of potential or
        expected contraction indicated by the tables below is considered acceptable
        by
        Management and is compliant with the Bank’s ALCO policies.  Management will
        continue to perform this analysis each quarter to further validate the expected
        results against actual data.
  The
        hypothetical impacts of sudden interest rate movements applied to the Company’s
        asset and liability balances are modeled monthly. The results of these models
        indicate how much of the Company’s net interest income is “at risk” from various
        rate changes over a one year horizon. This exercise is valuable in identifying
        risk exposures. Management believes the results for the Company’s September 30,
        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 September 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)
              
              $
              35,411
              
              $
              36,895
              
              $
              38,283
              
              $
              40,023
              
              $
              42,255$
                  Change from base
              
              $
              (2,872
              )
              $
              (1,388
              )
              $
              -
              
              $
              1,740
              
              $
              3,972%
                  Change from base
              
              
              -7.50
              %
              
              -3.63
              %
              
              0.00
              %
              
              4.54
              %
              
              10.38
              %
 
 It
        is
        important to note that the above table is a summary of several forecasts
        and
        actual results may vary. The forecasts are based on estimates and assumptions
        of
        Management that may turn out to be different and may change over time. Factors
        affecting these estimates and assumptions include, but are not limited to
        1)
        competitor behavior, 2) economic conditions both locally and nationally,
        3)
        actions taken by the Federal Reserve Board, 4) customer behavior and 5)
        Management’s responses. Changes that vary significantly from the assumptions and
        estimates may have significant effects on the Company’s net interest income;
        therefore, the results of this analysis should not be relied upon as indicative
        of actual future results.
 
 The
        following tables show Management’s estimates of how the loan portfolio is broken
        out between variable-daily, variable at various time lines, fixed rate loans
        and
        estimates of re-pricing opportunities for the entire loan portfolio at September
        30, 2008.
 
 *(dollars
                  in thousands)***Percent
                  of****Rate
                  Type**
              
              **Balance**
              
              **Total**Variable
                  - daily
              
              $
              289,210
              
              
              43.4
              %Variable
                  other than daily
              
              
              216,706
              
              
              32.5
              %Fixed
                  rate
              
              
              160,484
              
              
              24.1
              %Total
                  gross loans
              
              $
              666,400
              
              
              100.0
              %
 
 The
        table
        above identifies approximately 43.4% of the loan portfolio that will re-price
        immediately in a changing rate environment. At September 30, 2008, approximately
        $505.9 million or 75.9% of the Bank’s loan portfolio is considered
        variable.
 
 *(dollars in thousands)***Percent of****Re-Pricing**
              
              **Balance**
              
              **Total**< 1 Year
              
              $
              398,939
              
              
              59.9
              %1-3
                  Years
              
              
              148,932
              
              
              22.3
              %3-5
                  Years
              
              
              66,974
              
              
              10.1
              %>
                  5 Years
              
              
              51,555
              
              
              7.7
              %Total
                  gross loans
              
              $
              666,400
              
              
              100.0
              %
  -
            50
            -
  The
        following table provides a summary of the loans the Bank can expect to see
        come
        off their floors if the prime rate were to increase by the amounts identified
        below as of September 30, 2008:
 
 **Move in Prime Rate (bps)***(dollars in thousands)*
              
              **+100**
              
              **+150**
              
              **+200 or more**Variable
                  daily
              
              $
              5,896
              
              $
              27,051
              
              $
              127,093Variable
                  other than daily
              
              
              8,196
              
              
              24,257
              
              
              67,511Cumulative
                  total variable at floor
              
              $
              14,092
              
              $
              51,308
              
              $
              194,604
 
 **Item
        4. Controls and Procedures**
 
 *Evaluation
        of Disclosure Controls and Procedures*
 
 As
        of the
        end of the period covered by this report, the Company carried out an evaluation,
        under the supervision and with the participation of its management, including
        the Company’s Chief Executive Officer and Chief Financial Officer, of the
        effectiveness of the design and operation of the Company’s disclosure controls
        and procedures pursuant to Exchange Act Rules 13a-15 and 15d-15. Based upon
        that
        evaluation, the Chief Executive Officer and Chief Financial Officer concluded
        that the Company’s disclosure controls and procedures are effective to provide
        reasonable assurances that information required to be disclosed in the reports
        the Company files or submits under the Securities Exchange Act of 1934 is
        recorded, processed, summarized and reported within the time periods specified
        in the SEC’s rules and forms.
 
 *Changes
        in Internal Control Over Financial Reporting*
 
 There
        was
        no change in the Company’s internal controls over financial reporting during the
        quarter ended September 30, 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. Unregistered Sales of Equity Securities and Use of Proceeds**
 
 *Unregistered
        Sale of Equity Securities*
 
 None.
  -
            51
            -
  *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 were to be made,
        as conditions warrant, from time to time in the open market or through privately
        negotiated transactions. The duration of the program was for one year and
        the
        timing of purchases was to 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 2006 plan to 100,000. In July 2007,
        the Board of Directors authorized a one year extension of this plan, which
        expired in August 2008 and was not renewed by the Company’s Board of
        Directors.
 
 As
        of
        September 30, 2008, the Company repurchased and retired 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 nine months ended
        September 30, 2008. As mentioned, the Repurchase Plan expired in August
        2008.
 
 **Item
        3. Defaults upon Senior Securities**
 
 Not
        applicable.
 
 **Item
        4. Submission of Matters to a Vote of Security Holders**
 
 None.
 
 **Item
        5. Other Information**
 
 Not
        applicable.
  -
            52
            -
  **Item
        6. Exhibits**
 
 *(a)
        Exhibits:*
 
 Exhibit
                  (31.1)
              
              Certification
                  of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
                  Act of 2002Exhibit
                  (31.2)
              
              Certification
                  of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
                  Act of 2002Exhibit
                  (32.1)
              
              Certification
                  of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley
                  Act of 2002Exhibit
                  (32.2)
              
              Certification
                  of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley
                  Act of 2002
  -
            53
            -
  **Signatures**
 
 Pursuant
        to the requirements of the Securities Exchange Act of 1934, the registrant
        has
        duly caused this report to be signed on its behalf by the undersigned thereunto
        duly authorized.
 
 **Heritage
        Oaks Bancorp**
 
 DATE:
        November 3, 2008
 
 /s/
                  Lawrence P. Ward
 Lawrence
        P. Ward
 President
 Chief
        Executive Officer
 
 /s/
                  Margaret A. Torres
 Margaret
        A. Torres
 Executive
        Vice President
 Chief
        Financial Officer
 (Principal
        Financial and Accounting Officer)
  -
            54
            -