**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**


**FORM
      10-K**





x
      ANNUAL REPORT PURSUANT
      TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 for the Year
      ended December
      31, 2006




OR




o
      TRANSITION REPORT
      PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
      EXCHANGE ACT OF 1934 For the transition period from _________ to
      ________





Commission
      file number 0-25020





**Heritage
      Oaks Bancorp**


(Exact
      name of registrant as specified in its charter)





State
                of California
            
            77-0388249(State
                or other jurisdiction of
            
            (I.R.S.
                Identification No.)employee
                incorporation or organization)545
                12th Street, Paso Robles, California 93446
            
            (805)
                239-5200(Address
                of principal executive offices) (Zip Code)
            
            (Registrant’s
                telephonenumber,
                including area code)





Securities
                registered pursuant to Section 12(b) of the Act: NoneSecurities
                registered pursuant to Section 12(g) of the
                Act:




Title
                of each class
            
            Name
                of each exchange on which registeredCommon
                Stock, (no par value)
            
            NASDAQ
                Capital Market




Indicate
      by check mark if the registrant is a well-known, seasoned issuer as defined
      in
      Rule 405 of the Securities Act. Yes o No x





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Act. Yes o No x





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 12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days. Yes x No o





Indicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K is not contained herein, and will not be contained, to the best
      of the registrant's knowledge, in definitive proxy or information statements
      incorporated by reference in Part III of this Form 10-K or any amendment to
      this
      Form 10-K o.





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




Large
      Accelerated filer  o      
Accelerated filer  xNon-accelerated filer  o.





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


Yes
o
      No x





The
      aggregate market value of the voting and non-voting common equity held by
      non-affiliates of the Registrant at June 30, 2006 was $76.5 million. As of
      February 1, 2007, the Registrant had 6,377,997 shares of Common Stock
      outstanding.










**DOCUMENTS
      INCORPORATED BY REFERENCE**




The
      information required in Part III, Items 10 through 14 are incorporated by
      reference to the registrant’s definitive proxy statement for the 2007 annual
      meeting of shareholders.





**TABLE
      OF CONTENTS**





PART
                IItem
                1.
            
            Business.
            
            3Item
                1A.
            
            Risk
                Factors.
            
            13Item
                1B.
            
            Unresolved
                Staff Comments.
            
            17Item
                2.
            
            Properties.
            
            17Item
                3.
            
            Legal
                Proceedings.
            
            18Item
                4.
            
            Submission
                of Matters to a Vote of Security Holders.
            
            18PART
                IIItem
                5.
            
            Market
                for Registrant’s Common Equity, Related Stockholder Matters and Issuer
                Purchases of Equity Securities.
            
            18Item
                6.
            
            Selected
                Financial Data.
            
            22Item
                7.
            
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations.
            
            23Item
                7A.
            
            Quantitative
                and Qualitative Disclosures about Market Risk.
            
            45Item
                8.
            
            Financial
                Statements and Supplementary Data.
            
            48Item
                9.
            
            Changes
                in and Disagreements with Accountants on Accounting and Financial
                Disclosure.
            
            86Item
                9A.
            
            Controls
                and Procedures.
            
            86Item
                9B.
            
            Other
                Information.
            
            87PART
                III
            
            
            
            87Item
                10.
            
            Directors,
                Executive Officers and Corporate Governance.
            
            87Item
                11.
            
            Executive
                Compensation.
            
            87Item
                12.
            
            Security
                Ownership of Certain Beneficial Owners and Management and RelatedStockholder
                Matters.
            
            87Item
                13.
            
            Certain
                Relationships and Related Transactions, and Director
                Independence.
            
            87Item
                14.
            
            Principal
                Accounting Fees and Services.
            
            87PART
                IVItem
                15.
            
            Exhibits,
                Financial Statement Schedules.
            
            88Signatures
            
            
            
            92




-2-





**PART
      I**





**Certain
      statements contained in this Annual Report on Form 10-K (“Annual Report”),
      including, without limitation, statements containing the words “believes”,
“anticipates”, “intends”, “expects”, and words of similar impact, constitute
“forward-looking statements” within the meaning of Section 27A of the Securities
      Act of 1933 and Section 21E of the Securities and Exchange Act of 1934. Such
      forward-looking statements involve known and unknown risks, uncertainties and
      other factors that may cause the actual results, performance or achievements
      of
      the Company to be materially different from any future results, performance
      or
      achievements expressed or implied by such forward-looking statements. Such
      factors include, among others, the following: general economic and business
      conditions in those areas in which the Company operates, demographic changes,
      competition, fluctuations in interest rates, changes in business strategy or
      development plans, changes in governmental regulation, credit quality, the
      availability of capital to fund the expansion of the Company’s business,
      economic, political and global changes arising from the war on terrorism and
      other factors referenced in this report, including in “Item 1A. Risk Factors.”
The Company disclaims any obligation to update any such factors or to publicly
      announce the results of any revisions to any of the forward-looking statements
      contained herein to reflect future events or developments.**





**ITEM
      1. DESCRIPTION OF BUSINESS.**





**General**





Heritage
      Oaks Bancorp (the "Company", “we” or “our”) is a California corporation
      organized in 1994 to act as the holding company of Heritage Oaks Bank (the
      “Bank"). In 1994, the Company acquired all of the outstanding common stock of
      the Bank in a holding company formation transaction.





In
      April
      2002, the Company formed Heritage Oaks Capital Trust I (the “Trust I”). The
      Trust I is a statutory business trust formed under the laws of the State of
      Delaware. The Trust I is a wholly-owned, non-financial, non-consolidated
      subsidiary of the Company.





In
      October 2006, the Company formed Heritage Oaks Capital Trust II (the “Trust
      II”). The Trust II is a statutory business trust formed under the laws of the
      State of Delaware. The Trust II is a wholly-owned, non-financial,
      non-consolidated subsidiary of the Company.





Other
      than holding the shares of the Bank, the Company conducts no significant
      activities, although it is authorized, with the prior approval of the Board
      of
      Governors of the Federal Reserve System (the "Federal Reserve Board"), the
      Company's principal regulator, to engage in a variety of activities which are
      deemed closely related to the business of banking. The Company has also
      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, nor to engage in such other permitted
      activities.





**Banking
      Services**





The
      Bank
      was licensed by the California Department of Financial Institutions (“DFI”) and
      commenced operation in January 1983. As a California state bank, the Bank is
      subject to primary supervision, examination and regulation by the DFI and the
      Federal Deposit Insurance Corporation (“FDIC”). The Bank is also subject to
      certain other federal laws and regulations. The deposits of the Bank are insured
      by the FDIC up to the applicable limits thereof.





At
      December 31, 2006, the Company had approximately $542 million in consolidated
      assets, $439 million in net consolidated loans, $421 million in consolidated
      deposits, and $49 million in stockholders' equity.





The
      Bank
      is headquartered in Paso Robles, California with one branch office in Paso
      Robles, two branches in San Luis Obispo, one branch office in Cambria, one
      branch office in Arroyo Grande, three branch offices in Santa Maria, one branch
      office in Atascadero, one branch office in Morro Bay, and one branch office
      in
      Templeton. The Bank conducts a commercial banking business in San Luis Obispo
      County and Northern Santa Barbara County, including accepting demand, savings
      and time deposits, and making commercial, real estate, SBA, agricultural, credit
      card, and consumer loans. The Bank also offers installment note collection,
      issues cashier’s checks and money orders, sells travelers checks, and provides
      bank-by-mail, night depository, safe deposit boxes, and other customary banking
      services. The Bank does not offer trust services or international banking
      services and does not plan to do so in the near future.




-3-




The
      Bank’s operating policies since inception have emphasized small business,
      commercial and retail banking. Most of the Bank’s customers are retail
      customers, farmers and small to medium-sized businesses. The Bank takes real
      estate, listed and unlisted securities, savings and time deposits, automobiles,
      machinery and equipment as collateral for loans. The areas in which the Bank
      has
      directed virtually all of its lending activities are (i) commercial and
      agricultural loans, (ii) installment loans, (iii) construction loans, and (iv)
      other real estate loans or commercial loans secured by real estate. As of
      December 31, 2006, these four categories accounted for approximately 19.1%,
      1.3%, 23.8% and 55.8% respectively, of the Bank’s loan portfolio. As of December
      31, 2006, $353.9 million or 79.5% of the Bank’s $445 million in gross loans
      consisted of interim construction and other real estate secured loans, primarily
      for single family residences or for commercial development. Commercial and
      agricultural loans increased $24.9 million or 41.5% and other real estate loans
      or commercial loans secured by real estate increased $23.1 million or 10.3%
      between year-end 2005 and year-end 2006. See “Item 7. - Management’s Discussion
      and Analysis of Financial Condition and Results of Operations.”





Most
      of
      the Bank’s deposits are attracted by local promotional activities and
      advertising in the local media. A material portion of the Bank’s deposits have
      not been obtained from a single person or a few persons, the loss of any one
      or
      more of which would have a materially adverse effect on the business of the
      Bank. Management considers three account relationships with customers engaged
      in
      mortgage related businesses to be volatile deposit relationships. These deposit
      accounts, which are closely monitored by bank management, had combined balances
      of $44.1 million or 10.5% of total deposits at December 31, 2006 compared to
      $52.2 million or 12.5% of total deposits at December 31, 2005 . Management
      and the Board of Directors of the Bank are aware that changes in mortgage market
      conditions have impacted these relationships during 2006. As of December 31,
      2006, the Bank had approximately 23,891 deposit accounts consisting of
      non-interest bearing (“demand”), interest-bearing demand and money market
      accounts with balances totaling $275.7 million for an average balance per
      account of approximately $11.5 thousand; 9,608 savings accounts with balances
      totaling $23.4 million for an average balance per account of approximately
      $2.4
      thousand; and 3,127 time certificate of deposit accounts with balances totaling
      $121.4 million, for an average balance per account of approximately $38.8
      thousand.





The
      principal sources of the Company’s consolidated revenues are (i) interest and
      fees on loans, (ii) interest on investments, (iii) service charges on deposit
      accounts and other charges and fees, (iv) mortgage origination fees and (v)
      miscellaneous income. For the year ended December 31, 2006, these sources
      comprised 82.0%, 6.0%, 5.9%, 1.3% and 4.8%, respectively, of the Company’s total
      operating income.





The
      Company has not engaged in any material research activities relating to the
      development of new services or the improvement of existing bank services, except
      as otherwise discussed herein. There has been no significant change in the
      types
      of services offered by the Bank since its inception. The Company has no present
      plans regarding "a new line of business" requiring the investment of a material
      amount of total assets. Most of the Company’s business originates from San Luis
      Obispo and Northern Santa Barbara Counties and there is no emphasis on foreign
      sources and application of funds. The Company’s business, based upon performance
      to date, does not appear to be seasonal. Management of the Company is unaware
      of
      any material effect upon the Company’s capital expenditures, earnings or
      competitive position as a result of federal, state or local environmental
      regulations.





The
      Bank
      holds service marks issued by the U.S. Patent and Trademark Office for the
      “Acorn” design, the “Oakley” design and “Deeply Rooted in Your
      Hometown.”





**Employees**





As
      of
      December 31, 2006, the Bank had 212 full-time equivalent employees. The Company
      has only two salaried employees. The Bank believes that its employee relations
      are positive.





-4-




**Local
      Economic Climate**




The
      economy in the Company’s service area is based primarily on agriculture,
      tourism, light industry, oil and retail trade. Services supporting these
      industries have also developed in the areas of medical, financial and
      educational services. The population of San Luis Obispo County and the City
      of
      Santa Maria (in Northern Santa Barbara County) totaled approximately 260,000
      and
      92,000, respectively, according to economic data provided by local county and
      title company sources. The moderate climate allows a year round growing season
      for numerous vegetable 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. Although on average the climate in our markets is generally very mild,
      we
      did experience a significant freeze in early 2007. This did not have a
      significant impact on our business. Vineyards in production have grown
      significantly over the past several years throughout the Company’s service area.
      Access to numerous recreational activities, including lakes, mountains and
      beaches, provide a relatively stable tourist industry from many areas including
      the Los Angeles/Orange County basin, the San Francisco Bay area and the San
      Joaquin Valley. Principally due to the diversity of the various industries
      in
      the Company’s service area, the area, while not immune from economic
      fluctuations, does tend to enjoy a more stable level of economic activity than
      many other areas of California.





Throughout
      the primary market area of the Company, the softening housing market of 2006
      is
      expected to continue into 2007, though it is unknown just how long-lasting
      the
      slowdown might be. The number of homes sold in 2006 was 25% less than 2005,
      according to real estate research firm DataQuick.





Some
      economists predict housing prices will rise again next year based on the
      nontraditional nature of the market that includes buyers bringing in equity
      earned in other parts of the state. An economic forecast created for the county
      by University of California at Santa Barbara projects the median home price
      for
      2007 to be up 2% from that in 2006. The 2008 median price is expected to rise
      by
      5%.




**Competition**




Banking
      and the financial services business in California generally, and in the
      Company’s service area specifically, is highly competitive. The increasingly
      competitive environment is a result primarily of changes in regulation, changes
      in technology and product delivery systems, and the accelerating pace of
      consolidation among financial services providers and the appearance of new
      banking organizations. The flattening and inverted yield curve environment
      during the past two years further drove competition as borrowers have expanded
      choices of maturities within attractive ranges of offered interest rates
      resulting in various borrower strategies based upon interest rate expectations
      including choosing longer term fixed rate loans over variable Prime-based
      loans.





In
      order
      to compete with other financial institutions in its service area, the Bank
      relies principally upon local advertising programs; direct personal contact
      by
      officers, directors, employees, and shareholders; and specialized services
      such
      as courier pick-up and delivery of non-cash banking items. The Bank emphasizes
      to customers the advantages of dealing with a locally owned and community
      oriented institution. The Bank also seeks to provide special services and
      programs for individuals in its primary service area who are employed in the
      agricultural, professional and business fields, such as loans for equipment,
      furniture, tools of the trade or expansion of practices or businesses. Larger
      banks may have a competitive advantage because of higher lending limits and
      major advertising and marketing campaigns. They also perform services, such
      as
      trust services, international banking, discount brokerage and insurance services
      that the Bank is not authorized or prepared to offer currently. The Bank has
      made arrangements with correspondent banks and with others to provide such
      services for its customers. For borrowers requiring loans in excess of the
      Bank’s legal lending limits, the Bank has offered, and intends to offer in the
      future, such loans on a participating basis with correspondent banks and with
      other independent banks, retaining the portion of such loans which is within
      its
      lending limit. As of December 31, 2006, the Bank’s legal lending limits to a
      single borrower and such borrower's related parties was approximately $9.3
      million on an unsecured basis and approximately $15.5 million on a fully secured
      basis. These calculations are based on regulatory capital plus reserves of
      $62.1
      million for the Bank.





Commercial
      banks compete with savings and loan associations, credit unions, other financial
      institutions, securities brokerage firms, and other entities for funds. For
      instance, yields on corporate and government debt securities and other
      commercial paper affect the ability of commercial banks to attract and hold
      deposits. Commercial banks also compete for loans with savings and loan
      associations, credit unions, consumer finance companies, mortgage companies
      and
      other lending institutions.




-5-




The
      financial services industry is undergoing rapid technological changes involving
      frequent introductions of new technology-driven products and services that
      have
      further increased competition. There can also be no assurance that these
      technological improvements, if made, will increase the Company’s operational
      efficiency or that the Company will be able to effectively implement new
      technology-driven products and services or be successful in marketing these
      products and services to our customers.





**Effect
      of Government Policies and Recent Legislation**




Banking
      is a business that depends on rate differentials. In general, the difference
      between the interest rate paid by the Company on deposits and other borrowings
      and the interest rate received by the Company on loans extended to its customers
      and securities held in the portfolio comprise the major portion of the Company’s
      earnings. These rates are highly sensitive to many factors that are beyond
      the
      control of the Company. Accordingly, the earnings and growth of the Company
      are
      subject to the influence of domestic and foreign economic conditions, including
      inflation, recession and unemployment.





The
      commercial banking business is not only affected by general economic conditions
      but is also influenced by the monetary and fiscal policies of the federal
      government and the policies of regulatory agencies, particularly the Federal
      Reserve Board. The Federal Reserve Board implements national monetary policies
      (with objectives such as curbing inflation and combating recession) by its
      open-market operations in United States Government securities, by adjusting
      the
      required level of reserves for financial institutions subject to its reserve
      requirements and by varying the discount rates applicable to borrowings by
      depository institutions. The actions of the Federal Reserve Board in these
      areas
      influence the growth of bank loans, investments and deposits and also affect
      interest rates charged on loans and paid on deposits. The nature and impact
      on
      the Company of any future changes in monetary policies cannot be predicted.





From
      time
      to time, legislation is enacted which has the effect of increasing the cost
      of
      doing business, limiting or expanding permissible activities or affecting the
      competitive balance between banks and other financial institutions. Proposals
      to
      change the laws and regulations governing the operations and taxation of banks,
      bank holding companies and other financial institutions are frequently made
      in
      Congress, in the California legislature and before various bank regulatory
      and
      other professional agencies. See “Supervision and Regulation-Financial Services
      Modernization Legislation and Sarbanes - Oxley Act of 2002”.





**Supervision
      and Regulation**




General




The
      Company and the Bank are extensively regulated under both federal and state
      law.
      Set forth below is a summary description of certain laws that relate to the
      regulation of the Company and the Bank. The description does not purport to
      be
      complete and is qualified in its entirety by reference to the applicable laws
      and regulations.




The
      Company




The
      Company is a bank holding company within the meaning of the Bank Holding Company
      Act of 1956, as amended (the "Bank Holding Company Act"), and is registered
      as
      such with, and subject to the supervision of, the Federal Reserve Board. The
      Company is required to file with the Federal Reserve Board quarterly and annual
      reports and such additional information as the Federal Reserve Board may require
      pursuant to the Bank Holding Company Act. The Federal Reserve Board may conduct
      examinations of bank holding companies and their subsidiaries.





The
      Company is required to obtain the approval of the Federal Reserve Board before
      it may acquire all or substantially all of the assets of any bank, or ownership
      or control of the voting shares of any bank if, after giving effect to such
      acquisition of shares, the Company would own or control more than 5% of the
      voting shares of such bank. Prior approval of the Federal Reserve Board is
      also
      required for the merger or consolidation of the Company and another bank holding
      company.





The
      Company is prohibited by the Bank Holding Company Act, except in certain
      statutorily prescribed instances, from acquiring direct or indirect ownership
      or
      control of more than 5% of the outstanding voting shares of any company that
      is
      not a bank or bank holding company and from engaging, directly or indirectly,
      in
      activities other than those of banking, managing or controlling banks or
      furnishing services to its subsidiaries. However, the Company may, subject
      to
      the prior approval of the Federal Reserve Board, engage in any, or acquire
      shares of companies engaged in, activities that are deemed by the Federal
      Reserve Board to be so closely related to banking or managing or controlling
      banks as to be a proper incident thereto. See discussion under "Financial
      Modernization Act" below for additional information.




-6-




The
      Federal Reserve Board may require that the Company terminate an activity or
      terminate control of or liquidate or divest subsidiaries or affiliates when
      the
      Federal Reserve Board determines that the activity or the control or the
      subsidiary or affiliates constitutes a significant risk to the financial safety,
      soundness or stability of any of its banking subsidiaries. The Federal Reserve
      Board also has the authority to regulate provisions of certain bank holding
      company debt, including authority to impose interest ceilings and reserve
      requirements on such debt. Under certain circumstances, the Company must file
      written notice and obtain approval from the Federal Reserve Board prior to
      purchasing or redeeming its equity securities.





Under
      the
      Federal Reserve Board's regulations, a bank holding company is required to
      serve
      as a source of financial and managerial strength to its subsidiary banks and
      may
      not conduct its operations in an unsafe and unsound manner. In addition, it
      is
      the Federal Reserve Board's policy that in serving as a source of strength
      to
      its subsidiary banks, a bank holding company should stand ready to use available
      resources to provide adequate capital funds to its subsidiary banks during
      periods of financial stress or adversity and should maintain the financial
      flexibility and capital-raising capacity to obtain additional resources for
      assisting its subsidiary banks. A bank holding company's failure to meet its
      obligations to serve as a source of strength to its subsidiary banks will
      generally be considered by the Federal Reserve Board to be an unsafe and unsound
      banking practice or a violation of the Federal Reserve Board's regulations
      or
      both.





The
      Company and the Bank are prohibited from engaging in certain tie-in arrangements
      in connection with any extension of credit, sale or lease of property or
      furnishing of services. For example, with certain exceptions, neither the
      Company nor the Bank may condition an extension of credit to a customer on
      either (1) a requirement that the customer obtain additional services provided
      by us or (2) an agreement by the customer to refrain from obtaining other
      services from a competitor.





The
      Company is subject to the periodic reporting requirements of the Securities
      Exchange Act of 1934, as amended, and files reports and proxy statements
      pursuant to such Act with the Securities and Exchange Commission (the
“SEC”)





The
      Bank




The
      Bank
      is chartered under the laws of the State of California and its deposits are
      insured by the FDIC to the extent provided by law. The Bank is subject to the
      supervision of, and is regularly examined by, the DFI and the FDIC. For the
      Bank, such supervision and regulation includes comprehensive reviews of all
      major aspects of the Bank’s business and condition. Various requirements and
      restrictions under the laws of the United States and the State of California
      affect the operations of the Bank. Federal and California statutes relate to
      many aspects of the Bank’s operations, including reserves against deposits,
      interest rates payable on deposits, loans, investments, mergers and
      acquisitions, borrowings, dividends and locations of branch offices. Further,
      the Bank is required to maintain certain levels of capital.





If,
      as a
      result of an examination of a bank, the FDIC or the DFI should determine that
      the financial condition, capital resources, asset quality, earnings prospects,
      management, liquidity, or other aspects of a bank’s operations are
      unsatisfactory or that a bank or its respective management is violating or
      has
      violated any law or regulation, various remedies are available to these
      regulatory agencies. Such remedies include the power to enjoin "unsafe or
      unsound" practices, to require affirmative action to correct any conditions
      resulting from any violation or practice, to issue an administrative order
      that
      can be judicially enforced, to direct an increase in capital, to restrict
      growth, to assess civil monetary penalties, to remove officers and directors,
      and ultimately to terminate deposit insurance, which for a California chartered
      bank would result in a revocation of the bank’s charter.





Capital
      Standards




The
      Federal Reserve Board and the FDIC have adopted risk-based minimum capital
      guidelines intended to provide a measure of capital that reflects the degree
      of
      risk associated with a banking organization's operations for both transactions
      reported on the balance sheet as assets and transactions, such as letters of
      credit and recourse arrangements, which are recorded as off balance sheet items.
      Under these guidelines, nominal dollar amounts of assets and credit equivalent
      amounts of off balance sheet items are multiplied by one of several risk
      adjustment percentages, which range from 0% for assets with low credit risk,
      such as certain U.S. Treasury securities, to 100% for assets with relatively
      high credit risk, such as business loans.




-7-




A
      banking
      organization's risk-based capital ratios are obtained by dividing its qualifying
      capital by its total risk adjusted assets. The regulators measure risk-adjusted
      assets, which includes off balance sheet items, against both total qualifying
      capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and
      Tier 1 capital. Tier 1 capital consists primarily of common stock, retained
      earnings, non-cumulative perpetual preferred stock (cumulative perpetual
      preferred stock for bank holding companies) and minority interests in certain
      subsidiaries, less most intangible assets. Tier 2 capital may consist of a
      limited amount of the allowance for possible loan and lease losses, cumulative
      preferred stock, long term preferred stock, eligible term subordinated debt
      and
      certain other instruments with some characteristics of equity. The inclusion
      of
      elements of Tier 2 capital is subject to certain other requirements and
      limitations of the federal banking agencies. The federal banking agencies
      require a minimum ratio of qualifying total capital to risk-adjusted assets
      of
      8% and a minimum ratio of Tier 1 capital to risk-adjusted assets of 4%.





In
      addition to the risk-based guidelines, federal banking regulators require
      banking organizations to maintain a minimum amount of Tier 1 capital to total
      assets, referred to as the leverage ratio. For a banking organization rated
      in
      the highest of the five categories used by regulators to rate banking
      organizations, the minimum leverage ratio of Tier 1 capital to total assets
      is
      3%. For all banking organizations not rated in the highest category, the minimum
      leverage ratio must be at least 4%. In addition to these uniform risk-based
      capital guidelines and leverage ratios that apply across the industry, the
      regulators have the discretion to set individual minimum capital requirements
      for specific institutions at rates significantly above the minimum guidelines
      and ratios. Future changes in regulations or practices could further reduce
      the
      amount of capital recognized for purposes of capital adequacy. Such a change
      could affect the ability of the Company to grow and could restrict the amount
      of
      profits, if any, available for the payment of dividends.





The
      following table presents the amount of the capital ratios for the Company and
      the Bank and the minimum regulatory capital requirements as of December 31,
      2006:


Minimum
                    RegulatoryCapital
                  Requirements
              
              Heritage
                Oaks
                  Bancorp
              
              HeritageOaks
                  BankLeverage
                  Ratio
              
              
              4.00
              %
              
              11.00
              %
              
              9.89
              %Tier
                  I Risk Weighted
              
              
              4.00
              %
              
              11.51
              %
              
              10.37
              %Total
                  Risk Based
              
              
              8.00
              %
              
              12.36
              %
              
              11.21
              %




Under
      applicable regulatory guidelines, the Bank was considered "Well Capitalized"
      at
      December 31, 2006.





Under
      applicable regulatory guidelines, the Company’s trust preferred securities
      issued by our subsidiary capital trusts qualify as Tier 1 capital up to a
      maximum limit of 25% of Tier 1 capital. Any additional portion of the trust
      preferred securities would qualify as Tier II capital. As of December 31, 2006,
      the subsidiary trusts had $16 million in trust preferred securities outstanding,
      of which $14.35 million qualify as Tier 1 capital.





In
      addition, the DFI has authority to take possession of the business and
      properties of a bank in the event that the tangible shareholders' equity of
      a
      Bank is less than the greater of (i) 4% of the banks total assets or (ii)
      $1,000,000.




Prompt
      Corrective Action and Other Enforcement Mechanisms




Federal
      banking agencies possess broad powers to take corrective and other supervisory
      action to resolve the problems of insured depository institutions, including
      but
      not limited to those institutions that fall below one or more prescribed minimum
      capital ratios described above. An institution that, based upon its capital
      levels, is classified as well capitalized, adequately capitalized, or
      undercapitalized may be treated as though it were in the next lower capital
      category if the appropriate federal banking agency, after notice and opportunity
      for hearing, determines that an unsafe or unsound condition or an unsafe or
      unsound practice warrants such treatment. At each successive lower capital
      category, an insured depository institution is subject to more restrictions.
      The
      federal banking agencies, however, may not treat a significantly
      undercapitalized institution as critically undercapitalized unless its capital
      ratio actually warrants such treatment.




-8-




In
      addition to measures taken under the prompt corrective action provisions,
      commercial banking organizations may be subject to potential enforcement actions
      by the federal regulators for unsafe or unsound practices in conducting their
      businesses or for violations of any law, rule, regulation, or any condition
      imposed in writing by the agency or any written agreement with the agency.
      Enforcement actions may include:





·
            the
                imposition of a conservator or receiver or the issuance of a
                cease-and-desist order that can be judicially
                enforced;


·
            the
                termination of insurance of deposits (in the case of a depository
                institution);


·
            the
                imposition of civil money
                penalties;


·
            the
                issuance of directives to increase
                capital;


·
            the
                issuance of formal and informal
                agreements;


·
            the
                issuance of removal and prohibition orders against institution-affiliated
                parties; and,


·
            the
                enforcement of such actions through injunctions or restraining orders
                based upon a judicial determination that the agency would be harmed
                if
                such equitable relief was not
                granted.




Additionally,
      a holding company's inability to serve as a source of strength to its subsidiary
      banking organizations could serve as an additional basis for a regulatory action
      against the holding company.





Banks
      are
      also subject to certain Federal Reserve Board restrictions on extensions of
      credit to executive officers, directors, principal shareholders or any related
      interests of such persons (i.e., insiders). Extensions of credit (1) must be
      made on substantially the same terms and pursuant to the same credit
      underwriting procedures as those for comparable transactions with persons who
      are neither insiders nor employees, and (2) must not involve more than the
      normal risk of repayment or present other unfavorable features. Banks are also
      subject to certain lending limits and restrictions on overdrafts to insiders.
      A
      violation of these restrictions may result in regulatory sanctions on the bank
      or its insiders.





Safety
      and Soundness Standards





The
      Federal Deposit Insurance Corporation Improvement Act (“FDICIA”) imposes certain
      specific restrictions on transactions and requires federal banking regulators
      to
      adopt overall safety and soundness standards for depository institutions related
      to internal control, loan underwriting and documentation and asset growth.
      Among
      other things, FDICIA limits the interest rates paid on deposits by
      undercapitalized institutions, restricts the use of brokered deposits, limits
      the aggregate extensions of credit by a depository institution to an executive
      officer, director, principal shareholder or related interest, and reduces
      deposit insurance coverage for deposits offered by undercapitalized institutions
      for deposits by certain employee benefits accounts. The federal banking agencies
      may require an institution to submit to an acceptable compliance plan as well
      as
      have the flexibility to pursue other more appropriate or effective courses
      of
      action given the specific circumstances and severity of an institution's
      noncompliance with one or more standards.




Premiums
      for Deposit Insurance




The
      Bank’s deposits are currently insured to a maximum of $100,000 per depositor
      ($250,000 for certain retirement accounts) through the Deposit Insurance Fund
      (“DIF”) administered by the FDIC. The Bank is required to pay deposit insurance
      premiums, which are assessed semiannually and paid quarterly. In November 2006
      the FDIC adopted a new risk-based insurance assessment system effective January
      1, 2007 designed to tie what banks pay for deposit insurance more closely to
      the
      risks they pose. The FDIC also adopted a new base schedule of rates that the
      FDIC can adjust up or down, depending on the needs of the DIF, and set initial
      premiums for 2007 that range from 5 cents per $100 of domestic deposits for
      banks in the lowest risk category to 43 cents per $100 of domestic deposits
      for
      banks in the highest risk category. The new assessment system is not expected
      to
      result in a material impact on the Bank.





The
      FDIC
      is also empowered to make special assessments on insured depository institutions
      in amounts determined by the FDIC to be necessary to give it adequate assessment
      income to repay amounts borrowed from the U.S. Treasury and other sources or
      for
      any other purpose the FDIC deems necessary.





The
      FDIC
      is authorized to terminate a depository institution's deposit insurance upon
      a
      finding by the FDIC that the institution's financial condition is unsafe or
      unsound or that the institution has engaged in unsafe or unsound practices
      or
      has violated any applicable rule, regulation, order or condition enacted or
      imposed by the institution's regulatory agency.




-9-




Sarbanes-Oxley
      Act of 2002




On
      July
      30, 2002, the Sarbanes-Oxley Act of 2002 (“SOX”), was signed into law to address
      corporate and accounting fraud. SOX establishes a new accounting oversight
      board
      that will enforce auditing standards and restricts the scope of services that
      accounting firms may provide to their public company audit clients. Among other
      things, SOX also (i) requires chief executive officers and chief financial
      officers to certify to the accuracy of periodic reports filed with the SEC;
      (ii)
      imposes new disclosure requirements regarding internal controls,
      off-balance-sheet transactions, and pro forma (non-GAAP) disclosures; (iii)
      accelerates the time frame for reporting of insider transactions and periodic
      disclosures by public companies; and (iv) requires companies to disclose whether
      or not they have adopted a code of ethics for senior financial officers and
      whether the audit committee includes at least one “audit committee financial
      expert.”





Under
      SOX, the SEC is required to regularly and systematically review corporate
      filings, based on certain enumerated factors. To deter wrongdoing, SOX: (i)
      subjects bonuses issued to top executives to disgorgement if a restatement
      of a
      company’s financial statements was due to corporate misconduct; (ii) prohibits
      an officer or director from misleading or coercing an auditor; (iii) prohibits
      insider trades during pension fund “blackout periods”; (iv) imposes new criminal
      penalties for fraud and other wrongful acts; and (v) extends the period during
      which certain securities fraud lawsuits can be brought against a company or
      its
      officers.





As
      a
      public reporting company, the Company is subject to the requirements of SOX
      and
      related rules and regulations issued by the SEC and NASDAQ. It is anticipated
      that the Company will incur additional expense as a result of the Act, but
      we do
      not expect that such compliance will have a material impact on our
      business.





Financial
      Services Modernization Legislation




On
      November 12, 1999, the Gramm- Leach-Bliley Act of 1999 (the "Financial Services
      Modernization Act") was signed into law. The Financial Services Modernization
      Act is intended to modernize the banking industry by removing barriers to
      affiliation among banks, insurance companies, the securities industry and other
      financial service providers. It provides financial organizations with the
      flexibility of structuring such affiliations through a holding company structure
      or through a financial subsidiary of a bank, subject to certain limitations.
      The
      Financial Services Modernization Act establishes a new type of bank holding
      company, known as a financial holding company, which may engage in an expanded
      list of activities that are "financial in nature," which include securities
      and
      insurance brokerage, securities underwriting, insurance underwriting and
      merchant banking. The Company has not sought “financial holding company” status
      and has no present plans to do so.





The
      Financial Services Modernization Act also sets forth a system of functional
      regulation that makes the Federal Reserve Board the "umbrella supervisor" for
      holding companies, while providing for the supervision of the holding company's
      subsidiaries by other federal and state agencies.





In
      addition, the Bank is subject to other provisions of the Financial Services
      Modernization Act, including those relating to CRA, privacy and safe-guarding
      confidential customer information, regardless of whether the Company elects
      to
      become a financial holding company or to conduct activities through a financial
      subsidiary of the Bank. The Company does not, however, currently intend to
      file
      notice with the Federal Reserve Board to become a financial holding company
      or
      to engage in expanded financial activities through a financial subsidiary of
      the
      Bank.





The
      Company and the Bank do not believe that the Financial Services Modernization
      Act will have a material adverse effect on their operations in the near-term.
      However, to the extent that it permits banks, securities firms, and insurance
      companies to affiliate, the financial services industry may experience further
      consolidation. The Financial Services Modernization Act is intended to grant
      to
      community banks certain powers as a matter of right that larger institutions
      have accumulated on an ad hoc basis. Nevertheless, this act may have the result
      of increasing the amount of competition that the Company faces from larger
      institutions and other types of companies offering financial products, many
      of
      which may have substantially more financial resources than the Company.




USA
      Patriot Act of 2001




On
      October 26, 2001, President Bush signed the Uniting and Strengthening America
      by
      Providing Appropriate Tools Required to Intercept and Obstruct Terrorism, or
      the
      Patriot Act, of 2001. Among other things, the Patriot Act (i) prohibits banks
      from providing correspondent accounts directly to foreign shell banks; (ii)
      imposes due diligence requirements on banks opening or holding accounts for
      foreign financial institutions or wealthy foreign individuals (iii) requires
      financial institutions to establish an anti-money-laundering compliance program,
      and (iv) eliminates civil liability for persons who file suspicious activity
      reports. The Patriot Act also increases governmental powers to investigate
      terrorism, including expanded government access to account records and make
      rules to implement the Patriot Act. On March 9, 2006, the President signed
      the
      USA Patriot Improvement and Reauthorization Act, which extended and modified
      the
      original act. While we believe the Patriot Act, as amended and reauthorized,
      may, to some degree, affect our recordkeeping and reporting expenses, we do
      not
      believe that it will have a material adverse effect on our business and
      operations.




-10-




Transactions
      between Affiliates




Transactions
      between a bank and its "affiliates" are quantitatively and qualitatively
      restricted under the Federal Reserve Act. The Federal Reserve Board issued
      Regulation W on October 31, 2002, which comprehensively implements Sections
      23A and 23B of the Federal Reserve Act. Sections 23A and 23B and Regulation
      W
      restrict loans by a depository institution to its affiliates, asset purchases
      by
      a depository institution from its affiliates, and other transactions between
      a
      depository institution and its affiliates. Regulation W unifies in one public
      document the Federal Reserve Board’s interpretations of Section 23A and 23B.
      Regulation W had an effective date of April 1, 2003.




Community
      Reinvestment Act




The
      Bank
      is subject to certain fair lending requirements and reporting obligations
      involving home mortgage lending operations and Community Reinvestment Act
      ("CRA") activities. The CRA generally requires the federal banking agencies
      to
      evaluate the record of a financial institution in meeting the credit needs
      of
      their local communities, including low and moderate income neighborhoods. In
      addition to substantial penalties and corrective measures that may be required
      for a violation of certain fair lending laws, the federal banking agencies
      may
      take compliance with such laws and CRA into account when regulating and
      supervising other activities. When a bank holding company applies for approval
      to acquire a bank or other bank holding company, the Federal Reserve Board
      will
      review the assessment of each subsidiary bank of the applicant bank holding
      company, and such records may be the basis for denying the application. A bank's
      compliance with its CRA obligations is based on a performance-based evaluation
      system which bases CRA ratings on an institution's lending service and
      investment performance, resulting in a rating by the appropriate bank regulatory
      agency of "outstanding", "satisfactory", "needs to improve" or "substantial
      noncompliance.” At its last examination by the FDIC, the Bank received a CRA
      rating of "Satisfactory."





Privacy





Federal
      banking rules limit the ability of banks and other financial institutions to
      disclose non-public information about consumers to nonaffiliated third parties.
      Pursuant to these rules, financial institutions must provide:





·
            initial
                notices to customers about their privacy policies, describing the
                conditions under which they may disclose non-public information to
                nonaffiliated third parties and
                affiliates;





·
            annual
                notices of their privacy policies to current customers;
                and





·
            a
                reasonable method for customers to “opt out” of disclosures to
                nonaffiliated third parties.





These
      privacy provisions affect how consumer information is transmitted through
      diversified financial companies and conveyed to outside vendors. We have
      implemented our privacy policies in accordance with the law.





In
      recent
      years, a number of states have implemented their own versions of privacy laws.
      For example, in 2003, California adopted standards that are more restrictive
      than federal law, allowing bank customers the opportunity to bar financial
      companies from sharing information with their affiliates.





Predatory
      Lending





The
      term
      "predatory lending," much like the terms "safety and soundness" and "unfair
      and
      deceptive practices," is far-reaching and covers a potentially broad range
      of
      behavior. As such, it does not lend itself to a concise or a comprehensive
      definition. But typically predatory lending involves at least one, and perhaps
      all three, of the following elements:





·
            making
                unaffordable loans based on the assets of the borrower rather than
                on the
                borrower's ability to repay an obligation, or asset-based
                lending;




-11-




·
            inducing
                a borrower to refinance a loan repeatedly in order to charge high
                points
                and fees each time the loan is refinanced, or loan flipping;
                and





·
            engaging
                in fraud or deception to conceal the true nature of the loan obligation
                from an unsuspecting or unsophisticated
                borrower.





Federal
      Reserve Board regulations aimed at curbing such lending significantly widened
      the pool of high-cost home-secured loans covered by the Home Ownership and
      Equity Protection Act of 1994, a federal law that requires extra disclosures
      and
      consumer protections to borrowers. The following triggers coverage under the
      Home Ownership and Equity Protection Act of 1994:





·
            interest
                rates for first lien mortgage loans in excess of 8 percentage points
                above
                comparable Treasury securities,





·
            subordinate-lien
                loans of 10 percentage points above Treasury securities,
                and





·
            fees
                such as optional insurance and similar debt protection costs paid
                in
                connection with the credit transaction, when combined with points
                and fees
                if deemed excessive.





In
      addition, the regulation bars loan flipping by the same lender or loan servicer
      within a year. Lenders also will be presumed to have violated the law—which says
      loans shouldn't be made to people unable to repay them—unless they document that
      the borrower has the ability to repay. Lenders that violate the rules face
      cancellation of loans and penalties equal to the finance charges paid. The
      Company does not expect these rules and potential state action in this area
      to
      have a material impact on our financial condition or results of
      operations.





Bank
      Secrecy Act and Money Laundering Control Act





In
      1970,
      Congress passed the Currency and Foreign Transactions Reporting Act, otherwise
      known as the Bank Secrecy Act (the “BSA”), which established requirements for
      recordkeeping and reporting by banks and other financial institutions. The
      BSA
      was designed to help identify the source, volume and movement of currency and
      other monetary instruments into and out of the United States in order to help
      detect and prevent money laundering connected with drug trafficking, terrorism
      and other criminal activities. The primary tool used to implement BSA
      requirements is the filing of Suspicious Activity Reports. Today, the BSA
      requires that all banking institutions develop and provide for the continued
      administration of a program reasonably designed to assure and monitor compliance
      with certain recordkeeping and reporting requirements regarding both domestic
      and international currency transactions. These programs must, at a minimum,
      provide for a system of internal controls to assure ongoing compliance, provide
      for independent testing of such systems and compliance, designate individuals
      responsible for such compliance and provide appropriate personnel training.





**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), insider ownership reports 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 Annual Report on Form
      10-K.





The
      Company also posts its Committee Charters, Code of Ethics, Code of Conduct
      and
      Corporate Governance Guidelines on the Company website.




-12-




**ITEM
      1A.**  **RISK
      FACTORS**





***An
      investment in our common stock is subject to risks inherent to our business.
      The
      material risks and uncertainties that management believes may affect our
      business are described below. Before making an investment decision, you should
      carefully consider the risks and uncertainties described below together with
      all
      of the other information included or incorporated by reference in this Annual
      Report. The risks and uncertainties described below are not the only ones facing
      our business. Additional risks and uncertainties that management is not aware
      of
      or focused on or that management currently deems immaterial may also impair
      our
      business operations. This Annual Report is qualified in its entirety by these
      risk factors.***





***If
      any of the following risks actually occur, our financial condition and results
      of operations could be materially and adversely affected. If this were to
      happen, the value of our common stock could decline significantly, and you
      could
      lose all or part of your investment.***





**Risks
      Associated with our Business.**




**We
      are highly dependent on real estate and a downturn in the real estate market
      could hurt our business.**





A
      significant portion of our loan portfolio is dependent on real estate. At
      December 31, 2006, real estate served as the principal source of collateral
      with
      respect to approximately 79.5% of our loan portfolio. A decline in current
      economic conditions, a decline in the local housing market, such as the one
      we
      are experiencing currently, or rising interest rates could have an adverse
      effect on the demand for new loans, the ability of borrowers to repay
      outstanding loans, the value of real estate and other collateral securing loans
      and the value of real estate owned by us, as well as our financial condition
      and
      results of operations in general and the market value of our common stock.




Acts
      of
      nature, including earthquakes, floods and fires, which may cause uninsured
      damage and other loss of value to real estate that secures these loans, may
      also
      negatively impact our financial condition.





**We
      also have a concentration in higher risk commercial real estate
      loans.**





We
      also
      have a high concentration in commercial real estate or CRE loans. CRE loans
      as
      defined by final guidance issued by Bank regulators is defined as construction,
      land development, ****** other
      land loans, loans secured by multifamily (5 or more) residential properties,
      and
      loans secured by non-farm nonresidential properties. Following this definition,
      approximately 71.8% of our lending portfolio can be classified as CRE lending.
      CRE loans generally involve a higher degree of credit risk than residential
      mortgage lending due, among other things, to the large amounts loaned to
      individual borrowers. Losses incurred on loans to a small number of borrowers
      could have a material adverse impact on our income and financial condition.
      In
      addition, unlike residential mortgage loans, commercial real estate loans
      generally depend on the cash flow from the property to service the debt. Cash
      flow may be significantly affected by general economic conditions.




In
      addition, federal banking regulators recently issued final guidance regarding
      commercial real estate lending. This guidance suggests that institutions that
      are potentially exposed to significant commercial real estate concentration
      risk
      will be subject to increased regulatory scrutiny. Institutions that have
      experienced rapid growth in commercial real estate lending, have notable
      exposure to a specific type of commercial real estate lending, or are
      approaching or exceed certain supervisory criteria that measure an institution’s
      commercial real estate portfolio against its capital levels, may be subject
      to
      such increased regulatory scrutiny. Our commercial real estate portfolio may
      be
      viewed as falling within one or more of the foregoing categories, and
      accordingly we may become subject to increased regulatory scrutiny because
      of
      our commercial real estate portfolio. If it is determined by our regulator
      that
      we have an undue concentration in commercial real estate lending, we may be
      required to maintain increased levels of capital and/or be required to reduce
      our concentration in commercial real estate loans.




**Our
      real estate lending also exposes us to the risk of environmental
      liabilities.**





In
      the
      course of our business, we may foreclose and take title to real estate, and
      could be subject to environmental liabilities with respect to these properties.
      We may be held liable to a governmental entity or to third persons for property
      damage, personal injury, investigation and clean-up costs incurred by these
      parties in connection with environmental contamination, or may be required
      to
      investigate or clean up hazardous or toxic substances, or chemical releases
      at a
      property. The costs associated with investigation or remediation activities
      could be substantial. In addition, as the owner or former owner of a
      contaminated site, we may be subject to common law claims by third parties
      based
      on damages and costs resulting from environmental contamination emanating from
      the property. If we ever become subject to significant environmental
      liabilities, our business, financial condition, liquidity and results of
      operations could be materially and adversely affected.




-13-




**Our
      business is subject to interest rate risk and changes in interest rates may
      adversely affect our performance and financial condition.**





Our
      earnings are impacted by changing interest rates. Changes in interest rates
      impact the demand for new loans, the credit profile of our borrowers, the rates
      received on loans and securities and rates paid on deposits and borrowings.
      The
      difference between the rates received on loans and securities and the rates
      paid
      on deposits and borrowings is known as interest rate spread. Given our current
      volume and mix of interest-bearing liabilities and interest-earning assets,
      we
      would expect our interest rate spread to increase if interest rates rise and,
      conversely, to decline if interest rates fall. Increasing levels of competition
      in the banking and financial services business may decrease our net interest
      margin by forcing us to offer lower lending interest rates and pay higher
      deposit interest rates. Although we believe our current level of interest rate
      sensitivity is reasonable, significant fluctuations in interest rates and
      increasing competition may have an adverse effect on our business, financial
      condition and results of operations.




A
      sustained decrease in market interest rates could adversely affect our earnings.
      When interest rates decline, borrowers tend to refinance higher-rate, fixed-rate
      loans at lower rates, prepaying their existing loans. Under those circumstances,
      we would not be able to reinvest those prepayments in assets earning interest
      rates as high as the rates on the prepaid loans. In addition, our commercial
      real estate and commercial loans, which carry interest rates that, in general,
      adjust in accordance with changes in the prime rate, will adjust to lower rates.
      We are also significantly affected by the level of loan demand available in
      our
      market. The inability to make sufficient loans directly affects the interest
      income we earn. Lower loan demand will generally result in lower interest income
      realized as we place funds in lower yielding investments.




**Failure
      to successfully execute our strategy could adversely affect our
      performance.**





Our
      financial performance and profitability depends on our ability to execute our
      corporate growth strategy. Continued growth, however, may present operating
      and
      other problems that could adversely affect our business, financial condition
      and
      results of operations. Accordingly, there can be no assurance that we will
      be
      able to execute our growth strategy or maintain the level of profitability that
      we have recently experienced. Factors that may adversely affect our ability
      to
      attain our long-term financial performance goals include those stated elsewhere
      in this section, as well as:




·
            Inability
                to control non-interest expense, including, but not limited to, rising
                employee, regulatory compliance, and healthcare
                costs;




·
            Inability
                to increase non-interest income;
                and




·
            Continuing
                ability to expand, through de novo branching or finding acquisition
                targets at valuation levels we find
                attractive.




**Economic
      conditions in the Central Coast of California area could adversely affect our
      operations and/or cause us to sustain losses.**





Our
      retail and commercial banking operations are concentrated primarily in San
      Luis
      Obispo and Santa Barbara Counties. As a result of this geographic concentration,
      our results of operations depend largely upon economic conditions in this area.
      A significant source of risk arises from the possibility that losses will be
      sustained if a significant number of our borrowers, guarantors and related
      parties fail to perform in accordance with the terms of their loans. This risk
      increases when the economy is weak. We have adopted underwriting and credit
      monitoring procedures and credit policies, including the establishment and
      review of the allowance for credit losses, that management believes is
      appropriate to minimize this risk by assessing the likelihood of nonperformance,
      tracking loan performance and diversifying our credit portfolio. These policies
      and procedures, however, may not prevent unexpected losses that could materially
      adversely affect our results of operations in general and the market value
      of
      our stock.




-14-




Our
      primary market area is an increasingly competitive and overcrowded
      banking **** market. 
      Our ability to achieve the growth outlined in our corporate strategic
      goals may be dependent in part on an ability to grow through the successful
      addition of new branches or the identification and acquisition of potential
      targets at acceptable pricing levels either inside or outside of our primary
      market.  If we are unable to attract significant new business through
      strategic branching, or acquire new business through our acquisition of other
      banks, our growth in loans and deposits and, therefore, our earnings, may
      be adversely affected.




**We
      face strong competition from financial service companies and other companies
      that offer banking services that could hurt our business.**





The
      financial services business in our market areas is highly competitive. It is
      becoming increasingly competitive due to changes in regulation, technological
      advances, and the accelerating pace of consolidation among financial services
      providers. We face competition both in attracting quality assets and deposits
      and in making loans. We compete for loans principally through the interest
      rates
      and loan fees we charge and the efficiency and quality of services we provide.
      Increasing levels of competition in the banking and financial services business
      may reduce our market share, decrease loan demand, cause the prices we charge
      for our services to fall, or decrease our net interest margin by forcing us
      to
      offer lower lending interest rates and pay higher deposit interest rates.
      Therefore, our results may differ in future periods depending upon the nature
      or
      level of competition.




Technology
      and other changes are allowing parties to complete financial transactions that
      historically have involved banks through alternative methods. For example,
      consumers can now maintain funds that would have historically been held as
      bank
      deposits in brokerage accounts or mutual funds. Consumers can also complete
      transactions such as paying bills and/or transferring funds directly without
      the
      assistance of banks. The process of eliminating banks as intermediaries, known
      as “disintermediation,” could result in the loss of fee income, as well as the
      loss of customer deposits and the related income generated from those deposits.
      The loss of these revenue streams and the lower cost deposits as a source of
      funds could have a material adverse effect on our financial condition and
      results of operations.





**We
      may not be able to attract and retain skilled people** .




Our
      success depends, in large part, on our ability to attract and retain key people.
      Competition for the best people in most of our activities can be intense and
      we
      may not be able to hire people or to retain them. The unexpected loss of
      services of one or more of our key personnel could have a material adverse
      impact on our business because of their skills, knowledge of our market, years
      of industry experience and the difficulty of promptly finding qualified
      replacement personnel.





**Our
      internal operations are subject to a number of risks.**





We
      are
      subject to certain operations risks, including, but not limited to, data
      processing system failures and errors, customer or employee fraud and
      catastrophic failures resulting from terrorist acts or natural disasters. We
      maintain a system of internal controls to mitigate against such occurrences
      and
      maintain insurance coverage for such risks that are insurable, but should such
      an event occur that is not prevented or detected by our internal controls,
      uninsured or in excess of applicable insurance limits, it could have a
      significant adverse impact on our business, financial condition or results
      of
      operations.




*Information
      Systems* .
      We rely
      heavily on communications and information systems to conduct our business.
      Any
      failure, interruption or breach in security of these systems could result in
      failures or disruptions in our customer relationship management, general ledger,
      deposit, loan and other systems. While we have policies and procedures designed
      to prevent or limit the effect of the failure, interruption or security breach
      of our information systems, there can be no assurance that any such failures,
      interruptions or security breaches will not occur or, if they do occur, that
      they will be adequately addressed. The occurrence of any failures, interruptions
      or security breaches of our information systems could damage our reputation,
      result in a loss of customer business, subject us to additional regulatory
      scrutiny, or expose us to civil litigation and possible financial liability,
      any
      of which could have a material adverse effect on our financial condition and
      results of operations.





*Technological
      Advances* .
      The
      financial services industry is continually undergoing rapid technological change
      with frequent introductions of new technology-driven products and services.
      The
      effective use of technology increases efficiency and enables financial
      institutions to better serve customers and to reduce costs. Our future success
      depends, in part, upon our ability to address the needs of our customers by
      using technology to provide products and services that will satisfy customer
      demands, as well as to create additional efficiencies in our operations. Many
      of
      our competitors have substantially greater resources to invest in technological
      improvements. We may not be able to effectively implement new technology-driven
      products and services or be successful in marketing these products and services
      to our customers. Failure to successfully keep pace with technological change
      affecting the financial services industry could have a material adverse impact
      on our business and, in turn, our financial condition and results of operations.




-15-





*Severe
      Weather, Natural Disasters, Acts of War or Terrorism and Other External
      Events* .
      Severe
      weather, natural disasters, acts of war or terrorism and other adverse external
      events could have a significant impact on our ability to conduct business.
      Such
      events could affect the stability of our deposit base, impair the ability of
      borrowers to repay outstanding loans, impair the value of collateral securing
      loans, cause significant property damage, result in loss of revenue and/or
      cause
      us to incur additional expenses. For example, the Central Coast of California
      is
      subject to earthquakes and fires. Operations in our market could be disrupted
      by
      both the evacuation of large portions of the population as well as damage and
      or
      lack of access to our banking and operation facilities. While we have not
      experienced such an occurrence to date, other severe weather or natural
      disasters, acts of war or terrorism or other adverse external events may occur
      in the future. Although management has established disaster recovery policies
      and procedures, the occurrence of any such event could have a material adverse
      effect on our business, which, in turn, could have a material adverse effect
      on
      our financial condition and results of operations.




**We
      depend on cash dividends from our subsidiary bank to meet our cash
      obligations.**





As
      a
      holding company, dividends from our subsidiary bank provide a substantial
      portion of our cash flow used to service the interest payments on our trust
      preferred securities and our other obligations, including cash dividends. See
      “Item 5 - Market for Common Equity and Related Stockholder Matters.” Various
      statutory provisions restrict the amount of dividends our subsidiary bank can
      pay to us without regulatory approval.





**Risks
      Associated with our Industry.**





**We
      are subject to government regulation that could limit or restrict our
      activities, which in turn could adversely impact our
      operations.**





The
      financial services industry is regulated extensively. Federal and State
      regulation is designed primarily to protect the deposit insurance funds and
      consumers, and not to benefit our shareholders. These regulations can sometimes
      impose significant limitations on our operations.





New
      laws
      and regulations or changes in existing laws and regulations or repeal of
      existing laws and regulations may adversely impact our business. For example,
      operating expenses of approximately $161 thousand were attributable to
      compliance with the Sarbanes-Oxley Act provisions in the year ended December
      31,
      2006. We anticipate that continued compliance with, among other regulatory
      provisions, The Sarbanes-Oxley Act will impact future operating
      expenses.





Further,
      federal monetary policy, particularly as implemented through the Federal Reserve
      System, significantly affects economic conditions for us.





**New
      legislative and regulatory proposals may affect our operations and growth.**





Proposals
      to change the laws and regulations governing the operations and taxation of,
      and
      federal insurance premiums paid by, banks and other financial institutions
      and
      companies that control such institutions are frequently raised in the
      U.S. Congress, state legislatures and before bank regulatory authorities.
      The likelihood of any major changes in the future and the impact such changes
      might have on us or our subsidiaries are impossible to determine. Similarly,
      proposals to change the accounting treatment applicable to banks and other
      depository institutions are frequently raised by the SEC, the federal banking
      agencies, the IRS and other appropriate authorities. The likelihood and impact
      of any additional future changes in law or regulation and the impact such
      changes might have on us or our subsidiaries are impossible to determine at
      this
      time.





-16-




**Risks
      Associated with our Stock.**





**Our
      Stock Trades Less Frequently Than Others.**





Although
      our common stock is listed for trading on the NASDAQ Capital Market, the trading
      volume in our common stock is less than that of other larger financial services
      companies. A public trading market having the desired characteristics of depth,
      liquidity and orderliness depends on the presence in the marketplace of willing
      buyers and sellers of our common stock at any given time. This presence depends
      on the individual decisions of investors and general economic and market
      conditions over which we have no control. Given the lower trading volume of
      our
      common stock, significant sales of our common stock, or the expectation of
      these
      sales, could cause our stock price to fall.





**Our
      Stock Price Is Affected by a Variety of Factors.** **





Stock
      price volatility may make it more difficult for you to resell your common stock
      when you want and at prices you find attractive. Our stock price can fluctuate
      significantly in response to a variety of factors discussed in this section,
      including, among other things:




·
            Actual
                or anticipated variations in quarterly results of operations.  ·
            Recommendations
                by securities analysts.


·
            Operating
                and stock price performance of other companies that investors deem
                comparable to our company.




·
            News
                reports relating to trends, concerns and other issues in the financial
                services industry.





·
            Perceptions
                in the marketplace regarding our company and/or its
                competitors.




**Our
      Common Stock Is Not An Insured Deposit** . **





Our
      common stock is not a bank deposit and, therefore, is not insured against loss
      by the FDIC, any other deposit insurance fund or by any other public or private
      entity. Investment in our common stock is inherently risky for the reasons
      described in this “Risk Factors” section and elsewhere in this report and is
      subject to the same market forces that affect the price of common stock in
      any
      company. As a result, if you acquire our common stock, you may lose some or
      all
      of your investment.





**Our
      Articles Of Incorporation and By-Laws, As Well As Certain Banking Laws, May
      Have An Anti-Takeover Effect.**





Provisions
      of our articles of incorporation, bylaws and federal banking laws, including
      regulatory approval requirements, could make it more difficult for a third
      party
      to acquire us, even if doing so would be perceived to be beneficial to our
      shareholders. The combination of these provisions may hinder a non-negotiated
      merger or other business combination, which, in turn, could adversely affect
      the
      market price of our common stock.





**ITEM
      1B. UNRESOLVED STAFF COMMENTS.**




None





**ITEM
      2.**  **DESCRIPTION
      OF PROPERTIES.**





The
      company’s headquarters is located at 545 12 th Street
      in Paso Robles, California. It is an office owned and occupied solely by the
      bank. Additionally, the company owns and occupies a three story administrative
      facility from where all administrative functions are based. This facility is
      located at 1222 Vine Street in Paso Robles, California. The company also
      occupies 11 branches within the counties of San Luis Obispo and Santa Barbara.
      The bank currently owns 5 of the 12 branches that it occupies and leases the
      remaining 7 branches from various unaffiliated parties for an approximate
      aggregate amount of $67,704 per month. Additionally, the company subleases
      part
      or all of 3 branches to unaffiliated parties. The income associated with these
      subleases is approximately $16,450 per month.





The
      Company believes its facilities are adequate for its present needs. The Company
      believes that the insurance coverage on all properties is adequate. Most of
      the leases contain multiple renewal options and provisions for rental increases,
      principally for changes in the cost of living index, property taxes and
      maintenance.





-17-





**ITEM
      3.**  **LEGAL
      PROCEEDINGS.**





The
      Bank
      is, from time to time, subject to various pending and threatened legal actions
      which arise out of the normal course of its business. Neither the Company nor
      the Bank is a party to any pending material legal or administrative proceedings
      (other than ordinary routine litigation incidental to the Company's or the
      Bank’s business).





**ITEM
      4.**  **SUBMISSION
      OF MATTERS TO A VOTE OF SECURITY HOLDERS.**





None.




**PART
      II**





**ITEM
      5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
      PURCHASES OF EQUITY SECURITIES.**





**Market
      Information**




The
      Company’s Common Stock trades on the NASDAQ Capital Market under the symbol
“HEOP.”




The
      following table summarizes those trades of the Company’s Common Stock on NASDAQ,
      setting forth the approximate high and low closing sales prices for each
      quarterly period ended since January 1, 2005.




Closing
                PricesQuarter
              Ended 2006
            
            High
            
            LowDecember
                31,
            
            $
            19.06
            
            $
            16.36September
                30,
            
            
            17.00
            
            
            15.87June
                30,
            
            
            19.53
            
            
            16.50March
                31,
            
            
            22.90
            
            
            18.32




Closing
                PricesQuarter
              Ended 2005
            
            High
            
            LowDecember
                31,
            
            $
            21.40
            
            $
            16.67September
                30,
            
            
            17.00
            
            
            14.33June
                30,
            
            
            15.00
            
            
            13.08March
                31,
            
            
            15.23
            
            
            12.79





Prices
      listed above have been adjusted to reflect all stock dividend and split
      activity.





**Holders**





As
      of
      February 1, 2006, there were approximately 1,815 holders of the Company's Common
      Stock. There are no other classes of equity securities
      outstanding.





**Dividends**





The
      Company is a legal entity separate and distinct from the Bank. The Company's
      shareholders are entitled to receive dividends when and as declared by its
      Board
      of Directors, out of funds legally available therefore, subject to the
      restrictions set forth in the California General Corporation Law (the
      "Corporation Law"). The Corporation Law provides that a corporation may make
      a
      distribution to its shareholders if the corporation's retained earnings equal
      at
      least the amount of the proposed distribution. The Corporation Law also provides
      that, in the event that sufficient retained earnings are not available for
      the
      proposed distribution, a corporation may nevertheless make a distribution to
      its
      shareholders if it meets two conditions, which generally stated are as follows:
      (i) the corporation's assets equal at least 1-1/4 times its liabilities, and
      (ii) the corporation's current assets equal at least its current liabilities
      or,
      if the average of the corporation's earnings before taxes on income and before
      interest expenses for the two preceding fiscal years was less than the average
      of the corporation's interest expenses for such fiscal years, then the
      corporation's current assets must equal at least 1-1/4 times its current
      liabilities. Refer to “Item 7. Management’s Discussion and Analysis of Financial
      condition and Results of Operations” on junior subordinated debenture
      limitations on dividends.




-18-




The
      ability of the Company to pay a cash dividend and to service the debt on its
      junior subordinated debenture depends largely on the Bank’s ability to pay a
      cash dividend to the Company. The payment of cash dividends by the Bank is
      subject to restrictions set forth in the California Financial Code (the
      "Financial Code"). The Financial Code provides that a bank may not make a cash
      distribution to its shareholders in excess of the lesser of (a) bank’s retained
      earnings; or (b) bank’s net income for its last three fiscal years, less the
      amount of any distributions made by the bank or by any majority-owned subsidiary
      of the bank to the shareholders of the bank during such period. However, a
      bank
      may, with the approval of the DFI, make a distribution to its shareholders
      in an
      amount not exceeding the greatest of (x) its retained earnings; (y) its net
      income for its last fiscal year; or (z) its net income for its current fiscal
      year. In the event that the DFI determines that the shareholders' equity of
      a
      bank is inadequate or that the making of a distribution by the bank would be
      unsafe or unsound, the DFI may order the bank to refrain from making a proposed
      distribution. The FDIC may also restrict the payment of dividends if such
      payment would be deemed unsafe or unsound or if after the payment of such
      dividends, the bank would be included in one of the "undercapitalized"
      categories for capital adequacy purposes pursuant to federal law. (See, "Item
      1
      - Description of Business - Prompt Corrective Action and Other Enforcement
      Mechanisms.") Additionally, while the Federal Reserve Board has no general
      restriction with respect to the payment of cash dividends by an adequately
      capitalized bank to its parent holding company, the Federal Reserve Board might,
      under certain circumstances, place restrictions on the ability of a particular
      bank to pay dividends based upon peer group averages and the performance and
      maturity of the particular bank, or object to management fees to be paid by
      a
      subsidiary bank to its holding company on the basis that such fees cannot be
      supported by the value of the services rendered or are not the result of an
      arm's length transaction.





Under
      these provisions, the amount available for distribution from the Bank to the
      Company was approximately $15.2 million at December 31, 2006.





The
      following table outlines stock dividend and stock split activity since
      2000:


Stock
                  Dividend Percentage
              
              Record
                  Date5%
              
              April
                  3, 20005%
              
              March
                  16, 20015%
              
              March
                  8, 20022
                  for 1 Split
              
              August
                  2, 20025%
              
              March
                  14, 20035%
              
              April
                  9, 20045%
              
              April
                  8, 20053
                  for 2 Split
              
              November,
                  10 2005





**Cash
      Dividends**





On
      April
      21, 2006, the Board of Directors of Heritage Oaks Bancorp, declared a special
      $0.25 cents per-share dividend for all shareholders of record on May 8, 2006,
      payable on May 19, 2006.





On
      July
      21, 2006, the Board of Directors of Heritage Oaks Bancorp, declared the
      company’s first quarterly cash dividend of $0.08 cents per-share for all
      shareholders of record on August 11, 2006, payable on August 25,
      2006.





On
      October 20, 2006, the Board of Directors of Heritage Oaks Bancorp, the Board
      declared an $0.08 per-share quarterly cash dividend for all shareholders of
      record on November 3, 2006, payable on November 17, 2006.





Whether
      or not dividends will be paid in the future will be determined by the Board
      of
      Directors after consideration of various factors. The Company’s profitability
      and regulatory capital ratios in addition to other financial conditions will
      be
      key factors considered by the Board of Directors in making such determinations
      regarding the payment of dividends by the Company.




-19-




**Securities
      Authorized for Issuance Under Equity Compensation Plans**





In
      May
      2005, stockholders approved the Company’s 2005 Equity Based Compensation Plan
      (the “2005 Plan”). The principal purpose of the 2005 Plan is to promote the
      success of the Company by providing an additional means to attract, motivate,
      retain and reward key employees and directors of the Company and its
      subsidiaries with stock options and other equity based incentives for high
      levels of individual performance and improved financial performance of the
      Company. The 2005 Plan provides no further grants may be made from the 1997
      Stock Option Plan.




The
      2005
      Plan authorizes the granting of: Incentive Stock Options; Non-Qualified Stock
      Options; Stock Appreciation Rights; Restricted Stock Awards; Restricted Stock
      Units; and Performance Share Cash Only Awards. Vesting restrictions on awards
      may be time based and/or performance based; Participation in the 2005 Plan
      is
      limited to officers at the level of Vice President or above and other officers
      who provide substantial services to the Company as well as the Company’s
      directors.




The
      following table summarizes information as of December 31, 2006 relating to
      equity compensation plans of the Company pursuant to which grants of options,
      restricted stock or other rights to acquire shares may be granted from time
      to
      time:





Plan
                Category
            
            Plan
                Year
            
            Number
                of securities to be issued upon exercise of outstanding options,
                warrants
                of rights
            
            Weighted
                average exercise price of outstanding options, warrants of rights
            
            Number
                of securities remaining available for future issuanceEquity
                compensation
              plans
                approved by
              security
                holders
            
            
            1990
              1997
              2005
            
            
            3,136
              433,434
              66,050
            2
            $
              $
              $
            2.55
              5.45
              0.00
            
            
            -0-
              -0-
              568,513
            1Equity
                compensation
              plans
                not approved by
              security
                holders
            
            
            
            
            
            N/A
            
            
            N/A
            
            
            N/ATotal
            
            
            
            
            
            502,620
            
            $
            5.42
            
            
            568,513




1 No
      further grants may be made from the 1997 Stock Option Plan.




2 The
      awards reflected in the table from the 2005 Plan were in the form of restricted
      stock grants. Restrictions lapse completely on the fifth anniversary date from
      issuance.





**Purchases
      of Equity Securities**





On
      July
      21, 2006, the Company adopted a one year stock repurchase program in the initial
      amount of 40,000 shares and an expiration date of July 21, 2007. **** The
      repurchase program seeks to reduce the number of outstanding shares resulting
      in
      an improvement to the Company’s earnings per share and to its return on
      equity **.** In
      October 2006, the Company approved an increase in the stock repurchase program
      to a total of 100,000 shares. The total number of shares repurchased in 2006
      was
      40,000. The average price per share paid during 2006 was $17.96. All of these
      shares were purchased at current market prices on the date of transaction in
      compliance with the SEC rules. **** As
      of
      December 31, 2006, the Company could repurchase up to an additional 60,000
      shares under the July 2006 authorization.





-20-




The
      table
      below summarizes our monthly repurchases and redemptions of our common equity
      securities during the three months ended December 31st, 2006.





**Period**
            
            **Total
                Number of Shares Purchased**
            
            **Average
                Price Paid Per Share**
            
            **Remaining
                Shares That May be Purchased Under the
                Authorization**September2006
            
            
            —
            
            
            —
            
            
            25,000October
                2006
            
            
            —
            
            
            —
            
            
            85,000
            1)November
                2006
            
            
            10,000
            
            $
            18.90
            
            
            75,000December
                2006
            
            
            15,000
            
            $
            18.72
            
            
            60,000Fourth
                Quarter 2006 Totals
            
            
            25,000
            
            $
            18.79
            
            
            60,000


**1)** **Includes
        the additional 60,000 shares added to the plan in October 2006**
  -21-





**ITEM
      6.**  **SELECTED
      FINANCIAL DATA.**





The
      table
      below provides selected financial data that highlights the Company’s performance
      results for the five years ended December 31, 2006, 2005, 2004, 2003 and 2002.





**Selected
        Financial Data**
  **For
                  the Year Ended December 31,****2006**
              
              **2005**
              
              **2004**
              
              **2003**
              
              **2002****(Dollars
                  in thousands except per share and ratio data)****Results
                of
                Operations**Total
                  Interest Income
              
              $
              36,372
              
              $
              30,175
              
              $
              23,313
              
              $
              18,174
              
              $
              16,035Total
                  Interest Expense
              
              
              9,316
              
              
              5,016
              
              
              3,361
              
              
              3,463
              
              
              3,491Net
                  Interest Income
              
              
              27,056
              
              
              25,159
              
              
              19,952
              
              
              14,711
              
              
              12,544Provision
                  for Possible Loan Losses
              
              
              600
              
              
              710
              
              
              410
              
              
              370
              
              
              545Net
                  Interest Income after Provisionfor
                  Possible Loan Losses
              
              
              26,456
              
              
              24,449
              
              
              19,542
              
              
              14,341
              
              
              11,999Total
                  Non-Interest Income
              
              
              4,952
              
              
              5,009
              
              
              4,999
              
              
              3,797
              
              
              3,463Total
                  Non-Interest Expenses
              
              
              20,955
              
              
              18,718
              
              
              17,198
              
              
              12,425
              
              
              11,074Income
                  Before Income Tax Provision
              
              
              10,453
              
              
              10,740
              
              
              7,343
              
              
              5,713
              
              
              4,388Provision
                  for Income Taxes
              
              
              3,791
              
              
              4,103
              
              
              2,759
              
              
              2,117
              
              
              1,649Net
                  Income
              
              $
              6,662
              
              $
              6,637
              
              $
              4,584
              
              $
              3,596
              
              $
              2,739**Earnings
                  Per Share**Basic:
              
              $
              1.05
              
              $
              1.08
              
              $
              0.77
              
              $
              0.71
              
              $
              0.57Diluted:
              
              $
              1.01
              
              $
              1.01
              
              $
              0.71
              
              $
              0.67
              
              $
              0.52**Financial
                  Condition**Total
                  Assets
              
              $
              541,774
              
              $
              488,501
              
              $
              448,012
              
              $
              441,948
              
              $
              337,511Net
                  Loans
              
              $
              439,277
              
              $
              362,635
              
              $
              334,964
              
              $
              274,051
              
              $
              187,311Deposits
              
              $
              420,521
              
              $
              417,797
              
              $
              370,441
              
              $
              366,439
              
              $
              264,178Shareholder's
                  Equity
              
              $
              49,472
              
              $
              44,845
              
              $
              37,250
              
              $
              32,288
              
              $
              19,813**Selected
                  Financial Ratios**Return
                  on Average Assets
              
              
              1.32
              %
              
              1.38
              %
              
              1.02
              %
              
              1.05
              %
              
              0.98
              %Return
                  on Average Equity
              
              
              14.10
              %
              
              16.06
              %
              
              13.15
              %
              
              15.52
              %
              
              15.56
              %Return
                  on Average Tangible Equity
              
              
              16.22
              %
              
              19.11
              %
              
              16.61
              %
              
              16.39
              %
              
              15.56
              %Average
                  Equity to Average Assets
              
              
              9.37
              %
              
              8.61
              %
              
              7.79
              %
              
              6.76
              %
              
              6.33
              %Efficiency
                  Ratio1
              
              
              65.47
              %
              
              62.04
              %
              
              68.93
              %
              
              67.13
              %
              
              69.18
              %Dividend
                  Payout Ratio
              
              
              39.05
              %
              
              -
              
              
              -
              
              
              -
              
              
              -





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





-22-




**ITEM
      7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION** **AND
      RESULTS OF OPERATIONS.**





The
      following is an analysis of the financial condition and results of operations
      of
      the Company for the three years ended December 31, 2006. The analysis should
      be
      read in connection with the consolidated financial statements and notes thereto
      appearing elsewhere in this report.





**Executive
      Summary**





Both
      changes in short term interest rates as well as changes to the shape of the
      yield curve influence the Company and its markets. Generally, in 2006 increases
      in longer term interest rates were not commensurate with the rise in short
      term
      interest rates that has occurred since June 2004 resulting in smaller
      differentials between long and short term interest rates. This effect first
      created a flattening yield curve that has since become inverted, that is to
      say,
      short term rates are higher than long term rates. The effects of the inverted
      yield curve can be wide ranging, but generally, it has been credited for slowing
      the housing market and economy.





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





Beginning
      in January 2001 and continuing through July 2003, actions by the Federal Reserve
      Bank (the “FRB”) to cut target interest rates resulted in the Prime Rate being
      reduced from 9.50% to 4.00%. Beginning in June 2004 through December 2006,
      the
      FRB increased the Prime Rate from 4.00% to 8.25%.





Historically,
      the largest and most variable source of income for the Company is net interest
      income. The results of operations for the years 2006, 2005 and 2004 reflect
      the
      impact of changes in short term rates as well as growth in the volume of both
      interest earning assets and interest bearing liabilities during these periods.





During
      2006, the steady increase in the Prime Rate was the primary driver of the
      Company’s 16 basis point increase in net interest margin, from 5.78% to 5.94%
      compared to a 68 basis point increase during 2005 and a 28 basis point increase
      for 2004. The declining increase, year over year, in the net interest margin
      is
      primarily due to disintermediation and the migration of lower cost deposits
      to
      higher yielding alternative deposits and the need to use borrowed funds, which
      typically are a more costly source of funding than deposits.





In
      2006
      earnings were influenced by loan growth increasing net interest income, however,
      net income remained relatively unchanged year over year due to a significant
      rise in interest expense coupled with higher operating expenses.





At
      the
      end of 2005 the Company began a branding initiative which included an extensive
      assessment, both internally and externally of all bank delivery channels.
      Recommended actions were incorporated into a comprehensive Marketing Strategic
      Plan which is currently in process of implementation. The increase in
      non-interest expense has been primarily the result of expenses related to the
      branding project, the addition of staff including the EVP / Human Resources
      and
      EVP/Product Delivery and full service branch expansion within the bank’s
      existing footprint in the town of Templeton. The Company has invested
      significant resources in these new initiatives throughout 2006 in an effort
      to
      improve our service delivery and image and expect to continue the investment
      in
      2007 with the expectation of returns on these investments adding to shareholder
      value.




**Results
      of Operations**





The
      Company reported net income of $6.7 million for the year ended December 31,
      2006
      compared to $6.6 million and $4.6 million for the years 2005 and 2004
      respectively. This represents a nominal increase for 2006 over 2005 and 45%
      for
      2005 over 2004. Basic earnings per share were $1.05, $1.08 and $0.77 at December
      31, 2006, 2005 and 2004, respectively. Diluted earnings per share were $1.01,
      $1.01 and $0.71 at December 31, 2006, 2005 and 2004, respectively. The earnings
      were mostly unchanged in 2006 primarily due to an increase in interest expense
      on interest bearing accounts and borrowed funds along with an increase in salary
      and employee expenses. The increase in earnings for 2005 over 2004 was primarily
      attributable to an interest rate environment favorable to the Company’s
      asset-sensitive balance sheet.




-23-




**Net
      Interest Income and Interest Margin**





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





-24-




The
      table
      below sets forth the average balance sheet information, interest income and
      expense, average yields and rates and net interest income and margin for the
      years ended December 31, 2006, 2005 and 2004. The average balance of
      non-accruing loans has been included in loan totals.




**AVERAGE
        BALANCE SHEET INFORMATION**
  **(dollars
                  in thousands)**
              
              **For
                  the year ending December 31,****2006**
              
              
              
              
              
              **2005**
              
              
              
              
              
              **2004****Avg.**
              
              **Yield/**
              
              **Amt.**
              
              **Avg.**
              
              **Yield/**
              
              **Amt.**
              
              **Avg.**
              
              **Yield/**
              
              **Amt.****Balance**
              
              **Rate**
              
              **Interest**
              
              **Balance**
              
              **Rate**
              
              **Interest**
              
              **Balance**
              
              **Rate**
              
              **Interest**Interest
                  Earning Assets:Interest
                  bearing deposits with other banks
              
              $
              2,267
              
              
              6.66
              %
              $
              151
              
              $
              1,149
              
              
              4.44
              %
              $
              51
              
              $
              2,154
              
              
              1.90
              %
              $
              41Investment
                  securities taxable
              
              
              25,503
              
              
              4.25
              %
              
              1,083
              
              
              38,499
              
              
              3.81
              %
              
              1,465
              
              
              49,178
              
              
              3.76
              %
              
              1,849Investment
                  securities non-taxable
              
              
              16,319
              
              
              4.30
              %
              
              702
              
              
              13,701
              
              
              4.33
              %
              
              593
              
              
              11,511
              
              
              4.40
              %
              
              506Federal
                  funds sold
              
              
              11,179
              
              
              4.82
              %
              
              539
              
              
              19,529
              
              
              3.42
              %
              
              667
              
              
              24,287
              
              
              1.24
              %
              
              302Loans
                  (1) (2)
              
              
              400,229
              
              
              8.47
              %
              
              33,897
              
              
              362,735
              
              
              7.55
              %
              
              27,399
              
              
              304,402
              
              
              6.77
              %
              
              20,615Total
                  interest earning assets
              
              
              455,497
              
              
              7.99
              %
              
              36,372
              
              
              435,613
              
              
              6.93
              %
              
              30,175
              
              
              391,532
              
              
              5.95
              %
              
              23,313Allowance
                  for possible loan losses
              
              
              (3,931
              )
              
              
              
              
              
              
              
              (3,577
              )
              
              
              
              
              
              
              
              (3,158
              )Other
                  assets
              
              
              52,311
              
              
              
              
              
              
              
              
              48,168
              
              
              
              
              
              
              
              
              59,054TOTAL
                  ASSETS
              
              $
              503,877
              
              
              
              
              
              
              
              $
              480,204
              
              
              
              
              
              
              
              $
              447,428Interest
                  -bearing liabilities:Savings/NOW/money
                  market
              
              
              160,841
              
              
              1.55
              %
              
              2,497
              
              
              167,223
              
              
              1.01
              %
              
              1,695
              
              
              158,291
              
              
              0.44
              %
              
              699Time
                  deposits
              
              
              106,342
              
              
              4.21
              %
              
              4,472
              
              
              65,128
              
              
              2.74
              %
              
              1,784
              
              
              69,715
              
              
              1.54
              %
              
              1,071Other
                  borrowings
              
              
              27,854
              
              
              5.21
              %
              
              1,452
              
              
              27,966
              
              
              3.41
              %
              
              954
              
              
              31,023
              
              
              3.72
              %
              
              1,155FF
                  Purchased
              
              
              1,020
              
              
              5.49
              %
              
              56
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Long
                  Term Debt
              
              
              9,694
              
              
              8.65
              %
              
              839
              
              
              8,248
              
              
              7.07
              %
              
              583
              
              
              8,248
              
              
              5.29
              %
              
              436Total
                  interest-bearing liabilities
              
              
              305,751
              
              
              3.05
              %
              
              9,316
              
              
              268,565
              
              
              1.87
              %
              
              5,016
              
              
              267,277
              
              
              1.26
              %
              
              3,361Demand
                  deposits
              
              
              146,458
              
              
              
              
              
              
              
              
              166,780
              
              
              
              
              
              
              
              
              142,796Other
                  liabilities
              
              
              4,432
              
              
              
              
              
              
              
              
              3,519
              
              
              
              
              
              
              
              
              2,501Stockholders'
                  equityCommon
                  stock
              
              
              29,367
              
              
              
              
              
              
              
              
              28,049
              
              
              
              
              
              
              
              
              23,071Retained
                  earnings
              
              
              18,003
              
              
              
              
              
              
              
              
              13,268
              
              
              
              
              
              
              
              
              11,510Valuation
                  Allowance Investments
              
              
              (134
              )
              
              
              
              
              
              
              
              23
              
              
              
              
              
              
              
              
              273Total
                  stockholders' equity
              
              
              47,236
              
              
              
              
              
              
              
              
              41,340
              
              
              
              
              
              
              
              
              34,854TOTAL
                  LIABILITIES AND STOCKHOLDERS'EQUITY
              
              $
              503,877
              
              
              
              
              
              
              
              $
              480,204
              
              
              
              
              
              
              
              $
              447,428Net
                  Interest Income
              
              
              
              
              
              
              
              $
              27,056
              
              
              
              
              
              
              
              $
              25,159
              
              
              
              
              
              
              
              $
              19,952Net
                  Interest Margin (3)
              
              
              
              
              
              5.94
              %
              
              
              
              
              
              
              
              5.78
              %
              
              
              
              
              
              
              
              5.10
              %
  (1) Nonaccrual
        loans have been included in total loans.




(2)
Loan
      fees
      of $1,275, $1,044 and $1,021, for 2006, 2005 and 2004, respectively have been
      included in the interest income computation.


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


-25-




The
      following table provides a summary of the changes in interest income and
      interest expense related to changes in interest rates and volume for the years
      ended December 31, 2006, 2005, 2004.




**RATE/VOLUME
        ANALYSIS**
  2006
              
              2005
              
              2004Average
              
              Average
              
              
              
              Average
              
              Average
              
              
              
              Average
              
              AverageIncrease
                  (decrease) in:
              
              Bal/Vol
              
              Rate
              
              Total
              
              Bal/Vol
              
              Rate
              
              Total
              
              Bal/Vol
              
              Rate
              
              TotalInterest
                  income:Loans
                  (1)
              
              $
              986
              
              $
              5,512
              
              $
              6,498
              
              $
              5,104
              
              $
              1,680
              
              $
              6,784
              
              $
              5,293
              
              $
              (608
              )
              $
              4,685Investment
                  securities taxable
              
              
              (537
              )
              
              155
              
              
              (382
              )
              
              (401
              )
              
              17
              
              
              (384
              )
              
              242
              
              
              108
              
              
              350Investment
                  securities non-taxable (2):
              
              
              172
              
              
              (7
              )
              
              165
              
              
              147
              
              
              (15
              )
              
              132
              
              
              94
              
              
              (15
              )
              
              79Taxable
                  equivalent adjustment (2):
              
              
              (58
              )
              
              2
              
              
              (56
              )
              
              (50
              )
              
              5
              
              
              (45
              )
              
              (32
              )
              
              5
              
              
              (27
              )Interest-bearing
                  deposits
              
              
              172
              
              
              (21
              )
              
              151
              
              
              (19
              )
              
              29
              
              
              10
              
              
              29
              
              
              (1
              )
              
              28Federal
                  funds sold
              
              
              (333
              )
              
              154
              
              
              (179
              )
              
              (59
              )
              
              424
              
              
              365
              
              
              (14
              )
              
              38
              
              
              24Total
              
              
              401
              
              
              5,796
              
              
              6,197
              
              
              4,722
              
              
              2,140
              
              
              6,862
              
              
              5,612
              
              
              (473
              )
              
              5,139Interest
                  expense:Savings,
                  now, money market
              
              
              (67
              )
              
              869
              
              
              802
              
              
              39
              
              
              957
              
              
              996
              
              
              216
              
              
              (142
              )
              
              74Time
                  deposits
              
              
              5,080
              
              
              (2,392
              )
              
              2,688
              
              
              (70
              )
              
              783
              
              
              713
              
              
              414
              
              
              (469
              )
              
              (55
              )Other
                  borrowings
              
              
              (4
              )
              
              502
              
              
              498
              
              
              (3
              )
              
              (198
              )
              
              (201
              )
              
              (15
              )
              
              (117
              )
              
              (132
              )FF
                  Purchased
              
              
              56
              
              
              -
              
              
              56
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Long
                  term borrowings
              
              
              17
              
              
              239
              
              
              256
              
              
              -
              
              
              147
              
              
              147
              
              
              13
              
              
              (2
              )
              
              11Total
              
              
              5,082
              
              
              (782
              )
              
              4,300
              
              
              (34
              )
              
              1,689
              
              
              1,655
              
              
              628
              
              
              (730
              )
              
              (102
              )Increase
                  (decrease) in netInterest
                  income
              
              $
              (4,682
              )
              $
              6,578
              
              $
              1,897
              
              $
              4,756
              
              $
              451
              
              $
              5,207
              
              $
              4,984
              
              $
              257
              
              $
              5,241


(1)
            Loan
            fees of $1,275, $1,440 and $1,021, for 2006, 2005 and 2004, respectively
            have
            been included in the interest income computation.
 (2)
            Adjusted to a fully taxable equivalent basis using a tax rate of
            34%.
  Note
          A:
          Average balances of all categories in each period were included in the
          volume
          computations.
 Note
        B:
        Average yield rates in each period were used in rate computations. Change
        attributable to both volume and
        rate
        have been allocated in proportion to the relationship between their absolute
        dollar amounts.




During
      2006 there was a $6.2 million increase in interest income and a $4.3 million
      increase in interest expense compared to 2005. The resulting $1.9 million
      increase in net interest income was the result of a number of dynamics affecting
      both average balance and interest rate considerations. The Company experienced
      an increase in its average earning assets outstanding of $19.9 million. This
      increase was primarily attributable to the net increase in average loans, which
      were up by $37.5 million. The increase in loans was partially offset by
      decreases in average federal funds sold of $8.4 million and taxable investment
      securities of $13 million. Average interest bearing liabilities increased by
      $37.2 million while non-interest bearing demand deposits decreased by $20.3
      million during this period. In addition, earning asset yields were approximately
      106 basis points higher in 2006 compared to 2005 while the cost of interest
      bearing liabilities increased by 118 basis points.





During
      2005 there was a $6.9 million increase in interest income and a $1.7 million
      increase in interest expense compared to 2004. The resulting $5.2 million
      increase in net interest income was the result of a number of dynamics affecting
      both average balance and interest rate considerations. The Company experienced
      an increase in its average earning assets outstanding of $44.1 million. This
      increase was primarily attributable to the net increase in average loans, which
      were up by $58.3 million. The increase in loans was partially offset by
      decreases in average federal funds sold of $4.8 million and taxable investment
      securities of $10.7 million. Also, average interest bearing liabilities
      increased by $1.3 million, significantly less than the increase in earning
      assets. Non-interest bearing demand deposits increased by $23.9 million during
      this period and provided low-cost funding for the growth in earning assets.
      In
      addition, earning asset yields were approximately 100 basis points higher in
      2005 compared to 2004 while deposit costs excluding demand deposits increased
      61
      basis points.




-26-




The
      hypothetical impacts of sudden interest rate movements applied to the Company’s
      asset and liability balances are modeled monthly. The results of this movement
      indicate how much of the Company’s net interest income is “at risk” from various
      rate changes over a one year horizon. This exercise is valuable in identifying
      risk exposures. The results for the Company’s December 31, 2006 balances
      indicate that the net interest income at risk over a one year time horizon
      from
      a 1.0% and 2.0% upward and downward rate movement are within the Company’s
      policy guidelines for such changes. See, “Item 7A - Quantitative and Qualitative
      Disclosures about Market Risk.”





The
      tables below set forth changes from 2005 to 2006 for average interest earning
      assets and their respective average yields.




Average
                  Balance
              
              
              
              
              
              Average
                  Yieldfor
                  the year ending
              
              
              
              
              
              for
                  the year ending(dollars
                  in thousands)
              
              31-Dec
              
              $
              
              %
              
              31-DecInterest
                  Earning Assets:
              
              2006
              
              2005
              
              Variance
              
              Variance
              
              2006
              
              2005
              
              VarianceTime
                  deposits with other banks
              
              $
              2,267
              
              $
              1,149
              
              $
              1,118
              
              
              97.30
              %
              
              6.66
              %
              
              4.44
              %
              
              2.22
              %Investment
                  securities taxable
              
              
              25,503
              
              
              38,499
              
              
              (12,996
              )
              
              -33.76
              %
              
              4.25
              %
              
              3.81
              %
              
              0.44
              %Investment
                  securities non-taxable
              
              
              16,319
              
              
              13,701
              
              
              2,618
              
              
              19.11
              %
              
              4.30
              %
              
              4.33
              %
              
              -0.03
              %Federal
                  funds sold
              
              
              11,179
              
              
              19,529
              
              
              (8,350
              )
              
              -42.76
              %
              
              4.82
              %
              
              3.42
              %
              
              1.40
              %Loans
                  (1) (2)
              
              
              400,229
              
              
              362,735
              
              
              37,494
              
              
              10.34
              %
              
              8.47
              %
              
              7.55
              %
              
              0.92
              %Total
                  interest earning assets
              
              $
              455,497
              
              $
              435,613
              
              $
              19,884
              
              
              4.56
              %
              
              7.99
              %
              
              6.93
              %
              
              1.06
              %




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




(2) Loan
      fees
      of $1,275, $1,440 and $1,021, for 2006, 2005 and 2004,
      respectively have
      been
      included in the interest income computation.


The
      tables below sets forth changes from 2005 to 2006 for average interest bearing
      liabilities and their respective average rates paid.




Average
                  Balance
              
              
              
              
              
              Average
                  Ratefor
                  the year ending
              
              
              
              
              
              for
                  the year ending(dollars
                  in thousands)
              
              31-Dec
              
              $
              
              %
              
              31-DecInterest
                  bearing liabilities:
              
              2006
              
              2005
              
              Variance
              
              Variance
              
              2006
              
              2005
              
              VarianceSavings/NOW/money
                  market
              
              $
              160,841
              
              $
              167,223
              
              $
              (6,382
              )
              
              -3.82
              %
              
              1.55
              %
              
              1.01
              %
              
              0.54
              %Time
                  deposits
              
              
              106,342
              
              
              65,128
              
              
              41,214
              
              
              63.28
              %
              
              4.21
              %
              
              2.74
              %
              
              1.47
              %Other
                  borrowings (1) (2)
              
              
              27,854
              
              
              27,966
              
              
              (112
              )
              
              -0.40
              %
              
              5.21
              %
              
              3.41
              %
              
              1.80
              %FF
                  Purchased
              
              
              1,020
              
              
              -
              
              
              1,020
              
              
              0.00
              %
              
              5.49
              %
              
              0.00
              %
              
              5.49
              %Long
                  Term Debt
              
              
              9,694
              
              
              8,248
              
              
              1,446
              
              
              17.53
              %
              
              8.65
              %
              
              7.07
              %
              
              1.58
              %Total
                  interest-bearing liabilities
              
              $
              305,751
              
              $
              268,565
              
              $
              37,186
              
              
              13.85
              %
              
              3.05
              %
              
              1.87
              %
              
              1.18
              %


(1) Consists
        of FHLB Borrowings of $25,973 and Repurchase Agreements of
        $1,881





(2) Average
        Rate Paid of 5.25% on FHLB Borrowings and 4.63% on Repurchase
        Agreements


-27-




**Non-Interest
      Income**





The
      table
      below sets forth changes from 2005 to 2006 and 2004 to 2005 for non-interest
      income exclusive of gains on sale of securities, SBA loans and premises.





Non-Interest
        Income Components
  **For
                  the Year Ended****December
                  31,****(dollars
                  in thousands)**
              
              **2006**
              
              **2005**
              
              **$
                  Variance**
              
              **%
                  Variance**Service
                  Charges on Deposit Accounts
              
              $
              2,427
              
              $
              2,430
              
              $
              (3
              )
              
              -0.1
              %ATM/Debit
                  Card Transaction/Interchange Fees
              
              
              711
              
              
              629
              
              
              82
              
              
              13.0
              %Bancard
              
              
              122
              
              
              160
              
              
              (38
              )
              
              -23.8
              %Mortgage
                  Origination Fees
              
              
              552
              
              
              897
              
              
              (345
              )
              
              -38.5
              %Earnings
                  on Cash Surrender Value Life Ins
              
              
              393
              
              
              323
              
              
              70
              
              
              21.7
              %Other
              
              
              737
              
              
              482
              
              
              255
              
              
              52.9
              %**TOTAL**
              
              **$**
              **4,942**
              
              **$**
              **4,921**
              
              **$**
              **21**
              
              
              **0.4**
              **%**
  **For
                  the Year Ended****December
                  31,****(dollars
                  in thousands)**
              
              **2005**
              
              **2004**
              
              **$
                  Variance**
              
              **%
                  Variance**Service
                  Charges on Deposit Accounts
              
              $
              2,430
              
              $
              2,173
              
              $
              257
              
              
              11.8
              %ATM/Debit
                  Card Transaction/Interchange Fees
              
              
              629
              
              
              583
              
              
              46
              
              
              7.9
              %Bancard
              
              
              160
              
              
              116
              
              
              44
              
              
              37.9
              %Mortgage
                  Origination Fees
              
              
              897
              
              
              602
              
              
              295
              
              
              49.0
              %Earnings
                  on Cash Surrender Value Life Ins
              
              
              323
              
              
              294
              
              
              29
              
              
              9.9
              %Other
              
              
              482
              
              
              446
              
              
              36
              
              
              8.1
              %**TOTAL**
              
              **$**
              **4,921**
              
              **$**
              **4,214**
              
              **$**
              **707**
              
              
              **16.8**
              **%**





For
      2006
      compared to 2005, total non interest income remained relatively unchanged seeing
      a year over year increase of only 0.4%.





Mortgage
      Origination Fees decreased in 2006 in comparison to 2005 due primarily to a
      decrease in mortgage volumes as a result of increasing interest rates and a
      leveling of property values in the region. Management is very aware that the
      revenue generated by this line of business is impacted by rate volatility and
      that if rates continue to rise or the availability of credit is diminished,
      then
      mortgage volumes at the Company could decline and impact the level of mortgage
      origination fee income. To mitigate material decreases in net revenue from
      this
      line of business, Management has taken steps to ensure that fixed costs are
      minimal due to commission based remuneration.





For
      2005
      compared to 2004, increases in Service Charges on Deposit Accounts were
      generally commensurate with and primarily due to deposit growth.





Mortgage
      Origination Fees increased in 2005 in comparison to 2004 due primarily to
      increased mortgage volumes as a result of decreasing interest rates and the
      availability of credit to mortgage consumers.





-28-


**Non-Interest
      Expenses**





The
      table
      below sets forth changes in non-interest expense for 2006, 2005, and 2004.





Non-Interest
        Expense Components
  **For
                  the Year Ended****December
                  31,****(dollars
                  in thousands)**
              
              **2006**
              
              **2005**
              
              **$
                  Variance**
              
              **%
                  Variance**Salaries
                  and Employee Benefits
              
              $
              11,573
              
              $
              9,746
              
              $
              1,827
              
              
              18.7
              %Occupany
                  and Equipment
              
              
              2,607
              
              
              2,491
              
              
              116
              
              
              4.7
              %Data
                  Processing
              
              
              2,138
              
              
              2,200
              
              
              (62
              )
              
              -2.8
              %Advertising
                  and promotional
              
              
              851
              
              
              582
              
              
              269
              
              
              46.2
              %Regulatory
                  fees
              
              
              112
              
              
              106
              
              
              6
              
              
              5.7
              %Other
                  professional fees and outside services
              
              
              1,207
              
              
              802
              
              
              405
              
              
              50.5
              %Legal
                  fees and other litigation expense
              
              
              154
              
              
              122
              
              
              32
              
              
              26.2
              %Loan
                  Department Costs
              
              
              147
              
              
              182
              
              
              (35
              )
              
              -19.2
              %Stationery
                  and supplies
              
              
              327
              
              
              311
              
              
              16
              
              
              5.1
              %Director
                  fees
              
              
              290
              
              
              247
              
              
              43
              
              
              17.4
              %Core
                  Deposit Intangible Amortization
              
              
              300
              
              
              573
              
              
              (273
              )
              
              -47.6
              %Other
              
              
              1,249
              
              
              1,356
              
              
              (107
              )
              
              -7.9
              %**$**
              **20,955**
              
              **$**
              **18,718**
              
              **$**
              **2,237**
              
              
              **12.0**
              **%**
  **For
                  the Year Ended****December
                  31,****(dollars
                  in thousands)**
              
              **2005**
              
              **2004**
              
              **$
                  Variance**
              
              **%
                  Variance**Salaries
                  and Employee Benefits
              
              $
              9,746
              
              $
              8,457
              
              $
              1,289
              
              
              15.2
              %Occupany
                  and Equipment
              
              
              2,491
              
              
              2,570
              
              
              (79
              )
              
              -3.1
              %Data
                  Processing
              
              
              2,200
              
              
              2,570
              
              
              (370
              )
              
              -14.4
              %Advertising
                  and promotional
              
              
              582
              
              
              515
              
              
              67
              
              
              13.0
              %Regulatory
                  fees
              
              
              106
              
              
              114
              
              
              (8
              )
              
              -7.0
              %Other
                  professional fees and outside services
              
              
              802
              
              
              530
              
              
              272
              
              
              51.3
              %Legal
                  fees and other litigation expense
              
              
              122
              
              
              76
              
              
              46
              
              
              60.5
              %Loan
                  Department Costs
              
              
              182
              
              
              181
              
              
              1
              
              
              0.6
              %Stationery
                  and supplies
              
              
              311
              
              
              374
              
              
              (63
              )
              
              -16.8
              %Director
                  fees
              
              
              247
              
              
              179
              
              
              68
              
              
              38.0
              %Core
                  Deposit Intangible Amortization
              
              
              573
              
              
              421
              
              
              152
              
              
              36.1
              %Other
              
              
              1,356
              
              
              1,211
              
              
              145
              
              
              12.0
              %**$**
              **18,718**
              
              **$**
              **17,198**
              
              **$**
              **1,520**
              
              
              **8.8**
              **%**




Salary/Related
      Expense





Salaries
      and employee related expense incurred the greatest dollar increase of any
      non-interest expense category during both 2006 and 2005. For the year ended
      December 31, 2006, the primary sources of the increase in this category were
      salaries and higher group insurance costs. These increases are due in part
      to
      expansion of our Executive Management team contributing to higher officer
      salaries and also an increase in full and part time employee salaries all
      related directly to the growth and profitability of the bank. Full time
      equivalent (FTE) employees increased from 170 at December 31, 2004 to 186 at
      December 31, 2005 and to 212 at December 31, 2006.





The
      bonus
      accrual for 2006 was approximately 40% less in 2006 compared to 2005. Bonus
      and
      commissions expense increases during 2004 and 2005 were influenced by the
      Company’s commitment to incentive based pay. Management believes that incentive
      based pay is a significant part of the Company’s corporate culture and has
      served to help provide above average return to shareholders. All employees
      participate either on a monthly, quarterly or annual basis.





Group
      insurance costs increased by approximately $223 thousand in 2006 and $160
      thousand in 2005. The Company has made efforts to contain these costs while
      at
      the same time ensuring that employees receive appropriate and fair
      consideration.





-29-





Occupancy
      and Equipment





Occupancy
      and equipment expense increased in 2006 due to branch expansion in the town
      of
      Templeton and the completion of the administrative building that has been under
      construction since late 2004. The Company was able to eliminate two leased
      facilities and consolidate administrative operations in the new structure that
      was occupied in June 2006.





Occupancy
      and equipment expense decreased $78 thousand in 2005 compared to 2004. In July
      2005 the Company entered into a sale-leaseback transaction of its branch office
      in the city of Atascadero. The sale price was $900 thousand and resulted in
      a
      gain to the Company of approximately $283 thousand which will be amortized
      into
      income over the term of the leaseback. While this transaction increases
      occupancy expense, the net income statement effect of the sale-leaseback will
      be
      a reduction in the net monthly cost of operating the branch.





Data
      Processing Expense





Data
      processing expense remained relatively unchanged between 2005 and 2006 seeing
      a
      slight 2.8% decrease year over year. Data processing expense declined $370
      thousand in 2005 compared to 2004. The primary cause of the decline was $540
      thousand of non-recurring expenses in 2004 related to the March 2005 final
      conversion of Hacienda’s core and other ancillary processing services into the
      Bank’s systems. Nearly 83% of this conversion cost is being saved over 18 months
      via a credit from its current data processing vendor of $25 thousand per month.
      In addition, the conversion allowed the Company to discontinue incurring
      Hacienda’s legacy data processing costs beginning in March 2005. The Company
      ceased receiving this monthly credit in October 2006.





Other
      Professional Fees and Outside Services





The
      Company incurred $1,207 thousand in other professional fees and outside services
      during 2006. These expenses increased by $405 thousand and $272 thousand in
      2006
      and 2005 respectively. The increase for 2006 was attributable to higher audit
      and tax accounting costs, attorney’s fees, consulting fees associated with
      branch expansion, compensation compliance and compliance with the Sarbanes-Oxley
      Act, Section 404.





Core
      Deposit Intangible Amortization





Following
      the acquisition of Hacienda in late 2003 the Company incurred significantly
      higher core deposit intangible amortization during 2005 and 2004. The Company
      chose to amortize the Hacienda-related intangibles by utilizing an amortization
      schedule in accordance with FAS 141 and FAS 142. In accordance with this
      schedule, the Company has incurred less expense in 2006 than in 2005 or 2004.
      Pursuant to the amortization schedule, the expense for 2007 is estimated to
      be
      $354 thousand compared to $300 thousand in 2006.





**Provision
      for Income Taxes**





The
      provision for income taxes was 36.3%, 38.2% and 37.6% of net pre-tax income
      for
      years ended December 31, 2006, 2005 and 2004, respectively. The decrease in
      effective rate for 2006 was due to analysis associated with FASB 109. The
      Company expects the effective tax rate to be approximately 38% for 2007.




**Provision
      and Allowance for Credit Losses**





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





The
      Bank
      recognizes that credit losses will be experienced and the risk of loss will
      vary
      with, among other things, general economic conditions; the type of loan being
      made; the creditworthiness of the borrower over the term of the loan and in
      the
      case of a collateralized loan, the quality of the collateral for such loan.
      The
      allowance for loan loss represents the Bank’s estimate of the allowance
      necessary to provide for probable incurred losses in the portfolio. In making
      this determination, the Bank analyzes the ultimate collectibility of the loans
      in the portfolios by incorporating feedback provided by internal loan staff,
      an
      independent loan review function, and information provided by examinations
      performed by regulatory agencies. The Bank makes monthly evaluations as to
      the
      adequacy of the allowance for loan losses.




-30-





The
      analysis of the allowance for loan losses is comprised of three components;
      specific credit allocation; general portfolio allocation; and subjectively
      by
      determined allocation. Effective January 1, 1995 the Bank adopted Statement
      of
      Financial Accounting Standards No.114, Accounting by Creditors for Impairment
      of
      a Loan (SFAS 114), as amended by SFAS No. 118, Accounting by Creditors for
      Impairment of a Loan - Income Recognition and Disclosures. These pronouncements
      provide that when it is probable that a creditor will be unable to collect
      all
      amounts due in accordance with the terms of the loan that such loan is deemed
      impaired. Impaired loans are accounted for differently in that the amount of
      the
      impairment is measured and reflected in the records of the creditor. The
      allowance for credit losses related to loans that are identified for evaluation
      in accordance with Statement 114 is based on discounted cash flows using the
      loan’s initial 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 Banks’ 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 estimate, and ultimate losses will vary
      from current estimates. These estimates are reviewed monthly by the Bank’s
      Director’s Loan Committee and full Board of Directors, and as adjustments,
      either positive or negative, become necessary, a corresponding increase or
      decrease is made in the provision for loan losses. The methodology used to
      determine the adequacy of the allowance for possible loan losses for the year
      2006 is consistent with prior periods.





The
      Bank’s provision for loan losses was $600 thousand, $710 thousand and $410
      thousand for 2006, 2005 and 2004 respectively. The loan loss provision
      represents coverage for general loan portfolio growth and real estate
      concentrations. Net loan charge-offs (loans charged off, net of loans recovered)
      were $400 thousand for 2006, $76 thousand for 2005 and $233 thousand for 2004.
      Losses in 2006 came primarily from a single loan charge off and the general
      loan
      portfolio continues to show sound loan underwriting. The allowance for credit
      losses as a percent of total gross loans at year-end 2006, 2005 and 2004 was
      0.92%, 1.05% and 0.96%, respectively.





Loans
      are
      placed on non-accrual when a loan is specifically determined to be impaired
      or
      when principal or interest is delinquent for 90 days or more. Any unpaid
      interest previously accrued on those loans is reversed from income. Interest
      income generally is not recognized on specific impaired loans unless the
      likelihood of further loss is remote. Interest payments received on such loans
      are applied as a reduction on the loan principal balance.





Loans
      on
      non-accrual status totaled $55 thousand, $54 thousand and $872 thousand at
      December 31, 2006, 2005 and 2004, respectively. The decrease in non-accrual
      totals was the result of resolving several loan situations. Typically, these
      loans have adequate collateral protection and/or personal guaranties to provide
      a source of repayment to the Bank. The loans on non-accrual are related to
      several commercial loans that are being addressed by specific workout plans
      at
      this time. Interest income that would have been recognized on non-accrual loans
      if they had performed in accordance with the terms of the loans was
      approximately $63 thousand, $87 thousand and $126 thousand for the period ended
      December 31, 2006, 2005 and 2004, respectively.





Non-performing
      loans include non-accrual loans, restructured loans and accruing loans that
      are
      90 days or more delinquent. The Bank had no loans that were 90 days or more
      delinquent and still accruing interest at December 31, 2006. Total
      non-performing loans were $55 thousand and $54 thousand at December 31, 2006
      and
      December 31, 2005 respectively.





-31-


The
      following table summarizes the analysis of the allowance for loan losses as
      of
      December 31, 2006, 2005, 2004, 2003 and 2002:


**Analysis
        of Allowance for Loan Losses** (in
          thousands)


**2006**
              
              **2005**
              
              **2004**
              
              **2003**
              
              **2002**Balance
                  at Beginning of Period
              
              $
              3,881
              
              $
              3,247
              
              $
              3,070
              
              $
              2,336
              
              $
              1,744Balance
                  of Hacienda Bank atBeginning
                  of Period
              
              
              -
              
              
              -
              
              
              -
              
              
              597
              
              
              -Charge-offs:Commercial,
                  Fianacial and Agricultural
              
              
              508
              
              
              86
              
              
              202
              
              
              463
              
              
              76Real
                  Estate- Construction
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Commercial
                  Real Estate
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Installment
                  Loans to Individuals:
              
              
              44
              
              
              12
              
              
              29
              
              
              -
              
              
              -Money
                  Plus
              
              
              9
              
              
              2
              
              
              5
              
              
              3
              
              
              5Credit
                  Cards
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Other
                  Installment
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Total
                  charge-offs
              
              
              561
              
              
              100
              
              
              236
              
              
              466
              
              
              81Recoveries:Commercial,
                  Fianacial and Agricultural
              
              
              101
              
              
              -
              
              
              1
              
              
              232
              
              
              127Real
                  Estate- Construction
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Real
                  Estate-Mortgage
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Installment
                  Loans to Individuals:
              
              
              56
              
              
              24
              
              
              2
              
              
              1
              
              
              -Money
                  Plus
              
              
              4
              
              
              -
              
              
              -
              
              
              -
              
              
              1Credit
                  Cards
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Other
                  Installment
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Total
                  recoveries
              
              
              161
              
              
              24
              
              
              3
              
              
              233
              
              
              128Net
                  Charge-offs
              
              
              400
              
              
              76
              
              
              233
              
              
              233
              
              
              (47
              )Additions
                  Charged to Operations
              
              
              600
              
              
              710
              
              
              410
              
              
              370
              
              
              545Balance
                  at End of Period
              
              
              4,081
              
              
              3,881
              
              
              3,247
              
              
              3,070
              
              
              2,336Gross
                  Loans at End of Period
              
              $
              444,983
              
              $
              368,133
              
              $
              339,693
              
              $
              278,135
              
              $
              190,469Ratio
                  of Net Charge-offs During theYear
                  to Average Loans outstanding
              
              
              0.10
              %
              
              0.02
              %
              
              0.08
              %
              
              0.10
              %
              
              -0.03
              %Ratio
                  of Reserves to Gross Loans
              
              
              0.92
              %
              
              1.05
              %
              
              0.96
              %
              
              1.10
              %
              
              1.23
              %Ratio
                  of Non-performing Loans tothe
                  Allowance for Credit Losses
              
              
              1.35
              %
              
              1.39
              %
              
              28.77
              %
              
              50.20
              %
              
              57.62
              %
  **Allocation
        of the Allowance for Loan Losses**
  2006
              
              2005
              
              2004
              
              2003
              
              2002%
                  Total
              
              
              
              %
                  Total
              
              
              
              %
                  Total
              
              
              
              %
                  Total
              
              
              
              %
                  Total(dollars
                  in thousands)
              
              Amount
              
              Loans
              
              Amount
              
              Loans
              
              Amount
              
              Loans
              
              Amount
              
              Loans
              
              Amount
              
              LoansCommercial,
                  Fianacial and Agricultural
              
              $
              779
              
              
              19
              %
              $
              633
              
              
              16
              %
              $
              475
              
              
              15
              %
              $
              541
              
              
              18
              %
              $
              494
              
              
              21
              %Real
                  Estate- Construction
              
              
              969
              
              
              24
              %
              
              812
              
              
              21
              %
              
              641
              
              
              20
              %
              
              527
              
              
              17
              %
              
              498
              
              
              21
              %Commercial
                  Real Estate
              
              
              2,177
              
              
              53
              %
              
              2,221
              
              
              57
              %
              
              1,934
              
              
              60
              %
              
              1,793
              
              
              58
              %
              
              1,178
              
              
              50
              %Home
                  Equity Lines of Credit
              
              
              99
              
              
              2
              %
              
              152
              
              
              4
              %
              
              141
              
              
              4
              %
              
              148
              
              
              5
              %
              
              116
              
              
              5
              %Installment
                  Loans to Individuals
              
              
              51
              
              
              1
              %
              
              59
              
              
              2
              %
              
              53
              
              
              2
              %
              
              57
              
              
              2
              %
              
              47
              
              
              2
              %All
                  Other Loans (including overdrafts)
              
              
              5
              
              
              0
              %
              
              4
              
              
              0
              %
              
              3
              
              
              0
              %
              
              4
              
              
              0
              %
              
              3
              
              
              0
              %Total
              
              $
              4,081
              
              
              100
              %
              $
              3,881
              
              
              100
              %
              $
              3,247
              
              
              100
              %
              $
              3,070
              
              
              100
              %
              $
              2,336
              
              
              100
              %








-32-





**Financial
      Condition**





Total
      assets of the Company were $541.8 million at December 31, 2006 compared to
      $488.5 million at December 31, 2005, this represents an increase of $53.3
      million or 11.0%. A favorable lending environment allowed the Company to
      increase net loans by $76.6 million. The investment portfolio trended downward
      during the year primarily due to prepayments on mortgage-backed securities.
      The
      portfolio ended 2006 with a book value $6.0 million less than at December 31,
      2005.





The
      growth in assets was fueled by robust loan growth. Deposits remained relatively
      unchanged from 2005, and as a result the loan growth was funded mainly by
      additional borrowing from the FHLB. FHLB advances grew by $40.0 million from
      2005 totaling $50.0 million at 2006 year end.




Earning
      assets as a percent of total assets was 90.4% at December 31, 2006 compared
      to
      93.6% and 91.6% at December 31, 2005 and 2004 respectively.





For
      2005,
      total assets increased by $40.5 million or 9.0%. The major contributing factor
      to this growth was due to growth in loans of $27.7 million. The growth in loans
      for 2005 can be attributed to a continued favorable interest rate environment.




The
      bank
      was able to fund the majority of the loan growth in 2005 by an increase in
      deposits of $47.4 million, $20.6 million of which were low or no cost Demand
      Deposits.




Earning
      assets as a percent of total assets was 93.6% at December 31, 2005 compared
      to
      91.6% at December 31, 2004. In addition to the increase in the percent of
      earning assets, the change in the mix was such that a large portion of low
      yielding Fed Funds Sold moved into higher yielding loans.





**Loans**





A
      significant portion of total assets is the Company’s gross loans that were
      $445.0 million and $368.1 million at December 31, 2006 and 2005, respectively.
      Approximately 60% of gross loans at December 31, 2006 re-price within one year.
      If interest rates change, the yield on the loans that renew or re-price
      according to their terms, will also change. The Company has an Asset/Liability
      Management system that models various interest rate environments for all rate
      sensitive assets and liabilities. In a 100 basis point increase action by the
      FRB, the model indicates that the net interest income would increase by
      approximately $1.6 million while a 100 basis point decline would decrease net
      interest income by $1.7 million.





The
      table
      below sets forth the composition of the loan portfolio as of December 31, 2006,
      2005, 2004, 2003 and 2002.





**COMPOSITION
        OF LOAN PORTFOLIO**
 (dollars
        in thousands)
  2006
              
              2005
              
              2004
              
              2003
              
              2002Amount
              
              Percent
              
              Amount
              
              Percent
              
              Amount
              
              Percent
              
              Amount
              
              Percent
              
              Amount
              
              PercentCommercial,
                  Financial and Agricultural
              
              $
              84,976
              
              
              19
              %
              $
              60,050
              
              
              16
              %
              $
              49,584
              
              
              15
              %
              $
              49,024
              
              
              18
              %
              $
              40,373
              
              
              21
              %Real
                  Estate- Construction
              
              
              105,712
              
              
              24
              %
              
              76,981
              
              
              21
              %
              
              66,833
              
              
              20
              %
              
              47,720
              
              
              17
              %
              
              40,723
              
              
              21
              %Commercial
                  Real Estate
              
              
              237,401
              
              
              53
              %
              
              210,690
              
              
              57
              %
              
              202,765
              
              
              60
              %
              
              162,463
              
              
              58
              %
              
              96,324
              
              
              50
              %Home
                  Equity Lines of Credit
              
              
              10,792
              
              
              2
              %
              
              14,398
              
              
              4
              %
              
              14,708
              
              
              4
              %
              
              13,417
              
              
              5
              %
              
              10,486
              
              
              5
              %Installment
                  Loans to Individuals
              
              
              5,598
              
              
              1
              %
              
              5,620
              
              
              2
              %
              
              5,538
              
              
              2
              %
              
              5,173
              
              
              2
              %
              
              2,291
              
              
              2
              %All
                  Other Loans (including overdrafts)
              
              
              504
              
              
              0
              %
              
              394
              
              
              0
              %
              
              265
              
              
              0
              %
              
              338
              
              
              0
              %
              
              272
              
              
              0
              %Total
                  Loans, Gross
              
              
              444,983
              
              
              100
              %
              
              368,133
              
              
              100
              %
              
              339,693
              
              
              100
              %
              
              278,135
              
              
              100
              %
              
              190,469
              
              
              100
              %Deferred
                  Loan Fees
              
              
              (1,625
              )
              
              
              
              
              (1,617
              )
              
              
              
              
              (1,482
              )
              
              
              
              
              (1,014
              )
              
              
              
              
              (822
              )Reserve
                  for Possible Loan Losses
              
              
              (4,081
              )
              
              
              
              
              (3,881
              )
              
              
              
              
              (3,247
              )
              
              
              
              
              (3,070
              )
              
              
              
              
              (2,336
              )Total
                  Loans, Net
              
              $
              439,277
              
              
              
              
              $
              362,635
              
              
              
              
              $
              334,964
              
              
              
              
              $
              274,051
              
              
              
              
              $
              187,311Loans
                  Held For Sale
              
              $
              1,764
              
              
              
              
              $
              3,392
              
              
              
              
              $
              2,253
              
              
              
              
              $
              4,402
              
              
              
              
              $
              8,166






-33-


The
      following are the approximate maturities and sensitivity to change in interest
      rates for the loan portfolio at December 31, 2006.





The
        following are the approximate maturities and sensitivity to change in interest
        rates for the
        loan
        portfolio at December 31, 2006
  Due
                  Within
              
              Due
                  Over
              
              Due
                  Over
              
              Due
                  Over
              
              Due
                  Over(in
                    thousands)
              
              3
                  months
              
              3
                  mos through
              
              12
                  mo
              
              3
                  yrs
              
              5
                  yrs
              
              Due
                  OverFixed
                  Rate Loans
              
              or
                  less
              
              12
                  months
              
              through
                  3 yrs
              
              through
                  5 yrs
              
              through
                  15 yrs
              
              15
                  yrs
              
              TotalCommercial,
                  Financial and Agricultural
              
              $
              1,398
              
              $
              2,611
              
              $
              2,843
              
              $
              5,372
              
              $
              4,026
              
              $
              -
              
              $
              16,250Real
                  Estate- Construction
              
              
              6,948
              
              
              8,944
              
              
              3,961
              
              
              18
              
              
              3,500
              
              
              -
              
              
              23,371Commercial
                  Real Estate
              
              
              1,763
              
              
              139
              
              
              4,564
              
              
              6,108
              
              
              64,638
              
              
              5,010
              
              
              82,222Home
                  Equity Lines of Credit
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Installment
                  Loans to Individuals
              
              
              149
              
              
              116
              
              
              603
              
              
              1,193
              
              
              2,419
              
              
              194
              
              
              4,674All
                  Other Loans (including overdrafts)
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Totals
              
              $
              10,258
              
              $
              11,810
              
              $
              11,971
              
              $
              12,691
              
              $
              74,583
              
              $
              5,204
              
              $
              126,517
  Due
                  Within
              
              Due
                  Over
              
              Due
                  Over
              
              Due
                  Over
              
              Due
                  Over(in
                    thousands)
              
              3
                  months
              
              3
                  mos through
              
              12
                  mo
              
              3
                  yrs
              
              5
                  yrs
              
              Due
                  OverVariable
                  Rate Loans
              
              or
                  less
              
              12
                  months
              
              through
                  3 yrs
              
              through
                  5 yrs
              
              through
                  15 yrs
              
              15
                  yrs
              
              TotalCommercial,
                  Financial and Agricultural
              
              $
              52,780
              
              $
              1,580
              
              $
              9,757
              
              $
              4,609
              
              $
              -
              
              $
              -
              
              $
              68,726Real
                  Estate- Construction
              
              
              79,292
              
              
              -
              
              
              3,049
              
              
              -
              
              
              -
              
              
              -
              
              
              82,341Commercial
                  Real Estate
              
              
              34,189
              
              
              17,805
              
              
              60,934
              
              
              40,906
              
              
              1,345
              
              
              -
              
              
              155,179Home
                  Equity Lines of Credit
              
              
              10,792
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              10,792Installment
                  Loans to Individuals
              
              
              913
              
              
              11
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              924All
                  Other Loans (including overdrafts)
              
              
              504
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              504Totals
              
              $
              178,470
              
              $
              19,396
              
              $
              73,740
              
              $
              45,515
              
              $
              1,345
              
              $
              -
              
              $
              318,466Totals
                  All Loans
              
              $
              188,728
              
              $
              31,206
              
              $
              85,711
              
              $
              58,206
              
              $
              75,928
              
              $
              5,204
              
              $
              444,983




The
      following table sets forth changes from 2005 to 2006 for the loan portfolio
      categories.





(in
                  thousands)
              
              2006
              
              2005
              
              $
                  Variance
              
              %
                  VarianceCommercial,
                  Financial and Agricultural
              
              $
              84,976
              
              $
              60,050
              
              $
              24,926
              
              
              41.51
              %Real
                  Estate- Construction
              
              
              105,712
              
              
              76,981
              
              
              28,731
              
              
              37.32
              %Commercial
                  Real Estate
              
              
              237,401
              
              
              210,690
              
              
              26,711
              
              
              12.68
              %HELOC
              
              
              10,792
              
              
              14,398
              
              
              (3,606
              )
              
              -25.05
              %Installment
                  Loans to Individuals
              
              
              5,598
              
              
              5,620
              
              
              (22
              )
              
              -0.39
              %All
                  Other Loans (including overdrafts)
              
              
              504
              
              
              394
              
              
              110
              
              
              27.92
              %Total
                  Loans, Gross
              
              
              444,983
              
              
              368,133
              
              
              76,850
              
              
              20.88
              %Deferred
                  Loan Fees
              
              
              (1,625
              )
              
              (1,617
              )
              
              (8
              )
              
              0.49
              %Reserve
                  for Possible Loan Losses
              
              
              (4,081
              )
              
              (3,881
              )
              
              (200
              )
              
              5.15
              %Total
                  Loans, Net
              
              $
              439,277
              
              $
              362,635
              
              $
              76,642
              
              
              21.13
              %Loans
                  Held For Sale
              
              $
              1,764
              
              $
              3,392
              
              $
              (1,628
              )
              
              -48.00
              %




The
      increase in commercial, financial and agricultural loans is attributed primarily
      to a $2.7 million new line of credit to a winery, a $5 million line of credit
      to
      a financial services company, an $8 million line of credit to a title company
      (collateralized by securities), a $1.9 million agricultural property loan,
      $3.4
      million to acquire 3 restaurants and numerous other new $.5 to $1.0 million
      business lines of credit to medical groups, contractors and others.





The
      increase in real estate-construction loans can be attributed to several large
      new construction projects and the funding of existing construction projects.
      New
      loans include: a residential tract development for $4.7 million, a strip center
      for $4.0 million, a medical office complex for $6.7 million, an office complex
      for $1.7 million, increases in hotel loans to several clients for $2.9 million
      and $1.2 million, a $1.7 million mixed use property, an office building for
      $1.2
      million, a $1.2 million hotel site land loan, a spec residence for $1.6 million,
      an apartment construction loan increase of $1.8 million, a meat processing
      facility for $1.2 million, a 4 home tract development for $2.2 million, a spec
      residence for $1.2 million, 4 loans on land for tract development of $2.4,
      $1.3,
      $1.2 and $1.2 million, and numerous other smaller projects. Construction loans
      are typically granted for a one year period and then, with income properties,
      are amortized over not more than 30 years with 10 to 15 year maturities.




-34-





The
      increase in commercial real estate loans is attributed to several of the
      construction loans moving into amortizing loans and to new commercial property
      loans. During the period, numerous loans were also refinanced and paid off
      through out of area lenders and mortgage brokers. New loans include a hotel
      for
      $5.4 million, a theatre complex for $7.3 million, restaurant properties for
      $2.6
      million, a medical office for $1.3 million, a gas station for $2.0 million,
      an
      auto dealership for $1.2 million, a RV park for $1.2 million, an office building
      for $1.0 million, a medical office for $1.0 million and several smaller real
      estate loans.




The
      Bank
      presently has a concentration of loans in construction/land in the amount of
      $105.7 million which represents 204% of the Company’s Tier I Capital. Of this,
      60% are owner occupied thus the concentration is 144% net of owner occupied.
      Un-disbursed commitments total $41.8 million which combined with disbursed
      represent 284.6% of the Bank’s Tier I Capital with 81% owner occupied. At
      December 31, 2006 there were 87 construction loans with outstanding balances
      and
      remaining commitments of approximately $81.6 million and $38.4 million,
      respectively. The single largest construction loan has an original commitment
      amount of approximately $12.6 million with a balance of approximately $6.3
      million at December 31, 2006. The loan, an office complex in San Luis Obispo,
      Ca, has since paid down by $5.2 million. At December 31, 2006, there were 54
      land loans with balances of approximately $24.1 million. The single largest
      land
      loan has a balance of approximately $1.7 million and is for a residential
      development. While these loans may be considered somewhat riskier than certain
      other real estate loans, the construction/land loans are spread throughout
      our
      market area and have consistently performed in a satisfactory manner.





Single
      family residence construction loans represent 19.07% of the total construction
      and land loan commitments. Land loans account for 19.33%, tract for 0.12%,
      multiple family income properties for 9.68%, owner occupied commercial
      properties for 28.62% and non-owner occupied commercial properties for 23.18%.





Hotel
      loans disbursed are not considered to be a concentration with balances of $46.4
      million which represents 91.1% of the Bank’s Tier I Capital. There are several
      hotel construction loans that increase total commitments to $68.6 million which
      represents a concentration at 132% of the Bank’s Tier I Capital. At December 31,
      2006, there were 35 motel loans. The single largest loan is a construction
      loan
      for $9.2 million with $4.7 million disbursed, for luxury suite/spa facility
      located in Paso Robles, Ca. The hotel loans are also made to clients throughout
      our market. These loans have also typically paid as agreed.





In
      September 2004, the Bank issued an $11.7 million irrevocable standby letter
      of
      credit to guarantee the payment of Taxable Variable Rate Demand Bonds. The
      primary purpose of the bond issue was to refinance existing debt and provide
      funds for capital improvements and expansion of an assisted living facility
      in
      San Luis Obispo. The project is approximately 100% complete with lease up in
      process. The letter of credit will expire in September 2007.





Construction
      loan demand for both single family and commercial real estate moderated during
      the first quarter of 2006 and then increased during the balance of the year.
      Increased interest rates and construction costs impacted commercial real estate
      activity. Home sales have slowed with builders now offering additional buyer
      incentives and lower prices. However, the area still remains desirable with
      prices considerably lower than the major metropolitan areas to the Company’s
      North and South. Reasonable mortgage rates and financing options such as
      interest only mortgages and 40 year loans have kept many in the market. Because
      the bulk of the Company’s loan portfolio is concentrated in commercial loans, we
      currently do not anticipate the potential slowing of the housing market in
      the
      coming year to have a major impact on our business. The continued availability
      of land for subdivision use also continued to drive the market in the North
      San
      Luis Obispo and Santa Maria markets. Builders are moving to more rural
      communities within our market area in order to construct more affordable homes.





Business
      properties are also in demand with low vacancies and competitive loan rates.
      Commercial property values and rental rates have increased during the year.
      Investors, many seeking exchange properties, continue to seek properties in
      our
      market area. Capitalization rates have steadily decreased with increased demand.
      Capitalization rate (the rate at which a stream of future cash flows is
      discounted to find their present value) ranges over the last three years are:
      6.5% to 7.5% in 2004, 5.5% to 6.5% in 2005, and 5.0% to 6.5% in 2006. Low
      capitalization rate properties typically require larger down payments in order
      to satisfy bank debt coverage requirements. The Bank expects to experience
      continued growth in commercial real estate loans during 2007. Interest rate
      margins are expected to decrease somewhat due to competitive pressures and
      increasing cost of funds.




-35-




Loans
      held for sale consist of mortgage originations that have already been sold
      pursuant to correspondent mortgage loan agreements. There is no interest rate
      risk associated with these loans as the commitments are in place at the time
      that the Bank funds them. Settlement from the correspondents is typically within
      30 to 45 days.





At
      December 31, 2006, the Bank had no foreign loans outstanding. The Bank did
      not
      have any concentrations of loans except as disclosed above.





The
      Bank’s management is responsible for monitoring loan performance, 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 requires regular
      review as well as an internal loan classification process. Annually, the loan
      portfolio is also reviewed by an experienced, outside loan reviewer not
      affiliated with the Bank. A list of delinquencies, the watch list, loan grades
      and the outside loan review are reviewed regularly by the Bank’s Board of
      Directors.





The
      Bank
      has a non-accrual policy that requires a loan greater than 90 days past due
      to
      be placed on non-accrual status unless such loan is well-collateralized and
      in
      the process of collection. When loans are placed on non-accrual status, all
      uncollected interest accrued is reversed from earnings. Once on non-accrual
      status, interest on a loan is only recognized on a cash basis. 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. At
      December 31, 2006 non-accrual loans were $55 thousand.





If
      a
      loan’s credit quality deteriorates to the point that collection of principal is
      believed by management to be doubtful and the value of collateral securing
      the
      obligation is sufficient the Bank generally takes steps to protect and liquidate
      the collateral. Any loss resulting from the difference between the loan balance
      and the fair market value of the property is recognized by a charge to the
      reserve for loan losses. When the property is held for sale after foreclosure,
      it is subject to a periodic appraisal. If the appraisal indicates that the
      property will sell for less than its recorded value, the Bank recognizes the
      loss by a charge to non-interest expense.





In
      mid
      2006, a line of credit to a contractor went into default with the business
      liquidated and a resultant $500,000 charge off was incurred. A small residual
      balance remains with payment expected during 2007. Recovery of any significant
      portion of the charged off amount is not expected.





**Total
      Cash and Due from Banks**





Total
      cash and due from banks were $19.2 million, $18.3 million and $13.1 million
      at
      December 31, 2006, 2005 and 2004, respectively. This line item will vary
      depending on cash letters from the previous night and actual cash on hand in
      the
      branches. In December 2004, the Bank implemented a deposit re-classification
      program that enabled the Bank to reduce reserve requirements with the FRB by
      approximately $15 million.





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




-36-





**COMPOSITION
        OF OTHER EARNING ASSETS**
 (in
        thousands)
  2006
              
              2005
              
              2004Amount
              
              Percent
              
              Amount
              
              Percent
              
              Amount
              
              PercentFederal
                  Home Loan Bank, FRB and other stock
              
              $
              2,350
              
              
              5
              %
              $
              1,885
              
              
              3
              %
              $
              1,809
              
              
              3
              %Available-for-Sale
                  Investments
              
              
              38,445
              
              
              85
              %
              
              44,402
              
              
              61
              %
              
              57,394
              
              
              84
              %Federal
                  Funds Sold
              
              
              3,870
              
              
              9
              %
              
              26,280
              
              
              36
              %
              
              5,775
              
              
              8
              %Interest
                  Bearing Deposits other finanical institutions
              
              
              318
              
              
              1
              %
              
              298
              
              
              0
              %
              
              3,498
              
              
              5
              %Total
                  Other Earning Assets
              
              $
              44,983
              
              
              100
              %
              $
              72,865
              
              
              100
              %
              $
              68,476
              
              
              100
              %





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 Bank’s board of directors on a regular basis.





Securities
      available-for-sale are carried at fair value, with related unrealized net gains
      or losses, net of deferred income taxes, recorded as an adjustment to equity
      capital. As of December 31, 2006, there were net unrealized gains in the
      portfolio of $80 thousand compared to net unrealized losses of $158 thousand
      at
      December 31, 2005. During 2006 the portfolio decreased in size due primarily
      to
      prepayments on mortgage-backed securities. The fair value increased due
      generally to the effect of the inverted yield curve that created relatively
      stagnant long term interest rates in 2006. During 2005, the portfolio decreased
      in fair value due to a rising rate environment for long term investments.





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.





-37-




The
                  amortized cost and fair values of investment securities available
                  for sale
                  at December, 2006:
  Gross
              
              GrossDecember
                  31, 2006
              
              Amortized
              
              Unrealized
              
              Unrealized
              
              Fair(in
                  thousands)
              
              Cost
              
              Gains
              
              Losses
              
              ValueObligations
                  of U.S. government agencies and corporations
              
              $
              205
              
              $
              -
              
              $
              (4
              )
              $
              201Mortgage-backed
                  securities
              
              
              21,969
              
              
              16
              
              
              (381
              )
              
              21,604Obligations
                  of State and Political Subdivisions
              
              
              16,139
              
              
              540
              
              
              (38
              )
              
              16,641Other
                  Securities
              
              
              9
              
              
              -
              
              
              -
              
              
              9Total
              
              $
              38,322
              
              $
              556
              
              $
              (423
              )
              $
              38,455Gross
              
              
              GrossDecember
                  31, 2005
              
              
              Amortized
              
              
              Unrealized
              
              
              Unrealized
              
              
              Fair(in
                    thousands)
              
              
              Cost
              
              
              Gains
              
              
              Losses
              
              
              ValueObligations
                  of U.S. government agencies and corporations
              
              $
              826
              
              $
              -
              
              $
              (20
              )
              $
              806Mortgage-backed
                  securities
              
              
              28,795
              
              
              13
              
              
              (518
              )
              
              28,290Obligations
                  of State and Political Subdivisions
              
              
              15,036
              
              
              364
              
              
              (103
              )
              
              15,297Other
                  Securities
              
              
              9
              
              
              -
              
              
              -
              
              
              9Total
              
              $
              44,666
              
              $
              377
              
              $
              (641
              )
              $
              44,402




The
                  Amortized cost, fair value, and maturites at December 31, 2006
                  are as
                  follows:(in
                  thousands)
  Securities
                  Available-for-Sale
              
              WeightedAmortized
              
              Fair
              
              AverageCost
              
              Value
              
              YieldDue
                  in One Year or Less
              
              $
              517
              
              $
              515
              
              
              1.93
              %Due
                    after One Yearthrough
                    Five Years
              
              
              2,747
              
              
              2,786
              
              
              4.35
              %Due
                    after Five Yearsthrough
                    TenYears
              
              
              6,809
              
              
              7,000
              
              
              4.47
              %Due
                  after TenYears
              
              
              6,280
              
              
              6,550
              
              
              4.64
              %Mortgage-backedSecurities
              
              
              21,969
              
              
              21,604
              
              
              4.31
              %Total
              
              $
              38,322
              
              $
              38,455
              
              
              4.36
              %
  -38-





**Deposits
      and Borrowed Funds**





The
      following table sets forth information for the last three fiscal years regarding
      the composition of deposits at December 31, and the average rates paid on each
      of these categories:




**COMPOSITION
                  OF DEPOSITS**(in
                  thousands)**2006**
              
              **2005**
              
              **2004****Average**
              
              
              
              **Average**
              
              
              
              **Average****Balance**
              
              **Rate
                  Paid**
              
              **Balance**
              
              **Rate
                  Paid**
              
              **Balance**
              
              **Rate
                  Paid**Non-Interest
                  Bearing Demand
              
              $
              153,005
              
              
              0.00
              %
              $
              164,014
              
              
              0.00
              %
              $
              143,455
              
              
              0.00
              %Interest
                  Bearing Demand
              
              
              45,164
              
              
              0.17
              %
              
              50,598
              
              
              0.16
              %
              
              60,256
              
              
              0.05
              %Savings
              
              
              23,406
              
              
              0.40
              %
              
              29,386
              
              
              0.30
              %
              
              36,232
              
              
              0.25
              %Money
                  Market
              
              
              77,540
              
              
              2.70
              %
              
              90,122
              
              
              0.91
              %
              
              69,527
              
              
              0.95
              %Time
                  Deposits
              
              
              121,406
              
              
              4.21
              %
              
              83,677
              
              
              2.74
              %
              
              60,971
              
              
              1.54
              %Total
                  Deposits
              
              $
              420,521
              
              
              1.68
              %
              $
              417,797
              
              
              0.87
              %
              $
              370,441
              
              
              0.48
              %
  Set
                    forth is a maturity schedule of domestic time certificates of
                    deposit of $100,000 and over at December 31,
                    2006:**TIME
                  DEPOSITS $100,000 AND OVER:**(dollars
                  in thousands)
  Less
                  than 3 months
              
              $
              22,9133
                  to
                  12 months
              
              
              6,818Over
                  1 year
              
              
              899Total
              
              $
              30,630





The
      following table sets forth changes from 2006 to 2005 for deposit
      categories.


2006
              
              2005
              
              $
                  Variance
              
              %
                  VarianceNon-Interest
                  Bearing Demand
              
              $
              153,005
              
              $
              164,014
              
              $
              (11,009
              )
              
              -6.71
              %Interest
                  Bearing Demand
              
              
              45,164
              
              
              50,598
              
              
              (5,434
              )
              
              -10.74
              %-Savings
              
              
              23,406
              
              
              29,386
              
              
              (5,980
              )
              
              -20.35
              %-Money
                  Market
              
              
              77,540
              
              
              90,122
              
              
              (12,582
              )
              
              -13.96
              %-Time
                  Deposits
              
              
              121,406
              
              
              83,677
              
              
              37,729
              
              
              45.09
              %Total
                  Deposits
              
              $
              420,521
              
              $
              417,797
              
              $
              2,724
              
              
              0.65
              %





The
      Company has experienced a shift in deposit categories throughout 2006 as lower
      cost funds migrated either internally to higher yielding products (time
      deposits) or to external competitive products. It is common knowledge throughout
      the local financial community that there is a fierce battle for deposit
      maintenance and gathering. One of the most notable initiatives during 2006
      was
      the assessment of our deposit products and the delivery channels of same. The
      entire experience, along with assessment, enhancement and change in many
      delivery channels are the cornerstone to increasing core deposits in 2007.





-39-




Non-interest
      bearing demand deposits were 36.4% of total deposits at December 31, 2006 and
      decreased by approximately $11.0 million or 7% during 2006. The Bank has three
      large deposit relationships that it considers to be volatile. These deposits
      are
      held by long time customers of the Bank that engage in mortgage related
      activities. During 2006, the balances carried by these relationships decreased
      by approximately $8 million at December 31, 2006 compared to December 31, 2005.
      The decrease in mortgage related activity during 2006 had a direct impact on
      the
      deposit balances held by these entities. These volatile account relationships
      are included in the volatile liability dependency report that the Bank produces
      on a monthly basis. Management and the Board of Directors of the Bank are aware
      that as mortgage market conditions change, these relationships are impacted.





Savings,
      NOW and money market deposits were $146.1 million at December 31, 2006 compared
      to $170.1 million at December 31, 2005. This represents a decrease of
      approximately $24.0 million or 14%.





During
      2006, time deposits increased by $37.7 million primarily as a result of
      increasing offering rates related to promotional activities at the Bank.
      Management also believes that depositors have become more sensitive to interest
      rate differentials between various deposit products as interest rates have
      risen
      since mid-2004. As depositors have become more rate sensitive the Bank has
      had
      to raise some offering rates to attract and retain deposits.





During
      2005, time deposits increased by $22.7 million. This increase was a factor
      of a
      rising interest rate environment that started in 2004 and continued throughout
      2005.





Core
      deposits (time deposits less than $100,000, demand, and savings) gathered in
      the
      local communities served by the Company continue to be the primary source of
      funds for loans and investments. Core deposits of $389.9 million represented
      92.7% of total deposits at December 31, 2006 as compared to $400.4 million
      or
      95.8% of total deposits at December 31, 2005. While the Company has a policy
      in
      place that permits Brokered Funds, at December 31, 2006, no action has been
      taken to include these on the balance sheet.





In
      October 2005 the Company renewed a promissory note with Pacific Coast Bankers
      Bank (PCBB) for a revolving line of credit in the amount of $3.5 million. The
      note is revolving in nature for the first two years and 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 December 31, 2006, the Company had a zero balance outstanding on
      this
      loan. The Company pledged 646,598 shares (51%) of the Bank’s stock as collateral
      for the loan. At December 31, 2006, the interest rate on the note was 8.25%
      and
      is variable and moves with prime. Under the terms of the agreement, the Company
      will not incur any additional debt over $2 million exclusive of inter-company
      debt and existing debt without the prior written consent of PCBB. In addition,
      the Bank must be “well” capitalized on an on-going basis as defined by bank
      Regulators. The note was renewed as an additional financing option for the
      Company. The original 2 year note was executed In October 2003 and was
      originally obtained to assist with the cash and capital needs for the
      acquisition of Hacienda.





The
      Bank
      has established borrowing lines with the Federal Home Loan Bank (FHLB). At
      December 31, 2006, the Bank had borrowings with the FHLB of $50 million that
      are
      collateralized by loans. The average rate paid on FHLB borrowings for 2006
      was
      5.25%. In addition, the Bank has an $11.7 million letter of credit secured
      by
      loans. At December 31, 2006, the Bank, under the FHLB programs, has a remaining
      borrowing capacity with existing collateral of approximately $53.3 million
      and
      $9.1 million secured by loans and securities, respectively. The
      Bank
      utilizes securities sold under repurchase agreements as a source of funds.
      The
      Bank had $1.4 million in securities sold under repurchase agreements at December
      31, 2006 compared to $3.8 million and $766 thousand at December 31, 2005 and
      2004 respectively.





**Capital**





The
      Company's total stockholders equity was $49.2 million at December 31, 2006
      compared to $44.8 million and $37.3 million at December 31, 2005 and 2004
      respectively. The change in capital during 2006 was due to net income of $6.7
      million, total cash dividends paid of $2.6 million, stock options exercised
      of
      $712 thousand, stock repurchased of $720 thousand, additional paid in capital
      of
      $336 thousand and an increase in accumulated other comprehensive income of
      $238
      thousand.





On
      April
      10, 2002, the Company issued $8,248,000 of Floating Rate Junior Subordinated
      Deferrable Interest Debentures (the “debt securities”) to Heritage Oaks Capital
      Trust I, a statutory trust created under the laws of the State of Delaware.
      These debt securities are subordinated to effectively all borrowings of the
      Company and are due and payable on April 22, 2032. Interest is payable quarterly
      on these debt securities at 6-Month LIBOR plus 3.7% for an effective rate of
      9.09% as of December 31, 2006. The debt securities can be called at any time
      commencing on April 22, 2007, at par. The debt securities can also be redeemed
      at par if certain events occur that impact the tax treatment, regulatory
      treatment or the capital treatment of the issuance. The Company also purchased
      a
      3% minority interest totaling $248,000 in Heritage Oaks Capital Trust I. The
      balance of the equity of Heritage Oaks Capital Trust I is comprised of mandatory
      redeemable preferred securities and is included in other assets. The Company
      anticipates that this issuance will be called on April 22, 2007 and the funds
      from the October issuance described in the next paragraph will be used to
      satisfy the called obligations.




-40-





On
      October 27, 2006, the Company issued $8,248,000 of Floating Rate Junior
      Subordinated Deferrable Interest Debentures (the “debt securities”) to Heritage
      Oaks Capital Trust II, a statutory trust created under the laws of the State
      of
      Delaware. These debt securities are subordinated to effectively all borrowings
      of the Company and are due and payable on October 27, 2036. Interest is payable
      quarterly on these debt securities at 3-Month LIBOR plus 1.71% for an effective
      rate of 7.10% as of December 31, 2006. The debt securities can be called at
      any
      time commencing on October 27, 2011, at par. The debt securities can also be
      redeemed at par if certain events occur that impact the tax treatment or the
      capital treatment of the issuance. The Company also purchased a 3% minority
      interest totaling $248,000 in Heritage Oaks Capital Trust II. The balance of
      the
      equity of Heritage Oaks Capital Trust II is comprised of mandatory redeemable
      preferred securities and is included in other assets.





Under
      FASB Interpretation (FIN) No. 46, “Consolidation of Variable Interest Entities,
      an interpretation of ARB No. 51,” the Company is not allowed to consolidate
      Heritage Oaks Capital Trust I and II into the Company’s financial statements.
      Prior to the issuance of FIN No. 46, Bank holding companies typically
      consolidated these entities. On February 28, 2005, the Federal Reserve Board
      issued a new rule which provides that, notwithstanding the deconsolidation
      of
      such trusts, junior subordinated debentures, such as those issued by the
      Company, may continue to constitute up to 25% of a bank holding company's Tier
      1
      capital, subject to certain new limitations which will not become effective
      until March 31, 2009 and which, in any event, are not expected to affect the
      treatment of the Company's Junior Subordinated Debentures as Tier 1 capital
      for
      regulatory purposes. As of December 31, 2006, the Company has included $14.35
      million of the net junior subordinated debt in its Tier1 Capital for regulatory
      capital purposes.”





If
      the
      Company elects to defer interest payments pursuant to terms of the agreement,
      then the Company may not (i) declare or pay any dividends or distributions
      on,
      or redeem, purchase, acquire or make a liquidation payment with respect to
      any
      of the Company’s capital stock, or (ii) make any payment of principal of or
      premium, if any, or interest on or repay, repurchase or redeem any debt
      securities of the Company that rank pari passu with or junior in interest to
      the
      Debt Securities, other than, among other items, a dividend in the form of stock,
      warrants, options or other rights in the same stock as that on which the
      dividend is being paid or ranks pari passu with or junior to such stock. The
      prohibition on payment of dividends and payments on pari passu or junior debt
      also applies in the case of an event of default under the
      agreements.




At
      December 31, 2006, the Company had sufficient cash to service the $16.4 million
      in junior subordinated debenture interest payments for approximately six years
      without dividends from subsidiaries. The Bank’s capacity to provide cash to the
      Company, while remaining “well-capitalized”, was approximately $6 million at
      December 31, 2006.





Capital
      ratios for commercial banks in the United States are generally calculated using
      three different formulas. These calculations are referred to as the "Leverage
      Ratio" and two "risk based" calculations known as: "Tier One Risk Based Capital
      Ratio" and the "Total Risk Based Capital Ratio." These standards were developed
      through joint efforts of banking authorities from 12 different countries around
      the world. The standards essentially take into account the fact that different
      types of assets have different levels of risk associated with them. Furthermore,
      they take into account the off-balance sheet exposures of banks when assessing
      capital adequacy.





The
      Leverage Ratio calculation simply divides common stockholders’ equity (reduced
      by any goodwill a bank may have) by the total assets of the Bank. 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" of the Bank. 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.




-41-





Summarized
      below are the Company’s and the Bank’s capital ratios at December 31, 2006.


Minimum
                  Regulatory
              
              Heritage
              
              HeritageCapital
                  Requirements
              
              Oaks
                  Bancorp
              
              Oaks
                  BankLeverage
                  Ratio
              
              
              4.00
              %
              
              11.00
              %
              
              9.89
              %Tier
                  I Risk Weighted
              
              
              4.00
              %
              
              11.51
              %
              
              10.37
              %Total
                  Risk Based
              
              
              8.00
              %
              
              12.36
              %
              
              11.21
              %





For
      the
      Company, approximately $14.4 million of the $16 million of the trust preferred
      securities are accounted for as Tier I Capital, with the remaining $1.6 million
      accounted for as Tier II for purposes of calculating Regulatory
      Capital.





**Liquidity**





The
      objective of liquidity management is to ensure the continuous availability
      of
      funds to meet the demands of depositors, investors and borrowers. Asset
      liquidity is primarily derived from loan payments and the maturity of other
      earning assets. Liquidity from liabilities is obtained primarily from the
      receipt of new deposits. The Bank’s Asset Liability Committee (ALCO) is
      responsible for managing the on-and off-balance sheet commitments to meet the
      needs of customers while achieving the Bank’s financial objectives. ALCO meets
      regularly to assess the projected funding requirements by reviewing historical
      funding patterns, current and forecasted economic conditions and individual
      customer funding needs. Deposits generated from the Bank’s customers serve as
      the primary source of liquidity. The Bank has credit arrangements with
      correspondent banks that serve as a secondary liquidity source. At December
      31,
      2006, these credit lines totaled $13.4 million and the Bank had no borrowings
      against those lines. The Bank is a member of the FHLB and has collateralized
      borrowing capacities remaining of $62.4 million at December 31, 2006.





The
      Bank
      manages liquidity by maintaining a majority of the investment portfolio in
      federal funds sold and other liquid investments. At December 31, 2006, the
      ratio
      of liquid assets not pledged for collateral and other purposes to deposits
      and
      other liabilities was 9.31% compared to 16.05% in 2005. The ratio of net loans
      to deposits (LTD), another key liquidity ratio, was 104.5% at December 31,
      2006
      compared to 86.8% at December 31, 2005 both of which remain within the Bank’s
      policy guidelines. While the Bank still provides the majority of loan funding
      with core deposits, due to the highly competitive nature of deposit gathering
      the Bank has found it necessary to rely on borrowed funds. With the banking
      industry’s common use of alternative funding sources, i.e. FHLB borrowing, in
      2006 the Bank implemented a tracking ratio of Loan-to-Funding (LTF). This ratio
      is calculated by dividing gross loans by the sum of total deposits and
      alternative funding sources both available and used. At December 31, 2006,
      the
      LTF ratio was 84.03%. The Bank’s key focus remains to increase core deposits and
      minimize alternative funding sources.





**Inflation**





The
      assets and liabilities of a financial institution are primarily monetary in
      nature. As such they represent obligations to pay or receive fixed and
      determinable amounts of money that are not affected by future changes in prices.
      Generally, the impact of inflation on a financial institution is reflected
      by
      fluctuations in interest rates, the ability of customers to repay debt and
      upward pressure on operating expenses. The effect on inflation during the
      three-year period ended December 31, 2006 has been significant to the Company’s
      financial position or results of operations in regard to fluctuation in interest
      rates creating changing net interest margins. Inflation has not been a factor
      in
      customers’ ability to repay debt but has been a factor in upward pressure on
      operation expenses.





**Critical
      Accounting Policies and Estimates**





Our
      accounting policies are integral to understanding the results reported.
      Accounting policies are described in detail in Note 1 of the NOTES TO
      CONSOLIDATED FINANCIAL STATEMENTS. Our most complex accounting policies require
      management’s judgment to ascertain the valuation of assets, liabilities,
      commitments and contingencies. We have established detailed policies and control
      procedures that are intended to ensure valuation methods are well controlled
      and
      applied consistently from period to period. In addition, the policies and
      procedures are intended to ensure that the process for changing methodologies
      occurs in an appropriate manner. The following is a brief description of our
      current accounting policies involving significant management valuation
      judgments.




-42-




Allowance
      for Loan and Lease Losses




The
      allowance for loan and lease losses represents management’s best estimate of
      losses inherent in the existing loan portfolio. The allowance for loan and
      lease
      losses is increased by the provision for loan and lease losses charged to
      expense and reduced by loans charged-off, net of recoveries. The allowance
      for
      loan and lease losses is determined based on management’s assessment of several
      factors: reviews and evaluation of individual loans, changes in the nature
      and
      volume of the loan portfolio, current economic conditions and the related impact
      on specific borrowers and industry groups, historical loan loss experiences
      and
      the level of classified and nonperforming loans.




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




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





Securities
      Available for Sale




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




Goodwill
      and Other Intangible Assets




As
      discussed in Note 6 of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, we assess
      goodwill and other intangible assets each year for impairment. This assessment
      involves estimating cash flows for future periods. If the future cash flows
      were
      materially less than the recorded goodwill and other intangible assets balances,
      we would be required to take a charge against earnings to write down the assets
      to the lower value. The Company’s assessment at December 31, 2006 pursuant to
      its Goodwill Impairment Testing Policy resulted in no impairment.




Deferred
      Tax Assets




We
      use an
      estimate of future earnings to support our position that the benefit of our
      deferred tax assets will be realized. If future income should prove nonexistent
      or less than the amount of the deferred tax assets within the tax years to
      which
      they may be applied, the asset may not be realized and our net income will
      be
      reduced. Our deferred tax assets are described further in Note 9 of the NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS.




Supplemental
      Employee Compensation Benefits Agreements




As
      described in Note 12 of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, we
      have
      entered into supplemental employee compensation benefits agreements with certain
      executive and senior officers. The measurement of the liability under these
      agreements includes estimates involving life expectancy, length of time before
      retirement, and expected benefit levels. Should these estimates prove materially
      wrong, we could incur additional or reduced expense to provide the benefits.




**Recent
      Accounting Developments**





In
      July
      2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation
      No. 48, *Accounting
      for Uncertainty in Income Taxes—an interpretation of FASB Statement No.
      109* (FIN 48)
      which clarifies the accounting and disclosure for uncertainty in tax positions,
      as defined. FIN 48 seeks to reduce the diversity in practice associated with
      certain aspects of the recognition and measurement related to accounting for
      income taxes. This interpretation is effective for fiscal years beginning after
      December 15, 2006. The Company is in the process of determining the impact
      this
      interpretation will have on our results from operations or financial position.




-43-





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





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





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





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





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




-44-





In
      February of 2007, the FASB Issued SFAS No. 159, *Establishing
      the Fair Value Option for Financial Assets and Liabilities.* The
      Financial Accounting Standards Board has issued SFAS 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 does
      not expect the adoption of FAS 159 to have a material effect on the Company's
      financial condition.





This
      discussion should be read in conjunction with the consolidated financial
      statements of the Company, including the notes thereto, appearing elsewhere
      in
      this report.





**Off-Balance
      sheet Arrangements, Contractual Obligations and Contingent
      Liabilities**





In
      the
      ordinary course of business, the Company may enter into off-balance sheet
      financial instruments consisting of commitments to extend credit, commercial
      letters of credit, and standby letters of credit. Such financial instruments
      are
      recorded in the financial statement when they are funded or related fees are
      incurred or received.


Less
                  than
              
              One
                  to Three
              
              Three
                  to Five
              
              More
                  than(in
                  thousands)
              
              one
                  year
              
              Years
              
              Years
              
              Five
                  Years
              
              TotalLong
                  Term Debt Obligations
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              16,496
              
              $
              16,496Operating
                  Lease Obligations
              
              
              882
              
              
              1,684
              
              
              1,017
              
              
              205
              
              
              3,788Totals
              
              $
              882
              
              $
              1,684
              
              $
              1,017
              
              $
              16,701
              
              $
              20,284


As
      noted
      in Footnote 10 to the financial statements, the Company is contingently liable
      for letters of credit made to its customers in the ordinary course of business
      totaling $17.7 million at December 31, 2006, up from $17.0 million one year
      earlier. Additionally, the Company has un-disbursed loan commitments, also
      made
      in the ordinary course of business, totaling $166.5 million, which was down
      from
      the $167.7 million outstanding one year earlier. The Company has an allowance
      for losses-unfunded commitments totaling $163 thousand at December 31, 2006,
      to
      cover losses inherent in its letter of credit accommodations and un-disbursed
      loan commitments.





There
      are
      no Special Purpose Entity (“SPE”) trusts, corporations, or other legal entities
      established by the Company which reside off-balance sheet. There are no other
      off-balance sheet items other than the aforementioned items related to letter
      of
      credit accommodations and un-disbursed loan commitments.





As
      noted
      in Footnote 15 to the financial statements, the Company does make loans to
      related parties (directors and officers) in the ordinary course of business
      at
      prevailing rates and terms. These loans totaled $15.5 million and $14.6 million
      at the end of 2006 and 2005, respectively.





**Item
      7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES 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 $16.4 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 Northern Santa Barbara County and San Luis Obispo
      County, California, are subject to risks associated with the local
      economy.




-45-




The
      fundamental objective of the Company’s management of its assets and liabilities
      is to maximize the Company’s economic value while maintaining adequate liquidity
      and an exposure to interest rate risk deemed by Management to be acceptable.
      Management believes an acceptable degree of exposure to interest rate risk
      results from the management of assets and liabilities through maturities,
      pricing and mix to attempt to neutralize the potential impact of changes in
      market interest rates. The Company’s profitability is dependent to a large
      extent upon its net interest income, which is the difference between its
      interest income on interest-earning assets, such as loans and investments,
      and
      its interest expense on interest-bearing liabilities, such as deposits and
      borrowings. The Company is subject to interest rate risk to the degree that
      its
      interest-earning assets re-price differently than its interest-bearing
      liabilities. The Company manages its mix of assets and liabilities with the
      goals of limiting its exposure to interest rate risk, ensuring adequate
      liquidity, and coordinating its sources and uses of funds.




The
      Company seeks to control interest rate risk exposure in a manner that will
      allow
      for adequate levels of earnings and capital over a range of possible interest
      rate environments. The Company has adopted formal policies and practices to
      monitor and manage interest rate risk exposure.  Management believes
      historically it has effectively managed the effect of changes in interest rates
      on its operating results.  Management believes that it can continue to
      manage the short-term effect of interest rate changes under various interest
      rate scenarios.




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




The
      hypothetical impacts of sudden interest rate movements applied to the Company’s
      asset and liability balances are modeled monthly. The results of this movement
      indicate how much of the Company’s net interest income is “at risk” from various
      rate changes over a one year horizon. This exercise is valuable in identifying
      risk exposures. The results for the Company’s December 31, 2006 balances
      indicate that the net interest income at risk over a one year time horizon
      for a
      1% and 2% rate increase and decrease are within the Company’s policy guidelines
      for such changes.


December
                  31, 2006
              
              Shock
                  Rate Scenarios(dollars
                  in Thousands)
              
              -200bp
              
              -100bp
              
              Base
              
              +100bp
              
              +200bpNet
                  Interest Income (NII)
              
              $
              25,819
              
              $
              26,788
              
              $
              27,859
              
              $
              28,766
              
              $
              29,677$
                  Change from Base
              
              $
              (2,040
              )
              $
              (1,070
              )
              $
              -
              
              $
              907
              
              $
              1,818%
                  Change from Base
              
              
              -7.32
              %
              
              -3.84
              %
              
              0.00
              %
              
              3.26
              %
              
              6.53
              %





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.





-46-





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


(dollars
                  in Thousands)%
                  ofGross
                  Loans
              
              Balance
              
              TotalVariable-Daily
              
              $
              179,542
              
              
              40
              %Variable-Other
                  than daily
              
              
              198,509
              
              
              45
              %Fixed
              
              
              66,933
              
              
              15
              %Total
                  Gross Loans
              
              $
              444,983
              
              
              100
              %%
                  ofGross
                    LoansRe-Pricing
              
              
              Balance
              
              
              Total<
                  1 Year
              
              $
              265,501
              
              
              60
              %1-3
                  Years
              
              
              97,910
              
              
              22
              %3-5
                  Years
              
              
              58,115
              
              
              13
              %>
                  5 Years
              
              
              23,457
              
              
              5
              %$
              444,983
              
              
              100
              %Non-performing
                  Loans
              
              $
              55%
                  Gross Loans
              
              
              0.01
              %





The
      table
      above identifies approximately 40% of the loan portfolio that will re-price
      immediately in a changing rate environment.





The
      Company also attempts to quantify the impact of interest rate changes on
      borrowers’ ability to pay on loans and the impact of similar rate changes on the
      value of collateral held against loans. To this end, the Company, from time
      to
      time, will sample loans and analyze them under a rate shock scenario to
      specifically assess the impact of the rate shock on financial ratios such as
      interest rate coverage and loan-to-value. The results of the analysis have
      generally revealed that in the case of such a rate shock, a high percentage
      of
      loans tested would continue to express ratios within current underwriting
      guidelines. The results of these analyses are considered
      acceptable by management.





-47-




**ITEM
      8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.**







**HERITAGE
      OAKS BANCORP AND SUBSIDIARIES**





**DECEMBER
      31, 2006, 2005, AND 2004**




**Contents**


**Financial
                  Statements**Report
                  of Independent Registered Public Accounting Firm
              
              49Management’s
                  Report on Internal Control Over Financial Reporting
              
              51Consolidated
                  Balance Sheets December 31, 2006 and 2005
              
              52Consolidated
                  Statements of Income For the Years Ended December 31, 2006, 2005,
                  and
                  2004
              
              53Consolidated
                  Statement of Changes in Stockholders' Equity For the Years Ended
                  December
                  31, 2006, 2005, and 2004
              
              54Consolidated
                  Statements of Cash Flows For the Years Ended December 31, 2006,
                  2005, and
                  2004
              
              55**Notes
                  to Consolidated Financial Statements**
              
              57
  -48-




**Report
      of Independent Registered Public Accounting Firm**





Board
      of
      Directors


Heritage
      Oaks Bancorp


Paso
      Robles, California





We
      have
      audited the accompanying consolidated balance sheets of Heritage Oaks Bancorp
      and Subsidiaries (the “Company”) as of December 31, 2006 and 2005, and the
      related consolidated statements of income, changes in stockholders' equity
      and
      cash flows for each of the three years in the period ended December 31, 2006.
      These consolidated financial statements are the responsibility of the Company’s
      management. Our responsibility is to express an opinion on these consolidated
      financial statements based on our audits.





We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. An audit includes examining,
      on a
      test basis, evidence supporting the amounts and disclosures in the financial
      statements. An audit also includes assessing the accounting principles used
      and
      significant estimates made by management, as well as evaluating the overall
      financial statement presentation. We believe that our audits provide a
      reasonable basis for our opinion.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the financial position of Heritage Oaks Bancorp and
      Subsidiaries as of December 31, 2006 and 2005, and the results of its
      operations, changes in its stockholders' equity, and its cash flows for each
      of
      the three years in the period ended December 31, 2006, in conformity with U.S.
      generally accepted accounting principles.





We
      have
      also audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the effectiveness of Heritage Oaks Bancorp
      and
      Subsidiaries internal control over financial reporting as of December 31, 2006,
      based on criteria established in Internal Control - Integrated Framework issued
      by the Committee of Sponsoring Organizations of the Treadway Commission and
      our
      report dated March 1, 2007 expressed an unqualified opinion
      thereon.








/s/
      Vavrinek, Trine, Day & Co., LLP


Rancho
      Cucamonga, California


March
      1,
      2007




-49-




**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**





Board
      of
      Directors and Stockholders


Heritage
      Oaks Bancorp and Subsidiary


Paso
      Robles, California





We
      have
      audited management’s assessment, included in the accompanying Report of
      Management, that Heritage Oaks Bancorp and Subsidiary (the “Company”) maintained
      effective internal control over financial reporting as of December 31, 2006,
      based on criteria established in Internal Control - Integrated Framework issued
      by the Committee of Sponsoring Organizations of the Treadway Commission
      (COSO).





The
      Company’s management is responsible for maintaining effective internal control
      over financial reporting and for its assessment of the effectiveness of internal
      control over financial reporting. Our responsibility is to express an opinion
      on
      management’s assessment and an opinion on the effectiveness of the Company’s
      internal control over financial reporting based on our audit.





We
      conducted our audit in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether effective
      internal control over financial reporting was maintained in all material
      respects. Our audit included obtaining an understanding of internal control
      over
      financial reporting, evaluating management’s assessment, testing and evaluating
      the design and operating effectiveness of internal control, and performing
      such
      other procedures as we considered necessary in the circumstances. We believe
      that our audit provides a reasonable basis for our opinion.





A
      company’s internal control over financial reporting is a process designed to
      provide reasonable assurance regarding the reliability of financial reporting
      and the preparation of financial statements for external purposes in conformity
      with U.S. generally accepted accounting principles.





A
      company’s internal control over financial reporting includes those policies and
      procedures that (1) pertain to the maintenance of records that, in reasonable
      detail, accurately and fairly reflect the transactions and dispositions of
      the
      assets of the company; (2) provide reasonable assurance that transactions are
      recorded as necessary to permit preparation of financial statements in
      accordance with U.S. generally accepted accounting principles, and the receipts
      and expenditures of the company are being made only in accordance with
      authorizations of management and directors of the company; and (3) provide
      reasonable assurance regarding prevention or timely detection of unauthorized
      acquisition, use, or disposition of the company’s assets that could have a
      material effect on the financial statements.





Because
      of its inherent limitations, internal control over financial reporting may
      not
      prevent or detect misstatements. Also, projections of any evaluation of
      effectiveness to future periods are subject to the risk that controls may become
      inadequate because of changes in conditions, or that the degree of compliance
      with the policies or procedures may deteriorate.





In
      our
      opinion, management’s assessment that Heritage Oaks Bancorp and Subsidiary
      maintained effective internal control over financial reporting as of December
      31, 2006, is fairly stated, in all material respects, based on criteria
      established in Internal Control - Integrated Framework issued by the Committee
      of Sponsoring Organizations of the Treadway Commission (COSO). Also in our
      opinion, the Company maintained, in all material respects, effective internal
      control over financial reporting as of December 31, 2006, based on criteria
      established in Internal Control - Integrated Framework issued by the Committee
      of Sponsoring Organizations of the Treadway Commission (COSO).





We
      have
      also audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the consolidated balance sheets as of December
      31, 2006 and 2005, and the related consolidated statements of income,
      stockholders equity and cash flows for each of the three years in the period
      ended December 31, 2006 and our report dated March 1, 2007 expressed an
      unqualified opinion.




/s/
      Vavrinek, Trine, Day & Co., LLP


Rancho
      Cucamonga, California


March
      1,
      2007




-50-




**Management’s
      Report on Internal Control Over Financial Reporting**




The
      management of the Company is responsible for establishing and maintaining
      adequate internal control over financial reporting. The Company’s internal
      control over financial reporting is a process designed under the supervision
      of
      the Company’s Chief Executive Officer and Chief Financial Officer to provide
      reasonable assurance regarding the reliability of financial reporting and the
      preparation of the Company’s financial statements for external purposes in
      accordance with U.S. generally accepted accounting principles.




As
      of
      December 31, 2006, management assessed the effectiveness of the Company’s
      internal control over financial reporting based on the criteria for effective
      internal control over financial reporting established in *Internal
      Control—Integrated Framework issued by the Committee of Sponsoring Organizations
      of the Treadway Commission* (COSO).
      Based on the assessment, management determined that the Company maintained
      effective internal control over financial reporting as of December 31,
      2006, based on those criteria.




Vavrinek,
      Trine, Day & Co., LLP, the independent registered public accounting firm
      that audited the consolidated financial statements of the Company included
      in
      this Annual Report on Form 10-K, has issued an attestation report on
      management’s assessment of the Company’s internal control over financial
      reporting as of December 31, 2006. The report, which expresses unqualified
      opinions on management’s assessment and on the effectiveness of the Company’s
      internal control over financial reporting as of December 31, 2006, is
      included below under the heading “Report of Independent Registered Public
      Accounting Firm.”




The
      Company’s management, including its Chief Executive Officer and Chief Financial
      Officer, does not expect that its disclosure controls and procedures, or its
      internal controls will prevent all error and all fraud. A control system, no
      matter how well conceived and operated, can provide only reasonable, not
      absolute, assurance that the objectives of the control system are met. Further,
      the design of a control system must reflect the fact that there are resource
      constraints, and the benefit of controls must be considered relative to their
      costs. Because of the inherent limitations in all control systems, no evaluation
      of controls can provide absolute assurance that all control issues and instances
      of fraud, if any, within the Company have been detected.





/s/ Lawrence
                P. Ward
            
            /s/ Margaret
                A. Torres**Lawrence
                P. Ward**
              **Chief
                Executive Officer**
            
            **Margaret
                A. Torres**
              **Executive
                Vice President, Chief Financial
                Officer**





-51-




**HERITAGE
      OAKS BANCORP AND SUBSIDIARIES**


**CONSOLIDATED
      BALANCE SHEETS**


**DECEMBER
      31, 2006 AND 2005**


**(Dollars
      in thousands, except per share amounts)**


2006
              
              2005**Assets**Cash
                  and due from banks
              
              $
              19,164
              
              $
              18,279Federal
                  funds sold
              
              
              3,870
              
              
              26,280Total
                  Cash and Cash Equivalents
              
              
              23,034
              
              
              44,559Interest-bearing
                  deposits in other financial institutions
              
              
              318
              
              
              298Investment
                  securities, available-for-sale
              
              
              38,445
              
              
              44,402Federal
                  Home Loan Bank and Federal Reserve Bank Stock, at cost
              
              
              2,350
              
              
              1,885Loans
                  held for sale
              
              
              1,764
              
              
              3,392Loans,
                  net of deferred fees of $1,625 and $1,617 and allowance
                  forloan
                  loss of $4,081 and $3,881 at December 31, 2006and
                  2005, respectively
              
              
              439,277
              
              
              362,635Property
                  premises and equipment, net
              
              
              14,581
              
              
              11,905Net
                  deferred tax asset
              
              
              2,414
              
              
              2,358Cash
                  surrender value of life insurance
              
              
              9,435
              
              
              7,706Goodwill
              
              
              4,865
              
              
              4,865Intangible
                  assets
              
              
              1,148
              
              
              1,448Other
                  assets
              
              
              4,143
              
              
              3,048Total
                  Assets
              
              $
              541,774
              
              $
              488,501**Liabilities
                  and Stockholders' Equity**LiabilitiesDepositsDemand
                  non-interest bearing
              
              $
              153,005
              
              $
              164,014Savings,
                  NOW and money market deposits
              
              
              146,110
              
              
              170,106Time
                  deposits of $100 or more
              
              
              30,630
              
              
              17,414Time
                  deposits under $100
              
              
              90,776
              
              
              66,263Total
                  Deposits
              
              
              420,521
              
              
              417,797FHLB
                  advances and other borrowings
              
              
              50,000
              
              
              10,000Securities
                  sold under agreement to repurchase
              
              
              1,364
              
              
              3,847Junior
                  subordinated debentures
              
              
              16,496
              
              
              8,248Other
                  liabilities
              
              
              3,921
              
              
              3,764Total
                  Liabilities
              
              
              492,302
              
              
              443,656COMMITMENTS
                  AND CONTINGENCIES (Notes #5 and #10)
              
              
              -
              
              
              -Stockholders'
                  EquityCommon
                  stock, no par value; 20,000,000 shares authorized;6,345,639
                  and 6,231,982 shares issued andoutstanding
                  for 2006 and 2005, respectively
              
              
              29,247
              
              
              29,255Additional
                  paid in capital
              
              
              336
              
              
              -Retained
                  earnings
              
              
              19,809
              
              
              15,748Accumulated
                  other comprehensive income/(loss),net
                  of taxes of $96 in 2006 and $204 in 2005
              
              
              80
              
              
              (158
              )Total
                  Stockholders' Equity
              
              
              49,472
              
              
              44,845Total
                  Liabilities and Stockholders' Equity
              
              $
              541,774
              
              $
              488,501





-52-




**HERITAGE
      OAKS BANCORP AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF INCOME**


**FOR
      THE YEARS ENDED DECEMBER 31, 2006, 2005, AND 2004**


**(Dollars
      in thousands, except per share amounts)**


2006
              
              2005
              
              2004**Interest
                  Income**Interest
                  and fees on loans
              
              $
              33,897
              
              $
              27,399
              
              $
              20,615Interest
                  on Investment SecuritiesObligations
                  of U.S. Government Agencies
              
              
              1,083
              
              
              1,389
              
              
              1,767Obligations
                  of State and Political Subdivisions
              
              
              702
              
              
              593
              
              
              506Interest
                  on time deposits with other banks
              
              
              9
              
              
              9
              
              
              11Interest
                  on Federal funds sold
              
              
              539
              
              
              667
              
              
              302Interest
                  on other securities
              
              
              142
              
              
              118
              
              
              112Total
                  Interest Income
              
              
              36,372
              
              
              30,175
              
              
              23,313**Interest
                  Expense**Interest
                  on savings, NOW and money market deposits
              
              
              2,497
              
              
              1,695
              
              
              699Interest
                  on time deposits in denominations of$100
                  or more
              
              
              626
              
              
              413
              
              
              118Interest
                  on time deposits under $100
              
              
              3,845
              
              
              1,371
              
              
              953Other
                  borrowings
              
              
              2,348
              
              
              1,537
              
              
              1,591Total
                  Interest Expense
              
              
              9,316
              
              
              5,016
              
              
              3,361Net
                  interest income before provision forpossible
                  loan losses
              
              
              27,056
              
              
              25,159
              
              
              19,952Provision
                  for Possible Loan Losses
              
              
              600
              
              
              710
              
              
              41026,456
              
              
              24,449
              
              
              19,542**Noninterest
                  Income**Fees
                  and service charges
              
              
              2,427
              
              
              2,430
              
              
              2,173Investment
                  securities gain/(loss), net
              
              
              9
              
              
              -
              
              
              28Gain
                  on sale of SBA loans, net
              
              
              19
              
              
              84
              
              
              45Gain/(loss)
                  on sale of premise, net
              
              
              (38
              )
              
              4
              
              
              712Other
              
              
              2,535
              
              
              2,491
              
              
              2,041Total
                  Noninterest Income
              
              
              4,952
              
              
              5,009
              
              
              4,999**Noninterest
                  Expenses**Salaries
                  and employee benefits
              
              
              11,573
              
              
              9,746
              
              
              8,457Equipment
                  expenses
              
              
              868
              
              
              824
              
              
              929Occupancy
                  expenses
              
              
              1,739
              
              
              1,667
              
              
              1,640Other
                  expenses
              
              
              6,775
              
              
              6,481
              
              
              6,172Total
                  Noninterest Expenses
              
              
              20,955
              
              
              18,718
              
              
              17,198Income
                  Before Provision for Income Taxes
              
              
              10,453
              
              
              10,740
              
              
              7,343Provision
                  for Income Taxes
              
              
              3,791
              
              
              4,103
              
              
              2,759Net
                  Income
              
              $
              6,662
              
              $
              6,637
              
              $
              4,584Earnings
                  Per ShareBasic
              
              $
              1.05
              
              $
              1.08
              
              $
              0.77Diluted
              
              $
              1.01
              
              $
              1.01
              
              $
              0.71





-53-





**HERITAGE
      OAKS BANCORP AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY**


**FOR
      YEARS ENDED DECEMBER 31, 2006, 2005, AND 2004**


**(Dollars
      in thousands, except per share amounts)**


AccumulatedCommon
                  Stock
              
              Additional
              
              
              
              
              
              Other
              
              TotalNumber
                  of
              
              
              
              Paid-In
              
              Comprehensive
              
              Retained
              
              Comprehensive
              
              Stockholders'Shares
              
              Amount
              
              Capital
              
              Income
              
              Earnings
              
              Income/(loss)
              
              Equity**Balance,
                  January 1, 2004**
              
              
              3,604,497
              
              $
              20,649
              
              $
              -
              
              
              
              
              $
              11,541
              
              $
              98
              
              $
              32,288Exercise
                  of stock options
              
              
              33,625
              
              
              335
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              335(including
                  $136 tax benefit from exerciseof
                  stock options)Cash
                  paid to stockholders in lieu offractional
                  shares on 5% stock dividend
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (6
              )
              
              
              
              
              (6
              )5%
                  stock dividend
              
              
              179,821
              
              
              3,066
              
              
              
              
              
              
              
              
              (3,066
              )
              
              
              
              
              -Comprehensive
                  incomeNet
                  income
              
              
              
              
              
              
              
              
              
              
              $
              4,584
              
              
              4,584
              
              
              
              
              
              4,584Unrealized
                  security holding gains(net
                  of $44 tax)
              
              
              
              
              
              
              
              
              
              
              
              66
              
              
              
              
              
              66
              
              
              66Less
                  reclassification adjustmentsfor
                  gains (net of $11 tax)
              
              
              
              
              
              
              
              
              
              
              
              (17
              )
              
              
              
              
              (17
              )
              
              (17
              )Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              $
              4,633**Balance,
                  December 31, 2004**
              
              
              3,817,943
              
              
              24,050
              
              
              -
              
              
              
              
              
              13,053
              
              
              147
              
              
              37,250Exercise
                  of stock options
              
              
              144,674
              
              
              1,275
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,275(including
                  $588 tax benefit from exerciseof
                  stock options)Cash
                  paid to stockholders in lieu offractional
                  shares on 5% stock dividend
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (7
              )
              
              
              
              
              (7
              )5%
                  stock dividend
              
              
              195,013
              
              
              3,930
              
              
              
              
              
              
              
              
              (3,930
              )
              
              
              
              
              -3
                  for 2 stock split
              
              
              2,074,352Cash
                  paid to stockholders in lieu offractional
                  shares on 3 for 2 stock split
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (5
              )
              
              
              
              
              (5
              )Comprehensive
                  incomeNet
                  income
              
              
              
              
              
              
              
              
              
              
              $
              6,637
              
              
              6,637
              
              
              
              
              
              6,637Unrealized
                  security holding losses(net
                  of $204 tax)
              
              
              
              
              
              
              
              
              
              
              
              (305
              )
              
              
              
              
              (305
              )
              
              (305
              )Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              $
              6,332**Balance,
                  December 31, 2005**
              
              
              6,231,982
              
              
              29,255
              
              
              -
              
              
              
              
              
              15,748
              
              
              (158
              )
              
              44,845Exercise
                  of stock options
              
              
              87,607
              
              
              712
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              712(including
                  $365 tax benefit from exerciseof
                  stock options)Cash
                  dividends paid in 2006
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (2,601
              )
              
              
              
              
              (2,601
              )Share-based
                  compensation expense
              
              
              
              
              
              -
              
              
              336
              
              
              
              
              
              
              
              
              
              
              
              336Issuance
                  of Restricted Stock Awards
              
              
              66,050Stock
                  Repurchased
              
              
              (40,000
              )
              
              (720
              )
              
              
              
              
              
              
              
              
              
              
              
              
              
              (720
              )Comprehensive
                  incomeNet
                  income
              
              
              
              
              
              
              
              
              
              
              $
              6,662
              
              
              6,662
              
              
              
              
              
              6,662Unrealized
                  security holding gains(net
                  of $92 tax)
              
              
              
              
              
              
              
              
              
              
              
              233
              
              
              
              
              
              233
              
              
              233Less
                  reclassification adjustmentsfor
                  gains (net of $4 tax)
              
              
              
              
              
              
              
              
              
              
              
              5
              
              
              
              
              
              5
              
              
              5Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              $
              6,900**Balance,
                  December 31, 2006**
              
              
              6,345,639
              
              $
              29,247
              
              $
              336
              
              
              
              
              $
              19,809
              
              $
              80
              
              $
              49,472
  -54-





**HERITAGE
      OAKS BANCORP AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


**FOR
      THE YEARS DECEMBER 31, 2006, 2005, AND 2004**


**(Dollars
      in thousands, except per share amounts)**


2006
              
              2005
              
              2004**Cash
                  Flows from Operating Activities**Net
                  income
              
              $
              6,662
              
              $
              6,637
              
              $
              4,584Adjustments
                  to reconcile net income tonet
                  cash provided by operating activitiesNet
                  cash provided by operating activitiesDepreciation
                  and amortization
              
              
              958
              
              
              897
              
              
              949Provision
                  for possible loan losses
              
              
              600
              
              
              710
              
              
              410Provision
                  for possible losses on unfundedloan
                  commitments
              
              
              -
              
              
              10
              
              
              25Realized
                  gain on sales of available-for-salesecurities,
                  net
              
              
              (9
              )
              
              -
              
              
              (28
              )Amortization
                  of premiums/discounts oninvestment
                  securities, net
              
              
              (17
              )
              
              184
              
              
              407Amortization
                  of core deposit intangibles
              
              
              300
              
              
              573
              
              
              421Share-based
                  compensation expense
              
              
              336
              
              
              -
              
              
              -Gain/(loss)
                  on sale of property, premises and equipment, net
              
              
              38
              
              
              (4
              )
              
              (712
              )Net
                  change in loans held for sale
              
              
              1,628
              
              
              (1,139
              )
              
              2,149Net
                  increase in cash surrender value of life insurance
              
              
              (343
              )
              
              (276
              )
              
              (271
              )FHLB
                  Dividends received
              
              
              (97
              )
              
              (76
              )
              
              (72
              )Decrease/(Increase)
                  in deferred tax asset
              
              
              (220
              )
              
              (236
              )
              
              20Decrease/(Increase)
                  in other assets
              
              
              (727
              )
              
              (119
              )
              
              183Increase/(decrease)
                  in other liabilities
              
              
              158
              
              
              672
              
              
              269Excess
                  tax benefit from share-based payment arrangements
              
              
              (365
              )
              
              -
              
              
              -**NET
                  CASH PROVIDED BY OPERATING ACTIVITIES**
              
              
              8,902
              
              
              7,833
              
              
              8,334**Cash
                  Flows From Investing Activities**Purchase
                  of securities available-for-sale
              
              
              (1,190
              )
              
              (2,588
              )
              
              (3,012
              )Purchase
                  of mortgage-backed securities available-for-sale
              
              
              -
              
              
              -
              
              
              (17,295
              )Net
                  redemption (purchase) of Federal Home Loan Bank and
                  FederalReserve
                  Bank stock
              
              
              -
              
              
              -
              
              
              222Proceeds
                  from sales of mortgage-backed securities
              
              
              -
              
              
              -
              
              
              1,534Proceeds
                  from principal reductions and maturitiesof
                  securities available-for-sale
              
              
              500
              
              
              1,350
              
              
              1,315Proceeds
                  from principal reductions and maturities ofmortgage-backed
                  securities
              
              
              7,071
              
              
              13,537
              
              
              14,723Net
                  change in interest-bearing deposits inother
                  financial institutions
              
              
              (20
              )
              
              200
              
              
              -Purchase
                  of FHLB stock
              
              
              (368
              )
              
              -
              
              
              -Purchase
                  of life insurance policies
              
              
              (1,386
              )
              
              (300
              )
              
              -Recoveries
                  on loans
              
              
              161
              
              
              25
              
              
              3Increase
                  in loans, net
              
              
              (77,403
              )
              
              (28,406
              )
              
              (61,326
              )Proceeds
                  from sale of property, premises and equipment
              
              
              -
              
              
              900
              
              
              900Purchase
                  of property, premises and equipment, net
              
              
              (3,672
              )
              
              (3,059
              )
              
              (1,646
              )**NET
                  CASH USED IN INVESTING ACTIVITIES**
              
              
              (76,307
              )
              
              (18,341
              )
              
              (64,582
              )
  -55-


**HERITAGE
      OAKS BANCORP AND SUBSIDIARIES**


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


**FOR
      THE YEARS DECEMBER 31, 2006, 2005, AND 2004**


**(Dollars
      in thousands, except per share amounts)**


2006
              
              2005
              
              2004**Cash
                  Flows From Financing Activities**Increase
                  in deposits, net
              
              $
              2,724
              
              $
              47,356
              
              $
              4,002Net
                  increase/(decrease) in FHLB borrowings
              
              
              40,000
              
              
              (18,500
              )
              
              -Net
                  (decrease)/increase in notes payable
              
              
              -
              
              
              -
              
              
              (3,500
              )Proceeds
                  from issuance of junior subordinated debentures
              
              
              8,248
              
              
              -
              
              
              -Net
                  increase in securities sold under agreement to repurchase
              
              
              (2,483
              )
              
              3,081
              
              
              306Proceeds
                  from exercise of stock options
              
              
              347
              
              
              1,275
              
              
              199Excess
                  tax benefit from share-based payment arrangements
              
              
              365
              
              
              -
              
              
              -Cash
                  paid for stock repurchase
              
              
              (720
              )
              
              -
              
              
              -Cash
                  dividends paid
              
              
              (2,601
              )
              
              -
              
              
              -Cash
                  paid in lieu of fractional shares
              
              
              -
              
              
              (12
              )
              
              (6
              )**NET
                  CASH PROVIDED BY FINANCING ACTIVITIES**
              
              
              45,880
              
              
              33,200
              
              
              1,001**Net
                  Increase/(Decrease) in Cash and Cash Equivalents**
              
              
              (21,525
              )
              
              22,692
              
              
              (55,247
              )**Cash
                  and Cash Equivalents**,
                  Beginning of year
              
              
              44,559
              
              
              21,867
              
              
              77,114**Cash
                  and Cash Equivalents**,
                  End of year
              
              $
              23,034
              
              $
              44,559
              
              $
              21,8672006
              
              
              2005
              
              
              2004**Supplemental
                  Disclosures of Cash Flow Information**Interest
                  paid
              
              $
              8,976
              
              $
              4,912
              
              $
              3,453Income
                  taxes paid
              
              $
              3,670
              
              $
              3,825
              
              $
              2,575**Supplemental
                  Disclosures of Non-Cash Flow Information**Change
                  in other valuation allowance for investment securities
              
              $
              163
              
              $
              (509
              )
              $
              82Tax
                  benefit of stock options exercised
              
              $
              365
              
              $
              588
              
              $
              136
  -56-


**HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2006, 2005, AND 2004**
 **(Dollars
          in thousands, except per share amounts)**
  **Note
        #1 - Summary of Significant Accounting Policies**
 
 The
        accounting and reporting policies of Heritage Oaks Bancorp (the Company)
        and
        subsidiaries conform to accounting principles generally accepted in the United
        States of America and to general practices within the banking industry. A
        summary of the Company's significant accounting and reporting policies
        consistently applied in the preparation of the accompanying financial statements
        follows:
 
 Principles
        of Consolidation
 
 The
        consolidated financial statements include the Company and its wholly owned
        subsidiaries, Heritage Oaks Bank, (the “Bank”) and CCMS Systems, Inc.
        Inter-company balances and transactions have been eliminated.
  Nature
        of Operations
 
 The
        Company has been organized as a single operating segment. The Bank operates
        eleven branches within San Luis Obispo and Northern Santa Barbara counties.
        The
        Bank offers traditional banking products such as checking, savings and
        certificates of deposit, as well as mortgage loans and commercial and consumer
        loans to customers who are predominately small to medium-sized businesses
        and
        individuals.
 
 Investment
        in Non-Consolidated Subsidiary
 
 The
        Company accounts for its investments in its wholly owned special purpose
        entities, Heritage Oaks Capital Trust I (the “Trust I”) and Heritage Oaks
        Capital Trust II (the “Trust II”), using the equity method under which the
        subsidiary’s net earnings are recognized in the Company’s statements of income.
 
 Use
        of
        Estimates in the Preparation of Financial Statements
 
 The
        preparation of financial statements in conformity with accounting principles
        generally accepted in the United States of America requires management to
        make
        estimates and assumptions that affect the reported amounts of assets and
        liabilities and disclosure of contingent assets and liabilities at the date
        of
        the financial statements and the reported amounts of revenues and expenses
        during the reporting period. Actual results could differ from those
        estimates.
 
 Estimates
        that are particularly susceptible to significant change relate to the
        determination of the allowance for loan losses on loans and the valuation
        of
        real estate acquired in connection with foreclosures or in satisfaction of
        loans. In connection with the determination of the allowances for losses
        on
        loans and foreclosed real estate, management obtains independent appraisals
        for
        significant properties.
 
 While
        management uses available information to recognize losses on loans and
        foreclosed real estate, future additions to the allowances may be necessary
        based on changes in local economic conditions. In addition, regulatory agencies,
        as an integral part of their examination process, periodically review the
        Company’s allowances for losses on loans and foreclosed real estate. Such
        agencies may require the Company to recognize additions to the allowances
        based
        on their judgments about information available to them at the time of their
        examination. Because of these factors, it is reasonably possible that the
        allowances for losses on loans and foreclosed real estate may
        change.
  -57-
 **HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2006, 2005, AND 2004**
 **(Dollars
          in thousands, except per share amounts)**
 **Note
        #1 - Summary of Significant Accounting Policies** , **Continued**
 
 Cash
        and Due From Banks
 
 Banking
        regulations require that all banks maintain a percentage of their deposits
        as
        reserves in cash or on deposit with the Federal Reserve Bank. The Banks complied
        with the reserve requirements as of December 31, 2006.
 
 The
        Company maintains amounts due from banks that exceed federally insured limits.
        The Company has not experienced any losses in such accounts.
 
 Cash
        and Cash Equivalents
 
 For
        purposes of reporting cash flows, cash and cash equivalents include cash,
        due
        from banks, federal funds sold and money market funds. Generally, federal
        funds
        are sold for one-day periods.
 
 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, equity,
        and mortgage-backed securities that the Company has the positive intent and
        ability to hold to maturity are classified as held-to-maturity and are measured
        at amortized cost; debt and equity securities bought and held principally
        for
        the purpose of selling in the near term are classified as trading securities
        and
        are measured at fair value, with unrealized gains and losses included in
        earnings; debt and equity securities not classified as either held-to-maturity
        or trading securities are deemed as available-for-sale and are measured at
        fair
        value, with unrealized gains and losses, net of applicable taxes, reported
        in a
        separate component of stockholders' equity. Gains or losses on sales of
        investment securities are determined on the specific identification method.
        Premiums and discounts are amortized or accreted using the interest method
        over
        the expected lives of the related securities.
 
 Declines
        in the fair values of individual held-to-maturity and available-for-sale
        securities below their cost that are other than temporary result in write-downs
        of individual securities to their fair value. The related write-downs are
        included in earnings as realized losses. In estimating other-than-temporary
        impairment losses, management considers (1) the length of time and the extent
        to
        which the fair value has been less than cost, (2) the financial condition
        and
        near-term prospects of the issuer, and (3) the intent and ability of the
        Company
        to retain its investment in the issuer for a period of time sufficient to
        allow
        for any anticipated recover in fair value.
  Loans
        and Interest on Loans
 
 Loans
        receivable that management has the intent and ability to hold for the
        foreseeable future or until maturity or payoff are reported at their outstanding
        unpaid principal balances reduced by any charge-offs of specific valuation
        accounts and net of any deferred fees or costs on originated loans, or
        unamortized premiums or discounts on purchased loans.
 
 Loan
        origination fees and certain direct origination costs are capitalized and
        recognized as an adjustment of the yield of the related loan.
 
 Loans
        on
        which the accrual of interest has been discontinued are designated as
        non-accrual loans. The accrual of interest on loans is discontinued when
        principal or interest is past due 90 days based on contractual terms of the
        loan
        or when, in the opinion of management, there is reasonable doubt as to
        collectibility. When loans are placed on non-accrual status, all interest
        previously accrued but not collected is reversed against current period interest
        income. Interest income generally is not recognized on specific impaired
        loans
        unless the likelihood of further loss is remote. Interest payments received
        on
        such loans are applied as a reduction to the loan principal balance. Interest
        accruals are resumed on such loans only when they are brought current with
        respect to interest and principal and when, in the judgment of management,
        the
        loans are estimated to be fully collectible as to all principal and
        interest.
  -58-
 **HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2006, 2005, AND 2004**
 **(Dollars
          in thousands, except per share amounts)**
 **Note
        #1 - Summary of Significant Accounting Policies,
        Continued**
 
 The
        Company considers a loan to be impaired when it is probable that the Company
        will be unable to collect all amounts due (principal and interest) according
        to
        the contractual terms of the loan agreement. Measurement of impairment is
        based
        on the expected future cash flows of an impaired loan which are to be discounted
        at the loan’s effective interest rate, or measured by reference to an observable
        market value, if one exists, or the fair value of the collateral for a
        collateral-dependent loan. The Company selects the measurement method on
        a
        loan-by-loan basis except that collateral-dependent loans for which foreclosure
        is probable are measured at the fair value of the collateral. The Bank
        recognizes interest income on impaired loans based on its existing methods
        of
        recognizing interest income on non-accrual loans.
 
 All
        loans
        are generally charged off at such time the loan is classified as a
        loss.
  Loans
        Held for Sale
 
 Loans
        held for sale are carried at the lower of aggregate cost or market value,
        which
        is determined by the specified value in the commitments. Net unrealized losses,
        if any, are recognized through a valuation allowance by charges to
        expense.
 
 Allowance
        for Loan Losses
 
 The
        allowance for loan losses is maintained at a level which, in management's
        judgment, is adequate to absorb credit losses inherent in the loan portfolio.
        The amount of the allowance is based on management's evaluation of the
        collectibility of the loan portfolio, including the nature of the portfolio,
        credit concentrations, trends in historical loss experience, specific impaired
        loans, and economic conditions. Allowances for impaired loans are generally
        determined based on collateral values or the present value of estimated cash
        flows. The allowance is increased by a provision for loan losses, which is
        charged to expense and reduced by charge-offs, net of recoveries. Changes
        in the
        allowance relating to impaired loans are charged or credited to the provision
        for loan losses. Because of uncertainties inherent in the estimation process,
        management’s estimate of credit losses inherent in the loan portfolio and the
        related allowance may change.
 
 Property,
        Premises and Equipment
 
 Land
        is
        carried at cost. Premises and equipment are carried at cost less accumulated
        depreciation and amortization. Depreciation is computed using the straight-line
        method over the estimated useful lives, which ranges from three to ten years
        for
        furniture and fixtures and forty years for buildings. Leasehold improvements
        are
        amortized using the straight-line method over the estimated useful lives
        of the
        improvements or the remaining lease term, whichever is shorter. Expenditures
        for
        betterments or major repairs are capitalized and those for ordinary repairs
        and
        maintenance are charged to operations as incurred. Total depreciation expenses
        for the reporting periods ending December 31, 2006, 2005, and 2004 were
        approximately $958, $897, and $949, respectively.
 -59-
 **HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2006, 2005, AND 2004**
 **(Dollars
          in thousands, except per share amounts)**
 **Note
        #1 - Summary of Significant Accounting Policies, Continued**
 
 Goodwill
        and Intangible Assets
 
 The
        Company has engaged in the acquisition of financial institutions and the
        assumption of deposits and purchase of assets from other financial institutions.
        The Company has paid premiums on these acquisitions, and such premiums are
        recorded as intangible assets, in the form of goodwill or core deposit
        intangible assets.
 
 Goodwill
        represents the excess of the purchase price over the estimated fair value
        of the
        net assets acquired. In accordance with the provisions of Statement of Financial
        Accounting No. (“SFAS”) 142, goodwill is not being amortized whereas
        identifiable intangible assets with finite lives are amortized over their
        useful
        lives. On an annual basis, the Company is required to test goodwill for
        impairment. The Company’s assessment at December 31, 2006 pursuant to its
        Goodwill Impairment Testing Policy resulted in no impairment.
 
 Core
        deposit intangibles represent the intangible value of depositor relationships
        resulting from deposit liabilities assumed in acquisitions. Core deposit
        intangibles are being amortized over six and ten years. Intangibles are
        evaluated periodically for impairment. Should such an assessment indicate
        that
        the undiscounted value of an intangible may be impaired, the net book value
        of
        the intangible would be written down to the net estimated recoverable
        value.
 
 Income
        Taxes
 
 Provisions
        for income taxes are based on amounts reported in the statements of income
        (after exclusion of non-taxable income such as interest on state and municipal
        securities) and include deferred taxes on temporary differences in the
        recognition of income and expense for tax and financial statement purposes.
        Deferred taxes are computed on the liability method as prescribed in SFAS
        No.
        109, "Accounting for Income Taxes."
 
 Advertising
        Costs
 
 The
        Company expenses the costs of advertising in the period incurred.
 
 Disclosure
        about Fair Value of Financial Instruments
 
 SFAS
        No.
        107 specifies the disclosure of the estimated fair value of financial
        instruments. The Company’s estimated fair value amounts have been determined by
        the Company using available market information and appropriate valuation
        methodologies.
 
 However,
        considerable judgment is required to develop the estimates of fair value.
        Accordingly, the estimates are not necessarily indicative of the amounts
        the
        Company could have realized in a current market exchange. The use of different
        market assumptions and/or estimation methodologies may have a material effect
        on
        the estimated fair value amounts.
 
 Although
        management is not aware of any factors that would significantly affect the
        estimated fair value amounts, such amounts have not been comprehensively
        revalued for purposes of these financial statements since the balance sheet
        date
        and, therefore, current estimates of fair value may differ significantly
        from
        the amounts presented in the accompanying notes.
  -60-
 **HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2006, 2005, AND 2004**
 **(Dollars
          in thousands, except per share amounts)**
  **Note
        #1 - Summary of Significant Accounting Policies, Continued**
 
 Financial
        Instruments
 
 In
        the
        ordinary course of business, the Company has entered into off-balance sheet
        financial instruments consisting of commitments to extend credit, commercial
        letters of credit, and standby letters of credit as described in Note #10.
        Such
        financial instruments are recorded in the financial statements when they
        are
        funded or related fees are incurred or received.
 
 Comprehensive
        Income
 
 In
        accordance with SFAS No. 130, “ *Reporting
        Comprehensive Income* ,”
the
        Company classifies items of other comprehensive income by their nature in
        the
        financial statements and displays the accumulated other comprehensive income
        separately from retained earnings in the equity section of the Balance
        Sheet *.* Changes
        in
 
 unrealized
        gain (loss) on available-for-sale securities net of income taxes is the only
        component of accumulated other comprehensive income for the
        Company.
 
 Reclassifications
 
 Certain
        amounts in the 2005 and 2004 financial statements have been reclassified
        to
        conform to the 2006 presentation.
 
 Earnings
        Per Share (EPS)
 
 Basic
        EPS
        excludes dilution and is computed by dividing income available to common
        stockholders by the weighted-average number of common shares outstanding
        for the
        period. Diluted EPS reflects the potential dilution that could occur if
        securities or other contracts to issue common stock were exercised or converted
        into common stock or resulted in the issuance of common stock that then shared
        in the earnings of the entity.
 
 Change
        in Accounting Principle - Share-Based Compensation
 
 Effective
        January 1, 2006, the Company adopted the provisions of Statement of
        Financial Accounting Standards (“SFAS”) No. 123R, *Share-Based
        Payments* ,
        a
        revision to the previously issued guidance on accounting for stock options
        and
        other forms of equity-based compensation. SFAS No. 123R requires companies
        to recognize in the income statement the grant-date fair value of stock options
        and other equity-based forms of compensation issued to employees over the
        employees’ requisite service period (generally the vesting period). Prior to
        January 1, 2006, we accounted for share-based compensation to employees
        under the intrinsic value method prescribed in Accounting Principles Board
        (“APB”) Opinion No. 25, *Accounting
        for Stock Issued to Employees* .
        Under
        the intrinsic value method, compensation expense is recognized only to the
        extent an option’s exercise price is less than the market value of the
        underlying stock on the date of grant. No share-based compensation expense
        was
        reflected in net income as all options are required by the plan to be granted
        with an exercise price equal to the estimated fair value of the underlying
        common stock on the date of grant. We also followed the disclosure requirements
        of SFAS No. 123, *Accounting
        for Stock-Based Compensation* ,
        as
        amended by SFAS No. 148, *Accounting
        for Share-Based Compensation - Transition and Disclosure.* We
        adopted SFAS No. 123R under the *modified
        prospective* method
        which means that the unvested portion of previously granted awards and any
        awards that are granted or modified after the date of adoption will be measured
        and accounted for under the provisions of SFAS No. 123R. Accordingly,
        financial statement amounts for prior periods presented have not been restated
        to reflect the fair value method of recognizing compensation cost relating
        to
        stock options. The Company will continue to use straight-line recognition
        of
        expenses for awards with graded vesting.
  -61-
 **HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2006, 2005, AND 2004**
 **(Dollars
          in thousands, except per share amounts)**
  **Note
          #1 - Summary of Significant Accounting Policies,
          Continued**
 
 In
        March
        2005, the Securities and Exchange Commission (the SEC) issued Staff Accounting
        Bulletin No. 107 (SAB No. 107) regarding the SEC's interpretation of SFAS
        No.123(R) and the valuation of share-based payments for public companies.
        The
        Company has applied the provisions of SAB No. 107 in its adoption of SFAS
        No.
        123(R).
 
 As
        a
        result of adopting SFAS No. 123R on January 1, 2006, the Company’s
        results for the year ended December 31, 2006 reflected the following changes:
 For
                    the yeard endedDecember
                    31, 2006(in
                    thousands, except per share data)
                
                Increase/(Decrease)Salaries
                    and employee benefits
                
                $
                116Income
                    before income taxes
                
                $
                (116
                )Provision
                    for income taxes
                
                
                (46
                )Net
                    income
                
                $
                (70
                )Basic
                    earnings per share
                
                $
                (0.01
                )Diluted
                    earnings per share
                
                $
                (0.01
                )
 Prior
        to
        January 1, 2006, had compensation cost for the Company’s stock option plans been
        determined based on the fair value at the grant dates for awards under those
        plans consistent with the method of SFAS No. 123, the Company’s net income and
        earnings per share would have been reduced to the pro forma amount indicated
        below:
 2005
                
                2004Net
                    income:As
                    reported
                
                $
                6,637
                
                $
                4,584Stock-based
                    compensation using the intrinsicvalue
                    method
                
                
                -
                
                
                -Stock-based
                    compensation that would havebeen
                    reported using the fair value methodof
                    SFAS 123
                
                
                (89
                )
                
                (64
                )Pro
                    forma net income
                
                $
                6,548
                
                $
                4,520Basic
                    earnings per share:As
                    reported
                
                $
                1.08
                
                $
                0.77Pro
                    forma
                
                
                1.06
                
                
                0.76Diluted
                    earnings per share:As
                    reported
                
                $
                1.01
                
                $
                0.71Pro
                    forma
                
                
                1.00
                
                
                0.70
  Prior
        to
        the adoption of SFAS No. 123(R), the Company presented the tax benefit of
        stock
        option exercises as operating cash flows, upon the adoption of SFAS No. 123(R),
        tax benefits resulting from tax deductions in excess of the compensation
        cost
        recognized for those options are classified as financing cash
        flows.
  -62-
 **HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2006, 2005, AND 2004**
 **(Dollars
          in thousands, except per share amounts)**
  **Note
        #1 - Summary of Significant Accounting Policies, Continued**
 
 Current
        Accounting Pronouncements
 
 In
        July
        2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation
        No. 48, *Accounting
        for Uncertainty in Income Taxes—an interpretation of FASB Statement No.
        109* (FIN 48)
        which clarifies the accounting and disclosure for uncertainty in tax positions,
        as defined. FIN 48 seeks to reduce the diversity in practice associated with
        certain aspects of the recognition and measurement related to accounting
        for
        income taxes. This interpretation is effective for fiscal years beginning
        after
        December 15, 2006. The Company is in the process of determining the impact
        that
        this interpretation may have on our results from operations or financial
        position.
 
 ACCOUNTING
        FOR CERTAIN HYBRID FINANCIAL INSTRUMENTS: In February 2006, the FASB issued
        SFAS
        No. 155, "Accounting for Certain Hybrid Financial Instruments - an amendment
        of
        FASB Statements No. 133 and 140." SFAS No. 155 simplifies accounting for
        certain
        hybrid instruments currently governed by SFAS No. 133, "Accounting for
        Derivative Instruments and Hedging Activities," by allowing fair value
        re-measurement of hybrid instruments that contain an embedded derivative
        that
        otherwise would require bifurcation. SFAS No. 155 also eliminates the guidance
        in SFAS No.133 Implementation Issue No. D1, "Application of Statement 133
        to
        Beneficial Interests in Securitized Financial Assets," which provides such
        beneficial interests are not subject to SFAS No.133. SFAS No. 155 amends
        SFAS
        No. 140, "Accounting for Transfers and Servicing of Financial Assets and
        Extinguishments of Liabilities - a Replacement of FASB Statement No. 125,"
        by
        eliminating the restriction on passive derivative instruments that a qualifying
        special-purpose entity may hold. This statement is effective for financial
        instruments acquired or issued after the beginning of the Company’s fiscal year
        2007. The Company does not expect the adoption of this statement to have
        a
        material impact on the Company’s financial condition, results of operations or
        cash flows.
 
 ACCOUNTING
        FOR SERVICING OF FINANCIAL ASSETS: In March 2006, the Financial Accounting
        Standards Board (FASB) issued SFAS No. 156, "Accounting for Servicing of
        Financial Assets- an amendment of FASB Statement No. 140." SFAS No.156 requires
        an entity to recognize a servicing asset or servicing liability each time
        it
        undertakes an obligation to service a financial asset by entering into a
        servicing contract in specific situations. Additionally, the servicing asset
        or
        servicing liability shall be initially measured at fair value; however, an
        entity may elect the "amortization method" or "fair value method" for subsequent
        balance sheet reporting periods. SFAS No.156 is effective as of an entity's
        first fiscal year beginning after September 15, 2006. Early adoption is
        permitted as of the beginning of an entity's fiscal year, provided the entity
        has not yet issued financial statements, including interim financial statements,
        for any period of that fiscal year. The Company does not expect the adoption
        of
        this statement to have a material impact on its financial condition, results
        of
        operations or cash flows.
 
 In
        September 2006, the FASB issued Statement of Financial Accounting Standards
        No. 157, *Fair
        Value Measurements* (FAS
        157). FAS 157 enhances existing guidance for measuring assets and liabilities
        using fair value. Prior to the issuance of FAS 157, guidance for applying
        fair
        value was incorporated in several accounting pronouncements. FAS 157 provides
        a
        single definition of fair value, together with a framework for measuring
        it, and
        requires additional disclosure about the use of fair value to measure assets
        and
        liabilities. FAS 157 also emphasizes that fair value is a market-based
        measurement, not an entity-specific measurement, and sets out a fair value
        hierarchy with the highest priority being quoted prices in active markets.
        Under
        FAS 157, fair value measurements are disclosed by level within that hierarchy.
        While FAS 157 does not add any new fair value measurements, it does change
        current practice. Changes to practice include: (1) a requirement for an
        entity to include its own credit standing in the measurement of its liabilities;
        (2) a modification of the transaction price presumption; (3) a
        prohibition on the use of block discounts when valuing large blocks of
        securities for broker-dealers and investment companies; and (4) a
        requirement to adjust the value of restricted stock for the effect of the
        restriction even if the restriction lapses within one year. FAS 157 is effective
        for financial statements issued for fiscal
        years beginning after November 15, 2007, and interim periods within those
        fiscal years. The Company has not determined the impact of adopting FAS 157
        on
        its financial statements.
  -63-
 **HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2006, 2005, AND 2004**
 **(Dollars
          in thousands, except per share amounts)**
  **Note
        #1 - Summary of Significant Accounting Policies, Continued**
 
 In
        September 2006, the FASB issued Statement of Financial Accounting Standards
        No. 158, *Employers’
        Accounting for Defined Benefit Pension and Other Postretirement Plans (an
        amendment of FASB Statements No. 87, 88, 106, and 132R)* (FAS
        158), requires an employer to: (a) Recognize in its statement of financial
        position an asset for a plan’s over funded status or a liability for a plan’s
        under funded status; (b) measure a plan’s assets and its obligations that
        determine its funded status as of the end of the employer’s fiscal year (with
        limited exceptions); and (c) recognize changes in the funded status of a
        defined benefit postretirement plan in the year in which the changes occur.
        Those changes will be reported in comprehensive income of a business entity
        and
        in changes in net assets of a not-for-profit organization. The requirement
        by
        FAS 158 to recognize the funded status of a benefit plan and the disclosure
        requirements of FAS 158 are effective as of the end of the fiscal year ending
        after December 15, 2006 for entities with publicly traded equity
        securities. The requirement to measure plan assets and benefit obligations
        as of
        the date of the employer’s fiscal year-end statement of financial position is
        effective for fiscal years ending after December 15, 2008. The Company does
        not expect the adoption of FAS 158 to have a material effect on the financial
        position of the company at December 31, 2006.
  In
        February of 2007, the FASB Issued SFAS No. 159, *Establishing
        the Fair Value Option for Financial Assets and Liabilities.* The
        Financial Accounting Standards Board has issued SFAS 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
        does
        not expect the adoption of FAS 159 to have a material effect on the Company's
        financial condition.
  **Note
        #2 - Investment Securities**
  At
        December 31, 2006 and 2005, the investment securities portfolio was comprised
        of
        securities classified as available-for-sale, in accordance with SFAS No.
        115,
        resulting in investment securities available-for-sale being carried at fair
        value adjusted for amortization of premiums and accretions of discounts,
        and
        fair market value adjustments for securities transferred from
        available-for-sale.
  -64-
 **HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2006, 2005, AND 2004**
 **(Dollars
          in thousands, except per share amounts)**
  The
        amortized cost and fair values of investment securities available-for-sale
        at
        December 31, 2006, were:
 Gross
                
                GrossAmortized
                
                Unrealized
                
                UnrealizedCost
                
                Gains
                
                Losses
                
                Fair
                    ValueObligations
                    of U.S. Governmentagencies
                    and corporations
                
                $
                205
                
                $
                -
                
                $
                (4
                )
                $
                201Mortgage-backed
                    securities
                
                
                21,959
                
                
                16
                
                
                (381
                )
                
                21,594Obligations
                    of state and politicalsubdivisions
                
                
                16,139
                
                
                540
                
                
                (38
                )
                
                16,641Other
                    securities
                
                
                9
                
                
                -
                
                
                -
                
                
                9Total
                
                $
                38,312
                
                $
                556
                
                $
                (423
                )
                $
                38,445
 The
        amortized cost and fair values of investment securities available-for-sale
        at
        December 31, 2005, were:
 Gross
                
                GrossAmortized
                
                Unrealized
                
                UnrealizedCost
                
                Gains
                
                Losses
                
                Fair
                    ValueObligations
                    of U.S. Governmentagencies
                    and corporations
                
                $
                826
                
                $
                -
                
                $
                (20
                )
                $
                806Mortgage-backed
                    securities
                
                
                28,795
                
                
                13
                
                
                (518
                )
                
                28,290Obligations
                    of state and politicalsubdivisions
                
                
                15,036
                
                
                364
                
                
                (103
                )
                
                15,297Other
                    securities
                
                
                9
                
                
                -
                
                
                -
                
                
                9Total
                
                $
                44,666
                
                $
                377
                
                $
                (641
                )
                $
                44,402
 There
        were no investment securities held-to-maturity at December 31, 2006 and December
        31, 2005.
 
 The
        amortized cost and fair values of investment securities available-for-sale
        at
        December 31, 2006, by contractual maturity are shown below. Actual maturities
        may differ from contractual maturities because borrowers may have the right
        to
        call or prepay obligations with or without call or prepayment
        penalties.
 SecuritiesAvailable-for-SaleAmortizedCost
                
                Fair
                    ValueDue
                    in one year or less
                
                $
                517
                
                $
                515Due
                    after one year through five years
                
                
                2,747
                
                
                2,786Due
                    after five years through ten years
                
                
                6,809
                
                
                7,000Due
                    after ten years
                
                
                6,280
                
                
                6,550Mortgage-backed
                    securities
                
                
                21,959
                
                
                21,594Total
                    Securities
                
                $
                38,312
                
                $
                38,445
 Proceeds
        from sales, maturities and principal reductions of investment securities
        available-for-sale during 2006, 2005, and 2004, were $500, $1,350, and $1,315,
        respectively. In 2006, there was a gross gain of $9 reported and there were
        no
        gross gains or losses reported during 2005 and 2004.
 
 Proceeds
        from sales and maturities and principal reductions of mortgage-backed securities
        in 2006, 2005, and 2004, were $7,071, $13,537, and $14,723, respectively.
        There
        were no gross gains or losses reported during 2006 and 2005. In 2004 gross
        gains
        on these sales were $28. Unrealized (losses)/gains on investment securities
        and
        mortgage-backed securities included in shareholders’ equity net of tax at
        December 31, 2006, 2005, and 2004 were $80, ($158), and $147, net of tax
        of $53,
        ($106) and $98 respectively.
  -65-
 **HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2006, 2005, AND 2004**
 **(Dollars
          in thousands, except per share amounts)**
  **Note
        #2 - Investment Securities, Continued**
 
 Securities
        having a carrying value and a fair value of approximately $21,645 and $25,366
        at
        December 31, 2006 and 2005, respectively, were pledged to secure public deposits
        and for other purposes as required by law.
 
 At
        the
        June 29, 2005 FASB Board meeting, the Board agreed to issue FSP FAS 115-1, *The
        Meaning of Other-Than-Temporary Impairment and Its Application to Certain
        Investments* which
        will replace the guidance previously set forth in EITF 03-1, *The
        Meaning of Other-Than -Temporary Impairment and Its Application to Certain
        Investments.* This FSP
        effectively eliminates the accounting guidance provided in EITF-03-1 in favor
        of
        existing impairment recognition guidance under SFAS No. 115, SAB No. 59,
        APB No.
        18, and EITF Topic D-44. The FSP is for periods beginning after September
        15,
        2005, but its adoption has not had a material impact on the Company’s
        consolidated financial statements.
 
 Those
        investment securities available for sale which have an unrealized loss position
        at December 31, 2006 and 2005, are detailed below: (amounts in
        thousands)
 Securities
                    in a Loss
                
                Securities
                    in a LossPosition
                    for Less than
                
                Position
                    for 12 Months12
                    Months
                
                or
                    Longer
                
                TotalFair
                
                Unrealized
                
                Fair
                
                Unrealized
                
                Fair
                
                UnrealizedValue
                
                Loss
                
                Value
                
                Loss
                
                Value
                
                LossDecember
                    31, 2006Obligations
                      of U.S. Governmentagencies
                      and corporations
                
                $
                -
                
                $
                -
                
                $
                201
                
                $
                (4
                )
                $
                201
                
                $
                (4
                )Mortgage-backed
                    securities
                
                
                379
                
                
                (4
                )
                
                19,603
                
                
                (377
                )
                
                19,982
                
                
                (381
                )Obligations
                      of state and politicalsubdivisions
                
                
                1,311
                
                
                (12
                )
                
                872
                
                
                (26
                )
                
                2,183
                
                
                (38
                )Other
                    securities
                
                
                -
                
                
                -Total
                
                $
                1,690
                
                $
                (16
                )
                $
                20,676
                
                $
                (407
                )
                $
                22,366
                
                $
                (423
                )December
                    31, 2005Obligations
                      of U.S. Governmentagencies
                      and corporations
                
                $
                -
                
                $
                -
                
                $
                806
                
                $
                (20
                )
                $
                806
                
                $
                (20
                )Mortgage-backed
                    securities
                
                
                14,111
                
                
                (250
                )
                
                11,902
                
                
                (268
                )
                
                26,013
                
                
                (518
                )Obligations
                      of state and politicalsubdivisions
                
                
                4,237
                
                
                (83
                )
                
                620
                
                
                (20
                )
                
                4,857
                
                
                (103
                )Other
                    securities
                
                
                -
                
                
                -Total
                
                $
                18,348
                
                $
                (333
                )
                $
                13,328
                
                $
                (308
                )
                $
                31,676
                
                $
                (641
                )
  There
        are
        twenty two securities that have been in a loss position for twelve months
        or
        longer. These securities are guaranteed by either the U.S. Government or
        other
        governments. These unrealized losses relate principally to current interest
        rates for similar types of securities. In analyzing an issuer’s financial
        condition, the Company considers whether the securities are issued by the
        federal government or its agencies, whether downgrades by bond rating agencies
        have occurred, and the results of reviews of the issuer’s financial condition.
        As the Company has the ability to hold these securities until maturity, or
        for
        the foreseeable future, no declines are deemed to be other-than-temporary.
  -66-
 **HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2006, 2005, AND 2004**
 **(Dollars
          in thousands, except per share amounts)**
  **Note
        #3 - Loans**
  Major
        classifications of loans were:
 2006
                
                2005Commercial,
                    financial and agricultural
                
                $
                84,976
                
                $
                60,050Real
                    Estate - construction
                
                
                105,712
                
                
                76,981Real
                    Estate - other
                
                
                237,401
                
                
                210,690Home
                    Equity lines of credit
                
                
                10,792
                
                
                14,398Installment
                    loans to individuals
                
                
                5,598
                
                
                5,620All
                    other loans (including overdrafts)
                
                
                504
                
                
                394444,983
                
                
                368,133Less:
                    Deferred loan fees
                
                
                (1,625
                )
                
                (1,617
                )Less:
                    Allowance for loan losses
                
                
                (4,081
                )
                
                (3,881
                )Total
                    Loans
                
                $
                439,277
                
                $
                362,635Loans
                    held for sale
                
                $
                1,764
                
                $
                3,392
  Concentration
        of Credit Risk
 
 At
        December 31, 2006 and 2005, approximately $353,905 and $302,069 of the Bank’s
        loan portfolio was collateralized by various forms of real estate. Such loans
        are generally made to borrowers located in San Luis Obispo County and Northern
        Santa Barbara County. The Bank attempts to reduce their 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.
 
 Loans
        serviced for others are not included in the accompanying balances sheets.
        The
        unpaid principal balance of loans serviced for others was $7.5 million, $3.6
        million and $3.5 million at December 31, 2006, 2005 and 2004, respectively.
 
 The
        following is a summary of the investment in impaired loans, the related
        allowance for loan losses, and income recognized thereon as of December
        31:
 2006
                
                2005
                
                2004Impaired
                    loans with a valuation allowance
                
                $
                -
                
                $
                54
                
                $
                821Impaired
                    loans without a valuation allowance
                
                
                55
                
                
                -
                
                
                113Total
                    impaired loans
                
                $
                55
                
                $
                54
                
                $
                934Valuation
                    allowance related to impaired loans
                
                $
                -
                
                $
                16
                
                $
                453Average
                    recorded investment in impaired loans
                
                $
                131
                
                $
                374
                
                $
                1,076Cash
                    receipts applied to reduce principal balance
                
                $
                273
                
                $
                8
                
                $
                110Interest
                    income recognized for cash payments
                
                $
                -
                
                $
                -
                
                $
                48
 The
        provisions of SFAS No. 114 and SFAS No. 118 permit the valuation allowance
        reported above to be determined on a loan-by-loan basis or by aggregating
        loans
        with similar risk characteristics. Because the loans currently identified
        as
        impaired have unique risk characteristics, the valuation allowance was
        determined on a loan-by-loan basis.
  -67-
 **HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2006, 2005, AND 2004**
 **(Dollars
          in thousands, except per share amounts)**
  **Note
        #3 - Loans, Continued**
 
 Non-accruing
        loans totaled approximately $55 and $54 at December 31, 2006 and 2005,
        respectively. As of December 31, 2006 and 2005, all loans on non-accrual
        were
        classified as impaired. If interest on non-accrual loans had been recognized
        at
        the original interest rates, interest income would have increased $63, $87,
        and
        $126, in 2006, 2005, and 2004, respectively. No additional funds are committed
        to be advanced in connection with impaired loans.
 
 At
        December 31, 2006 and 2005, the Bank had no loans past due 90 days or more
        and
        still accruing interest.
 
 At
        December 31, 2006, there were no loans classified as troubled debt
        restructurings.
 
 The
        Bank
        also originates Small Business Administration (“SBA”) loans for sale to
        governmental agencies and institutional investors. At December 31, 2006 and
        2005, the unpaid principal balance of SBA loans serviced for others totaled
        $1,355 and $1,715, respectively. The gain on sale of SBA loans was $19, $84,
        and
        $45 for the years ended December 31, 2006, 2005, and 2004,
        respectively.
  **Note
        #4 - Allowance for Loan Losses**
 
 Transactions
        in the allowance for loan losses are summarized as follows:
 2006
                
                2005
                
                2004Balance,
                    Beginning of Year
                
                $
                3,881
                
                $
                3,247
                
                $
                3,070Additions
                    charged to operating expense
                
                
                600
                
                
                710
                
                
                410Loans
                    charged off
                
                
                (561
                )
                
                (100
                )
                
                (236
                )Recoveries
                    of loans previously charged off
                
                
                161
                
                
                24
                
                
                3Balance,
                    End of Year
                
                $
                4,081
                
                $
                3,881
                
                $
                3,247
  **Note
        #5 - Property, Premises and Equipment**
  Property,
        premises and equipment consisted of the following:
  2006
                
                2005Building
                    and improvements
                
                $
                12,578
                
                $
                7,330Furniture
                    and equipment
                
                
                5,759
                
                
                4,64118,337
                
                
                11,971Less:
                    Accumulated depreciation and amortization
                
                
                7,540
                
                
                6,65210,797
                
                
                5,319Land
                
                
                3,784
                
                
                3,782Construction
                    in progress
                
                
                -
                
                
                2,804Total
                
                $
                14,581
                
                $
                11,905
 During
        2003, the Bank purchased land for future development of a Paso Robles,
        California administrative facility for approximately $1,100. The construction
        was completed and the Bank moved into the facility in June 2006.
 
 In
        July
        2005 the Company entered into a sale-leaseback transaction, with a
        non-affiliated party, for the Atascadero Branch Office with the Bank as the
        lessee. The sale price was $900 and resulted in a gain to the Company of
approximately
        $283 which is being amortized against rental expense over the first 5 year
        term
        of the lease. The Bank’s new lease calls for payments of $5 per month for 5
        years with 4 separate 5 year options to extend.
  -68-
 **HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2006, 2005, AND 2004**
 **(Dollars
          in thousands, except per share amounts)**
  **Note
        #5 - Property, Premises and Equipment, Continued**
  The
        Company leases land, buildings, and equipment under non-cancelable operating
        leases expiring at various dates through 2012. The following is a schedule
        of
        future minimum lease payments based upon obligations at year-end.
 Year
                      EndingDecember 31,
                
                Amount2007
                
                $
                8822008
                
                
                9482009
                
                
                7362010
                
                
                6162011
                
                
                401More
                    than 5 years
                
                
                205Total
                
                $
                3,788
 The
        leases contain options to extend for periods from five to twenty years. Options
        to extend which have been exercised and the related lease costs are included
        above. Total expenditures charged for leases for the reporting periods ended
        December 31, 2006, 2005, and 2004, were approximately $628, $663, and $622,
        respectively.
 
 The
        Company has four (4) subleases in place, three (3) of which are for additional
        space within existing branch offices. One sublease is for an entire facility
        that was vacated as the result of consolidation from the 2003 Hacienda Bank
        acquisition. The subleases are for various terms and accounted for approximately
        $197 credit to rental expense in 2006. The Company expects to receive sublease
        revenue for 2008 and 2009 of approximately $160 and $54, respectively.
  **Note
        #6 - Intangible Assets**
  Intangible
        assets consisted of core deposit intangibles subject to amortization with
        a net
        carrying value of $1,148 and $1,448, net of $1,375 and $1,075 accumulated
        amortization as of December 31, 2006 and 2005, respectively. Amortization
        expense for the periods ended December 31, 2006, 2005, and 2004 was $300,
        $573,
        and $421, respectively. The estimated future amortization expense for the
        next
        five years is $354 for 2007, $388 for 2008, $337 for 2009, $40 for 2010,
        and $29
        for 2011.
  **Note
        #7 - Time Deposit Liabilities**
 
 At
        December 31, 2006, the Banks had time certificates of deposit with maturity
        distributions as follows:
 Year
                      EndingDecember 31,2007
                
                $
                114,7252008
                
                
                4,6012009
                
                
                7422010
                
                
                1,338$
                121,406
 -69-
 
 **HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005, AND 2004**
 **(Dollars
        in thousands, except per share amounts)**


**Note
        #8 - Borrowings**
 
 The
        Bank
        has borrowing lines with correspondent banks totaling $13.5 million. At December
        31, 2006 there were no balances outstanding on these borrowing
        lines.
  Federal
        Home Loan Bank (FHLB) Advances
  The
        Bank
        has established borrowing lines with the Federal Home Loan Bank (FHLB). At
        December 31, 2006, the Bank had the following borrowings, all of which are
        collateralized by loans, with the FHLB:
  **Amount**
                
                **Interest**
                
                
                
                **Maturity****Borrowed**
                
                **Rate**
                
                **Variable/Fixed**
                
                **Date**$
                    10,000
                
                
                5.44
                %
                
                Fixed
                
                
                26-Feb-07$
                    10,000
                
                
                5.50
                %
                
                Fixed
                
                
                25-Jul-07$
                    10,000
                
                
                5.39
                %
                
                Variable-
                    Daily
                
                
                28-Sep-07$
                    10,000
                
                
                5.37
                %
                
                Variable-
                    Daily
                
                
                26-Nov-07$
                    10,000
                
                
                5.37
                %
                
                Variable-
                    Daily
                
                
                12-Dec-07$
                    50,000
 In
        addition, the Bank has an $11.7 million letter of credit secured by
        loans.
 
 At
        December 31, 2006, the Bank has a remaining borrowing capacity with existing
        collateral of approximately $53 million and $9 million secured by loans and
        securities, respectively.
 
 The
        Bank
        has pledged approximately $278.7 million in loans to the FHLB.
 
 Securities
        Sold Under Agreements to Repurchase
 
 Securities
        sold under agreements to repurchase, which are classified as secured borrowings,
        generally mature within one to four days from the transaction date. Securities
        sold under agreements to repurchase are reflected at the amount of cash received
        in connection with the transaction. As of December 31, 2006 and 2005, the
        Bank
        had $1,364 and $3,847 in securities sold under agreements to repurchase.
        Interest expense recorded was $88, $44, and $8 for the years ended December
        31,
        2006, 2005, and 2004, respectively. The carrying value of underlying securities
        provided as collateral for these transactions was $4,330 and $5,771 at December
        31, 2006 and 2005, respectively.
  Notes
        Payable
  On
        October 10, 2005, the Company renewed a revolving line of credit in the amount
        of $3,500 through Pacific Coast Bankers Bank (PCBB). The line is secured
        by 51%
        of the outstanding shares of the Bank’s stock. The line bears interest at the
        Wall Street Journal prime rate. Interest payments are due quarterly. The
        line is
        scheduled to mature on October 10, 2007 at which time the line converts to
        an
        eight-year term loan maturing on October 10, 2015. Principal and interest
        payments are due quarterly. Under the terms of the agreement, the Company
        will
        not incur any additional debt over $2,000 exclusive of the inter-company
        debt
        and existing debt without prior written consent of PCBB. In addition, the
        Bank
        must be “well” capitalized on an on-going basis as defined by the Regulators. At
        December 31, 2006, the outstanding balance owed was $0.
  -70-
 
 **HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005, AND 2004**
 **(Dollars
        in thousands, except per share amounts)**


**Note
        #8 - Borrowings, Continued**
 
 Junior
        Subordinated Debentures
 
 On
        April
        10, 2002, the Company issued $8,248 of Floating Rate Junior Subordinated
        Deferrable Interest Debentures (the “debt securities”) to Heritage Oaks Capital
        Trust I, a statutory trust created under the laws of the State of Delaware.
        These debt securities are subordinated to effectively all borrowings of the
        Company and are due and payable on April 22, 2032. Interest is payable quarterly
        on these debt securities at 6-Month LIBOR plus 3.7% for an effective rate
        of
        9.09% as of December 31, 2006. The debt securities can be called at any time
        commencing on April 22, 2007, at par. The debt securities can also be redeemed
        at par if certain events occur that impact the tax treatment or the capital
        treatment of the issuance. The Company also purchased a 3% minority interest
        totaling $248 in Heritage Oaks Capital Trust I. The balance of the equity
        of
        Heritage Oaks Capital Trust I is comprised of mandatorily redeemable preferred
        securities and is included in other assets.
 
 On
        October 27, 2006, the Company issued $8,248 of Floating Rate Junior Subordinated
        Deferrable Interest Debentures (the “debt securities”) to Heritage Oaks Capital
        Trust II, a statutory trust created under the laws of the State of Delaware.
        These debt securities are subordinated to effectively all borrowings of the
        Company and are due and payable on October 27, 2036. Interest is payable
        quarterly on these debt securities at 3-Month LIBOR plus 1.71% for an effective
        rate of 7.10% as of December 31, 2006. The debt securities can be called
        at any
        time commencing on October 27, 2011, at par. The debt securities can also
        be
        redeemed at par if certain events occur that impact the tax treatment or
        the
        capital treatment of the issuance. The Company also purchased a 3% minority
        interest totaling $248 in Heritage Oaks Capital Trust II. The balance of
        the
        equity of Heritage Oaks Capital Trust II is comprised of mandatorily redeemable
        preferred securities and is included in other assets.
 
 Under
        FASB Interpretation (FIN) No. 46, *“Consolidation
        of Variable Interest Entities, an interpretation of ARB No.
        51,”* the
        Company is not allowed to consolidate Heritage Oaks Capital Trust I and II
        into
        the Company’s financial statements. Prior to the issuance of FIN No. 46, Bank
        holding companies typically consolidated these entities. On February 28,
        2005,
        the Federal Reserve Board issued a new rule which provides that, notwithstanding
        the deconsolidation of such trusts, junior subordinated debentures, such
        as
        those issued by the Company, may continue to constitute up to 25% of a bank
        holding company's Tier 1 capital, subject to certain new limitations which
        will
        not become effective until March 31, 2009 and which, in any event, are not
        expected to affect the treatment of the Company's Junior Subordinated Debentures
        as Tier 1 capital for regulatory purposes. As of December 31, 2006, the Company
        has included $14.35 million of the net junior subordinated debt in its Tier1
        Capital for regulatory capital purposes.
 
 **Note
        #9 - Income Taxes**
 
 The
        current and deferred amounts of the provision (benefit) for income taxes
        were:
 Year
                    Ending December 31,2006
                
                2005
                
                2004Federal
                    Income TaxCurrent
                
                $
                2,924
                
                $
                3,045
                
                $
                2,031Deferred
                
                
                (191
                )
                
                (134
                )
                
                16Total
                    Federal Taxes
                
                
                2,733
                
                
                2,911
                
                
                2,047State
                    Franchise TaxCurrent
                
                
                1,087
                
                
                1,291
                
                
                706Deferred
                
                
                (29
                )
                
                (99
                )
                
                6Total
                    State Franchise Tax
                
                
                1,058
                
                
                1,192
                
                
                712Total
                    Income Taxes
                
                $
                3,791
                
                $
                4,103
                
                $
                2,759
  -71-
 
 **HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005, AND 2004**
 **(Dollars
        in thousands, except per share amounts)**


**Note
        #9 - Income Taxes, Continued**
 
 The
        provision for taxes on income differed from the amounts computed using the
        federal statutory tax rate of 34 percent is as follows:
  2006
                
                2005
                
                2004Amount
                
                Percent
                
                Amount
                
                Percent
                
                Amount
                
                PercentTax
                    provision at federal statutory tax rate
                
                $
                3,554
                
                
                34.0
                
                $
                3,652
                
                
                34.0
                
                $
                2,497
                
                
                34.0State
                    income taxes, net of federalincome
                    tax benefit
                
                
                698
                
                
                7.2
                
                
                768
                
                
                7.2
                
                
                507
                
                
                6.9Tax
                    exempt income and other, Net
                
                
                (461
                )
                
                (4.9
                )
                
                (317
                )
                
                (3.0
                )
                
                (245
                )
                
                (3.4
                )Total
                    Tax Provision
                
                $
                3,791
                
                
                36.3
                
                $
                4,103
                
                
                38.2
                
                $
                2,759
                
                
                37.5
 The
        net
        deferred tax asset is determined as follows:
 2006
                
                2005Deferred
                    Tax AssetsReserves
                    for loan losses
                
                $
                1,605
                
                $
                1,414Fixed
                    assets
                
                
                233
                
                
                357Accruals
                
                
                1,233
                
                
                800Investment
                    securities valuation
                
                
                -
                
                
                109Deferred
                    Fees
                
                
                84
                
                
                231Net
                    operating loss carryforward
                
                
                345
                
                
                506Total
                    Deferred Tax Assets
                
                
                3,500
                
                
                3,417Deferred
                    Tax LiabilitiesFair
                    value adjustment for purchased assets
                
                
                363
                
                
                480Investment
                    securities valuation
                
                
                55
                
                
                -Deferred
                    costs, prepaids and FHLB
                
                
                668
                
                
                579Total
                    Deferred Tax Liabilities
                
                
                1,086
                
                
                1,059Net
                    Deferred Tax Assets
                
                $
                2,414
                
                $
                2,358
 As
        part
        of a transaction with Hacienda Bank, the Company has approximately $1.0 million
        of net operating losses (NOL) available for carry forward at December 31,
        2006.
        The realization of the NOL is limited for federal tax purposes and for state
        tax
        purposes under current tax law. Any amount not utilized for federal tax purposes
        will expire on various years through 2014.
  **Note
        #10 - Commitments and Contingencies**
 
 The
        Company is involved in various litigation. In the opinion of management and
        the
        Company’s legal counsel, the disposition of all such litigation pending will not
        have a material effect on the Company’s financial statements.
 
 In
        the
        normal course of business, the Bank enters into financial commitments to
        meet
        the financing needs of their customers. These financial commitments include
        commitments to extend credit and standby letters of credit. Those instruments
        involve, to varying degrees, elements of credit and interest rate risk not
        recognized in the statement of financial position.
 
 The
        Bank’s exposure to loan loss in the event of nonperformance on commitments to
        extend credit and standby letters of credit is represented by the contractual
        amount of those instruments. The Bank uses the same credit policies in making
        commitments as they do for loans reflected in the consolidated financial
        statements.
  -72-
 **HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2006, 2005, AND 2004**
 **(Dollars
          in thousands, except per share amounts)**
  **Note
        #10 - Commitments and Contingencies, Continued**
  
 As
        of
        December 31, 2006 and 2005, the Bank had the following outstanding financial
        commitments whose contractual amount represents credit risk:
  2006
                
                2005Commitments
                    to extend credit
                
                $
                166,540
                
                $
                167,698Standby
                    letters of credit
                
                
                17,691
                
                
                17,033$
                184,231
                
                $
                184,731
 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. Standby letters of
        credit are conditional commitments to guarantee the performance of a Bank
        customer to a third party. Since many of the commitments and standby letters
        of
        credit are expected to expire without being drawn upon, the total amounts
        do not
        necessarily represent future cash requirements. The Bank evaluates each
        customer's credit worthiness on a case-by-case basis. The amount of collateral
        obtained if deemed necessary by the Bank is based on management's credit
        evaluation of the customer.
 
 **Note
        #11 - Regulatory Matters**
 
 The
        Company (on a consolidated basis) and the Bank is subject to various regulatory
        capital requirements administered by federal banking agencies. Failure to
        meet
        minimum capital requirements can initiate certain mandatory, and possibly
        additional discretionary, actions by regulators that, if undertaken, could
        have
        a direct material effect on the Company’s and the Bank’s financial statements.
        Under capital adequacy guidelines and the regulatory framework for prompt
        corrective action, the Company and the Bank must meet specific capital
        guidelines that involve quantitative measures of the Company’s and the Bank’s
        assets, liabilities and certain off-balance sheet items as calculated under
        regulatory accounting practices. The Company’s and the Bank’s capital amounts
        and classification are also subject to qualitative judgments by the regulators
        about components, risk weightings and other factors. Prompt corrective action
        provisions are not applicable to bank holding companies.
 
 Quantitative
        measures established by regulation to ensure capital adequacy require the
        Company and the Bank to maintain minimum amounts and ratios (set forth in
        the
        table below) of total and Tier 1 capital (as defined in the regulations)
        to
        risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average
        assets (as defined). Management believes, as of December 31, 2006, that the
        Company and the Bank meets all capital adequacy requirements to which it
        is
        subject.
 
 As
        of the
        most recent notification, the Federal Deposit Insurance Corporation categorized
        the Bank as well-capitalized under the regulatory framework for prompt
        corrective action. There are no conditions or events since that notification
        that management believes have changed the Bank's category. To be categorized
        as
        well-capitalized, the Bank must maintain minimum capital ratios as set forth
        in
        the table below. The following table also sets forth the Company’s and the
        Bank’s actual regulatory capital amounts and ratios:
  -73-


**HERITAGE
      OAKS BANCORP AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2006, 2005, AND 2004**


**(Dollars
      in thousands, except per share amounts)**


**Note
      #11 - Regulatory Matters, Continued**


Capital
                  NeededTo
                  Be WellCapitalized
                  UnderFor
                  Capital
              
              Prompt
                  CorrectiveActual
                  Regulatory
              
              Adequacy
                  Purposes
              
              Action
                  ProvisionsCapital
              
              
              
              Capital
              
              
              
              CapitalAmount
              
              Ratio
              
              Amount
              
              Ratio
              
              Amount
              
              Ratio**As
                  of December 31, 2006**Total
                  capital to risk-weighted assets:Company
              
              $
              61,973
              
              
              12.36
              %
              $
              40,112
              
              
              8.0
              %
              
              N/A
              
              
              N/AHeritage
                  Oaks Bank
              
              
              56,179
              
              
              11.21
              %
              
              40,092
              
              
              8.0
              %
              $
              50,115
              
              
              10.0
              %Tier
                  1 capital to risk-weighted assets:Company
              
              
              57,729
              
              
              11.51
              %
              
              20,062
              
              
              4.0
              %
              
              N/A
              
              
              N/AHeritage
                  Oaks Bank
              
              
              51,935
              
              
              10.37
              %
              
              20,033
              
              
              4.0
              %
              
              30,049
              
              
              6.0
              %Tier
                  1 capital to average assets:Company
              
              
              57,729
              
              
              11.00
              %
              
              20,993
              
              
              4.0
              %
              
              N/A
              
              
              N/AHeritage
                  Oaks Bank
              
              
              51,935
              
              
              9.89
              %
              
              21,005
              
              
              4.0
              %
              
              26,256
              
              
              5.0
              %**As
                  of December 31, 2005**Total
                  capital to risk-weighted assets:Company
              
              $
              50,736
              
              
              11.93
              %
              $
              34,022
              
              
              8.0
              %
              
              N/A
              
              
              N/AHeritage
                  Oaks Bank
              
              
              48,071
              
              
              11.33
              %
              
              33,942
              
              
              8.0
              %
              $
              42,428
              
              
              10.0
              %Tier
                  1 capital to risk-weighted assets:Company
              
              
              46,692
              
              
              10.98
              %
              
              17,010
              
              
              4.0
              %
              
              N/A
              
              
              N/AHeritage
                  Oaks Bank
              
              
              44,027
              
              
              10.38
              %
              
              16,966
              
              
              4.0
              %
              
              25,449
              
              
              6.0
              %Tier
                  1 capital to average assets:Company
              
              
              46,692
              
              
              9.61
              %
              
              19,435
              
              
              4.0
              %
              
              N/A
              
              
              N/AHeritage
                  Oaks Bank
              
              
              44,027
              
              
              9.11
              %
              
              19,331
              
              
              4.0
              %
              
              24,164
              
              
              5.0
              %




As
      disclosed in Note #8, Borrowings - Junior Subordinated Debentures, subject
      to
      percentage limitations, the proceeds from the issuance of trust preferred
      securities are considered Tier 1 capital by the Company for regulatory purposes.
      However, as a result of the issuance of FIN 46 and FIN 46R, the trust subsidiary
      is not consolidated in these financial statements and therefore the proceeds
      received by the Company from the trust subsidiary is reported as subordinated
      debt. On February 28, 2005, the Federal Reserve Board issued a new rule which
      provides that, notwithstanding the deconsolidation of such trusts, junior
      subordinated debentures, such as those issued by the Company, may continue
      to
      constitute up to 25% of a bank holding company's Tier 1 capital, subject to
      certain new limitations which will not become effective until March 31, 2009
      and
      which, in any event, are not expected to affect the treatment of the Company's
      Junior Subordinated Debentures as Tier 1 capital for regulatory purposes.





**Note
      #12 - Salary Continuation Plan**





The
      Company established salary continuation plan-agreements with the President,
      Chief Financial Officer, Chief Lending Officer, Chief Administrative Officer
      and
      certain Senior Vice Presidents, as authorized by the Board of Directors. These
      agreements provide for annual cash payments for a period not to exceed 15 years,
      payable at age 60-65, depending on the agreement. In the event of death prior
      to
      retirement age, annual cash payments would be made to the beneficiaries for
      a
      determined number of years. The present values of the Company’s liability under
      these Agreements were approximately $1,617 and $1,250 at December 31, 2006
      and
      2005, respectively, and are included in other liabilities in the Company’s
      Consolidated Financial Statements. The Company maintains life insurance
      policies, which are intended to fund all costs of the plan. The cash surrender
      values of these life insurance policies totaled approximately $9,435 and $7,706,
      at December 31, 2006 and 2005, respectively.





-74-


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005, AND 2004**
 **(Dollars
        in thousands, except per share amounts)**





**Note
      #13 - Employee Benefit Plans**





401(k)
      Pension Plan





During
      1994, the Company established a savings plan for employees that allow
      participants to make contributions by salary deduction equal to 15 percent
      or
      less of their salary pursuant to section 401(k) of the Internal Revenue Code.
      Employee contributions are matched up to 25 percent of the employee’s
      contribution. Employees vest immediately in their own contributions and they
      vest in the Company’s contribution based on years of service. Expenses of the
      savings plan were approximately $148, $109, and $93, for the years ended
      December 31, 2006, 2005, and 2004, respectively.




Employee
      Stock Ownership Plan




The
      Company sponsors an employee stock ownership plan (ESOP) that covers all
      employees who have completed 12 consecutive months of service, are over 21
      years
      of age and work a minimum of 1,000 hours per year. The amount of the annual
      contribution to the ESOP is at the discretion of the Board of Directors. The
      contributions made to this plan were approximately $364 in 2006, $216 in 2005
      and $206 in 2004.




**Note
      #14 - Share-Based Compensation Plans**




At
      December 31, 2006, the Company had two stock option plans, which are described
      below.




The
“1990
      Stock Option Plan”




The
      Company adopted the 1990 Stock Option Plan, which is a tandem stock option
      plan
      permitting options to be granted either as “Incentive Stock Options” or as
“Non-Qualified Stock Options” under the Internal Revenue Code. All outstanding
      options were granted at prices which equal the fair market value on the day
      of
      grant. Options granted vest at a rate of 25 percent per year for four years
      and
      expire no later than ten years from the date of grant. The plan provided for
      issuance of up to 350,075 shares of the Company’s un-issued common stock and is
      subject to the specific approval of the Board of Directors. The Company’s 1990
      stock option plan expired in July 2000.





-75-


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005, AND 2004**
 **(Dollars
        in thousands, except per share amounts)**


**Note
      #14 - Equity Compensation Plans, Continued**




The
      following tables summarize information about the 1990 stock option plan
      outstanding at December 31, 2006.


2006Weighted-Weighted-
              
              AverageAverage
              
              Remaining
              
              AggregateExercise
              
              Contractural
              
              IntrinsicShares
              
              Price
              
              Term
                  (Years)
              
              Value
                  ($)Outstanding
                  at beginning of year
              
              
              3,136
              
              $
              2.55GrantedCancelled
              
              
              -
              
              $
              -Exercised
              
              
              -
              
              $
              -Outstanding
                  at end of year
              
              
              3,136
              
              $
              2.55
              
              
              0.53
              
              $
              48,138Options
                  available for granting atend
                  of year
              
              
              -Options
                  exercisable at year-end
              
              
              3,136
              
              $
              2.55
              
              
              0.53
              
              $
              48,138Weighted-average
                  fair value ofoptions
                  granted during the year
              
              
              -





The
“1997
      Stock Option Plan”




The
      Company adopted the 1997 Stock Option Plan, which is a tandem stock option
      plan
      permitting options to be granted either as “Incentive Stock Options” or as
“Non-Qualified Stock Options” under the Internal Revenue Code. All outstanding
      options were granted at prices which equal the fair market value on the day
      of
      the grant. Options granted vest at a rate of 20 percent per year for five years,
      and expire no later than ten years from the date of grant. The plan provides
      for
      issuance of up to 427,531 shares of the Company’s unissued common stock and is
      subject to the specific approval of the Board of Directors.





During
      1999, the Board of Directors approved an amendment to the 1997 Stock Option
      Plan. Under this amendment, the plan provides for issuance of up to 241,288
      additional shares of the Company’s common stock.





On
      May
      26, 2005, the stockholders of the Company approved the 2005 Equity Based
      Compensation Plan (the “2005 Plan”). Pursuant to stockholder approval, no
      further grants will be made from the 1997 Stock Option Plan.





The
      fair
      value of each option granted was estimated on the date of grant using the
      Black-Scholes option pricing model with the following assumptions:


For
                  the yeard ended31-Dec-05
              
              31-Dec-04Dividend
                  Yield
              
              
              0.00
              %
              
              0.00
              %Expected
                  life (years)
              
              
              7.50
              
              
              10.00Expected
                  volatility
              
              
              24.00
              %
              
              24.00
              %Risk-free
                  rate
              
              
              4.11
              %
              
              4.22
              %Weighted
                  average grant date fair value of options granted
              
              $
              5.24
              
              $
              4.89





No
      options were granted during 2006.





-76-


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005, AND 2004**
 **(Dollars
        in thousands, except per share amounts)**


**Note
      #14 - Equity Compensation Plans, Continued**




The
      following summarizes information about the 1997 stock option plan outstanding
      at
      December 31, 2006.


2006Weighted-Weighted-
              
              AverageAverage
              
              Remaining
              
              AggregateExercise
              
              Contractural
              
              IntrinsicShares
              
              Price
              
              Term
                  (Years)
              
              Value
                  ($)Outstanding
                  at beginning of year
              
              
              522,780
              
              $
              5.20Granted
              
              
              -
              
              $
              -Cancelled
              
              
              (1,739
              )
              $
              6.48Exercised
              
              
              (87,607
              )
              $
              3.95Outstanding
                  at end of year
              
              
              433,434
              
              $
              5.45
              
              
              3.65
              
              $
              5,396Options
                  available for granting atend
                  of year
              
              
              -Options
                  exercisable at year-end
              
              
              368,525
              
              $
              4.51
              
              
              
              
              $
              4,935Weighted-average
                  fair value ofoptions
                  granted during the year
              
              
              -





The
      total
      intrinsic value (which is the amount by which the stock price exceeded the
      exercise price on the date of exercise) of options exercised during the three
      years ended 2006, 2005 and 2004 was $887, $2,043 and $340, respectively. The
      Company received income tax benefits of $365, $588 and $136 for the years ended
      December 31, 2006, 2005 and 2004, respectively, related to the exercise of
      non-qualified employee stock options, and disqualifying dispositions in the
      exercise of incentive stock options. Prior to the adoption of SFAS No. 123R,
      the
      Company presented all tax benefits of deductions resulting from the exercise
      of
      stock options as operating cash flows in the Statement of Cash flows. SFAS
      No.
      123R requires the cash flows from the tax benefits resulting from tax deductions
      in excess of the compensation cost recognized for those options (excess tax
      benefits) to be classified as financing cash flows. The amount of excess tax
      benefit classified as a financing cash flow in at December 31, 2006 was $365.
      As
      of December 31, 2006, there was approximately $256 of total unrecognized
      compensation cost related to non-vested stock options which is expected to
      be
      recognized over a period of 3.1 years.





The
“2005
      Equity Based Compensation Plan”




On
      May
      26, 2005, the stockholders of the Company approved the 2005 Equity Based
      Compensation Plan (the “2005 Plan”). Upon approval by stockholders, no further
      grants would be made from the 1997 Stock Option Plan. The 2005 Plan authorizes
      the granting of Incentive Stock Options, Non-Qualified Stock Options, Stock
      Appreciation Rights (“SARs”), Restricted Stock Awards, Restricted Stock Units
      and Performance Share Cash Only Awards. The 2005 Plan provides for a maximum
      of
      ten percent (10%) of the Company’s issued and outstanding shares of common stock
      as of March 25, 2005 and adjusted on each anniversary thereafter to be ten
      percent (10%) of the then issued and outstanding number of shares.




-77-


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005, AND 2004**
 **(Dollars
        in thousands, except per share amounts)**




**Note
      #14 - Equity Compensation Plans, Continued**




The
          Company grants restricted stock periodically as a part of the 2005 Plan
          for the
          benefit of employees. Restricted shares issued are typically new shares
          and
          currently vest in five years with a “cliff” vesting. The following table
          summarizes information about non-vested restricted shares as of December
          31,
          2006 and changes for the year ended December 31, 2006:
  For
                    the year endedDecember
                    31, 2006Restricted
                    Shares
                
                Average
                    GrantOutstanding
                
                Date
                    Fair ValueBalance,
                    beginning of period
                
                
                3,750
                
                $
                16.57Granted
                
                
                67,050
                
                $
                19.00Vested
                
                
                -
                
                $
                -Forfeited/expired
                
                
                (4,750
                )
                $
                17.11Balance,
                    end of period
                
                
                66,050
                
                $
                19.00





The
      compensation cost related to restricted stock that has been charged against
      income (included in salaries and employee benefits) was $220 and $3 for the
      years ended December 31, 2006 and 2005, respectively. The total income tax
      benefit recognized in the income statement related to restricted stock was
      $80
      for the year ended December 31, 2006. No restricted shares vested during 2006
      and 2005. At December 31, 2006, there was $1,038 of total unrecognized
      compensation cost related to non-vested restricted stock which is expected
      to be
      recognized over a weighted-average period of 4.0 years.




**Note
      #15 - Related Party Transactions**




The
      Bank
      has entered into loan and deposit transactions with certain directors and
      executive officers of the Bank and the Company. These loans were made and
      deposits were taken in the ordinary course of the Bank’s business and, in
      management’s opinion, were made at prevailing rates and terms.





An
      analysis of loans to directors and executive officers is as
      follows:


2006
              
              2005Outstanding
                  Balance, Beginning of Year
              
              $
              14,603
              
              $
              5,213Additional
                  loans made
              
              
              3,715
              
              
              10,181Repayments
              
              
              (2,840
              )
              
              (791
              )Outstanding
                  Balance, End of Year
              
              $
              15,478
              
              $
              14,603





Deposits
      from related parties held by the Bank at December 31, 2006 and 2005 amounted
      to
      approximately $3,513 and $3,619, respectively.





**Note
      #16 - Restriction on Transfers of Funds to Parent**




There
      are
      legal limitations on the ability of the Bank to provide funds to the Company.
      Dividends declared by the Bank may not exceed, in any calendar year, without
      approval of the California Department of Financial Institutions (DFI), its
      respective net income for the year and the retained net income for the preceding
      two years. Section 23A of the Federal Reserve Act restricts the Bank from
      extending credit to the Company and other affiliates amounting to more than
      20
      percent of its contributed capital and retained earnings.




-78-


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005, AND 2004**
 **(Dollars
        in thousands, except per share amounts)**




**Note
      #17 - Fair Value of Financial Instruments**





The
      fair
      value of a financial instrument is the amount at which the asset or obligation
      could be exchanged in a current transaction between willing parties, other
      than
      a forced or liquidation sale. Fair value estimates are made at a specific point
      in time based on relevant market information and information about the financial
      instrument. These estimates do not reflect any premium or discount that could
      result from offering for sale at one time the entire holdings or a particular
      financial instrument. Because no market value exists for a significant portion
      of the financial instruments, fair value estimates are based on judgments
      regarding future expected loss experience, current economic conditions, risk
      characteristics of various financial instruments, and other factors. These
      estimates are subjective in nature, involve uncertainties and matters of
      judgment and, therefore, cannot be determined with precision. Changes in
      assumptions could significantly affect the estimates.





Fair
      value estimates are based on financial instruments both on and off the balance
      sheet without attempting to estimate the value of anticipated future business
      and the value of assets and liabilities that are not considered financial
      instruments. Additionally, tax consequences related to the realization of the
      unrealized gains and losses can have a potential effect on fair value estimates
      and have not been considered in many of the estimates.





The
      estimated fair value of financial instruments at December 31 is summarized
      as
      follows:


2006
              
              2005Carrying
              
              
              
              CarryingAmount
              
              Fair
                  Value
              
              Amount
              
              Fair
                  ValueAssetsCash
                  and cash equivalents
              
              $
              23,034
              
              $
              23,034
              
              $
              44,559
              
              $
              44,559Interest-bearing
                  deposits
              
              
              318
              
              
              318
              
              
              298
              
              
              298Investments
                  and mortgage-backed securities
              
              
              38,445
              
              
              38,445
              
              
              44,402
              
              
              44,402FHLB
                  and FRB stock
              
              
              2,350
              
              
              2,350
              
              
              1,885
              
              
              1,885Loans
                  receivable, net of deferred fees and costs
              
              
              443,358
              
              
              444,396
              
              
              366,516
              
              
              364,652Loans
                  held for sale
              
              
              1,764
              
              
              1,764
              
              
              3,392
              
              
              3,392Accrued
                  interest receivable
              
              
              2,627
              
              
              2,627
              
              
              1,977
              
              
              1,977LiabilitiesNoninterest-bearing
                  deposits
              
              
              153,005
              
              
              153,005
              
              
              164,014
              
              
              164,014Interest-bearing
                  deposits
              
              
              267,516
              
              
              268,991
              
              
              253,783
              
              
              253,958FHLB
                  advances
              
              
              50,000
              
              
              50,163
              
              
              10,000
              
              
              10,071Securities
                  sold under repurchase agreements
              
              
              1,364
              
              
              1,364
              
              
              3,847
              
              
              3,847Notes
                  payable
              
              
              -
              
              
              -
              
              
              -
              
              
              -Junior
                  Subordinated Debentures
              
              
              16,496
              
              
              16,352
              
              
              8,248
              
              
              8,248Accrued
                  interest payable
              
              
              851
              
              
              851
              
              
              511
              
              
              511Notional
              
              Cost
                  to Cede
              
              Notional
              
              Cost
                  to CedeAmount
              
              or
                  Assume
              
              Amount
              
              or
                  AssumeOff-Balance
                  Sheet InstrumentsCommitments
                  to extend credit andstandby
                  letters of credit
              
              $
              184,231
              
              $
              1,842
              
              $
              184,731
              
              $
              1,847





The
      following methods and assumptions were used by the Company in estimating fair
      value disclosures:





·  Cash
      and Cash Equivalents





The
      carrying amounts reported in the balance sheet for cash and cash equivalents
      approximate those assets' fair values due to the short-term nature of the
      assets.





·  Interest
      Bearing Deposits




-79-


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005, AND 2004**
 **(Dollars
        in thousands, except per share amounts)**


**Note
      #17 - Fair Value of Financial Instruments, Continued**





Fair
      values for time deposits are estimated using a discounted cash flow analysis
      that applies interest rates currently being offered on certificates to a
      schedule of aggregated contractual maturities on such time
      deposits.





·  Investment
      and Mortgage-Backed Securities





Fair
      values are based upon quoted market prices, where available.





·  Loans
      and Loans Held for Sale





For
      variable-rate loans that re-price frequently and with no significant change
      in
      credit risk, fair values are based on carrying amounts. The fair values for
      other loans (for example, fixed rate commercial real estate and rental property
      mortgage loans and commercial and industrial loans) are estimated using
      discounted cash flow analysis, based on interest rates currently being offered
      for loans with similar terms to borrowers of similar credit quality. Loan
      fair
      value estimates include judgments regarding future expected loss experience
      and
      risk characteristics. The carrying amount of accrued interest receivable
      approximates its fair value.





·  Deposits





The
      fair
      values disclosed for demand deposits (for example, interest-bearing checking
      accounts and passbook accounts) are, by definition, equal to the amount payable
      on demand at the reporting date (that is, their carrying amounts). The fair
      values for certificates of deposit are estimated using a discounted cash flow
      calculation that applies interest rates currently being offered on certificates
      to a schedule of aggregated contractual maturities on such time deposits. The
      carrying amount of accrued interest payable approximates fair
      value.





·  FHLB
      Advances





The
      fair
      value disclosed for FHLB advances is determined by discounting contractual
      cash
      flows at current market interest rates for similar instruments.





·  Securities
      Sold Under Agreement to Repurchase





The
      carrying amounts reported in the balance sheets for securities sold under
      agreement to repurchase approximate those liabilities’ fair values due to the
      short-term nature of the liabilities.




·  Junior
      Subordinated Debentures





The
      fair
      value disclosed for junior subordinated debentures is based on carrying amounts.
      The debentures are variable-rate notes that re-price frequently.





·  Off-balance
      Sheet Instruments





Fair
      values of commitments to extend credit and standby letters of credit are based
      upon fees currently charged to enter into similar agreements, taking into
      account the remaining terms of the agreement and the counterparties' credit
      standing.





-80-


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005, AND 2004**
 **(Dollars
        in thousands, except per share amounts)**


**Note
      #18 - Earnings Per Share (EPS)**





The
      following is a reconciliation of net income and shares outstanding to the income
      and number of shares used to compute EPS. Share information has been
      retroactively adjusted for the stock dividend as discussed in Note
      #20.




2006
              
              2005
              
              2004Net
              
              
              
              Net
              
              
              
              NetIncome
              
              Shares
              
              Income
              
              Shares
              
              Income
              
              SharesNet
                  income as reported
              
              $
              6,662
              
              
              
              
              $
              6,637
              
              
              
              
              $
              4,584Shares
                  outstanding at year-end
              
              
              
              
              
              6,345,639
              
              
              
              
              
              6,231,982
              
              
              
              
              
              6,013,260Impact
                  of weighting sharespurchased
                  during the year
              
              
              
              
              
              (11,715
              )
              
              
              
              
              (64,045
              )
              
              
              
              
              (22,762
              )Used
                  in Basic EPS
              
              
              6,662
              
              
              6,333,924
              
              
              6,637
              
              
              6,167,937
              
              
              4,584
              
              
              5,990,498Dilutive
                  effect of outstandingstock
                  options
              
              
              
              
              
              261,869
              
              
              
              
              
              383,452
              
              
              
              
              
              444,270Used
                  in Dilutive EPS
              
              $
              6,662
              
              
              6,595,793
              
              $
              6,637
              
              
              6,551,389
              
              $
              4,584
              
              
              6,434,768





**Note
      #19 - Other Income/Expense**





The
      following is a breakdown of fees and other income and expenses for the years
      ended December 31, 2006, 2005, and 2004:


2006
              
              2005
              
              2004Fees
                  and Other IncomeATM/Debit
                  Card Transaction/Interchange Fees
              
              $
              711
              
              $
              629
              
              $
              583Bankcard
                  merchant fees
              
              
              122
              
              
              160
              
              
              116Mortgage
                  origination fees
              
              
              552
              
              
              897
              
              
              602Earnings
                  on cash surrender value oflife
                  insurance policies
              
              
              393
              
              
              323
              
              
              294Other
              
              
              757
              
              
              482
              
              
              446$
              2,535
              
              $
              2,491
              
              $
              2,041Other
                  ExpensesData
                  processing
              
              $
              2,138
              
              $
              2,200
              
              $
              2,570Advertising
                  and promotional
              
              
              851
              
              
              582
              
              
              515Regulatory
                  fees
              
              
              112
              
              
              106
              
              
              114Other
                  professional fees and outside services
              
              
              1,207
              
              
              802
              
              
              530Legal
                  fees and other litigation expenses
              
              
              154
              
              
              122
              
              
              76Loan
                  department costs
              
              
              147
              
              
              182
              
              
              181Stationery
                  and supplies
              
              
              327
              
              
              311
              
              
              374Director
                  fees
              
              
              290
              
              
              247
              
              
              179Core
                  deposit amortization
              
              
              300
              
              
              573
              
              
              421Other
              
              
              1,249
              
              
              1,356
              
              
              1,212Total
              
              $
              6,775
              
              $
              6,481
              
              $
              6,172








-81-


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005, AND 2004**
 **(Dollars
        in thousands, except per share amounts)**


**Note
      #20 - Cash Dividends, Stock Dividends and Stock Splits**





Stock
      Dividends and Stock Splits





On
      March
      26, 2004, the Board of Directors declared a five percent stock dividend payable
      on April 23, 2004 to stockholders of record on April 9, 2004. Cash was paid
      in
      lieu of fractional shares at the rate of $17.00 per share and amounted to
      $6.





On
      March
      25, 2005, the Board of Directors declared a five percent stock dividend payable
      on April 22, 2005 to stockholders of record on April 8, 2005. Cash was paid
      in
      lieu of fractional shares at the rate of $20.15 per share and amounted to
      $8.





On
      October 21, 2005, the Board of Directors declared a 3-for-2 stock split payable
      on December 2, 2005 to stockholders of record on November 10, 2005. Cash was
      paid in lieu of fractional shares at the rate of $18.86 per share and amounted
      to $5.





All
      references in financial statements and notes to financial statements to number
      of shares, per share amounts, and market prices of the Company’s common stock
      have been restated to reflect the increased number of shares
      outstanding.




Cash
      Dividends





On
      April
      21, 2006, the Board of Directors of Heritage Oaks Bancorp, declared a special
      $0.25 cents per-share dividend for all shareholders of record on May 8, 2006,
      payable on May 19, 2006.





On
      July
      21, 2006, the Board of Directors of Heritage Oaks Bancorp, declared the
      Company’s first quarterly cash dividend of $0.08 cents per-share for all
      shareholders of record on August 11, 2006, payable on August 25,
      2006.





On
      October 20, 2006, the Board of Directors of Heritage Oaks Bancorp, the Board
      declared an $0.08 per-share quarterly cash dividend for all shareholders of
      record on November 3, 2006, payable on November 17, 2006.




**Note
      #21- Stock Repurchase Program**





In
      July
      2006, the Company adopted a stock repurchase program authorizing the repurchase
      of up to 40,000 shares of Company stock. In October 2006, the Board of Directors
      approved the authorization to repurchase an additional 60,000 shares of Company
      stock to its current stock repurchase program, which now provides for a total
      of
      up to 100,000 shares. Purchases are to be made, as conditions warrant, from
      time
      to time in the open market. The duration of the program is one year and the
      timing of purchases will depend on market conditions.




During
      the year ended December 31, 2006, 40,000 shares were repurchased and retired
      under the repurchase program. As of December 31, 2006, under the plan, the
      Company has the authority to purchase 60,000 shares of Company stock through
      July 2007.




-82-


**HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECMEBER
          31, 2006, 2005, AND 2004**
 **(Dollars
          in thousands)**
  **Note
          #22 - Condensed Financial Information of Heritage Oaks Bancorp (Parent
          Company)**





**Balance
        Sheets**
  2006
              
              2005**Assets**Cash
              
              $
              7,276
              
              $
              487Federal
                  funds sold
              
              
              -
              
              
              2,150Total
                  cash and cash equivalents
              
              
              7,276
              
              
              2,637Prepaid
                  and other assets
              
              
              627
              
              
              443Investment
                  in subsidiaries
              
              
              58,523
              
              
              50,428Total
                  Assets
              
              $
              66,426
              
              $
              53,508**Liabilities
                  and Stockholders' Equity**Notes
                  payable
              
              $
              -
              
              $
              -Junior
                  subordinated debentures
              
              
              16,496
              
              
              8,248Other
                  liabilities
              
              
              458
              
              
              415Total
                  Liabilities
              
              
              16,954
              
              
              8,663Stockholders'
                  EquityCommon
                  stock
              
              
              29,583
              
              
              29,255Retained
                  earnings
              
              
              19,889
              
              
              15,590Total
                  Stockholders' Equity
              
              
              49,472
              
              
              44,845Total
                  Liabilities andStockholders'
                  Equity
              
              $
              66,426
              
              $
              53,508






-83-


**HERITAGE
      OAKS BANCORP AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECMEBER
      31, 2006, 2005, AND 2004**


**(Dollars
      in thousands)**





**Note
      #22 - Condensed Financial Information of Heritage Oaks Bancorp (Parent Company),** **Continued**





**Statements
        of Income**
  2006
              
              2005
              
              2004**Income**Equity
                  in undisbursed income of subsidiaries
              
              $
              7,297
              
              $
              7,201
              
              $
              5,039Interest
                  income
              
              
              73
              
              
              65
              
              
              21Other
              
              
              -
              
              
              31
              
              
              57Total
                  Income
              
              
              7,370
              
              
              7,297
              
              
              5,117**Expense**Salary
                  expense
              
              
              114
              
              
              85
              
              
              75Equipment
                  expense
              
              
              (57
              )
              
              (10
              )
              
              15Other
                  professional fees and outside services
              
              
              254
              
              
              268
              
              
              130Interest
                  expense
              
              
              839
              
              
              583
              
              
              517Other
              
              
              -
              
              
              126
              
              
              112Total
                  Expense
              
              
              1,150
              
              
              1,052
              
              
              849Total
                  Operating Income
              
              
              6,220
              
              
              6,245
              
              
              4,268Income
                  tax benefit
              
              
              (442
              )
              
              (392
              )
              
              (316
              )Net
                  Income
              
              $
              6,662
              
              $
              6,637
              
              $
              4,584








-84-




**HERITAGE
      OAKS BANCORP AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECMEBER
      31, 2006, 2005, AND 2004**


**(Dollars
      in thousands)**





**Note
      #22 - Condensed Financial Information of Heritage Oaks Bancorp (Parent Company),** **Continued**





**Statements
        of Cash Flows**
  2006
              
              2005
              
              2004**Cash
                  Flows From Operating Activities**Net
                  income
              
              $
              6,662
              
              $
              6,637
              
              $
              4,584Adjustments
                  to Reconcile Net Income to Net CashProvided
                  By/(Used in) Operating ActivitiesDepreciation
              
              
              -
              
              
              8
              
              
              15Increase
                  in other assets
              
              
              (981
              )
              
              (56
              )
              
              229Increase
                  in other liabilities
              
              
              281
              
              
              18
              
              
              10Share-based
                  compensation expense
              
              
              25
              
              
              -
              
              
              -Undistributed
                  income of subsidiaries
              
              
              (7,297
              )
              
              (7,201
              )
              
              (5,039
              )Net
                  Cash Used In Operating Activities
              
              
              (1,310
              )
              
              (594
              )
              
              (201
              )**Cash
                  Flows From Investing Activities**Net
                  Proceeds from sale of fixed assets
              
              
              -
              
              
              900
              
              
              -Contribution
                  to subsidiary
              
              
              311
              
              
              -
              
              
              -Net
                  Cash Provided By/(Used In) Investing Activities
              
              
              311
              
              
              900
              
              
              -**Cash
                  Flows From Financing Activities**Cash
                  dividends received
              
              
              -
              
              
              -
              
              
              3,500Cash
                  paid in lieu of fractional shares
              
              
              -
              
              
              (12
              )
              
              (6
              )Cash
                  dividends paid
              
              
              (2,602
              )
              
              -
              
              
              -Issuance
                  of junior subordinated debentures
              
              
              8,248
              
              
              -
              
              
              -Increase/(decrease)
                  in notes payable
              
              
              -
              
              
              -
              
              
              (3,500
              )Stock
                  repurchased
              
              
              (720
              )
              
              -
              
              
              -Proceeds
                  from the exercise of options
              
              
              712
              
              
              1,275
              
              
              335Net
                  Cash Provided ByFinancing
                  Activities
              
              
              5,638
              
              
              1,263
              
              
              329**Net
                  Increase in Cash****and
                  Cash Equivalents**
              
              
              4,639
              
              
              1,569
              
              
              128**Cash
                  and Cash Equivalents**,
                  Beginning of Year
              
              
              2,637
              
              
              1,068
              
              
              940**Cash
                  and Cash Equivalents**,
                  End of Year
              
              $
              7,276
              
              $
              2,637
              
              $
              1,068





-85-




**Note
      #23 - Quarterly Financial Information (unaudited)**





The
      following table provides a summary of results for the periods
      indicated:


**For
                  the quarters ended****December 31,**
              
              **September 30,**
              
              **June 30,**
              
              **March 31,**
              
              **December 31,**
              
              **September 30,**
              
              **June 30,**
              
              **March 31,***(Dollars
                  in thousands, except per share data)*
              
              **2006**
              
              **2006**
              
              **2006**
              
              **2006**
              
              **2005**
              
              **2005**
              
              **2005**
              
              **2005**Interest
                  income
              
              $
              9,932
              
              $
              9,568
              
              $
              8,666
              
              $
              8,206
              
              $
              8,349
              
              $
              7,940
              
              $
              7,139
              
              $
              6,748Net
                  interest income
              
              
              6,951
              
              
              7,022
              
              
              6,635
              
              
              6,447
              
              
              6,787
              
              
              6,593
              
              
              6,015
              
              
              5,763Provision
                  for credit losses
              
              
              120
              
              
              180
              
              
              180
              
              
              120
              
              
              180
              
              
              170
              
              
              180
              
              
              180Non-interest
                  income
              
              
              1,301
              
              
              1,222
              
              
              1,211
              
              
              1,218
              
              
              1,222
              
              
              1,389
              
              
              1,267
              
              
              1,132Other
                  expenses
              
              
              5,539
              
              
              5,384
              
              
              5,048
              
              
              4,984
              
              
              4,857
              
              
              4,875
              
              
              4,563
              
              
              4,423Income
                  before provision for income taxes
              
              
              2,593
              
              
              2,680
              
              
              2,618
              
              
              2,561
              
              
              2,972
              
              
              2,937
              
              
              2,539
              
              
              2,292Net
                  income
              
              $
              1,649
              
              $
              1,733
              
              $
              1,673
              
              $
              1,606
              
              $
              1,809
              
              $
              1,805
              
              $
              1,606
              
              $
              1,417Earnings
                  per common share:Basic
              
              $
              0.26
              
              $
              0.27
              
              $
              0.26
              
              $
              0.26
              
              $
              0.29
              
              $
              0.29
              
              $
              0.26
              
              $
              0.23Diluted
              
              $
              0.25
              
              $
              0.26
              
              $
              0.25
              
              $
              0.24
              
              $
              0.27
              
              $
              0.28
              
              $
              0.25
              
              $
              0.22





**ITEM
      9.**  **CHANGES
      WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.**




None.





**ITEM
      9A. CONTROLS AND PROCEDURES.**





As
      required by SEC Rule 13a-15(b), the Company carried out an evaluation, under
      the
      supervision and with the participation of the Company’s management, including
      the Company’s Chief Executive Officer along with the Company’s Chief Financial
      Officer, of the effectiveness of the design and operation of the Company’s
      disclosure controls and procedures as of the end of the period covered by this
      report. The evaluation of disclosure controls and procedures includes an
      evaluation of some components of the Company’s internal control over financial
      reporting, and internal control over financial reporting is also separately
      evaluated on an annual basis for purposes of providing the management report
      which is set forth below. Based upon that evaluation, the Company’s Chief
      Executive Officer along with the Company’s Chief Financial Officer concluded
      that the Company’s disclosure controls and procedures are effective in timely
      alerting them to material information relating to the Company (including its
      consolidated subsidiary) required to be included in the Company’s periodic SEC
      filings. There have been no significant changes in the Company’s internal
      control over financial reporting during the Company’s most recent fiscal quarter
      that have materially affected, or are likely to materially affect, the Company’s
      internal control over financial reporting.




Disclosure
      controls and procedures are the Company’s controls and other procedures that are
      designed to ensure that information required to be disclosed by the Company
      in
      the reports that it files or submits under the Exchange Act is recorded,
      processed, summarized and reported within the time periods specified in the
      SEC’s rules and forms. These controls and subsequent results are communicated to
      executive management providing the ability to make timely decisions regarding
      required disclosure.




-86-


**ITEM
      9B. OTHER INFORMATION.**




None.




**PART
      III**





**ITEM
      10. DIRECTORS,,EXECUTIVE OFFICERS OF THE REGISTRANT, AND CORPORATE** **GOVERNANCE**





**Code
      of Ethics**





We
      have
      adopted a Code of Conduct, which applies to all employees, officers and
      directors of the Company and Bank. Our Code of Conduct meets the requirements
      of
      a “code of ethics” as defined by Item 406 of Regulation S-K and applies to our
      Chief Executive Officer, Chief Financial Officer and Chief Accounting Officer,
      as well as all other employees, as indicated above. Our Code of Conduct is
      posted on our website at *www.heritageoaksbancorp.com* ** under
      the
      heading “Investor Relations - Governance Documents.” Any change to or waiver of
      the code of conduct (other than technical, administrative and other
      non-substantive changes) will be posted on the Company’s website or reported on
      a Form 8-K filed with the Securities and Exchange Commission. While the Board
      may consider a waiver for an executive officer or director, the Board does
      not
      expect to grant such waivers.





There
      have been no material changes to the procedures by which security holders may
      recommend nominees to the Company’s Board during 2006.





The
      balance of the information required by Item 10 of Form 10-K is incorporated
      by
      reference from the information contained in the Company’s Proxy Statement for
      the 2007 Annual Meeting of Shareholders which will be filed pursuant to
      Regulation 14-A





**ITEM
      11. EXECUTIVE COMPENSATION.**





The
      information required by Item 11 of Form 10-K is incorporated by reference from
      the information contained in the Company’s Proxy Statement for the 2007 Annual
      Meeting of Shareholders which will be filed pursuant to Regulation
      14-A.





**ITEM
      12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS.**





The
      information required by Item 12 of Form 10-K is incorporated by reference from
      the information contained in the Company’s Proxy Statement for the 2007 Annual
      Meeting of Shareholders which will be filed pursuant to Regulation 14-A. See
      (Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters and
      Issuer Purchases of Equity Securities).





**ITEM
      13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR** **INDEPENDENCE.**





The
      information required by Item 13 of Form 10-K is incorporated by reference from
      the information contained in the Company’s Proxy Statement for the 2007 Annual
      Meeting of Shareholders which will be filed pursuant to Regulation
      14-A.





**ITEM
      14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.**





The
      information required by Item 14 of Form 10-K is incorporated by reference from
      the information contained in the Company’s Proxy Statement for the 2007 Annual
      Meeting of Shareholders which will be filed pursuant to Regulation
      14-A.




-87-




**PART
      IV**





**ITEM
      15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.**





(b)
      Exhibits:


(2.1a)
              
              Branch
                  Purchase and Assumption Agreement and Real Property Purchase Agreement
                  entered into between Westamerica Bank and Heritage Oaks Bank, dated
                  July
                  16, 2001 filed with the SEC in the Company’s 10-QSB for the period ending
                  June 30, 2001.(2.1b)
              
              Agreement
                  to Merge and Plan of Reorganization, dated June 11, 2003, filed
                  with the
                  SEC in the Company’s 8-K of June 12, 2003.(3.1a)
              
              Articles
                  of Incorporation incorporated by reference from Exhibit 3.1a to
                  Registration Statement on Form S-4 No. 33-77504 filed with the
                  SEC on
                  April, 1994.(3.1b)
              
              Amendment
                  to the Articles of Incorporation filed with the Secretary of State
                  on
                  October 16, 1997 filed with the SEC in the Company’s 10-KSB for the year
                  ending December 31, 1997.(3.2)
              
              The
                  Company Bylaws as amended November 16, 2000 filed with the SEC
                  in the
                  Company’s 10-KSB for the year ended December 31, 2000.(4.1)
              
              Specimen
                  form of The Company stock certificate incorporated by reference
                  from
                  Exhibit 4.1 to Registration Statement on Form S-4 No. 33-77504
                  filed with
                  the SEC on April 8, 1994.(10.1)
              
              1990
                  Stock Option Plan incorporated by reference from Exhibit 10.2 to
                  Registration Statement on Form S-4 No. 33-77504, filed with the
                  SEC on
                  April 8, 1994.(10.2)
              
              Form
                  of Stock Option Agreement incorporated by reference from Exhibit
                  4.2 to
                  Registration Statement on Form S-4 No. 33-77504, filed with the
                  SEC on
                  April 8, 1994.(10.3)
              
              Lawrence
                  P. Ward Employment Letter Agreement, dated February 28, 2002,filed
                  with the SEC in the Company’s 10-KSB Report for the year ended December
                  31, 2001.(10.4)
              
              401(k)
                  Pension and Profit Sharing Plan filed with the SEC in the Company’s 10K
                  Report for the year ended December 31, 1994.(10.5)
              
              The
                  Company 1995 Bonus Plan, filed with the SEC in the Company’s 10K Report
                  for the year ended December 31, 1994.(10.6)
              
              Salary
                  Continuation Agreement with Lawrence P. Ward, filed with the SEC
                  in the
                  Company’s 10-QSB Report for the quarter ended March 31,
                  2001.
   -88-
   (10.7)
              
              Salary
                  Continuation Agreement with Gwen R. Pelfrey, filed with the SEC
                  in the
                  Company’s 10K Report for the year ended December 31,
                  1994.(10.8)
              
              Woodland
                  Shopping Center Lease, filed with the SEC in the Company’s 10K Report for
                  the year ended December 31, 1994.(10.9)
              
              1135
                  Santa Rosa Street Lease, filed with the SEC in the Company’s 10KSB Report
                  for the year ended December 31, 1995.(10.10)
              
              Lease
                  Agreement for Cambria Branch Office dated February 21, 1997 filed
                  with the
                  SEC in the Company’s 10KSB reported for the year ended December
                  31,1996.(10.11)
              
              1997
                  Stock Option Plan incorporated by reference from Exhibit 4a to
                  Registration Statement on Form S-8 No.333-31105 filed with the
                  SEC on July
                  11, 1997 as amended, incorporated by reference, from Registration
                  Statement on Form S-8, File No. 333-83235 filed with the SEC on
                  July 20,
                  1999.(10.12)
              
              Form
                  of Stock Option Agreement incorporated by reference from Exhibit
                  4b to
                  Registration Statement on Form S-8 No. 333-31105 filed with the
                  SEC on
                  July 11, 1997.(10.13)
              
              Madonna
                  Road Lease filed with the SEC in the Company’s 10KSB for the year ended
                  December 31, 1997.(10.14)
              
              Santa
                  Maria lease commencing November 1, 1998 filed with the SEC in the
                  Company’s 10-KSB for the year ended December 31, 1998.(10.15)
              
              Master
                  data processing agreement with Mid West payment Systems, Inc. commencing
                  October 1, 1998 filed with the SEC in the Company’s 10-KSB for the year
                  ended December 31, 1998.(10.16)
              
              Salary
                  Continuation Agreement with Margaret A. Torres, filed with the
                  SEC in the
                  Company’s 10KSB Report for the year ended December 31,
                  1999.(10.17)
              
              Salary
                  Continuation Agreement with Paul Tognazzini, filed with the SEC
                  in the
                  Company’s 10-KSB Report for the year ended December 31,
                  2001.(10.18)
              
              Atascadero
                  Branch Lease entered into on March 31, 1999. filed with the SEC
                  in the
                  Company’s 10-KSB reported for the year ended December
                  31,1999.(10.19)
              
              Service
                  Bureau Processing Agreement entered into between Alltel Information
                  Services, Inc. and Heritage Oaks Bank, dated August 1, 1999. Filed
                  with
                  the SEC in the Company’s 10-KSB reported for the year ended December 31,
                  1999.(10.20)
              
              ASSET
                  PURCHASE AGREEMENT entered into between Travelex America, Inc.
                  and
                  Heritage Oaks Bank, dated November 21 , 2000 filed with the SEC
                  in the
                  Company’s 10-KSB reported for the year ended December 31,
                  2000.
   -89-
   (10.21)
              
              Change
                  in Terms Agreement and Business Loan Agreement entered into between
                  the
                  Company and Pacific Coast Banker’s Bank on November 8, 2000, filed with
                  the SEC in the Company’s 10-KSB reported for the year ended December 31,
                  2001.(10.22)
              
              Executive
                  Salary Continuation Agreement dated February 1, 2002 between Heritage
                  Oaks
                  Bank and Margaret A. Torres, filed with the SEC in the Company’s 10-QSB
                  reported for March 31, 2002.(10.23)
              
              Executive
                  Salary Continuation Agreement dated February 1, 2002 between Heritage
                  Oaks
                  Bank and Paul Tognazzini, filed with the SEC in the Company’s 10-QSB
                  reported for March 31, 2002.(10.24)
              
              Executive
                  Salary Continuation Agreement dated February 1, 2002 between Heritage
                  Oaks
                  Bank and Gwen R. Pelfrey, filed with the SEC in the Company’s 10-QSB
                  reported for March 31, 2002.(10.25)
              
              Executive
                  Salary Continuation Agreement dated February 1, 2002 between Heritage
                  Oaks
                  Bank and Gloria Brady, filed with the SEC in the Company’s 10-QSB reported
                  for March 31, 2002.(10.26)
              
              Executive
                  Salary Continuation Agreement dated February 1, 2002 between Heritage
                  Oaks
                  Bank and Joe Carnevali, filed with the SEC in the Company’s 10-QSB
                  reported for March 31, 2002.(10.27)
              
              Executive
                  Salary Continuation Agreement dated February 1, 2002 between Heritage
                  Oaks
                  Bank and Donna Breuer, filed with the SEC in the Company’s 10-QSB reported
                  for March 31, 2002.(10.28)
              
              Executive
                  Salary Continuation Agreement dated February 1, 2002 between Heritage
                  Oaks
                  Bank and Chris Sands, filed with the SEC in the Company’s 10-QSB reported
                  for March 31, 2002.(10.29)
              
              Money
                  Access Services Processing Agreement for ATM processing, signed
                  on October
                  3, 2002, filed with the SEC in the Company’s 10QSB reported for September
                  30, 2002.(10.30)
              
              The
                  Company Employee Stock Ownership Plan, Summary Plan Description,
                  filed
                  with the SEC in the Company’s 10-KSB reported for December 31,
                  2002.(10.31)
              
              The
                  Company Employee Stock Ownership Plan, Summary of Material Modifications
                  to the Summary Plan Description dated July 2002, filed with the
                  SEC in the
                  Company’s 10-KSB reported for December 31, 2002.(10.32)
              
              A
                  Construction Agreement dated February 12, 2003 between Heritage
                  Oaks Bank
                  and HBE financial Facilities, a Division of HBE Corporation, filed
                  with
                  the SEC in the Company’s 10-QSB for March 31, 2003.(10.33)
              
              Executive
                  Salary Continuation Agreement dated July 1, 2003 between Heritage
                  Oaks
                  Bank and Mark Stasinis, filed with the SEC in the Company’s 10-QSB
                  reported for June 30, 2003.(10.34)
              
              Executive
                  Salary Continuation Agreement dated July 1, 2003 between Heritage
                  Oaks
                  Bank and Kelley Stolz, filed with the SEC in the Company’s 10-QSB reported
                  for June 30, 2003.
   -90-
   (10.35)
              
              Executive
                  Salary Continuation Agreement dated July 1, 2003 between Heritage
                  Oaks
                  Bank and Paul Deline, filed with the SEC in the Company’s 10-QSB reported
                  for June 30, 2003.(10.36)
              
              Executive
                  Salary Continuation Agreement dated July 1, 2003 between Heritage
                  Oaks
                  Bank and Mitch Massey, filed with the SEC in the Company’s 10-QSB reported
                  for June 30, 2003.(10.37)
              
              Employment
                  Agreement with David Duarte, President and Chief Operating Officer
                  of
                  Hacienda Bank, dated September 5, 2003 and filed with the SEC in
                  the
                  Company’s 10-QSB reported for September 30, 2003.(10.38)
              
              Promissory
                  Note executed on October 3, 2003 for $3.5 million with Pacific
                  Coast
                  Bankers Bank, filed with the SEC in the Company’s 10-QSB reported for
                  September 30, 2003.(10.39)
              
              Employment
                  Agreement with Lawrence P. Ward, President and Chief Executive
                  Officer of
                  Heritage Oaks Bank, dated February 1, 2004 and filed with the SEC
                  in the
                  Company’s 10-KSB reported for December 31, 2003.(10.40)
              
              Executive
                  Salary Continuation Agreement dated November 1, 2003 between Hacienda
                  Bank
                  and David Duarte, filed with the SEC in the Company’s 10-KSB reported for
                  December 31, 2003.(10.41)
              
              Fifth
                  Amendment to Service Bureau Processing Agreement dated June 19,
                  2004
                  between Fidelity Information Services, Inc. and Heritage Oaks Bank,
                  filed
                  with the SEC in the Company’s 10QSB for June 30, 2004.(10.42)
              
              Atascadero
                  Branch Lease entered into on July 15, 2005, filed with the SEC
                  in the
                  Company’s 10-Q for the quarter ended September 30, 2005(14)
              
              Code
                  of Ethics, filed with the SEC in the Company’s 10-KSB for the year ended
                  December 31, 2003.(21)
              
              Subsidiaries
                  of the Company. Heritage Oaks Bank is the only financial subsidiaries
                  of
                  the Company.(23)
              
              Consent
                  of Independent Registered Accounting Firm(31.1)
              
              Certification
                  of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
                  Act of 2002(31.2)
              
              Certification
                  of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
                  Act of 2002(32.1)
              
              Certification
                  of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley
                  Act of 2002(32.2)
              
              Certification
                  of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley
                  Act of 2002




-91-




SIGNATURES





Pursuant
      to the requirements of Section 13 of the Securities Exchange Act of 1934, the
      Company has duly caused this report to be signed on its behalf by the
      undersigned thereunto duly authorized.




THE
      COMPANY


/s/ Lawrence P. Ward
            
            
            /s/
              Margaret A. TorresLAWRENCE
              P. WARD
            
            
            MARGARET
              A. TORRESPresident and Chief Executive Officer
              Dated:March
                1, 2007
            
            
            Executive Vice President, Chief Financial
                Officer
              and Principal Accounting Officer
              Dated:March 1, 2007




Pursuant
      to the requirements of the Securities Exchange Act of 1934, this report has
      been
      signed below by the following persons on behalf of the Registrant and in the
      capacities and on the dates indicated.


/s/
                  B.R. Bryant
              
              Chairman
                  of the Board
              
              March
                  1, 2007B.R.
                  BRYANT/s/
                  Donald H. Campbell
              
              Vice
                  Chairman
              
              March
                  1, 2007DONALD
                  H. CAMPBELL
              
              of
                  the Board of Directors/s/
                  Kenneth Dewar
              
              Director
              
              March
                  1, 2007KENNETH
                  DEWAR/s/
                  Mark C. Fugate
              
              Director
              
              March
                  1, 2007MARK
                  C. FUGATE/s/
                  Dolores T. Lacey
              
              Director
              
              March
                  1, 2007DOLORES
                  T. LACEY/s/
                  Merle F. Miller
              
              Director
              
              March
                  1, 2007MERLE
                  F. MILLER/s/
                  Michael Morris
              
              Director
              
              March
                  1, 2007MICHAEL
                  MORRIS/s/
                  Daniel J. O’Hare
              
              Director
              
              March
                  1, 2007DANIEL
                  J. O’HARE/s/
                  Alex Simas
              
              Director
              
              March
                  1, 2007ALEX
                  SIMAS/s/
                  Ole K. Viborg
              
              Director
              
              March
                  1, 2007OLE
                  K. VIBORG/s/
                  Lawrence P. Ward
              
              Director
              
              March
                  1, 2007LAWRENCE
                  P. WARD
   -92-


EXHIBIT
      INDEX


ExhibitSequentialNumber
              
              Description23
              
              Consent
                  of Independent Accountants31.1
              
              Certification
                  of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
                  Act of 200231.2
              
              Certification
                  of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
                  Act of 200232.1
              
              Certification
                  of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley
                  Act of 200232.2
              
              Certification
                  of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley
                  Act of 2002
  -93-