UNITED
STATES
 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
fiscal year ended December 31, 2008.





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:000-25020


HERITAGE
OAKS BANCORP


(Exact
name of registrant as specified in its charter)





California
              
              77-0388249(State
      or other jurisdiction of
              
              (I.R.S.
      Identification No.)Incorporation
      or organization)545
      12th StreetPaso
      Robles, California
              
              93446(Address
      of Principal Executive Offices)
              
              (Zip
      Code)





(805)
369-5200


(Registrant’s
Telephone Number)





Securities
registered pursuant to Section 12(b) of the Act:  None





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





COMMON
      STOCK, (no par value)
              NASDAQ
      Global MarketTitle
      of each class
              Name
      of each exchange on which
registered





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 (§229.405 of this chapter) 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, a non-accelerated filer, or smaller reporting
company.  See definitions of “large accelerated filer,” “accelerated
filer” and “smaller reporting company” in Rule 12b-2 of the Exchange
Act.


Large
accelerated filer o  Accelerated
filer x  Non-accelerated
filer o Smaller
reporting company 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, 2008 was $57.1
million.  As of February 24, 2009, the Registrant had 7,752,553 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 2009 annual
meeting of shareholders.





Heritage
Oaks Bancorp and Subsidiaries


Table
of Contents





Part I
                
                
                3Item
      1. Business
                
                
                3Item
      1A. Risk Factors
                
                
                14Item
      1B. Unresolved Staff Commitments
                
                
                21Item
      2. Properties
                
                
                21Item
      3. Legal Proceedings
                
                
                22Item
      4. Submission of Matters to a Vote of Securities Holders
                
                
                22Part
      II
                
                
                22Item
      5. Market for Registrant’s Common Equity, Related Stockholder Matters and
      Issuer Purchases of Equity Securities
                
                
                22Item
      6. Selected Financial Data
                
                
                25Item
      7. Management’s Discussion and Analysis of Financial Condition and Results
      of Operations
                
                
                26Item
      7A. Quantitative and Qualitative Disclosures about Market
    Risk
                
                
                56Item
      8. Financial Statements and Supplementary Data
                
                
                59Item
      9. Changes in and Disagreements with Accountants on Accounting and
      Financial Disclosure
                
                
                103Item
      9A. Controls and Procedures
                
                
                103Item
      9B. Other Information
                
                
                103Part
      III
                
                
                104Item
      10. Directors, Executive Officers and Corporate Governance
                
                
                104Item
      11. Executive Compensation
                
                
                104Item
      12. Security Ownership of Certain Beneficial Owners and Management and
      Related Stockholder Matters
                
                
                104Item
      13. Certain Relationships and Related Transactions, and Director
      Independence
                
                
                104Item
      14. Principal Accounting Fees and Services
                
                
                104Part
      IV
                
                
                105Item
      15. Exhibits, Financial Statement Schedules
                
                
                105Signatures
                
                
                106Exhibit
      Index
                
                
                107Certifications










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: the current economic downturn and related financial crisis in the
United States and abroad, and the response by government and bank regulators,
general economic and business conditions in those areas in which the Company
operates, demographic changes, competition, fluctuations in interest rates, the
recent disruptions of the United States credit markets, 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.  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
October 2006, the Company formed Heritage Oaks Capital Trust II (the “Trust
II”).  Trust II is a statutory business trust formed under the laws of
the State of Delaware and is a wholly-owned, non-financial, non-consolidated
subsidiary of the Company.





On April
23, 2007, the Company redeemed all of the Floating Rate Junior Subordinated Debt
Securities it held associated with Heritage Oaks Capital Trust I, a wholly owned
subsidiary of Heritage Oaks Bancorp.  The redemption price was 100% of
the principal amount redeemed plus accrued and unpaid interest as of the
redemption date.  As a result of the redemption of the securities
associated with Heritage Oaks Capital Trust I, the Trust was dissolved on June
1, 2007.  See also Note 8 to the Consolidated Financial Statements
filed on this Form 10-K for a more detailed discussion related to the redemption
of these securities.





In June
of 2007, the Company sold four of its properties to First States Group, L.P.
(“First States”), an unaffiliated party, in a sale-leaseback transaction for
$12.8 million.  In connection with the sale, the Bank entered into
four separate lease agreements with First States Investors, LLC to lease back
three branches and one administrative facility under which the bank will
continue to utilize for the normal course of business.  The three
branches are located in Paso Robles, Arroyo Grande and Santa Maria,
California.  The administrative facility is located in Paso Robles,
California.  See also Item 2 Description of Properties, on this Form
10-K for a more detailed discussion related to this sale-leaseback
transaction.





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





On
October 12, 2007 the Company acquired Business First National Bank (“Business
First”).  Business First was merged into Heritage Oaks Bank, a wholly
owned subsidiary of the Company.  The acquisition added two branches
to the Heritage Oaks Bank network and marked the Company’s entry into southern
Santa Barbara County.  The Company is operating these two branches as
Business First, a division of Heritage Oaks Bank.  The consideration
paid for Business First was $19.5 million, consisting of approximately 75%
common stock and 25% cash.  Business First shareholders received
0.5758 shares of Heritage Oaks Bancorp common stock for each share of Business
First they owned and $3.44 per share in cash.  Upon the acquisition of
Business First, Dr. Michael J. Behrman and Mr. Michael E. Pfau, previous members
of Business First’s Board of Directors, were added to the Board of Directors of
the Company.  See also Note 23 to the Consolidated Financial
Statements filed on this Form 10-K for additional information regarding this
acquisition.


3





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 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, 2008, the Company had approximately $805.6 million in consolidated
assets, $668.0 million in net consolidated loans, $603.5 million in consolidated
deposits, and $70.0 million in stockholders' equity.





The Bank
is headquartered in Paso Robles, California with one branch office in Paso
Robles, Arroyo Grande, Atascadero, Cambria, Morro Bay, Templeton and San Miguel,
two branch offices in San Luis Obispo and Santa Barbara and three branch offices
in Santa Maria.  The Bank conducts a commercial banking business in
the counties of San Luis Obispo and Santa Barbara, 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, online banking, 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.





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: commercial and industrial loans, installment loans,
construction loans, and other real estate loans or commercial loans secured by
real estate.  As of December 31, 2008, the Bank had approximately
$680.1 million in gross loan balances, of which approximately $499.7 million or
73.5% consisted of interim construction and other real estate secured loans,
primarily for single family residences or for commercial
development.  A more detailed discussion of the loan portfolio can be
found under Item 7. Management’s Discussion and Analysis of Financial Condition
and Results of Operations and Note 3 of the Consolidated Financial Statements
filed on this Form 10-K.





Most of
the Bank’s deposits are obtained through 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 these accounts would have a materially adverse effect on
the business of the Bank.  However, there are several deposit
relationships that the Bank considers to be volatile.  These accounts
are closely monitored by Bank Management and had combined balances of $61.6
million or 10.2% of total deposits at December 31, 2008.  A more
detailed discussion of the Bank’s deposits and accounts Management considers to
be volatile can be found under Item 7. Management’s Discussion and Analysis of
Financial Condition and Results of Operations of this Form 10-K.





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.


4





The
following provides a breakdown of the components that make up the Company’s
consolidated revenues for the years ended December 31, 2008, 2007 and
2006:





For
      the Years Ended December 31,Percent
                                
                                
                                
                                
                                
                                Percent
                                
                                
                                
                                
                                
                                Percent(dollar
      amounts in thousands)
                                
                                2008
                                
                                
                                Composition
                                
                                
                                2007
                                
                                
                                Composition
                                
                                
                                2006
                                
                                
                                CompositionInterest and fees on loans
                                
                                $
                                47,038
                                
                                
                                
                                83.5
                                %
                                
                                $
                                42,425
                                
                                
                                
                                84.0
                                %
                                
                                $
                                33,897
                                
                                
                                
                                82.0
                                %Interest
      on investments
                                
                                
                                3,112
                                
                                
                                
                                5.5
                                %
                                
                                
                                2,749
                                
                                
                                
                                5.4
                                %
                                
                                
                                2,475
                                
                                
                                
                                6.0
                                %Service
      charges, other charges and fees
                                
                                
                                3,284
                                
                                
                                
                                5.8
                                %
                                
                                
                                2,774
                                
                                
                                
                                5.5
                                %
                                
                                
                                2,427
                                
                                
                                
                                5.9
                                %Mortgage
      origination fees
                                
                                
                                568
                                
                                
                                
                                1.0
                                %
                                
                                
                                461
                                
                                
                                
                                0.9
                                %
                                
                                
                                552
                                
                                
                                
                                1.3
                                %Miscellaneous
      income
                                
                                
                                2,354
                                
                                
                                
                                4.2
                                %
                                
                                
                                2,114
                                
                                
                                
                                4.2
                                %
                                
                                
                                1,973
                                
                                
                                
                                4.8
                                %Total
      consolidated revenues
                                
                                $
                                56,356
                                
                                
                                
                                100.0
                                %
                                
                                $
                                50,523
                                
                                
                                
                                100.0
                                %
                                
                                $
                                41,324
                                
                                
                                
                                100.0
                                %





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 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.  Additionally, Management 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, 2008, The Bank had 223 full-time equivalent
employees.  The Bank believes that its employee relations are
positive.





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, the
City of Santa Maria (in Northern Santa Barbara County), and the City of Santa
Barbara totaled approximately 262,000, 86,000, and 86,000 respectively,
according to the most recent economic data provided by the U.S. Census
Bureau.  The moderate climate allows a year round growing season for
numerous vegetables and fruits.  Vineyards and cattle ranches also
contribute largely to the local economy.  The Central Coast’s leading
agricultural industry is the production of high quality wine grapes and
production of premium quality wines. Vineyards in production have grown
significantly over the past several years throughout the Company’s service
area.  Access to numerous recreational activities including lakes,
mountains and beaches, provide a relatively stable tourist industry from many
areas including the Los Angeles/Orange County basin, the San Francisco Bay area
and the San Joaquin Valley. While the economy in our primary markets of San Luis
Obispo and Santa Barbara counties have not been immune to the negative impacts
of both the national and state economies, the abundant tourism that has
developed over the past decade in our market area, especially in the wine
industry and coastal communities, has helped sustain our local economy in
previous economic downturns.





2008
proved to be a challenging year not only on the national level, but within the
state of California and more specifically our primary market area.  As
the U.S. housing market continued to wane throughout 2008 and economic growth
began to significantly slow, the ability of borrowers to satisfy their
obligations to the financial sector began to languish.  These among
other factors placed severe stress on the U.S. financial system, leading to a
crisis of confidence, further downturn in economic growth and unprecedented
volatility in the U.S. equity and credit markets.  As mentioned, our
primary market area has historically enjoyed a more stable level of economic
activity; however we believe these more macro level concerns have started to
become more evident within our market area.  Recent indications show
the unemployment rate within California to be approximately
9.3%.  This is up approximately 3.4% from the 5.9% reported at
December 2007.  Within our primary market area, recent indications
show the unemployment rate within San Luis Obispo and Santa Barbara counties to
be approximately 6.6% and 6.3%, respectively.  This represents
increases of approximately 2.3% and 1.9% from the 4.3% and 4.4% reported for San
Luis Obispo and Santa Barbara counties at December
2007.  Additionally, housing prices have fallen significantly year
over year within California, showing an approximate 42% year over year decline
as of December 2008.  Within the Company’s primary market, we have
seen housing prices fall in San Luis Obispo and Santa Barbara counties from year
ago levels by approximately 29% and 34%, respectively.  However, sales
have been relatively strong within the Company’s primary market area, climbing
approximately 32% during 2008, the majority of which can be attributed to sales
of foreclosed properties.  That said, the lack of oversupply in our
market, desirable climate, close proximity to beaches, water sport lakes and the
wine industry, for both San Luis Obispo and Santa Barbara Counties have to some
degree provided support for the real-estate market in our area.


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.





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.





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.  The recent stresses placed on the U.S.
financial system have had a direct impact on the levels of liquidity at many
financial institutions, which in turn has made the competition for deposits more
challenging in the current economic environment.  Commercial banks
also compete for loans with savings and loan associations, credit unions,
consumer finance companies, mortgage companies, and other lending
institutions.





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 its investment 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, combating recession and providing
liquidity) by its open-market operations in U.S. 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.


6





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
also “Supervision and Regulation - Sarbanes-Oxley Act of 2002 and Financial
Services Modernization Legislation.”





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.





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.


7





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.





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 include off balance sheet items, against both total
qualifying capital (the sum of Tier I capital and limited amounts of Tier II
capital) and Tier I capital.  Tier I 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
II capital may consist of a limited amount of the allowance for possible loan
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 II 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 I 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 I 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 I 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.


8





The
regulatory capital requirements, as well as the actual capital ratios for the
Bank and the Company as of December 31, 2008, are presented in detail in Note
11, Regulatory Matters of the Consolidated Financial Statements.  See
also “Capital” within Management’s Discussion and Analysis of Financial
Condition and Results of Operations of this Form 10-K.  As of December
31, 2008, both the Bank and the Company exceeded the minimum capital
requirements to be well capitalized.





Under
applicable regulatory guidelines, the Company’s trust preferred securities
issued by our subsidiary capital trusts qualify as Tier I capital up to a
maximum limit of 25% of total Tier I capital.  Any additional portion
of the trust preferred securities would qualify as Tier II
capital.  As of December 31, 2008, the subsidiary trusts had $13.4
million in trust preferred securities outstanding, of which $13.0 million
qualify as Tier I 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.





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.


9





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
deposits of the Bank have historically been insured by the FDIC up to $100,000
per insured depositor, except certain types of retirement accounts, which are
insured up to $250,000 per insured depositor. On October 3, 2008, the
maximum amount insured under FDIC deposit insurance was temporarily increased
from $100,000 to $250,000 per insured depositor through December 31, 2009.
This increase was part of the Emergency Economic Stabilization Act of 2008.
Additionally, the Bank has elected to participate in the FDIC’s Temporary
Liquidity Guarantee Program. Under this program, all non-interest bearing
deposit transaction accounts at the Bank with balances over $250,000 will also
be fully insured through December 31, 2009 at an additional cost to the
Bank of 10 basis points per dollar over $250,000 on a per account
basis.




The FDIC
has set a designated reserve ratio of 1.25% ($1.25 against $100 of insured
deposits) for the Deposit Insurance Fund (“DIF”). The Federal Deposit Insurance
Reform Act of 2005 (“FDIC Act”) provides the FDIC Board of Directors the
authority to set the designated reserve ratio between 1.15% and 1.50%. The FDIC
must adopt a restoration plan when the reserve ratio falls below 1.15% and begin
paying dividends when the reserve ratio exceeds 1.35%. There is no requirement
to achieve a specific ratio within a given time frame. The FDIC Board of
Directors has not declared any dividends as of December 31, 2008. The DIF
reserve ratio calculated by the FDIC that was in effect at December 31,
2008 was 0.76%.




In 2007,
FDIC regulations established a new risk-based assessment system under which
deposit insurance assessments are based upon supervisory ratings for all insured
institutions, financial ratios for most institutions, and long-term debt issuer
ratings for large institutions that have them.




In 2007
and 2008, the annual insurance premiums on bank deposits insured by the DIF
varied between $0.05 per $100 of deposits for banks classified in the highest
capital and supervisory evaluation categories to $0.43 per $100 of deposits for
banks classified in the lowest capital and supervisory evaluation categories. In
2007 and 2008 the Bank was classified in the highest capital and supervisory
evaluation category.  Under the FDIC Act, the Bank received a one time
assessment credit of approximately $126 thousand, discussed more fully
below.  In 2007, the Bank exhausted this credit.




In 2006,
the annual insurance premiums on bank deposits insured by the DIF varied between
$0 per $100 of deposits for banks classified in the highest capital and
supervisory evaluation categories to $0.27 per $100 of deposits for banks
classified in the lowest capital and supervisory evaluation categories. In 2006,
the Bank paid no annual insurance premiums because of the one time assessment
credit discussed above.




The FDIC
Act required the FDIC to establish a one-time historical assessment credit that
provides banks a credit that could be used to offset insurance assessments. This
one-time historical assessment credit was established to benefit banks that had
funded deposit insurance funds prior to December 31, 1996. This one-time
historical assessment credit was based upon the Bank’s insured deposits as of
December 31, 1996. As stated above, the Bank’s one-time historical
assessment credit was $126 thousand when it was established in 2006. During
2007, the Bank fully utilized this credit and only partially offset 2007
assessments. As a result, the Bank’s Federal deposit insurance expense increased
in 2008 and will increase further in 2009.


10




As
required by law, in October 2008, the FDIC Board adopted a restoration plan
that would increase the reserve ratio to the 1.15% threshold within five years.
As part of that plan, in December, 2008, the FDIC Board of Directors voted to
increase risk-based assessment rates uniformly by seven cents, on an annual
basis, for the first quarter of 2009 due to deteriorating financial conditions
in the banking industry.




In
addition to risk-based deposit insurance assessments, additional assessments may
be imposed by the Financing Corporation, a separate U.S. government agency
affiliated with the FDIC, on insured deposits to pay for the interest cost of
Financing Corporation bonds. Financing Corporation assessment rates for 2008
ranged from $.0110 to $.0114 per $100 of deposits. Financing Corporation
assessments of $68 thousand, $55 thousand and $51 thousand were paid by the Bank
for the years ended December 31, 2008, 2007 and 2006, respectively, and are
included in other expense.




The FDIC
is authorized to terminate a depository institution’s deposit insurance if it
finds that the institution is being operated in an unsafe and unsound manner or
has violated any rule, regulation, order or condition administered by the
institution’s regulatory authorities. Any such termination of deposit insurance
would likely have a material adverse effect on the Bank, the severity of which
would depend on the amount of deposits affected by such a
termination.




Under
federal law, deposits and certain claims for administrative expenses and
employee compensation against an insured depository institution are afforded a
priority over other general unsecured claims against such an institution,
including federal funds and letters of credit, in the liquidation or other
resolution of such an institution by any receiver appointed by regulatory
authorities. Such priority creditors would include the FDIC.





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. The Company has
incurred additional expense as a result of the Act, although not material, and
does not expect that such compliance will have a material impact on our business
in future periods.





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.


11





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 its 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, The Uniting and Strengthening America by Providing Appropriate
Tools Required to Intercept and Obstruct Terrorism, or the Patriot Act, of 2001
was signed into law. 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 to make rules to implement the Patriot Act.  On March 9, 2006, the
USA Patriot Improvement and Reauthorization Act was signed into law, which
extended and modified the original act.  While we believe the Patriot
Act, as amended and reauthorized, may, to some degree, affect our operations, we
do not believe that it will have a material adverse effect on our business and
operations.





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 another 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.”  In its last
examination by the FDIC, the Bank received a CRA rating of
"Satisfactory."


12





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;





·
            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.


13





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.





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 May
Hurt Our Business


A
significant portion of our loan portfolio is dependent on real
estate.  At December 31, 2008, real estate served as the principal
source of collateral with respect to approximately 73.5% of our loan
portfolio.  A decline in current economic conditions, a decline in the
local housing market, both of which 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.


14





We
Also Have a Concentration in Higher Risk Commercial Real Estate
Loans


We also
have a high concentration in commercial real estate (“CRE”) loans. CRE loans as
defined by final guidance issued by Bank regulators are 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 64.5% 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.





Additionally,
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.
At the most recent regulatory examination in October 2008, there was no
recommendation in regard to these issues.





Recession
and Changes in Domestic and Foreign Financial Markets May Have a Material
Negative Impact on Our Results of Operations and Financial
Condition


Economic
indices have shown that since the fourth quarter of 2007, the United States
economy has been in a recession. This has been reflected in significant business
failures and job losses, including the potential bankruptcies of three U.S.
automobile manufacturing companies and by job losses in excess of 500,000 in
each of November and December 2008.  Job losses at this level are
expected to continue during the first calendar quarter of 2009.





In
addition, in the past year, the domestic and foreign financial markets,
securities trading markets and economies generally have experienced significant
turmoil including, without limitation, government takeovers of troubled
institutions, government brokered mergers of such firms to avoid bankruptcy or
failures, bankruptcies of securities trading firms and insurance companies,
failures of financial institutions and securities brokerage firms, declines in
real property values, and wide fluctuations in energy prices, all of which have
contributed to reduced availability of credit for businesses and consumers,
elevated foreclosures on residential and commercial properties, falling home
prices, reduced liquidity and a lack of stability across the entire financial
sector.  These recent events and the corresponding uncertainty and
decline in financial markets are likely to continue for the foreseeable
future.  The full extent of the repercussions to our nation’s economy
in general and our business in particular therefrom are not fully known at this
time.  Such events may have a negative effect on (i) our ability to
service our existing customers and attract new customers, (ii) the ability of
our borrowers to operate their business as successfully as in the past, (iii)
the financial security and net worth of our customers, and (iv) the ability of
our customers to repay their loans with us in accordance with the terms
thereof.





We do not
believe these difficult conditions are likely to improve in the near
future.  A worsening of these conditions would likely exacerbate the
adverse effects of these difficult market and economic conditions on us, our
customers and the other financial institutions in our market.





Recently
Enacted Legislation and Other Measures Undertaken by the U.S. Treasury, the FRB
and Other Governmental Agencies May Not Help Stabilize the U.S. Financial System
or Improve the Housing Market


On
October 3, 2008, President Bush signed into law the Emergency Economic
Stabilization Act of 2008 (the “EESA”), which, among other measures, authorized
the Treasury Secretary to establish the Troubled Asset Relief Program
(“TARP”). EESA gives broad authority to Treasury to purchase, manage,
modify, sell and insure the troubled mortgage related assets that triggered the
current economic crisis as well as other “troubled assets.” EESA includes
additional provisions directed at bolstering the economy,
including:





·
            Authority
      for the FRB to pay interest on depository institution
      balances;


15





·
            Mortgage
      loss mitigation and homeowner
protection;





·
            Temporary
      increase in FDIC insurance coverage from $100,000 to $250,000 through
      December 31, 2009; and





·
            Authority
      to the SEC to suspend mark-to-market accounting requirements for any
      issuer or class of category of
transactions.





Pursuant
to the TARP, the Treasury has the authority to, among other things, purchase up
to $700 billion of mortgages, mortgage-backed securities and certain other
financial instruments from financial institutions for the purpose of stabilizing
and providing liquidity to the U.S. financial markets. Under the TARP, the
Treasury has created a capital purchase program, pursuant to which it is
providing access to capital to financial institutions through a standardized
program to acquire preferred stock (accompanied by warrants) from eligible
financial institutions that will serve as Tier 1 capital.





EESA also
contains a number of significant employee benefit and executive compensation
provisions, some of which apply to employee benefit plans generally, and others
which impose on financial institutions that participate in the TARP program
restrictions on executive compensation.





EESA
followed, and has been followed by, numerous actions by the FRB, Congress,
Treasury, the SEC and others to address the liquidity and credit crisis that has
followed the sub-prime meltdown that commenced in 2007. These measures
include homeowner relief that encourage loan restructuring and modification; the
establishment of significant liquidity and credit facilities for financial
institutions and investment banks; the lowering of the federal funds rate;
emergency action against short selling practices; a temporary guaranty program
for money market funds; the establishment of a commercial paper funding facility
to provide back-stop liquidity to commercial paper issuers; coordinated
international efforts to address illiquidity and other weaknesses in the banking
sector.





On
October 14, 2008, the FDIC announced the establishment of a temporary
liquidity guarantee program to provide insurance for all non-interest bearing
transaction accounts and guarantees of certain newly issued senior unsecured
debt issued by financial institutions (such as the Bank) and bank holding
companies (such as the Company). Under the program, newly issued senior
unsecured debt issued on or before June 30, 2009 will be insured in the
event the issuing institution subsequently fails, or its holding company files
for bankruptcy. The debt includes all newly issued unsecured senior debt
(e.g., promissory notes, commercial paper and inter-bank funding). The aggregate
coverage for an institution may not exceed 125% of its debt outstanding on
December 31, 2008 that was scheduled to mature before June 30,
2009. The guarantee will extend to June 30, 2012 even if the maturity
of the debt is after that date.





On
February 17, 2009, President Obama signed into law The American Recovery and
Reinvestment Act of 2009 (the “Stimulus Bill”), more commonly known as the
economic stimulus or economic recovery package.  The Stimulus Bill
includes a wide variety of programs intended to stimulate the economy and
provide for extensive infrastructure, energy, health and education
needs.  In addition, the Stimulus Bill imposes certain new executive
compensation and corporate expenditure limits on all current and future TARP
recipients that are in addition to those previously announced by the U.S.
Treasury.





The
actual impact that EESA, the Stimulus Bill and such related measures undertaken
to alleviate the credit crisis will have generally on the financial markets,
including the extreme levels of volatility and limited credit availability
currently being experienced, is unknown. The failure of such measures to
help stabilize the financial markets and a continuation or worsening of current
financial market conditions could materially and adversely affect our business,
financial condition, results of operations, access to credit or the trading
price of our common stock.





Current
Levels of Market Volatility are Unprecedented


The
capital and credit markets have been experiencing volatility and disruption for
more than a year. In recent months, the volatility and disruption has reached
unprecedented levels.  In some cases, the markets have produced
significant downward pressure on stock prices and credit availability for
certain issuers without regard to those issuers’ underlying financial strength.
If current levels of market disruption and volatility continue or worsen, there
can be no assurance that we will not experience an adverse effect, which may be
material, on our ability to access capital and on our business, financial
condition and results of operations.


16





FDIC
Deposit Insurance Assessments Will Increase Substantially, Which Will Adversely
Affect Our Net Earnings


FDIC
deposit insurance expense for the year ended December 31, 2008 was
approximately $388 thousand.  Deposit insurance assessments will
increase in 2009 due to recent strains on the FDIC deposit insurance fund
resulting from the cost of recent bank failures and an increase in the number of
banks likely to fail over the next few years.  On December 16, 2008,
the FDIC issued a final rule increasing that assessment range for the first
quarter of 2009.  The FDIC has announced that it intends to issue a final
rule in early 2009, to be effective on April 1, 2009, to set new assessment
rates beginning with the second quarter of 2009 and to make other changes to its
assessment rule.  It has also stated that it may need to set a higher
base rate schedule at the time of the issuance of its final assessment rate
rule, depending upon the information available at that time including, without
limitation, on its updated bank failure and loss projections.





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.





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 May 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


17


·
            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 May 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
loan losses, that Management believes is appropriate to minimize this risk by
assessing the likelihood of nonperformance, tracking loan performance and
diversifying our loan portfolio.  These policies and procedures,
however, may not prevent unexpected losses that may have material adverse
affects on our results of operations in general and the market value of our
stock.





Our
primary market area is an increasingly competitive and overcrowded bankingmarket.  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 the 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, Which May Hurt Our Business


As
previously mentioned, 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 rates on our
deposits.  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.


18





·
            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.





·
            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 other obligations, including any 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 May Limit or Restrict Our Activities,
Which in Turn May 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.  We
anticipate that continued compliance with various regulatory provisions will
impact future operating expenses.  Further, federal monetary policy,
particularly as implemented through the Federal Reserve System, significantly
affects economic conditions for us.


19





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.





Risks
Associated With Our Stock





Our
Participation in the U.S. Treasury’s Capital Purchase Program (“CPP”) May Pose
Certain Risks to Holders of Our Common Stock


As
previously disclosed, the Company recently received preliminary approval to
participate in the CPP by selling to the U.S. Treasury up to $21.0 million in
preferred stock and warrants to purchase approximately $3.2 million of the
Company’s common stock.  The Company currently anticipates
participating in the CPP.  Although the Company believes that its
anticipated participation in the CPP is in the best interests of our
shareholders in that it will enhance Company and Bank capital and provide
additional funds for future growth, it may pose certain risks to the holders of
our common stock such as the following:





·
            Under
      the terms outlined by the U.S. Treasury for participants in the CPP, the
      Company is required to issue warrants to the U.S Treasury to purchase
      shares of its common stock.  The issuance of these warrants may
      be significantly dilutive to current common
  stockholders.





·
            Warrants
      issued to the U.S. Treasury are immediately exercisable, thus the U.S.
      Treasury may at any time become a significant holder of the Company’s
      common stock and possess significant voting
  power.





·
            Although
      the preferred equity issued to the U.S. Treasury is non-voting, the terms
      of the CPP stipulate that the U.S. Treasury may vote their senior equity
      in matters deemed by the U.S. Treasury to have an impact on their
      holdings.





·
            Under
      the terms of the CPP the Company must seek the approval of the U.S.
      Treasury for any increases in dividends paid to holders of our common
      stock as well as any repurchases of our common
  stock.





·
            Although
      the Company does not foresee any material changes to the terms associated
      with its participation in the CPP, the U.S. Government, as a sovereign
      body, may at any time change the terms of our participation in the CPP and
      or significantly influence Company
policy.





For more
information about the Company’s participation in the CPP, see Note. 24
Subsequent Events, of the Consolidated Financial Statements filed on this Form
10-K.





Our
Stock Trades Less Frequently Than Others


Although
our common stock is listed for trading on the NASDAQ Global 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:


20





·
            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; and





·
            Perceptions
      in the marketplace regarding our company and/or its competitors and the
      industry in which we operate.





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 Commitments





None.





Item
2.  Properties





The
Company’s headquarters are located at 545 12th Street
in Paso Robles, California.  It is an office occupied solely by the
Bank.  Additionally, the Company 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 fourteen branches within the
counties of San Luis Obispo and Santa Barbara.  The bank currently
owns one of the fourteen branches that it occupies and leases the remaining
branches from various parties for an approximate aggregate amount of $184
thousand per month.  Additionally, the Company subleases part of three
branches to unaffiliated parties.  The income associated with these
subleases is approximately $13 thousand per month.





In June
of 2007, the Company sold four of its properties to First States Group, L.P.
(“First States”), an unaffiliated party, in a sale-leaseback transaction for
approximately $12.8 million.  In connection with the sale, the Bank
entered into four separate lease agreements with First States Investors, LLC to
lease back three branches and one administrative facility.  The three
branches are located in Paso Robles, Arroyo Grande and Santa Maria,
California.  The administrative facility is located in Paso Robles,
California.  The annual base rents for the Paso Robles, Arroyo Grande,
and Santa Maria branches are $204 thousand, $95 thousand, and $155 thousand,
respectively.  The initial annual base rent for the administrative
facility is $466 thousand.  Each of the four leases contain an annual
rent escalation clause equal to the lower of CPI-U (Consumer Price Index for all
Urban Consumers) or 2.5 percent, commencing in the second year of the lease
term.  Each of the four leases provide for an initial term of 15 years
with the option to renew for two 10 year terms.  The Company entered
into this transaction in order to convert non-earning assets to earning
assets.





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.


21





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 Securities Holders





There
were no matters submitted to a vote of the shareholders in the fourth quarter of
2008.





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 Global 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, 2007:





Closing
      PricesQuarters
      Ended
                    
                    High
                    
                    
                    LowDecember
      31, 2008
                    
                    $
                    8.65
                    
                    
                    $
                    4.88September
      30, 2008
                    
                    
                    9.14
                    
                    
                    
                    6.80June
      30, 2008
                    
                    
                    12.38
                    
                    
                    
                    9.10March
      31, 2008
                    
                    
                    12.70
                    
                    
                    
                    10.89December
      31, 2007
                    
                    $
                    16.99
                    
                    
                    $
                    12.60September
      30, 2007
                    
                    
                    18.19
                    
                    
                    
                    14.60June
      30, 2007
                    
                    
                    18.73
                    
                    
                    
                    17.23March
      31, 2007
                    
                    
                    18.45
                    
                    
                    
                    17.18





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





Holders





As of
February 2, 2009, there were 2,437 holders of the Company's Common
Stock.  There are no other classes of equity securities
outstanding.  However, the Company recently received shareholder
approval to authorize a class of preferred stock to, among other things, allow
for the Company’s participation in the U.S. Treasury’s CPP.





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.


22





The
ability of the Company to pay a cash dividend and to service the debt on its
junior subordinated debentures 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 $15.0
million at December 31, 2008.





On
January 9, 2009, the Company received preliminary approval to participate in the
U.S. Treasury’s CPP.  Under the terms of the program, the Company must
obtain approval by the U.S. Treasury for a period of three years following the
initial date of the U.S. Treasury’s investment for any proposed increases in the
payment of cash dividends on its common stock.  For additional
information related to the Company’s participation in the CPP, see Note 24.
Subsequent Events, of the Consolidated Financial Statements filed on this Form
10-K.





The
following table provides a summary of dividends the Company has declared and
paid on its common stock during the last two years ending December 31,
2008:





DividendAmount
                            
                            
                            Declaration
                            
                            Record
                            
                            PayableDividend
      Type
                            
                            Per
      Share
                            
                            
                            Date
                            
                            Date
                            
                            DateStock
      dividend
                            
                            
                            5
                            %
                            
                            04/24/08
                            
                            05/02/08
                            
                            05/16/08Regular
      quarterly dividend
                            
                            $
                            0.08
                            
                            
                            01/24/08
                            
                            02/01/08
                            
                            02/15/08Regular
      quarterly dividend
                            
                            $
                            0.08
                            
                            
                            10/17/07
                            
                            11/02/07
                            
                            11/16/07Regular
      quarterly dividend
                            
                            $
                            0.08
                            
                            
                            07/18/07
                            
                            08/03/07
                            
                            08/17/07Regular
      quarterly dividend
                            
                            $
                            0.08
                            
                            
                            04/20/07
                            
                            05/04/07
                            
                            05/18/07Regular
      quarterly dividend
                            
                            $
                            0.08
                            
                            
                            01/19/07
                            
                            02/02/07
                            
                            02/16/07





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.  As part of a capital preservation initiative, during the
second quarter of 2008, the Company suspended quarterly cash
dividends.





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.


23





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, 2008 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:




Number
      ofSecurities
      To Be
                            
                            
                            Weighted
      Average
                            
                            
                            Number
      of SecuritiesIssued
      Upon Exercise
                            
                            
                            Exercise
      Price of
                            
                            
                            Remaining
      AvailablePlan
      Category
                            
                            of
      Outstanding Options
                            
                            
                            Outstanding
      Options
                            
                            
                            For
      Future IssuanceEquity
      compensation plans approved by security holders:
                            
                            
                            408,830
                            (1)
                            
                            $
                            9.34
                            
                            
                            
                            516,294
                            (2)Equity
      compensation plans not approved by security holders:
                            
                            
                            N/A
                            
                            
                            
                            N/A
                            
                            
                            
                            N/A




(1) Under
the 2005 Equity Based Compensation Plan, the Company is authorized to issue
restricted stock awards.  Restricted stock awards are not included in
the table above.  At December 31, 2008 there were 63,761 shares of
restricted stock issued and outstanding.  See also Note 14. Share
Based Compensation Plans, of the Consolidated Financial Statements on this Form
10-K for more information on the Company's equity compensation
plans.


(2)
Includes securities available for issuance of stock options and restricted
stock.





Purchases of Equity
Securities





On July
21, 2006, the Board of Directors adopted a resolution authorizing the repurchase
of up to 42,000 shares of the Company’s common stock. Purchases were to be made,
as conditions warrant, from time to time in the open market or through privately
negotiated transactions. The duration of the program was for one year and the
timing of purchases was to depend on market conditions.  Subsequently,
on October 20, 2006, the Board of Directors adopted a resolution to increase the
number of shares available for repurchase under the 2006 plan to
105,000.  In July 2007, the Board of Directors authorized a one year
extension of this plan, which expired in August 2008.





As of
December 31, 2008, the Company repurchased and retired 56,175 shares of its
common stock under the 2006 stock repurchase plan at a weighted average price of
$16.61.  The Company made no repurchases of its common stock during
2008.  As mentioned above, the Repurchase Plan expired in August
2008.


24


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, 2008, 2007, 2006, 2005 and 2004
and for the three months ended December 31, 2008 and 2007:
 
 For the Three Months Ended,December 31,
                                                  
                                                  
                                                  At or for the Years
       Ended December 31,(dollar
      amounts in thousands, except per share data)
                                                  
                                                  2008
                                                  
                                                  
                                                  2007
                                                  
                                                  
                                                  2008
                                                  
                                                  
                                                  2007
                                                  
                                                  
                                                  2006
                                                  
                                                  
                                                  2005
                                                  
                                                  
                                                  2004Consolidated
      Income Data:Interest
      income
                                                  
                                                  $
                                                  12,223
                                                  
                                                  
                                                  $
                                                  13,155
                                                  
                                                  
                                                  $
                                                  50,150
                                                  
                                                  
                                                  $
                                                  45,174
                                                  
                                                  
                                                  $
                                                  36,372
                                                  
                                                  
                                                  $
                                                  30,175
                                                  
                                                  
                                                  $
                                                  23,313Interest
      expense
                                                  
                                                  
                                                  2,871
                                                  
                                                  
                                                  
                                                  4,374
                                                  
                                                  
                                                  
                                                  12,564
                                                  
                                                  
                                                  
                                                  14,751
                                                  
                                                  
                                                  
                                                  9,316
                                                  
                                                  
                                                  
                                                  5,016
                                                  
                                                  
                                                  
                                                  3,361Net
      interest income
                                                  
                                                  
                                                  9,352
                                                  
                                                  
                                                  
                                                  8,781
                                                  
                                                  
                                                  
                                                  37,586
                                                  
                                                  
                                                  
                                                  30,423
                                                  
                                                  
                                                  
                                                  27,056
                                                  
                                                  
                                                  
                                                  25,159
                                                  
                                                  
                                                  
                                                  19,952Provision
      for loan losses
                                                  
                                                  
                                                  6,000
                                                  
                                                  
                                                  
                                                  140
                                                  
                                                  
                                                  
                                                  12,215
                                                  
                                                  
                                                  
                                                  660
                                                  
                                                  
                                                  
                                                  600
                                                  
                                                  
                                                  
                                                  710
                                                  
                                                  
                                                  
                                                  410Net
      interest income after provision for loan losses
                                                  
                                                  
                                                  3,352
                                                  
                                                  
                                                  
                                                  8,641
                                                  
                                                  
                                                  
                                                  25,371
                                                  
                                                  
                                                  
                                                  29,763
                                                  
                                                  
                                                  
                                                  26,456
                                                  
                                                  
                                                  
                                                  24,449
                                                  
                                                  
                                                  
                                                  19,542Non-interest
      income
                                                  
                                                  
                                                  1,498
                                                  
                                                  
                                                  
                                                  1,439
                                                  
                                                  
                                                  
                                                  6,206
                                                  
                                                  
                                                  
                                                  5,349
                                                  
                                                  
                                                  
                                                  4,952
                                                  
                                                  
                                                  
                                                  5,009
                                                  
                                                  
                                                  
                                                  4,999Non-interest
      expense
                                                  
                                                  
                                                  7,208
                                                  
                                                  
                                                  
                                                  6,874
                                                  
                                                  
                                                  
                                                  29,434
                                                  
                                                  
                                                  
                                                  23,908
                                                  
                                                  
                                                  
                                                  20,955
                                                  
                                                  
                                                  
                                                  18,718
                                                  
                                                  
                                                  
                                                  17,198Income/(loss)
      before income taxes
                                                  
                                                  
                                                  (2,358
                                                  )
                                                  
                                                  
                                                  3,206
                                                  
                                                  
                                                  
                                                  2,143
                                                  
                                                  
                                                  
                                                  11,204
                                                  
                                                  
                                                  
                                                  10,453
                                                  
                                                  
                                                  
                                                  10,740
                                                  
                                                  
                                                  
                                                  7,343Provision
      for income taxes
                                                  
                                                  
                                                  (1,104
                                                  )
                                                  
                                                  
                                                  1,228
                                                  
                                                  
                                                  
                                                  497
                                                  
                                                  
                                                  
                                                  4,287
                                                  
                                                  
                                                  
                                                  3,791
                                                  
                                                  
                                                  
                                                  4,103
                                                  
                                                  
                                                  
                                                  2,759Net
      income/(loss)
                                                  
                                                  $
                                                  (1,254
                                                  )
                                                  
                                                  $
                                                  1,978
                                                  
                                                  
                                                  $
                                                  1,646
                                                  
                                                  
                                                  $
                                                  6,917
                                                  
                                                  
                                                  $
                                                  6,662
                                                  
                                                  
                                                  $
                                                  6,637
                                                  
                                                  
                                                  $
                                                  4,584Share
      Data:Earnings
      per share - basic
                                                  
                                                  $
                                                  (0.16
                                                  )
                                                  
                                                  $
                                                  0.26
                                                  
                                                  
                                                  $
                                                  0.22
                                                  
                                                  
                                                  $
                                                  0.99
                                                  
                                                  
                                                  $
                                                  1.00
                                                  
                                                  
                                                  $
                                                  1.02
                                                  
                                                  
                                                  $
                                                  0.73Earnings
      per share - diluted
                                                  
                                                  $
                                                  (0.16
                                                  )
                                                  
                                                  $
                                                  0.25
                                                  
                                                  
                                                  $
                                                  0.21
                                                  
                                                  
                                                  $
                                                  0.96
                                                  
                                                  
                                                  $
                                                  0.96
                                                  
                                                  
                                                  $
                                                  0.96
                                                  
                                                  
                                                  $
                                                  0.68Dividend
      payout ratio (1)
                                                  
                                                  
                                                  0.00
                                                  %
                                                  
                                                  
                                                  29.58
                                                  %
                                                  
                                                  
                                                  35.54
                                                  %
                                                  
                                                  
                                                  30.76
                                                  %
                                                  
                                                  
                                                  39.05
                                                  %
                                                  
                                                  
                                                  0.00
                                                  %
                                                  
                                                  
                                                  0.00
                                                  %Book
      value per share
                                                  
                                                  $
                                                  9.03
                                                  
                                                  
                                                  $
                                                  9.04
                                                  
                                                  
                                                  $
                                                  9.03
                                                  
                                                  
                                                  $
                                                  9.04
                                                  
                                                  
                                                  $
                                                  7.42
                                                  
                                                  
                                                  $
                                                  6.85
                                                  
                                                  
                                                  $
                                                  5.90Actual
      shares outstanding at end of period (2)
                                                  
                                                  
                                                  7,753,078
                                                  
                                                  
                                                  
                                                  7,683,829
                                                  
                                                  
                                                  
                                                  7,753,078
                                                  
                                                  
                                                  
                                                  7,683,829
                                                  
                                                  
                                                  
                                                  6,662,921
                                                  
                                                  
                                                  
                                                  6,543,581
                                                  
                                                  
                                                  
                                                  6,313,923Weighted
      average shares outstanding - Basic
                                                  
                                                  
                                                  7,660,342
                                                  
                                                  
                                                  
                                                  7,682,730
                                                  
                                                  
                                                  
                                                  7,641,726
                                                  
                                                  
                                                  
                                                  6,984,174
                                                  
                                                  
                                                  
                                                  6,650,620
                                                  
                                                  
                                                  
                                                  6,476,334
                                                  
                                                  
                                                  
                                                  6,290,023Weighted
      average shares outstanding - Diluted
                                                  
                                                  
                                                  7,721,460
                                                  
                                                  
                                                  
                                                  7,887,206
                                                  
                                                  
                                                  
                                                  7,753,013
                                                  
                                                  
                                                  
                                                  7,228,804
                                                  
                                                  
                                                  
                                                  6,925,582
                                                  
                                                  
                                                  
                                                  6,878,958
                                                  
                                                  
                                                  
                                                  6,756,506Consolidated
      Balance Sheet Data:Total
      cash and cash equivalents
                                                  
                                                  $
                                                  24,571
                                                  
                                                  
                                                  $
                                                  46,419
                                                  
                                                  
                                                  $
                                                  24,571
                                                  
                                                  
                                                  $
                                                  46,419
                                                  
                                                  
                                                  $
                                                  23,034
                                                  
                                                  
                                                  $
                                                  44,559
                                                  
                                                  
                                                  $
                                                  21,867Total
      investments and other securities
                                                  
                                                  $
                                                  50,762
                                                  
                                                  
                                                  $
                                                  47,556
                                                  
                                                  
                                                  $
                                                  50,762
                                                  
                                                  
                                                  $
                                                  47,556
                                                  
                                                  
                                                  $
                                                  38,445
                                                  
                                                  
                                                  $
                                                  44,402
                                                  
                                                  
                                                  $
                                                  57,394Total
      gross loans
                                                  
                                                  $
                                                  680,147
                                                  
                                                  
                                                  $
                                                  613,217
                                                  
                                                  
                                                  $
                                                  680,147
                                                  
                                                  
                                                  $
                                                  613,217
                                                  
                                                  
                                                  $
                                                  444,983
                                                  
                                                  
                                                  $
                                                  368,133
                                                  
                                                  
                                                  $
                                                  339,693Allowance
      for loan losses
                                                  
                                                  $
                                                  (10,412
                                                  )
                                                  
                                                  $
                                                  (6,143
                                                  )
                                                  
                                                  $
                                                  (10,412
                                                  )
                                                  
                                                  $
                                                  (6,143
                                                  )
                                                  
                                                  $
                                                  (4,081
                                                  )
                                                  
                                                  $
                                                  (3,881
                                                  )
                                                  
                                                  $
                                                  (3,247
                                                  )Total
      assets
                                                  
                                                  $
                                                  805,588
                                                  
                                                  
                                                  $
                                                  745,554
                                                  
                                                  
                                                  $
                                                  805,588
                                                  
                                                  
                                                  $
                                                  745,554
                                                  
                                                  
                                                  $
                                                  541,774
                                                  
                                                  
                                                  $
                                                  488,501
                                                  
                                                  
                                                  $
                                                  448,012Total
      deposits
                                                  
                                                  $
                                                  603,521
                                                  
                                                  
                                                  $
                                                  644,808
                                                  
                                                  
                                                  $
                                                  603,521
                                                  
                                                  
                                                  $
                                                  644,808
                                                  
                                                  
                                                  $
                                                  420,521
                                                  
                                                  
                                                  $
                                                  417,797
                                                  
                                                  
                                                  $
                                                  370,441Federal
      Home Loan Bank borrowings
                                                  
                                                  $
                                                  109,000
                                                  
                                                  
                                                  $
                                                  8,000
                                                  
                                                  
                                                  $
                                                  109,000
                                                  
                                                  
                                                  $
                                                  8,000
                                                  
                                                  
                                                  $
                                                  50,000
                                                  
                                                  
                                                  $
                                                  10,000
                                                  
                                                  
                                                  $
                                                  28,500Junior
      subordinated debt
                                                  
                                                  $
                                                  13,403
                                                  
                                                  
                                                  $
                                                  13,403
                                                  
                                                  
                                                  $
                                                  13,403
                                                  
                                                  
                                                  $
                                                  13,403
                                                  
                                                  
                                                  $
                                                  16,496
                                                  
                                                  
                                                  $
                                                  8,248
                                                  
                                                  
                                                  $
                                                  8,248Total
      stockholders' equity
                                                  
                                                  $
                                                  70,033
                                                  
                                                  
                                                  $
                                                  69,450
                                                  
                                                  
                                                  $
                                                  70,033
                                                  
                                                  
                                                  $
                                                  69,450
                                                  
                                                  
                                                  $
                                                  49,472
                                                  
                                                  
                                                  $
                                                  44,845
                                                  
                                                  
                                                  $
                                                  37,250Selected
      Other Balance Sheet Data:Average
      assets
                                                  
                                                  $
                                                  794,989
                                                  
                                                  
                                                  $
                                                  709,304
                                                  
                                                  
                                                  $
                                                  779,575
                                                  
                                                  
                                                  $
                                                  605,736
                                                  
                                                  
                                                  $
                                                  503,877
                                                  
                                                  
                                                  $
                                                  480,204
                                                  
                                                  
                                                  $
                                                  447,428Average
      earning assets
                                                  
                                                  $
                                                  738,651
                                                  
                                                  
                                                  $
                                                  654,146
                                                  
                                                  
                                                  $
                                                  722,061
                                                  
                                                  
                                                  $
                                                  555,871
                                                  
                                                  
                                                  $
                                                  455,497
                                                  
                                                  
                                                  $
                                                  435,613
                                                  
                                                  
                                                  $
                                                  391,532Average
      stockholders' equity
                                                  
                                                  $
                                                  71,995
                                                  
                                                  
                                                  $
                                                  67,343
                                                  
                                                  
                                                  $
                                                  71,748
                                                  
                                                  
                                                  $
                                                  55,927
                                                  
                                                  
                                                  $
                                                  47,236
                                                  
                                                  
                                                  $
                                                  41,340
                                                  
                                                  
                                                  $
                                                  34,854Selected
      Financial Ratios :Return
      on average assets
                                                  
                                                  
                                                  -0.63
                                                  %
                                                  
                                                  
                                                  1.11
                                                  %
                                                  
                                                  
                                                  0.21
                                                  %
                                                  
                                                  
                                                  1.14
                                                  %
                                                  
                                                  
                                                  1.32
                                                  %
                                                  
                                                  
                                                  1.38
                                                  %
                                                  
                                                  
                                                  1.02
                                                  %Return
      on average stockholders' equity
                                                  
                                                  
                                                  -6.93
                                                  %
                                                  
                                                  
                                                  11.65
                                                  %
                                                  
                                                  
                                                  2.29
                                                  %
                                                  
                                                  
                                                  12.37
                                                  %
                                                  
                                                  
                                                  14.10
                                                  %
                                                  
                                                  
                                                  16.06
                                                  %
                                                  
                                                  
                                                  13.15
                                                  %Net
      interest margin (3)
                                                  
                                                  
                                                  5.04
                                                  %
                                                  
                                                  
                                                  5.33
                                                  %
                                                  
                                                  
                                                  5.21
                                                  %
                                                  
                                                  
                                                  5.47
                                                  %
                                                  
                                                  
                                                  5.94
                                                  %
                                                  
                                                  
                                                  5.78
                                                  %
                                                  
                                                  
                                                  5.10
                                                  %Efficiency
      ratio (4)
                                                  
                                                  
                                                  66.43
                                                  %
                                                  
                                                  
                                                  67.26
                                                  %
                                                  
                                                  
                                                  67.27
                                                  %
                                                  
                                                  
                                                  66.83
                                                  %
                                                  
                                                  
                                                  65.47
                                                  %
                                                  
                                                  
                                                  62.04
                                                  %
                                                  
                                                  
                                                  68.93
                                                  %Capital
      Ratios:Average
      stockholders' equity to average assets
                                                  
                                                  
                                                  9.06
                                                  %
                                                  
                                                  
                                                  9.49
                                                  %
                                                  
                                                  
                                                  9.20
                                                  %
                                                  
                                                  
                                                  9.23
                                                  %
                                                  
                                                  
                                                  9.37
                                                  %
                                                  
                                                  
                                                  8.61
                                                  %
                                                  
                                                  
                                                  7.79
                                                  %Leverage
      Ratio
                                                  
                                                  
                                                  8.90
                                                  %
                                                  
                                                  
                                                  9.60
                                                  %
                                                  
                                                  
                                                  8.90
                                                  %
                                                  
                                                  
                                                  9.60
                                                  %
                                                  
                                                  
                                                  11.00
                                                  %
                                                  
                                                  
                                                  9.61
                                                  %
                                                  
                                                  
                                                  8.34
                                                  %Tier
      1 Risk-Based Capital ratio
                                                  
                                                  
                                                  9.37
                                                  %
                                                  
                                                  
                                                  10.08
                                                  %
                                                  
                                                  
                                                  9.37
                                                  %
                                                  
                                                  
                                                  10.08
                                                  %
                                                  
                                                  
                                                  11.51
                                                  %
                                                  
                                                  
                                                  10.98
                                                  %
                                                  
                                                  
                                                  9.78
                                                  %Total
      Risk-Based Capital ratio
                                                  
                                                  
                                                  10.62
                                                  %
                                                  
                                                  
                                                  11.04
                                                  %
                                                  
                                                  
                                                  10.62
                                                  %
                                                  
                                                  
                                                  11.04
                                                  %
                                                  
                                                  
                                                  12.36
                                                  %
                                                  
                                                  
                                                  11.93
                                                  %
                                                  
                                                  
                                                  10.65
                                                  %Selected
      Asset Quality Ratios:Non-performing
      loans to total loans (5)
                                                  
                                                  
                                                  2.75
                                                  %
                                                  
                                                  
                                                  0.06
                                                  %
                                                  
                                                  
                                                  2.75
                                                  %
                                                  
                                                  
                                                  0.06
                                                  %
                                                  
                                                  
                                                  0.01
                                                  %
                                                  
                                                  
                                                  0.01
                                                  %
                                                  
                                                  
                                                  0.27
                                                  %Non-performing
      assets to total loans
                                                  
                                                  
                                                  2.94
                                                  %
                                                  
                                                  
                                                  0.06
                                                  %
                                                  
                                                  
                                                  2.94
                                                  %
                                                  
                                                  
                                                  0.06
                                                  %
                                                  
                                                  
                                                  0.01
                                                  %
                                                  
                                                  
                                                  0.01
                                                  %
                                                  
                                                  
                                                  0.27
                                                  %Non-performing
      assets to total assets (6)
                                                  
                                                  
                                                  2.48
                                                  %
                                                  
                                                  
                                                  0.05
                                                  %
                                                  
                                                  
                                                  2.48
                                                  %
                                                  
                                                  
                                                  0.05
                                                  %
                                                  
                                                  
                                                  0.01
                                                  %
                                                  
                                                  
                                                  0.01
                                                  %
                                                  
                                                  
                                                  0.21
                                                  %Allowance
      for loan losses to total loans
                                                  
                                                  
                                                  1.53
                                                  %
                                                  
                                                  
                                                  1.00
                                                  %
                                                  
                                                  
                                                  1.53
                                                  %
                                                  
                                                  
                                                  1.00
                                                  %
                                                  
                                                  
                                                  0.92
                                                  %
                                                  
                                                  
                                                  1.05
                                                  %
                                                  
                                                  
                                                  0.96
                                                  %Allowance
      for loan losses to non-performing loans
                                                  
                                                  
                                                  55.75
                                                  %
                                                  
                                                  
                                                  1817.46
                                                  %
                                                  
                                                  
                                                  55.75
                                                  %
                                                  
                                                  
                                                  1817.46
                                                  %
                                                  
                                                  
                                                  7420.00
                                                  %
                                                  
                                                  
                                                  7187.00
                                                  %
                                                  
                                                  
                                                  348.00
                                                  %Net
      charge-offs (recoveries) to average loans
                                                  
                                                  
                                                  0.88
                                                  %
                                                  
                                                  
                                                  0.02
                                                  %
                                                  
                                                  
                                                  1.21
                                                  %
                                                  
                                                  
                                                  0.00
                                                  %
                                                  
                                                  
                                                  0.10
                                                  %
                                                  
                                                  
                                                  0.02
                                                  %
                                                  
                                                  
                                                  0.08
                                                  %
 
 (1) For
2008 cash dividends totaling $0.08 per share were paid.  For the years
2007 and 2006, cash dividends totaling $0.32 and $0.49 per share were paid. In the
first quarter of 2006, the Company paid a special cash dividend of $0.25 per
share.  No cash dividends were paid in 2005 and 2004.
 (2)
Actual shares have been adjusted to fully reflect stock dividends and stock
splits.
 (3) Net
interest margin represents net interest income as a percentage of average
interest-earning assets.
 (4)
Efficiency ratio represents non-interest expenses, excluding loan loss
provision, as a percentage of the aggregate of net interest income and
non-interest income.
 (5)
Non-performing loans are defined as loans that are past due 90 days or more as
well as loans placed in non-accrual status.
 (6)
Non-performing assets are defined as assets that are past due 90 days or more
and assets placed in non-accrual status plus other real estate
owned.
  25
  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 years ended December 31, 2008, 2007 and 2006.  The
analysis should be read in connection with the consolidated financial statements
and notes thereto appearing elsewhere in this report.
 
 When
viewing financial information found on this Form 10-K as of and for the periods
ended December 31, 2008, 2007 and 2006, it is important to consider that the
Company acquired Business First on October 12, 2007.  Therefore, the
Company’s financial position and results of operations will not reflect the
acquisition for periods prior to that date.  2008 represents the first
full calendar year for which balances and operating results for Business First
are fully reflected in the Company’s financial statements.
 
 Financial
Overview
 
 For the
years ended December 31, 2008, 2007 and 2006 the Company earned $1.7 million,
$6.9 million and $6.7 million or $0.21, $0.96 and $0.96 per share on a fully
diluted basis, respectively.  On a year over year basis, net income
declined approximately $5.3 million or 76.2%.  The primary factor
behind the decline can be attributed to substantial provisions the Bank made to
the allowance for loan losses during 2008.
 
 The
following provides financial highlights as of and for the year ended December
31, 2008:
 
 ·
              Interest
      income for the year ended December 31, 2008 was approximately $50.2
      million, which represents an increase of approximately $5.0 million or
      11.0%.  The rise in interest income is mainly attributable to
      the acquisition of Business First.  The Business First
      acquisition occurred during the fourth quarter of 2007, thus 2008
      represents the first year that balances for Business First and
      corresponding interest income and expense are reflected for a full
      calendar year.  For the year ended December 31, 2008, the
      Business First acquisition accounted for approximately $12.1 million in
      interest income.
 
 ·
              Interest
      expense for the year ended December 31, 2008 was approximately $12.6
      million, which represents a decline of approximately $2.2 million or
      14.8%.  The primary reason behind the year over year decline in
      interest expense can be attributed to the dramatic declines in the
      overnight Fed Funds rate made by the FOMC during 2008.  For the
      year ended December 31, 2008, Business First accounted for approximately
      $1.8 million of interest expense.
 
 ·
              Net
      interest income for the year ended December 31, 2008 was approximately
      $37.6 million.  When compared to the same period ended a year
      earlier, this represents an increase of approximately $7.2 million or
      23.5%.  The year over year rise in net interest income can be
      attributed to the acquisition of Business First, the abundant availability
      of inexpensive alternative funding sources and the re-pricing of our
      deposits in conjunction with the moves made by the FOMC to lower the
      overnight Fed Funds rate. Given that a relatively large portion of the
      Bank’s deposits possess a floating interest rate, Management was able to
      re-price the Bank’s interest bearing liabilities more rapidly, mitigating
      substantial declines in the net interest margin during
      2008.  For the year ended December 31, 2008, the net interest
      margin was 5.21%, representing a decline of 26 basis points when compared
      to the 5.47% reported for the year ended December 31,
  2007.
 
 ·
              For
      the year ended December 31, 2008, non-interest income totaled
      approximately $6.2 million or $0.9 million higher than the $5.3 million
      reported for the same period ended a year earlier.  The majority
      of the year over year increase can be attributed to higher service charges
      on deposit accounts obtained in the acquisition of Business
      First.  Additionally, during the second quarter of 2008, the
      Bank recognized income in the approximate amount of $0.3 million related
      to the initial public offering of Visa,
Inc.
 
 ·
              Non-interest
      expenses for the year ended December 31, 2008 were approximately $29.4
      million or $5.5 million higher than the $23.9 million reported for the
      same period ended a year
earlier.
  26
  The
following provides a summary of significant changes contributing to the year
over year increase in non-interest expenses:
 
 ·
              Increases
      in salaries and employee benefits accounted for approximately 37.3% or
      $2.1 million of the year over year increase.  Additional staff
      from the Business First acquisition as well as branch expansion within
      2008 contributed significantly to higher salaries and employee
      benefits.
 
 ·
              Also
      contributing to the year over year increase in non-interest expenses was
      an approximate $0.4 million increase in data processing costs related to
      increased transaction volume stemming from the Business First
      acquisition.
 
 ·
              Higher
      regulatory fees also contributed to the year over year
      increase.  During 2008, the Company incurred regulatory fees
      that were approximately $0.3 million higher that that reported for the
      same period ended a year earlier, resulting from the absence of a one-time
      credit the Company recognized during 2007 for past contributions it made
      to the FDIC insurance fund.
 
 ·
              Expenses
      related to the amortization of the Bank’s core deposit intangible (“CDI”)
      were approximately $0.5 million higher in 2008 when compared to
      2007.
 
 ·
              Occupancy
      expenses for 2008 were approximately $0.8 million higher than that
      reported for the same period ended a year earlier.  Additional
      rental costs stemming from the Business First acquisition, branch
      expansion, and the impact of the sale leaseback transaction the Bank
      entered into during the second quarter of 2007 all contributed to the year
      over year increase within this
category.
 
 As the
Company moves into 2009, Management has implemented various cost containment
measures and continues to explore other areas where additional efficiencies may
be gained.  See also, “Non-Interest Expenses” under Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of
Operations on this Form 10-K for a more detailed analysis of the Company’s
non-interest expenses.
 
 ·
              As
      a result of the items mentioned in the preceding discussion the Company’s
      operating efficiency ratio for the year ended December 31, 2008 was
      67.27%.  For the years ended December 31, 2007 and 2006 the
      operating efficiency ratio was 66.83% and 65.47%,
      respectively.
 
 ·
              Return
      on equity (“ROE”) for the year ended December 31, 2008 was
      2.29%.  ROE declined substantially from that reported for 2007
      as a result of the substantial provisions the Bank made to the allowance
      for loan losses during 2008.  For the years ended December 2007
      and 2006 the Company reported returns on equity of 12.37% and 14.10%,
      respectively.
 
 ·
              Return
      on average assets (“ROAA”) for the year ended December 31, 2008 was
      0.21%.  A lower ROAA from that reported for 2007 is attributable
      in large part to the substantial increases in loan loss provisions
      previously mentioned.  For the years ended December 31, 2007 and
      2006 the Company reported returns on average assets of 1.14% and 1.32%,
      respectively.
 
 ·
              At
      December 31, 2008 net loan balances were $668.0 million or approximately
      $62.7 million higher than that reported at December 31,
      2007.  See also, “Loans” under Item 7. Management’s Discussion
      and Analysis of Financial Condition and Results of Operations on this Form
      10-K for a more detailed discussion on the Company’s loan
      portfolio.
 
 ·
              Total
      deposit balances at December 31, 2008 were approximately $41.3 million
      lower than the $644.8 million reported at December 31,
      2007.  The dramatic decline in the over night Federal Funds rate
      during 2008 and Management’s response in lowering offering rates in an
      effort to mitigate declines in the net interest margin, contributed
      greatly to the year over year decline.  Declines in deposit
      balances were most evident within promotional deposit products and money
      market balances.  See also, “Deposits and Borrowed Funds” under
      Item 7. Management’s Discussion and Analysis of Financial Condition and
      Results of Operations on this Form 10-K for a more detailed discussion
      regarding deposit balances.
 
 ·
              Federal
      Home Loan Bank (“FHLB”) borrowings were $109.0 million at December 31,
      2008.  This represents an increase of approximately $101.0
      million when compared to the $8.0 million reported at December 31,
      2007.  The substantial increase in FHLB borrowing can be
      attributed to the large decline in deposit balances during 2008 as a
      result of Management’s effort to maintain an appropriate cost of funds in
      a declining rates environment.
  27
  ·
              At
      December 31, 2008, the allowance for loan losses was $10.4 million. As a
      percentage of total gross and non-performing loan balances, the allowance
      for loan losses was 1.53% and 55.75%, respectively. For the year ended
      December 31, 2008, provision for loan losses was approximately $12.2
      million. When compared to the same period ended a year earlier, this
      represents increases of approximately $11.5 million. The increased
      provision for loan losses can be attributed in part to weakened economic
      conditions, increases in the trend of delinquent loans, as well as loans
      the Bank charged-off during 2008.
 
 At
December 31, 2008, the balance of loans placed on non-accrual status was
approximately $18.3 million. This represents an increase of approximately $18.0
million from the $0.3 million reported at December 31, 2007. During 2008, the
Bank charged-off approximately $8.1 million in loans and recovered approximately
$0.1 million in loan balances previously charged-off.  At December 31,
2008 the balance of Other Real Estate Owned (“OREO”) was $1.3
million.  During the fourth quarter of 2008, the Bank moved
approximately $1.1 million in non-performing loan balances to Other Real Estate
Owned status. See also “Non Performing Assets” under Item 7. Management’s
Discussion and Analysis of Financial Condition and Results of Operations on this
Form 10-K for additional information related to non-performing
assets.
 
 Recent
Developments
 
 During
the third and fourth quarters of 2008, the credit and equity markets came under
significant duress as confidence by many in the U.S. financial system began to
wane.  During the later part of 2007 and throughout 2008, U.S.
financial institutions were forced to significantly write-down the values of
certain classes of assets in response to the weakened real estate
market.  This lead to great strains on the capital levels of many
financial institutions, which in turn lead to a lack of confidence by many and
others providing funding to the nation’s banks, leading to a crisis of
liquidity.  With liquidity levels of many financial institutions
significantly weakened, borrowing costs began to rise considerably and the flow
of credit to consumers and between banks all but came to a halt.  In
response to this, the weakened economy and other factors, the U.S. Congress
passes the Emergency Economic Stabilization Act of 2008 (the
“EESA”).  Under the EESA, the Department of the U.S. Treasury formed
the Troubled Asset Relief Program (the “TARP”).  The TARP gives the
U.S. Treasury the power to make purchases of certain troubled assets as well as
the direct purchase of equity from U.S. financial institutions under the
CPP.  Although the Company’s liquidity levels remain adequate and the
Bank and Company remain well capitalized, the Company applied to participate in
the CPP to keep all capital raising options available.  Recently, the
Company received preliminary approval on January 9, 2009 to sell $21.0 million
in preferred equity to the U.S. Treasury.  On February 27, 2009, the
Company received shareholder approval to add an authorized class of preferred
stock to the Company’s Articles of Incorporation that will allow the Company to
participate in the CPP and also allow for more flexibility in capital raising
efforts in general.  For a more detailed discussion regarding the
Company’s participation in the CPP, see Note. 24. Subsequent Events, of the
Consolidated Financial Statements filed on this Form 10-K.
 
 On
October 12, 2007 the Company acquired Business First National Bank (“Business
First”).  Business First was merged with and into Heritage Oaks Bank,
a wholly owned subsidiary of the Company.  The consideration paid for
Business First was approximately $19.5 million, consisting of approximately 75%
common stock and 25% cash.  Business First shareholders received
0.5758 shares of Heritage Oaks Bancorp common stock for each share of Business
First they owned and $3.44 per share in cash.  For more information
related to the acquisition of Business First, see Note 23. Business
Combinations, of the Consolidated Financial Statements filed on this Form
10-K.
 
 In April
2007, the Company redeemed all the Floating Rate Junior Subordinated Debt
Securities it held associated with Heritage Oaks Capital Trust I.  The
redemption price was 100% of the principal amount redeemed, or $8.2 million,
plus $0.4 million for the standard interest payment due on April 22,
2007.  As a result of the redemption of these securities, the trust
was dissolved on June 1, 2007.  Subsequently, the Company, in
September 2007, issued $5.2 million in Junior Subordinated Debt Securities to
Heritage Oaks Capital Trust III.  Interest on these securities is
payable quarterly at a fixed rate of 6.89%.  The Company used the
proceeds from the sale of the securities to assist in the acquisition of
Business First, for general corporate purposes, and for capital contributions to
the Bank for future growth.  For a more detailed discussion regarding
these securities, see Note 8. Borrowings, of the Consolidated Financial
Statements filed on this Form 10-K.
  28
  In June
2007, the Company completed the sale of four of the Bank’s properties to First
States Group, L.P. (“First States”), an unaffiliated party, for $12.8
million.  In connection with the sale, the Bank entered into four
separate lease agreements with First States Investors, LLC to lease back three
branches and one administrative facility under which the Bank will continue to
utilize for the normal course of business.  Each of the four leases
provide for an initial term of 15 years with the option to renew for two 10 year
terms.  In connection with the sale of the properties mentioned, the
Bank will recognize a gain of approximately $3.4 million.  This gain
will be recognized over a fifteen year period in accordance with SFAS No. 13
“Accounting for
Leases.”  In addition to deferring the gain on sale, the Bank
has recorded an income tax liability and a deferred tax asset in the approximate
amounts of $1.4 million, directly related to the deferred gain on
sale.  For the year ended December 31, 2007, the Company recognized a
gain of approximately $0.1 million related to the sale-leaseback transaction,
which was recorded as an offset to rental expense.  The Company
entered into this transaction in order to convert non-earning assets to earning
assets.  See also Item 2. Properties, of this Form 10-K for additional
information related to this transaction.
 
 Results
of Operations
 
 The
Company reported net income of $1.7 million for the year ended December 31, 2008
compared to $6.9 million and $6.7 million for the years 2007 and 2006,
respectively.  Basic earnings per share were $0.22, $0.99 and $1.00 at
December 31, 2008, 2007 and 2006, respectively.  Diluted earnings per
share were $0.21, $0.96 and $0.96 at December 31, 2008, 2007 and 2006,
respectively.  Earnings were negatively impacted on a year over year
basis due in large part to the substantial increase in provisions the Bank made
to the allowance for loan losses.  Additionally, the dramatic decline
in interest rates during 2008 contributed to a lower net interest margin,
placing additional pressure on earnings.  For the year ended December
31, 2008, the Company’s net interest margin was 5.21%, compared to the 5.47% and
5.94% reported for the years ended December 31, 2007 and 2006,
respectively.
 
 Net
Interest Income and Margin
 
 Net
interest income, the primary component of the net earnings of a financial
institution, refers to the difference between the interest paid on deposits and
borrowings, and the interest earned on loans and investments.  The net
interest margin is the amount of net interest income expressed as a percentage
of average earning assets.  Factors considered in the analysis of net
interest income are the composition and volume of earning assets and
interest-bearing liabilities, the amount of non-interest-bearing liabilities,
non-accruing loans, and changes in market interest rates.
  29
  The table
below sets forth average balance sheet information, interest income and expense,
average yields and rates and net interest income and margin for the years ended
December 31, 2008, 2007 and 2006.  The average balance of non-accruing
loans has been included in loan totals:
 
 For The Year Ended,
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      For The Year Ended,
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      For The Year Ended,December 31, 2008
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      December 31, 2007
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      December 31, 2006Yield/
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      Income/
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      Yield/
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      Income/
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      Yield/
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      Income/(dollar amounts in thousands)
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      Balance
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      Rate
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      Expense
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      Balance
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      Rate
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      Expense
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      Balance
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      Rate
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      ExpenseInterest
      Earning AssetsInvestments
      with other banks
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      214
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      3.74
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      8
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      499
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      1.60
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      8
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      315
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      2.86
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      9Investment
      securities taxable
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      42,080
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      5.28
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      2,223
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      25,585
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      4.87
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      1,246
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      27,455
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      4.46
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      1,225Investment
      securities non-taxable
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      17,079
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      4.34
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      741
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      16,535
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      4.29
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      710
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      16,319
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      4.30
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      702Federal
      funds sold
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      6,583
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      2.13
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      140
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      15,878
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      4.94
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      785
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      11,179
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      4.82
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      539Loans
      (1) (2)
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      656,105
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      7.17
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      47,038
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      497,374
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      8.53
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      42,425
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      400,229
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      8.47
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      33,897Total
      interest earning assets
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      722,061
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      6.95
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      50,150
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      555,871
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      8.13
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      45,174
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      455,497
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      7.99
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      36,372Allowance
      for possible loan losses
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      (7,845
                                                                                                                                                                                                                                      )
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      (4,784
                                                                                                                                                                                                                                      )
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      (3,931
                                                                                                                                                                                                                                      )Other
      assets
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      65,359
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      54,649
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      52,311Total
      assets
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      779,575
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      605,736
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      503,877Interest
      Bearing LiabilitiesSavings/NOW/money
      market
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      293,063
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      1.49
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      4,375
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      207,684
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      2.36
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      4,911
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      160,841
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      1.55
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      2,497Time
      deposits
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      159,496
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      3.34
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      5,328
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      145,565
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      4.78
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      6,960
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      106,342
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      4.21
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      4,472Other
      borrowings
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      79,164
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      2.50
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      1,979
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      34,991
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      5.42
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      1,896
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      27,854
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      5.21
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      1,452Federal
      funds purchased
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      3,406
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      2.55
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      87
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      1,138
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      5.54
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      63
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      1,020
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      5.49
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      56Long-term
      debt
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      13,403
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      5.93
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      795
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      12,234
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      7.53
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      921
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      9,694
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      8.65
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      839Total
      interest-bearing liabilities
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      548,532
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      2.29
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      12,564
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      401,612
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      3.67
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      14,751
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      305,751
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      3.05
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      9,316Demand
      deposits
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      151,529
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      141,123
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      146,458Other
      liabilities
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      7,766
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      7,074
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      4,432Total
      liabilities
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      707,827
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      549,809
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      456,641Stockholders'
      EquityCommon
      stock
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      46,829
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      32,909
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      29,367Additional
      paid in capital
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      852
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      507
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      -Retained
      earnings
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      24,435
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      22,463
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      18,003Valuation
      allowance investments
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      (368
                                                                                                                                                                                                                                      )
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      48
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      (134
                                                                                                                                                                                                                                      )Total
      stockholders' equity
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      71,748
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      55,927
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      47,236Total
      liabilities and stockholders' equity
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      779,575
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      605,736
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      503,877Net
      interest income
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      37,586
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      30,423
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      $
                                                                                                                                                                                                                                      27,056Net
      interest margin (3)
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      5.21
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      5.47
                                                                                                                                                                                                                                      %
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      
                                                                                                                                                                                                                                      5.94
                                                                                                                                                                                                                                      %
 
 (1)
              Non-accruing
      loans have been included in total
loans.
 (2)
              Loan
      fees of $1,297; $1,227; and $1,275 for the years ending December 31, 2008;
      2007; and 2006 respectively have been included in interest income
      computation.
 (3)
              Net
      interest margin has been calculated by dividing the net interest income by
      total average earning assets.
 
 The table
below sets forth changes from 2007 to 2008 for average interest-earning assets
and their respective average yields:
 
 Average Balance
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            Average YieldFor The Year Ended,
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            For The Year Ended,December 31,
                                            
                                            
                                            Variance
                                            
                                            
                                            December 31,(dollar amounts in thousands)
                                            
                                            2008
                                            
                                            
                                            2007
                                            
                                            
                                            dollar
                                            
                                            
                                            percentage
                                            
                                            
                                            2008
                                            
                                            
                                            2007
                                            
                                            
                                            VarianceInterest-Earning
      Assets:Time
      deposits with other banks
                                            
                                            $
                                            214
                                            
                                            
                                            $
                                            499
                                            
                                            
                                            $
                                            (285
                                            )
                                            
                                            
                                            -57.11
                                            %
                                            
                                            
                                            3.74
                                            %
                                            
                                            
                                            1.60
                                            %
                                            
                                            
                                            2.14
                                            %Investment
      securities taxable
                                            
                                            
                                            42,080
                                            
                                            
                                            
                                            25,585
                                            
                                            
                                            
                                            16,495
                                            
                                            
                                            
                                            64.47
                                            %
                                            
                                            
                                            5.28
                                            %
                                            
                                            
                                            4.87
                                            %
                                            
                                            
                                            0.41
                                            %Investment
      securities non-taxable
                                            
                                            
                                            17,079
                                            
                                            
                                            
                                            16,535
                                            
                                            
                                            
                                            544
                                            
                                            
                                            
                                            3.29
                                            %
                                            
                                            
                                            4.34
                                            %
                                            
                                            
                                            4.29
                                            %
                                            
                                            
                                            0.04
                                            %Federal
      funds sold
                                            
                                            
                                            6,583
                                            
                                            
                                            
                                            15,878
                                            
                                            
                                            
                                            (9,295
                                            )
                                            
                                            
                                            -58.54
                                            %
                                            
                                            
                                            2.13
                                            %
                                            
                                            
                                            4.94
                                            %
                                            
                                            
                                            -2.82
                                            %Loans
      (1) (2)
                                            
                                            
                                            656,105
                                            
                                            
                                            $
                                            497,374
                                            
                                            
                                            
                                            158,731
                                            
                                            
                                            
                                            31.91
                                            %
                                            
                                            
                                            7.17
                                            %
                                            
                                            
                                            8.53
                                            %
                                            
                                            
                                            -1.36
                                            %Total
      interest earning assets
                                            
                                            $
                                            722,061
                                            
                                            
                                            $
                                            555,871
                                            
                                            
                                            $
                                            166,190
                                            
                                            
                                            
                                            29.90
                                            %
                                            
                                            
                                            6.95
                                            %
                                            
                                            
                                            8.13
                                            %
                                            
                                            
                                            -1.18
                                            %
 
 (1)
                Non-accruing
      loans have been included in loan
totals.
 (2)
              Loan
      fees of $1,297 and $1,227 have been included in the interest income
      computation for the years ended December 31, 2008 and 2007,
      respectively.
  30
  Net
interest income for the year ended December 31, 2008 was approximately $37.6
million or $7.2 million and 23.5% higher than the $30.4 million reported for the
year ended December 31, 2007.  Average earning assets at December 31,
2008 were approximately $722.1 million or $166.2 million and 29.9% higher than
that reported a year earlier.  Of the year over year increase in
average earning assets approximately $136.5 million can be attributed to the
acquisition of Business First.  The Business First acquisition
occurred during the fourth quarter of 2007, thus 2008 represents the first year
that average balances for Business First are reflected for a full calendar
year.
 
 The
increase in average earning assets can be attributed in large part to an
approximate $158.7 million increase in average gross loan balances during
2008.  Of this increase, approximately $137.2 million can be
attributed to the acquisition of Business First.  For the year ended
December 31, 2008, the yield earned on the loan portfolio was 7.17%, which
represents a decline of approximately 136 basis points from the 8.53% reported
for 2007.  The decline in the yield of the loan portfolio is primarily
attributable to the dramatic decline in the overnight Fed Funds rate during
2008.  It is the decline in the yield on the loan portfolio that
contributed greatly to the decline in the yield on average earning
assets.  For the year ended December 31, 2008, the yield on average
earning assets was 6.95%.  This when compared to the 8.13% the Company
reported for the year ended December 31, 2007, represents a decline of
approximately 118 basis points.  The yield on average earning assets
for the year ended December 31, 2006 was 7.99%.
 
 The table
below sets forth changes from 2007 to 2008 for average interest-bearing
liabilities and the respective average rates paid:
 
 Average Balance
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              Average RateFor The Year Ended,
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              For The Year Ended,December 31,
                                              
                                              
                                              Variance
                                              
                                              
                                              December 31,(dollar
      amounts in thousands)
                                              
                                              2008
                                              
                                              
                                              2007
                                              
                                              
                                              dollar
                                              
                                              
                                              percentage
                                              
                                              
                                              2008
                                              
                                              
                                              2007
                                              
                                              
                                              VarianceInterest-Bearing
      Liabilities:Savings/NOW/money
      market
                                              
                                              $
                                              293,063
                                              
                                              
                                              $
                                              207,684
                                              
                                              
                                              $
                                              85,379
                                              
                                              
                                              
                                              41.11
                                              %
                                              
                                              
                                              1.49
                                              %
                                              
                                              
                                              2.36
                                              %
                                              
                                              
                                              -0.87
                                              %Time
      deposits
                                              
                                              
                                              159,496
                                              
                                              
                                              
                                              145,565
                                              
                                              
                                              
                                              13,931
                                              
                                              
                                              
                                              9.57
                                              %
                                              
                                              
                                              3.34
                                              %
                                              
                                              
                                              4.78
                                              %
                                              
                                              
                                              -1.44
                                              %Other
      borrowings (1) (2)
                                              
                                              
                                              79,164
                                              
                                              
                                              
                                              34,991
                                              
                                              
                                              
                                              44,173
                                              
                                              
                                              
                                              126.24
                                              %
                                              
                                              
                                              2.50
                                              %
                                              
                                              
                                              5.42
                                              %
                                              
                                              
                                              -2.92
                                              %Federal
      funds purchased
                                              
                                              
                                              3,406
                                              
                                              
                                              
                                              1,138
                                              
                                              
                                              
                                              2,268
                                              
                                              
                                              
                                              199.30
                                              %
                                              
                                              
                                              2.55
                                              %
                                              
                                              
                                              5.54
                                              %
                                              
                                              
                                              -2.98
                                              %Long
      term debt
                                              
                                              
                                              13,403
                                              
                                              
                                              
                                              12,234
                                              
                                              
                                              
                                              1,169
                                              
                                              
                                              
                                              9.56
                                              %
                                              
                                              
                                              5.93
                                              %
                                              
                                              
                                              7.53
                                              %
                                              
                                              
                                              -1.60
                                              %Total
      interest-bearing liabilities
                                              
                                              $
                                              548,532
                                              
                                              
                                              $
                                              401,612
                                              
                                              
                                              $
                                              146,920
                                              
                                              
                                              
                                              36.58
                                              %
                                              
                                              
                                              2.29
                                              %
                                              
                                              
                                              3.67
                                              %
                                              
                                              
                                              -1.38
                                              %
 
 (1)
              Consists
      of Federal Home Loan Bank borrowings of $76,881 and $33,136 and repurchase
      agreements of $2,283 and $1,855 for the years ended December 31, 2008 and
      2007, respectively.
 (2)
              Average
      rate paid on Federal Home Loan Bank borrowings and repurchase agreements
      of 2.51% and 5.44% and 2.01% and 4.91% for the years ended December 31,
      2008 and 2007, respectively.
 
 Average
interest bearing liabilities increased approximately $146.9 million from the
$401.6 million reported at December 31, 2007.  The year over year
increase can be attributed to higher average balances of savings, NOW and money
market accounts of which approximately $41.1 million of the change can be
attributed to the acquisition of Business First.  Additionally, the
year over year increase in FHLB borrowing also contributed significantly to the
increase in interest bearing liabilities.  For the year ended December
31, 2008, the rate the Company paid on interest bearing liabilities was 2.29% or
138 basis points lower than the 3.67% reported for 2007.  A
significantly lower overnight Fed Funds rate during the majority of 2008,
contributed significantly to the year over year decline in the rate paid on
average interest bearing liabilities.  As the Federal Reserve moved
aggressively to lower rates during 2008 in response to, among other things,
weakness in the credit markets and general economic conditions, the Bank moved
to lower the rates paid on its deposits.  This in conjunction with
declines in the cost of relatively short term borrowing from the FHLB, were
primary factors in the decline of the rate paid on interest bearing
liabilities.
 
 For the
year ended December 31, 2008, the average balance of floating rate interest
bearing deposits was approximately $293.1 million or 53.4% of total interest
bearing liabilities.  The ability to rapidly re-price the majority of
its interest bearing liabilities in conjunction with the moves made by the FOMC
during 2008 to lower the overnight Fed Funds rate was instrumental to the Bank
in mitigating a substantial decline in its net interest margin.
 
 The
hypothetical impacts of sudden interest rate movements applied to the Company’s
asset and liability balances are modeled monthly.  The results of
these models indicate how much of the Company’s net interest income is “at risk”
from various rate changes over a one year horizon.  This exercise is
valuable in identifying risk exposures.  The results for the Company’s
December 31, 2008 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.
  31
  The
following table sets forth the dollar difference in interest earned and paid for
each major category of interest-earning assets and interest-bearing liabilities
and the amount of such change attributable to changes in average balances
(volume) or changes in interest rates for the three years ended December 31,
2008, 2007 and 2006:
 
 For The Year Ended,
                                                
                                                
                                                For The Year Ended,
                                                
                                                
                                                For The Year Ended,December 31, 2008
                                                
                                                
                                                December 31, 2007
                                                
                                                
                                                December 31, 2006(dollar
      amounts in thousands)
                                                
                                                Volume
                                                
                                                
                                                Rate
                                                
                                                
                                                Total
                                                
                                                
                                                Volume
                                                
                                                
                                                Rate
                                                
                                                
                                                Total
                                                
                                                
                                                Volume
                                                
                                                
                                                Rate
                                                
                                                
                                                TotalInterest
      income:Loans
      (1)
                                                
                                                $
                                                12,099
                                                
                                                
                                                $
                                                (7,486
                                                )
                                                
                                                $
                                                4,613
                                                
                                                
                                                $
                                                8,288
                                                
                                                
                                                $
                                                240
                                                
                                                
                                                $
                                                8,528
                                                
                                                
                                                $
                                                2,990
                                                
                                                
                                                $
                                                3,508
                                                
                                                
                                                $
                                                6,498Investment
      securities taxable
                                                
                                                
                                                881
                                                
                                                
                                                
                                                96
                                                
                                                
                                                
                                                977
                                                
                                                
                                                
                                                (86
                                                )
                                                
                                                
                                                107
                                                
                                                
                                                
                                                21
                                                
                                                
                                                
                                                (604
                                                )
                                                
                                                
                                                364
                                                
                                                
                                                
                                                (240
                                                )Investment
      securities non-taxable (2)
                                                
                                                
                                                36
                                                
                                                
                                                
                                                11
                                                
                                                
                                                
                                                47
                                                
                                                
                                                
                                                14
                                                
                                                
                                                
                                                (2
                                                )
                                                
                                                
                                                12
                                                
                                                
                                                
                                                171
                                                
                                                
                                                
                                                (6
                                                )
                                                
                                                
                                                165Taxable
      equivalent adjustment (2)
                                                
                                                
                                                (12
                                                )
                                                
                                                
                                                (4
                                                )
                                                
                                                
                                                (16
                                                )
                                                
                                                
                                                (5
                                                )
                                                
                                                
                                                1
                                                
                                                
                                                
                                                (4
                                                )
                                                
                                                
                                                (58
                                                )
                                                
                                                
                                                2
                                                
                                                
                                                
                                                (56
                                                )Interest-bearing
      deposits
                                                
                                                
                                                (7
                                                )
                                                
                                                
                                                7
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                4
                                                
                                                
                                                
                                                (5
                                                )
                                                
                                                
                                                (1
                                                )
                                                
                                                
                                                (28
                                                )
                                                
                                                
                                                (14
                                                )
                                                
                                                
                                                (42
                                                )Federal
      funds sold
                                                
                                                
                                                8,811
                                                
                                                
                                                
                                                (9,456
                                                )
                                                
                                                
                                                (645
                                                )
                                                
                                                
                                                232
                                                
                                                
                                                
                                                14
                                                
                                                
                                                
                                                246
                                                
                                                
                                                
                                                (3,648
                                                )
                                                
                                                
                                                3,520
                                                
                                                
                                                
                                                (128
                                                )Net
      increase (decrease)
                                                
                                                
                                                21,808
                                                
                                                
                                                
                                                (16,832
                                                )
                                                
                                                
                                                4,976
                                                
                                                
                                                
                                                8,447
                                                
                                                
                                                
                                                355
                                                
                                                
                                                
                                                8,802
                                                
                                                
                                                
                                                (1,177
                                                )
                                                
                                                
                                                7,374
                                                
                                                
                                                
                                                6,197Interest
      expense:Savings,
      NOW, money market
                                                
                                                
                                                1,627
                                                
                                                
                                                
                                                (2,163
                                                )
                                                
                                                
                                                (536
                                                )
                                                
                                                
                                                249
                                                
                                                
                                                
                                                2,165
                                                
                                                
                                                
                                                2,414
                                                
                                                
                                                
                                                (62
                                                )
                                                
                                                
                                                864
                                                
                                                
                                                
                                                802Time
      deposits
                                                
                                                
                                                618
                                                
                                                
                                                
                                                (2,250
                                                )
                                                
                                                
                                                (1,632
                                                )
                                                
                                                
                                                2,009
                                                
                                                
                                                
                                                479
                                                
                                                
                                                
                                                2,488
                                                
                                                
                                                
                                                1,456
                                                
                                                
                                                
                                                1,232
                                                
                                                
                                                
                                                2,688Other
      borrowings
                                                
                                                
                                                1,490
                                                
                                                
                                                
                                                (1,407
                                                )
                                                
                                                
                                                83
                                                
                                                
                                                
                                                390
                                                
                                                
                                                
                                                54
                                                
                                                
                                                
                                                444
                                                
                                                
                                                
                                                (4
                                                )
                                                
                                                
                                                502
                                                
                                                
                                                
                                                498Federal
      funds purchased
                                                
                                                
                                                72
                                                
                                                
                                                
                                                (48
                                                )
                                                
                                                
                                                24
                                                
                                                
                                                
                                                7
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                7
                                                
                                                
                                                
                                                56
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                56Long
      term borrowings
                                                
                                                
                                                82
                                                
                                                
                                                
                                                (208
                                                )
                                                
                                                
                                                (126
                                                )
                                                
                                                
                                                201
                                                
                                                
                                                
                                                (119
                                                )
                                                
                                                
                                                82
                                                
                                                
                                                
                                                112
                                                
                                                
                                                
                                                144
                                                
                                                
                                                
                                                256Net
      increase (decrease)
                                                
                                                
                                                3,889
                                                
                                                
                                                
                                                (6,076
                                                )
                                                
                                                
                                                (2,187
                                                )
                                                
                                                
                                                2,856
                                                
                                                
                                                
                                                2,579
                                                
                                                
                                                
                                                5,435
                                                
                                                
                                                
                                                1,558
                                                
                                                
                                                
                                                2,742
                                                
                                                
                                                
                                                4,300Total
      net increase (decrease)
                                                
                                                $
                                                17,919
                                                
                                                
                                                $
                                                (10,756
                                                )
                                                
                                                $
                                                7,163
                                                
                                                
                                                $
                                                5,591
                                                
                                                
                                                $
                                                (2,224
                                                )
                                                
                                                $
                                                3,367
                                                
                                                
                                                $
                                                (2,735
                                                )
                                                
                                                $
                                                4,632
                                                
                                                
                                                $
                                                1,897
 
 (1)
              Loan
      fees of $1,297, $1,227 and $1,275, for 2008, 2007 and 2006, respectively
      have been included in the interest income
  computation.
 (2)
              Adjusted
      to a fully taxable equivalent basis using a tax rate of
    34%.
 
 Non-Interest
Income
 
 The table
below sets forth changes for 2008, 2007 and 2006 in non-interest income
exclusive of gains on sale of securities, SBA loans and premises:
 
 For The Years Ended
                                        
                                        
                                        VariancesDecember 31,
                                        
                                        
                                        2008
                                        
                                        
                                        2007(dollar
      amounts in thousands)
                                        
                                        2008
                                        
                                        
                                        2007
                                        
                                        
                                        2006
                                        
                                        
                                        dollar
                                        
                                        
                                        percentage
                                        
                                        
                                        dollar
                                        
                                        
                                        percentageService
      charges on deposit accounts
                                        
                                        $
                                        3,284
                                        
                                        
                                        $
                                        2,774
                                        
                                        
                                        $
                                        2,427
                                        
                                        
                                        $
                                        510
                                        
                                        
                                        
                                        18.4
                                        %
                                        
                                        $
                                        347
                                        
                                        
                                        
                                        14.3
                                        %ATM/Debit
      Card transaction/interchange fees
                                        
                                        
                                        843
                                        
                                        
                                        
                                        765
                                        
                                        
                                        
                                        711
                                        
                                        
                                        
                                        78
                                        
                                        
                                        
                                        10.2
                                        %
                                        
                                        
                                        54
                                        
                                        
                                        
                                        7.6
                                        %Bancard
                                        
                                        
                                        231
                                        
                                        
                                        
                                        224
                                        
                                        
                                        
                                        122
                                        
                                        
                                        
                                        7
                                        
                                        
                                        
                                        3.1
                                        %
                                        
                                        
                                        102
                                        
                                        
                                        
                                        83.6
                                        %Mortgage
      origination fees
                                        
                                        
                                        568
                                        
                                        
                                        
                                        461
                                        
                                        
                                        
                                        552
                                        
                                        
                                        
                                        107
                                        
                                        
                                        
                                        23.2
                                        %
                                        
                                        
                                        (91
                                        )
                                        
                                        
                                        -16.5
                                        %Earnings
      on cash surrender value life insurance
                                        
                                        
                                        474
                                        
                                        
                                        
                                        433
                                        
                                        
                                        
                                        393
                                        
                                        
                                        
                                        41
                                        
                                        
                                        
                                        9.5
                                        %
                                        
                                        
                                        40
                                        
                                        
                                        
                                        10.2
                                        %Other
                                        
                                        
                                        769
                                        
                                        
                                        
                                        650
                                        
                                        
                                        
                                        737
                                        
                                        
                                        
                                        119
                                        
                                        
                                        
                                        18.3
                                        %
                                        
                                        
                                        (87
                                        )
                                        
                                        
                                        -11.8
                                        %Total
                                        
                                        $
                                        6,169
                                        
                                        
                                        $
                                        5,307
                                        
                                        
                                        $
                                        4,942
                                        
                                        
                                        $
                                        862
                                        
                                        
                                        
                                        16.2
                                        %
                                        
                                        $
                                        365
                                        
                                        
                                        
                                        7.4
                                        %
 For the
year ended December 31, 2008, non-interest income increased approximately $862
thousand or 16.2% when compared to the same period ended a year
earlier.  Of the year over year increase, approximately $346 thousand
or 40.1% can be attributed to the Business First acquisition.
 
 Service
charges on deposit accounts contributed to the majority of the increase in
non-interest income, with a year over year increase of approximately $510
thousand or 18.4%.  The majority of the increase within this category
can be attributed to the additional deposit relationships the Bank obtained in
the Business First acquisition.  For the year ended December 31, 2008,
the Business First acquisition accounted for approximately $290 thousand of the
year over year increase within this category.
 
 The
increase within the category of “other” can be attributed in large part to
income the Bank recognized during 2008 in the approximate amount of $273
thousand related to the mandatory redemption of preferred shares the Company
received in connection with the initial public offering of Visa,
Inc.
 
 Debit
card interchange income was approximately $78 thousand or 10.2% higher for the
year ended December 31, 2008 when compared to the same period ended a year
earlier.  The primary reason behind the year over year increase within
this category can be attributed to promotions the Bank rolled out during 2008
designed to promote additional debit card usage.
  32
  Mortgage
origination fees increased approximately $107 thousand or 23.2% from that
reported for 2007.  This can be attributed to a significant increase
in the number of loan re-finances as homeowners moved to take advantage of lower
interest rates during the first, third and fourth quarters of
2008.  Additionally, since the fourth quarter of 2007, the Bank has
moved to strengthen the origination team with additional high quality, seasoned
professionals.  Management believes these additions will help to
strengthen the Bank’s position to become one of the preferred originators within
its current market footprint.
 
 The
following table provides a summary of the total dollar volume and number of
mortgage loans funded during the years ended December 31, 2008, 2007 and
2006:
 
 For The Years Ended December 31,
                                    
                                    
                                    Variance(dollar amounts in thousands)
                                    
                                    2008
                                    
                                    
                                    2007
                                    
                                    
                                    2006
                                    
                                    
                                    2008 vs. 2007
                                    
                                    
                                    2007 vs. 2006Dollar
      volume
                                    
                                    $
                                    64,199
                                    
                                    
                                    $
                                    50,623
                                    
                                    
                                    $
                                    65,895
                                    
                                    
                                    
                                    26.8
                                    %
                                    
                                    
                                    -23.2
                                    %Number
      of loans
                                    
                                    
                                    179
                                    
                                    
                                    
                                    147
                                    
                                    
                                    
                                    202
                                    
                                    
                                    
                                    21.8
                                    %
                                    
                                    
                                    -27.2
                                    %
 
 Non-Interest
Expenses
 
 The table
below sets forth changes in non-interest expense for 2008, 2007, and
2006:
 
 For The Years Ended
                                                  
                                                  
                                                  VariancesDecember 31,
                                                  
                                                  
                                                  2008
                                                  
                                                  
                                                  2007(dollar
      amounts in thousands)
                                                  
                                                  2008
                                                  
                                                  
                                                  2007
                                                  
                                                  
                                                  2006
                                                  
                                                  
                                                  dollar
                                                  
                                                  
                                                  percentage
                                                  
                                                  
                                                  dollar
                                                  
                                                  
                                                  percentageSalaries
      and employee benefits
                                                  
                                                  $
                                                  15,561
                                                  
                                                  
                                                  $
                                                  13,501
                                                  
                                                  
                                                  $
                                                  11,573
                                                  
                                                  
                                                  $
                                                  2,060
                                                  
                                                  
                                                  
                                                  15.3
                                                  %
                                                  
                                                  $
                                                  1,928
                                                  
                                                  
                                                  
                                                  16.7
                                                  %Occupancy
      and equipment
                                                  
                                                  
                                                  4,542
                                                  
                                                  
                                                  
                                                  3,381
                                                  
                                                  
                                                  
                                                  2,607
                                                  
                                                  
                                                  
                                                  1,161
                                                  
                                                  
                                                  
                                                  34.3
                                                  %
                                                  
                                                  
                                                  774
                                                  
                                                  
                                                  
                                                  29.7
                                                  %Data
      processing
                                                  
                                                  
                                                  2,704
                                                  
                                                  
                                                  
                                                  2,267
                                                  
                                                  
                                                  
                                                  2,138
                                                  
                                                  
                                                  
                                                  437
                                                  
                                                  
                                                  
                                                  19.3
                                                  %
                                                  
                                                  
                                                  129
                                                  
                                                  
                                                  
                                                  6.0
                                                  %Advertising
      and promotional
                                                  
                                                  
                                                  823
                                                  
                                                  
                                                  
                                                  718
                                                  
                                                  
                                                  
                                                  851
                                                  
                                                  
                                                  
                                                  105
                                                  
                                                  
                                                  
                                                  14.6
                                                  %
                                                  
                                                  
                                                  (133
                                                  )
                                                  
                                                  
                                                  -15.6
                                                  %Regulatory
      fees
                                                  
                                                  
                                                  475
                                                  
                                                  
                                                  
                                                  146
                                                  
                                                  
                                                  
                                                  112
                                                  
                                                  
                                                  
                                                  329
                                                  
                                                  
                                                  
                                                  225.3
                                                  %
                                                  
                                                  
                                                  34
                                                  
                                                  
                                                  
                                                  30.4
                                                  %Other
      professional fees and outside services
                                                  
                                                  
                                                  1,197
                                                  
                                                  
                                                  
                                                  1,247
                                                  
                                                  
                                                  
                                                  1,207
                                                  
                                                  
                                                  
                                                  (50
                                                  )
                                                  
                                                  
                                                  -4.0
                                                  %
                                                  
                                                  
                                                  40
                                                  
                                                  
                                                  
                                                  3.3
                                                  %Legal
      fees and other litigation expense
                                                  
                                                  
                                                  150
                                                  
                                                  
                                                  
                                                  100
                                                  
                                                  
                                                  
                                                  154
                                                  
                                                  
                                                  
                                                  50
                                                  
                                                  
                                                  
                                                  50.0
                                                  %
                                                  
                                                  
                                                  (54
                                                  )
                                                  
                                                  
                                                  -35.1
                                                  %Loan
      department costs
                                                  
                                                  
                                                  214
                                                  
                                                  
                                                  
                                                  129
                                                  
                                                  
                                                  
                                                  147
                                                  
                                                  
                                                  
                                                  85
                                                  
                                                  
                                                  
                                                  65.9
                                                  %
                                                  
                                                  
                                                  (18
                                                  )
                                                  
                                                  
                                                  -12.2
                                                  %Stationery
      and supplies
                                                  
                                                  
                                                  428
                                                  
                                                  
                                                  
                                                  350
                                                  
                                                  
                                                  
                                                  327
                                                  
                                                  
                                                  
                                                  78
                                                  
                                                  
                                                  
                                                  22.3
                                                  %
                                                  
                                                  
                                                  23
                                                  
                                                  
                                                  
                                                  7.0
                                                  %Director
      fees
                                                  
                                                  
                                                  318
                                                  
                                                  
                                                  
                                                  289
                                                  
                                                  
                                                  
                                                  290
                                                  
                                                  
                                                  
                                                  29
                                                  
                                                  
                                                  
                                                  10.0
                                                  %
                                                  
                                                  
                                                  (1
                                                  )
                                                  
                                                  
                                                  -0.3
                                                  %Core
      deposit intangible amortization
                                                  
                                                  
                                                  861
                                                  
                                                  
                                                  
                                                  393
                                                  
                                                  
                                                  
                                                  300
                                                  
                                                  
                                                  
                                                  468
                                                  
                                                  
                                                  
                                                  119.1
                                                  %
                                                  
                                                  
                                                  93
                                                  
                                                  
                                                  
                                                  31.0
                                                  %Other
                                                  
                                                  
                                                  2,161
                                                  
                                                  
                                                  
                                                  1,387
                                                  
                                                  
                                                  
                                                  1,249
                                                  
                                                  
                                                  
                                                  774
                                                  
                                                  
                                                  
                                                  55.8
                                                  %
                                                  
                                                  
                                                  138
                                                  
                                                  
                                                  
                                                  11.0
                                                  %Total
                                                  
                                                  $
                                                  29,434
                                                  
                                                  
                                                  $
                                                  23,908
                                                  
                                                  
                                                  $
                                                  20,955
                                                  
                                                  
                                                  $
                                                  5,526
                                                  
                                                  
                                                  
                                                  23.1
                                                  %
                                                  
                                                  $
                                                  2,953
                                                  
                                                  
                                                  
                                                  14.1
                                                  %
 ·
              Salaries and Employee
      Benefits
 
 Expenses
within this category incurred the greatest dollar increase of any non-interest
expense category during 2008.  The majority of the year over year
increase within this category can be attributed to additional staff the Bank
obtained in the acquisition of Business First.  For the year ended
December 31, 2008, Business First accounted for approximately $1.6 million of
the year over year change within this category.  Additionally, the
addition of a full service branch in the town of San Miguel has also contributed
to the year over year rise within this category.  For the years ended
December 31, 2008, 2007 and 2006 the number of full time equivalent (“FTE”)
employees stood at 223, 242 and 212, respectively.
 
 For the
year ended December 31, 2007 expenses within this category totaled $13.5 million
or approximately $1.9 million higher than that reported for 2006.  The
majority of the increase within 2007 can be attributed to the acquisition of
Business First as well as the addition of staff related to the opening of two
full service branches.
 
 ·
              Occupancy and
      Equipment
 
 Expenses
within this category increased approximately $1.2 million over the prior
year.  The primary factors contributing to the increase are the
acquisition of Business First, additional rental expense incurred in connection
with the sale leaseback transaction the Bank entered into during the second
quarter of 2007, and the addition of a full service branch in the town of San
Miguel.  For the year ended December 31, 2008, the acquisition of
Business First and the 2007 sale leaseback transaction accounted for
approximately $720 thousand and $243 thousand of the year over year change
within this category, respectively.
  33
  For the
year ended December 31, 2007 expenses within this category totaled $3.4 million
or approximately $774 thousand over the prior year.  The primary
factors contributing to the increase in 2007 were the sale lease-back
transaction, previously mentioned, the opening of two new branches in the towns
of Templeton and San Miguel as well as the acquisition of Business
First.  Additionally, during 2007, the Bank incurred approximately $60
thousand in additional property tax expense related to the 2006 - 2007
assessment of its administrative facility of which construction was completed
during 2006.
 
 As
mentioned, during the second quarter of 2007, the Bank sold four of its
properties in a sale leaseback transaction.  In connection with the
sale, the Bank recorded a deferred gain in the approximate amount of $3.4
million, which will be recognized over a period of fifteen years as a credit to
rental expense.  For the years ended December 31, 2008 and 2007, the
Bank recognized approximately $227 thousand and $114 thousand of the deferred
gain on sale related to the sale lease-back transaction,
respectively.
 
 ·
              Data Processing
      Expense
 
 For the
year ended December 31, 2008, data processing expenses totaled $2.7 million or
approximately $437 thousand higher than that reported for 2007.  The
year over year increase can be attributed to higher transaction processing
volumes associated with the acquisition of Business First.  Expenses
within this category totaled approximately $2.3 million for the year ended
December 31, 2007, representing a slight increase over 2006 in the approximate
amount of $129 thousand.
 
 ·
              Regulatory
      Fees
 
 For the
year ended December 31, 2008, expenses within this category totaled
approximately $475 thousand or approximately $329 thousand higher that that
reported for 2007.  During 2007, the Bank received a one-time
assessment credit under the Federal Deposit Insurance Reform Act of 2005 to
recognize its past contributions to the FDIC insurance fund.  It is
the absence of this credit in 2008 that has contributed to the substantial year
over year increase within this category.
 
 ·
              Other Professional Fees and
      Outside Services
 
 The
Company incurred approximately $1.2 million in other professional fees and
outside services during 2008, remaining relatively unchanged from
2007.  Expenses within this category include, among other things,
audit and tax accounting fees, various insurance related expenses, consulting
fees and other outside services.  For the year ended December 31, 2007
expenses within this category totaled $1.2 million, which were relatively
unchanged from 2006.
 
 ·
              Core Deposit Intangible (“CDI”)
      Amortization
 
 Amortizations
for the Hacienda acquisition in October 2003 and the Business First acquisition
in October 2007 are scheduled pursuant to analysis prepared by a third party to
determine the fair value of deposits acquired in accordance with SFAS No. 141
and SFAS No. 142.  Accordingly, expense incurred for CDI amortization
for the year ended December 31, 2008 and 2007 was $861 thousand and $393
thousand, respectively.
 
 ·
              Other
      Expenses
 
 Expenses
within this category totaled $2.2 million for the year ended December 31, 2008,
representing an increase of approximately $774 thousand over that reported for
2007.  In addition to the full year of expense associated with the
addition of Business First in the approximate amount of $308 thousand, the other
significant factor that contributed to the increase within this category was
approximately $283 thousand in higher net sundry losses.
  34
  Provision
for Income Taxes
 
 The
amount of the tax provision is determined by applying the Company’s statutory
income tax rates to pre-tax book income, adjusted for permanent differences
between pre-tax book income and actual taxable income. Such permanent
differences include, but are not limited to, tax-exempt interest income, and
increases in the cash surrender value of bank-owned life
insurance.  For the years ended December 31, 2008, 2007 and 2006
provision for income taxes was $0.5 million, $4.3 million, and $3.8 million,
respectively.  The Company’s effective tax rate for the years ended
December 31, 2008, 2007 and 2006 was 23.2%, 38.3%, and 36.3%,
respectively.  The Company’s effective tax rate for the year ended
December 31, 2008 was substantially lower than that reported for 2007 due in
large part to the substantial provisions the Bank made to the allowance for loan
losses during the year.  As a result, income from permanent items such
as interest on municipal securities and earnings on holdings of bank owned life
insurance represented a larger percentage of overall taxable income for the
year.
 
 Provision
and Allowance for Loan Losses
 
 An
allowance for loan losses has been established by Management to provide for
those loans that may not be repaid in their entirety for a variety of
reasons.  The allowance is maintained at a level considered by
Management to be adequate to provide for probable incurred
losses.  The allowance for loan losses is comprised of three
components: specific credit allocation, general portfolio allocation, and
subjectively by determined allocation.  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 Bank
recognizes that credit losses will be experienced and the risk of loss will vary
with, among other things, general economic conditions; the type of loan being
made; the creditworthiness of the borrower over the term of the loan and in the
case of a collateralized loan, the quality of the collateral for such
loan.  The allowance for loan losses represents the Bank’s estimate of
the allowance necessary to provide for probable incurred losses in the
portfolio.  In making this determination, the Bank analyzes the
ultimate collectibility of the loans in the portfolio by incorporating feedback
provided by internal loan staff, an independent loan review function, and
information provided by examinations performed by regulatory
agencies.  The Bank makes monthly evaluations as to the adequacy of
the allowance for loan losses.
 
 The Bank
accounts for problem loans in accordance with Statement of Financial Accounting
Standards (“SFAS”) No.114,“Accounting by Creditors for Impairment of a Loan,” as amended by SFAS
No. 118, “Accounting by
Creditors for Impairment of a Loan - Income Recognition and
Disclosures.”  These pronouncements provide that when it is
probable that a creditor will be unable to collect all amounts due in accordance
with the terms of the loan that such loan is deemed
impaired.  Impaired loans are accounted for differently in that the
amount of the impairment is measured and reflected in the records of the
creditor.  The allowance for credit losses related to loans that are
identified for evaluation in accordance with SFAS No. 114 is based on discounted
cash flows using the loan’s initial effective interest rate or the fair value of
the collateral for certain collateral dependent loans.  The general
portfolio allocation consists of an assigned reserve percentage based on the
credit rating of the loan.  The subjective portion is determined based
on loan history and the Bank’s evaluation of various factors including current
economic conditions and trends in the portfolio including delinquencies and
impairment, as well as changes in the composition of the portfolio.
 
 The
allowance for loan losses is based on estimates, and ultimate losses will vary
from current estimates.  These estimates are reviewed monthly by the
Bank’s Directors, 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 2008 is consistent with prior periods.
 
 The
Bank’s provision for loan losses was $12.2 million, $0.7 million and $0.6
million for the years ended December 31, 2008, 2007 and 2006,
respectively.
  35
  Provisions
made to the allowance for loan losses during 2008, were approximately $11.5
million higher than that reported for 2007. As economic conditions worsened on
national, state and local levels, the Bank moved to increase the allowance as
required by monthly analyses the Bank conducts in determining its adequacy to
cover potential losses in the loan portfolio.  The Bank employs the
use of a “watch list” and loan grading system to assist in monitoring the
quality of certain credits in the loan portfolio.  As loans on the
watch list and any other loan within the portfolio experience deterioration, the
Bank typically moves to downgrade such loans, resulting in an increase in the
required allowance to cover any potential losses.  Management believes
the significant economic downturn witnessed during 2008 has had a considerable
impact on the ability of certain borrowers to satisfy their obligations to the
Bank, resulting in watch list expansion, loan downgrades and corresponding
increases in loan loss provisions.  Additionally, the Bank makes
estimates as to the impact that certain economic factors will have on various
credits within the portfolio.  Negative economic trends witnessed
during 2008 contributed substantially to increases in the required allowance to
cover potential losses in the loan portfolio, resulting in increases in loan
loss provisions.
 
 Increases
in the balance of non-performing loans as well as charge-offs during 2008 also
contributed to the additional provisions the Bank made to the allowance for loan
losses.  Losses in the commercial and industrial, construction and
land segments of the loan portfolio when compared to prior periods, increased
dramatically during 2008.  Although the majority of losses within
these segments of the portfolio were the result of several large write-downs,
the Bank has witnessed an increase in the number and total dollar volume of past
due and non-accruing balances within the commercial and industrial, construction
and land segments.  Continued increases in the number and dollar
volume of non-performing loans may result in further provisions to the allowance
for loan losses.
 
 As we
look forward into 2009, Management anticipates there to be further weakness in
economic conditions on national, state and local levels.  Many
economic forecasts suggest further increases in the national unemployment rate,
which will undoubtedly place continued pressure on conditions within the Bank’s
primary market area.  Continued economic pressures may negatively
impact the financial condition of borrowers to whom the Bank has extended credit
and as a result the Bank may be required to make further significant provisions
to the allowance for loan losses during 2009.  That said, Management
has been and will continue to be proactive in looking for signs of deterioration
within the loan portfolio in an effort to manage credit quality and mitigate any
further losses.
 
 As of
December 31, 2008, Management believes, based on all current and available
information, the allowance for loan losses is adequate to absorb current
estimable losses within the loan portfolio.
 
 The
allowance for loan losses as a percent of total gross loans at December 31,
2008, 2007 and 2006 was 1.53%, 1.00% and 0.92%, respectively.  Net
loan charge-offs (loans charged-off, net of loans recovered) were $7.9 million
and $0.4 million for 2008 and 2006, respectively.  For the year ended
December 31, 2007, the Bank had a net recovery of $21 thousand.  Net
charge-offs for 2006 were primarily the result of a single loan
charge-off.
 
 For
additional information related to non-performing assets see “Non-Performing
Assets” under Item 7. Management’s Discussion and Analysis of Financial
Condition and Results of Operations on page 45 of this report filed on Form
10-K.
  36


The
following table provides an analysis of the allowance for loan losses for the
years ended December 31, 2008, 2007, 2006, 2005, and 2004:
 
 For
      the Years Ended December 31,(dollars
      amounts in thousands)
                          
                          2008
                          
                          
                          2007
                          
                          
                          2006
                          
                          
                          2005
                          
                          
                          2004Balance,
      beginning of period
                          
                          $
                          6,143
                          
                          
                          $
                          4,081
                          
                          
                          $
                          3,881
                          
                          
                          $
                          3,247
                          
                          
                          $
                          3,070Balance
      of Business First National Bank, beginning of period
                          
                          
                          -
                          
                          
                          
                          1,381
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Charge-offs:Real
      Estate SecuredMulti-family
      residential
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Residential
      1 to 4 family
                          
                          
                          555
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Home
      equity line of credit
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Commercial
                          
                          
                          340
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Farmland
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -CommercialCommercial
      and industrial
                          
                          
                          3,854
                          
                          
                          
                          233
                          
                          
                          
                          508
                          
                          
                          
                          86
                          
                          
                          
                          202Agriculture
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Other
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Construction
                          
                          
                          1,837
                          
                          
                          
                          16
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Land
                          
                          
                          1,434
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Installment
      loans to individuals
                          
                          
                          20
                          
                          
                          
                          -
                          
                          
                          
                          44
                          
                          
                          
                          12
                          
                          
                          
                          29All
      other loans
                          
                          
                          36
                          
                          
                          
                          -
                          
                          
                          
                          9
                          
                          
                          
                          2
                          
                          
                          
                          5Total
      charge-offs
                          
                          
                          8,076
                          
                          
                          
                          249
                          
                          
                          
                          561
                          
                          
                          
                          100
                          
                          
                          
                          236Recoveries:Real
      Estate SecuredMulti-family
      residential
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Resiential
      1 to 4 family
                          
                          
                          2
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Home
      equity line of credit
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Commercial
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Farmland
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -CommercialCommercial
      and industrial
                          
                          
                          107
                          
                          
                          
                          191
                          
                          
                          
                          101
                          
                          
                          
                          -
                          
                          
                          
                          1Agriculture
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Other
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Construction
                          
                          
                          -
                          
                          
                          
                          70
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Land
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Installment
      loans to individuals
                          
                          
                          1
                          
                          
                          
                          3
                          
                          
                          
                          56
                          
                          
                          
                          24
                          
                          
                          
                          2All
      other loans
                          
                          
                          20
                          
                          
                          
                          6
                          
                          
                          
                          4
                          
                          
                          
                          -
                          
                          
                          
                          -Total
      recoveries
                          
                          
                          130
                          
                          
                          
                          270
                          
                          
                          
                          161
                          
                          
                          
                          24
                          
                          
                          
                          3Net
      charge-offs / (recoveries)
                          
                          
                          7,946
                          
                          
                          
                          (21
                          )
                          
                          
                          400
                          
                          
                          
                          76
                          
                          
                          
                          233Additions
      to allowance charged to operations
                          
                          
                          12,215
                          
                          
                          
                          660
                          
                          
                          
                          600
                          
                          
                          
                          710
                          
                          
                          
                          410Balance,
      end of period
                          
                          $
                          10,412
                          
                          
                          $
                          6,143
                          
                          
                          $
                          4,081
                          
                          
                          $
                          3,881
                          
                          
                          $
                          3,247Gross
      loans, end of period
                          
                          $
                          680,147
                          
                          
                          $
                          613,217
                          
                          
                          $
                          444,983
                          
                          
                          $
                          368,133
                          
                          
                          $
                          339,693Net
      charge-offs to average loans
                          
                          
                          1.21
                          %
                          
                          
                          0.00
                          %
                          
                          
                          0.10
                          %
                          
                          
                          0.02
                          %
                          
                          
                          0.08
                          %Allowance
      for loan losses to total gross loans
                          
                          
                          1.53
                          %
                          
                          
                          1.00
                          %
                          
                          
                          0.92
                          %
                          
                          
                          1.05
                          %
                          
                          
                          0.96
                          %Non-performing
      loans to allowance for loan losses
                          
                          
                          179.36
                          %
                          
                          
                          5.50
                          %
                          
                          
                          1.35
                          %
                          
                          
                          1.39
                          %
                          
                          
                          28.77
                          %
  37
 
 For
reporting purposes, the Company allocates the allowance for loan losses across
product types within the loan portfolio based upon their
composition.  However, substantially all of the allowance is available
to absorb all credit losses without restriction, unless specific reserves have
been established.  The following table provides a summary of the
allowance for loan losses and its allocation to each major loan category, based
on the composition of the loan portfolio as of December 31, 2008, 2007, 2006,
2005, and 2004:
 
 2008
                                  
                                  
                                  2007
                                  
                                  
                                  2006
                                  
                                  
                                  2005
                                  
                                  
                                  2004Percent
                                  
                                  
                                  
                                  
                                  
                                  Percent
                                  
                                  
                                  
                                  
                                  
                                  Percent
                                  
                                  
                                  
                                  
                                  
                                  Percent
                                  
                                  
                                  
                                  
                                  
                                  PercentAmount
                                  
                                  
                                  of
      Total
                                  
                                  
                                  Amount
                                  
                                  
                                  of
      Total
                                  
                                  
                                  Amount
                                  
                                  
                                  of
      Total
                                  
                                  
                                  Amount
                                  
                                  
                                  of
      Total
                                  
                                  
                                  Amount
                                  
                                  
                                  of
      Total(dollars
      amounts in thousands)
                                  
                                  Allocated
                                  
                                  
                                  Loans
                                  
                                  
                                  Allocated
                                  
                                  
                                  Loans
                                  
                                  
                                  Allocated
                                  
                                  
                                  Loans
                                  
                                  
                                  Allocated
                                  
                                  
                                  Loans
                                  
                                  
                                  Allocated
                                  
                                  
                                  LoansReal
      Estate SecuredMulti-family
      residential
                                  
                                  $
                                  250
                                  
                                  
                                  
                                  2.4
                                  %
                                  
                                  $
                                  129
                                  
                                  
                                  
                                  2.1
                                  %
                                  
                                  $
                                  86
                                  
                                  
                                  
                                  2.1
                                  %
                                  
                                  $
                                  35
                                  
                                  
                                  
                                  0.9
                                  %
                                  
                                  $
                                  23
                                  
                                  
                                  
                                  0.7
                                  %Residential
      1 to 4 family
                                  
                                  
                                  364
                                  
                                  
                                  
                                  3.5
                                  %
                                  
                                  
                                  246
                                  
                                  
                                  
                                  4.0
                                  %
                                  
                                  
                                  49
                                  
                                  
                                  
                                  1.2
                                  %
                                  
                                  
                                  50
                                  
                                  
                                  
                                  1.3
                                  %
                                  
                                  
                                  71
                                  
                                  
                                  
                                  2.2
                                  %Home
      equity line of credit
                                  
                                  
                                  406
                                  
                                  
                                  
                                  3.9
                                  %
                                  
                                  
                                  172
                                  
                                  
                                  
                                  2.8
                                  %
                                  
                                  
                                  98
                                  
                                  
                                  
                                  2.4
                                  %
                                  
                                  
                                  155
                                  
                                  
                                  
                                  4.0
                                  %
                                  
                                  
                                  140
                                  
                                  
                                  
                                  4.3
                                  %Commercial
                                  
                                  
                                  4,354
                                  
                                  
                                  
                                  41.8
                                  %
                                  
                                  
                                  2,747
                                  
                                  
                                  
                                  44.7
                                  %
                                  
                                  
                                  1,878
                                  
                                  
                                  
                                  46.0
                                  %
                                  
                                  
                                  1,976
                                  
                                  
                                  
                                  50.9
                                  %
                                  
                                  
                                  1,685
                                  
                                  
                                  
                                  51.9
                                  %Farmland
                                  
                                  
                                  167
                                  
                                  
                                  
                                  1.6
                                  %
                                  
                                  
                                  117
                                  
                                  
                                  
                                  1.9
                                  %
                                  
                                  
                                  167
                                  
                                  
                                  
                                  4.1
                                  %
                                  
                                  
                                  155
                                  
                                  
                                  
                                  4.0
                                  %
                                  
                                  
                                  159
                                  
                                  
                                  
                                  4.9
                                  %CommercialCommercial
      and industrial
                                  
                                  
                                  2,405
                                  
                                  
                                  
                                  23.1
                                  %
                                  
                                  
                                  1,339
                                  
                                  
                                  
                                  21.8
                                  %
                                  
                                  
                                  665
                                  
                                  
                                  
                                  16.3
                                  %
                                  
                                  
                                  567
                                  
                                  
                                  
                                  14.6
                                  %
                                  
                                  
                                  380
                                  
                                  
                                  
                                  11.7
                                  %Agriculture
                                  
                                  
                                  208
                                  
                                  
                                  
                                  2.0
                                  %
                                  
                                  
                                  117
                                  
                                  
                                  
                                  1.9
                                  %
                                  
                                  
                                  110
                                  
                                  
                                  
                                  2.7
                                  %
                                  
                                  
                                  62
                                  
                                  
                                  
                                  1.6
                                  %
                                  
                                  
                                  62
                                  
                                  
                                  
                                  1.9
                                  %Other
                                  
                                  
                                  10
                                  
                                  
                                  
                                  0.1
                                  %
                                  
                                  
                                  6
                                  
                                  
                                  
                                  0.1
                                  %
                                  
                                  
                                  4
                                  
                                  
                                  
                                  0.1
                                  %
                                  
                                  
                                  8
                                  
                                  
                                  
                                  0.2
                                  %
                                  
                                  
                                  32
                                  
                                  
                                  
                                  1.0
                                  %ConstructionSingle
      family residential
                                  
                                  
                                  177
                                  
                                  
                                  
                                  1.7
                                  %
                                  
                                  
                                  98
                                  
                                  
                                  
                                  1.6
                                  %
                                  
                                  
                                  69
                                  
                                  
                                  
                                  1.7
                                  %
                                  
                                  
                                  66
                                  
                                  
                                  
                                  1.7
                                  %
                                  
                                  
                                  65
                                  
                                  
                                  
                                  2.0
                                  %Single
      family residential - Spec.
                                  
                                  
                                  239
                                  
                                  
                                  
                                  2.3
                                  %
                                  
                                  
                                  190
                                  
                                  
                                  
                                  3.1
                                  %
                                  
                                  
                                  98
                                  
                                  
                                  
                                  2.4
                                  %
                                  
                                  
                                  50
                                  
                                  
                                  
                                  1.3
                                  %
                                  
                                  
                                  32
                                  
                                  
                                  
                                  1.0
                                  %Tract
                                  
                                  
                                  42
                                  
                                  
                                  
                                  0.4
                                  %
                                  
                                  
                                  18
                                  
                                  
                                  
                                  0.3
                                  %
                                  
                                  
                                  -
                                  
                                  
                                  
                                  0.0
                                  %
                                  
                                  
                                  -
                                  
                                  
                                  
                                  0.0
                                  %
                                  
                                  
                                  -
                                  
                                  
                                  
                                  0.0
                                  %Multi-family
                                  
                                  
                                  94
                                  
                                  
                                  
                                  0.9
                                  %
                                  
                                  
                                  92
                                  
                                  
                                  
                                  1.5
                                  %
                                  
                                  
                                  49
                                  
                                  
                                  
                                  1.2
                                  %
                                  
                                  
                                  43
                                  
                                  
                                  
                                  1.1
                                  %
                                  
                                  
                                  62
                                  
                                  
                                  
                                  1.9
                                  %Hospitality
                                  
                                  
                                  281
                                  
                                  
                                  
                                  2.7
                                  %
                                  
                                  
                                  166
                                  
                                  
                                  
                                  2.7
                                  %
                                  
                                  
                                  45
                                  
                                  
                                  
                                  1.1
                                  %
                                  
                                  
                                  16
                                  
                                  
                                  
                                  0.4
                                  %
                                  
                                  
                                  10
                                  
                                  
                                  
                                  0.3
                                  %Commercial
                                  
                                  
                                  333
                                  
                                  
                                  
                                  3.2
                                  %
                                  
                                  
                                  307
                                  
                                  
                                  
                                  5.0
                                  %
                                  
                                  
                                  486
                                  
                                  
                                  
                                  11.9
                                  %
                                  
                                  
                                  446
                                  
                                  
                                  
                                  11.5
                                  %
                                  
                                  
                                  253
                                  
                                  
                                  
                                  7.8
                                  %Land
                                  
                                  
                                  947
                                  
                                  
                                  
                                  9.1
                                  %
                                  
                                  
                                  313
                                  
                                  
                                  
                                  5.1
                                  %
                                  
                                  
                                  220
                                  
                                  
                                  
                                  5.4
                                  %
                                  
                                  
                                  190
                                  
                                  
                                  
                                  4.9
                                  %
                                  
                                  
                                  218
                                  
                                  
                                  
                                  6.7
                                  %Installment
      loans to individuals
                                  
                                  
                                  125
                                  
                                  
                                  
                                  1.2
                                  %
                                  
                                  
                                  80
                                  
                                  
                                  
                                  1.3
                                  %
                                  
                                  
                                  53
                                  
                                  
                                  
                                  1.3
                                  %
                                  
                                  
                                  58
                                  
                                  
                                  
                                  1.5
                                  %
                                  
                                  
                                  52
                                  
                                  
                                  
                                  1.6
                                  %All
      other loans (including overdrafts)
                                  
                                  
                                  10
                                  
                                  
                                  
                                  0.1
                                  %
                                  
                                  
                                  6
                                  
                                  
                                  
                                  0.1
                                  %
                                  
                                  
                                  4
                                  
                                  
                                  
                                  0.1
                                  %
                                  
                                  
                                  4
                                  
                                  
                                  
                                  0.1
                                  %
                                  
                                  
                                  3
                                  
                                  
                                  
                                  0.1
                                  %Total
      allowance for loan losses
                                  
                                  $
                                  10,412
                                  
                                  
                                  
                                  100.0
                                  %
                                  
                                  $
                                  6,143
                                  
                                  
                                  
                                  100.0
                                  %
                                  
                                  $
                                  4,081
                                  
                                  
                                  
                                  100.0
                                  %
                                  
                                  $
                                  3,881
                                  
                                  
                                  
                                  100.0
                                  %
                                  
                                  $
                                  3,247
                                  
                                  
                                  
                                  100.0
                                  %
 
 Financial
Condition
 
 At
December 31, 2008 total assets were $805.6 million.  When compared to
the $745.6 million reported at December 31, 2007, total assets increased by
$60.0 million.  The year over year increase in total assets is
primarily attributable to a $66.9 million increase in gross loan
balances.  From 2006 to 2007 total assets increased approximately
$203.8 million.  Of this increase, approximately $152.2 million was
attributed to the acquisition of and growth in Business First
assets.
 
 Although
the Bank experienced a significant amount of loan pay-downs during the year, the
number of and dollar volume of loans funded remained strong.  At
December 31, 2008, net loan balances were $668.0 million.  This, when
compared to the $605.3 million the Company reported at the end of 2007,
represents an increase of approximately $62.7 million.  From 2006 to
2007 approximately $150.0 million of the growth in net loan balances can be
attributed to the acquisition of and growth in Business First net loan
balances.
 
 At
December 31, 2008 total deposits were $603.5 million or $41.3 million lower than
the $644.8 million reported at the end of 2007.  The year over year
decline in deposit balances can be attributed in large part to the dramatic
decline in the overnight Fed Funds rate during 2008 and funds the Bank
subsequently let run-off in favor of somewhat irrational pricing at other
financial institutions.  From 2006 to 2007 total deposits increased
approximately $224.3 million.  Of this increase, approximately $123.6
million can be attributed to the acquisition of Business First.
 
 Federal
Home Loan Bank (“FHLB”) borrowings increased approximately $101.0 million from
that reported at the end of 2007.  The dramatic year over year
increase in wholesale borrowings is primarily attributable to the planned
deposit run-off mentioned in the preceding paragraph.  For additional
information regarding the Bank’s FHLB borrowings, see Note 8, Borrowings, of the
Consolidated Financial Statements filed on this Form 10-K.
 
 As of
December 31, 2008 earning assets to total assets were 93.2% compared to 92.3% at
December 31, 2007.
  38
 
 Loans
 
 At
December 31, 2008, total gross loans were $680.1 million, or $66.9 million
higher than the $613.2 million reported at the end of 2007.  From 2006
to 2007 gross loans increased approximately $168.2 million.  Of this
increase, approximately $151.3 million can be attributed to the acquisition of
and growth in Business First gross loans from the date of the
acquisition.
 
 The table
below sets forth the composition of the loan portfolio as of December 31, 2008,
2007, 2006, 2005 and 2004:
 
 2008
                                  
                                  
                                  2007
                                  
                                  
                                  2006
                                  
                                  
                                  2005
                                  
                                  
                                  2004(dollar
      amounts in thousands)
                                  
                                  Amount
                                  
                                  
                                  Percent
                                  
                                  
                                  Amount
                                  
                                  
                                  Percent
                                  
                                  
                                  Amount
                                  
                                  
                                  Percent
                                  
                                  
                                  Amount
                                  
                                  
                                  Percent
                                  
                                  
                                  Amount
                                  
                                  
                                  PercentReal
      Estate SecuredMulti-family
      residential
                                  
                                  $
                                  16,206
                                  
                                  
                                  
                                  2.4
                                  %
                                  
                                  $
                                  12,779
                                  
                                  
                                  
                                  2.1
                                  %
                                  
                                  $
                                  9,563
                                  
                                  
                                  
                                  2.1
                                  %
                                  
                                  $
                                  3,495
                                  
                                  
                                  
                                  0.9
                                  %
                                  
                                  $
                                  2,290
                                  
                                  
                                  
                                  0.7
                                  %Residential
      1 to 4 family
                                  
                                  
                                  23,910
                                  
                                  
                                  
                                  3.5
                                  %
                                  
                                  
                                  24,326
                                  
                                  
                                  
                                  4.0
                                  %
                                  
                                  
                                  5,267
                                  
                                  
                                  
                                  1.2
                                  %
                                  
                                  
                                  4,925
                                  
                                  
                                  
                                  1.3
                                  %
                                  
                                  
                                  7,383
                                  
                                  
                                  
                                  2.2
                                  %Home
      equity line of credit
                                  
                                  
                                  26,409
                                  
                                  
                                  
                                  3.9
                                  %
                                  
                                  
                                  17,470
                                  
                                  
                                  
                                  2.8
                                  %
                                  
                                  
                                  10,792
                                  
                                  
                                  
                                  2.4
                                  %
                                  
                                  
                                  14,685
                                  
                                  
                                  
                                  4.0
                                  %
                                  
                                  
                                  14,708
                                  
                                  
                                  
                                  4.3
                                  %Commercial
                                  
                                  
                                  285,631
                                  
                                  
                                  
                                  41.8
                                  %
                                  
                                  
                                  274,266
                                  
                                  
                                  
                                  44.7
                                  %
                                  
                                  
                                  204,470
                                  
                                  
                                  
                                  46.0
                                  %
                                  
                                  
                                  187,231
                                  
                                  
                                  
                                  50.9
                                  %
                                  
                                  
                                  176,350
                                  
                                  
                                  
                                  51.9
                                  %Farmland
                                  
                                  
                                  10,723
                                  
                                  
                                  
                                  1.6
                                  %
                                  
                                  
                                  11,557
                                  
                                  
                                  
                                  1.9
                                  %
                                  
                                  
                                  18,101
                                  
                                  
                                  
                                  4.1
                                  %
                                  
                                  
                                  14,753
                                  
                                  
                                  
                                  4.0
                                  %
                                  
                                  
                                  16,742
                                  
                                  
                                  
                                  4.9
                                  %CommercialCommercial
      and industrial
                                  
                                  
                                  157,674
                                  
                                  
                                  
                                  23.1
                                  %
                                  
                                  
                                  134,178
                                  
                                  
                                  
                                  21.8
                                  %
                                  
                                  
                                  72,550
                                  
                                  
                                  
                                  16.3
                                  %
                                  
                                  
                                  53,301
                                  
                                  
                                  
                                  14.6
                                  %
                                  
                                  
                                  39,679
                                  
                                  
                                  
                                  11.7
                                  %Agriculture
                                  
                                  
                                  13,744
                                  
                                  
                                  
                                  2.0
                                  %
                                  
                                  
                                  11,367
                                  
                                  
                                  
                                  1.9
                                  %
                                  
                                  
                                  12,117
                                  
                                  
                                  
                                  2.7
                                  %
                                  
                                  
                                  5,939
                                  
                                  
                                  
                                  1.6
                                  %
                                  
                                  
                                  6,379
                                  
                                  
                                  
                                  1.9
                                  %Other
                                  
                                  
                                  620
                                  
                                  
                                  
                                  0.1
                                  %
                                  
                                  
                                  535
                                  
                                  
                                  
                                  0.1
                                  %
                                  
                                  
                                  309
                                  
                                  
                                  
                                  0.1
                                  %
                                  
                                  
                                  809
                                  
                                  
                                  
                                  0.2
                                  %
                                  
                                  
                                  3,526
                                  
                                  
                                  
                                  1.0
                                  %ConstructionSingle
      family residential
                                  
                                  
                                  11,414
                                  
                                  
                                  
                                  1.7
                                  %
                                  
                                  
                                  10,239
                                  
                                  
                                  
                                  1.6
                                  %
                                  
                                  
                                  7,785
                                  
                                  
                                  
                                  1.7
                                  %
                                  
                                  
                                  6,118
                                  
                                  
                                  
                                  1.7
                                  %
                                  
                                  
                                  6,910
                                  
                                  
                                  
                                  2.0
                                  %Single
      family residential - Spec.
                                  
                                  
                                  15,395
                                  
                                  
                                  
                                  2.3
                                  %
                                  
                                  
                                  18,718
                                  
                                  
                                  
                                  3.1
                                  %
                                  
                                  
                                  10,805
                                  
                                  
                                  
                                  2.4
                                  %
                                  
                                  
                                  4,337
                                  
                                  
                                  
                                  1.3
                                  %
                                  
                                  
                                  3,271
                                  
                                  
                                  
                                  1.0
                                  %Tract
                                  
                                  
                                  2,431
                                  
                                  
                                  
                                  0.4
                                  %
                                  
                                  
                                  1,664
                                  
                                  
                                  
                                  0.3
                                  %
                                  
                                  
                                  179
                                  
                                  
                                  
                                  0.0
                                  %
                                  
                                  
                                  150
                                  
                                  
                                  
                                  0.0
                                  %
                                  
                                  
                                  -
                                  
                                  
                                  
                                  0.0
                                  %Multi-family
                                  
                                  
                                  5,808
                                  
                                  
                                  
                                  0.9
                                  %
                                  
                                  
                                  9,054
                                  
                                  
                                  
                                  1.5
                                  %
                                  
                                  
                                  5,343
                                  
                                  
                                  
                                  1.2
                                  %
                                  
                                  
                                  4,176
                                  
                                  
                                  
                                  1.1
                                  %
                                  
                                  
                                  6,341
                                  
                                  
                                  
                                  1.9
                                  %Hospitality
                                  
                                  
                                  18,630
                                  
                                  
                                  
                                  2.7
                                  %
                                  
                                  
                                  16,784
                                  
                                  
                                  
                                  2.7
                                  %
                                  
                                  
                                  4,723
                                  
                                  
                                  
                                  1.1
                                  %
                                  
                                  
                                  1,650
                                  
                                  
                                  
                                  0.4
                                  %
                                  
                                  
                                  882
                                  
                                  
                                  
                                  0.3
                                  %Commercial
                                  
                                  
                                  21,484
                                  
                                  
                                  
                                  3.2
                                  %
                                  
                                  
                                  30,677
                                  
                                  
                                  
                                  5.0
                                  %
                                  
                                  
                                  52,766
                                  
                                  
                                  
                                  11.9
                                  %
                                  
                                  
                                  42,427
                                  
                                  
                                  
                                  11.5
                                  %
                                  
                                  
                                  26,565
                                  
                                  
                                  
                                  7.8
                                  %Land
                                  
                                  
                                  61,681
                                  
                                  
                                  
                                  9.1
                                  %
                                  
                                  
                                  31,064
                                  
                                  
                                  
                                  5.1
                                  %
                                  
                                  
                                  24,111
                                  
                                  
                                  
                                  5.4
                                  %
                                  
                                  
                                  18,123
                                  
                                  
                                  
                                  4.9
                                  %
                                  
                                  
                                  22,864
                                  
                                  
                                  
                                  6.7
                                  %Installment
      loans to individuals
                                  
                                  
                                  7,851
                                  
                                  
                                  
                                  1.2
                                  %
                                  
                                  
                                  7,977
                                  
                                  
                                  
                                  1.3
                                  %
                                  
                                  
                                  5,598
                                  
                                  
                                  
                                  1.3
                                  %
                                  
                                  
                                  5,620
                                  
                                  
                                  
                                  1.5
                                  %
                                  
                                  
                                  5,538
                                  
                                  
                                  
                                  1.6
                                  %All
      other loans (including overdrafts)
                                  
                                  
                                  536
                                  
                                  
                                  
                                  0.1
                                  %
                                  
                                  
                                  562
                                  
                                  
                                  
                                  0.1
                                  %
                                  
                                  
                                  504
                                  
                                  
                                  
                                  0.1
                                  %
                                  
                                  
                                  394
                                  
                                  
                                  
                                  0.1
                                  %
                                  
                                  
                                  265
                                  
                                  
                                  
                                  0.1
                                  %Total
      loans, gross
                                  
                                  $
                                  680,147
                                  
                                  
                                  
                                  100.0
                                  %
                                  
                                  $
                                  613,217
                                  
                                  
                                  
                                  100.0
                                  %
                                  
                                  $
                                  444,983
                                  
                                  
                                  
                                  100.0
                                  %
                                  
                                  $
                                  368,133
                                  
                                  
                                  
                                  100.0
                                  %
                                  
                                  $
                                  339,693
                                  
                                  
                                  
                                  100.0
                                  %Deferred
      loan fees
                                  
                                  
                                  1,701
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  1,732
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  1,625
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  1,617
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  1,482Reserve
      for possible loan losses
                                  
                                  
                                  10,412
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  6,143
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  4,081
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  3,881
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  3,247Total
      loans, net
                                  
                                  $
                                  668,034
                                  
                                  
                                  
                                  
                                  
                                  
                                  $
                                  605,342
                                  
                                  
                                  
                                  
                                  
                                  
                                  $
                                  439,277
                                  
                                  
                                  
                                  
                                  
                                  
                                  $
                                  362,635
                                  
                                  
                                  
                                  
                                  
                                  
                                  $
                                  334,964Loans
      held for sale
                                  
                                  $
                                  7,939
                                  
                                  
                                  
                                  
                                  
                                  
                                  $
                                  902
                                  
                                  
                                  
                                  
                                  
                                  
                                  $
                                  1,764
                                  
                                  
                                  
                                  
                                  
                                  
                                  $
                                  3,392
                                  
                                  
                                  
                                  
                                  
                                  
                                  $
                                  2,253
  39
 
 The
following table sets forth the year over year changes in loan balances for each
major category of the loan portfolio as of December 31, 2008:
 
 Variance(dollar
      amounts in thousands)
                          
                          2008
                          
                          
                          2007
                          
                          
                          Dollar
                          
                          
                          PercentageReal
      Estate SecuredMulti-family
      residential
                          
                          $
                          16,206
                          
                          
                          $
                          12,779
                          
                          
                          $
                          3,427
                          
                          
                          
                          26.8
                          %Residential
      1 to 4 family
                          
                          
                          23,910
                          
                          
                          
                          24,326
                          
                          
                          
                          (416
                          )
                          
                          
                          -1.7
                          %Home
      equity line of credit
                          
                          
                          26,409
                          
                          
                          
                          17,470
                          
                          
                          
                          8,939
                          
                          
                          
                          51.2
                          %Commercial
                          
                          
                          285,631
                          
                          
                          
                          274,266
                          
                          
                          
                          11,365
                          
                          
                          
                          4.1
                          %Farmland
                          
                          
                          10,723
                          
                          
                          
                          11,557
                          
                          
                          
                          (834
                          )
                          
                          
                          -7.2
                          %CommercialCommercial
      and industrial
                          
                          
                          157,674
                          
                          
                          
                          134,178
                          
                          
                          
                          23,496
                          
                          
                          
                          17.5
                          %Agriculture
                          
                          
                          13,744
                          
                          
                          
                          11,367
                          
                          
                          
                          2,377
                          
                          
                          
                          20.9
                          %Other
                          
                          
                          620
                          
                          
                          
                          535
                          
                          
                          
                          85
                          
                          
                          
                          15.9
                          %ConstructionSingle
      family residential
                          
                          
                          11,414
                          
                          
                          
                          10,239
                          
                          
                          
                          1,175
                          
                          
                          
                          11.5
                          %Single
      family residential - Spec.
                          
                          
                          15,395
                          
                          
                          
                          18,718
                          
                          
                          
                          (3,323
                          )
                          
                          
                          -17.8
                          %Tract
                          
                          
                          2,431
                          
                          
                          
                          1,664
                          
                          
                          
                          767
                          
                          
                          
                          46.1
                          %Multi-family
                          
                          
                          5,808
                          
                          
                          
                          9,054
                          
                          
                          
                          (3,246
                          )
                          
                          
                          -35.9
                          %Hospitality
                          
                          
                          18,630
                          
                          
                          
                          16,784
                          
                          
                          
                          1,846
                          
                          
                          
                          11.0
                          %Commercial
                          
                          
                          21,484
                          
                          
                          
                          30,677
                          
                          
                          
                          (9,193
                          )
                          
                          
                          -30.0
                          %Land
                          
                          
                          61,681
                          
                          
                          
                          31,064
                          
                          
                          
                          30,617
                          
                          
                          
                          98.6
                          %Installment
      loans to individuals
                          
                          
                          7,851
                          
                          
                          
                          7,977
                          
                          
                          
                          (126
                          )
                          
                          
                          -1.6
                          %All
      other loans (including overdrafts)
                          
                          
                          536
                          
                          
                          
                          562
                          
                          
                          
                          (26
                          )
                          
                          
                          -4.6
                          %Total
      loans, gross
                          
                          $
                          680,147
                          
                          
                          $
                          613,217
                          
                          
                          $
                          66,930
                          
                          
                          
                          10.9
                          %Deferred
      loan fees
                          
                          
                          1,701
                          
                          
                          
                          1,732
                          
                          
                          
                          (31
                          )
                          
                          
                          -1.8
                          %Reserve
      for possible loan losses
                          
                          
                          10,412
                          
                          
                          
                          6,143
                          
                          
                          
                          4,269
                          
                          
                          
                          69.5
                          %Total
      loans, net
                          
                          $
                          668,034
                          
                          
                          $
                          605,342
                          
                          
                          $
                          62,692
                          
                          
                          
                          10.4
                          %Loans
      held for sale
                          
                          $
                          7,939
                          
                          
                          $
                          902
                          
                          
                          $
                          7,037
                          
                          
                          
                          780.2
                          %
 
 ·
              Real Estate
      Secured
 
 At
December 31, 2008, real estate secured balances were $362.9 million or
approximately $22.5 million higher than that reported at December 31,
2007.  The year over year growth within this category can be
attributed to increases in commercial real estate and home equity lines of
credit.  During 2008 the Bank made eleven loans within the commercial
real estate category in amounts ranging from $0.8 million to $1.4
million.  In total, these loans represent approximately $11.2 million
in new fundings for the Bank and were made to borrowers in industries classified
as professional, commercial, retail, hospitality, and restaurants / food
establishments.  Additionally, throughout 2008 there were several
large construction loans that moved into the commercial real estate category as
amortizing loans, contributing to the year over year
increase.  Offsetting the growth within this category were some
significant pay downs during 2008.  Notable pay-downs / payoffs within
this category in amounts ranging from $1.0 million to $3.1 million totaled
approximately $16.0 million.  The Bank also participated approximately
$7.0 million in commercial real estate balances during 2008.
 
 In
September 2004, the Bank issued an $11.7 million irrevocable standby letter of
credit to guarantee the payment of taxable variable rate demand bonds that has
since been reduced to $11.4 million.  The primary purpose of the bond
issue was to refinance existing debt and provide funds for capital improvement
and expansion of an assisted living facility.  The project is 100%
complete and fully leased.  The letter of credit will expire in
September 2009.
 
 At
December 31, 2008, real estate secured loans represented a concentration at
513.8% of the Bank’s total risk-based capital, however, the risk within this
particular category is mitigated by the diversification noted in the table
below.   Commercial real estate loans made up the majority of
this concentration with balances of approximately $285.6 million or 375.2% of
the Bank’s total risk-based capital.  Substantially all loans within
this category are made to borrowers within the Bank’s primary market area in
need of longer term financing for the purchase of real estate for various
commercial purposes.
  40
  At
December 31, 2008, approximately $160.1 million or 44.1% of the real estate
secured portfolio was considered owner occupied.
 
 The
following provides a break-down of the Bank’s real estate secured portfolio as
of December 31, 2008:
 
 December
      31, 2008
                            
                            
                            
                            
                            
                            Percent
      of
                            
                            
                            
                            
                            
                            SingleUndisbursed
                            
                            
                            Total
      Bank
                            
                            
                            Percent
                            
                            
                            Bank's
      Total Risk
                            
                            
                            Number
                            
                            
                            Largest(dollar amounts inthousands)
                            
                            Balance
                            
                            
                            Commitment
                            
                            
                            Exposure
                            
                            
                            Composition
                            
                            
                            Based
      Capital
                            
                            
                            of
      Loans
                            
                            
                            LoanReal
      Estate SecuredRetail
                            
                            $
                            39,066
                            
                            
                            $
                            76
                            
                            
                            $
                            39,142
                            
                            
                            
                            10.0
                            %
                            
                            
                            51.1
                            %
                            
                            
                            56
                            
                            
                            $
                            3,320Professional
                            
                            
                            70,961
                            
                            
                            
                            2,681
                            
                            
                            
                            73,642
                            
                            
                            
                            18.8
                            %
                            
                            
                            96.1
                            %
                            
                            
                            101
                            
                            
                            
                            8,875Hospitality
                            
                            
                            57,218
                            
                            
                            
                            11
                            
                            
                            
                            57,229
                            
                            
                            
                            14.6
                            %
                            
                            
                            74.7
                            %
                            
                            
                            37
                            
                            
                            
                            10,891Multi-family
                            
                            
                            16,206
                            
                            
                            
                            339
                            
                            
                            
                            16,545
                            
                            
                            
                            4.2
                            %
                            
                            
                            21.6
                            %
                            
                            
                            16
                            
                            
                            
                            5,837Home
      equity lines of credit
                            
                            
                            26,409
                            
                            
                            
                            21,615
                            
                            
                            
                            48,024
                            
                            
                            
                            12.4
                            %
                            
                            
                            62.7
                            %
                            
                            
                            289
                            
                            
                            
                            1,250Residential
      1 to 4 family
                            
                            
                            23,910
                            
                            
                            
                            1,513
                            
                            
                            
                            25,423
                            
                            
                            
                            6.5
                            %
                            
                            
                            33.2
                            %
                            
                            
                            67
                            
                            
                            
                            3,000Farmland
                            
                            
                            10,723
                            
                            
                            
                            365
                            
                            
                            
                            11,088
                            
                            
                            
                            2.8
                            %
                            
                            
                            14.5
                            %
                            
                            
                            22
                            
                            
                            
                            2,000Healthcare
      / medical
                            
                            
                            15,790
                            
                            
                            
                            -
                            
                            
                            
                            15,790
                            
                            
                            
                            4.0
                            %
                            
                            
                            20.6
                            %
                            
                            
                            29
                            
                            
                            
                            2,202Restaurants
      / food establishments
                            
                            
                            7,263
                            
                            
                            
                            24
                            
                            
                            
                            7,287
                            
                            
                            
                            1.9
                            %
                            
                            
                            9.5
                            %
                            
                            
                            14
                            
                            
                            
                            2,600Commercial
                            
                            
                            78,122
                            
                            
                            
                            1,314
                            
                            
                            
                            79,436
                            
                            
                            
                            20.3
                            %
                            
                            
                            103.7
                            %
                            
                            
                            114
                            
                            
                            
                            4,764Other
                            
                            
                            17,211
                            
                            
                            
                            405
                            
                            
                            
                            17,616
                            
                            
                            
                            4.5
                            %
                            
                            
                            23.0
                            %
                            
                            
                            29
                            
                            
                            
                            2,100Total
      real estate secured
                            
                            $
                            362,879
                            
                            
                            $
                            28,343
                            
                            
                            $
                            391,222
                            
                            
                            
                            100.0
                            %
                            
                            
                            510.7
                            %
                            
                            
                            774
                            
                            
                            $
                            46,839
 
 ·
              Commercial
 
 At
December 31, 2008, loans within this category were approximately $26.0 million
higher than that reported at December 31, 2007.  Higher commercial and
industrial balances were the primary factor behind the year over year increase
within this category.  During 2008, the Bank funded several large
loans within this category in amounts ranging from $0.8 million to $8.0 million,
with the majority of these fundings are classified as
professional.  Tempering the increase in this category were notable
pay downs / pay-offs in amounts ranging from $0.7 million to $3.2
million.  Commercial and industrial loans are typically made to
borrowers in need of working capital to support their enterprise.
 
 At
December 31, 2008, commercial and industrial balances were considered a
concentration at 326.3% of the Bank’s total risk-based
capital.  Within this category our credit exposure is somewhat diverse
with respect to the industries that the Bank makes loans to.
 
 At
December 31, 2008, agriculture loans were approximately $2.4 million higher than
that reported at December 31, 2007.  The year over year increase
within this category can be attributed to several new loans in amounts ranging
from $0.3 million to $0.4 million.  Loans within this category are
typically made to borrowers within the Bank’s primary market to finance the
production of agriculture.
 
 The
following table provides a break-down of the commercial and industrial portfolio
as of December 31, 2008:
 
 December
      31, 2008
                              
                              
                              
                              
                              
                              Percent
      of
                              
                              
                              
                              
                              
                              SingleUndisbursed
                              
                              
                              Total
      Bank
                              
                              
                              Percent
                              
                              
                              Bank's
      Total Risk
                              
                              
                              Number
                              
                              
                              Largest(dollaramountsinthousands)
                              
                              Balance
                              
                              
                              Commitment
                              
                              
                              Exposure
                              
                              
                              Composition
                              
                              
                              Based
      Capital
                              
                              
                              of
      Loans
                              
                              
                              LoanCommercial
      and IndustrialAgriculture
                              
                              $
                              3,375
                              
                              
                              $
                              1,467
                              
                              
                              $
                              4,842
                              
                              
                              
                              1.9
                              %
                              
                              
                              6.3
                              %
                              
                              
                              25
                              
                              
                              $
                              2,000Oil
      gas and utilities
                              
                              
                              541
                              
                              
                              
                              1,090
                              
                              
                              
                              1,631
                              
                              
                              
                              0.7
                              %
                              
                              
                              2.1
                              %
                              
                              
                              9
                              
                              
                              
                              750Construction
                              
                              
                              19,540
                              
                              
                              
                              14,010
                              
                              
                              
                              33,550
                              
                              
                              
                              13.5
                              %
                              
                              
                              43.8
                              %
                              
                              
                              165
                              
                              
                              
                              2,750Manufacturing
                              
                              
                              10,650
                              
                              
                              
                              11,299
                              
                              
                              
                              21,949
                              
                              
                              
                              8.8
                              %
                              
                              
                              28.6
                              %
                              
                              
                              114
                              
                              
                              
                              2,100Wholesale
      and retail
                              
                              
                              15,689
                              
                              
                              
                              6,259
                              
                              
                              
                              21,948
                              
                              
                              
                              8.8
                              %
                              
                              
                              28.6
                              %
                              
                              
                              124
                              
                              
                              
                              1,250Transportation and warehousing
                              
                              
                              2,968
                              
                              
                              
                              863
                              
                              
                              
                              3,831
                              
                              
                              
                              1.5
                              %
                              
                              
                              5.0
                              %
                              
                              
                              36
                              
                              
                              
                              596Media
      and information services
                              
                              
                              12,787
                              
                              
                              
                              1,706
                              
                              
                              
                              14,493
                              
                              
                              
                              5.8
                              %
                              
                              
                              18.9
                              %
                              
                              
                              25
                              
                              
                              
                              8,000Financial
      services
                              
                              
                              16,111
                              
                              
                              
                              7,729
                              
                              
                              
                              23,840
                              
                              
                              
                              9.6
                              %
                              
                              
                              31.1
                              %
                              
                              
                              47
                              
                              
                              
                              6,000Real
      estate / rental and leasing
                              
                              
                              15,547
                              
                              
                              
                              13,758
                              
                              
                              
                              29,305
                              
                              
                              
                              11.8
                              %
                              
                              
                              38.2
                              %
                              
                              
                              98
                              
                              
                              
                              3,500Professional
      services
                              
                              
                              19,718
                              
                              
                              
                              10,567
                              
                              
                              
                              30,285
                              
                              
                              
                              12.2
                              %
                              
                              
                              39.5
                              %
                              
                              
                              148
                              
                              
                              
                              2,000Healthcare
      / medical
                              
                              
                              14,645
                              
                              
                              
                              18,387
                              
                              
                              
                              33,032
                              
                              
                              
                              13.3
                              %
                              
                              
                              43.1
                              %
                              
                              
                              111
                              
                              
                              
                              11,355Restaurants
      / food establishments
                              
                              
                              17,980
                              
                              
                              
                              2,697
                              
                              
                              
                              20,677
                              
                              
                              
                              8.3
                              %
                              
                              
                              27.0
                              %
                              
                              
                              102
                              
                              
                              
                              3,400All
      other
                              
                              
                              8,123
                              
                              
                              
                              899
                              
                              
                              
                              9,022
                              
                              
                              
                              3.8
                              %
                              
                              
                              11.8
                              %
                              
                              
                              68
                              
                              
                              
                              2,530Commercial
      and industrial
                              
                              $
                              157,674
                              
                              
                              $
                              90,731
                              
                              
                              $
                              248,405
                              
                              
                              
                              100.0
                              %
                              
                              
                              324.0
                              %
                              
                              
                              1,072
                              
                              
                              
                              46,231
  41
 
 ·
              Construction
 
 At
December 31, 2008, loans within this category were approximately $12.0 million
lower than that reported at December 31, 2008.  Contributing to the
year over year decline were several large pay downs / pay-offs in the aggregate
amount of $13.7 million.  Additionally and as previously mentioned,
during the year there were several large construction loans that were
re-classified to commercial real estate, contributing to the year over
decline.  The Bank classifies real estate construction loans as
construction until projects are complete.  If upon the completion of
construction the loan is retained, it is re-classified as real estate
secured.
 
 During
2008, the Bank made several notable loans within this category in the aggregate
amount of $11.3 million.  These loans were made to borrowers within
the Bank’s primary market area to finance the construction of single family
dwellings, medical and professional office buildings, a hotel, and an assisted
living facility.  Construction loans are typically granted for one
year and then, with income properties, are amortized over a period of not more
than 30 years with 10 to 15 year maturities.
 
 At
December 31, 2008 construction balances were considered a concentration at
136.9% of the Bank’s total risk-based capital.  Within this
concentration, approximately $22.0 million or 29.3% of the construction
portfolio was considered owner occupied as of December 31, 2008.
 
 The
following provides a break-down of the Bank’s construction portfolio as of
December 31, 2008:
 
 December
      31, 2008
                            
                            
                            
                            
                            
                            Percent
      of
                            
                            
                            
                            
                            
                            SingleUndisbursed
                            
                            
                            Total
      Bank
                            
                            
                            Percent
                            
                            
                            Bank's
      Total Risk
                            
                            
                            Number
                            
                            
                            Largest(dollar
      amounts in thousands)
                            
                            Balance
                            
                            
                            Commitment
                            
                            
                            Exposure
                            
                            
                            Composition
                            
                            
                            Based
      Capital
                            
                            
                            of
      Loans
                            
                            
                            LoanConstructionSingle
      family residential
                            
                            $
                            11,414
                            
                            
                            $
                            9,350
                            
                            
                            $
                            20,764
                            
                            
                            
                            19.9
                            %
                            
                            
                            27.1
                            %
                            
                            
                            21
                            
                            
                            $
                            4,600Single
      family residential - Spec.
                            
                            
                            15,395
                            
                            
                            
                            1,340
                            
                            
                            
                            16,735
                            
                            
                            
                            16.1
                            %
                            
                            
                            21.8
                            %
                            
                            
                            14
                            
                            
                            
                            3,480Tract
                            
                            
                            2,431
                            
                            
                            
                            552
                            
                            
                            
                            2,983
                            
                            
                            
                            2.9
                            %
                            
                            
                            3.9
                            %
                            
                            
                            11
                            
                            
                            
                            649Multi-family
                            
                            
                            5,808
                            
                            
                            
                            2,175
                            
                            
                            
                            7,983
                            
                            
                            
                            7.7
                            %
                            
                            
                            10.4
                            %
                            
                            
                            5
                            
                            
                            
                            3,584Commercial
                            
                            
                            21,484
                            
                            
                            
                            6,046
                            
                            
                            
                            27,530
                            
                            
                            
                            26.4
                            %
                            
                            
                            35.9
                            %
                            
                            
                            21
                            
                            
                            
                            4,000Hospitality
                            
                            
                            18,630
                            
                            
                            
                            9,548
                            
                            
                            
                            28,178
                            
                            
                            
                            27.0
                            %
                            
                            
                            36.8
                            %
                            
                            
                            5
                            
                            
                            
                            7,853Total
      construction
                            
                            $
                            75,162
                            
                            
                            $
                            29,011
                            
                            
                            $
                            104,173
                            
                            
                            
                            100.0
                            %
                            
                            
                            135.9
                            %
                            
                            
                            77
                            
                            
                            $
                            24,166
 
 ·
              Land
 
 At
December 31, 2008, land balances were approximately $30.6 million higher than
that reported at December 31, 2007.  The year over year increase
within this category can be attributed to the funding of six loans in excess of
$1.0 million in the aggregate amount of $17.5 million.
 
 Two of
the largest loans within this category consist of loans for residential tract
developments in the aggregate amount of $13.3 million.  These projects
are located in Kern County of the California Central Valley.  One
project is approved for 314 single family lots.  This project has also
been approved for approximately 8.6 acres of commercial development and 13.5
acres for recreational purposes.  The project was funded in the first
quarter of 2008 and has an approximate loan to value of 50.0%, based on an
appraisal conducted earlier in the year.  At December 31, 2008 the
balance of this loan was approximately $11.0 million, with approximately $1.2
million un-disbursed. The purpose of the second project is to provide affordable
housing to a market that generally consists of renters and is the only new
housing development in its area.  This loan funded in March 2008 at
approximately $4.1 million and has subsequently been paid down by approximately
$2.0 million from proceeds of sold homes.  The borrower is actively
marketing the remaining finished homes and sales continue to occur at a rate of
one to two homes per month.  Additionally, the housing in this project
qualifies for the USDA Direct Loan program whereby individuals or families
receive financial assistance directly from the Housing and Community Facilities
Programs (“HCFP”) in the form of a home loan at an affordable interest
rate.  As of December 31, 2008, these loans were performing under the
contractual terms of their respective loan agreements.
 
 Kern
County, somewhat outside of the Company’s market footprint, has a population of
approximately 817,000 and depends on agriculture, oil, light industry,
warehousing and distribution, and educational services to support its
economy.  This region of California’s Central Valley has experienced
significant population growth over the last five years relative to other areas
of the state, with annual percentage increases of 2.5% or more per year over the
last five years.  Affordable housing, relative to other metropolitan
areas within California, has been a significant factor behind the growth in Kern
County’s population.  However, like many other areas within
California, real estate prices within the California Central Valley have fallen
significantly, with recent indications showing year over year declines of
approximately 30% and an approximate six month supply of unsold homes within
Kern County, specifically.  Management acknowledges that as economic
conditions worsen across the state, the level of growth previously experienced
within the California Central Valley will no doubt be negatively
impacted.  As such, Management continues to carefully monitor loans
made to borrowers in the Central Valley for any sign of
deterioration.
  42
 
 The
following provides a break-down of the Bank’s land portfolio as of December 31,
2008:
 
 December
      31, 2008
                            
                            
                            
                            
                            
                            Percent
      of
                            
                            
                            
                            
                            
                            SingleUndisbursed
                            
                            
                            Total
      Bank
                            
                            
                            Percent
                            
                            
                            Bank's
      Total Risk
                            
                            
                            Number
                            
                            
                            Largest(dollar
      amounts in thousands)
                            
                            Balance
                            
                            
                            Commitment
                            
                            
                            Exposure
                            
                            
                            Composition
                            
                            
                            Based
      Capital
                            
                            
                            of
      Loans
                            
                            
                            LoanLandSingle
      family residential
                            
                            $
                            8,486
                            
                            
                            $
                            -
                            
                            
                            $
                            8,486
                            
                            
                            
                            13.0
                            %
                            
                            
                            11.1
                            %
                            
                            
                            26
                            
                            
                            $
                            1,200Single
      family residential - Spec.
                            
                            
                            2,114
                            
                            
                            
                            -
                            
                            
                            
                            2,114
                            
                            
                            
                            3.2
                            %
                            
                            
                            2.8
                            %
                            
                            
                            8
                            
                            
                            
                            618Tract
                            
                            
                            32,257
                            
                            
                            
                            3,106
                            
                            
                            
                            35,363
                            
                            
                            
                            54.2
                            %
                            
                            
                            46.1
                            %
                            
                            
                            12
                            
                            
                            
                            12,208Multi-family
                            
                            
                            2,723
                            
                            
                            
                            58
                            
                            
                            
                            2,781
                            
                            
                            
                            4.3
                            %
                            
                            
                            3.6
                            %
                            
                            
                            4
                            
                            
                            
                            2,604Commercial
                            
                            
                            12,020
                            
                            
                            
                            446
                            
                            
                            
                            12,466
                            
                            
                            
                            19.1
                            %
                            
                            
                            16.3
                            %
                            
                            
                            20
                            
                            
                            
                            1,500Hospitality
                            
                            
                            4,081
                            
                            
                            
                            -
                            
                            
                            
                            4,081
                            
                            
                            
                            6.2
                            %
                            
                            
                            5.3
                            %
                            
                            
                            4
                            
                            
                            
                            2,340Total
      land
                            
                            $
                            61,681
                            
                            
                            $
                            3,610
                            
                            
                            $
                            65,291
                            
                            
                            
                            100.0
                            %
                            
                            
                            85.2
                            %
                            
                            
                            74
                            
                            
                            $
                            20,470
 
 ·
              Installment
 
 At
December 31, 2008, installment loans were substantially unchanged from year ago
levels.  Loans within this category include loans to individual
borrowers for a variety of reasons including: automobile purchases, personal
loans, credit card purchases as well as loans for other consumer
goods.  The Bank typically makes such loans to borrowers within the
Bank’s primary market area.
 
 ·
              Loans Held for
      Sale
 
 At
December 31, 2008 loans held for sale were approximately $7.0 million higher
than that reported at December 31, 2007.  The year over year increase
can be attributed in part to the strong demand the Bank has seen for mortgage
re-financing given the dramatic decline in interest rates during
2008.
 
 ·
              Foreign
      Loans
 
 At
December 31, 2008, the Bank had no foreign loans outstanding.
  43
 
 The
following table provides a summary of the approximate maturities and sensitivity
to change in interest rates for the loan portfolio at December 31,
2008:
 
 Due
      Over
                                
                                
                                Due
      Over
                                
                                
                                Due
      OverDue
      Less
                                
                                
                                Due
                                
                                
                                12
      Months
                                
                                
                                3
      Years
                                
                                
                                5
      YearsThan
      3
                                
                                
                                3
      To 12
                                
                                
                                Through
                                
                                
                                Through
                                
                                
                                Through
                                
                                
                                Due
      Over
                                
                                
                                Total(dollar
      amounts inthousands)
                                
                                Months
                                
                                
                                Months
                                
                                
                                3
      Years
                                
                                
                                5
      Years
                                
                                
                                15
      Years
                                
                                
                                15
      Years
                                
                                
                                TotalReal
      Estate SecuredMulti-family
      residential
                                
                                $
                                6,985
                                
                                
                                $
                                -
                                
                                
                                $
                                894
                                
                                
                                $
                                4,312
                                
                                
                                $
                                4,015
                                
                                
                                $
                                -
                                
                                
                                $
                                16,206Residential
      1 to 4 family
                                
                                
                                4,706
                                
                                
                                
                                7,464
                                
                                
                                
                                6,631
                                
                                
                                
                                1,285
                                
                                
                                
                                3,488
                                
                                
                                
                                336
                                
                                
                                
                                23,910Home
      equity line of credit
                                
                                
                                26,409
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                26,409Commercial
                                
                                
                                38,113
                                
                                
                                
                                34,721
                                
                                
                                
                                78,892
                                
                                
                                
                                27,362
                                
                                
                                
                                105,418
                                
                                
                                
                                1,125
                                
                                
                                
                                285,631Farmland
                                
                                
                                4,561
                                
                                
                                
                                793
                                
                                
                                
                                3,274
                                
                                
                                
                                1,777
                                
                                
                                
                                318
                                
                                
                                
                                -
                                
                                
                                
                                10,723CommercialCommercial
      and industrial
                                
                                
                                55,944
                                
                                
                                
                                41,288
                                
                                
                                
                                16,802
                                
                                
                                
                                23,534
                                
                                
                                
                                20,106
                                
                                
                                
                                -
                                
                                
                                
                                157,674Agriculture
                                
                                
                                9,112
                                
                                
                                
                                2,160
                                
                                
                                
                                1,630
                                
                                
                                
                                446
                                
                                
                                
                                396
                                
                                
                                
                                -
                                
                                
                                
                                13,744Other
                                
                                
                                153
                                
                                
                                
                                57
                                
                                
                                
                                106
                                
                                
                                
                                77
                                
                                
                                
                                227
                                
                                
                                
                                -
                                
                                
                                
                                620ConstructionSingle
      family residential
                                
                                
                                2,725
                                
                                
                                
                                7,040
                                
                                
                                
                                447
                                
                                
                                
                                -
                                
                                
                                
                                1,202
                                
                                
                                
                                -
                                
                                
                                
                                11,414Single
      family residential - Spec.
                                
                                
                                10,281
                                
                                
                                
                                5,114
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                15,395Tract
                                
                                
                                2,431
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                2,431Multi-family
                                
                                
                                1,860
                                
                                
                                
                                364
                                
                                
                                
                                3,584
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                5,808Hospitality
                                
                                
                                16,292
                                
                                
                                
                                1,138
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                1,200
                                
                                
                                
                                -
                                
                                
                                
                                18,630Commercial
                                
                                
                                15,214
                                
                                
                                
                                4,374
                                
                                
                                
                                1,896
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                21,484Land
                                
                                
                                23,567
                                
                                
                                
                                19,209
                                
                                
                                
                                16,438
                                
                                
                                
                                2,360
                                
                                
                                
                                107
                                
                                
                                
                                -
                                
                                
                                
                                61,681Installment
      loans to individuals
                                
                                
                                2,332
                                
                                
                                
                                287
                                
                                
                                
                                1,402
                                
                                
                                
                                1,359
                                
                                
                                
                                1,938
                                
                                
                                
                                533
                                
                                
                                
                                7,851All
      other loans (including overdrafts)
                                
                                
                                536
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                536Total
      loans, gross
                                
                                $
                                221,221
                                
                                
                                $
                                124,009
                                
                                
                                $
                                131,996
                                
                                
                                $
                                62,512
                                
                                
                                $
                                138,415
                                
                                
                                $
                                1,994
                                
                                
                                $
                                680,147Variable
      rate loans
                                
                                
                                157,295
                                
                                
                                
                                33,475
                                
                                
                                
                                73,502
                                
                                
                                
                                16,256
                                
                                
                                
                                3,142
                                
                                
                                
                                -
                                
                                
                                
                                283,670Fixed
      rate loans
                                
                                
                                63,926
                                
                                
                                
                                90,534
                                
                                
                                
                                58,494
                                
                                
                                
                                46,256
                                
                                
                                
                                135,273
                                
                                
                                
                                1,994
                                
                                
                                
                                396,477Total
      loans, gross
                                
                                $
                                221,221
                                
                                
                                $
                                124,009
                                
                                
                                $
                                131,996
                                
                                
                                $
                                62,512
                                
                                
                                $
                                138,415
                                
                                
                                $
                                1,994
                                
                                
                                $
                                680,147
 
 The
Company has an Asset/Liability Management system that models various interest
rate environments for all rate sensitive assets and liabilities.  At
December 31, 2008, the simulation indicated that a -100 basis point move made by
the Federal Open Market Committee (“FOMC”) would reduce interest income on loans
by approximately $1.7 million, while a +100 basis point move would increase
interest income on loans by approximately $1.7 million.
 
 ·
              Summary of Market
      Condition
 
 The
residential real estate market came under significant pressure during 2007 and
remained under considerable pressure throughout 2008.  The market was
negatively impacted by rising interest rates during the majority of 2007,
negative sentiment surrounding market values of real estate, an over supply of
newly constructed homes and inflationary pressures.  Additionally, as
conditions in the credit markets worsened during the later half of 2007 and into
2008, financial institutions became more reluctant to extend new credit to
borrowers, pushing the cost of certain types of credit higher in a rates down
environment and contributing further to the decline in real estate
prices.  As more and more home owners began to see interest rate
resets on adjustable rate mortgages late in 2007 and into 2008, the number of
non-performing loans and defaults rose significantly in the industry as a
whole.  As we moved further into 2008, the credit markets came under
increasingly intense pressure, specifically during the third and fourth
quarters. This was fueled in part by a widespread lack of confidence in the U.S.
financial system, which led many financial institutions to further tighten the
extension of new credit given concerns over the lack of liquidity, asset
quality, and the conservation of capital.  Contributing significantly
to the troubles seen in the housing market and U.S. financial system have been a
weakened economy and consequently higher levels of unemployment, placing
considerable pressure on the U.S. consumer’s ability to satisfy their
outstanding obligations to the financial sector.  The Company believes
these factors have contributed greatly to the increased level of non-performing
assets the Bank experienced during 2008.
  44
 
 Sales of
single family homes have fallen significantly year over year in the Company’s
market area and California as a whole, with recent indications showing price
declines of approximately 42% statewide and 29% to 34% within the Company’s
market area.  Along with other segments in the real estate sector,
commercial real estate prices in the Company’s market area experienced some
pressure during 2008 and the Company has begun to see a slight increase in
vacancy rates in certain retail and office segments, though not to any
considerable extent.  During 2007 the demand for business and
professional properties in the Company’s market area remained relatively strong,
with low vacancies, competitive loan rates, and many investors seeking exchange
properties.  This helped to provide some insulation against a
significant downturn in prices as well as the volume of
sales.  However, the Company realizes that any prolonged and
significant downturn in the national and local economies will have an impact on
the values of commercial real estate within its market footprint as well as the
borrowers to whom the Bank has extended such credit and thus continues to
closely monitor the credits within this segment of the loan portfolio for
potential signs of deterioration.  Additionally, the Bank is aware
that as economic conditions worsen and levels of unemployment continue to rise,
borrowers to whom the Bank has extended commercial lines of credit may come
under additional pressure to satisfy their outstanding
obligations.  That said, the Bank continues to employ stringent
lending standards and remains very selective with regard to any additional
commercial real estate, real estate construction, land and commercial loans it
chooses to originate in an effort to effectively manage risk in this difficult
credit environment.
 
 Although,
the Company’s market footprint has historically enjoyed a more stable level of
economic growth, we are not completely immune to the effects of a slowdown on a
state or national level.  As previously mentioned, with the
availability of credit significantly diminished and the effects of a weakened
economy placing more pressure on borrowers, the ability of consumers to satisfy
outstanding obligations to the financial sector, as a whole, has begun to
languish.  We believe that within certain areas of our local economy
these more macro level concerns have started to become more evident,
specifically with respect to real estate development in the single family
residential market.  This has no doubt had an impact on the level of
and type of loans the Bank has placed on non-accrual and charged-off during
2008.  Additionally, the Company has devoted considerable resources to
the monitoring of credits within the loan portfolio in order to take any
appropriate steps when and if necessary to mitigate any material adverse impact
the slowing of the single family residential and commercial real-estate markets
may have on the Bank overall.
 
 Capitalization
rates, the rate at which a stream of cash flows are discounted to find their
present value, for the last three years were as follows: 5.0% to 6.5% in 2006,
6.0% to 7.0% in 2007, and 4.5% to 8.0% in 2008.
 
 Non-Performing
Assets
 
 The
Bank’s Management is responsible for monitoring loan performance, which is done
through various methods, including a review of loan delinquencies and personal
knowledge of customers.  Additionally, the Bank maintains both a
“watch” list of loans that, for a variety of reasons, Management believes
require regular review as well as an internal loan classification
process.  Semi-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, internal loan classifications and the
outside loan review are reviewed regularly by the Bank’s Board of
Directors.
 
 Management
acknowledges that due to negative undertones associated with the economy and
real estate markets, the internal watch list expanded during
2008.  While credit quality is consistently monitored, Management has
implemented additional precautionary actions that include but are not limited to
pro-actively identifying credit weaknesses earlier in the collection cycle,
increasing the oversight frequency of watch list credits and devoting additional
internal resources to monitor those credits.  Although the Bank
believes these actions will serve to potentially minimize any future losses the
Bank may incur related to problem loans, we cannot guarantee that the Bank will
not experience an increase in non-performing loans, given continued
uncertainties surrounding the state and national economies as well the U.S.
financial system.
 
 The Bank
has a non-accrual policy that requires a loan greater than 90 days past due
and/or is specifically determined to be impaired to be placed on non-accrual
status unless such loan is well-collateralized and in the process of
collection.  When loans are placed on non-accrual status, all accrued
but uncollected interest income is reversed from earnings.  Once on
non-accrual status payments received on such loans are applied as a reduction of
the loan principal balance.  Interest on a loan is only recognized on
a cash basis and is generally not recognized on specific impaired loans unless
the likelihood of further loss is remote.  Loans may be returned to
accrual status if Management believes that all remaining principal and interest
is fully collectible and there has been at least six months of sustained
repayment performance since the loan was placed on non-accrual.
 
 If a
loan’s credit quality deteriorates to the point that collection of principal is
believed by Management to be doubtful and the value of collateral securing the
obligation is sufficient the Bank generally takes steps to protect and liquidate
the collateral.  Any loss resulting from the difference between the
loan balance and the fair market value of the collateral is recognized by a
charge to the allowance for loan losses.  When collateral is held for
sale after foreclosure, it is subject to a periodic appraisal.  If the
appraisal indicates that the collateral will sell for less than its recorded
value, the Bank recognizes the loss by a charge to non-interest
expense.
  45


The
following table provides a summary of the Bank’s non-performing assets as of
December 31, 2008 and 2007:





December 31,(dollar amounts in
    thousands)
                            
                            2008
                            
                            
                            2007Loans
      delinquent 90 days or more and still accruing
                            
                            $
                            348
                            
                            
                            $
                            -Non
      Accruing Loans:Commercial
      real estate
                            
                            $
                            1,961
                            
                            
                            $
                            261Residential
      1-4 family
                            
                            
                            265
                            
                            
                            
                            -Home
      equity lines of credit
                            
                            
                            320Commercial
                            
                            
                            7,060
                            
                            
                            
                            62Construction
                            
                            
                            5,990
                            
                            
                            
                            -Land
                            
                            
                            2,720
                            
                            
                            
                            -Installment
      loans
                            
                            
                            11
                            
                            
                            
                            15Total
      non-accruing loans
                            
                            $
                            18,327
                            
                            
                            $
                            338Other
      real estate owned
                            
                            $
                            1,337
                            
                            
                            $
                            -Total
      non-performing assets
                            
                            $
                            20,012
                            
                            
                            $
                            338Ratio
      of allowance for credit losses to total gross loans
                            
                            
                            1.53
                            %
                            
                            
                            1.00
                            %Ratio
      of allowance for credit losses to total non-performing
    loans
                            
                            
                            55.75
                            %
                            
                            
                            1817
                            %Ratio
      of non-performing loans to total gross loans
                            
                            
                            2.75
                            %
                            
                            
                            0.06
                            %Ratio
      of non-performing assets to total assets
                            
                            
                            2.48
                            %
                            
                            
                            0.05
                            %





At
December 31, 2008, total non-accruing loans were $18.3 million or approximately
$18.0 million higher than the $0.3 million reported at December 31,
2007.  Notable increases were within the categories of commercial
real-estate, commercial and industrial, construction and
land.  Approximately $13.5 million of the year over year increase can
be attributed to nine loans the Bank made to six borrowers.  At
December 31, 2008, significant non-accruing balances were as
follows:





·
            Commercial and
      industrial





Significant
balances include two loans to two borrowers with respective balances of
approximately $3.6 million and $1.5 million.  During the fourth
quarter, the Bank charged-off approximately $2.1 million in balances related to
these loans.  Both loans are secured by real estate within the Bank’s
primary market area.





·
            Commercial real
      estate





Significant
balances include one loan to one borrower in the approximate amount of $0.9
million.  Management continues to work with this borrower to bring
about a speedy resolution.  This loan is secured by real estate within
the Bank’s primary market area.





·
            Construction





Significant
balances include four loans to two borrowers in the aggregate amount of $6.0
million, with the two largest balances at approximately $2.1 million and $1.6
million at December 31, 2008.  During 2008, the Bank charged-off
approximately $1.4 million in balances related to the four loans within this
category.  These loans are secured by real estate within the Bank’s
primary market area.


46


·
            Land





Significant
balances within this category include one loan to one borrower in the amount
$1.3 million.  During the fourth quarter of 2008, the Bank charged-off
approximately $1.2 million in outstanding balances related to this
loan.  This loan is secured by improved land zoned for the
construction of town homes in the coastal region of the Bank’s primary market
area.





The
following table provides additional information related to the loans the Bank
has placed on non-accruing status as of December 31, 2008:





December 31,
                                              
                                              
                                              Percent
                                              
                                              
                                              Number(dollar amounts in thousands)
                                              
                                              2008
                                              
                                              
                                              Composition
                                              
                                              
                                              of Loans
                                              
                                              Loan Information / Collateral InformationCommercial
      real estate
                                              
                                              $
                                              1,961
                                              
                                              
                                              
                                              10.7
                                              %
                                              
                                              
                                              5
                                              
                                              Includes
      five loans to four borrowers all collateralized by various forms of real
      estate within the Bank's primary market area.Residential
      1-4 family
                                              
                                              
                                              265
                                              
                                              
                                              
                                              1.4
                                              %
                                              
                                              
                                              1
                                              
                                              One
      loan secured by 2nd deed of trust within the Bank's primary market
      area.Commercial
                                              
                                              
                                              7,060
                                              
                                              
                                              
                                              38.5
                                              %
                                              
                                              
                                              12
                                              
                                              Includes
      twelve loans to eleven borrowers all collateralized by various forms of
      real estate and business assets.Construction
                                              
                                              
                                              5,990
                                              
                                              
                                              
                                              32.7
                                              %
                                              
                                              
                                              5
                                              
                                              Includes
      five loans to three borrowers all collateralized by real estate properties
      in various phases of construction.Land
                                              
                                              
                                              2,720
                                              
                                              
                                              
                                              14.8
                                              %
                                              
                                              
                                              5
                                              
                                              Includes
      five loans to five borrowers.  Loans within this category are
      secured by land, 1st trust deeds on fully improved commercial lots, and a
      second position on SFR property.Installment
      loans
                                              
                                              
                                              11
                                              
                                              
                                              
                                              0.1
                                              %
                                              
                                              
                                              1
                                              
                                              Collateralized
      by a mobile home property.Home
      equity lines of credit
                                              
                                              
                                              320
                                              
                                              
                                              
                                              1.7
                                              %
                                              
                                              
                                              1
                                              
                                              Secured
      by 3rd trust deed on property in Bank's primary market
    area.Total
      non-accruing loans
                                              
                                              $
                                              18,327
                                              
                                              
                                              
                                              100.0
                                              %





A
majority of balances on non-accrual at December 31, 2007 relate to one loan to
one borrower.  After working with this particular borrower and
obtaining at least six months of sustained repayments, the Bank returned this
loan to accruing status during 2008.  Substantially all other balances
on non-accrual status as of December 31, 2007 were charged-off during
2008.





Interest
income that would have been recognized on non-accruing loans if they had
performed in accordance with the terms of their respective loan agreements was
approximately $0.9 million and $0.1 million at December 31, 2008 and 2007,
respectively.





Non-performing
loans include non-accrual loans, restructured loans and accruing loans that are
90 days or more delinquent.  At December 31, 2008, there were two
loans that were 90 days or more delinquent and still accruing
interest.  These balances totaled approximately $0.3
million.  There were no loans 90 days or more past due and still
accruing at December 31, 2007.


47


The
following table provides a reconciliation for the change in the balance of
non-accruing loans for the year ended December 31, 2008:





Balance
                          
                          
                          Additions to
                          
                          
                          
                          
                          
                          
                          
                          
                          Returns to
                          
                          
                          Transfers
      to OREO
                          
                          
                          BalanceDecember 31,
                          
                          
                          Non-Accruing
                          
                          
                          Net
                          
                          
                          
                          
                          
                          Preforming
                          
                          
                          or Foreclosed
                          
                          
                          December 31,(dollar amounts in thousands)
                          
                          2007
                          
                          
                          Balances
                          
                          
                          Paydowns
                          
                          
                          Charge-offs
                          
                          
                          Status
                          
                          
                          Collateral
                          
                          
                          2008Real
      Estate SecuredMulti-family
      residential
                          
                          $
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          -Residential
      1 to 4 family
                          
                          
                          -
                          
                          
                          
                          1,275
                          
                          
                          
                          (11
                          )
                          
                          
                          (555
                          )
                          
                          
                          -
                          
                          
                          
                          (444
                          )
                          
                          
                          265Home
      equity line of credit
                          
                          
                          -
                          
                          
                          
                          320
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          320Commercial
                          
                          
                          261
                          
                          
                          
                          2,577
                          
                          
                          
                          (104
                          )
                          
                          
                          (340
                          )
                          
                          
                          (236
                          )
                          
                          
                          (197
                          )
                          
                          
                          1,961Farmland
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -CommercialCommercial
      and industrial
                          
                          
                          62
                          
                          
                          
                          11,505
                          
                          
                          
                          (113
                          )
                          
                          
                          (3,854
                          )
                          
                          
                          (477
                          )
                          
                          
                          (63
                          )
                          
                          
                          7,060Agriculture
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Other
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -ConstructionSingle
      family residential
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Single
      family residential - Spec.
                          
                          
                          -
                          
                          
                          
                          8,916
                          
                          
                          
                          (541
                          )
                          
                          
                          (1,837
                          )
                          
                          
                          -
                          
                          
                          
                          (548
                          )
                          
                          
                          5,990Tract
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Multi-family
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Hospitality
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Commercial
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Land
                          
                          
                          -
                          
                          
                          
                          4,281
                          
                          
                          
                          (8
                          )
                          
                          
                          (1,434
                          )
                          
                          
                          -
                          
                          
                          
                          (119
                          )
                          
                          
                          2,720Installment
      loans to individuals
                          
                          
                          15
                          
                          
                          
                          50
                          
                          
                          
                          (4
                          )
                          
                          
                          (20
                          )
                          
                          
                          -
                          
                          
                          
                          (30
                          )
                          
                          
                          11All
      other loans
                          
                          
                          -
                          
                          
                          
                          36
                          
                          
                          
                          -
                          
                          
                          
                          (36
                          )
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Totals
                          
                          $
                          338
                          
                          
                          $
                          28,960
                          
                          
                          $
                          (781
                          )
                          
                          $
                          (8,076
                          )
                          
                          $
                          (713
                          )
                          
                          $
                          (1,401
                          )
                          
                          $
                          18,327





The
following table provides a reconciliation for the change in the balance of loans
classified as 90 days past due and still accruing for the year ended December
31, 2008:


Balance
                      
                      
                      Additions to
                      
                      
                      Transfers
      to Non-
                      
                      
                      
                      
                      
                      Returns to
                      
                      
                      Transfers
      to OREO
                      
                      
                      BalanceDecember 31,
                      
                      
                      90 Day Plus
                      
                      
                      Accruing
                      
                      
                      
                      
                      
                      Preforming
                      
                      
                      or Foreclosed
                      
                      
                      December 31,(dollar amounts in thousands)
                      
                      2007
                      
                      
                      Balances
                      
                      
                      Status
                      
                      
                      Charge-offs
                      
                      
                      Status
                      
                      
                      Collateral
                      
                      
                      2008Loans
      90 days deliquent or more and still accruing
                      
                      $
                      -
                      
                      
                      $
                      441
                      
                      
                      $
                      (93
                      )
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      348





Total
Cash and Due from Banks





Total
cash and due from banks were $17.9 million and $23.3 million at December 31,
2008 and 2007, 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 Federal Reserve and provide additional funds for
investment.





Other
Earning Assets





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.


48


The
following table summarizes the balances of the Company’s other earning assets as
of December 31, 2008, 2007 and 2006:





2008
                              
                              
                              2007
                              
                              
                              2006(dollar amounts in
    thousands)
                              
                              Amount
                              
                              
                              Percent
                              
                              
                              Amount
                              
                              
                              Percent
                              
                              
                              Amount
                              
                              
                              PercentFederal
      Home Loan Bank and Federal Reserve Bank stock
                              
                              $
                              5,123
                              
                              
                              
                              8.2
                              %
                              
                              $
                              3,045
                              
                              
                              
                              4.1
                              %
                              
                              $
                              2,350
                              
                              
                              
                              5.2
                              %Available-for-sale
      investments
                              
                              
                              50,762
                              
                              
                              
                              81.0
                              %
                              
                              
                              47,556
                              
                              
                              
                              64.2
                              %
                              
                              
                              38,445
                              
                              
                              
                              85.5
                              %Federal
      funds sold
                              
                              
                              6,650
                              
                              
                              
                              10.6
                              %
                              
                              
                              23,165
                              
                              
                              
                              31.3
                              %
                              
                              
                              3,870
                              
                              
                              
                              8.6
                              %Interest
      bearing deposits other financial institutions
                              
                              
                              119
                              
                              
                              
                              0.2
                              %
                              
                              
                              330
                              
                              
                              
                              0.4
                              %
                              
                              
                              318
                              
                              
                              
                              0.7
                              %Total
      other earning assets
                              
                              $
                              62,654
                              
                              
                              
                              100.0
                              %
                              
                              $
                              74,096
                              
                              
                              
                              100.0
                              %
                              
                              $
                              44,983
                              
                              
                              
                              100.0
                              %





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





·
            Investment
      Securities





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.  At December 31, 2008 the securities portfolio had net
unrealized losses, net of taxes of approximately $1.1 million.  At
December 31, 2007, the securities portfolio had a net unrealized gain of $184
thousand.  The year over year decline in the fair value of the
securities portfolio is primarily attributable to the extreme market turbulence
the credit markets experienced during 2008, placing pressure on holdings within
the portfolio.





During
the third and fourth quarters of 2008, the credit markets came under significant
duress as investor and consumer confidence in the U.S. financial system became
significantly destabilized.  As a result, many financial institutions
in severe need of liquidity were forced to de-leverage for a variety of reasons,
selling significant portions of their investment holdings which in turn placed
considerable pressure on the values of many classes of investment
securities.  In particular, mortgage related securities came under
substantial pressure and the Bank’s portfolio was not completely immune to
this.  Although substantially all of the Bank’s mortgage related
securities are considered “investment grade,” overall lack of confidence in the
housing market, the inability of many consumers to meet their mortgage related
obligations, and the strong need for liquidity during 2008 have, among other
things, been influential in placing pressure on the prices of these types of
securities.




At
December 31, 2008, the balance of the investment portfolio was approximately
$50.8 million or $3.2 million higher than that reported at December 31,
2007.  Although the values of certain securities within the portfolio
declined in the face of considerable market turbulence, purchases the Bank made
during 2008 in the approximate amount of $18.4 million, offset by principal
payments, maturities and calls in the aggregate amount of $11.7 million,
contributed to the overall increase in the balance of the
portfolio.





As part
of the 2007 acquisition of Business First, the Bank acquired five whole loan CMO
securities with a remaining principle balance of approximately $4.4
million.  The Bank performed an extensive review of the underlying
collateral for these securities, including but not limited to updates on: credit
enhancements, loan-to-values, credit scores, delinquency rates and default
rates. As of December 31, 2008, these securities had a remaining principal
balance of approximately $3.7 million and a net unrealized loss of approximately
$1.0 million.  At December 31, 2008, the Bank had a total of nine
whole loan CMO holdings with a remaining principal balance of approximately
$18.9 million and a net unrealized loss of approximately $2.1 million,
contributing significantly to the year over year decline in the overall market
value of the portfolio. The Bank continues to perform extensive analyses on the
underlying tranches associated with all of these securities. By analyzing the
tranche separate from the “mother” security, the Bank has determined that there
is no impairment and as such, is not taking any action to write-down these
securities. These investment securities continue to demonstrate cash flows as
expected and the credit support component of these tranches has actually
increased from the origination date.   As of December 31, 2008,
Management does not believe the loss in market value of these securities is
other than temporary.





The
majority of the Bank’s mortgage securities, other than those discussed in the
preceding paragraph were issued by:  The Government National Mortgage
Association (“Ginnie Mae”), The Federal National Mortgage Association (“Fannie
Mae”), and The Federal Home Loan Mortgage Corporation (“Freddie
Mac”).  These securities carry the guarantee of the issuing
agencies.


49


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.





The
following tables provide a summary of the Company’s securities portfolio,
including amortized cost and fair value as of December 31, 2008 and
2007:





Gross
                  
                  
                  Gross(dollar
      amounts in thousands)
                  
                  Amortized
                  
                  
                  Unrealized
                  
                  
                  Unrealized
                  
                  
                  FairDecember 31, 2008
                  
                  Cost
                  
                  
                  Gains
                  
                  
                  Losses
                  
                  
                  ValueObligations
      of U.S. government agencies and corporations
                  
                  $
                  149
                  
                  
                  $
                  -
                  
                  
                  $
                  (1
                  )
                  
                  $
                  148Mortgage-backed
      securities
                  
                  
                  35,339
                  
                  
                  
                  166
                  
                  
                  
                  (2,102
                  )
                  
                  
                  33,403Obligations
      of state and political subdivisions
                  
                  
                  17,020
                  
                  
                  
                  373
                  
                  
                  
                  (291
                  )
                  
                  
                  17,102Other
      securities
                  
                  
                  109
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  109Total
                  
                  $
                  52,617
                  
                  
                  $
                  539
                  
                  
                  $
                  (2,394
                  )
                  
                  $
                  50,762December
      31, 2007Obligations
      of U.S. government agencies and corporations
                  
                  $
                  3,674
                  
                  
                  $
                  12
                  
                  
                  $
                  (6
                  )
                  
                  $
                  3,680Mortgage-backed
      securities
                  
                  
                  26,793
                  
                  
                  
                  71
                  
                  
                  
                  (206
                  )
                  
                  
                  26,658Obligations
      of state and political subdivisions
                  
                  
                  16,667
                  
                  
                  
                  478
                  
                  
                  
                  (36
                  )
                  
                  
                  17,109Other
      securities
                  
                  
                  109
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  109Total
                  
                  $
                  47,243
                  
                  
                  $
                  561
                  
                  
                  $
                  (248
                  )
                  
                  $
                  47,556





The
following table sets forth the maturity distribution of available-for-sale
securities in the investments portfolio and the weighted average yield for each
category at December 31, 2008:





WeightedAmortized
                  
                  
                  Fair
                  
                  
                  Average(dollar amounts in
    thousands)
                  
                  Cost
                  
                  
                  Value
                  
                  
                  YieldDue
      in one year or less
                  
                  $
                  6,845
                  
                  
                  $
                  6,865
                  
                  
                  
                  4.11
                  %Due
      after one year through five years
                  
                  
                  21,576
                  
                  
                  
                  20,794
                  
                  
                  
                  5.01
                  %Due
      after five years through ten years
                  
                  
                  16,109
                  
                  
                  
                  15,305
                  
                  
                  
                  5.59
                  %Due
      after ten years
                  
                  
                  8,087
                  
                  
                  
                  7,798
                  
                  
                  
                  4.55
                  %Total
      available-for-sale securities
                  
                  $
                  52,617
                  
                  
                  $
                  50,762
                  
                  
                  
                  4.99
                  %





·
            Federal Funds
      Sold





As of
December 31, 2008, total other earning assets were approximately $11.4 million
lower than that reported at December 31, 2007.  The year over year
decline can be attributed in large part to a $16.5 million decline in the
balance of federal funds sold.  Although the balance of federal funds
sold can vary significantly from day to day as a result of many factors,
including the liquidity needs of our depositors, the year over year decline is
also attributable to lower deposit balances during 2008 and fewer excess funds
available for short-term over night investment.


50


Deposits
and Borrowed Funds





The
following table sets forth information for the last three fiscal years regarding
the composition of deposits at December 31, the average rates paid on each of
these categories, and the year over year variance from 2007 to
2008:





2008
                          
                          
                          2007
                          
                          
                          Variance
                          
                          
                          2006Average
                          
                          
                          
                          
                          
                          Average
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          Average(dollar amounts in thousands)
                          
                          Balance
                          
                          
                          Rate Paid
                          
                          
                          Balance
                          
                          
                          Rate Paid
                          
                          
                          Dollar
                          
                          
                          Percent
                          
                          
                          Balance
                          
                          
                          Rate PaidNon-interest bearing demand
                          
                          $
                          147,044
                          
                          
                          
                          0.00
                          %
                          
                          $
                          153,684
                          
                          
                          
                          0.00
                          %
                          
                          $
                          (6,640
                          )
                          
                          
                          -4.32
                          %
                          
                          $
                          153,005
                          
                          
                          
                          0.00
                          %Interest-bearing
      demand
                          
                          
                          72,952
                          
                          
                          
                          0.60
                          %
                          
                          
                          69,558
                          
                          
                          
                          0.45
                          %
                          
                          
                          3,394
                          
                          
                          
                          4.88
                          %
                          
                          
                          45,164
                          
                          
                          
                          0.17
                          %Savings
                          
                          
                          21,835
                          
                          
                          
                          0.81
                          %
                          
                          
                          41,599
                          
                          
                          
                          0.90
                          %
                          
                          
                          (19,764
                          )
                          
                          
                          -47.51
                          %
                          
                          
                          23,406
                          
                          
                          
                          0.40
                          %Money
      market
                          
                          
                          173,199
                          
                          
                          
                          1.95
                          %
                          
                          
                          206,754
                          
                          
                          
                          3.57
                          %
                          
                          
                          (33,555
                          )
                          
                          
                          -16.23
                          %
                          
                          
                          77,540
                          
                          
                          
                          2.70
                          %Time
      deposits
                          
                          
                          139,872
                          
                          
                          
                          3.30
                          %
                          
                          
                          160,692
                          
                          
                          
                          4.77
                          %
                          
                          
                          (20,820
                          )
                          
                          
                          -12.96
                          %
                          
                          
                          121,406
                          
                          
                          
                          4.21
                          %Brokered
      funds
                          
                          
                          48,619
                          
                          
                          
                          2.98
                          %
                          
                          
                          12,521
                          
                          
                          
                          5.37
                          %
                          
                          
                          36,098
                          
                          
                          
                          288.30
                          %
                          
                          
                          -
                          
                          
                          
                          0.00
                          %Total
      deposits
                          
                          $
                          603,521
                          
                          
                          
                          1.61
                          %
                          
                          $
                          644,808
                          
                          
                          
                          2.40
                          %
                          
                          $
                          (41,287
                          )
                          
                          
                          -6.40
                          %
                          
                          $
                          420,521
                          
                          
                          
                          1.68
                          %





The
following table provides a maturity distribution of domestic time certificates
of deposits of $100,000 and over as of December 31, 2008 and 2007:





(dollar
      amounts in thousands)
                    
                    2008
                    
                    
                    2007Less
      than 3 months
                    
                    $
                    31,876
                    
                    
                    $
                    48,0533
      to 12 months
                    
                    
                    29,917
                    
                    
                    
                    17,909Over
      1 year
                    
                    
                    13,318
                    
                    
                    
                    10,004Total
                    
                    $
                    75,111
                    
                    
                    $
                    75,966





·
            Deposits





At
December 31, 2008 the Bank had 32,102 deposit accounts consisting of
non-interest bearing (“demand”), interest-bearing demand and money market
accounts with balances totaling $393.2 million for an average balance per
account of approximately $12.3 thousand; 12,842 savings accounts with balances
totaling $21.8 million for an average balance per account of approximately $1.7
thousand; and 3,620 time certificate of deposit accounts, exclusive of brokered,
with balances totaling $139.9 million, for an average balance per account of
approximately $38.6 thousand.





As
indicated in the tables above, total deposit balances at December 31, 2008 were
approximately $603.5 million.  This represents a decline of
approximately $41.3 million compared to the $644.8 million reported at the end
of 2007.  Lower balances of non-interest bearing demand, money market
and time deposits contributed significantly to the year over year
declines.





2008
presented many challenges to the Bank with respect to the gathering of core
deposits.  As conditions in the credit markets and economic
environment worsened, many financial institutions in severe need of liquidity
began to engage in somewhat irrational deposit pricing, contributing to some
run-off in core as well as non-core promotional deposit
balances.  Management chose not to engage in this type of pricing and
instead chose to seek funding from other sources such as the Federal Home Loan
Bank (“FHLB”) and brokered deposits in an effort to not only maintain our net
interest margin, but to maintain a deposit base based on customer
relationship.





At
December 31, 2008, the funds the Bank considers to be brokered represented
approximately $48.6 million or 8.1% of total deposits.  The balance of
these funds consisted of $20.1 million in time deposits and $28.5 million in
money market balances.  For the year ended December 31, 2008, the
weighted average rate the Bank paid for these funds was 2.98%.





Core
deposits (demand, savings and money market, exclusive of brokered funds)
gathered in the local communities served by the Bank continue to be the primary
source of funds for loans and investments.  At December 31, 2008, core
deposits represented approximately $415.0 million or 68.8% of total
deposits.  This when compared to the $471.6 million balance at
December 31, 2007, represents a decline of approximately $56.6
million.  The majority of the year over year decline can be attributed
to run-off of promotional money market balances in favor of somewhat irrational
offering rates with other financial institutions.  As previously
mentioned, the Bank has chosen to pursue other sources of funding to a certain
degree in light of the declines we have seen in core balances in an effort to
protect the net interest margin and maintain a healthy deposit base based on
relationship.


51


Deposit
balances at December 31, 2007 were $644.8 million or approximately $224.3
million higher than that reported at December 31, 2006.  The increase
in deposit balances in 2007 can be attributed to the acquisition of Business
First as well as promotions the Bank engaged in during 2007 designed to attract
lower cost core deposits in order to fund the strong loan growth the Bank saw
during the first half of that year, as well as to pay down higher cost Federal
Home Loan Bank (“FHLB”) borrowings at that time.  During 2007, money
market account balances increased approximately $129.2
million.  Exclusive of the acquisition of Business First, money market
accounts increased approximately $102.5 million, directly related to the Bank’s
promotional activities.





·
            Volatile
      Deposits





The table
below provides a summary for deposit balances the Bank considers to be volatile
as of December 31, 2008 and 2007:





Percent of
                  
                  
                  
                  
                  
                  Percent ofDecember 31,
                  
                  
                  Total
                  
                  
                  December 31,
                  
                  
                  Total
                  
                  
                  Dollar(dollar amounts in thousands)
                  
                  2008
                  
                  
                  Deposits
                  
                  
                  2007
                  
                  
                  Deposits
                  
                  
                  VarianceNon-interest
      bearing demand
                  
                  $
                  11,193
                  
                  
                  
                  1.9
                  %
                  
                  $
                  15,724
                  
                  
                  
                  2.4
                  %
                  
                  $
                  (4,531
                  )Interest
      bearing demand
                  
                  
                  21,695
                  
                  
                  
                  3.6
                  %
                  
                  
                  22,884
                  
                  
                  
                  3.5
                  %
                  
                  
                  (1,189
                  )Savings
      deposits
                  
                  
                  196
                  
                  
                  
                  0.0
                  %
                  
                  
                  1,233
                  
                  
                  
                  0.2
                  %
                  
                  
                  (1,037
                  )Money
      market deposits
                  
                  
                  28,482
                  
                  
                  
                  4.7
                  %
                  
                  
                  73,151
                  
                  
                  
                  11.3
                  %
                  
                  
                  (44,669
                  )Total
      volatile deposits
                  
                  $
                  61,566
                  
                  
                  
                  10.2
                  %
                  
                  $
                  112,992
                  
                  
                  
                  17.4
                  %
                  
                  $
                  (51,426
                  )





The Bank
monitors the balance of various accounts that it considers to be volatile for a
variety of reasons and provides this data to the Bank’s Board of Directors on a
regular basis.  Accounts may be added to or removed from the volatile
liability dependency report when, based on Management’s judgment, it is
determined that these funds are not suitable for any form of long term
investment or that risk associated with these types of funds leaving the Bank
has become minimal.  Of the $61.6 million in volatile deposits
reported at December 31, 2008, approximately $47.3 million or 76.8% can be
attributed to four particular relationships.





The
following provides a summary of the notable relationships that comprise the
majority of volatile deposit balances as of December 31, 2008:





Volatile
non-interest bearing demand accounts represent relationships where the
depositors engage in mortgage related activities.  These balances
declined approximately $4.5 million from the end of 2007.  Pressures
on the mortgage industry for the majority of 2007 and 2008 have had a direct
impact on the balance of these accounts.  Management and the Board of
Directors of the Bank are aware that as conditions in the mortgage market
change, these relationships may continue to be impacted.





The
majority of interest bearing demand deposits the Bank considers to be volatile
are held by two depositors one of which represents public funds.





The
majority of money market deposits the Bank considers to be volatile were held by
one depositor.  The year over year decline in the balance of this
account contributed substantially to the year over year decline in total
volatile balances within this category.  At December 31, 2007, the
Bank was aware that balances associated with this one particular relationship
would experience ongoing declines due to the customer’s intention to invest in
other vehicles and also make tax payments.





·
            Borrowed
      Funds





The Bank
has a variety of sources from which it may obtain secondary
funding.  These sources include, among others, the Federal Home Loan
Bank (“FHLB”), credit lines established with correspondent banks and brokered
funds.





At
December 31, 2008, FHLB borrowings were $109.0 million or approximately $101.0
million higher than that reported at December 31, 2007.  The dramatic
year over year increase in FHLB borrowing can be attributed to the funding of
loan growth, the purchase of investment securities and the decision by
Management to let higher cost deposits run-off in favor of irrational deposit
pricing at other financial institutions.  At December 31, 2008, the
Bank’s remaining capacity to borrow from the FHLB was approximately $68.5
million.  Additionally, on September 17, 2004, the Bank issued a
Letter of Credit in the amount of approximately $11.7 million, which has since
been reduced to $11.4 million, to a customer in regard to a senior care
facility. The Letter of Credit was issued pursuant to a Letter of Credit
Reimbursement Agreement between the Bank and the FHLB. It is collateralized by a
blanket lien with the FHLB that includes all qualifying loans on the Bank’s
balance sheet. The letter of credit will expire in September
2009.  For additional information related to the Bank’s borrowings
with the FHLB, please see Note 8. Borrowings, of the Consolidated Financial
Statements filed on this Form 10-K.


52


In
October 2007 the Company renewed a promissory note with Pacific Coast Bankers
Bank (“PCBB”) for a revolving line of credit in the amount of $3.5
million.  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, 2008, the was no outstanding
balance on this line of credit. The Company pledged 646,598 shares (51%) of the
Bank’s stock as collateral for the loan.  At December 31, 2008, the
interest rate on the note was 3.25% and is variable and moves with prime. Under
the terms of the agreement, the Company will not incur any additional debt over
$2.0 million exclusive of inter-company debt and existing debt without the prior
written consent of PCBB.  In addition, the Bank must be “well”
capitalized on an on-going basis as defined by bank Regulators.  The
note was renewed as an additional financing option for the
Company.  The original two year note was executed in October 2003 and
was originally obtained to assist with cash and capital needs for the
acquisition of Hacienda Bank.





The Bank
has established a credit arrangement with a correspondent bank to provide an
additional source of short-term liquidity.  As of December 31, 2008,
there was no outstanding balance on this line and the remaining capacity to
borrow against this line was $20.0 million.  During the fourth
quarter, another line of credit in the amount of $20.0 million previously with
one of the Bank’s correspondent banks was temporarily suspended. Due to overall
instability in the financial markets, this particular correspondent bank
determined the need to re-assess all lines of credit. We are in the process of
providing updated agreements and expect the line to be re-activated within the
first quarter of 2009. If not, the Bank has been solicited by other
correspondent banks to provide a similar credit arrangement.





The Bank
has a policy in place that permits the purchase of brokered funds as a secondary
source for funding. This policy permits the Bank to purchase brokered funds in
an amount not to exceed 10% of total assets.  During the second
quarter of 2008, the Bank purchased $30.0 million in brokered time deposits of
which $20.0 million matured during the third and fourth quarters.  The
Bank subsequently purchased $10.0 million during the fourth
quarter.  At December 31, 2008, the balance of brokered time deposits
was approximately $20.1 million or $7.5 million higher than the $12.6 million
reported at December 31, 2007.





During
the third quarter of 2008, the Bank entered into an agreement with an entity
that works on behalf of brokerages to sell excess un-invested funds to other
financial institutions seeking additional liquidity. These funds are considered
brokered money market funds whose balances are subject to change.  At
December 31, 2008, the Bank had approximately $28.5 million in such
funding.





The Bank
utilizes securities sold under repurchase agreements as an additional source of
funds.  The Bank had $2.8 million in securities sold under repurchase
agreements at December 31, 2008 compared to $1.9 million at December 31,
2007.





Capital





At
December 31, 2008, stockholders’ equity was $70.0 million.  When
compared to the $69.5 million the Company reported at December 31, 2007, this
represents an increase of approximately $0.5 million.  The change in
equity is attributable to 2008 net income of approximately $1.6 million, the
payment of a cash dividend in the first quarter in the aggregate amount of $0.6
million, $0.4 million in proceeds from the exercise of stock options, $0.4
million related to the expensing of share-based compensation, and a $1.3 million
decline in accumulated other comprehensive income during the year.





At
December 31, 2007, stockholders’ equity was approximately $20.0 million higher
than that reported at December 31, 2006.  Of this increase
approximately $14.1 million can be attributed to the issuance of 892,724 shares
of the Company’s common stock to shareholders of Business First in connection
with the acquisition.





At
December 31, 2008, the Company had $13.4 million in Junior Subordinated
Deferrable Interest Debentures (the “debt securities”) issued and
outstanding.  These securities have been issued to Heritage Oaks
Capital Trusts II and III.  At December 31, 2008, the Company has
included $13.0 million of the net Junior Subordinated Debt in its Tier I Capital
for regulatory reporting purposes.  For a more detailed discussion
regarding these debt securities, see Note 8. Borrowings, of the Consolidated
Financial Statements filed on this Form 10-K.


53


As
previously mentioned, on January 9, 2009, the Company received preliminary
approval to participate in the U.S. Treasury’s CPP.  Under the terms
of the program, the Company will sell $21.0 million in Senior Preferred Stock to
the U.S. Treasury.  The Company will also issue warrants to the U.S.
Treasury to purchase shares of our common stock in an amount equal to 15% of the
preferred issuance.  The Company anticipates all funds from the
preferred issuance to qualify as Tier I capital.  For more information
on the Company’s participation in the U.S. Treasury’s CPP, see Note 24.
Subsequent Events, of the Consolidated Financial Statements filed on this Form
10-K.





Capital
ratios for commercial banks in the United States are generally calculated using
three different formulas.  These calculations are referred to as the
"Leverage Ratio" and two "risk based" calculations known as: "Tier One Risk
Based Capital Ratio" and the "Total Risk Based Capital Ratio."  These
standards were developed through joint efforts of banking authorities from
different countries around the world.  The standards essentially take
into account 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.





Summarized
below are the Company’s and the Bank’s capital ratios at December 31, 2008 and
2007:





Regulatory Standard
                            
                            
                            December 31, 2008
                            
                            
                            December 31, 2007Adequately
                            
                            
                            Well
                            
                            
                            Heritage
      Oaks
                            
                            
                            Heritage
      OaksRatio
                            
                            Capitalized
                            
                            
                            Capitalized
                            
                            
                            Bancorp
                            
                            
                            Bank
                            
                            
                            Bancorp
                            
                            
                            BankLeverage
      ratio
                            
                            
                            4.00
                            %
                            
                            
                            5.00
                            %
                            
                            
                            8.90
                            %
                            
                            
                            8.66
                            %
                            
                            
                            9.60
                            %
                            
                            
                            9.02
                            %Tier
      I capital to risk weighted assets
                            
                            
                            4.00
                            %
                            
                            
                            6.00
                            %
                            
                            
                            9.37
                            %
                            
                            
                            9.10
                            %
                            
                            
                            10.08
                            %
                            
                            
                            9.43
                            %Total
      risk based capital to risk weighted assets
                            
                            
                            8.00
                            %
                            
                            
                            10.00
                            %
                            
                            
                            10.62
                            %
                            
                            
                            10.36
                            %
                            
                            
                            11.04
                            %
                            
                            
                            10.40
                            %





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, 2008, these credit lines totaled $20.0 million and the Bank had no
borrowings against those lines.  As previously mentioned, the Bank is
a member of the FHLB and has collateralized borrowing capacities remaining of
$68.5 million at December 31, 2008.





The Bank
manages liquidity by maintaining a majority of the investment portfolio in
federal funds sold and other liquid investments.  The majority of
these investments include obligations of state and political subdivisions
(municipal bonds) and mortgage related securities that provide a relatively
steady stream of cash flows.  As of December 31,2008, the Company
believes investments in the portfolio can be liquidated at their current fair
values in the event they are needed to provide liquidity.





As
previously mentioned, a line of credit in the amount of $20.0 million with one
of the Bank’s correspondent banks was temporarily suspended due to the
instability of the financial markets during the fourth quarter.  This
particular correspondent bank determined it needed to re-assess all lines of
credit extended to other banks.  The Bank is in the process of
providing updated agreements and expects the line to be re-activated within the
first quarter of 2009.  If not, the Bank has been solicited by other
correspondent banks to provide a similar credit arrangement.


54


The
following table provides a summary of the remaining borrowing capacity the
Company has with various secondary liquidity sources as of December 31,
2008:





(dollar amounts in
    thousands)
                  
                  December 31, 2008Federal
      Home Loan Bank remaining borrowing capacity
                  
                  $
                  68,538Correspondent
      bank credit arrangements
                  
                  
                  20,000Brokered
      funds availability
                  
                  
                  35,489Revolving
      line of credit - Holding Company
                  
                  
                  3,500Total
      available secondary liquidity source
                  
                  $
                  127,527





The
following table provides additional information regarding the Company’s
liquidity as of December 31, 2008:





(dollar amounts in
    thousands)
                  
                  December 31, 2008Total
      cash and due from
                  
                  $
                  17,921Federal
      funds sold
                  
                  
                  6,650Unencumbered
      available for sale investments
                  
                  
                  7,403Loans
      held for sale
                  
                  
                  7,939Total
      available secondary funding
                  
                  
                  127,527Total
      liquid assets and available funding
                  
                  $
                  167,440Total
      deposits and other borrowing
                  
                  $
                  715,317Ratio
      of liquid assets and available funding to total deposits and other
      borrowings
                  
                  
                  23.4
                  %





During
2008, the financial markets proved to be challenging for many financial
institutions, including the Bank.  As a result of these challenging
market conditions, many banks experienced considerable liquidity constraints,
increases in the cost of certain types of borrowing, and increased pressures on
deposit pricing in efforts to retain core funding balances.  Although
the Bank did not experience any significant liquidity constraints during 2008,
extremely competitive deposit pricing at other financial institutions in severe
need of liquidity have posed significant challenges to the Bank in our effort to
attract and retain core deposits.  However, the Bank believes its
considerable availability of secondary funding sources combined with its ability
to re-price deposits, if so needed, provides ample liquidity to continue to meet
the needs of its depositors, investors and borrowers.





At
December 31, 2008, the ratio of liquid assets not pledged for collateral and
other purposes to deposits and other liabilities was 6.79% compared to 9.59% in
2007.  The ratio of net loans to deposits (“LTD”), another key
liquidity ratio, was 110.7% at December 31, 2008 compared to 93.9% at December
31, 2007 both of which are and were 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 and given the current
economic environment, the Bank has found it necessary to rely on borrowed funds
from time to time.  With the banking industry’s common use of
alternative funding sources, i.e. FHLB borrowing, the Bank implemented a
tracking ratio of Loan-to-Funding (“LTF”) in 2006.  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, 2008 and
2007, the LTF ratio was 87.2% and 80.6%.  The Bank’s key focus has
been and remains to increase core deposits and minimize alternative funding
sources.





Critical
Accounting Policies and Estimates





Our
accounting policies are integral to understanding the Company’s financial
condition and results of operations.  Accounting policies Management
considers to be significant are disclosed in Note 1 of the Consolidated
Financial Statements filed on this Form 10-K.  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.


55


The
following is a brief listing of our current accounting policies involving
significant Management valuation judgments:





·
            Investment
      Securities


·
            Loans
      and Interest on Loans


·
            Other
      Real Estate Owned


·
            Loans
      Held for Sale


·
            Allowance
      for Loan Losses


·
            Property,
      Premises and Equipment


·
            Goodwill
      and Other Intangible Assets


·
            Income
      Taxes


·
            Deferred
      Tax Assets


·
            Advertising
      Costs


·
            Supplemental
      Employee Compensation Benefits
Agreements





As
mentioned, please see Note 1 of the Consolidated Financial Statements filed on
this Form 10-K for a more detailed discussion regarding the Company’s critical
accounting policies.  Additionally, 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 statements when they are funded or
related fees are incurred or received.  The following table provides a
summary for the Company’s long-term debt and other obligations as of December
31, 2008 and 2007:





Less Than
                    
                    
                    One To Three
                    
                    
                    Three To Five
                    
                    
                    More Than
                    
                    
                    December 31,
                    
                    
                    December 31,(dollar amounts in thousands)
                    
                    One Year
                    
                    
                    Years
                    
                    
                    Years
                    
                    
                    Five Years
                    
                    
                    2008
                    
                    
                    2007Long-term
      debt obligations and other borrowings
                    
                    $
                    99,000
                    
                    
                    $
                    10,000
                    
                    
                    $
                    -
                    
                    
                    $
                    13,403
                    
                    
                    $
                    122,403
                    
                    
                    $
                    21,403Operating
      lease obligations
                    
                    
                    2,150
                    
                    
                    
                    5,199
                    
                    
                    
                    1,115
                    
                    
                    
                    7,837
                    
                    
                    
                    16,301
                    
                    
                    
                    16,873Total
      long-term debt and other obligations
                    
                    $
                    101,150
                    
                    
                    $
                    15,199
                    
                    
                    $
                    1,115
                    
                    
                    $
                    21,240
                    
                    
                    $
                    138,704
                    
                    
                    $
                    38,276





As
disclosed in Note 10 to the Consolidated Financial Statements, the Company is
contingently liable for letters of credit made to its customers in the ordinary
course of business totaling $18.5 million at December 31, 2008, $1.9 million
higher than the $16.6 million reported at the end of
2007.  Additionally, at December 31, 2008 and 2007 the Company had
un-disbursed loan commitments, also made in the ordinary course of business,
totaling approximately $200.2 million and $245.9 million,
respectively.  The Company has an allowance for losses-unfunded
commitments totaling $236 thousand at December 31, 2008, 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
disclosed in Note 15 of the Consolidated Financial Statements filed on this Form
10-K, 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 $28.5 million and $18.3 million at the end of 2008 and 2007,
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 $13.4 million in subordinated debentures issued by the Company’s
subsidiary grantor trusts.  As a result, all significant interest rate
risk procedures are performed at the banking subsidiary level.  The
subsidiary bank’s real estate loan portfolio, concentrated primarily within
Santa Barbara and San Luis Obispo Counties, of California, are subject to risks
associated with the local economy.


56


The
fundamental objective behind the management of the Company’s 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, 2008 balances indicate that the net interest income at risk over a
one year time horizon for a 1% and 2% rate increase and decrease are within the
Company’s policy guidelines for such changes.





Rate Shock Scenarios(dollar amounts in
    thousands)
                      
                      
                      -200bp
                      
                      
                      
                      -100bp
                      
                      
                      Base
                      
                      
                      
                      +100bp
                      
                      
                      
                      +200bpNet
      interest income (NII)
                      
                      $
                      37,858
                      
                      
                      $
                      39,270
                      
                      
                      $
                      40,451
                      
                      
                      $
                      41,602
                      
                      
                      $
                      42,866$
      Change from base
                      
                      $
                      (2,593
                      )
                      
                      $
                      (1,181
                      )
                      
                      $
                      -
                      
                      
                      $
                      1,151
                      
                      
                      $
                      2,415%
      Change from base
                      
                      
                      -6.41
                      %
                      
                      
                      -2.92
                      %
                      
                      
                      0.00
                      %
                      
                      
                      2.85
                      %
                      
                      
                      5.97
                      %





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.


57


The
following table provides a summary of the loans the Bank can expect to see come
off their floors if the prime rate were to increase by the amounts presented as
of December 31, 2008:





Move in Prime Rate (bps)(dollar amounts in
    thousands)
                      
                      
                      +200
                      
                      
                      
                      +250
                      
                      
                      
                      +300
                      
                      
                      
                      +350Variable
      daily
                      
                      $
                      4,128
                      
                      
                      $
                      10,108
                      
                      
                      $
                      37,124
                      
                      
                      $
                      90,642Variable
      other than daily
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      23,046
                      
                      
                      
                      63,342Cumulative
      total variable at floor
                      
                      $
                      4,128
                      
                      
                      $
                      10,108
                      
                      
                      $
                      60,170
                      
                      
                      $
                      153,984





As
evidenced in the table above, the Bank can expect to see approximately $154.0
million in loans come off their floors if the prime rate were to increase by 350
basis points as of December 31, 2008.





The
following table provides a summary for loans that currently possess a fixed rate
or are at their floors as of December 31, 2008:





Percent of(dollar amounts in
    thousands)
                  
                  Balances
                  
                  
                  Gross LoansFixed
      rate
                  
                  $
                  145,214
                  
                  
                  
                  21.4
                  %Variable
      daily - floor
                  
                  
                  176,764
                  
                  
                  
                  25.6
                  %Variable
      other than daily - floor
                  
                  
                  83,079
                  
                  
                  
                  12.2
                  %Total
      fixed / floor
                  
                  $
                  405,057
                  
                  
                  
                  59.2
                  %





As
evidenced in the table above, approximately $405.1 million or 59.2% of loans in
the portfolio are either fixed or at their floor.





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.


58


Item
8.  Financial Statements and Supplementary Data







Heritage
Oaks Bancorp and Subsidiaries





Management's
      Assessment of Internal Control Over Financial Reporting
                        60Report
      of Independent Registered Public Accounting Firm on Internal Control Over
      Financial Reporting
                        61Report
      of Independent Registered Public Accounting Firm
                        62Consolidated
      Financial Statements:Consolidated
      Balance SheetsAs
      of December 31, 2008 and 2007
                        63Consolidated
      Statements of IncomeFor
      the Years Ended December 31, 2008, 2007 and 2006
                        64Consolidated
      Statements of Stockholders' EquityAs
      of December 31, 2008, 2007 and 2006
                        65Consolidated
      Statements of Cash FlowsFor
      the Years Ended December 31, 2008, 2007 and 2006
                        66Notes
      to Consolidated Financial Statements
                        68The
      following un-audited supplementary financial data is included in this
      Annual Report on Form 10-K:Quarterly
      Financial Information
                        103


59


Management’s
Assessment of 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, 2008, 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) and guidance issued by the Securities and Exchange
Commission.  Based on the assessment, management determined that the
Company maintained effective internal control over financial reporting as of
December 31, 2008, 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, 2008.  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,
2008, 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. TorresLawrence
      P. Ward
                    Chief
      Executive Officer
                  
                  Margaret
      A. Torres
                    Executive
      Vice President,
                    Chief
      Financial
Officer


60


Report
of Independent Registered Public Accounting Firm





Board of
Directors and Stockholders


Heritage
Oaks Bancorp and Subsidiary


Paso
Robles, California





We have
audited Heritage Oaks Bancorp and Subsidiaries (the Company) internal control
over financial reporting as of December 31, 2008, 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 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 of internal control over financial
reporting included obtaining an understanding of internal control over financial
reporting, assessing the risk that a material weakness exists, and testing and
evaluating the design and operating effectiveness of internal control based on
the assessed risk.  Our audit also included 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, the Company maintained, in all material respects, effective internal
control over financial reporting as of December 31, 2008, 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, the consolidated balance sheets of the Company as of
December 31, 2008 and 2007, and the related consolidated statements of
operations, shareholders’ equity and comprehensive income and cash flows for the
three years in the period ended December 31, 2008, and our report
dated March 6, 2009 expressed an unqualified opinion on those financial
statements.





/s/Vavrinek, Trine, Day & Co.,
      LLPRancho
      Cucamonga, CaliforniaMarch
      6, 2009


61


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, 2008 and 2007, 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,
2008.  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, 2008 and 2007, 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, 2008, 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 Company’s internal control over financial
reporting as of December 31, 2008, 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 6, 2009
expressed an unqualified opinion thereon.





/s/Vavrinek, Trine, Day
      & Co., LLPRancho
      Cucamonga, CaliforniaMarch 6, 2009




62




Heritage
Oaks Bancorp


and
Subsidiaries


Consolidated
Balance Sheets





December 31,(dollar amounts in
    thousands)
                      
                      2008
                      
                      
                      2007AssetsCash
      and due from banks
                      
                      $
                      17,921
                      
                      
                      $
                      23,254Federal
      funds sold
                      
                      
                      6,650
                      
                      
                      
                      23,165Total
      cash and cash equivalents
                      
                      
                      24,571
                      
                      
                      
                      46,419Interest-bearing
      deposits with other financial institutions
                      
                      
                      119
                      
                      
                      
                      330Investment
      securities, available-for-sale
                      
                      
                      50,762
                      
                      
                      
                      47,556Federal
      Home Loan Bank stock, at cost
                      
                      
                      5,123
                      
                      
                      
                      3,045Loans
      held for sale
                      
                      
                      7,939
                      
                      
                      
                      902Loans,
      net of deferred fees of $1,701 and $1,732 and allowance for loan loss of
      $10,412 and $6,143 at December 31, 2008 and 2007,
    respectively
                      
                      
                      668,034
                      
                      
                      
                      605,342Property
      premises and equipment, net
                      
                      
                      6,827
                      
                      
                      
                      6,390Net
      deferred tax asset
                      
                      
                      7,708
                      
                      
                      
                      5,290Bank
      owned life insurance
                      
                      
                      10,737
                      
                      
                      
                      9,923Goodwill
                      
                      
                      11,049
                      
                      
                      
                      10,911Core
      deposit intangible
                      
                      
                      3,691
                      
                      
                      
                      4,551Other
      real estate owned
                      
                      
                      1,337
                      
                      
                      
                      -Other
      assets
                      
                      
                      7,691
                      
                      
                      
                      4,895Total
      assets
                      
                      $
                      805,588
                      
                      
                      $
                      745,554LiabilitiesDeposits:Demand,
      non-interest bearing
                      
                      $
                      147,044
                      
                      
                      $
                      153,684Savings,
      NOW and money market deposits
                      
                      
                      296,488
                      
                      
                      
                      317,911Time
      deposits of $100 or more
                      
                      
                      75,111
                      
                      
                      
                      75,966Time
      deposits under $100
                      
                      
                      84,878
                      
                      
                      
                      97,247Total
      deposits
                      
                      
                      603,521
                      
                      
                      
                      644,808Short
      term FHLB borrowing
                      
                      
                      99,000
                      
                      
                      
                      -Long
      term FHLB borrowing
                      
                      
                      10,000
                      
                      
                      
                      8,000Securities
      sold under agreement to repurchase
                      
                      
                      2,796
                      
                      
                      
                      1,936Junior
      subordinated debentures
                      
                      
                      13,403
                      
                      
                      
                      13,403Other
      liabilities
                      
                      
                      6,835
                      
                      
                      
                      7,957Total
      liabilities
                      
                      
                      735,555
                      
                      
                      
                      676,104Commitments
      and contingencies (Notes 5 and 10)
                      
                      
                      -
                      
                      
                      
                      -Stockholders'
      EquityCommon
      stock, no par value; 20,000,000 shares authorized; 7,753,078 and 7,683,829
      shares issued and outstanding for 2008 and 2007,
    respectively
                      
                      
                      48,649
                      
                      
                      
                      43,996Additional
      paid in capital
                      
                      
                      1,055
                      
                      
                      
                      672Retained
      earnings
                      
                      
                      21,420
                      
                      
                      
                      24,598Accumulated
      other comprehensive income/loss, net of tax of $763 and $129 in 2008 and
      2007, respectively
                      
                      
                      (1,091
                      )
                      
                      
                      184Total
      stockholders' equity
                      
                      
                      70,033
                      
                      
                      
                      69,450Total
      liabilities and stockholders' equity
                      
                      $
                      805,588
                      
                      
                      $
                      745,554





The
accompanying notes are an integral part of these consolidated financial
statements.


63


Heritage
Oaks Bancorp


and
Subsidiaries


Consolidated
Statements of Income





For The Years Ended December
      31,(dollar amounts in thousands except per share
      data)
                    
                    2008
                    
                    
                    2007
                    
                    
                    2006Interest
      IncomeInterest
      and fees on loans
                    
                    $
                    47,038
                    
                    
                    $
                    42,425
                    
                    
                    $
                    33,897Interest
      on investment securities:Obligations
      of U.S. government agencies
                    
                    
                    1,970
                    
                    
                    
                    1,042
                    
                    
                    
                    1,083Obligations
      of state and political subdivisions
                    
                    
                    741
                    
                    
                    
                    710
                    
                    
                    
                    702Interest
      on time deposits with other banks
                    
                    
                    8
                    
                    
                    
                    8
                    
                    
                    
                    9Interest
      on federal funds sold
                    
                    
                    140
                    
                    
                    
                    785
                    
                    
                    
                    539Interest
      on other securities
                    
                    
                    253
                    
                    
                    
                    204
                    
                    
                    
                    142Total
      interest income
                    
                    
                    50,150
                    
                    
                    
                    45,174
                    
                    
                    
                    36,372Interest
      ExpenseInterest
      on savings, NOW and money market deposits
                    
                    
                    4,375
                    
                    
                    
                    4,911
                    
                    
                    
                    2,497Interest
      on time deposits in denominations of $100 or more
                    
                    
                    2,436
                    
                    
                    
                    2,046
                    
                    
                    
                    626Interest
      on time deposits under $100
                    
                    
                    2,892
                    
                    
                    
                    4,914
                    
                    
                    
                    3,845Other
      borrowings
                    
                    
                    2,861
                    
                    
                    
                    2,880
                    
                    
                    
                    2,348Total
      interest expense
                    
                    
                    12,564
                    
                    
                    
                    14,751
                    
                    
                    
                    9,316Net
      interest income before provision for possible loan losses
                    
                    
                    37,586
                    
                    
                    
                    30,423
                    
                    
                    
                    27,056Provision
      for possible loan losses
                    
                    
                    12,215
                    
                    
                    
                    660
                    
                    
                    
                    600Net
      interest income after provision for possible loan losses
                    
                    
                    25,371
                    
                    
                    
                    29,763
                    
                    
                    
                    26,456Non-Interest
      IncomeFees
      and service charges
                    
                    
                    3,284
                    
                    
                    
                    2,774
                    
                    
                    
                    2,427Investment
      securities gain, net
                    
                    
                    37
                    
                    
                    
                    6
                    
                    
                    
                    9Gain
      on sale of SBA loans, net
                    
                    
                    -
                    
                    
                    
                    36
                    
                    
                    
                    19Loss
      on sale of premises, net
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    (38
                    )Other
                    
                    
                    2,885
                    
                    
                    
                    2,533
                    
                    
                    
                    2,535Total
      non-interest income
                    
                    
                    6,206
                    
                    
                    
                    5,349
                    
                    
                    
                    4,952Non-Interest
      ExpensesSalaries
      and employee benefits
                    
                    
                    15,561
                    
                    
                    
                    13,501
                    
                    
                    
                    11,573Equipment
                    
                    
                    1,404
                    
                    
                    
                    1,089
                    
                    
                    
                    868Occupancy
                    
                    
                    3,138
                    
                    
                    
                    2,292
                    
                    
                    
                    1,739Other
                    
                    
                    9,331
                    
                    
                    
                    7,026
                    
                    
                    
                    6,775Total
      non-interest expenses
                    
                    
                    29,434
                    
                    
                    
                    23,908
                    
                    
                    
                    20,955Income
      before provision for income taxes
                    
                    
                    2,143
                    
                    
                    
                    11,204
                    
                    
                    
                    10,453Provision
      for income taxes
                    
                    
                    497
                    
                    
                    
                    4,287
                    
                    
                    
                    3,791Net
      income
                    
                    $
                    1,646
                    
                    
                    $
                    6,917
                    
                    
                    $
                    6,662Earnings
      Per ShareBasic
                    
                    $
                    0.22
                    
                    
                    $
                    0.99
                    
                    
                    $
                    1.00Diluted
                    
                    $
                    0.21
                    
                    
                    $
                    0.96
                    
                    
                    $
                    0.96





The
accompanying notes are an integral part of these consolidated financial
statements.


64


Heritage
Oaks Bancorp


and
Subsidiaries


Consolidated
Statements of Stockholders' Equity





AccumulatedCommon
      Stock
                                                                                                              
                                                                                                              
                                                                                                              Additional
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              Other
                                                                                                              
                                                                                                              
                                                                                                              TotalNumber
      of
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              Paid-In
                                                                                                              
                                                                                                              
                                                                                                              Comprehensive
                                                                                                              
                                                                                                              
                                                                                                              Retained
                                                                                                              
                                                                                                              
                                                                                                              Comprehensive
                                                                                                              
                                                                                                              
                                                                                                              Stockholders'(dollar amounts in thousands)
                                                                                                              
                                                                                                              Shares
                                                                                                              
                                                                                                              
                                                                                                              Amount
                                                                                                              
                                                                                                              
                                                                                                              Capital
                                                                                                              
                                                                                                              
                                                                                                              Income
                                                                                                              
                                                                                                              
                                                                                                              Earnings
                                                                                                              
                                                                                                              
                                                                                                              Income/(loss)
                                                                                                              
                                                                                                              
                                                                                                              EquityBalance,
      December 31, 2005
                                                                                                              
                                                                                                              
                                                                                                              6,231,982
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              29,255
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              -
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              15,748
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              (158
                                                                                                              )
                                                                                                              
                                                                                                              $
                                                                                                              44,845Exercise
      of stock options  (including $365 tax benefit from exercise of
      stock options)
                                                                                                              
                                                                                                              
                                                                                                              87,607
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              712
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              712Cash
      dividends paid during 2006
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              (2,601
                                                                                                              )
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              (2,601
                                                                                                              )Share-based
      compensation expense
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              -
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              336
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              336Issuance
      of restricted share awards
                                                                                                              
                                                                                                              
                                                                                                              66,050Stock
      repurchases
                                                                                                              
                                                                                                              
                                                                                                              (40,000
                                                                                                              )
                                                                                                              
                                                                                                              
                                                                                                              (720
                                                                                                              )
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              (720
                                                                                                              )Comprehensive
      income:Net
      income
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              6,662
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              6,662
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              6,662Unrealized
      security holding gains  (net of $155 tax)
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              233
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              233
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              233Less
      reclassification adjustments for gains (net of $4 tax)
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              5
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              5
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              5Total
      comprehensive income
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              6,900Balance,
      December 31, 2006
                                                                                                              
                                                                                                              
                                                                                                              6,345,639
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              29,247
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              336
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              19,809
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              80
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              49,472Exercise
      of stock options (including $446 tax benefit from exercise of stock
      options)
                                                                                                              
                                                                                                              
                                                                                                              135,330
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              887
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              (25
                                                                                                              )
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              862Cash
      dividends paid during 2007
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              (2,128
                                                                                                              )
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              (2,128
                                                                                                              )Share-based
      compensation expense
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              361
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              361Issuance
      of restricted share awards
                                                                                                              
                                                                                                              
                                                                                                              1,500Retirement
      of restricted share awards
                                                                                                              
                                                                                                              
                                                                                                              (1,250
                                                                                                              )Stock
      repurchases
                                                                                                              
                                                                                                              
                                                                                                              (13,500
                                                                                                              )
                                                                                                              
                                                                                                              
                                                                                                              (215
                                                                                                              )
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              (215
                                                                                                              )Common
      stock issued in connection with acquisition of Business First National
      Bank
                                                                                                              
                                                                                                              
                                                                                                              850,213
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              14,077
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              14,077Comprehensive
      income:Net
      income
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              6,917
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              6,917
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              6,917Unrealized
      security holding gains (net of $76 tax)
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              104
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              104
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              104Total
      comprehensive income
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              7,021Balance,
      December 31, 2007
                                                                                                              
                                                                                                              
                                                                                                              7,317,932
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              43,996
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              672
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              24,598
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              184
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              69,450Exercise
      of stock options (including $115 tax benefit from exercise of stock
      options)
                                                                                                              
                                                                                                              
                                                                                                              74,706
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              420
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              4205%
      stock dividend distributed May 16, 2008
                                                                                                              
                                                                                                              
                                                                                                              366,294
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              4,233
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              (4,233
                                                                                                              )
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              -Cash
      paid in lieu of fractional shares
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              (5
                                                                                                              )
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              (5
                                                                                                              )Cash
      dividends paid during 2008
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              (586
                                                                                                              )
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              (586
                                                                                                              )Share-based
      compensation expense
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              383
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              383Issuance
      of restricted share awards
                                                                                                              
                                                                                                              
                                                                                                              1,050Retirement
      of restricted share awards
                                                                                                              
                                                                                                              
                                                                                                              (6,904
                                                                                                              )Comprehensive
      income:Net
      income
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              1,646
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              1,646
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              1,646Unrealized
      security holding losses (net of $892 tax benefit)
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              (1,297
                                                                                                              )
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              (1,297
                                                                                                              )
                                                                                                              
                                                                                                              
                                                                                                              (1,297
                                                                                                              )Realized
      gains on sale of securities (net of $15 tax)
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              22
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              22
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              22Total
      comprehensive income
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              371Balance,
      December 31, 2008
                                                                                                              
                                                                                                              
                                                                                                              7,753,078
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              48,649
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              1,055
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              21,420
                                                                                                              
                                                                                                              
                                                                                                              $
                                                                                                              (1,091
                                                                                                              )
                                                                                                              
                                                                                                              $
                                                                                                              70,033





The
accompanying notes are an integral part of these consolidated financial
statements.




65





Heritage
Oaks Bancorp


and
Subsidiaries


Consolidated
Statements of Cash Flows





For The Years Ended December 31,(dollar amounts in thousands)
                                                              
                                                              2008
                                                              
                                                              
                                                              2007
                                                              
                                                              
                                                              2006Cash
      flows from operating activities:Net
      income
                                                              
                                                              $
                                                              1,646
                                                              
                                                              
                                                              $
                                                              6,917
                                                              
                                                              
                                                              $
                                                              6,662Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
      and amortization
                                                              
                                                              
                                                              1,092
                                                              
                                                              
                                                              
                                                              984
                                                              
                                                              
                                                              
                                                              958Provision
      for possible loan losses
                                                              
                                                              
                                                              12,215
                                                              
                                                              
                                                              
                                                              660
                                                              
                                                              
                                                              
                                                              600Amortization
      of premiums / discounts on investment securities, net
                                                              
                                                              
                                                              (148
                                                              )
                                                              
                                                              
                                                              (78
                                                              )
                                                              
                                                              
                                                              (17
                                                              )Amortization
      of intangible assets
                                                              
                                                              
                                                              860
                                                              
                                                              
                                                              
                                                              393
                                                              
                                                              
                                                              
                                                              300Share-based
      compensation expense
                                                              
                                                              
                                                              383
                                                              
                                                              
                                                              
                                                              361
                                                              
                                                              
                                                              
                                                              336Federal
      Home Loan Bank dividends received
                                                              
                                                              
                                                              (209
                                                              )
                                                              
                                                              
                                                              (145
                                                              )
                                                              
                                                              
                                                              (97
                                                              )Gain
      on sale of available-for-sale securities
                                                              
                                                              
                                                              (37
                                                              )
                                                              
                                                              
                                                              (6
                                                              )
                                                              
                                                              
                                                              (9
                                                              )(Increase)
      / decrease in loans held for sale
                                                              
                                                              
                                                              (7,037
                                                              )
                                                              
                                                              
                                                              862
                                                              
                                                              
                                                              
                                                              1,628Net
      increase in bank owned life insurance
                                                              
                                                              
                                                              (414
                                                              )
                                                              
                                                              
                                                              (378
                                                              )
                                                              
                                                              
                                                              (343
                                                              )Increase
      in deferred tax asset
                                                              
                                                              
                                                              (1,526
                                                              )
                                                              
                                                              
                                                              (2,746
                                                              )
                                                              
                                                              
                                                              (220
                                                              )Increase
      in other assets
                                                              
                                                              
                                                              (4,221
                                                              )
                                                              
                                                              
                                                              (183
                                                              )
                                                              
                                                              
                                                              (727
                                                              )Loss
      on sale of property, premises and equipment, net
                                                              
                                                              
                                                              -
                                                              
                                                              
                                                              
                                                              -
                                                              
                                                              
                                                              
                                                              38(Decrease)
      / increase in other liabilities
                                                              
                                                              
                                                              (1,007
                                                              )
                                                              
                                                              
                                                              697
                                                              
                                                              
                                                              
                                                              158Excess
      tax benefit related to share-based compensation expense
                                                              
                                                              
                                                              (115
                                                              )
                                                              
                                                              
                                                              (446
                                                              )
                                                              
                                                              
                                                              (365
                                                              )Net
      cash provided by operating activities
                                                              
                                                              
                                                              1,482
                                                              
                                                              
                                                              
                                                              6,892
                                                              
                                                              
                                                              
                                                              8,902Cash
      flows from investing activities:Maturities
      of time deposits with other banks
                                                              
                                                              
                                                              211
                                                              
                                                              
                                                              
                                                              -
                                                              
                                                              
                                                              
                                                              (20
                                                              )Purchase
      of securities, available-for-sale
                                                              
                                                              
                                                              (18,417
                                                              )
                                                              
                                                              
                                                              (1,103
                                                              )
                                                              
                                                              
                                                              (1,190
                                                              )Sale
      of available-for-sale securities
                                                              
                                                              
                                                              1,537
                                                              
                                                              
                                                              
                                                              -Maturities
      and call of available-for-sale securities
                                                              
                                                              
                                                              2,210
                                                              
                                                              
                                                              
                                                              738
                                                              
                                                              
                                                              
                                                              500Proceeds
      from principal reductions and maturities of available-for-sale of
      mortgage-backed securities
                                                              
                                                              
                                                              9,482
                                                              
                                                              
                                                              
                                                              5,450
                                                              
                                                              
                                                              
                                                              7,071Redemption
      of Federal Reserve Bank stock
                                                              
                                                              
                                                              -
                                                              
                                                              
                                                              
                                                              361
                                                              
                                                              
                                                              
                                                              -Purchase
      of Federal Home Loan Bank stock
                                                              
                                                              
                                                              (1,869
                                                              )
                                                              
                                                              
                                                              -
                                                              
                                                              
                                                              
                                                              (368
                                                              )Sale
      of Federal Home Loan Bank stock
                                                              
                                                              
                                                              -
                                                              
                                                              
                                                              
                                                              282
                                                              
                                                              
                                                              
                                                              -Increase
      in loans, net
                                                              
                                                              
                                                              (75,037
                                                              )
                                                              
                                                              
                                                              (46,217
                                                              )
                                                              
                                                              
                                                              (77,403
                                                              )Allowance
      for loan and lease loss recoveries
                                                              
                                                              
                                                              130
                                                              
                                                              
                                                              
                                                              270
                                                              
                                                              
                                                              
                                                              161Purchase
      of property, premises and equipment, net
                                                              
                                                              
                                                              (1,579
                                                              )
                                                              
                                                              
                                                              (723
                                                              )
                                                              
                                                              
                                                              (3,672
                                                              )Proceeds
      from sale of property, premises and equipment
                                                              
                                                              
                                                              -
                                                              
                                                              
                                                              
                                                              12,810
                                                              
                                                              
                                                              
                                                              -Purchase
      of bank owned life insurance
                                                              
                                                              
                                                              (400
                                                              )
                                                              
                                                              
                                                              (110
                                                              )
                                                              
                                                              
                                                              (1,386
                                                              )Increase
      in cash from acquisition of Business First National Bank
                                                              
                                                              
                                                              -
                                                              
                                                              
                                                              
                                                              12,467
                                                              
                                                              
                                                              
                                                              -Net
      cash used in investing activities
                                                              
                                                              
                                                              (83,732
                                                              )
                                                              
                                                              
                                                              (15,775
                                                              )
                                                              
                                                              
                                                              (76,307
                                                              )Cash
      flows from financing activities:(Decrease)
      / increase in deposits, net
                                                              
                                                              
                                                              (41,287
                                                              )
                                                              
                                                              
                                                              90,868
                                                              
                                                              
                                                              
                                                              2,724Proceeds
      from Federal Home Loan Bank borrowing
                                                              
                                                              
                                                              380,000
                                                              
                                                              
                                                              
                                                              40,000
                                                              
                                                              
                                                              
                                                              80,000Repayments
      of Federal Home Loan Bank borrowing
                                                              
                                                              
                                                              (279,000
                                                              )
                                                              
                                                              
                                                              (94,598
                                                              )
                                                              
                                                              
                                                              (40,000
                                                              )Increase
      / (decrease) in repurchase agreements
                                                              
                                                              
                                                              860
                                                              
                                                              
                                                              
                                                              572
                                                              
                                                              
                                                              
                                                              (2,483
                                                              )Net
      (decrease) / increase in junior subordinated debentures
                                                              
                                                              
                                                              -
                                                              
                                                              
                                                              
                                                              (3,093
                                                              )
                                                              
                                                              
                                                              8,248Excess
      tax benefit related to share-based compensation expense
                                                              
                                                              
                                                              115
                                                              
                                                              
                                                              
                                                              446
                                                              
                                                              
                                                              
                                                              365Repurchase
      of common stock
                                                              
                                                              
                                                              -
                                                              
                                                              
                                                              
                                                              (215
                                                              )
                                                              
                                                              
                                                              (720
                                                              )Proceeds
      from exercise of stock options
                                                              
                                                              
                                                              305
                                                              
                                                              
                                                              
                                                              416
                                                              
                                                              
                                                              
                                                              347Cash
      paid in lieu of fractional shares
                                                              
                                                              
                                                              (5
                                                              )
                                                              
                                                              
                                                              -
                                                              
                                                              
                                                              
                                                              -Cash
      dividends paid
                                                              
                                                              
                                                              (586
                                                              )
                                                              
                                                              
                                                              (2,128
                                                              )
                                                              
                                                              
                                                              (2,601
                                                              )Net
      cash provided by financing activities
                                                              
                                                              
                                                              60,402
                                                              
                                                              
                                                              
                                                              32,268
                                                              
                                                              
                                                              
                                                              45,880Net
      (decrease) / increase in cash and cash equivalents
                                                              
                                                              
                                                              (21,848
                                                              )
                                                              
                                                              
                                                              23,385
                                                              
                                                              
                                                              
                                                              (21,525
                                                              )Cash
      and cash equivalents, beginning of year
                                                              
                                                              
                                                              46,419
                                                              
                                                              
                                                              
                                                              23,034
                                                              
                                                              
                                                              
                                                              44,559Cash
      and cash equivalents, end of year
                                                              
                                                              $
                                                              24,571
                                                              
                                                              
                                                              $
                                                              46,419
                                                              
                                                              
                                                              $
                                                              23,034


66





Supplemental
      Cash Flow DisclosuresCash
      Flow InformationInterest
      paid
                
                $
                12,630
                
                
                $
                14,848
                
                
                $
                8,976Income
      taxes paid
                
                $
                3,915
                
                
                $
                6,856
                
                
                $
                3,670Non-Cash
      Flow InformationChange
      in other valuation allowance for investment securities
                
                $
                (2,167
                )
                
                $
                180
                
                
                $
                397Loans
      transferred to OREO or foreclosed collateral
                
                $
                1,401
                
                
                $
                -
                
                
                $
                -Net
      change in assets and liabilities due to acquisition of Business
      FirstIncrease
      in interest-bearing deposits with other financial
    institutions
                
                $
                -
                
                
                $
                12
                
                
                $
                -Increase
      in investments
                
                $
                -
                
                
                $
                13,872
                
                
                $
                -Increase
      in Federal Home Loan Bank stock
                
                $
                -
                
                
                $
                1,193
                
                
                $
                -Increase
      in property premises and equipment
                
                $
                -
                
                
                $
                1,467
                
                
                $
                -Increase
      in goodwill and other intangible assets
                
                $
                -
                
                
                $
                9,844
                
                
                $
                -Increase
      in net loans
                
                $
                -
                
                
                $
                120,778
                
                
                $
                -Increase
      in other assets
                
                $
                -
                
                
                $
                837
                
                
                $
                -Increase
      in demand, money market, and savings accounts
                
                $
                -
                
                
                $
                99,074
                
                
                $
                -Increase
      in time certificates of deposit
                
                $
                -
                
                
                $
                34,345
                
                
                $
                -Increase
      in other borrowings
                
                $
                -
                
                
                $
                12,598
                
                
                $
                -Increase
      in other liabilities
                
                $
                -
                
                
                $
                376
                
                
                $
                -





The
accompanying notes are an integral part of these consolidated financial
statements.


67





Heritage
Oaks Bancorp and Subsidiaries


Notes to
Consolidated Financial Statements





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 fifteen branches within San Luis Obispo and 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 II (the “Trust II”) and Heritage Oaks
Capital Trust III (the “Trust III”), 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 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 allowance 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 and collateral, future additions to the allowance 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 allowance for losses on loans and foreclosed
real estate.  Such agencies may require the Company to recognize
additions to the allowance 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 allowance for losses on loans and foreclosed
real estate may change.





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
Bank is in compliance with the reserve requirements as of December 31,
2008.  The Company maintains amounts due from banks that exceed
federally insured limits.  The Company has not experienced any losses
in such accounts.


68





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 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.  The fair values of most securities that are
designated available for sale are based on quoted market prices.  If
quoted market prices are not available, fair values are extrapolated from the
quoted prices of similar instruments or through the use of other observable data
supporting a valuation model.  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 the security has
been in an unrealized loss position, (2) the extent to which the security’s fair
value is less than its cost, (3) the financial condition of the issuer, (4) any
adverse changes in ratings issued by various rating agencies, (5) the intent and
ability of the Bank to hold such securities for a period of time sufficient to
allow for any anticipated recovery in fair value and (6) in the case of mortgage
related securities, current cash flows, credit enhancements, loan-to-values,
credit scores, delinquency and default rates.





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 in 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.





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.


69





Other
Real Estate Owned





Real
estate and other property acquired in full or partial settlement of loan
obligations is referred to as other real estate owned (“OREO”).  OREO
is originally recorded in the Company’s financial statements at fair value less
any estimated costs to sell.  When property is acquired through
foreclosure or surrendered in lieu of foreclosure, the Company measures the fair
value of the property acquired against its recorded investment in the
loan.  If the fair value of the property at the time of acquisition is
less than the recorded investment in the loan, the difference is charged to the
allowance for loan losses.  Any subsequent fluctuations in the fair
value of OREO are recorded against a valuation allowance for foreclosed assets,
established through a charge to non-interest expense.  All related
operating or maintenance costs are charged to non-interest expense as
incurred.  Any subsequent gains or losses on the sale of OREO are
recorded in other income or expense as incurred.





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 and
volume of the portfolio, credit concentrations, trends in historical loss
experience, the level of certain classified balances and specific impaired
loans, and economic conditions and the related impact on specific borrowers and
industry groups.  The allowance is increased by a provision for loan
losses, which is charged to earnings 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.





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.  Allowances for impaired loans
are generally determined based on collateral values or the present value of
estimated cash flows.




As
mentioned, 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 losses and the associated provision for loan
losses.





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
improvements or major repairs are capitalized and those for ordinary repairs and
maintenance are charged to operations as incurred.


70





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 Standards (“SFAS”) No. 142, “Goodwill and Other Intangible
Assets,” goodwill is not 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, 2008, pursuant to its Goodwill Impairment Testing
Policy, was performed with the assistance of an independent third party and
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 amortized over a period of six to ten
years.





Intangibles
are evaluated periodically for impairment.  This evaluation involves
estimating cash flows for future periods.  If the future cash flows
were found to be materially less than the recorded balances of goodwill and
other intangible assets, the net book value of the intangible would be written
down, through a charge to earnings, 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 Statement of Financial Accounting Standards (“SFAS”) No. 109,
"Accounting for Income
Taxes."





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.  See also Note 9 Income Taxes, of these
Consolidated Financial Statements for additional information related to deferred
income taxes.





Supplemental
Employee Compensation Benefits Agreements





The
Company has 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 these benefits.





Disclosure
about 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.


71


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 more fully described in Note
10 of these Consolidated Financial Statements.  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 2006 and 2007 financial statements have been reclassified to
conform to the 2008 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.





Share-Based
Compensation





Effective
January 1, 2006, the Company adopted the provisions of SFAS
No. 123(R), “Share-Based
Payments,” a revision to the previously issued guidance on accounting for
stock options and other forms of equity-based compensation. SFAS No. 123(R)
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 was 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 Stock-Based
Compensation – Transition and Disclosure – An Amendment of FASB Statement 123.”We adopted SFAS No. 123(R) under the modified prospectivemethod
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. 123(R).  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.





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 also Note 14 of the Consolidated
Financial Statements for additional information related to share-based
compensation.


72





Recent
Accounting Pronouncements





In June
2008, the Financial Accounting Standards Board (“FASB”) issued Staff Position
No. EITF 03-6-1, Determining Whether Instruments
Granted in Share-Based Payment Transactions Are Participating Securities
("FSP EITF 03-6-1"). The FSP addresses whether instruments granted in
share-based payment transactions are participating securities prior to vesting
and, therefore, need to be included in the earnings allocation in computing EPS
under the two-class method. The FSP affects entities that accrue cash dividends
on share-based payment awards during the awards' service period when the
dividends do not need to be returned if the employees forfeit the
awards.  FSP EITF 03-6-1 is effective for fiscal years beginning
after December 15, 2008.  The Company does not expect the
adoption of FSP EITF 03-6-1 to have a material impact on its financial position,
results of operations and cash flows.





In July
2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income
Taxes—an interpretation of FASB Statement No. 109 (“FIN 48”) which
clarifies the accounting and disclosure for uncertainty in tax positions, as
defined. FIN 48 seeks to reduce the diversity in practice associated with
certain aspects of the recognition and measurement related to accounting for
income taxes and provides that the tax effects from an uncertain tax position be
recognized in the financial statements only if, based on its merits, the
position is more likely than not to be sustained in audit by the taxing
authorities. This interpretation is effective for fiscal years beginning after
December 15, 2006. Effective January 1, 2007, the Company adopted FIN 48. 
Management believes that all tax positions taken as of December 31, 2008 are
highly certain and, accordingly, no accounting adjustments have been made to the
financial statements.





In
September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.”
SFAS No. 157 enhances existing guidance for measuring assets and liabilities
using fair value. Prior to the issuance of SFAS No. 157, guidance for applying
fair value was incorporated in several accounting pronouncements. SFAS No. 157
provides a single definition of fair value, together with a framework for
measuring it, and requires additional disclosure about the use of fair value to
measure assets and liabilities. SFAS No. 157 also emphasizes that fair value is
a market-based measurement, not an entity-specific measurement, and sets forth a
fair value hierarchy with the highest priority being quoted prices in active
markets. Under SFAS No. 157, fair value measurements are disclosed by level
within that hierarchy. While SFAS No. 157 does not add any new fair value
measurements, it does change current practice. Changes to practice include:
(1) a requirement for an entity to include its own credit standing in the
measurement of its liabilities; (2) a modification of the transaction price
presumption; (3) a prohibition on the use of block discounts when valuing
large blocks of securities for broker-dealers and investment companies; and
(4) a requirement to adjust the value of restricted stock for the effect of
the restriction even if the restriction lapses within one year. SFAS No. 157 is
effective for financial statements issued for fiscal years beginning after
November 15, 2007, and interim periods within those fiscal years. Effective
January 1, 2008, the Company adopted SFAS No. 157. The adoption of this standard
has not had a material impact on the Company’s financial position, results of
operations or cash flows.





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





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


73





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





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





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





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





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


74





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





On
October 10, 2008, the FASB issued Financial Accounting Standards Board Staff
Position (“FSP”) FSP FAS 157-3, “Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not Active.” The FSP
clarifies the application of SFAS No. 157, “Fair Value Measurements”, in
a market that is not active and provides an example to illustrate key
considerations in determining the fair value of a financial asset when the
market for that financial asset is not active. The FSP is effective immediately,
and includes prior periods for which financial statements have not been issued,
and therefore the Company is subject to the provisions under the FSP effective
September 30, 2008. The implementation of FSP FAS 157-3 did not affect the
Company's fair value measurements as of December 31, 2008.





Note
2.  Investment Securities





At
December 31, 2008 and 2007, the investment securities portfolio was comprised
solely 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.





The
tables below set forth the fair values of investment securities
available-for-sale at December 31, 2008 and 2007:





Gross
                                
                                
                                Gross(dollar amounts in thousands)
                                
                                Amortized
                                
                                
                                Unrealized
                                
                                
                                UnrealizedAs of December 31, 2008
                                
                                Cost
                                
                                
                                Gains
                                
                                
                                Losses
                                
                                
                                Fair ValueObligations
      of U.S. Government agencies and corporations
                                
                                $
                                149
                                
                                
                                $
                                -
                                
                                
                                $
                                (1
                                )
                                
                                $
                                148Mortgage-backed
      securities
                                
                                
                                35,339
                                
                                
                                
                                166
                                
                                
                                
                                (2,102
                                )
                                
                                
                                33,403Obligations
      of state and political subdivisions
                                
                                
                                17,020
                                
                                
                                
                                373
                                
                                
                                
                                (291
                                )
                                
                                
                                17,102Other
      securities
                                
                                
                                109
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                109Total
                                
                                $
                                52,617
                                
                                
                                $
                                539
                                
                                
                                $
                                (2,394
                                )
                                
                                $
                                50,762As
      of December 31, 2007Obligations
      of U.S. Government agencies and corporations
                                
                                $
                                3,674
                                
                                
                                $
                                12
                                
                                
                                $
                                (6
                                )
                                
                                $
                                3,680Mortgage-backed
      securities
                                
                                
                                26,793
                                
                                
                                
                                71
                                
                                
                                
                                (206
                                )
                                
                                
                                26,658Obligations
      of state and political subdivisions
                                
                                
                                16,667
                                
                                
                                
                                478
                                
                                
                                
                                (36
                                )
                                
                                
                                17,109Other
      securities
                                
                                
                                109
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                109Total
                                
                                $
                                47,243
                                
                                
                                $
                                561
                                
                                
                                $
                                (248
                                )
                                
                                $
                                47,556





The
amortized cost and fair values of investment securities available-for-sale at
December 31, 2008 and 2007, 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.





2008
                              
                              
                              2007Amortized
                              
                              
                              
                              
                              
                              Amortized(dollar amounts in thousands)
                              
                              Cost
                              
                              
                              Fair Value
                              
                              
                              Cost
                              
                              
                              Fair ValueDue
      one year or less
                              
                              $
                              6,845
                              
                              
                              $
                              6,865
                              
                              
                              $
                              7,737
                              
                              
                              $
                              7,704Due
      after one year through five years
                              
                              
                              21,576
                              
                              
                              
                              20,794
                              
                              
                              
                              21,993
                              
                              
                              
                              22,005Due
      after five years through ten years
                              
                              
                              16,109
                              
                              
                              
                              15,305
                              
                              
                              
                              8,689
                              
                              
                              
                              8,856Due
      after ten years
                              
                              
                              8,087
                              
                              
                              
                              7,798
                              
                              
                              
                              8,824
                              
                              
                              
                              8,991Total
      securities
                              
                              $
                              52,617
                              
                              
                              $
                              50,762
                              
                              
                              $
                              47,243
                              
                              
                              $
                              47,556


75





During
2008, the Company sold $1.5 million of available for sale investments and
recognized gross gains in the approximate amount of $37 thousand.  For
the years ended December 31, 2007 and 2006, the Company reported gross gains
from the sale and maturity of available for sale investments in the approximate
amounts of $6 thousand and $9 thousand, respectively.





Securities
having a carrying value and a fair value of approximately $43.5 million and
$33.5 million at December 31, 2008 and 2007, respectively, were pledged to
secure public deposits and for other purposes as required by law.





Those
investment securities available for sale which have an unrealized loss position
at December 31, 2008 and 2007 are detailed below:





Securities In A Loss Position
                                    
                                    
                                    Securities In A Loss PositionFor Less Than Twelve Months
                                    
                                    
                                    For Twelve Months or More
                                    
                                    
                                    Total(dollar amounts in thousands)
                                    
                                    Fair
                                    
                                    
                                    Unrealized
                                    
                                    
                                    Fair
                                    
                                    
                                    Unrealized
                                    
                                    
                                    Fair
                                    
                                    
                                    UnrealizedAs of December 31, 2008
                                    
                                    Value
                                    
                                    
                                    Loss
                                    
                                    
                                    Value
                                    
                                    
                                    Loss
                                    
                                    
                                    Value
                                    
                                    
                                    LossObligations
      of U.S. Government agencies and corporations
                                    
                                    $
                                    94
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    54
                                    
                                    
                                    $
                                    (1
                                    )
                                    
                                    $
                                    148
                                    
                                    
                                    $
                                    (1
                                    )Mortgage-backed
      securities
                                    
                                    
                                    17,781
                                    
                                    
                                    
                                    (1,993
                                    )
                                    
                                    
                                    3,690
                                    
                                    
                                    
                                    (109
                                    )
                                    
                                    
                                    21,471
                                    
                                    
                                    
                                    (2,102
                                    )Obligations
      of state and political subdivisions
                                    
                                    
                                    6,804
                                    
                                    
                                    
                                    (291
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    6,804
                                    
                                    
                                    
                                    (291
                                    )Other
      securities
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Total
                                    
                                    $
                                    24,679
                                    
                                    
                                    $
                                    (2,284
                                    )
                                    
                                    $
                                    3,744
                                    
                                    
                                    $
                                    (110
                                    )
                                    
                                    $
                                    28,423
                                    
                                    
                                    $
                                    (2,394
                                    )As
      of December 31, 2007Obligations
      of U.S. Government agencies and corporations
                                    
                                    $
                                    1,497
                                    
                                    
                                    $
                                    (3
                                    )
                                    
                                    $
                                    171
                                    
                                    
                                    $
                                    (3
                                    )
                                    
                                    $
                                    1,668
                                    
                                    
                                    $
                                    (6
                                    )Mortgage-backed
      securities
                                    
                                    
                                    6,160
                                    
                                    
                                    
                                    (44
                                    )
                                    
                                    
                                    12,463
                                    
                                    
                                    
                                    (162
                                    )
                                    
                                    
                                    18,623
                                    
                                    
                                    
                                    (206
                                    )Obligations
      of state and political subdivisions
                                    
                                    
                                    2,104
                                    
                                    
                                    
                                    (30
                                    )
                                    
                                    
                                    527
                                    
                                    
                                    
                                    (6
                                    )
                                    
                                    
                                    2,631
                                    
                                    
                                    
                                    (36
                                    )Other
      securities
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Total
                                    
                                    $
                                    9,761
                                    
                                    
                                    $
                                    (77
                                    )
                                    
                                    $
                                    13,161
                                    
                                    
                                    $
                                    (171
                                    )
                                    
                                    $
                                    22,922
                                    
                                    
                                    $
                                    (248
                                    )





There are
ten securities that have been in a loss position for twelve months or longer as
of December 31, 2008, compared to sixteen as of December 31,
2007.  These unrealized losses can be attributed in part to the unrest
we have seen in the credit markets during 2008.





Management
periodically evaluates investments in the portfolio for other than temporary
impairment and more specifically when conditions warrant such an
evaluation.  When evaluating whether impairment is other then
temporary, Management considers, among other things, the following: (1) the
length of time the security has been in an unrealized loss position, (2) the
extent to which the security’s fair value is less than its cost, (3) the
financial condition of the issuer, (4) any adverse changes in ratings issued by
various rating agencies, (5) the intent and ability of the Bank to hold such
securities for a period of time sufficient to allow for any anticipated recovery
in fair value and (6) in the case of mortgage related securities, current cash
flows, credit enhancements, loan-to-values, credit scores, delinquency and
default rates.





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 at
December 31, 2008.


76





Note
3.  Loans





The
following table sets forth the balance for each major loan category as of
December 31, 2008 and 2007:





December 31,(dollar amounts in thousands)
                                
                                2008
                                
                                
                                2007Real
      Estate SecuredMulti-family
      residential
                                
                                $
                                16,206
                                
                                
                                $
                                12,779Residential
      1 to 4 family
                                
                                
                                23,910
                                
                                
                                
                                24,326Home
      equity line of credit
                                
                                
                                26,409
                                
                                
                                
                                17,470Commercial
                                
                                
                                285,631
                                
                                
                                
                                274,266Farmland
                                
                                
                                10,723
                                
                                
                                
                                11,557CommercialCommercial
      and industrial
                                
                                
                                157,674
                                
                                
                                
                                134,178Agriculture
                                
                                
                                13,744
                                
                                
                                
                                11,367Other
                                
                                
                                620
                                
                                
                                
                                535ConstructionSingle
      family residential
                                
                                
                                11,414
                                
                                
                                
                                10,239Single
      family residential - Spec.
                                
                                
                                15,395
                                
                                
                                
                                18,718Tract
                                
                                
                                2,431
                                
                                
                                
                                1,664Multi-family
                                
                                
                                5,808
                                
                                
                                
                                9,054Hospitality
                                
                                
                                18,630
                                
                                
                                
                                16,784Commercial
                                
                                
                                21,484
                                
                                
                                
                                30,677Land
                                
                                
                                61,681
                                
                                
                                
                                31,064Installment
      loans to individuals
                                
                                
                                7,851
                                
                                
                                
                                7,977All
      other loans (including overdrafts)
                                
                                
                                536
                                
                                
                                
                                562Total
      loans, gross
                                
                                
                                680,147
                                
                                
                                
                                613,217Deferred
      loan fees
                                
                                
                                1,701
                                
                                
                                
                                1,732Reserve
      for possible loan losses
                                
                                
                                10,412
                                
                                
                                
                                6,143Total
      loans, net
                                
                                $
                                668,034
                                
                                
                                $
                                605,342Loans
      held for sale
                                
                                
                                7,939
                                
                                
                                $
                                902





Concentration
of Credit Risk





At
December 31, 2008 and 2007, approximately $499.7 million and $458.6 million of
the Bank’s loan portfolio was collateralized by various forms of real
estate.  Such loans are generally made to borrowers located in the
counties San Luis Obispo and Santa Barbara.  The Bank attempts to
reduce its concentration of credit risk by making loans which are diversified by
project type.  While Management believes that the collateral presently
securing this portfolio is adequate, there can be no assurances that further
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 balance
sheets.  The unpaid principal balance of loans serviced for others was
$20.5 million, $18.2 million and $7.5 million at December 31, 2008, 2007 and
2006, respectively.





The Bank
also originates Small Business Administration (“SBA”) loans for sale to
governmental agencies and institutional investors.  At December 31,
2008 and 2007, the unpaid principal balance of SBA loans serviced for others
totaled $1.5 million and $2.0 million, respectively.  The Company did
not recognize gains from the sale of SBA loans in 2008, however gains on sales
were recorded in the amounts of $36 thousand and $19 thousand for the years
ended December 31, 2007 and 2006, respectively.


77





Impaired
Loans





The
following provides a summary of the Bank’s investment in impaired loans, the
corresponding valuation allowance for such loans, and income recognized thereon
as of December 31, 2008, 2007 and 2006:





December 31,(dollar amounts in thousands)
                              
                              2008
                              
                              
                              2007
                              
                              
                              2006Impaired
      loans with a valuation allowance
                              
                              $
                              1,091
                              
                              
                              $
                              62
                              
                              
                              $
                              -Impaired
      loans without a valuation allowance
                              
                              
                              17,236
                              
                              
                              
                              276
                              
                              
                              
                              55Total
      impaired loans
                              
                              $
                              18,327
                              
                              
                              $
                              338
                              
                              
                              $
                              55Valuation
      allowance related to impaired loans
                              
                              $
                              206
                              
                              
                              $
                              31
                              
                              
                              $
                              -Average
      recorded investment in impaired loans
                              
                              $
                              13,919
                              
                              
                              $
                              419
                              
                              
                              $
                              131Cash
      receipts applied to reduce principal balance
                              
                              $
                              1,638
                              
                              
                              $
                              151
                              
                              
                              $
                              273Interest
      income recognized from cash payments
                              
                              $
                              -
                              
                              
                              $
                              -
                              
                              
                              $
                              -





The
provisions of SFAS No. 114 and SFAS No. 118 permit the valuation allowances
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, valuation allowances
the Bank has recorded were determined on a loan-by-loan basis.





Non-accruing
loans totaled approximately $18.3 million and $0.3 million at December 31, 2008
and 2007, respectively.  As of December 31, 2008 and 2007, all loans
on non-accrual were classified as impaired.  If interest on
non-accruing loans had been recognized at the original interest rates, interest
income would have increased $0.9 million, $0.1 million, and $0.1 million, in
2008, 2007, and 2006, respectively.





At
December 31, 2008 there were two loans in the aggregate amount of $0.3 million
that were 90 days or more past due and still accruing.  There were no
loans 90 days or more past due and still accruing interest at December 31,
2007.  Additionally, there were and no loans classified as troubled
debt restructurings as of December 31, 2008 and 2007.





Note
4.  Allowance for Loan Losses





The
following table provides a summary of the activity within the allowance for loan
losses for the years ended December 31, 2008, 2007 and 2006:





For the Years Ended December 31,(dollar amounts in thousands)
                                  
                                  2008
                                  
                                  
                                  2007
                                  
                                  
                                  2006Balance,
      beginning of year
                                  
                                  $
                                  6,143
                                  
                                  
                                  $
                                  4,081
                                  
                                  
                                  $
                                  3,881Additions
      charged to operating expense
                                  
                                  
                                  12,215
                                  
                                  
                                  
                                  660
                                  
                                  
                                  
                                  600Loans
      charged off
                                  
                                  
                                  (8,076
                                  )
                                  
                                  
                                  (249
                                  )
                                  
                                  
                                  (561
                                  )Recoveries
      of loans previously charged off
                                  
                                  
                                  130
                                  
                                  
                                  
                                  270
                                  
                                  
                                  
                                  161Credit
      from purchase of Business First National Bank
                                  
                                  
                                  -
                                  
                                  
                                  
                                  1,381
                                  
                                  
                                  
                                  -Balance,
      end of year
                                  
                                  $
                                  10,412
                                  
                                  
                                  $
                                  6,143
                                  
                                  
                                  $
                                  4,081


78





Note
5.  Property, Premises and Equipment





At
December 31, 2008 and 2007, property, premises and equipment consisted of the
following:





December 31,(dollar amounts in thousands)
                                        
                                        2008
                                        
                                        
                                        2007Land
                                        
                                        $
                                        1,242
                                        
                                        
                                        $
                                        1,245Furniture
      and equipment
                                        
                                        
                                        8,394
                                        
                                        
                                        
                                        7,684Building
      and improvements
                                        
                                        
                                        5,941
                                        
                                        
                                        
                                        5,179Construction
      in progress
                                        
                                        
                                        202
                                        
                                        
                                        
                                        176Total
      cost
                                        
                                        
                                        15,779
                                        
                                        
                                        
                                        14,284Less:  accumulated
      depreciation and amortization
                                        
                                        
                                        8,952
                                        
                                        
                                        
                                        7,894Total
      property, premises and equipment
                                        
                                        $
                                        6,827
                                        
                                        
                                        $
                                        6,390





During
2003, the Bank purchased land for future development of a Paso Robles,
California administrative facility for approximately $1.1
million.  Construction was completed and the Bank moved into the
facility in June 2006.  In the second quarter of 2007, the Bank sold
this facility and three other branches to First States Group, L.P. in a sale
lease-back transaction for approximately $12.8 million.  The Bank
subsequently entered into four separate lease agreements with First States
Investors, LLC to lease back the three branches and administrative facility for
a period of 15 years with the option to renew for two 10 year
terms.  Each of the four leases are subject to an annual rent
escalation clause equal to the lower of CPI-U (Consumer Price Index for all
Urban Consumers) or 2.5 percent, commencing in the second year of the lease
term.  The sale of these properties resulted in a gain of
approximately $3.4 million that the Bank will recognize over a period of 15
years in accordance with SFAS No. 13 “Accounting for
Leases.”  For the years ended December 31, 2008 and 2007 the
Bank made payments in the aggregate amount of $922 thousand and $448 thousand,
respectively to lease these facilities.  Additionally, the Bank
recognized approximately $227 thousand and $114 thousand of the deferred gain on
sale during the years ended December 31, 2008 and 2007,
respectively.  The recognition of these gains is reflected in the
Company’s operating results for the periods mentioned as credits to occupancy
expense.





In
addition to the lease agreements mentioned in the preceding paragraph, the
Company leases land, buildings, and equipment under non-cancelable operating
leases expiring at various dates through 2022.  See Note 10,
Commitments and Contingencies of these Consolidated Financial Statements for a
more detailed discussion regarding the Company’s operating lease
obligations.





Note
6.  Intangible Assets





Goodwill





The
balance of goodwill at December 31, 2008 was approximately $11.0
million.  This when compared to the $10.9 million reported at December
31, 2008, represents an increase of approximately $0.1 million.





Core
Deposit Intangible (“CDI”)





Intangible
assets consisted of core deposit intangibles subject to
amortization.  Amortizations for 2008, 2007 and 2006 were $0.9
million, $0.4 million and $0.3 million, respectively.  In October
2007, the Company recorded approximately $3.8 million in CDI related to core
deposits it obtained in the acquisition of Business First.


79





The
following table summarizes the gross carrying amount, accumulated amortization
and net carrying amount of core deposit intangibles and provides an estimate for
future amortization as of December 31, 2008:





Gross Carrying
                    
                    
                    Accumulated
                    
                    
                    Net Carrying(dollar amounts in thousands)
                    
                    Amount
                    
                    
                    Amortization
                    
                    
                    AmountCore
      deposit intangible
                    
                    $
                    6,320
                    
                    
                    $
                    (2,629
                    )
                    
                    $
                    3,691





Beginning
                    
                    
                    Estimated
                    
                    
                    EndingPeriod
                    
                    Balance
                    
                    
                    Amortization
                    
                    
                    BalanceYear
      2009
                    
                    $
                    3,691
                    
                    
                    $
                    (1,049
                    )
                    
                    $
                    2,642Year
      2010
                    
                    $
                    2,642
                    
                    
                    $
                    (514
                    )
                    
                    $
                    2,128Year
      2011
                    
                    $
                    2,128
                    
                    
                    $
                    (653
                    )
                    
                    $
                    1,475Year
      2012
                    
                    $
                    1,475
                    
                    
                    $
                    (757
                    )
                    
                    $
                    718Year
      2013
                    
                    $
                    718
                    
                    
                    $
                    (718
                    )
                    
                    $
                    -





Note
7.  Time Deposit Liabilities





The
following table provides a summary for the maturity of the Bank’s time
certificates of deposit as of December 31, 2008:





Amount Due(dollar amounts in thousands)
                    
                    2009
                    
                    
                    2010
                    
                    
                    2011
                    
                    
                    2012
                    
                    
                    2013
                    
                    
                    TotalTime
      certificates of deposit
                    
                    $
                    140,276
                    
                    
                    $
                    15,909
                    
                    
                    $
                    3,044
                    
                    
                    $
                    587
                    
                    
                    $
                    173
                    
                    
                    $
                    159,989





As of
December 31, 2008 brokered time deposits in the approximate amount of $20.1
million were reflected in the table above.  Of these balances,
approximately $10.0 million will mature in 2009, approximately $7.5 million will
mature in 2010 and approximately $2.5 million will mature in 2011.





Note
8.  Borrowings





The Bank
has several sources from which it may obtain borrowed funds, including two
sources that it considers primary in obtaining secondary funding, Federal Funds
purchased through arrangements it has established with correspondent banks and
advances from the Federal Home Loan Bank.  Borrowing is obtained for a
variety of reasons including daily liquidity needs and balance sheet
growth.  The following provides a summary of the borrowing available
to the Bank and Company as well borrowings that were outstanding as of December
31, 2008:





Federal
Funds Purchased





The Bank
has borrowing lines with correspondent banks totaling $20.0 million as of
December 31, 2008.  As of December 31, 2008 there were no balances
outstanding on these borrowing lines.


80





Federal Home Loan Bank
Advances





As
previously mentioned, the Bank has established borrowing lines with the Federal
Home Loan Bank (“FHLB”).  At December 31, 2008, the Bank had the
following borrowings with the FHLB, the majority of which are collateralized by
loans.





(dollar
amounts in thousands)





Amount
                                                                
                                                                Interest
                                                                MaturityBorrowed
                                                                
                                                                Rate
                                                                
                                                                Variable/Fixed
                                                                Date$
                                                                10,000
                                                                
                                                                
                                                                0.05
                                                                %
                                                                Variable
                                                                Overnight40,000
                                                                
                                                                
                                                                0.08
                                                                %
                                                                Variable
                                                                Overnight10,000
                                                                
                                                                
                                                                2.85
                                                                %
                                                                Fixed
                                                                1/26/0910,000
                                                                
                                                                
                                                                2.60
                                                                %
                                                                Fixed
                                                                2/6/094,000
                                                                
                                                                
                                                                4.93
                                                                %
                                                                Fixed
                                                                2/27/0925,000
                                                                
                                                                
                                                                0.82
                                                                %
                                                                Adjustable
                                                                6/22/0910,000
                                                                
                                                                
                                                                2.89
                                                                %
                                                                Fixed
                                                                9/16/10$
                                                                109,000
                                                                
                                                                
                                                                1.17
                                                                %





At
December 31, 2008 approximately $455.6 million in loans and securities were
pledged as collateral to the FHLB for the borrowings presented in the table
above.  Additionally, the Bank has an $11.4 million letter of credit
with the FHLB secured by loans.  At December 31, 2008, the Bank had a
remaining borrowing capacity with existing collateral of approximately $68.5
million secured by loans and securities.





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.  At
December 31, 2008 and 2007, the Bank had $2.8 million and $1.9 million in
securities sold under agreements to repurchase.  Interest expense
recorded related to these borrowings was $46 thousand, $91 thousand, and $88
thousand for the years ended December 31, 2008, 2007, and 2006,
respectively.  The carrying value of underlying securities provided as
collateral for these transactions was $4.4 million at December 31, 2008 and
2007, respectively.





Notes
Payable





On
October 10, 2007, the Company renewed a revolving line of credit in the amount
of $3.5 million 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 with interest payments
due quarterly.  The line is scheduled to mature on October 10, 2009 at
which time the line converts to an eight-year term loan maturing on October 10,
2017 with principal and interest payments due quarterly.  Under the
terms of the agreement, the Company will not incur any additional debt over $2.0
million 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 our Regulators.  At
December 31, 2008 and 2007, there were no outstanding balances on this
line.





Junior
Subordinated Debentures





On
October 27, 2006 the Company issued $8.2 million of Floating Rate Junior
Subordinated Debt Securities to Heritage Oaks Capital Trust II, a statutory
trust created under the laws of the State of Delaware.  These
debentures are subordinated to effectively all borrowings of the
Company.  The Company used the proceeds from the issuance of these
securities for general corporate purposes, which include among other things,
capital contributions to the Bank, investments, payment of dividends, and
repurchases of our common stock.


81


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





On
September 20, 2007, the Company issued $5.2 million of Junior Subordinated
Deferrable Interest Debentures to Heritage Oaks Capital Trust III (“Trust III”),
a statutory trust created under the laws of the State of
Delaware.  These debentures issued to Trust III are subordinated to
effectively all borrowings of the Company.  The Company used the
proceeds from the sale of the securities to assist in the acquisition of
Business First, for general corporate purposes, and for capital contributions to
the Bank for future growth.





At
December 31, 2008, the Company had a total of $13.4 million in Junior
Subordinated Deferrable Interest Debentures issued and outstanding, issued to
Heritage Oaks Capital Trusts II and III.  The debt securities are
subordinated to effectively all borrowings of the Company and can be redeemed at
par if certain events occur that impact the tax treatment, regulatory treatment
or the capital treatment of the issuance.  Upon the issuance of the
debt securities, the Company purchased a 3.1% minority interest in both Heritage
Oaks Capital Trusts II and III, totaling $248 thousand and $155 thousand,
respectively.  The balance of the equity of Heritage Oaks Capital
Trusts II and III is comprised of mandatory redeemable preferred securities and
is included in other assets.  Interest associated with the securities
issued to Heritage Oaks Capital Trusts II and III is payable quarterly at a
variable rate of 3-month LIBOR plus 1.71% and 6.888% fixed,
respectively.





The
following table provides a summary of the securities the Company has issued to
Heritage Oaks Capital Trusts II and III as of December 31, 2008:





Amount
                                                
                                                
                                                Current
                                                
                                                Issue
                                                Scheduled
                                                Call(dollar amounts in thousands)
                                                
                                                Borrowed
                                                
                                                
                                                Rate
                                                
                                                Date
                                                Maturity
                                                Date
                                                Rate TypeHeritage
      Oaks Capital Trust II
                                                
                                                $
                                                8,248
                                                
                                                
                                                
                                                5.60
                                                %
                                                27-Oct-06
                                                Aug-37
                                                Nov-11
                                                Varibale
      3-month LIBOR + 1.71%Heritage
      Oaks Capital Trust III
                                                
                                                
                                                5,155
                                                
                                                
                                                
                                                6.89
                                                %
                                                20-Sep-07
                                                Sep-37
                                                Dec-12
                                                5-year
      Fixed SWAP + 2.00%Total
      Borrowings
                                                
                                                $
                                                13,403
                                                
                                                
                                                
                                                6.10
                                                %





The
Company has the right under the indentures to defer interest payments for a
period not to exceed twenty consecutive quarterly periods (each an “Extension
Period”) provided that no extension period may extend beyond the maturity of the
debt securities.  If the Company elects to defer interest payments
pursuant to terms of the agreements, then the Company may not (i) declare or pay
any dividends or distributions on, or redeem, purchase, acquire or make a
liquidation payment with respect to any of the Company’s capital stock, or (ii)
make any payment of principal or premium, if any, or interest on or repay,
repurchase or redeem any debt securities of the Company that rank pari passu
with or junior in interest to the Debt Securities, other than, among other
items, a dividend in the form of stock, warrants, options or other rights in the
same stock as that on which the dividend is being paid or ranks pari passu with
or junior to such stock.  The prohibition on payment of dividends and
payments on pari passu or junior debt also applies in the case of an event of
default under the agreements.





Under
FASB Interpretation No. 46, “Consolidation of Variable Interest
Entities, an interpretation of ARB No. 51”(“FIN 46”) the Company is not
allowed to consolidate Heritage Oaks Capital Trusts II and III into the
Company’s financial statements.  Prior to the issuance of FIN 46, Bank
holding companies typically consolidated these entities.  On February
28, 2005, the Federal Reserve Board issued a rule which provides that,
notwithstanding the deconsolidation of such trusts, junior subordinated
debentures, such as those issued by the Company, may continue to constitute up
to 25% of a bank holding company's Tier I capital, subject to certain new
limitations which will not become effective until March 31, 2009 and which, in
any event, are not expected to affect the treatment of the Company's Junior
Subordinated Debentures as Tier I capital for regulatory purposes.  As
of December 31, 2008, the Company has included $13.0 million of the net junior
subordinated debt in its Tier I Capital for regulatory capital
purposes.





At
December 31, 2008, the Company had sufficient cash to service interest payments
on the $13.4 million in junior subordinated debentures for approximately seven
quarters without dividends from subsidiaries.  The Bank’s capacity to
provide cash to the Company, while remaining “well-capitalized”, was
approximately $2.2 million at December 31, 2008.


82


Note
9.  Income Taxes





The
Company is subject to income taxation by both federal and state taxing
authorities.  Our federal income tax returns for the years ended
December 31, 2007, 2006 and 2005 are open to audit by the federal authorities
and our California state tax returns for the years ended December 31, 2007,
2006, 2005 and 2004 are open to audit by state authorities.




The
Company’s income tax provision differed from the amounts computed using the
federal statutory tax rate of 34 percent.  The following table
provides a summary for the computation of the Company’s income tax provision for
the years ended December 31, 2008, 2007 and 2006:





2008
                                      
                                      
                                      2007
                                      
                                      
                                      2006(dollar amounts in thousands)
                                      
                                      Amount
                                      
                                      
                                      Percent
                                      
                                      
                                      Amount
                                      
                                      
                                      Percent
                                      
                                      
                                      Amount
                                      
                                      
                                      PercentTax
      provision at federal statutory tax rate
                                      
                                      $
                                      728
                                      
                                      
                                      
                                      34.0
                                      
                                      
                                      $
                                      3,809
                                      
                                      
                                      
                                      34.0
                                      
                                      
                                      $
                                      3,554
                                      
                                      
                                      
                                      34.0State
      income taxes, net of federal income tax benefit
                                      
                                      
                                      134
                                      
                                      
                                      
                                      6.3
                                      
                                      
                                      
                                      777
                                      
                                      
                                      
                                      6.9
                                      
                                      
                                      
                                      698
                                      
                                      
                                      
                                      6.7Bank
      owned life insurance
                                      
                                      
                                      (139
                                      )
                                      
                                      
                                      (13.2
                                      )
                                      
                                      
                                      (217
                                      )
                                      
                                      
                                      (1.9
                                      )
                                      
                                      
                                      (221
                                      )
                                      
                                      
                                      (2.1
                                      )Tax
      exempt income, net of interest expense
                                      
                                      
                                      (282
                                      )
                                      
                                      
                                      (6.5
                                      )
                                      
                                      
                                      (129
                                      )
                                      
                                      
                                      (1.2
                                      )
                                      
                                      
                                      (117
                                      )
                                      
                                      
                                      (1.2
                                      )Other,
      net
                                      
                                      
                                      56
                                      
                                      
                                      
                                      2.6
                                      
                                      
                                      
                                      47
                                      
                                      
                                      
                                      0.5
                                      
                                      
                                      
                                      (123
                                      )
                                      
                                      
                                      (1.1
                                      )Total
      tax provision
                                      
                                      $
                                      497
                                      
                                      
                                      
                                      23.2
                                      
                                      
                                      $
                                      4,287
                                      
                                      
                                      
                                      38.3
                                      
                                      
                                      $
                                      3,791
                                      
                                      
                                      
                                      36.3





The
following table provides a summary for the current and deferred amounts of the
Company’s income tax provision (benefit) for the years ended December 31, 2008,
2007, and 2006:





(dollar amounts in thousands)
                                
                                2008
                                
                                
                                2007
                                
                                
                                2006Federal
      income tax:Current
                                
                                $
                                1,405
                                
                                
                                $
                                5,540
                                
                                
                                $
                                2,924Deferred
                                
                                
                                (1,111
                                )
                                
                                
                                (2,430
                                )
                                
                                
                                (191
                                )Total
      federal taxes
                                
                                
                                294
                                
                                
                                
                                3,110
                                
                                
                                
                                2,733State
      franchise tax:Current
                                
                                
                                618
                                
                                
                                
                                1,699
                                
                                
                                
                                1,087Deferred
                                
                                
                                (415
                                )
                                
                                
                                (522
                                )
                                
                                
                                (29
                                )Total
      state franchise tax
                                
                                
                                203
                                
                                
                                
                                1,177
                                
                                
                                
                                1,058Total
      income taxes
                                
                                $
                                497
                                
                                
                                $
                                4,287
                                
                                
                                $
                                3,791





The
following table provides a summary for the significant components of the
Company’s net deferred tax asset as of December 31, 2008 and 2007:





December 31,(dollar amounts in thousands)
                                      
                                      2008
                                      
                                      
                                      2007Deferred
      tax assets:Reserves
      for loan losses
                                      
                                      $
                                      4,251
                                      
                                      
                                      $
                                      2,470Fixed
      assets
                                      
                                      
                                      54
                                      
                                      
                                      
                                      35Accruals
                                      
                                      
                                      714
                                      
                                      
                                      
                                      686Alternative
      minimum tax credit
                                      
                                      
                                      -
                                      
                                      
                                      
                                      21Deferred
      income
                                      
                                      
                                      2,460
                                      
                                      
                                      
                                      2,501Deferred
      compensation
                                      
                                      
                                      1,332
                                      
                                      
                                      
                                      1,031Net
      operating loss carryforward
                                      
                                      
                                      237
                                      
                                      
                                      
                                      743Investment
      securities valuation
                                      
                                      
                                      763
                                      
                                      
                                      
                                      -Contribution
      carryforward
                                      
                                      
                                      -
                                      
                                      
                                      
                                      49Total
      deferred tax assets
                                      
                                      
                                      9,811
                                      
                                      
                                      
                                      7,536Deferred
      tax liabilities:Fair
      value adjustment for purchased assets
                                      
                                      
                                      1,073
                                      
                                      
                                      
                                      1,242Investment
      securities valuation
                                      
                                      
                                      -
                                      
                                      
                                      
                                      129Deferred
      costs, prepaids and FHLB advances
                                      
                                      
                                      1,030
                                      
                                      
                                      
                                      875Total
      deferred tax liabilities
                                      
                                      
                                      2,103
                                      
                                      
                                      
                                      2,246Net
      deferred tax assets
                                      
                                      $
                                      7,708
                                      
                                      
                                      $
                                      5,290





As part
of the bank acquisitions in 2003 and 2007, the Company has approximately $1.9
million and $1.3 million of net operating losses (“NOL”) available for
carry-forward for federal and state tax purposes, respectively, at December 31,
2008.  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 and state tax purposes will expire in various
years through 2025 and 2015, respectively.


83





As part
of the Company’s analysis for the potential impact FIN 48 might have on its
financial condition, results of operations and cash flows, it was concluded that
a previous position taken on the Company’s 2004 and 2005 tax returns in regard
to deferred loan fees could not be supported and as a result amended returns
were filed for those periods.  For income tax purposes, both Federal
and Franchise, this was a “timing” issue and did not flow through the income
statement. The balance sheet was impacted to the extent that current taxes
payable was increased and offset by a deferred tax asset in the same
amount.  The 2004 and 2005 amended tax returns were filed in June
2007.  Although no penalties were paid, the Company did pay
approximately $96 thousand in interest directly related to the 2004 and 2005
amended returns during the year ended December 31, 2007.





Note
10.  Commitments and Contingencies





The
Company is involved in various litigations from time to time.  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.





Commitments
to Extend Credit





In the
normal course of business, the Bank enters into financial commitments to meet
the financing needs of our 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.





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 and the amount of collateral obtained, if deemed necessary
by the Bank, is based on Management's credit evaluation of the
customer.





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 is done for loans reflected in the consolidated
financial statements.





As of
December 31, 2008 and 2007, the Bank had the following outstanding financial
commitments whose contractual amount represents credit risk:





December 31,(dollar amounts in thousands)
                                  
                                  2008
                                  
                                  
                                  2007Commitments
      to extend credit
                                  
                                  $
                                  210,058
                                  
                                  
                                  $
                                  245,894Standby
      letters of credit
                                  
                                  
                                  18,451
                                  
                                  
                                  
                                  16,629Total
      commitments and standby letters of credit
                                  
                                  $
                                  228,509
                                  
                                  
                                  $
                                  262,523





Other
Commitments





The
following table provides a summary of the future minimum lease payments the Bank
is expected to make based upon obligations at December 31, 2008:





Due
                
                
                Due
                
                
                Due
                
                
                Due
                
                
                Due
                
                
                Due More(dollar amounts in thousands)
                
                2009
                
                
                2010
                
                
                2011
                
                
                2012
                
                
                2013
                
                
                Than 5 Years
                
                
                TotalNon-cancelable
      operating leases
                
                $
                2,150
                
                
                $
                2,074
                
                
                $
                1,731
                
                
                $
                1,394
                
                
                $
                1,115
                
                
                $
                7,837
                
                
                $
                16,301


84





The
Company has leases that contain options to extend for periods from five to
twenty years.  Options to extend which have been exercised and the
related lease commitments are included in the table above.  Total rent
expense charged for leases during the reporting periods ended December 31, 2008,
2007, and 2006, were approximately $2.3 million, $1.4 million, and $0.6 million,
respectively.  Increases associated with lease expenditures can be
attributed to the sale lease-back transaction the Bank entered into during the
second quarter of 2007, as more fully discussed in Note 5 of these Consolidated
Financial Statements, branch expansion, and the acquisition of Business First
National Bank.





At
December 31, 2008, the Company had four subleases in place, two of which are for
additional space within existing branch offices and two are for an entire
facility that was vacated as the result of consolidation from the 2003 Hacienda
Bank acquisition.  These subleases are for various terms and accounted
for an approximate $230 thousand credit to rental expense during
2008.  The Company expects to receive sublease revenue for 2009 and
2010 of approximately $119 thousand and $65 thousand, respectively.





Note
11.  Regulatory Matters





The
Company (on a consolidated basis) and the Bank are 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 I capital (as defined in the regulations) to
risk-weighted assets (as defined) and of Tier I capital (as defined) to average
assets (as defined).  Management believes, as of December 31, 2008,
the Company and the Bank meet all capital adequacy requirements to which it is
subject.





As of the
most recent notification, the Federal Deposit Insurance Corporation (“FDIC”)
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 would otherwise change the Bank's
categorization.  To be categorized as well-capitalized, the Bank must
maintain minimum capital ratios as set forth in the table
below.


85


The
following table also sets forth the Company’s and the Bank’s actual regulatory
capital amounts and ratios as of December 31, 2008 and 2007:





Capital NeededTo Be Well CapitalizedCapital Needed For
                                      
                                      
                                      Under Prompt CorrectiveActual
                                      
                                      
                                      Adequacy Purposes
                                      
                                      
                                      Action ProvisionsCapital
                                      
                                      
                                      
                                      
                                      
                                      Capital
                                      
                                      
                                      
                                      
                                      
                                      Capital(dollar amounts in thousands)
                                      
                                      Amount
                                      
                                      
                                      Ratio
                                      
                                      
                                      Amount
                                      
                                      
                                      Ratio
                                      
                                      
                                      Amount
                                      
                                      
                                      RatioAs
      of December 31, 2008Total
      capital to risk-weighted assets:Company
                                      
                                      $
                                      78,660
                                      
                                      
                                      
                                      10.62
                                      %
                                      
                                      $
                                      59,251
                                      
                                      
                                      
                                      8.0
                                      %
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      N/AHeritage
      Oaks Bank
                                      
                                      $
                                      76,628
                                      
                                      
                                      
                                      10.36
                                      %
                                      
                                      $
                                      59,192
                                      
                                      
                                      
                                      8.0
                                      %
                                      
                                      $
                                      73,990
                                      
                                      
                                      
                                      10.0
                                      %Tier
      I capital to risk-weighted assets:Company
                                      
                                      $
                                      69,385
                                      
                                      
                                      
                                      9.37
                                      %
                                      
                                      $
                                      29,625
                                      
                                      
                                      
                                      4.0
                                      %
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      N/AHeritage
      Oaks Bank
                                      
                                      $
                                      67,362
                                      
                                      
                                      
                                      9.10
                                      %
                                      
                                      $
                                      29,596
                                      
                                      
                                      
                                      4.0
                                      %
                                      
                                      $
                                      44,394
                                      
                                      
                                      
                                      6.0
                                      %Tier
      I capital to average assets:Company
                                      
                                      $
                                      69,385
                                      
                                      
                                      
                                      8.90
                                      %
                                      
                                      $
                                      31,186
                                      
                                      
                                      
                                      4.0
                                      %
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      N/AHeritage
      Oaks Bank
                                      
                                      $
                                      67,362
                                      
                                      
                                      
                                      8.66
                                      %
                                      
                                      $
                                      31,115
                                      
                                      
                                      
                                      4.0
                                      %
                                      
                                      $
                                      38,893
                                      
                                      
                                      
                                      5.0
                                      %As
      of December 31, 2007Total
      capital to risk-weighted assets:Company
                                      
                                      $
                                      72,963
                                      
                                      
                                      
                                      11.04
                                      %
                                      
                                      $
                                      52,868
                                      
                                      
                                      
                                      8.0
                                      %
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      N/AHeritage
      Oaks Bank
                                      
                                      $
                                      68,563
                                      
                                      
                                      
                                      10.40
                                      %
                                      
                                      $
                                      52,765
                                      
                                      
                                      
                                      8.0
                                      %
                                      
                                      $
                                      65,956
                                      
                                      
                                      
                                      10.0
                                      %Tier
      I capital to risk-weighted assets:Company
                                      
                                      $
                                      66,599
                                      
                                      
                                      
                                      10.08
                                      %
                                      
                                      $
                                      26,434
                                      
                                      
                                      
                                      4.0
                                      %
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      N/AHeritage
      Oaks Bank
                                      
                                      $
                                      62,199
                                      
                                      
                                      
                                      9.43
                                      %
                                      
                                      $
                                      26,382
                                      
                                      
                                      
                                      4.0
                                      %
                                      
                                      $
                                      39,573
                                      
                                      
                                      
                                      6.0
                                      %Tier
      I capital to average assets:Company
                                      
                                      $
                                      66,599
                                      
                                      
                                      
                                      9.60
                                      %
                                      
                                      $
                                      27,761
                                      
                                      
                                      
                                      4.0
                                      %
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      N/AHeritage
      Oaks Bank
                                      
                                      $
                                      62,199
                                      
                                      
                                      
                                      9.02
                                      %
                                      
                                      $
                                      27,595
                                      
                                      
                                      
                                      4.0
                                      %
                                      
                                      $
                                      34,494
                                      
                                      
                                      
                                      5.0
                                      %





As
disclosed in Note 8. Borrowings, the proceeds from the issuance of Junior
Subordinated Debentures, subject to percentage limitations, are considered Tier
I capital by the Company for regulatory reporting purposes.  At
December 31, 2008 and 2007, the Company included $13.0 million of proceeds from
the issuance of the debt securities in its Tier I capital.





Note
12.  Salary Continuation Plan





The
Company established salary continuation agreements with the President and Chief
Executive Officer, Chief Financial Officer, Chief Lending Officer, Chief
Administrative Officer and certain Executive and 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.  At December 31, 2008 and 2007, the present value of
the Company’s liability under these Agreements was approximately $2.4 million
and $2.0 million, respectively, and is included in other liabilities in the
Company’s Consolidated Financial Statements.  For the years ended
December 31, 2008, 2007 and 2006, expenses associated with the Company’s salary
continuation plans were approximately $425 thousand, $373 thousand and $367
thousand, respectively.  The Company maintains life insurance
policies, which are intended to fund all costs associated with the
agreements.  The cash surrender values of these life insurance
policies totaled approximately $10.7 million and $9.9 million, at December 31,
2008 and 2007, respectively.


86




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 the Company incurred associated with the plan were
approximately $209 thousand, $168 thousand, and $148 thousand, for the years
ended December 31, 2008, 2007, and 2006, 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
Company’s annual contribution to the ESOP is at the discretion of the Board of
Directors.  The contributions made to this plan for the years ended
December 31, 2007 and 2006 were approximately $200 thousand, and $364 thousand,
respectively.  The Company made no contributions to the plan during
2008.





Note
14.  Share-Based Compensation Plans





At
December 31, 2008, the Company had two stock option plans, which are described
below:





The
“2005 Equity Based Compensation Plan”





The 2005
Equity Based Compensation 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.  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.  As of December 31, 2008, the
maximum number of shares that were available for issuance from the 2005 Plan was
516,294.





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





The
majority of options granted under the 2005 Plan represent fully vested
substitute options granted by the Company to Business First option holders upon
the acquisition.  All other option grants under the 2005 Plan were
made to various members of the Company’s Board of Directors and employees of the
Bank and vest at a rate of 33 1/3% per year for three years.  Options
granted under the 2005 Plan typically possess a term of ten years.





In the
event of a change in control in which the Company is not the surviving entity,
all awards granted under the 2005 Plan shall immediately vest and or become
immediately exercisable, except as otherwise determined at the time of grant of
the award and specified in the award agreement or unless the survivor
corporation, or the purchaser of assets of the Company agrees to assume the
obligations of the Company with respect to all outstanding awards or to
substitute such awards with equivalent awards with respect to the common stock
of the successor.


87


The
“1997 Stock Option Plan”
 
 The 1997
Stock Option Plan 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 equal to the fair market value of the Company’s stock 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 grant
date.  However, on May 26, 2005, the stockholders of the Company
approved the 2005 Plan, discussed in the preceding paragraph, which stipulates
no further grants will be made from the 1997 Stock Option Plan.
 
 Restricted
Stock Awards
 
 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 “cliff” vest in five years.
 
 The
following tables summarize activity with respect to restricted share-based
compensation for the years ended December 31, 2008 and 2007:
  Average GrantShares
                          
                          
                          Date Fair ValueBalance
      December 31, 2006
                          
                          
                          69,353
                          
                          
                          $
                          18.10Granted
                          
                          
                          1,575
                          
                          
                          $
                          16.36Vested
                          
                          
                          -
                          
                          
                          $
                          -Forfeited/expired
                          
                          
                          (1,313
                          )
                          
                          $
                          18.29Balance
      December 31, 2007
                          
                          
                          69,615
                          
                          
                          $
                          18.05Granted
                          
                          
                          1,050
                          
                          
                          $
                          12.14Vested
                          
                          
                          -
                          
                          
                          $
                          -Forfeited/expired
                          
                          
                          (6,904
                          )
                          
                          $
                          18.24Balance
      December 31, 2008
                          
                          
                          63,761
                          
                          
                          $
                          17.93
  The
compensation cost related to restricted stock that has been charged against
income (included in salaries and employee benefits) was $180 thousand, $247
thousand and $223 thousand for the years ended December 31, 2008, 2007 and 2006,
respectively.  The total income tax benefit recognized related to
restricted stock compensation was $74 thousand, $101 thousand, and $91 thousand
for the years ended December 31, 2008, 2007 and 2006.  No restricted
shares vested during 2008, 2007 and 2006.  At December 31, 2008, there
was $493 thousand of total unrecognized compensation cost related to non-vested
restricted stock which is expected to be recognized over a weighted average
period of 2.19 years.
  88
 
 Stock
Options
 
 The
following table provides a summary of information related to the Company’s stock
option awards for the years ended December 31, 2008, 2007 and 2006:
 
 Average
                                                                
                                                                
                                                                
                                                                
                                                                
                                                                Options
                                                                
                                                                
                                                                AverageExercise
                                                                
                                                                
                                                                Options
                                                                
                                                                
                                                                Available for
                                                                
                                                                
                                                                Fair ValueShares
                                                                
                                                                
                                                                Price
                                                                
                                                                
                                                                Exercisable
                                                                
                                                                
                                                                Grant
                                                                
                                                                
                                                                Options GrantedBalance
      at December 31, 2005
                                                                
                                                                
                                                                552,206
                                                                
                                                                
                                                                $
                                                                4.94
                                                                
                                                                
                                                                
                                                                454,058
                                                                
                                                                
                                                                
                                                                642,282
                                                                
                                                                
                                                                $
                                                                2.56Granted
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                $
                                                                -Forfeited
                                                                
                                                                
                                                                (2,864
                                                                )
                                                                
                                                                $
                                                                7.67Exercised
                                                                
                                                                
                                                                (91,978
                                                                )
                                                                
                                                                $
                                                                3.76Balance
      at December 31, 2006
                                                                
                                                                
                                                                457,364
                                                                
                                                                
                                                                $
                                                                5.16
                                                                
                                                                
                                                                
                                                                390,249
                                                                
                                                                
                                                                
                                                                596,939
                                                                
                                                                
                                                                $
                                                                2.57Granted
                                                                
                                                                
                                                                147,886
                                                                
                                                                
                                                                $
                                                                13.03Forfeited
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                $
                                                                -Exercised
                                                                
                                                                
                                                                (142,090
                                                                )
                                                                
                                                                $
                                                                2.93Balance
      at December 31, 2007
                                                                
                                                                
                                                                463,160
                                                                
                                                                
                                                                $
                                                                8.36
                                                                
                                                                
                                                                
                                                                379,848
                                                                
                                                                
                                                                
                                                                454,472
                                                                
                                                                
                                                                $
                                                                4.19Granted
                                                                
                                                                
                                                                29,150
                                                                
                                                                
                                                                $
                                                                10.97Forfeited
                                                                
                                                                
                                                                (7,910
                                                                )
                                                                
                                                                $
                                                                8.20Expired
                                                                
                                                                
                                                                (2
                                                                )
                                                                
                                                                $
                                                                4.42Exercised
                                                                
                                                                
                                                                (75,568
                                                                )
                                                                
                                                                $
                                                                4.05Balance
      at December 31, 2008
                                                                
                                                                
                                                                408,830
                                                                
                                                                
                                                                $
                                                                9.34
                                                                
                                                                
                                                                
                                                                331,742
                                                                
                                                                
                                                                
                                                                516,294
                                                                
                                                                
                                                                $
                                                                4.64
  The total
intrinsic value (the amount by which the stock price exceeded the exercise price
on the date of exercise) of options exercised in all plans during the three
years ended 2008, 2007 and 2006 was $0.3 million, $1.1 million and $0.9 million,
respectively.  The intrinsic value of options outstanding in all plans
at December 31, 2007 and 2006 was approximately $1.8 million and $5.4
million.  There was no intrinsic value for options outstanding as of
December 31, 2008.  The total intrinsic value of options exercisable
in all plans at December 31, 2007 and 2006 was approximately $1.8 million and
$5.0 million, respectively.  Given that the weighted average exercise
price of exercisable options was higher than the Company’s stock price at
December 31, 2008, there was substantially no intrinsic value for options
exercisable.   The Company received income tax benefits of $115,
$446 and $365 for the years ended December 31, 2008, 2007 and 2006,
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. 123(R), 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. 123(R)
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 at December 31, 2008 was
$115.
  89
 
 Share-Based
Compensation Expense
 
 The
following table provides a summary of the expense the Company has recognized
related to share-based compensation awards as a result of the Company’s January
1, 2006 adoption of SFAS No. 123(R).  The table below also shows the
impact those expenses have had on diluted earnings per share and the remaining
expense associated with those awards as of and for the years ended December 31,
2008, 2007 and 2006:
 
 (dollar
      amounts in thousands)
                                                            
                                                            2008
                                                            
                                                            
                                                            2007
                                                            
                                                            
                                                            2006Share-based
      compensation expense:Stock
      option expense
                                                            
                                                            $
                                                            202
                                                            
                                                            
                                                            $
                                                            114
                                                            
                                                            
                                                            $
                                                            113Restricted
      stock expense
                                                            
                                                            
                                                            181
                                                            
                                                            
                                                            
                                                            247
                                                            
                                                            
                                                            
                                                            223Total
      share-based compensation expense
                                                            
                                                            $
                                                            383
                                                            
                                                            
                                                            $
                                                            361
                                                            
                                                            
                                                            $
                                                            336Total
      share-based compensation expense, net of tax
                                                            
                                                            
                                                            256
                                                            
                                                            
                                                            $
                                                            246
                                                            
                                                            
                                                            $
                                                            198Diluted
      shares outstanding
                                                            
                                                            
                                                            7,753,013
                                                            
                                                            
                                                            
                                                            7,228,804
                                                            
                                                            
                                                            
                                                            6,925,582Impact
      on diluted earnings per share
                                                            
                                                            $
                                                            0.033
                                                            
                                                            
                                                            $
                                                            0.034
                                                            
                                                            
                                                            $
                                                            0.029Unrecognized
      compensation expense:Stock
      option expense
                                                            
                                                            $
                                                            277
                                                            
                                                            
                                                            $
                                                            364
                                                            
                                                            
                                                            $
                                                            227Restricted
      stock expense
                                                            
                                                            
                                                            493
                                                            
                                                            
                                                            
                                                            787
                                                            
                                                            
                                                            
                                                            1,038Total
      unrecognized share-based compensation expense
                                                            
                                                            $
                                                            770
                                                            
                                                            
                                                            $
                                                            1,151
                                                            
                                                            
                                                            $
                                                            1,265Total
      unrecognized share-based compensation expense, net of tax
                                                            
                                                            $
                                                            469
                                                            
                                                            
                                                            $
                                                            719
                                                            
                                                            
                                                            $
                                                            819
  As of
December 31, 2008, there was a total of approximately $277 thousand of
unrecognized compensation cost related to non-vested stock options which is
expected to be recognized over a weighted average period of 1.90
years.
 
 The
following table presents the assumptions used in the calculation of the weighted
average fair value of options granted at various dates during 2008 and 2007
using the Black-Scholes option pricing model:
 
 2008
                                    
                                    
                                    2007Expected
      volatility
                                    
                                    
                                    35.50
                                    %
                                    
                                    
                                    34.32
                                    %Expected
      term (years)
                                    
                                    
                                    10
                                    
                                    
                                    
                                    10Dividend
      yield
                                    
                                    
                                    2.40
                                    %
                                    
                                    
                                    2.00
                                    %Risk
      free rate
                                    
                                    
                                    3.53
                                    %
                                    
                                    
                                    4.36
                                    %Weighted-average
      grant date fair value
                                    
                                    $
                                    3.88
                                    
                                    
                                    $
                                    6.00
 
 The table
above presents the assumptions used to estimate the fair value of stock options
granted on the date of grant using the Black-Scholes pricing
model.  The Black-Scholes model incorporates a range of assumptions
for inputs that are disclosed in the table above.  Expected
volatilities are based on the daily historical stock price over the expected
life of the option.  The expected term of options granted is derived
from the output of the model and represents the period of time that options
granted are expected to be outstanding.  Dividend yields are estimated
based the dividend yield on the Company’s common stock at the time of
grant.  The risk-free rate for periods within the contractual life of
the stock option is based on the U.S. Treasury yield curve in effect at the time
of grant.
 
 Estimates
of fair value derived from the Company’s use of the Black-Scholes pricing model
are theoretical values for stock options and changes in the assumptions used in
the models could result in different fair value estimates.  The actual
value of the stock options granted will depend on the market value of the
Company’s common stock when the options are exercised.
 
 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.
  90
 
 The
following table sets forth loans made to directors and executive officers of the
Company as of December 31, 2008 and 2007:
 
 For the Years Ended December 31,(dollar amounts in thousands)
                                              
                                              2008
                                              
                                              
                                              2007Outstanding
      balance, beginning of year
                                              
                                              $
                                              18,308
                                              
                                              
                                              $
                                              15,478Business
      First, at date of acquisition
                                              
                                              
                                              -
                                              
                                              
                                              
                                              2,708Additional
      loans made
                                              
                                              
                                              15,994
                                              
                                              
                                              
                                              4,657Repayments
                                              
                                              
                                              (5,842
                                              )
                                              
                                              
                                              (4,535
                                              )Outstanding
      balance, end of year
                                              
                                              $
                                              28,460
                                              
                                              
                                              $
                                              18,308
  Deposits
from related parties held by the Bank at December 31, 2008 and 2007 amounted to
approximately $3.7 million and $8.7 million, 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.
 
 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.
  91
 
 The
estimated fair value of financial instruments at December 31, 2008 and 2007 is
summarized as follows:
 
 2008
                                
                                
                                2007Carrying
                                
                                
                                
                                
                                
                                Carrying(dollar amounts in thousands)
                                
                                Amount
                                
                                
                                Fair Value
                                
                                
                                Amount
                                
                                
                                Fair ValueAssetsCash
      and cash equivalents
                                
                                $
                                24,571
                                
                                
                                $
                                24,571
                                
                                
                                $
                                46,419
                                
                                
                                $
                                46,419Interest-bearing
      deposits
                                
                                
                                119
                                
                                
                                
                                119
                                
                                
                                
                                330
                                
                                
                                
                                330Investments
      and mortgage-backed securities
                                
                                
                                50,762
                                
                                
                                
                                50,762
                                
                                
                                
                                47,556
                                
                                
                                
                                47,556Federal
      Home Loan Bank and Federal Reserve Bank stock
                                
                                
                                5,123
                                
                                
                                
                                5,123
                                
                                
                                
                                3,045
                                
                                
                                
                                3,045Loans
      receivable, net of deferred fees and costs
                                
                                
                                678,446
                                
                                
                                
                                692,767
                                
                                
                                
                                611,485
                                
                                
                                
                                615,533Loans
      held for sale
                                
                                
                                7,939
                                
                                
                                
                                7,939
                                
                                
                                
                                902
                                
                                
                                
                                902Bank
      owned life insurance
                                
                                
                                10,737
                                
                                
                                
                                10,737
                                
                                
                                
                                9,923
                                
                                
                                
                                9,923Accrued
      interest receivable
                                
                                
                                3,053
                                
                                
                                
                                3,053
                                
                                
                                
                                2,671
                                
                                
                                
                                2,671LiabilitiesNon-interest-bearing
      deposits
                                
                                
                                147,044
                                
                                
                                
                                147,044
                                
                                
                                
                                153,684
                                
                                
                                
                                153,684Interest-bearing
      deposits
                                
                                
                                456,477
                                
                                
                                
                                457,760
                                
                                
                                
                                491,124
                                
                                
                                
                                495,511Federal
      Home Loan Bank advances
                                
                                
                                109,000
                                
                                
                                
                                109,373
                                
                                
                                
                                8,000
                                
                                
                                
                                8,159Securities
      sold under repurchase agreements
                                
                                
                                2,796
                                
                                
                                
                                2,796
                                
                                
                                
                                1,936
                                
                                
                                
                                1,936Junior
      subordinated debentures
                                
                                
                                13,403
                                
                                
                                
                                13,352
                                
                                
                                
                                13,403
                                
                                
                                
                                13,328Accrued
      interest payable
                                
                                
                                688
                                
                                
                                
                                688
                                
                                
                                
                                667
                                
                                
                                
                                667
 
 Notional
                          
                          
                          Cost to Cede
                          
                          Notional
                          
                          
                          Cost to CedeAmount
                          
                          
                          or Assume
                          
                          Amount
                          
                          
                          or AssumeOff-balance
      sheet instruments, commitments to extend creditand
      standby letters of credit
                          
                          $
                          228,509
                          
                          
                          $
                          2,285
                          
                          
                          $
                          262,523
                          
                          
                          $
                          2,625
  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
 
 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.
 
 ·
              Investments Including FHLB
      Stock, FRB Stock and Mortgage-Backed
  Securities
 
 Fair
values are based upon quoted market prices, where available. If quoted market
prices are not available, fair values are extrapolated from the quoted prices of
similar instruments or through the use of other observable data supporting a
valuation model.
 
 ·
              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.
  92
  ·
              Bank Owned Life
      Insurance
 
 Fair
values are based on current cash surrender values at each reporting date
provided by the underlying insurers.
 
 ·
              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 contractual cash
flows at current market interest rates for similar instruments.
 
 ·
              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.
 
 Note
18.  Fair Value Disclosures
 
 Effective
January 1, 2008, the Company determines the fair market values of certain
financial instruments based on the fair value hierarchy established in SFAS No.
157,“Fair Value
Measurements,” which requires an entity to maximize the use of observable
inputs and minimize the use of unobservable inputs when measuring fair value.
The standard describes three levels of inputs that may be used to measure fair
value.
 
 The
following provides a summary of the hierarchical levels, as defined by SFAS No.
157, used to measure fair value:
 
 Level 1 -
Quoted prices in active markets for identical assets or liabilities that the
reporting entity has the ability to access at the measurement date. Level 1
assets and liabilities may include debt and equity securities that are traded in
an active exchange market and that are highly liquid and are actively traded in
over-the-counter markets.
 
 Level 2 -
Observable inputs other than Level 1 prices, such as quoted prices for similar
assets or liabilities; quoted prices in markets that are not active; or other
inputs that are observable or can be corroborated by observable market data for
substantially the full term of the assets or liabilities. Level 2 assets and
liabilities may include debt securities with quoted prices that are traded less
frequently than exchange-traded instruments and other instruments whose value is
determined using a pricing model with inputs that are observable in the market
or can be derived principally from or corroborated by observable market data.
This category generally includes U.S. Government and agency mortgage-backed debt
securities, corporate debt securities, derivative contracts, residential
mortgage and loans held-for-sale.
  93
 
 Level 3 -
Unobservable inputs that are supported by little or no market activity and that
are significant to the fair value of the assets or liabilities. Level 3 assets
and liabilities include financial instruments whose value is determined using
pricing models, discounted cash flow methodologies, or similar techniques, as
well as instruments for which the determination of fair value requires
significant management judgment or estimation. This category generally includes
certain private equity investments, retained residual interests in
securitizations, residential MSRs, asset-backed securities (ABS), highly
structured or long-term derivative contracts and certain collateralized debt
obligations (CDO) where independent pricing information was not able to be
obtained for a significant portion of the underlying assets.
 
 Fair
Value Measurements
 
 The
Company used the following methods and significant assumptions to estimate fair
value:
 
 ·
                Securities
 
 The fair
value of securities available-for-sale are determined by obtaining quoted prices
on nationally recognized exchanges or matrix pricing which is a mathematical
technique used widely in the industry to value debt securities without relying
exclusively on quoted prices for the specific securities but rather relying on
the security’s relationship to other benchmark quoted securities.
 
 ·
                Loans Held For
      Sale
 
 The fair
value of loans held for sale is determined, when possible, using quoted
secondary market prices. If no such quoted price exists, the fair value of the
loan is determined using quoted prices for a similar asset or assets, adjusted
for the specific attributes of that loan.
 
 ·
                Impaired
      Loans
 
 A loan is
considered impaired when it is probable that payment of interest and principal
will not be made in accordance with the contractual terms of the loan
agreement.  Impairment is measured based on the fair value of the
underlying collateral or the discounted expected future cash
flows.  The Company measures impairment on all non-accrual loans for
which it has established specific reserves as part of the specific allocated
allowance component of the allowance for loan losses.  As such, the
Company records impaired loans as non-recurring Level 2 when the fair value of
the underlying collateral is based on an observable market price or current
appraised value.  When current market prices are not available or the
Company determines that the fair value of the underlying collateral is further
impaired below appraised values, the Company records impaired loans as
non-recurring Level 3.  At December 31, 2008, substantially all of the
Company’s impaired loans were evaluated based on the fair value of their
underlying collateral based upon the most recent appraisal available to
Management.
 
 ·
                Other Real Estate Owned and
      Foreclosed Collateral
 
 Other
real estate owned and foreclosed collateral are adjusted to fair value, less any
estimated costs to sell, at the time the loans are transferred into this
category.  The fair value of these assets is based on independent
appraisals, observable market prices for similar assets, or Management’s
estimation of value.  When the fair value is based on independent
appraisals or observable market prices for similar assets, the Company records
other real estate owned or foreclosed collateral as non-recurring Level
2.  When appraised values are not available, there is no observable
market price for similar assets, or Management determines the fair value of the
asset is further impaired below appraised values or observable market prices,
the Company records other real estate owned or foreclosed collateral as
non-recurring Level 3.
  94
  The
following table provides a summary of the financial instruments the Company
measures at fair value on a recurring basis as of December 31,
2008:
 
 Fair Value Measurements Using
                            
                            
                            Assets At(dollar amounts in thousands)
                            
                            Level 1
                            
                            
                            Level 2
                            
                            
                            Level 3
                            
                            
                            Fair ValueAssets:Available
      for sale investment securities
                            
                            $
                            -
                            
                            
                            $
                            49,988
                            
                            
                            $
                            774
                            
                            
                            $
                            50,762Total
      assets measured on a recurring basis
                            
                            $
                            -
                            
                            
                            $
                            49,988
                            
                            
                            $
                            774
                            
                            
                            $
                            50,762
 
 The
following table provides a summary of the changes in balance sheet carrying
values associated with Level 3 financial instruments during the twelve months
ended December 31, 2008:
 
 Available ForSale Investment(dollar amounts in thousands)
                          
                          SecuritiesBeginning
      balance
                          
                          $
                          712Total
      gains or losses (realized / unrealized)(1):Included
      in earnings
                          
                          
                          -Included
      in other comprehensive income
                          
                          
                          62Purchases
                          
                          
                          -Transfers
      in and/or out of Level 3
                          
                          
                          -Non-trading
      activity
                          
                          
                          -Ending
      balance
                          
                          $
                          774
 (1)
Realized or unrealized gains from the changes in values of Level 3 financial
instruments represent gains from changes in values of financial instruments only
for the period(s) in which the instruments were classified as Level
3.
 
 The
assets presented under level 3 of the fair value hierarchy described in SFAS No.
157 represent available for sale investment securities in the form of
certificates of participation where an active market for such securities is not
currently available.
 
 The
following table provides a summary of the financial instruments the Company
measures at fair value on a non-recurring basis as of December 31,
2008:
 
 Fair Value Measurements Using
                            
                            
                            Assets At(dollar amounts in thousands)
                            
                            Level 1
                            
                            
                            Level 2
                            
                            
                            Level 3
                            
                            
                            Fair ValueAssets:Impaired
      loans
                            
                            $
                            -
                            
                            
                            $
                            18,121
                            
                            
                            $
                            -
                            
                            
                            $
                            18,121Loans
      held for sale
                            
                            
                            -
                            
                            
                            
                            7,939
                            
                            
                            
                            -
                            
                            
                            
                            7,939Other
      real estate owned
                            
                            
                            -
                            
                            
                            
                            1,337
                            
                            
                            
                            -
                            
                            
                            
                            1,337Total
      assets measured on a non-recurring basis
                            
                            $
                            -
                            
                            
                            $
                            27,397
                            
                            
                            $
                            -
                            
                            
                            $
                            27,397
 
 In
addition to the assets presented in the table above, the Company uses fair value
measurements on a non-recurring basis in its assessment of assets classified as
Goodwill.  These assets are recorded at fair value initially and
assessed for impairment periodically thereafter.  During the fiscal
year ended December 31, 2008, the carrying amount of goodwill assets were
compared to their fair value.  No change in carrying amount resulted
in accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible
Assets.”  Additionally,
the Company has certain other loans that are measured at fair value on a
non-recurring basis such as loans that were acquired in the acquisition of
Business First National Bank.
  95
  Note
19.  Earnings Per Share
 
 The
following is a reconciliation of net income and shares outstanding to the income
and number of shares used to compute earnings per share.  Share
information has been retroactively adjusted for stock dividends as discussed in
Note 20 of these Consolidated Financial Statements:
 
 2008
                                                          
                                                          
                                                          2007
                                                          
                                                          
                                                          2006Net
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          Net
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          Net(dollar amounts in thousands
      except per share data)
                                                          
                                                          Income
                                                          
                                                          
                                                          Shares
                                                          
                                                          
                                                          Income
                                                          
                                                          
                                                          Shares
                                                          
                                                          
                                                          Income
                                                          
                                                          
                                                          SharesNet
      income as reported
                                                          
                                                          $
                                                          1,646
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          $
                                                          6,917
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          $
                                                          6,662Weighted
      average shares outstanding
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          7,641,726
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          6,984,174
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          6,650,620Basic
      earnings per share
                                                          
                                                          $
                                                          0.22
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          $
                                                          0.99
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          $
                                                          1.00Dilutive
      effect of share-basedcompensation
      awards
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          111,287
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          244,630
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          274,962Weighhted
      average diluted shares outstanding
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          7,753,013
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          7,228,804
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          6,925,582Diluted
      earnings per share
                                                          
                                                          $
                                                          0.21
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          $
                                                          0.96
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          $
                                                          0.96
 
 Note
20.  Other Income and Expense
 
 The
following tables provide a breakdown of fees and other income and expenses for
the years ended December 31, 2008, 2007, and 2006:
 
 For the Years Ended December 31,(dollar amounts in thousands)
                                
                                2008
                                
                                
                                2007
                                
                                
                                2006Fees
      and Other Income:ATM/Debit
      card transaction/interchange fees
                                
                                $
                                843
                                
                                
                                $
                                765
                                
                                
                                $
                                711Bankcard
      merchant fees
                                
                                
                                231
                                
                                
                                
                                224
                                
                                
                                
                                122Mortgage
      origination fees
                                
                                
                                568
                                
                                
                                
                                461
                                
                                
                                
                                552Earnings
      on cash surrender value of life insurance
                                
                                
                                474
                                
                                
                                
                                433
                                
                                
                                
                                393Other
                                
                                
                                769
                                
                                
                                
                                650
                                
                                
                                
                                757Total
      other income
                                
                                $
                                2,885
                                
                                
                                $
                                2,533
                                
                                
                                $
                                2,535
 
 For the Years Ended December 31,(dollar amounts in thousands)
                                
                                2008
                                
                                
                                2007
                                
                                
                                2006Other
      Expenses:Data
      processing
                                
                                $
                                2,704
                                
                                
                                $
                                2,267
                                
                                
                                $
                                2,138Advertising
      and promotional
                                
                                
                                823
                                
                                
                                
                                718
                                
                                
                                
                                851Regulatory
      fees
                                
                                
                                475
                                
                                
                                
                                146
                                
                                
                                
                                112Other
      professional fees and outside services
                                
                                
                                1,197
                                
                                
                                
                                1,247
                                
                                
                                
                                1,207Legal
      fees and other litigation expenses
                                
                                
                                150
                                
                                
                                
                                100
                                
                                
                                
                                154Loan
      department costs
                                
                                
                                214
                                
                                
                                
                                129
                                
                                
                                
                                147Stationery
      and supplies
                                
                                
                                428
                                
                                
                                
                                350
                                
                                
                                
                                327Director
      fees
                                
                                
                                318
                                
                                
                                
                                289
                                
                                
                                
                                290Core
      deposit intangible amortization
                                
                                
                                861
                                
                                
                                
                                393
                                
                                
                                
                                300Other
                                
                                
                                2,161
                                
                                
                                
                                1,387
                                
                                
                                
                                1,249Total
      other expenses
                                
                                $
                                9,331
                                
                                
                                $
                                7,026
                                
                                
                                $
                                6,775
  96
  Note
21.  Cash Dividends, Stock Dividends and Stock Splits
 
 Stock
Dividends and Stock Splits
 
 On April
24, 2008, the Board of Directors declared a five percent stock dividend payable
on May 16, 2008 to stockholders of record on May 2, 2008.  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
 
 The
following table provides a summary of dividends the Company has declared and
paid on its common stock during the last two years ending December 31,
2008:
 
 DividendAmount
                              
                              Declaration
                              
                              Record
                              
                              PayableDividend Type
                              
                              Per Share
                              
                              Date
                              
                              Date
                              
                              DateStock dividend
                              
                              
                              5
                              %
                              04/24/08
                              
                              05/02/08
                              
                              05/16/08Regular quarterly dividend
                              
                              $
                              0.08
                              
                              01/24/08
                              
                              02/01/08
                              
                              02/15/08Regular quarterly dividend
                              
                              $
                              0.08
                              
                              10/17/07
                              
                              11/02/07
                              
                              11/16/07Regular quarterly dividend
                              
                              $
                              0.08
                              
                              07/18/07
                              
                              08/03/07
                              
                              08/17/07Regular quarterly dividend
                              
                              $
                              0.08
                              
                              04/20/07
                              
                              05/04/07
                              
                              05/18/07Regular quarterly dividend
                              
                              $
                              0.08
                              
                              01/19/07
                              
                              02/02/07
                              
                              02/16/07
 
 Note
22.  Stock Repurchase Program
 
 On July
21, 2006, the Board of Directors adopted a resolution authorizing the repurchase
of up to 42,000 shares of the Company’s common stock. Purchases were to be made,
as conditions warrant, from time to time in the open market or through privately
negotiated transactions. The duration of the program was for one year and the
timing of purchases was to depend on market conditions.  Subsequently,
on October 20, 2006, the Board of Directors adopted a resolution to increase the
number of shares available for repurchase under the 2006 plan to
105,000.  In July 2007, the Board of Directors authorized a one year
extension of this plan, which expired in August 2008.
 
 As of
December 31, 2008, the Company repurchased and retired 56,175 shares of its
common stock under the 2006 stock repurchase plan at a weighted average price of
$16.61.  The Company made no repurchases of its common stock during
2008.  As mentioned above, the Repurchase Plan expired in August
2008.
 
 Note
23.  Business Combinations
 
 On
October 12, 2007 the Company acquired Business First National Bank (“Business
First”).  Business First was merged with and into the Bank, a wholly
owned subsidiary of the Company.  The consideration paid for Business
First was approximately $19.5 million, consisting of approximately 75% common
stock and 25% cash.  Business First shareholders received 0.5758
shares of the Company’s common stock for each share of Business First they owned
and $3.44 per share in cash.  Upon the acquisition of Business First,
the Company issued 892,724 shares of its common stock and approximately $5.1
million in cash to the former shareholders of Business First.  The
value of the shares issued in connection with this acquisition was approximately
$13.8 million and was determined by multiplying the number of new shares issued
by the closing market price of the Company’s common stock on the closing date of
October 12, 2007.  The remaining component of the consideration
related to the value of stock options previously issued by Business First that
were rolled into substitute stock option agreements granted by the
Company.
  97
  The
following table provides a summary of the assets acquired and liabilities
assumed as of the date of the acquisition:
 
 (dollar amounts in thousands)
                                              
                                              October 12, 2007Cash
      and cash equivalents
                                              
                                              $
                                              12,467Interest-bearing
      deposits with other financial institutions
                                              
                                              
                                              12Investments
      and Federal Home Loan Bank stock
                                              
                                              
                                              15,065Loans
                                              
                                              
                                              120,778Property,
      premises and equipment, net
                                              
                                              
                                              1,467Core
      deposit intangible
                                              
                                              
                                              3,797Goodwill
                                              
                                              
                                              6,047Other
      assets
                                              
                                              
                                              837Total
      assets acquired
                                              
                                              $
                                              160,470Non-interest-bearing
      deposits
                                              
                                              $
                                              42,145Interest-bearing
      deposits
                                              
                                              
                                              91,274Federal
      Home Loan Bank borrowings
                                              
                                              
                                              12,598Other
      liabilities
                                              
                                              
                                              376Total
      liabilities assumed
                                              
                                              $
                                              146,393Net
      assets acquired
                                              
                                              $
                                              14,077
 
 In
conjunction with the acquisition of Business First, the Company recorded
approximately $6.0 million in goodwill.  It should be noted that
goodwill associated with the Business First acquisition is not deductible for
tax purposes, since the acquisition is not considered a purchase of
assets.  During 2008, Goodwill related to the acquisition of Business
First increased approximately $0.1 million, due to costs capitalized related to
the acquisition.
 
 The
following table presents the assumptions used in the calculation of the weighted
average fair value of the substitute stock options agreements granted by the
Company on the date of grant using the Black-Scholes option pricing
model:
 
 October2007Expected
      volatility
                              
                              
                              33.48
                              %Expected
      term (years)
                              
                              
                              3.2Dividend
      yield
                              
                              
                              1.97
                              %Risk
      free rate
                              
                              
                              4.35
                              %Weighted-average
      grant date fair value
                              
                              $
                              5.35
 
 The
following un-audited pro-forma financial information assumes the acquisition of
Business First occurred on January 1, 2006.
 
 For The Years Ended December 31,(dollar amounts in thousands
      except per share data)
                            
                            2007
                            
                            
                            2006Revenues
                            
                            $
                            39,820
                            
                            
                            $
                            37,534Net
      income
                            
                            $
                            7,440
                            
                            
                            $
                            7,527Earnings
      per common share:Basic
                            
                            $
                            0.97
                            
                            
                            $
                            1.00Diluted
                            
                            $
                            0.93
                            
                            
                            $
                            0.96
  The
pro-forma financial information presented in the table above is based on certain
assumptions and estimates which the Company believes are
reasonable.  The pro-forma consolidated results of operations do not
purport to be indicative of the results which would actually have been obtained
had the acquisition occurred on the dates indicated or which may be obtained in
the future.
 
 As a
result of the acquisition, the combined organization is not only expected to be
able to compete more effectively and take advantage of banking opportunities in
Santa Barbara and San Luis Obispo counties, but generate certain efficiencies
and long-term cost savings as a result of economies of scale.
  98
 
 The
Company’s Consolidated Statements of Income include the results of operations of
Business First from October 12, 2007 through December 31, 2008.
 
 Note
24.  Subsequent Events
 
 On
January 7, 2009, the Company received preliminary approval (the “Preliminary
Approval”) to participate in the U.S. Treasury’s Capital Purchase Program
(“CPP”).  The Preliminary Approval provides for the purchase
approximately $21.0 million of the Company’s Senior Preferred Stock by the U.S.
Treasury.  The preferred stock will carry a coupon of 5% for five
years and 9% thereafter.  Senior preferred issued to the U.S. Treasury
will be non-voting, cumulative, and perpetual and may be redeemed at 100% of the
issue price following three years from the date of issue.  The Company
would be subject to certain limitations upon its participation in the CPP
including:
 
 ·
              The
      requirement to obtain consent from the U.S. Treasury for any proposed
      increases in common stock dividends prior to the third anniversary date of
      the preferred equity issuance.
 
 ·
              The
      Senior Preferred Stock cannot be redeemed for three years unless the
      Company obtains proceeds to replace the Senior Preferred Stock through a
      qualified equity offering.
 
 ·
              The
      U.S. Treasury must consent to any buy back of our common
      stock.
 
 ·
              The
      Company must adhere to restrictions placed on the amount of and type of
      compensation paid to its executives while participating in the CPP,
      pursuant to section 111 of the Emergency Economic Stabilization Act of
      2008 (“EESA”).
 
 In
addition, the Company would issue warrants to the U.S. treasury to purchase
shares of the Company’s common stock in an amount equal to 15% of the of the
preferred equity issuance or approximately $3.2 million (617,173
shares).  The warrants would be exercisable immediately at a price of
equal to the average closing price of the Company’s common stock over the 20-day
period ending the day prior to the Company’s preliminary approval ($5.15 per
share).  These warrants will expire after a period of 10 years from
issuance and are transferable by the U.S. Treasury.  It is expected
that the issuance of this warrant will increase the level of diluted shares
outstanding following its issuance.
 
 On
February 27, 2009, the Company received shareholder approval for an amendment of
our Articles of Incorporation to add a class of preferred stock, which is needed
if the Company ultimately participates in the CPP.  It is the
Company’s present intention to complete a transaction with the U.S. Treasury,
however recent changes to executive compensation limits made by comments are
causing the Company’s Board of Directors and Management to reanalyze the
CPP.
  99
  Note
25.  Parent Company Financial Information
  Heritage
Oaks Bancorp
 Condensed
Balance Sheets
 
 December 31,(dollar amounts in thousands)
                                                    
                                                    2008
                                                    
                                                    
                                                    2007AssetsCash
                                                    
                                                    $
                                                    538
                                                    
                                                    
                                                    $
                                                    215Federal
      funds sold
                                                    
                                                    
                                                    1,250
                                                    
                                                    
                                                    
                                                    4,000Total
      cash and cash equivalents
                                                    
                                                    
                                                    1,788
                                                    
                                                    
                                                    
                                                    4,215Prepaid
      and other assets
                                                    
                                                    
                                                    457
                                                    
                                                    
                                                    
                                                    493Investment
      in subsidiaries
                                                    
                                                    
                                                    81,413
                                                    
                                                    
                                                    
                                                    78,453Total
      assets
                                                    
                                                    $
                                                    83,658
                                                    
                                                    
                                                    $
                                                    83,161LiabilitiesJunior
      subordinated debentures
                                                    
                                                    $
                                                    13,403
                                                    
                                                    
                                                    $
                                                    13,403Other
      liabilities
                                                    
                                                    
                                                    222
                                                    
                                                    
                                                    
                                                    308Total
      liabilities
                                                    
                                                    
                                                    13,625
                                                    
                                                    
                                                    
                                                    13,711Stockholders'
      EquityCommon
      stock
                                                    
                                                    
                                                    48,649
                                                    
                                                    
                                                    
                                                    43,996Additional
      paid in capital
                                                    
                                                    
                                                    1,055
                                                    
                                                    
                                                    
                                                    672Retained
      earnings
                                                    
                                                    
                                                    21,420
                                                    
                                                    
                                                    
                                                    24,598Accumulated
      other comprehensive income
                                                    
                                                    
                                                    (1,091
                                                    )
                                                    
                                                    
                                                    184Total
      stockholders' equity
                                                    
                                                    
                                                    70,033
                                                    
                                                    
                                                    
                                                    69,450Total
      liabilities and stockholders' equity
                                                    
                                                    $
                                                    83,658
                                                    
                                                    
                                                    $
                                                    83,161
  100
  Heritage
Oaks Bancorp
 Condensed
Statements of Income
 
 For the Years Ended December 31,(dollar amounts in thousands)
                                                  
                                                  2008
                                                  
                                                  
                                                  2007
                                                  
                                                  
                                                  2006IncomeEquity
      in undisbursed income of subsidiaries
                                                  
                                                  $
                                                  2,230
                                                  
                                                  
                                                  $
                                                  7,512
                                                  
                                                  
                                                  $
                                                  7,297Interest
                                                  
                                                  
                                                  72
                                                  
                                                  
                                                  
                                                  77
                                                  
                                                  
                                                  
                                                  73Total
      income
                                                  
                                                  
                                                  2,302
                                                  
                                                  
                                                  
                                                  7,589
                                                  
                                                  
                                                  
                                                  7,370ExpenseSalary
                                                  
                                                  
                                                  127
                                                  
                                                  
                                                  
                                                  31
                                                  
                                                  
                                                  
                                                  114Equipment
                                                  
                                                  
                                                  (57
                                                  )
                                                  
                                                  
                                                  (57
                                                  )
                                                  
                                                  
                                                  (57
                                                  )Other
      professional fees and outside services
                                                  
                                                  
                                                  236
                                                  
                                                  
                                                  
                                                  199
                                                  
                                                  
                                                  
                                                  254Interest
                                                  
                                                  
                                                  755
                                                  
                                                  
                                                  
                                                  921
                                                  
                                                  
                                                  
                                                  839Total
      expense
                                                  
                                                  
                                                  1,061
                                                  
                                                  
                                                  
                                                  1,094
                                                  
                                                  
                                                  
                                                  1,150Total
      operating income
                                                  
                                                  
                                                  1,241
                                                  
                                                  
                                                  
                                                  6,495
                                                  
                                                  
                                                  
                                                  6,220Income
      tax benefit
                                                  
                                                  
                                                  (405
                                                  )
                                                  
                                                  
                                                  (422
                                                  )
                                                  
                                                  
                                                  (442
                                                  )Net
      income
                                                  
                                                  $
                                                  1,646
                                                  
                                                  
                                                  $
                                                  6,917
                                                  
                                                  
                                                  $
                                                  6,662
  101
  Heritage
Oaks Bancorp
 Condensed
Statements of Cash Flows
 
 For the Years Ended December 31,(dollar amounts in thousands)
                                                                
                                                                2008
                                                                
                                                                
                                                                2007
                                                                
                                                                
                                                                2006Cash
      flows from operating activities:Net
      income
                                                                
                                                                $
                                                                1,646
                                                                
                                                                
                                                                $
                                                                6,917
                                                                
                                                                
                                                                $
                                                                6,662Adjustments
      to reconcile net income to net cash provided by/(used in)operating
      activities:Decrease/(increase)
      in other assets
                                                                
                                                                
                                                                36
                                                                
                                                                
                                                                
                                                                227
                                                                
                                                                
                                                                
                                                                (670
                                                                )(Decrease)/increase
      in other liabilities
                                                                
                                                                
                                                                (86
                                                                )
                                                                
                                                                
                                                                (150
                                                                )
                                                                
                                                                
                                                                281Share-based
      compensation expense
                                                                
                                                                
                                                                127
                                                                
                                                                
                                                                
                                                                31
                                                                
                                                                
                                                                
                                                                25Undistributed
      income of subsidiaries
                                                                
                                                                
                                                                (2,230
                                                                )
                                                                
                                                                
                                                                (7,512
                                                                )
                                                                
                                                                
                                                                (7,297
                                                                )Net
      cash used in operating activities
                                                                
                                                                
                                                                (507
                                                                )
                                                                
                                                                
                                                                (487
                                                                )
                                                                
                                                                
                                                                (999
                                                                )Cash
      flows from investing activities:Contribution
      to subsidiary
                                                                
                                                                
                                                                (1,750
                                                                )
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                -Net
      cash provided by investing activities
                                                                
                                                                
                                                                (1,750
                                                                )
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                -Cash
      flows from financing activities:Cash
      dividends received
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                2,000
                                                                
                                                                
                                                                
                                                                -Cash
      paid in lieu of fractional shares
                                                                
                                                                
                                                                (5
                                                                )
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                -Cash
      dividends paid
                                                                
                                                                
                                                                (586
                                                                )
                                                                
                                                                
                                                                (2,128
                                                                )
                                                                
                                                                
                                                                (2,602
                                                                )(Decrease)/increase
      in junior subordinated debentures
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                (3,093
                                                                )
                                                                
                                                                
                                                                8,248Stock
      repurchased
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                (215
                                                                )
                                                                
                                                                
                                                                (720
                                                                )Proceeds
      from the exercise of options
                                                                
                                                                
                                                                421
                                                                
                                                                
                                                                
                                                                862
                                                                
                                                                
                                                                
                                                                712Net
      cash (used in)/provided by financing activities
                                                                
                                                                
                                                                (170
                                                                )
                                                                
                                                                
                                                                (2,574
                                                                )
                                                                
                                                                
                                                                5,638Net
      (decrease)/increase in cash and cash equivalents
                                                                
                                                                
                                                                (2,427
                                                                )
                                                                
                                                                
                                                                (3,061
                                                                )
                                                                
                                                                
                                                                4,639Cash
      and cash equivalents, beginning of year
                                                                
                                                                
                                                                4,215
                                                                
                                                                
                                                                
                                                                7,276
                                                                
                                                                
                                                                
                                                                2,637Cash
      and cash equivalents, end of year
                                                                
                                                                $
                                                                1,788
                                                                
                                                                
                                                                $
                                                                4,215
                                                                
                                                                
                                                                $
                                                                7,276
  102
 
 Quarterly
Financial Information (un-audited)
 
 The
following table provides a summary of results for the periods
indicated:
 
 For The Quarters Ended,Q4
                                            
                                            
                                            Q3
                                            
                                            
                                            Q2
                                            
                                            
                                            Q1
                                            
                                            
                                            Q4
                                            
                                            
                                            Q3
                                            
                                            
                                            Q2
                                            
                                            
                                            Q1(dollars in thousands, except per share data)
                                            
                                            2008
                                            
                                            
                                            2008
                                            
                                            
                                            2008
                                            
                                            
                                            2008
                                            
                                            
                                            2007
                                            
                                            
                                            2007
                                            
                                            
                                            2007
                                            
                                            
                                            2007Interest
      income
                                            
                                            $
                                            12,223
                                            
                                            
                                            $
                                            12,536
                                            
                                            
                                            $
                                            12,574
                                            
                                            
                                            $
                                            12,817
                                            
                                            
                                            $
                                            13,155
                                            
                                            
                                            $
                                            10,870
                                            
                                            
                                            $
                                            10,823
                                            
                                            
                                            $
                                            10,303Net
      interest income
                                            
                                            
                                            9,352
                                            
                                            
                                            
                                            9,525
                                            
                                            
                                            
                                            9,589
                                            
                                            
                                            
                                            9,120
                                            
                                            
                                            
                                            8,781
                                            
                                            
                                            
                                            7,328
                                            
                                            
                                            
                                            7,258
                                            
                                            
                                            
                                            7,034Provision
      for credit losses
                                            
                                            
                                            6,000
                                            
                                            
                                            
                                            3,200
                                            
                                            
                                            
                                            2,775
                                            
                                            
                                            
                                            240
                                            
                                            
                                            
                                            140
                                            
                                            
                                            
                                            210
                                            
                                            
                                            
                                            170
                                            
                                            
                                            
                                            140Non-interest
      income
                                            
                                            
                                            1,498
                                            
                                            
                                            
                                            1,513
                                            
                                            
                                            
                                            1,756
                                            
                                            
                                            
                                            1,439
                                            
                                            
                                            
                                            1,439
                                            
                                            
                                            
                                            1,309
                                            
                                            
                                            
                                            1,391
                                            
                                            
                                            
                                            1,231Other
      expenses
                                            
                                            
                                            7,208
                                            
                                            
                                            
                                            7,108
                                            
                                            
                                            
                                            7,498
                                            
                                            
                                            
                                            7,620
                                            
                                            
                                            
                                            6,874
                                            
                                            
                                            
                                            5,777
                                            
                                            
                                            
                                            5,563
                                            
                                            
                                            
                                            5,694Income
      before provision for income taxes
                                            
                                            
                                            (2,358
                                            )
                                            
                                            
                                            730
                                            
                                            
                                            
                                            1,072
                                            
                                            
                                            
                                            2,699
                                            
                                            
                                            
                                            3,206
                                            
                                            
                                            
                                            2,650
                                            
                                            
                                            
                                            2,916
                                            
                                            
                                            
                                            2,431Net
      income
                                            
                                            $
                                            (1,254
                                            )
                                            
                                            $
                                            534
                                            
                                            
                                            $
                                            691
                                            
                                            
                                            $
                                            1,675
                                            
                                            
                                            $
                                            1,978
                                            
                                            
                                            $
                                            1,628
                                            
                                            
                                            $
                                            1,800
                                            
                                            
                                            $
                                            1,510Earnings
      per common share:Basic
                                            
                                            $
                                            (0.16
                                            )
                                            
                                            $
                                            0.07
                                            
                                            
                                            $
                                            0.09
                                            
                                            
                                            $
                                            0.22
                                            
                                            
                                            $
                                            0.26
                                            
                                            
                                            $
                                            0.24
                                            
                                            
                                            $
                                            0.27
                                            
                                            
                                            $
                                            0.23Diluted
                                            
                                            $
                                            (0.16
                                            )
                                            
                                            $
                                            0.07
                                            
                                            
                                            $
                                            0.09
                                            
                                            
                                            $
                                            0.21
                                            
                                            
                                            $
                                            0.25
                                            
                                            
                                            $
                                            0.23
                                            
                                            
                                            $
                                            0.26
                                            
                                            
                                            $
                                            0.22
  Item
9.  Changes in and Disagreements 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 can be found under Item 8. Financial Statements and Supplementary Data,
beginning on page 59 of this report. 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 Securities Exchange Act of 1934
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.
 
 Item
9B.  Other Information
 
 None.
  103


Part
III





Item
10.  Directors, Executive Officers 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 Principal
Accounting Officer, as well as all other employees, as indicated
above.  Our Code of Conduct is posted on our website at www.heritageoaksbancorp.comunder 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 2008.





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 2009 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 2009 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 2009 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 2009 Annual
Meeting of Shareholders which will be filed pursuant to Regulation
14-A.




Item
14.  Principal Accounting 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 2009 Annual
Meeting of Shareholders which will be filed pursuant to Regulation
14-A.




104





Part
IV





Item
15.  Exhibits, Financial Statement Schedules




(a)
1. Financial Statements





The
Company’s Consolidated Financial Statements, include the notes thereto, and the
report of the independent registered public accounting firm thereon, are set
forth in the index for Item 8 of this form.




(a)
2. Financial Statement Schedules





All
financial statement schedules for the Company have been included in the
Consolidated Financial Statements or the related
footnotes.  Additionally, a listing of the supplementary financial
information required by this item is set forth in the index for Item 8 of this
Form 10-K.




(a)
3. Exhibits





A list of
exhibits to this Form 10-K is set forth in the “Exhibit Index” immediately
preceding such exhibits and is incorporated herein by reference.




(b)
Exhibits Required By Item 601 of Regulation S-K





Reference
is made to the Exhibit Index on page 107 for exhibits filed as part of this
report.




(c)
Additional Financial Statements





Not
Applicable.


105





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
                    
                    Executive
      Vice President, Chief Financial OfficerDated:
      March 6, 2009
                    
                    and
      Principal Accounting OfficerDated:March
      6, 2009





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/ Michael Morris
                                                                                
                                                                                Chairman of the Board of
      Directors
                                                                                March 6, 2009Michael
      Morris/s/ Donald H. Campbell
                                                                                
                                                                                Vice Chairman of the Board of
      Directors
                                                                                March 6, 2009Donald
      H. Campbell/s/ Michael Behrman
                                                                                
                                                                                Director
                                                                                March 6, 2009Michael
      Behrman/s/ Kenneth Dewar
                                                                                
                                                                                Director
                                                                                March 6, 2009Kenneth
      Dewar/s/ Mark C. Fugate
                                                                                
                                                                                Director
                                                                                March 6, 2009Mark
      C. Fugate/s/ Dolores T. Lacey
                                                                                
                                                                                Director
                                                                                March 6, 2009Dolores
      T. Lacey/s/ Merle F. Miller
                                                                                
                                                                                Director
                                                                                March 6, 2009Merle
      F. Miller/s/ Daniel J. O’Hare
                                                                                
                                                                                Director
                                                                                March 6, 2009Daniel
      J. O’Hare/s/ Michael E. Pfau
                                                                                
                                                                                Director
                                                                                March 6, 2009Michael
      E. Pfau/s/ Alex Simas
                                                                                
                                                                                Director
                                                                                March 6, 2009Alex
      Simas/s/ Lawrence P. Ward
                                                                                
                                                                                Director
                                                                                March 6, 2009Lawrence
      P. Ward




106


Exhibit
Index




(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.(10.5)
                                                                                                                        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.(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.(10.11)
                                                                                                                        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.(10.15)
                                                                                                                        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.(10.19)
                                                                                                                        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.


107


(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 10-QSB 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.(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.(10.38)
                                                                                                              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.




108




(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.(10.43)
                                                                                                                                              Form
      of Change in Control Agreements.(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**




**Filed
herewith.




109