**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**




**FORM
        10-K**





xANNUAL
      REPORT PURSUANT
      TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE YEAR
      ENDED
      DECEMBER 31, 2007.





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 NO. **** 0-25020


**HERITAGE
      OAKS BANCORP**


(Exact
      name of registrant as specified in its charter)




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


**545
                  12th Stree**
                  **PASO
                    ROBLES, CALIFORNIA 93446**
              
              **(805)
                  369-5200**(Address
                  of Principal Executive Offices) (Zip Code)
              
              (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
                CAPITAL MARKET**Title
                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
oNo
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
oNo
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
xNo
o





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





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





The
      aggregate market value of the voting and non-voting common equity held by
      non-affiliates of the Registrant at December 31, 2007 was $92.2 million. As
      of
      February 28, 2008, the Registrant had 7,318,932 shares of Common Stock
      outstanding.












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





**TABLE
                      OF CONTENTS****PART
                      I**ITEM
                      1.
                  BUSINESS.
                  3ITEM
                      1A.
                  RISK
                      FACTORS.
                  12ITEM
                      1B.
                  UNRESOLVED
                      STAFF COMMENTS.
                  17ITEM
                      2.
                  PROPERTIES.
                  18ITEM
                      3.
                  LEGAL
                      PROCEEDINGS.
                  18ITEM
                      4.
                  SUBMISSION
                      OF MATTERS TO A VOTE OF SECURITY HOLDERS.
                  18**PART
                      II**ITEM
                      5.
                  MARKET
                      FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
                      PURCHASES OF EQUITY SECURITIES.
                  19ITEM
                      6.
                  SELECTED
                      FINANCIAL DATA.
                  23ITEM
                      7.
                  MANAGEMENT’S
                      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
                      OF
                      OPERATIONS.
                  24ITEM
                      7A.
                  QUANTITATIVE
                      AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
                  44ITEM
                      8.
                  FINANCIAL
                      STATEMENTS AND SUPPLEMENTARY DATA.
                  46ITEM
                      9.
                  CHANGES
                      IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
                      DISCLOSURE.
                  87ITEM
                      9A.
                  CONTROLS
                      AND PROCEDURES.
                  87ITEM
                      9B.
                  OTHER
                      INFORMATION.
                  87**PART
                      III**ITEM
                      10.
                  DIRECTORS,
                      EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.
                  88ITEM
                      11.
                  EXECUTIVE
                      COMPENSATION.
                  88ITEM
                      12.
                  SECURITY
                      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
STOCKHOLDER
                      MATTERS.
                  88ITEM
                      13.
                  CERTAIN
                      RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
                      INDEPENDENCE.
                  88ITEM
                      14.
                  PRINCIPAL
                      ACCOUNTING FEES AND SERVICES.
                  88**PART
                      IV**ITEM
                      15.
                  EXHIBITS,
                      FINANCIAL STATEMENT SCHEDULES.
                  88**SIGNATURES**
                  
                  90**EXHIBIT
                      INDEX**
                  
                  91**CERTIFICATIONS**
  2




**PART
        I**
  **Certain
        statements contained in this Annual Report on Form 10-K (“Annual Report”),
        including, without limitation, statements containing the words “believes”,
“anticipates”, “intends”, “expects”, and words of similar impact, constitute
“forward-looking statements” within the meaning of Section 27A of the Securities
        Act of 1933 and Section 21E of the Securities and Exchange Act of 1934. Such
        forward-looking statements involve known and unknown risks, uncertainties
        and
        other factors that may cause the actual results, performance or achievements
        of
        the Company to be materially different from any future results, performance
        or
        achievements expressed or implied by such forward-looking statements. Such
        factors include, among others, the following: general economic and business
        conditions in those areas in which the Company operates, demographic changes,
        competition, fluctuations in interest rates, 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. DESCRIPTION OF BUSINESS**
 
 *GENERAL*
  Heritage
        Oaks Bancorp (the "Company," “we” or “our”) is a California corporation
        organized in 1994 to act as the holding company of Heritage Oaks Bank (the
        “Bank"). In 1994, the Company acquired all of the outstanding common stock
        of
        the Bank in a holding company formation transaction.





In
      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, Messrs. Michael J. Behrman and
      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 22 to the
      Consolidated Financial Statements filed on this Form 10-K for additional
      information regarding this acquisition.





Other
      than holding the shares of the Bank, the Company conducts no significant
      activities, although it is authorized, with the prior approval of the Board
      of
      Governors of the Federal Reserve System (the "Federal Reserve Board"), the
      Company's principal regulator, to engage in a variety of activities which are
      deemed closely related to the business of banking. The Company has also
      incorporated a subsidiary, CCMS Systems, Inc. which is currently inactive and
      has not been capitalized. The Company has no present plans to activate the
      proposed subsidiary, nor to engage in such other permitted
      activities.




3




*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, 2007, the Company had approximately $745.6 million in consolidated
      assets, $605.3 million in net consolidated loans, $644.8 million in consolidated
      deposits, and $69.5 million in stockholders' equity.





The
      Bank
      is headquartered in Paso Robles, California with one branch office in Paso
      Robles, two branch offices in San Luis Obispo, one branch office in Cambria,
      one
      branch office in Arroyo Grande, three branch offices in Santa Maria, one branch
      office in Atascadero, one branch office in Morro Bay, one branch office in
      Templeton, one branch office in San Miguel, and two branch offices in Santa
      Barbara. 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, 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 (i) commercial and
      agricultural loans, (ii) installment loans, (iii) construction loans, and (iv)
      other real estate loans or commercial loans secured by real estate. As of
      December 31, 2007, the Bank had approximately $613.2 million in gross loan
      balances, of which approximately $458.6 million or 74.8% 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 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 which would have a materially adverse effect on the business of the
      Bank. Management considers three account relationships with customers engaged
      in
      mortgage related businesses to be volatile deposit relationships. These deposit
      accounts, which are closely monitored by bank management, had combined balances
      of $15.7 million at December 31, 2007 compared to $44.1 million at December
      31,
      2006. Management and the Board of Directors of the Bank are aware that changes
      in mortgage market conditions may continue to have an impact on these
      relationships. In addition to the three accounts mentioned, the bank obtained
      two additional deposit relationships during the fourth quarter of 2007 that
      it
      considers to be volatile, at December 31, 2007, the combined balance of these
      accounts was approximately $42.6 million. In total, the bank has deposit
      relationships totaling approximately $58.3 million that it considers to be
      of
      volatile nature at December 31, 2007. A more detailed discussion of deposits
      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. For the year ended December 31, 2007, these sources
      comprised 84.0%, 5.4%, 5.5%, 0.9% and 4.2%, respectively, of the Company’s total
      operating income.





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





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





4




*EMPLOYEES*





As
      of
      December 31, 2007, The Bank had 242 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 260,000, 92,000, and 90,000 respectively, according to
      economic data provided by local county and title company sources. The moderate
      climate allows a year round growing season for numerous vegetable and fruits.
      Vineyards and cattle ranches also contribute largely to the local economy.
      The
      Central Coast’s leading agricultural industry is the production of high quality
      wine grapes and production of premium quality wines. Although on average the
      climate in our markets is generally very mild, we did experience significantly
      cooler weather in early 2007. This did not have a significant impact on our
      business. Vineyards in production have grown significantly over the past several
      years throughout the Company’s service area. Access to numerous recreational
      activities, including lakes, mountains and beaches, provide a relatively stable
      tourist industry from many areas including the Los Angeles/Orange County basin,
      the San Francisco Bay area and the San Joaquin Valley. Principally due to the
      diversity of the various industries in the Company’s service area, the area,
      while not immune from economic fluctuations, does tend to enjoy a more stable
      level of economic activity than many other areas of California.





Throughout
      the primary market area of the Company, the softening housing market of 2007
      is
      expected to continue into 2008, though it is unknown just how long-lasting
      the
      slowdown might be. The number of homes sold in 2007 was 25% less than 2006,
      according to real estate research firm DataQuick. The median price of an
      existing home in San Luis Obispo County was 1.9% less in December 2007 compared
      to December 2006. Some economists predict housing prices will moderate in 2008
      based on the nontraditional nature of the market that includes buyers bringing
      in equity earned in other parts of the state. Because of the desirable climate,
      close proximity to pristine beaches, water sport lakes and the ever popular
      wine
      industry, for both San Luis Obispo and Santa Barbara County, the real estate
      market for single family residences has to a great degree depended on those
      buyers with greater amounts of discretionary funds who could afford a second
      home or a more expensive primary residence. According to the chief economist
      for
      the California Association of Realtors, the Central Coast should fair
      better due to a somewhat constant demand for coastal property and the lack
      of
      over supply seen in many other parts of the state.


*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. Commercial banks also compete for loans with savings and loan
      associations, credit unions, consumer finance companies, mortgage companies
      and
      other lending institutions.




5




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


*EFFECT
        OF GOVERNMENT POLICIES AND RECENT LEGISLATION*





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





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





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


*SUPERVISION
        AND REGULATION*


·
            *General*





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





·
            *The
                Company*





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





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





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




6




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





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





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




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





·
            *The
                Bank*





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





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





·
            *Capital
                Standards*





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





A
      banking
      organization's risk-based capital ratios are obtained by dividing its qualifying
      capital by its total risk adjusted assets. The regulators measure risk-adjusted
      assets, which includes off balance sheet items, against both total qualifying
      capital (the sum of Tier 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 and lease losses, cumulative
      preferred stock, long term preferred stock, eligible term subordinated debt
      and
      certain other instruments with some characteristics of equity. The inclusion
      of
      elements of Tier 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%.




7





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.





The
      regulatory capital requirements, as well as the actual capital ratios for
      Heritage Oaks Bank and the Company as of December 31, 2007, are presented in
      detail in Note 11, Regulatory Matters of the Consolidated Financial Statements.
      See also “Capital” within Management’s Discussion and Analysis of this Form
      10-K. As of December 31, 2007, 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,
      2007, 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.




8




·
            *Safety
                and Soundness Standards*





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





·
            *Premiums
                for Deposit Insurance*





The
      Bank’s deposits are currently insured to a maximum of $100,000 per depositor by
      the FDIC except for certain retirement accounts which are insured up to
      $250,000. The Bank is required to pay deposit insurance premiums. The premium
      amount is based upon a risk classification system established by the FDIC.
      Banks
      with higher levels of capital and a low degree of supervisory concern are
      assessed lower premiums than banks with lower levels of capital or a higher
      degree of supervisory concern. Effective January 1, 2007 the FDIC adopted a
      new
      rule for the insurance assessment on deposits. Under the new rule the charge
      for
      annual insurance deposit assessments will range from a minimum of 5 basis points
      to a maximum of 43 basis points per $100 of insured deposits depending upon
      the
      risk assessment category into which the institution falls. Insured institutions
      are not all allowed to disclose their risk assessment classification and no
      assurance can be given as to what the future level of premiums will
      be.





Under
      the
      Federal Deposit Insurance Reform Act of 2005, the Bank received a one-time
      initial assessment credit to recognize its past contributions to the insurance
      fund. The Bank’s one-time assessment credit was approximately $126 thousand.
      This credit can be used to offset assessments until exhausted. During 2007,
      The
      Bank used the entire amount of the credit as an offset to its regular quarterly
      assessment.





In
      addition to the assessment for deposit insurance, institutions are required
      to
      make payments on bonds issued in the late 1980’s by the Financing Corporation to
      recapitalize a predecessor deposit insurance fund. This payment is established
      quarterly and during the year ending December 31, 2007 averaged 1.14 basis
      points of assessable deposits.





The
      FDIC
      has authority to increase insurance assessments. A significant increase in
      insurance premiums could have an adverse effect on the operating expenses and
      results of operations of the Company. Management cannot predict what insurance
      assessment rates will be in the future.





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





·
            *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.




9





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





·
            *Financial
                Services Modernization
                Legislation*





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




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





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





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





·
            *USA
                Patriot Act of 2001*





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





·
            *Transactions
                between Affiliates*





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





·
            *Community
                Reinvestment Act*





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




10




·
            *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.





11





·
            *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, 2007, real estate served as the principal source of collateral
        with
        respect to approximately 74.8% of our loan portfolio. A decline in current
        economic conditions, a decline in the local housing market, such as the one
        we
        are experiencing currently, or rising interest rates could have an adverse
        effect on the demand for new loans, the ability of borrowers to repay
        outstanding loans, the value of real estate and other collateral securing
        loans
        and the value of real estate owned by us, as well as our financial condition
        and
        results of operations in general and the market value of our common stock.




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




12




*WE
        ALSO HAVE A CONCENTRATION IN HIGHER RISK COMMERCIAL REAL ESTATE
        LOANS.*





We
      also
      have a high concentration in commercial real estate or CRE loans. CRE loans
      as
      defined by final guidance issued by Bank regulators 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 66.2% 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.


*THE
        CURRENT CHANGING ECONOMIC ENVIRONMENT POSES SIGNIFICANT CHALLENGES FOR
        US.*





We
      are
      operating in a challenging and uncertain economic environment, including
      generally uncertain national and local conditions. Financial institutions
      continue to be affected by the softening of the real estate market and
      constrained financial markets. While we have very limited direct exposure to
      the
      residential real estate market and while we have no sub-prime residential loans
      or securities backed by such loans on our books, we are nevertheless affected
      by
      these events. Continued declines in real estate values, home sales volumes
      and
      financial stress on borrowers as a result of the uncertain economic environment,
      including job losses, interest rate resets on adjustable rate mortgage loans
      and
      other factors could have adverse effects on our borrowers which would adversely
      affect our financial condition and results of operations. This deterioration
      in
      economic conditions coupled with a possible national economic recession could
      drive losses beyond that which is provided for in our allowance for loan losses
      and result in the following other consequences:





·
            Loan
                delinquencies, problem assets and foreclosures may
                increase;





·
            Demand
                for our products and services may
                decline;





·
            Low
                cost or non-interest bearing deposits may decrease;
                and





·
            Collateral
                for our loans, especially real estate, may decline in value, in turn
                reducing customers’ borrowing power, and reducing the value of assets and
                collateral associate with our existing
                loans.




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


*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.
  13





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





·
            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 credit losses, that management believes is
        appropriate to minimize this risk by assessing the likelihood of nonperformance,
        tracking loan performance and diversifying our credit portfolio. These policies
        and procedures, however, may not prevent unexpected losses that could materially
        adversely affect our results of operations in general and the market value
        of
        our stock.





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


*WE
        FACE STRONG COMPETITION FROM FINANCIAL SERVICE COMPANIES AND OTHER COMPANIES
        THAT OFFER BANKING SERVICES WHICH MAY HURT OUR
        BUSINESS.*


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




14





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


*WE
        MAY NOT BE ABLE TO ATTRACT AND RETAIN SKILLED PEOPLE.*




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


*OUR
        INTERNAL OPERATIONS ARE SUBJECT TO A NUMBER OF
        RISKS.*


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




·
            *Information
                Systems*





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





·
            *Technological
                Advances*





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





·
            *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.




15





·
            *We
                Depend On Cash Dividends From Our Subsidiary Bank To Meet Our Cash
                Obligations***





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


*OUR
        RECENT ACQUISITION OF BUSINESS FIRST NATIONAL BANK PRESENTS CERTAIN RISKS
        TO OUR
        OPERATIONS.*





There
      are
      risks commonly encountered with growth through acquisition of banks. These
      risks
      include, among other things:




·
            Difficulty
                of integrating the operations and personnel of the acquired bank
                and its
                branches;




·
            Potential
                disruption of our ongoing business;




·
            Inability
                of our management to maximize our financial and strategic position
                by the
                successful implementation of uniform product offerings and the
                incorporation of uniform technology into our product offerings and
                control
                systems; and




·
            Inability
                to maintain uniform standards, controls, procedures and policies
                and the
                impairment of relationships with employees and customers as a result
                of
                changes in management.




While
      we
      believe the integration of Business First National Bank is going well, we cannot
      assure you that we will be successful in overcoming these risks or any other
      problems encountered in connection with this acquisition. Our inability to
      improve the operating performance of Business First National Bank or to
      integrate its operations successfully could have a material adverse effect
      on
      our business, financial condition, results of operations and cash flows. In
      addition, we have incurred and will continue to incur substantial expenses,
      including the expenses of integrating the operations of Business First National
      Bank with our existing business.


**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. For example, operating expenses
      of approximately $128 thousand were attributable to compliance with the
      Sarbanes-Oxley Act provisions in the year ended December 31, 2007. We anticipate
      that continued compliance with, among other regulatory provisions, The
      Sarbanes-Oxley Act will impact future operating expenses. Further, federal
      monetary policy, particularly as implemented through the Federal Reserve System,
      significantly affects economic conditions for us.


*NEW
        LEGISLATIVE AND REGULATORY PROPOSALS MAY AFFECT OUR OPERATIONS AND
        GROWTH.* ****


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





16




**RISKS
        ASSOCIATED WITH OUR STOCK**


*OUR
        STOCK TRADES LESS FREQUENTLY THAN OTHERS* .


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


*OUR
        STOCK PRICE IS AFFECTED BY A VARIETY OF FACTORS.*





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





·
            Actual
                or anticipated variations in quarterly results of operations.





·
            Recommendations
                by securities analysts.





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





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





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




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


*OUR
        ARTICLES OF INCORPORATION AND BY-LAWS, AS WELL AS CERTAIN BANKING LAWS, MAY
        HAVE AN ANTI-TAKEOVER EFFECT.*


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


**ITEM
        1B. UNRESOLVED STAFF COMMITMENTS**
  None.





17




**ITEM
        2. DESCRIPTION OF PROPERTIES**
  The
        Company’s headquarters are located at 545 12 th 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 unaffiliated parties for an approximate
        aggregate amount of $189 thousand per month. Additionally, the Company subleases
        part of five branches to unaffiliated parties. The income associated with
        these
        subleases is approximately $24 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
      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.
      The initial annual base rents for the Paso Robles, Arroyo Grande, and Santa
      Maria branches are $199 thousand, $92 thousand, and $151 thousand, respectively.
      The initial annual base rent for the administrative facility is $455 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 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.


**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
      2007.




18




**PART
      II**





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




*MARKET
        INFORMATION*





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





The
      following table summarizes those trades of the Company’s Common Stock on NASDAQ,
      setting forth the approximate high and low closing sales prices for each
      quarterly period ended since January 1, 2006:




**Closing
                  Prices****Quarters
                  Ended**
              
              **High**
              
              **Low**December
                  31, 2007
              
              $
              16.99
              
              $
              12.60September
                  30, 2007
              
              
              18.19
              
              
              14.60June
                  30, 2007
              
              
              18.73
              
              
              17.23March
                  31, 2007
              
              
              18.45
              
              
              17.18December
                  31, 2006
              
              $
              19.06
              
              $
              16.36September
                  30, 2006
              
              
              17.00
              
              
              15.87June
                  30, 2006
              
              
              19.53
              
              
              16.50March
                  31, 2006
              
              
              22.90
              
              
              18.32




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





The
      following graph provides a five year comparison of cumulative total returns
      for
      Heritage Oaks Bancorp Common Stock, the NASDAQ Composite Index, and the SNL
      Western Bank Index.










*HOLDERS*





As
      of
      February 1, 2008, there were approximately 2,014 holders of the Company's Common
      Stock. There are no other classes of equity securities outstanding.





19




*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.





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 $20 million at
      December 31, 2007.




*CASH
        DIVIDENDS*





The
      following table provides a summary of cash dividends the Company has declared
      and paid on its common stock during 2007 and 2006:


**Dividend****Amount**
              
              **Declaration**
              
              **Record**
              
              **Payable****Dividend
                  Type**
              
              **Per
                  Share**
              
              **Date**
              
              **Date**
              
              **Date**Regular
                  quarterly dividend
              
              $
              0.08
              
              
              17-Oct-07
              
              
              2-Nov-07
              
              
              16-Nov-07Regular
                  quarterly dividend
              
              $
              0.08
              
              
              18-Jul-07
              
              
              3-Aug-07
              
              
              17-Aug-07Regular
                  quarterly dividend
              
              $
              0.08
              
              
              20-Apr-07
              
              
              4-May-07
              
              
              18-May-07Regular
                  quarterly dividend
              
              $
              0.08
              
              
              19-Jan-07
              
              
              2-Feb-07
              
              
              16-Feb-07Regular
                  quarterly dividend
              
              $
              0.08
              
              
              20-Oct-06
              
              
              3-Nov-06
              
              
              17-Nov-06Regular
                  quarterly dividend
              
              $
              0.08
              
              
              21-Jul-06
              
              
              11-Aug-06
              
              
              25-Aug-06Special
                  cash dividend
              
              $
              0.25
              
              
              21-Apr-06
              
              
              8-May-06
              
              
              19-May-06




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.




20




*SECURITIES
      AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS*





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




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




The
      following table summarizes information as of December 31, 2007 relating to
      equity compensation plans of the Company pursuant to which grants of options,
      restricted stock or other rights to acquire shares may be granted from time
      to
      time:




**Plan
                  Category**
              
              **Plan
                  Year**
              
              **Number
                  of Securities To Be Issued Upon Exercise of Outstanding Options,
                  Warrants
                  of Rights**
              
              
              
              **Weighted
                  Average Exercise Price of Outstanding Options, Warrants of
                  Rights**
              
              **Number
                  of Securities Remaining Available For Future
                  Issuance**Equity
                  compensation plans approved by security holders:
              
              
              1990
              
              
              -
              
              
              
              
              $
              -
              
              
              -1997
              
              
              300,243
              
              
              
              
              $
              6.47
              
              
              -
              
              
              (1)2005
              
              
              140,851
              
              
              (2)
              
              $
              13.68
              
              
              -2005
              
              
              66,300
              
              
              (3)
              
              $
              -
              
              
              432,830Equity
                  compensation plans not approved by security holders:
              
              
              N/A
              
              
              N/A
              
              
              
              
              
              N/A
              
              
              N/ATotals
              
              
              
              
              
              507,394
              
              
              
              
              $
              12.89
              
              
              432,830





(1)
                  No further grants may be made from the 1997 Stock Option
                  Plan.(2)
                  During 2007, 100,851 shares were granted in connection with the
                  acquisition of Business First.Additionally,
                  40,000 shares were granted to various members of the Board of Directors
                  from this plan.(3)
                  The awards presented here are in the form of restricted share grants.
                  Restrictions lapse completely on the fifth anniversary date from
                  issuance.




*PURCHASES
      OF EQUITY SECURITIES*





On
      July
      21, 2006, the Company’s Board of Directors adopted a one year stock repurchase
      program in the initial amount of 40,000 shares and an expiration date of July
      21, 2007. **** The
      repurchase program seeks to reduce the number of outstanding shares resulting
      in
      an improvement to the Company’s earnings per share and to its return on
      equity . **** In
      October 2006, the Board approved an increase in the stock repurchase program
      to
      a total of 100,000 shares. On July 18, 2007, the Board of Directors authorized
      an additional one year extension of the stock repurchase program, which will
      expire in July 2008. Under the one year extension the Company may repurchase
      up
      to 100,000 shares of its common stock. As of December 31, 2007, the Company
      had
      repurchased 53,500 shares of its common stock under the current plan, of which
      13,500 shares were repurchased during 2007 at an average cost of $15.92 per
      share. All of these shares were purchased at current market prices on the date
      of transaction in compliance with SEC rules. **** As
      of
      December 31, 2007, the Company was authorized to repurchase up to an additional
      46,500 shares under this program.




21




The
      table
      below summarizes our monthly repurchases and redemptions of our common equity
      securities during the three months ended December 31, 2007:


**Period**
              
              **Total
                  Number of Shares Purchased**
              
              **Average
                  Price Paid Per Share**
              
              **Total
                  Number of Shares Purchased As Part of Publicly Announced
                  Plan**
              
              **Remaining
                  Number of Shares That May Be Purchased Under The Publicaly Announced
                  Plan
                  (1)**October
              
              
              1,500
              
              $
              16.15
              
              
              1,500
              
              
              52,500November
              
              
              6,000
              
              $
              15.74
              
              
              6,000
              
              
              46,500December
              
              
              -
              
              $
              -
              
              
              -
              
              
              46,500Total
              
              
              7,500
              
              $
              15.82
              
              
              7,500
              
              
              46,500
  (1)
                  Includes the additional 60,000 shares added to the plan in October
                  2006





As
      indicated in the table above, the Company repurchased 7,500 shares of its common
      stock during the fourth quarter of 2007 at an average cost of $15.82 per
      share.




22


**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, 2007, 2006, 2005, 2004 and 2003
      and for the three months ended December 31, 2007 and 2006:




**For
                  the three months ended,**
                **December
                  31,**
              
              **At
                  or for the years ended December 31,***(dollar
                  amounts in thousands, except share data)*
              
              **2007**
              
              **2006**
              
              **2007**
              
              **2006**
              
              **2005**
              
              **2004**
              
              **2003****Consolidated
                  Income Data:**Interest
                  income
              
              $
              13,155
              
              $
              9,932
              
              $
              45,174
              
              $
              36,372
              
              $
              30,175
              
              $
              23,313
              
              $
              18,174Interest
                  expense
              
              
              4,374
              
              
              2,981
              
              
              14,751
              
              
              9,316
              
              
              5,016
              
              
              3,361
              
              
              3,463Net
                  interest income
              
              
              8,781
              
              
              6,951
              
              
              30,423
              
              
              27,056
              
              
              25,159
              
              
              19,952
              
              
              14,711Provision
                  for loan losses
              
              
              140
              
              
              120
              
              
              660
              
              
              600
              
              
              710
              
              
              410
              
              
              370Net
                  interest income after provision for loan losses
              
              
              8,641
              
              
              6,831
              
              
              29,763
              
              
              26,456
              
              
              24,449
              
              
              19,542
              
              
              14,341Non-interest
                  income
              
              
              1,439
              
              
              1,301
              
              
              5,349
              
              
              4,952
              
              
              5,009
              
              
              4,999
              
              
              3,797Non-interest
                  expense
              
              
              6,874
              
              
              5,539
              
              
              23,908
              
              
              20,955
              
              
              18,718
              
              
              17,198
              
              
              12,425Income
                  before income taxes
              
              
              3,206
              
              
              2,593
              
              
              11,204
              
              
              10,453
              
              
              10,740
              
              
              7,343
              
              
              5,713Provision
                  for income taxes
              
              
              1,228
              
              
              944
              
              
              4,287
              
              
              3,791
              
              
              4,103
              
              
              2,759
              
              
              2,117Net
                  income
              
              $
              1,978
              
              $
              1,649
              
              $
              6,917
              
              $
              6,662
              
              $
              6,637
              
              $
              4,584
              
              $
              3,596**Share
                  Data:**Earnings
                  per share - basic
              
              $
              0.27
              
              $
              0.26
              
              $
              1.04
              
              $
              1.05
              
              $
              1.08
              
              $
              0.77
              
              $
              0.71Earnings
                  per share - diluted
              
              $
              0.26
              
              $
              0.25
              
              $
              1.00
              
              $
              1.01
              
              $
              1.01
              
              $
              0.71
              
              $
              0.66Dividend
                  payout ratio (1)
              
              
              29.58
              %
              
              30.86
              %
              
              30.76
              %
              
              39.05
              %
              
              0.00
              %
              
              0.00
              %
              
              0.00
              %Book
                  value per share
              
              $
              9.49
              
              $
              7.80
              
              $
              9.49
              
              $
              7.80
              
              $
              7.20
              
              $
              6.19
              
              $
              5.42Actual
                  shares outstanding at end of period
              
              
              7,317,932
              
              
              6,345,639
              
              
              7,317,932
              
              
              6,345,639
              
              
              6,231,982
              
              
              3,817,943
              
              
              3,604,497Weighted
                  average shares outstanding - Basic
              
              
              7,316,886
              
              
              6,355,466
              
              
              6,651,594
              
              
              6,333,924
              
              
              6,167,937
              
              
              5,990,498
              
              
              5,057,687Weighted
                  average shares outstanding - Diluted
              
              
              7,511,625
              
              
              6,598,355
              
              
              6,884,575
              
              
              6,595,793
              
              
              6,551,389
              
              
              6,434,768
              
              
              5,407,251**Consolidated
                  Balance Sheet Data:**Total
                  cash and cash equivalents
              
              $
              46,419
              
              $
              23,034
              
              $
              46,419
              
              $
              23,034
              
              $
              44,559
              
              $
              21,867
              
              $
              77,114Total
                  investments and other securities
              
              $
              47,556
              
              $
              38,445
              
              $
              47,556
              
              $
              38,445
              
              $
              44,402
              
              $
              57,394
              
              $
              54,956Total
                  gross loans
              
              $
              613,217
              
              $
              444,983
              
              $
              613,217
              
              $
              444,983
              
              $
              368,133
              
              $
              339,693
              
              $
              278,135Allowance
                  for loan losses
              
              $
              (6,143
              )
              $
              (4,081
              )
              $
              (6,143
              )
              $
              (4,081
              )
              $
              (3,881
              )
              $
              (3,247
              )
              $
              (3,070
              )Total
                  assets
              
              $
              745,554
              
              $
              541,774
              
              $
              745,554
              
              $
              541,774
              
              $
              488,501
              
              $
              448,012
              
              $
              441,948Total
                  deposits
              
              $
              644,808
              
              $
              420,521
              
              $
              644,808
              
              $
              420,521
              
              $
              417,797
              
              $
              370,441
              
              $
              366,439Junior
                  subordinated debt
              
              $
              13,403
              
              $
              16,496
              
              $
              13,403
              
              $
              16,496
              
              $
              8,248
              
              $
              8,248
              
              $
              8,248Total
                  stockholders' equity
              
              $
              69,450
              
              $
              49,472
              
              $
              69,450
              
              $
              49,472
              
              $
              44,845
              
              $
              37,250
              
              $
              32,288**Selected
                  Other Balance Sheet Data:**Average
                  assets
              
              $
              709,304
              
              $
              530,829
              
              $
              605,736
              
              $
              503,877
              
              $
              480,204
              
              $
              447,428
              
              $
              343,171Average
                  earning assets
              
              $
              654,146
              
              $
              482,138
              
              $
              555,871
              
              $
              455,497
              
              $
              435,613
              
              $
              391,532
              
              $
              305,452Average
                  stockholders' equity
              
              $
              67,343
              
              $
              48,342
              
              $
              55,927
              
              $
              47,236
              
              $
              41,340
              
              $
              34,854
              
              $
              23,169**Selected
                  Financial Ratios :**Return
                  on average assets
              
              
              1.11
              %
              
              1.23
              %
              
              1.14
              %
              
              1.32
              %
              
              1.38
              %
              
              1.02
              %
              
              1.05
              %Return
                  on average stockholders' equity
              
              
              11.65
              %
              
              13.53
              %
              
              12.37
              %
              
              14.10
              %
              
              16.06
              %
              
              13.15
              %
              
              15.52
              %Net
                  interest margin (2)
              
              
              5.33
              %
              
              5.72
              %
              
              5.47
              %
              
              5.94
              %
              
              5.78
              %
              
              5.10
              %
              
              4.82
              %Efficiency
                  ratio (3)
              
              
              67.26
              %
              
              67.12
              %
              
              66.83
              %
              
              65.47
              %
              
              62.04
              %
              
              68.93
              %
              
              67.13
              %**Capital
                  Ratios:**Average
                  stockholders' equity to average assets
              
              
              9.49
              %
              
              9.11
              %
              
              9.23
              %
              
              9.37
              %
              
              8.61
              %
              
              7.79
              %
              
              6.75
              %Leverage
                  Ratio
              
              
              9.60
              %
              
              11.00
              %
              
              9.60
              %
              
              11.00
              %
              
              9.61
              %
              
              8.34
              %
              
              8.30
              %Tier
                  1 Risk-Based Capital ratio
              
              
              10.08
              %
              
              11.51
              %
              
              10.08
              %
              
              11.51
              %
              
              10.98
              %
              
              9.78
              %
              
              10.15
              %Total
                  Risk-Based Capital ratio
              
              
              11.04
              %
              
              12.36
              %
              
              11.04
              %
              
              12.36
              %
              
              11.93
              %
              
              10.65
              %
              
              11.14
              %**Selected
                  Asset Quality Ratios:**Non-performing
                  loans to total loans (4)
              
              
              0.06
              %
              
              0.01
              %
              
              0.06
              %
              
              0.01
              %
              
              0.01
              %
              
              0.27
              %
              
              0.59
              %Non-performing
                  assets to total loans
              
              
              0.06
              %
              
              0.01
              %
              
              0.06
              %
              
              0.01
              %
              
              0.01
              %
              
              0.27
              %
              
              0.59
              %Non-performing
                  assets to total assets (5)
              
              
              0.05
              %
              
              0.01
              %
              
              0.05
              %
              
              0.01
              %
              
              0.01
              %
              
              0.21
              %
              
              0.37
              %Allowance
                  for loan losses to total loans
              
              
              1.00
              %
              
              0.92
              %
              
              1.00
              %
              
              0.92
              %
              
              1.05
              %
              
              0.96
              %
              
              1.10
              %Allowance
                  for loan losses to non-performing loans
              
              
              1817.46
              %
              
              7420.00
              %
              
              1817.46
              %
              
              7420.00
              %
              
              7187.00
              %
              
              348.00
              %
              
              188.00
              %Allowance
                  for loan losses to non-performing assets
              
              
              1817.46
              %
              
              7420.00
              %
              
              1817.46
              %
              
              7420.00
              %
              
              7187.00
              %
              
              348.00
              %
              
              188.00
              %Net
                  charge-offs(recoveries) to average loans
              
              
              0.02
              %
              
              -0.02
              %
              
              0.00
              %
              
              0.10
              %
              
              0.02
              %
              
              0.08
              %
              
              0.10
              %
  (1)
                  Cash dividends totaling $0.08 per share were paid in the fourth
                  quarters
                  of 2007 and 2006. 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, 2004 and 2003.(2)
                  Net interest margin represents net interest income as a percentage
                  of
                  average interest-earning assets.(3)
                  Efficiency ratio represents noninterest expenses, excluding loan
                  loss
                  provision, as a percentage of the aggregate of net interest income
                  and
                  noninterest income.(4)
                  Non-performing loans are defined as loans that are past due 90
                  days or
                  more plus loans placed in non-accrual status.(5)
                  Non-performing assets are defined as assets that are past due 90
                  days or
                  more plus assets placed in non-accrual status plus other real estate
                  owned.




23


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





The
      following is an analysis of the financial condition and results of operations
      of
      the Company for the three years ended December 31, 2007. The analysis should
      be
      read in connection with the consolidated financial statements and notes thereto
      appearing elsewhere in this report.





**FINANCIAL
      OVERVIEW**





For
      the
      years ended December 31, 2007, 2006 and 2005 the Company earned $6.9 million,
      $6.7 million, and $6.6 million or $1.00, $1.01 and $1.01 per share on a fully
      diluted basis, respectively. For 2007, net income on a year over year basis
      grew
      approximately $0.3 million or 3.8%. The primary factor behind the year over
      year
      increase in net income was an $8.8 million or 24.2% increase in interest income,
      resulting from the Company’s continued loan growth, rising interest rates during
      the first half of 2007, and the acquisition of Business First. Since the
      acquisition, Business First has contributed approximately $2.3 million in
      interest income to the Bank. Although the Bank did experience a significant
      amount of loan pay-downs during the year, the dollar amount of loans funded
      rose
      significantly from the prior year end, contributing the overall rise in organic
      loan growth and ultimately interest income.





During
      2007, the Company experienced a significant rise in interest expense, which
      minimized the rise in net interest income. For the years ended December 31,
      2007, 2006 and 2005 interest expense was $14.8 million, $9.3 million and $5.0
      million, respectively. For 2007, on a year over year basis, interest expense
      grew approximately $5.4 million or 58.3%. This increase can be attributed to
      the
      considerable deposit growth the Bank experienced during 2007, specifically
      related to promotions designed to attract lower cost core deposits as well
      as
      rising interest rates during the first half of 2007. The growth in lower cost
      core deposits has, however, allowed the Bank to pay-down more expensive Federal
      Home Loan Bank borrowings in an effort to curb the rise in the Bank’s overall
      cost of funds. Additionally, of the rise in interest expense approximately
      $0.9
      million or 15.8% can be attributed to the acquisition of Business
      First.





The
      rise
      in interest expense during 2007 has placed pressure on the net interest margin.
      The Company’s net interest margin declined approximately 47 basis points in 2007
      to 5.47% from 5.94% in 2006 and approximately 31 basis points from the 5.78%
      reported in 2005. Competition for lower cost core deposits and rising interest
      rates during the majority of 2007 were primary factors in the year over year
      decline in the net interest margin.





The
      Company also experienced a $3.0 million or 14.0% rise in non-interest expense
      during 2007. For the years ended December 31, 2007, 2006 and 2005 non-interest
      expense was $23.9 million, $21.0 million and $18.7 million, respectively. For
      2007, the year over year rise in non-interest expenses is mainly attributable
      to
      a $1.9 million or 16.7% rise in salaries and employee benefits. The increase
      in
      this category can be attributed in part to a full year impact of the Templeton
      branch opened in August 2006 as well as the addition of staff for a full-service
      branch in the town of San Miguel that has since opened in early 2008.
      Additionally, the acquisition of Business First accounted for approximately
      $0.6
      million or 29.3% of the rise in salaries and employee benefits on a year over
      year basis.





For
      2007
      the Company’s efficiency ratio was 66.83%. This is slightly higher than the
      65.47% and 62.04% the Company reported for the years ended December 31, 2006
      and
      2005, respectively. The rise in the efficiency ratio can be attributed to the
      addition of staff needed to position the Company for future growth, the
      acquisition of Business First, and the rise in interest expense during 2007,
      as
      previously mentioned.





Return
      on
      Equity (“ROE”) was 12.37%, 14.10% and 16.06% for 2007, 2006 and 2005,
      respectively. In addition to the rise in interest and non-interest expenses,
      the
      acquisition of Business First has placed some pressure on ROE during the later
      half of 2007 due to the issuance of common stock to the former shareholders
      of
      Business First in connection with the acquisition.





At
      December 31, 2007, the Company had approximately $745.6 million in total assets.
      This, when compared to the $541.8 million reported at December 31, 2006,
      represents an increase of approximately $203.8 million or 37.6%. Of this
      increase, approximately $152.2 million can be attributed to the acquisition
      of
      and growth in Business First assets. During 2007, the increase in net loan
      balances contributed to the majority of the rise in total assets. Excluding
      the
      acquisition of Business First, the Bank’s loan portfolio grew approximately
      $16.0 million or 3.7%. In October 2007, the Bank acquired approximately $120.8
      million in net loans from Business First and since the date of the acquisition,
      Business First net loan balances have increased approximately $29.3 million
      or
      24.2%.





The
      growth in the Bank’s deposit balances have contributed to higher balances in
      federal funds sold. At December 31, 2007, federal funds sold were approximately
      $23.2 million, which represents an approximate $19.3 million increase over
      the
      $3.9 million reported at December 31, 2006.





24





At
      December 31, 2007, total deposits were $644.8 million. This, when compared
      to
      the $420.5 million reported at December 31, 2006, represents an increase of
      approximately $224.3 million. During 2007, the Bank engaged in promotions
      designed to attract lower cost core deposits in an effort to fund the strong
      loan growth the Bank saw during the first half of the year, and to pay-down
      higher cost Federal Home Loan Bank borrowings. These promotions have proven
      to
      be successful, as the Bank, excluding the acquisition of Business First
      experienced an increase in total deposits of approximately $100.7 million or
      23.9% during 2007. The majority of this increase can be attributed to a $110.2
      million increase in Savings, NOW and Money Market deposit balances. Upon the
      acquisition of Business First, the Bank acquired approximately $133.4 million
      in
      deposits.





As
      previously mentioned, the strong growth in lower cost core deposit balances
      during 2007 allowed the Bank to pay-down approximately $50.0 million in higher
      cost Federal Home Loan Bank (“FHLB”) borrowings. At December 31, 2007, the Bank
      had $8.0 million in FHLB advances, which were assumed upon the acquisition
      of
      Business First.





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.





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 amortized 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.
      See also Item 2. Description of Properties of this Form 10-K for additional
      information related to this transaction.





25




**RESULTS
      OF OPERATIONS**





The
      Company reported net income of $6.9 million for the year ended December 31,
      2007
      compared to $6.7 million and $6.6 million for the years 2006 and 2005
      respectively. Basic earnings per share were $1.04, $1.05 and $1.08 at December
      31, 2007, 2006 and 2005, respectively. Diluted earnings per share were $1.00,
      $1.01 and $1.01 at December 31, 2007, 2006 and 2005, respectively. Earnings
      were
      mostly unchanged from the prior year primarily due to an increase in interest
      expense on interest bearing accounts and borrowed funds along with an increase
      in non-interest expenses. Rising interest rates during the majority of 2007
      as
      well as competition for lower cost core deposits contributed to a 66 basis
      point
      rise in the Company’s cost of funds, which placed pressure on and resulted in a
      reduction in the net interest margin from 5.94% in 2006 to 5.47% in
      2007.





*NET
      INTEREST INCOME AND MARGIN*





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





The
      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, 2007, 2006 and 2005. The average balance of non-accruing loans
      has
      been included in loan totals:


**For
                  The Year Ended,**
                **December
                  31, 2007**
              
              
              **For
                  The Year Ended,**
                **December
                  31, 2006**
              
              
              **For
                  The Year Ended,**
                **December
                  31, 2005****Income/**
              
              
              
              
              
              
              
              
              **Income/**
              
              
              
              
              
              
              
              
              **Income/***(dollar amounts in thousands)*
              
              
              **Balance**
              
              
              **Rate**
              
              
              **Expense**
              
              
              **Balance**
              
              
              **Rate**
              
              
              **Expense**
              
              
              **Balance**
              
              
              **Rate**
              
              
              **Expense**Interest
                  Earning Assets:Investments
                  with other banks
              
              **$**
              **499**
              
              
              **1.60**
              **%**
              **$**
              **8**
              
              $
              315
              
              
              2.86
              %
              $
              9
              
              $
              1,149
              
              
              4.44
              %
              $
              51Investment
                  securities taxable
              
              
              **25,585**
              
              
              **4.87**
              **%**
              
              **1,246**
              
              
              27,455
              
              
              4.46
              %
              
              1,225
              
              
              38,499
              
              
              3.81
              %
              
              1,465Investment
                  securities non-taxable
              
              
              **16,535**
              
              
              **4.29**
              **%**
              
              **710**
              
              
              16,319
              
              
              4.30
              %
              
              702
              
              
              13,701
              
              
              4.33
              %
              
              593Federal
                  funds sold
              
              
              **15,878**
              
              
              **4.94**
              **%**
              
              **785**
              
              
              11,179
              
              
              4.82
              %
              
              539
              
              
              19,529
              
              
              3.42
              %
              
              667Loans
                  (1) (2)
              
              
              **497,374**
              
              
              **8.53**
              **%**
              
              **42,425**
              
              
              400,229
              
              
              8.47
              %
              
              33,897
              
              
              362,735
              
              
              7.55
              %
              
              27,399Total
                  interest earning assets
              
              
              **555,871**
              
              
              **8.13**
              **%**
              
              **45,174**
              
              
              455,497
              
              
              7.99
              %
              
              36,372
              
              
              435,613
              
              
              6.93
              %
              
              30,175Allowance
                  for possible loan losses
              
              
              **(4,784**
              **)**
              
              
              
              
              
              
              
              (3,931
              )
              
              
              
              
              
              
              
              (3,577
              )Other
                  assets
              
              
              **54,649**
              
              
              
              
              
              
              
              
              52,311
              
              
              
              
              
              
              
              
              48,168Total
                  assets
              
              **$**
              **605,736**
              
              
              
              
              
              
              
              $
              503,877
              
              
              
              
              
              
              
              $
              480,204Interest
                  Bearing Liabilities:Savings/NOW/money
                  market
              
              **$**
              **207,684**
              
              
              **2.36**
              **%**
              **$**
              **4,911**
              
              $
              160,841
              
              
              1.55
              %
              $
              2,497
              
              $
              167,223
              
              
              1.01
              %
              $
              1,695Time
                  deposits
              
              
              **145,565**
              
              
              **4.78**
              **%**
              
              **6,960**
              
              
              106,342
              
              
              4.21
              %
              
              4,472
              
              
              65,128
              
              
              2.74
              %
              
              1,784Other
                  borrowings
              
              
              **34,991**
              
              
              **5.42**
              **%**
              
              **1,896**
              
              
              27,854
              
              
              5.21
              %
              
              1,452
              
              
              27,966
              
              
              3.41
              %
              
              954Federal
                  funds purchased
              
              
              **1,138**
              
              
              **5.54**
              **%**
              
              **63**
              
              
              1,020
              
              
              5.49
              %
              
              56
              
              
              -
              
              
              0.00
              %
              
              -Long-term
                  debt
              
              
              **12,234**
              
              
              **7.53**
              **%**
              
              **921**
              
              
              9,694
              
              
              8.65
              %
              
              839
              
              
              8,248
              
              
              7.07
              %
              
              583Total
                  interest-bearing liabilities
              
              
              **401,612**
              
              
              **3.67**
              **%**
              
              **14,751**
              
              
              305,751
              
              
              3.05
              %
              
              9,316
              
              
              268,565
              
              
              1.87
              %
              
              5,016Demand
                  deposits
              
              
              **141,123**
              
              
              
              
              
              
              
              
              146,458
              
              
              
              
              
              
              
              
              166,780Other
                  liabilities
              
              
              **7,074**
              
              
              
              
              
              
              
              
              4,432
              
              
              
              
              
              
              
              
              3,519Stockholders'
                  Equity:Common
                  stock
              
              
              **32,909**
              
              
              
              
              
              
              
              
              29,367
              
              
              
              
              
              
              
              
              28,049Additional
                  paid in capital
              
              
              **507**
              
              
              
              
              
              
              
              
              -
              
              
              
              
              
              
              
              
              -Retained
                  earnings
              
              
              **22,463**
              
              
              
              
              
              
              
              
              18,003
              
              
              
              
              
              
              
              
              13,268Valuation
                  allowance investments
              
              
              **48**
              
              
              
              
              
              
              
              
              (134
              )
              
              
              
              
              
              
              
              23Total
                  stockholders' equity
              
              
              **55,927**
              
              
              
              
              
              
              
              
              47,236
              
              
              
              
              
              
              
              
              41,340Total
                  liabilities and stockholders' equity
              
              **$**
              **605,736**
              
              
              
              
              
              
              
              $
              503,877
              
              
              
              
              
              
              
              $
              480,204Net
                  interest income
              
              
              
              
              
              
              
              **$**
              **30,423**
              
              
              
              
              
              
              
              $
              27,056
              
              
              
              
              
              
              
              $
              25,159Net
                  interest margin (3)
              
              
              
              
              
              **5.47**
              **%**
              
              
              
              
              
              
              
              5.94
              %
              
              
              
              
              
              
              
              5.78
              %
 (1)
          Nonaccrual loans have been included in total loans.
 (2)
          Loan
          fees of $1,227; $1,275; and $1,440 for the years ending ending December
          31,
          2007; 2006; and 2005 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.
  26


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,
      2007, 2006 and 2005:


**For
                  The Year Ended,**
                **December
                  31, 2007**
              
              **For
                  The Year Ended,**
                **December
                  31, 2006**
              
              **For
                  The Year Ended,**
                **December
                  31, 2005***(dollar
                  amounts in thousands)*
              
              **Volume**
              
              **Rate**
              
              **Total**
              
              **Volume**
              
              **Rate**
              
              **Total**
              
              **Volume**
              
              **Rate**
              
              **Total****Interest
                  income:**Loans
                  (1)
              
              $
              8,288
              
              $
              240
              
              $
              8,528
              
              $
              2,990
              
              $
              3,508
              
              $
              6,498
              
              $
              4,230
              
              $
              2,554
              
              $
              6,784Investment
                  securities taxable
              
              
              (86
              )
              
              107
              
              
              21
              
              
              (604
              )
              
              364
              
              
              (240
              )
              
              (406
              )
              
              22
              
              
              (384
              )Investment
                  securities non-taxable (2):
              
              
              14
              
              
              (2
              )
              
              12
              
              
              171
              
              
              (6
              )
              
              165
              
              
              145
              
              
              (12
              )
              
              133Taxable
                  equivalent adjustment (2):
              
              
              (5
              )
              
              1
              
              
              (4
              )
              
              (58
              )
              
              2
              
              
              (56
              )
              
              (49
              )
              
              4
              
              
              (45
              )Interest-bearing
                  deposits
              
              
              4
              
              
              (5
              )
              
              (1
              )
              
              (28
              )
              
              (14
              )
              
              (42
              )
              
              (5
              )
              
              15
              
              
              10Federal
                  funds sold
              
              
              232
              
              
              14
              
              
              246
              
              
              (3,648
              )
              
              3,520
              
              
              (128
              )
              
              (46
              )
              
              411
              
              
              365Net
                  increase (decrease)
              
              
              8,447
              
              
              355
              
              
              8,802
              
              
              (1,177
              )
              
              7,374
              
              
              6,197
              
              
              3,869
              
              
              2,994
              
              
              6,863**Interest
                  expense:**Savings,
                  NOW, money market
              
              
              249
              
              
              2,165
              
              
              2,414
              
              
              (62
              )
              
              864
              
              
              802
              
              
              41
              
              
              955
              
              
              996Time
                  deposits
              
              
              2,009
              
              
              479
              
              
              2,488
              
              
              1,456
              
              
              1,232
              
              
              2,688
              
              
              (66
              )
              
              779
              
              
              713Other
                  borrowings
              
              
              390
              
              
              54
              
              
              444
              
              
              (4
              )
              
              502
              
              
              498
              
              
              (109
              )
              
              (92
              )
              
              (201
              )Federal
                  funds purchased
              
              
              7
              
              
              -
              
              
              7
              
              
              56
              
              
              -
              
              
              56
              
              
              -
              
              
              -
              
              
              -Long
                  term borrowings
              
              
              201
              
              
              (119
              )
              
              82
              
              
              112
              
              
              144
              
              
              256
              
              
              -
              
              
              147
              
              
              147Net
                  increase (decrease)
              
              
              2,856
              
              
              2,579
              
              
              5,435
              
              
              1,558
              
              
              2,742
              
              
              4,300
              
              
              (134
              )
              
              1,789
              
              
              1,655Total
                  net increase (decrease)
              
              $
              5,591
              
              $
              (2,224
              )
              $
              3,367
              
              $
              (2,735
              )
              $
              4,632
              
              $
              1,897
              
              $
              4,003
              
              $
              1,205
              
              $
              5,208
 (1)
          Loan
          fees of $1,227, $1,275 and $1,440, for 2007, 2006 and 2005, respectively
          have
          been included in the interest income computation.
 (2)
            Adjusted to a fully taxable equivalent basis using a tax rate of
            34%.


During
      2007 there was an $8.8 million increase in interest income and a $5.4 million
      increase in interest expense compared to 2006. The resulting $3.4 million
      increase in net interest income was the result of a number of dynamics affecting
      both average balance and interest rate considerations. For the year, average
      earning assets increased by $100.4 million. Although the acquisition of Business
      First contributed approximately $30.1 million to the increase in average earning
      assets, average loans exclusive of the acquisition increased $67.7 million
      from
      the prior year end. This increase in average loan balances, both organic and
      through the acquisition of Business First in conjunction with a rising rate
      environment throughout the majority of 2007 contributed to the majority of
      the
      rise in interest income.





Average
      interest bearing liabilities increased by $95.9 million during 2007, of which
      approximately $20.3 million can be attributed to the acquisition of Business
      First. The Bank, exclusive of the acquisition, experienced a rise in average
      Savings, NOW, and Money Market account balances of approximately $33.9 million
      and a rise in time certificates of deposits of approximately $32.3 million.
      The
      promotional activities the Bank engaged in during 2007 to attract lower cost
      sources of funding directly contributed to the rise in average interest-bearing
      deposit balances. During 2007, the cost of interest-bearing liabilities
      increased by approximately 62 basis points to 3.67% from the 3.05% reported
      at
      December 31, 2006. The rise in interest bearing liabilities in conjunction
      with
      the rise in interest rates during the majority of 2007, as previously mentioned,
      contributed to the overall decline in the net interest margin by 47 basis points
      to 5.47% from the 5.94% reported at December 31, 2006.





During
      2006 there was a $6.2 million increase in interest income and a $4.3 million
      increase in interest expense when compared to 2005. The Company experienced
      an
      increase in average earning assets of approximately $19.9 million. This increase
      was primarily attributable to an increase of $37.5 million in average loan
      balances from the end of 2005. The increase in average loan balances was
      partially offset by decreases in average federal funds sold of $8.4 million
      and
      a decline in taxable investment securities by approximately $13.0 million,
      primarily attributable to principal reductions and maturities of mortgage-backed
      securities. During 2006, the yield on average earning assets increased by
      approximately 106 basis points, while the cost of interest bearing liabilities
      increased by approximately 118 basis points when compared to 2005.




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, 2007 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.





27





The
      table
      below sets forth changes from 2006 to 2007 for average interest earning assets
      and their respective average yields:


*(dollar
                  amounts in thousands)*
              
              **Average
                  Balance**
                **For
                  The Year Ended,**
                **December
                  31,**
              
              **Variance**
              
              **Average
                  Yield**
                **For
                  The Year Ended,**
                **December
                  31,**Interest
                  Earning Assets:
              
              **2007**
              
              **2006**
              
              **dollar**
              
              **percentage**
              
              **2007**
              
              **2006**
              
              **Variance**Time
                  deposits with other banks
              
              $
              499
              
              $
              315
              
              $
              184
              
              
              58.41
              %
              
              1.60
              %
              
              2.86
              %
              
              -1.25
              %Investment
                  securities taxable
              
              
              25,585
              
              
              27,455
              
              
              (1,870
              )
              
              -6.81
              %
              
              4.87
              %
              
              4.46
              %
              
              0.41
              %Investment
                  securities non-taxable
              
              
              16,535
              
              
              16,319
              
              
              216
              
              
              1.32
              %
              
              4.29
              %
              
              4.30
              %
              
              -0.01
              %Federal
                  funds sold
              
              
              15,878
              
              
              11,179
              
              
              4,699
              
              
              42.03
              %
              
              4.94
              %
              
              4.82
              %
              
              0.12
              %Loans
                  (1) (2)
              
              
              497,374
              
              $
              400,229
              
              
              97,145
              
              
              24.27
              %
              
              8.53
              %
              
              8.47
              %
              
              0.06
              %Total
                  interest earning assets
              
              $
              555,871
              
              $
              455,497
              
              $
              100,374
              
              
              22.04
              %
              
              8.13
              %
              
              7.99
              %
              
              0.14
              %
 (1)
          Non-accrual loans have been included in loan totals.
 (2)
          Loan
          fees of $1,227 and $1,275 have been included in the interest income computation
          for the years ended December 31, 2007 and 2006,
          respectively.




The
      table
      below sets forth changes from 2006 to 2007 for average interest bearing
      liabilities and the respective average rates paid:


*(dollar
                  amounts in thousands)*
              
              **Average
                  Balance**
                **For
                  The Year Ended,**
                **December
                  31,**
              
              **Variance**
              
              **Average
                  Yield**
                **F****or
                  The Year Ended,**
                **December
                  31,**Interest
                  Bearing Liabilities:
              
              **2007**
              
              **2006**
              
              **dollar**
              
              **percentage**
              
              **2007**
              
              **2006**
              
              **Variance**Savings/NOW/money
                  market
              
              $
              207,684
              
              $
              160,841
              
              $
              46,843
              
              
              29.12
              %
              
              2.36
              %
              
              1.55
              %
              
              0.81
              %Time
                  deposits
              
              
              145,565
              
              
              106,342
              
              
              39,223
              
              
              36.88
              %
              
              4.78
              %
              
              4.21
              %
              
              0.57
              %Other
                  borrowings (1) (2)
              
              
              34,991
              
              
              27,854
              
              
              7,137
              
              
              25.62
              %
              
              5.42
              %
              
              5.21
              %
              
              0.21
              %Federal
                  funds purchased
              
              
              1,138
              
              
              1,020
              
              
              118
              
              
              11.57
              %
              
              5.54
              %
              
              5.49
              %
              
              0.05
              %Long
                  term debt
              
              
              12,234
              
              
              9,694
              
              
              2,540
              
              
              26.20
              %
              
              7.53
              %
              
              8.65
              %
              
              -1.12
              %Total
                  interest-bearing liabilities
              
              $
              401,612
              
              $
              305,751
              
              $
              95,861
              
              
              31.35
              %
              
              3.67
              %
              
              3.05
              %
              
              0.62
              %
 (1)
          Consists of Federal Home Loan Bank borrowings of $33,136 and $25,973 and
          repurchase agreements of $1,855 and $1,881 for
          the
          years ended December 31, 2007 and 2006, respectively.
 (2)
            Average rate paid on Federal Home Loan Bank borrowings and repurchase
            agreements
            of 5.44% and 5.25% and 4.91% and 4.63% for
            the
            years ended December 31, 2007 and 2006, respectively.





*NON-INTEREST
      INCOME*





The
      table
      below sets forth changes from 2006 to 2007 and 2005 to 2006 for non-interest
      income exclusive of gains on sale of securities, SBA loans and premises:




**For
                  The Years Ended**
              
              **Variances****December
                  31,**
              
              **2007**
              
              **2006***(dollar
                    amounts in thousands)*
              
              **2007**
              
              **2006**
              
              **2005**
              
              **dollar**
              
              **percentage**
              
              **dollar**
              
              **percentage**Service
                  charges on deposit accounts
              
              $
              2,774
              
              $
              2,427
              
              $
              2,430
              
              $
              347
              
              
              14.3
              %
              $
              (3
              )
              
              -0.1
              %ATM/Debit
                  Card transaction/interchange fees
              
              
              765
              
              
              711
              
              
              629
              
              
              54
              
              
              7.6
              %
              
              82
              
              
              13.0
              %Bancard
              
              
              224
              
              
              122
              
              
              160
              
              
              102
              
              
              83.6
              %
              
              (38
              )
              
              -23.8
              %Mortgage
                  origination fees
              
              
              461
              
              
              552
              
              
              897
              
              
              (91
              )
              
              -16.5
              %
              
              (345
              )
              
              -38.5
              %Earnings
                  on cash surrender value life insurance
              
              
              433
              
              
              393
              
              
              323
              
              
              40
              
              
              10.2
              %
              
              70
              
              
              21.7
              %Other
              
              
              650
              
              
              737
              
              
              482
              
              
              (87
              )
              
              -11.8
              %
              
              255
              
              
              52.9
              %Total
              
              $
              5,307
              
              $
              4,942
              
              $
              4,921
              
              $
              365
              
              
              7.4
              %
              $
              21
              
              
              0.4
              %




For
      the
      year ended December 31, 2007, non-interest income rose approximately $365
      thousand or 7.4% from the prior year. Of the increase in non-interest income,
      approximately $140 thousand or 38.4% can be attributed to the acquisition of
      Business First. Service charges on deposit accounts contributed to the majority
      of the increase in non-interest income, with an increase of approximately $347
      thousand over the prior year. Excluding the acquisition, income in this category
      increased approximately $225 thousand. Additionally, Bancard revenues also
      contributed significantly to the rise in non-interest income, increasing
      approximately $102 thousand over the prior year. The increase in this category
      can be attributed to a newly negotiated contract the Bank entered into during
      2007, allowing the Bank to obtain a greater portion of the total dollar volume
      of merchant credit card transactions. Additionally, the increase in these
      categories of non-interest income can be attributed in part to the additional
      deposit relationships the Bank obtained during 2007.




28





During
      2007, mortgage origination fees fell approximately $91 thousand or 16.5% from
      the prior year end. The decline in this category of non-interest income is
      attributable to declines in the number of mortgage originations during the
      year.
      Rising interest rates during the majority of 2007, the leveling of and decline
      in property values in the region, as well as increasingly negative sentiment
      surrounding the single family residential mortgage market have contributed
      to
      the decline in the number of and total dollar amount of mortgages originated
      during the year.





Management
      is very aware that the revenue generated by this line of business is impacted
      by
      rate volatility as well as property values and that if the availability of
      credit is diminished, then mortgage volumes at the Company could decline and
      impact the level of mortgage origination fee income. To mitigate material
      decreases in net revenue from this line of business, Management has taken steps
      to ensure that fixed costs are minimal due to commission based
      remuneration.





The
      following table provides a summary of the total dollar volume and number of
      mortgage loans funded during the years ended December 31, 2007, 2006 and
      2005:


**For
                  the years ended December 31,**
              
              **Variance***(dollar
                  amounts in thousands)*
              
              **2007**
              
              **2006**
              
              **2005**
              
              **2007
                  vs. 2006**
              
              **2006
                  vs. 2005**Dollar
                  volume
              
              $
              50,623
              
              $
              65,895
              
              $
              75,538
              
              
              -23.2
              %
              
              -12.8
              %Number
                  of loans
              
              
              147
              
              
              202
              
              
              224
              
              
              -27.2
              %
              
              -9.8
              %




In
      November 2007, the Bank hired Fred Bond as the Senior Vice President/Division
      Manager of the Mortgage Department. Management believes that with the slowdown
      in activity and reduction in competitive mortgage lending operations, there
      is
      an opportunity for the Bank to expand and capture a greater share of the market
      and become the preferred mortgage solution on the Central Coast. Officer Bond
      has built an enviable reputation in lending markets in the Bank’s primary market
      area, both as a highly productive lending manager and as an innovator in the
      business lending field. He also brings his successful track record in
      cross-selling, which will be a strong compliment to our branching
      network.




*NON-INTEREST
      EXPENSES*





The
      table
      below sets forth changes in non-interest expense for 2007, 2006, and 2005:


**For
                  The Years Ended**
              
              **Variances***(dollar
                  amounts in thousands)*
              
              **December
                  31,**
              
              **2007**
              
              **2006****2007**
              
              **2006**
              
              **2005**
              
              **dollar**
              
              **percentage**
              
              **dollar**
              
              **percentage**Salaries
                  and employee benefits
              
              $
              13,501
              
              $
              11,573
              
              $
              9,746
              
              $
              1,928
              
              
              16.7
              %
              $
              1,827
              
              
              18.7
              %Occupany
                  and equipment
              
              
              3,381
              
              
              2,607
              
              
              2,491
              
              
              774
              
              
              29.7
              %
              
              116
              
              
              4.7
              %Data
                  processing
              
              
              2,267
              
              
              2,138
              
              
              2,200
              
              
              129
              
              
              6.0
              %
              
              (62
              )
              
              -2.8
              %Advertising
                  and promotional
              
              
              718
              
              
              851
              
              
              582
              
              
              (133
              )
              
              -15.6
              %
              
              269
              
              
              46.2
              %Regulatory
                  fees
              
              
              146
              
              
              112
              
              
              106
              
              
              34
              
              
              30.4
              %
              
              6
              
              
              5.7
              %Other
                  professional fees and outside services
              
              
              1,247
              
              
              1,207
              
              
              802
              
              
              40
              
              
              3.3
              %
              
              405
              
              
              50.5
              %Legal
                  fees and other litigation expense
              
              
              100
              
              
              154
              
              
              122
              
              
              (54
              )
              
              -35.1
              %
              
              32
              
              
              26.2
              %Loan
                  department costs
              
              
              129
              
              
              147
              
              
              182
              
              
              (18
              )
              
              -12.2
              %
              
              (35
              )
              
              -19.2
              %Stationery
                  and supplies
              
              
              350
              
              
              327
              
              
              311
              
              
              23
              
              
              7.0
              %
              
              16
              
              
              5.1
              %Director
                  fees
              
              
              289
              
              
              290
              
              
              247
              
              
              (1
              )
              
              -0.3
              %
              
              43
              
              
              17.4
              %Core
                  deposit intangible amortization
              
              
              393
              
              
              300
              
              
              574
              
              
              93
              
              
              31.0
              %
              
              (274
              )
              
              -47.7
              %Other
              
              
              1,387
              
              
              1,249
              
              
              1,355
              
              
              138
              
              
              11.0
              %
              
              (106
              )
              
              -7.8
              %Total
              
              $
              23,908
              
              $
              20,955
              
              $
              18,718
              
              $
              2,953
              
              
              14.1
              %
              $
              2,237
              
              
              12.0
              %




·
              *Salaries
                  and Employee Benefits*





Expenses
      within this category incurred the greatest dollar increase of any non-interest
      expense category during both 2007 and 2006. Of the increase in this category,
      approximately $565 thousand can be attributed to the acquisition of Business
      First. Excluding the acquisition of Business First the primary factors behind
      the rise in salaries and employee benefits can be attributed to the addition
      of
      two full services branches as well as a higher bonus accrual for the year
      related to the growth of the Bank. For the years ended December 31, 2007, 2006
      and 2005 the number of Full time equivalent (FTE) employees stood at 242, 212,
      and 186, respectively.




29




As
      mentioned above, the bonus accrual for 2007 was approximately $492 thousand
      higher than in 2006. Bonus and commissions expense increases during the year
      were influenced by the Company’s commitment to incentive based pay. Management
      believes that incentive based pay is a significant part of the Company’s
      corporate culture and has served to help provide above average returns to
      shareholders. All employees participate either on a monthly, quarterly or annual
      basis.





The
      increase in this category from 2005 to 2006 can be attributed to the expansion
      of the executive management team, contributing to higher officer salaries.
      The
      executive management team was expanded in 2006 in order to position the Company
      for future growth.





·
              *Occupancy
                  and Equipment*





Expenses
      in this category increased $774 thousand or 29.7% over the prior year. The
      primary factors contributing to the increase in this category are the sale
      lease-back transaction the Bank completed during the second quarter, 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 the Bank sold four of its buildings in
      a
      sale lease-back transaction. In connection with the sale, the Bank recorded
      a
      deferred gain in the approximate amount of $3.4 million, which will be amortized
      over a period of fifteen years as a credit to rental expense. For the year
      ended
      December 31, 2007, the Bank recognized approximately $114 thousand of the
      deferred gain on sale related to the sale lease-back transaction. For the year
      ended December 31, 2006, occupancy and equipment expenses increased
      approximately $116 thousand from 2005.





·
              *Data
                  Processing Expense*





For
      the
      year ended December 31, 2007, data processing expenses remained relatively
      unchanged from 2006, showing only a slight increase of approximately $129
      thousand or 6.0%. The year over year increase can be attributed in part to
      the
      acquisition of Business First. Expenses in this category declined modestly
      from
      2005 to 2006, showing a decline of approximately $62 thousand or
      2.8%.




·
              *Other
                  Professional Fees and Outside Services*





The
      Company incurred approximately $1,247 thousand in other professional fees and
      outside services during 2007. While the majority of expenses in this category
      declined from the prior year, the Company incurred higher audit and tax
      accounting fees, which contributed to the overall increase from 2006. These
      expenses increased by $178 thousand in 2007 and $85 thousand in 2006,
      respectively. Increases in audit and tax accounting fees are mainly attributable
      to the Company’s compliance with Section 404 of the Sarbanes-Oxley Act of 2002.
      For the year ended December 31, 2006, other professional fees and outside
      services increased by $405 thousand. The increase from 2005 to 2006 can be
      attributed to higher audit and tax accounting fees, as previously mentioned,
      as
      well as higher consulting fees related to branch expansion, compensation
      compliance, and compliance with Section 404 of the Sarbanes-Oxley Act of
      2002.




·
              *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, 2007 and 2006 was $393 and $300, respectively.




*PROVISION
      FOR INCOME TAXES*





The
      provision for income tax was approximately 200 basis points higher at 38.26
      % in
      2007 compared to 36.27 % in 2006. 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. The provision for income taxes for the year ended
      December 31, 2005 was approximately 38.2%.




*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 is increased by
      provisions charged to earnings and is reduced by charge-offs, net of recoveries.
      The provision for loan losses is based upon past loan loss experience and
      management’s evaluation of the loan portfolio under current economic conditions.
      Loans are charged to the allowance for loan losses when, and to the extent,
      they
      are deemed by management to be un-collectible. The allowance for loan losses
      is
      composed of allocations for specific loans and a historical portion for all
      other loans.




30





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 portfolios by incorporating feedback provided by internal loan staff,
      an
      independent loan review function, and information provided by examinations
      performed by regulatory agencies. The Bank makes monthly evaluations as to
      the
      adequacy of the allowance for loan losses.





The
      analysis of the allowance for loan losses is comprised of three components;
      specific credit allocation; general portfolio allocation; and subjectively
      by
      determined allocation. The Bank accounts for problem loans in accordance with
      Statement of Financial Accounting Standards (“SFAS”) No.114, *“Accounting
      by Creditors for Impairment of a Loan,”* as
      amended by SFAS No. 118, *“Accounting
      by Creditors for Impairment of a Loan - Income Recognition and
      Disclosures.* ”
These
      pronouncements provide that when it is probable that a creditor will be unable
      to collect all amounts due in accordance with the terms of the loan that such
      loan is deemed impaired. Impaired loans are accounted for differently in that
      the amount of the impairment is measured and reflected in the records of the
      creditor. The allowance for 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
      Banks’ evaluation of various factors including current economic conditions and
      trends in the portfolio including delinquencies and impairment, as well as
      changes in the composition of the portfolio.





The
      allowance for loan losses is based on estimates, and ultimate losses will vary
      from current estimates. These estimates are reviewed monthly by the Bank’s
      Director’s, Loan Committee and full Board of Directors, and as adjustments,
      either positive or negative, become necessary, a corresponding increase or
      decrease is made in the provision for loan losses. The methodology used to
      determine the adequacy of the allowance for possible loan losses for the year
      2007 is consistent with prior periods.





The
      Bank’s provision for loan losses was $660 thousand, $600 thousand and $710
      thousand for 2007, 2006 and 2005, respectively. The loan loss provision
      represents coverage for general loan portfolio growth and real estate
      concentrations. Net loan charge-offs (loans charged-off, net of loans recovered)
      were $400 thousand and $76 thousand for 2006 and 2005, 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.
      The
      allowance for loan losses as a percent of total gross loans at December 31,
      2007, 2006 and 2005 was 1.00%, 0.92% and 1.05%, respectively.





For
      additional information related to non-performing assets see “Non Performing
      Assets” under Management’s Discussion and Analysis of Financial Condition and
      Results of Operations on page 36 of this report filed on Form 10-K.





31




The
      following table provides an analysis of the allowance for loan losses for the
      years ended December 31, 2007, 2006, 2005, 2004, and 2003:


*(dollars
                  amounts in thousands)*
              
              **2007**
              
              **2006**
              
              **2005**
              
              **2004**
              
              **2003**Balance,
                  beginning of period
              
              $
              4,081
              
              $
              3,881
              
              $
              3,247
              
              $
              3,070
              
              $
              2,336Balance
                  of Hacienda Bank, beginning of period
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              597Balance
                  of Business First National Bank, beginning of period
              
              
              1,381
              
              
              -
              
              
              -
              
              
              -
              
              
              -Charge-offs:Commercial,
                  financial and agricultural
              
              
              233
              
              
              508
              
              
              86
              
              
              202
              
              
              463Real
                  estate - construction
              
              
              16
              
              
              -
              
              
              -
              
              
              -
              
              
              -Real
                  estate - commercial
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Installment
                  loans to individuals:
              
              
              -
              
              
              44
              
              
              12
              
              
              29
              
              
              -Money
                  plus
              
              
              -
              
              
              9
              
              
              2
              
              
              5
              
              
              3Credit
                  cards
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Other
                  installment
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Total
                  charge-offs
              
              
              249
              
              
              561
              
              
              100
              
              
              236
              
              
              466Recoveries:Commercial,
                  fianacial and agricultural
              
              
              191
              
              
              101
              
              
              -
              
              
              1
              
              
              232Real
                  estate - construction
              
              
              70
              
              
              -
              
              
              -
              
              
              -
              
              
              -Real
                  estate - commercial
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Installment
                  loans to individuals:
              
              
              3
              
              
              56
              
              
              24
              
              
              2
              
              
              1Money
                  plus
              
              
              6
              
              
              4
              
              
              -
              
              
              -
              
              
              -Credit
                  cards
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Other
                  installment
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Total
                  recoveries
              
              
              270
              
              
              161
              
              
              24
              
              
              3
              
              
              233Net
                  charge-offs / (recoveries)
              
              
              (21
              )
              
              400
              
              
              76
              
              
              233
              
              
              233Additions
                  to allowance charged to operations
              
              
              660
              
              
              600
              
              
              710
              
              
              410
              
              
              370Balance,
                  end of period
              
              $
              6,143
              
              $
              4,081
              
              $
              3,881
              
              $
              3,247
              
              $
              3,070Gross
                  loans, end of period
              
              $
              613,217
              
              $
              444,983
              
              $
              368,133
              
              $
              339,693
              
              $
              278,135Net
                  charge-offs to average loans
              
              
              0.00
              %
              
              0.10
              %
              
              0.02
              %
              
              0.08
              %
              
              0.10
              %Allowance
                  for loan losses to total gross loans
              
              
              1.00
              %
              
              0.92
              %
              
              1.05
              %
              
              0.96
              %
              
              1.10
              %Non-performing
                  loans to allowance for loan losses
              
              
              5.50
              %
              
              1.35
              %
              
              1.39
              %
              
              28.77
              %
              
              50.20
              %





The
      following table provides a summary of the allowance for loan losses and its
      allocation to each major loan category as of December 31, 2007, 2006, 2005,
      2004, and 2003:


**2007**
              
              **2006**
              
              **2005**
              
              **2004**
              
              **2003****Percent**
              
              
              
              **Percent**
              
              
              
              **Percent**
              
              
              
              **Percent**
              
              
              
              **Percent***(dollars
                  amounts in thousands)*
              
              **Amount**
              
              **of
                  Total**
              
              **Amount**
              
              **of
                  Total**
              
              **Amount**
              
              **of
                  Total**
              
              **Amount**
              
              **of
                  Total**
              
              **Amount**
              
              **of
                  Total****Allocated**
              
              **Loans**
              
              **Allocated**
              
              **Loans**
              
              **Allocated**
              
              **Loans**
              
              **Allocated**
              
              **Loans**
              
              **Allocated**
              
              **Loans**Commercial,
                  financial and agricultural
              
              $
              1,463
              
              
              24
              %
              $
              779
              
              
              19
              %
              $
              633
              
              
              16
              %
              $
              475
              
              
              15
              %
              $
              541
              
              
              18
              %Real
                  estate - construction
              
              
              1,184
              
              
              19
              %
              
              969
              
              
              24
              %
              
              812
              
              
              21
              %
              
              641
              
              
              20
              %
              
              527
              
              
              17
              %Real
                  estate - commercial
              
              
              3,235
              
              
              53
              %
              
              2,177
              
              
              54
              %
              
              2,221
              
              
              57
              %
              
              1,934
              
              
              59
              %
              
              1,793
              
              
              58
              %Home
                  equity lines of credit
              
              
              175
              
              
              3
              %
              
              99
              
              
              2
              %
              
              152
              
              
              4
              %
              
              141
              
              
              4
              %
              
              148
              
              
              5
              %Installment
                  loans to individuals
              
              
              80
              
              
              1
              %
              
              51
              
              
              1
              %
              
              59
              
              
              2
              %
              
              53
              
              
              2
              %
              
              57
              
              
              2
              %All
                  other loans (including overdrafts)
              
              
              6
              
              
              0
              %
              
              6
              
              
              0
              %
              
              4
              
              
              0
              %
              
              3
              
              
              0
              %
              
              4
              
              
              0
              %Total
                  balance, allowance for loan losses
              
              $
              6,143
              
              
              100
              %
              $
              4,081
              
              
              100
              %
              $
              3,881
              
              
              100
              %
              $
              3,247
              
              
              100
              %
              $
              3,070
              
              
              100
              %


32


**FINANCIAL
      CONDITION**





At
      December 31, 2007 total assets were $745.6 million. When compared to the $541.8
      million reported at December 31, 2006, total assets increased by $203.8 million.
      Of the increase in total assets, approximately $152.2 million can be 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,
      2007, net loan balances were $605.3 million. This, when compared to the $439.3
      million the Company reported at the end of 2006, represents an increase of
      approximately $166.1 million. Of this increase, approximately $150.0 million
      can
      be attributed to the acquisition of and growth in Business First net loans
      balances.





At
      December 31, 2007 total deposits were $644.8 million or $224.3 million more
      than
      the $420.5 million reported at the end of 2006. Of the increase in deposit
      balances, approximately $123.6 million can be attributed to the acquisition
      Business First. Promotions designed to attract lower cost core deposits proved
      to be effective for the Bank during 2007, as approximately $100.7 million in
      new
      deposits were added exclusive of the acquisition of Business First.





As
      a
      result of the strong deposit growth the Bank saw during 2007, approximately
      $50.0 million in higher cost Federal Home Loan Bank (“FHLB”) borrowings were
      paid down from the end of 2006. At December 31, 2007, FHLB borrowings were
      $8.0
      million. These borrowings were acquired upon the acquisition of Business First.
      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, 2007 earning assets to total assets were 92.3% compared to 90.8%
      at
      December 31, 2006. During the second quarter, the Bank sold four of its
      properties in a sale lease-back transaction. The Bank pursued this transaction
      in an effort to convert non-earning assets to earning assets. Additionally,
      upon
      the acquisition of Business First, approximately $9.8 million of goodwill and
      core deposit intangible assets were added to the balance
      sheet.


*LOANS*





At
      December 31, 2007, total gross loans were $613.2 million, or $168.2 million
      higher than the $445.0 million reported at the end of 2006. Of the year over
      year increase in gross loan balances, 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, 2007,
      2006, 2005, 2004 and 2003:





*(dollar
                  amounts in thousands)*
              
              **2007**
              
              **2006**
              
              **2005**
              
              **2004**
              
              **2003****Amount**
              
              **Percent**
              
              **Amount**
              
              **Percent**
              
              **Amount**
              
              **Percent**
              
              **Amount**
              
              **Percent**
              
              **Amount**
              
              **Percent**Commercial,
                  financial and agricultural
              
              $
              146,080
              
              
              24
              %
              $
              84,976
              
              
              19
              %
              $
              60,050
              
              
              16
              %
              $
              49,584
              
              
              14
              %
              $
              49,024
              
              
              18
              %Real
                  estate - construction
              
              
              118,200
              
              
              19
              %
              
              105,712
              
              
              24
              %
              
              76,981
              
              
              21
              %
              
              66,833
              
              
              20
              %
              
              47,720
              
              
              17
              %Real
                  estate - commercial
              
              
              322,928
              
              
              53
              %
              
              237,401
              
              
              54
              %
              
              210,690
              
              
              57
              %
              
              202,765
              
              
              60
              %
              
              162,463
              
              
              58
              %Home
                  equity lines of credit
              
              
              17,470
              
              
              3
              %
              
              10,792
              
              
              2
              %
              
              14,398
              
              
              4
              %
              
              14,708
              
              
              4
              %
              
              13,417
              
              
              5
              %Installment
                  loans to individuals
              
              
              7,977
              
              
              1
              %
              
              5,598
              
              
              1
              %
              
              5,620
              
              
              2
              %
              
              5,538
              
              
              2
              %
              
              5,173
              
              
              2
              %All
                  other loans (including overdrafts)
              
              
              562
              
              
              0
              %
              
              504
              
              
              0
              %
              
              394
              
              
              0
              %
              
              265
              
              
              0
              %
              
              338
              
              
              0
              %Total
                  loans, gross
              
              
              613,217
              
              
              100
              %
              
              444,983
              
              
              100
              %
              
              368,133
              
              
              100
              %
              
              339,693
              
              
              100
              %
              
              278,135
              
              
              100
              %Deferred
                  loan fees
              
              
              (1,732
              )
              
              
              
              
              (1,625
              )
              
              
              
              
              (1,617
              )
              
              
              
              
              (1,482
              )
              
              
              
              
              (1,014
              )Reserve
                  for possible loan losses
              
              
              (6,143
              )
              
              
              
              
              (4,081
              )
              
              
              
              
              (3,881
              )
              
              
              
              
              (3,247
              )
              
              
              
              
              (3,070
              )Total
                  loans, net
              
              $
              605,342
              
              
              
              
              $
              439,277
              
              
              
              
              $
              362,635
              
              
              
              
              $
              334,964
              
              
              
              
              $
              274,051Loans
                  held for sale
              
              $
              902
              
              
              
              
              $
              1,764
              
              
              
              
              $
              3,392
              
              
              
              
              $
              2,253
              
              
              
              
              $
              4,402




33


The
      following table provides a summary of the approximate maturities and sensitivity
      to change in interest rates for the loan portfolio at December 31,
      2007:




**Due
                  Over**
              
              **Due
                  Over**
              
              **Due
                  Over****Due
                  Less**
              
              **Due**
              
              **12
                  Months**
              
              **3
                  Years**
              
              **5
                  Years****Than
                  3**
              
              **3
                  To 12**
              
              **Through**
              
              **Through**
              
              **Through**
              
              **Due
                  Over***(dollar
                  amounts in thousands)*
              
              **Months**
              
              **Months**
              
              **3
                  Years**
              
              **5
                  Years**
              
              **15
                  Years**
              
              **15
                  Years**
              
              **Total**Commercial,
                  financial and agricultural
              
              $
              93,677
              
              $
              10,974
              
              $
              14,409
              
              $
              16,097
              
              $
              10,821
              
              $
              102
              
              $
              146,080Real
                  estate - construction
              
              
              93,584
              
              
              15,933
              
              
              4,308
              
              
              137
              
              
              4,238
              
              
              -
              
              
              118,200Real
                  estate - commercial
              
              
              46,513
              
              
              43,400
              
              
              109,948
              
              
              40,818
              
              
              78,095
              
              
              4,154
              
              
              322,928Home
                  equity lines of credit
              
              
              17,316
              
              
              -
              
              
              -
              
              
              154
              
              
              -
              
              
              -
              
              
              17,470Installment
                  loans to individuals
              
              
              1,885
              
              
              97
              
              
              1,339
              
              
              1,879
              
              
              2,525
              
              
              252
              
              
              7,977All
                  other loans (including overdrafts)
              
              
              562
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              562Total
                  gross loans
              
              $
              253,537
              
              $
              70,404
              
              $
              130,004
              
              $
              59,085
              
              $
              95,679
              
              $
              4,508
              
              $
              613,217Variable
                  rate loans
              
              $
              238,347
              
              $
              41,497
              
              $
              98,188
              
              $
              33,290
              
              $
              4,311
              
              $
              -
              
              $
              415,633Fixed
                  rate loans
              
              
              15,190
              
              
              28,907
              
              
              31,816
              
              
              25,795
              
              
              91,368
              
              
              4,508
              
              
              197,584Total
                  gross loans
              
              $
              253,537
              
              $
              70,404
              
              $
              130,004
              
              $
              59,085
              
              $
              95,679
              
              $
              4,508
              
              $
              613,217




The
      Company has an Asset/Liability Management system that models various interest
      rate environments for all rate sensitive assets and liabilities. At December
      31,
      2007, 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 $2.1 million, while a +100 basis point move would increase
      interest income on loans by approximately $2.2 million.





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, 2007:


**Variance***(dollar
                  amounts in thousands)*
              
              **2007**
              
              **2006**
              
              **Dollar**
              
              **Percentage**Commercial,
                  financial and agricultural
              
              $
              146,080
              
              $
              84,976
              
              $
              61,104
              
              
              71.91
              %Real
                  estate - construction
              
              
              118,200
              
              
              105,712
              
              
              12,488
              
              
              11.81
              %Real
                  estate - commercial
              
              
              322,928
              
              
              237,401
              
              
              85,527
              
              
              36.03
              %Home
                  equity lines of credit
              
              
              17,470
              
              
              10,792
              
              
              6,678
              
              
              61.88
              %Installment
                  loans to individuals
              
              
              7,977
              
              
              5,598
              
              
              2,379
              
              
              42.50
              %All
                  other loans (including overdrafts)
              
              
              562
              
              
              504
              
              
              58
              
              
              11.55
              %Total
                  loans, gross
              
              
              613,217
              
              
              444,983
              
              
              168,234
              
              
              37.81
              %Deferred
                  loan fees
              
              
              (1,732
              )
              
              (1,625
              )
              
              (107
              )
              
              6.59
              %Reserve
                  for possible loan losses
              
              
              (6,143
              )
              
              (4,081
              )
              
              (2,062
              )
              
              50.53
              %Total
                  loans, net
              
              $
              605,342
              
              $
              439,277
              
              $
              166,065
              
              
              37.80
              %Loans
                  held for sale
              
              $
              902
              
              $
              1,764
              
              $
              (862
              )
              
              -48.85
              %




·
              *Commercial,
                  Financial and
                  Agricultural*





Commercial,
      financial and agricultural loans increased $61.1 million or 71.9% over the
      prior
      year end. Of this increase approximately $51.1 million can be attributed to
      the
      acquisition of Business First.  During
      2007, new loans within this category include: a loan made for the acquisition
      of
      a chain of hair salons, loans to an oil service company to acquire equipment,
      an
      agricultural property acquisition loan, a loan to purchase a restaurant, and
      other commercial purpose loans all totaling approximately $17.6 million.
      Additionally, numerous other new $0.5 to $1.5 million business lines of credit
      to medical groups, contractors, and other businesses were made throughout the
      year.





·
              *Real-Estate
                  Construction*





Loans
      within this category increased $12.5 million over the prior year end. Of this
      increase, approximately $8.1 million can be attributed to the acquisition of
      Business First. New loans made within this category include: a loan for a
      residential tract development, a condo development, three separate hotel
      projects, two separate loans for the construction of warehouses and commercial
      office space, a mixed use project, an addition to a small shopping center,
      a
      participation in a casino loan and other real-estate construction loans all
      totaling $64.3 million in new funding, as well as numerous other smaller
      projects. Additionally, during the third and fourth quarters of 2007, several
      large construction loans were made and these have only been partially funded.
      Construction loans are typically granted for a one year period and then, with
      income properties, are amortized over a period not more than 30 years with
      10 to
      15 year maturities.




34





The
      Bank
      presently has a concentration of loans in the category of construction / land
      in
      the amount of $118.2 million, which represents 190.0% of the Bank’s Tier I
      capital. Of this, approximately 12.4% are owner occupied, thus the concentration
      is 166.5% net of owner occupied. Un-disbursed commitments within this category
      total approximately $55.3 million and when combined with disbursed represent
      278.9% of the Bank’s Tier I Capital, with 10.2% owner occupied. At December 31,
      2007 there were 84 construction loans with balances and remaining commitments
      of
      approximately $87.1 million and $50.6 million, respectively. The single largest
      construction loan has an original commitment of amount of $10.9 million with
      a
      balance of approximately $10.8 million at December 31, 2007. At December 31,
      2007 there were 50 land loans with an aggregate balance of approximately $31.1
      million. The single largest loan is for a real-estate tract development with
      a
      commitment of $7.8 million and balance of $7.5 million. While these loans may
      be
      considered riskier than certain other real-estate loans, they are spread
      throughout our market area and have consistently performed in a satisfactory
      manner.




·
              *Real-Estate
                  Commercial*





As
      of
      December 31, 2007 loans in this category represented approximately $322.9
      million of the Bank’s loan portfolio. This, when compared to the $237.4 million
      reported at the end of 2006, represents an increase of approximately $85.5
      million. Of the increase, approximately $80.7 million can be attributed to
      the
      acquisition of Business First. Additionally, during the year several
      construction / land loans moved into amortizing loans and new commercial
      property loans were made. New loans funded within this category include: a
      loan
      to an airport fuel / service facility, a loan for a mixed use property, loans
      to
      two separate medical offices, an auto dealership loan, a loan for a metal
      fabrication building, and two separate hotel loans, all totaling $19.5 million
      as well as several other real-estate loans. During 2007, numerous loans were
      also refinanced and paid off through out of the area lenders and mortgage
      brokers. As a result, loan balances within this category increased by a modest
      $4.8 million, exclusive of the acquisition of Business First.





Hotel
      loans disbursed are not considered a concentration with balances of
      approximately $54.9 million, representing 88.3% of the Bank’s Tier I capital.
      There are several hotel construction loans that increase total commitments
      to
      $69.6 million, which represents a concentration at 111.9% of the Bank’s Tier I
      capital. At December 31, 2007, there were 45 hotel loans of which the single
      largest is a loan for $6.0 million with $5.4 million disbursed. These loans
      are
      made to clients throughout our market area and have historically performed
      in a
      satisfactory manner.





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 2008.





·
              *Loans
                  Held For Sale*





Loans
      held for sale consist of mortgage originations that have already been sold
      pursuant to correspondent mortgage loan agreements. There is no interest rate
      risk associated with these loans as the commitments are in place at the time
      the
      Bank funds them. Settlement from the correspondents is typically within 30
      to 45
      days. At December 31, 2007 and 2006 mortgage correspondent loans (loans held
      for
      sale) totaled approximately $0.9 million and $1.8 million,
      respectively.





·
              *Foreign
                  Loans*





At
      December 31, 2007, the Bank had no foreign loans outstanding. The Bank did
      not
      have any concentrations of loans except as disclosed above.





·
              *Summary
                  of Market Condition*





The
      local
      residential real-estate market came under significant pressure during 2007
      and
      was negatively impacted by rising interest rates during the majority of the
      year
      as well as negative sentiment surrounding market values of real-estate.
      Additionally, as more and more home owners began to see interest rate resets
      on
      adjustable rate mortgages, the number of non-performing loans and defaults
      began
      to rise in the industry as a whole. These effects were primarily felt by
      residential mortgage lenders, which is not the focus of the Bank. These factors
      eventually led to the tightening of credit and a downturn in real-estate
      markets. Although sales of single family homes have significantly fallen year
      over year in the Company’s market area, prices have only experienced a modest
      decline. Additionally, the Bank saw construction loan demand for both single
      family and commercial real-estate moderate during 2007. Although the lending
      environment has become more challenging, commercial real-estate prices in the
      Company’s market area remained relatively unchanged from the prior year even
      with slowing sales. The demand for business and professional properties in
      the
      Company’s market area remained strong during 2007, with relatively low
      vacancies, competitive loan rates, and many investors seeking exchange
      properties. Capitalization rates, the rate at which a stream of cash flows
      are
      discounted to find their present value, for the last three years were: 5.5%
      to
      6.5% in 2005, 5.0% to 6.5% in 2006, and 6.0% to 7.0% in 2007.




35





The
      Company continues to believe that the desirability of the area as well as the
      diversity of the loan portfolio will provide some insulation against a slowdown
      in growth. Additionally, the Company has and will continue to monitor lending
      trends in order to take the appropriate steps if necessary to mitigate any
      material adverse impact the slowing of the single family residential and
      commercial real-estate markets may have on the loan portfolio
      overall.





The
      following charts provide a break-down of the Construction/Land and Commercial
      Real Estate portions of the loan portfolio as of December 31, 2007:










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





The
      Bank
      has a non-accrual policy that requires a loan greater than 90 days past due
      and
      or is specifically determined to be impaired to be placed on non-accrual status
      unless such loan is well-collateralized and in the process of collection. When
      loans are placed on non-accrual status, all uncollected interest accrued is
      reversed from earnings. Once on non-accrual status, interest on a loan is only
      recognized on a cash basis and is generally 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 of the loan principal
      balance. Loans may be returned to accrual status if management believes that
      all
      remaining principal and interest is fully collectible and there has been at
      least six months of sustained repayment performance since the loan was placed
      on
      non-accrual.





Loans
      on
      non-accrual status totaled $338 thousand and $55 thousand at December 31, 2007
      and 2006, respectively. At December 31, 2007, non-performing loans consisted
      of
      four loans, of which, one for approximately $260 thousand that is real estate
      secured has a Loan To Value (LTV) of approximately <65% and is current, two
      loans that are less than $20 thousand each and are paying as agreed, and one
      less than $50 thousand that is in the process of collection. Interest income
      that would have been recognized on non-accruing loans if they had performed
      in
      accordance with the terms of the loans was approximately $65 thousand and $87
      thousand at December 31, 2007 and 2006, respectively.





36




The
      following table provides a summary of the Bank’s past due and non-accrual loans
      as of December 31, 2007 and 2006:


**December
                  31,***(dollar
                  amounts in thousands)*
              
              **2007**
              
              **2006**Loans
                  delinquent 90 days or more and still accruing
              
              $
              -
              
              $
              -Non-accruing
                  loans
              
              
              338
              
              
              55Total
                  non-performing loans
              
              $
              338
              
              $
              55Foreclosed
                  collateral
              
              
              -
              
              
              -Total
                  non-performing assets
              
              $
              338
              
              $
              55Ratio
                  of allowance for credit losses to total non-performing
                  loans
              
              
              1817
              %
              
              7420
              %Ratio
                  of non-performing loans to total gross loans
              
              
              0.06
              %
              
              0.01
              %Ratio
                  of non-performing loans to total assets
              
              
              0.05
              %
              
              0.01
              %





Non-performing
      loans include non-accrual loans, restructured loans and accruing loans that
      are
      90 days or more delinquent. The Bank had no loans that were 90 days or more
      delinquent and still accruing interest at December 31, 2007. Total
      non-performing loans were $338 thousand and $55 thousand at December 31, 2007
      and December 31, 2006 respectively.





Management
      acknowledges that due to negative undertones associated with the economy and
      real estate market, the internal “watch” list has expanded. 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 monitoring
      watch list credits. While there is no guarantee that the Bank will not
      experience an increase in non-performing loans, historically the Bank has been
      able to work through impaired credits with minimal net charge off history.





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





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





*TOTAL
      CASH AND DUE FROM BANKS*





Total
      cash and due from banks were $23.3 million and $19.2 million at December 31,
      2007 and 2006, 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.





37





The
      following table summarizes the balances of the Company’s other earning assets as
      of December 31, 2007, 2006 and 2005:





**2007**
            
            **2006**
            
            **2005***(dollar
                  amounts in thousands)*
            
            **Amount**
            
            **Percent**
            
            **Amount**
            
            **Percent**
            
            **Amount**
            
            **Percent**Federal
                Home Loan Bank and Federal Reserve Bank stock
            
            $
            3,045
            
            
            4.1
            %
            $
            2,350
            
            
            5.2
            %
            $
            1,885
            
            
            2.6
            %Available-for-sale
                investments
            
            
            47,556
            
            
            64.2
            %
            
            38,445
            
            
            85.5
            %
            
            44,402
            
            
            60.9
            %Federal
                funds sold
            
            
            23,165
            
            
            31.3
            %
            
            3,870
            
            
            8.6
            %
            
            26,280
            
            
            36.1
            %Interest
                bearing deposits other finanical institutions
            
            
            330
            
            
            0.4
            %
            
            318
            
            
            0.7
            %
            
            298
            
            
            0.4
            %Total
                other earning assets
            
            $
            74,096
            
            
            100.0
            %
            $
            44,983
            
            
            100.0
            %
            $
            72,865
            
            
            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 Bank’s board of directors on a regular basis.





Securities
      available-for-sale are carried at fair value, with related unrealized net gains
      or losses, net of deferred income taxes, recorded as an adjustment to equity
      capital. At December 31, 2007 and 2006 the securities portfolio had net
      unrealized gains, net of taxes of approximately $184 thousand and $80 thousand,
      respectively. The increase in the fair value of the securities portfolio during
      2007 can mainly be attributed to the decline in rates associated with certain
      fixed income markets during the later half of the year. At December 31, 2007,
      the portfolio had a fair value of approximately $47.6 million. This, when
      compared to the $38.5 million reported at December 31, 2006, represents an
      increase of approximately $9.1 million. In October of 2007, the Company acquired
      approximately $13.9 million in available for sale securities as a result of
      the
      acquisition of Business First. Exclusive of the acquisition, the securities
      portfolio declined by approximately $4.8 million, primarily due to principal
      pay-downs and prepayments of mortgage-backed securities.





During
      the third and fourth quarters of 2007, fixed income markets saw a significant
      re-pricing of credit risk, which caused the values of certain classes of fixed
      income instruments to fall, specifically those related to Collateralized Debt
      Obligations (“CDO”) and Mortgage-Backed Securities (“MBS”). However the Bank’s
      securities portfolio has continued to perform in a satisfactory manner, as
      the
      fair value of the securities portfolio in the third quarter increased
      approximately $395 thousand over the second quarter and declined approximately
      $82 thousand in the fourth quarter of 2007.





As
      part
      of the acquisition of Business First, the Bank acquired five whole loan CMO
      securities with a remaining principle balance of approximately $4.4 million.
      The
      Bank has 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. At December
      31, 2007, the market value of these securities has a net unrealized gain of
      $19
      thousand and has remained relatively unchanged since the date of acquisition
      in
      October 2007.





At
      December 31, 2007, other than the five whole loan CMOs discussed in the
      paragraph above, the remaining MBS and CMO’s in the Bank’s investment portfolio
      were issued by: The Government National Mortgage Association (“Ginnie Mae”), The
      Federal National Mortgage Association (“Fannie Mae”), and The Federal Home Loan
      Mortgage Corporation (“Freddie Mac”). These securities carry the guarantee of
      the issuing agencies.





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





38




The
      following tables provide a summary of the Company securities portfolio,
      including amortized cost and fair value as of December 31, 2007 and
      2006:


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


**Gross**
              
              **Gross***(dollar
                  amounts in thousands)*
              
              **Amortized**
              
              **Unrealized**
              
              **Unrealized**
              
              **Fair****December
                  31, 2006**
              
              **Cost**
              
              **Gains**
              
              **Losses**
              
              **Value**Obligations
                  of U.S. government agencies and corporations
              
              $
              205
              
              $
              -
              
              $
              (4
              )
              $
              201Mortgage-backed
                  securities
              
              
              21,969
              
              
              16
              
              
              (381
              )
              
              21,604Obligations
                  of state and political subdivisions
              
              
              16,139
              
              
              540
              
              
              (38
              )
              
              16,641Other
                  securities
              
              
              9
              
              
              -
              
              
              -
              
              
              9Total
              
              $
              38,322
              
              $
              556
              
              $
              (423
              )
              $
              38,455


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, 2007:


*(dollar
                  amounts in thousands)*
              
              **Amortized
                  Cost**
              
              **Fair
                  Value**
              
              **Weighted
                  Average Yield**Due
                  in one year or less
              
              $
              2,167
              
              $
              2,166
              
              
              3.77
              %Due
                  after one year through five years
              
              
              6,076
              
              
              6,189
              
              
              4.25
              %Due
                  after five years through ten years
              
              
              5,229
              
              
              5,391
              
              
              4.63
              %Due
                  after ten years
              
              
              6,978
              
              
              7,153
              
              
              4.56
              %Mortgage-backed
                  securities
              
              
              26,793
              
              
              26,657
              
              
              4.61
              %Total
                  available-for-sale securities
              
              $
              47,243
              
              $
              47,556
              
              
              4.52
              %
  39





*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 2006 to 2007:


*(dollar
                  amounts in thousands)*
              
              **2007**
              
              **2006**
              
              **Variance**
              
              **2005****Balance**
              
              **Average
                  Rate Paid**
              
              **Balance**
              
              **Average
                  Rate Paid**
              
              **Dollar**
              
              **Percent**
              
              **Balance**
              
              **Average
                  Rate Paid**Non-interest
                  bearing demand
              
              $
              153,684
              
              
              0.00
              %
              $
              153,005
              
              
              0.00
              %
              $
              679
              
              
              0.44
              %
              $
              164,014
              
              
              0.00
              %Interest-bearing
                  demand
              
              
              69,558
              
              
              0.45
              %
              
              45,164
              
              
              0.17
              %
              
              24,394
              
              
              54.01
              %
              
              50,598
              
              
              0.16
              %Savings
              
              
              41,599
              
              
              0.90
              %
              
              23,406
              
              
              0.40
              %
              
              18,193
              
              
              77.73
              %
              
              29,386
              
              
              0.30
              %Money
                  market
              
              
              206,754
              
              
              3.57
              %
              
              77,540
              
              
              2.70
              %
              
              129,214
              
              
              166.64
              %
              
              90,122
              
              
              0.91
              %Time
                  deposits
              
              
              173,213
              
              
              4.78
              %
              
              121,406
              
              
              4.21
              %
              
              51,807
              
              
              42.67
              %
              
              83,677
              
              
              2.74
              %Total
                  deposits
              
              $
              644,808
              
              
              2.40
              %
              $
              420,521
              
              
              1.68
              %
              $
              224,287
              
              
              53.34
              %
              $
              417,797
              
              
              0.87
              %




The
      following table provides a maturity distribution of domestic time certificates
      of deposits of $100,000 and over as of December 31, 2007 and 2006:


*(dollar
                  amounts in thousands)*
              
              **2007**
              
              **2006**Less
                  than 3 months
              
              $
              48,053
              
              $
              22,9133
                  to 12 months
              
              
              17,909
              
              
              6,818Over
                  1 year
              
              
              10,004
              
              
              899Total
              
              $
              75,966
              
              $
              30,630





At
      December 31, 2007 the Bank had approximately 28,659 deposit accounts consisting
      of non-interest bearing (“demand”), interest-bearing demand and money market
      accounts with balances totaling $430.0 million for an average balance per
      account of approximately $15.0 thousand; 11,310 savings accounts with balances
      totaling $41.6 million for an average balance per account of approximately
      $3.7
      thousand; and 3,964 time certificate of deposit accounts with balances totaling
      $173.2 million, for an average balance per account of approximately $43.7
      thousand.





As
      indicated in the tables above, total deposit balances at December 31, 2007
      were
      approximately $644.8 million. This represents an increase of approximately
      $224.3 million over the $420.5 million reported at the end of 2006.
      Approximately $123.6 million of the increase was the result of deposit balances
      at Business First at December 31, 2007.





During
      2007, the Bank engaged in promotions designed to attract lower cost core
      deposits in order to fund the strong loan growth the Bank saw during the first
      half of the year, as well as to pay down higher cost Federal Home Loan Bank
      (“FHLB”) borrowings. 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.





Non-interest
      bearing demand deposits accounted for 23.8% of total deposits at December 31,
      2007 and increased approximately $0.7 million or 0.4% during 2007. At December
      31, 2007, non-interest bearing demand deposits attributable to the acquisition
      of Business First were approximately $30.3 million. At December 31, 2006 the
      Bank had three large demand deposit relationships that it considered to be
      volatile. These deposits are held by long time customers of the Bank that engage
      in mortgage related activities. During 2007, the balances carried by these
      relationships decreased by approximately $28.4 million from the end of 2006.
      The
      decrease in mortgage related activity during 2007 had a direct impact on the
      deposit balances held by these entities. These volatile account relationships
      are included in the volatile liability dependency report that the Bank produces
      on a monthly basis. Management and the Board of Directors of the Bank are aware
      that as conditions in the mortgage market change, these relationships may
      continue to be impacted.





In
      addition to the accounts mentioned above, the Bank obtained two additional
      money
      market account deposit relationships during the fourth quarter of 2007 that
      it
      considers to be volatile. At December 31, 2007, the balance of these accounts
      totaled approximately $42.6 million. At December 31, 2007, total deposit
      balances of accounts that the Bank considers to be volatile were $58.3 million
      or 9.0% of total deposits.




40





At
      December 31, 2007, savings, NOW, and money market account balances were
      approximately $317.9 million or $171.8 million higher than the $146.1 million
      reported at the end of 2006. The 117.6% rise in this category of deposits can
      be
      attributed to the promotional activities the Bank engaged in during 2007 to
      attract lower cost core deposits, as well as the acquisition of Business First.
      At December 31, 2007, deposit balances in this category attributable to the
      acquisition accounted for approximately $61.6 million.





At
      December 31, 2007, time deposit balances were $173.2 million of which
      approximately $31.7 million can be attributed to Business First. This, when
      compared to the $121.4 million reported at the end of 2006, represents an
      increase of approximately $51.8 million. Exclusive of the acquisition, time
      deposit balances increased by approximately $20.1 million, which can be
      attributed to the promotional activities the Bank engaged in during the year.
      Management has been diligent in keeping maturities of time deposits relatively
      short in order to take advantage of any re-pricing opportunities in a rates-down
      scenario. At December 31, 2007, approximately $119.9 million or 69.2% of total
      time deposits will mature within 90 days or less.





Core
      deposits (time deposits less than $100,000, demand, and savings) gathered in
      the
      local communities served by the Company continue to be the primary source of
      funds for loans and investments. Core deposits of $568.8 million represented
      88.2% of total deposits at December 31, 2007 as compared to $389.9 million
      or
      92.7% of total deposits at December 31, 2006. While the Bank has a policy in
      place that permits the acquisition of brokered funds, the Bank, exclusive of
      Business First, has taken no action to do so as of December 31, 2007. However,
      upon the acquisition of Business First, the Bank acquired brokered funds that
      represent approximately $12.6 million of total deposits at December 31,
      2007.




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, 2007, the Company had a zero balance outstanding on
      this
      loan. The Company pledged 646,598 shares (51%) of the Bank’s stock as collateral
      for the loan. At December 31, 2007, the interest rate on the note was 7.25%
      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 2 year note was executed In October 2003 and was
      originally obtained to assist with the cash and capital needs for the
      acquisition of Hacienda Bank.





The
      Bank
      has established borrowing lines with the Federal Home Loan Bank (“FHLB”). At
      December 31, 2007, the Bank had borrowings with the FHLB of approximately $8.0
      million that are collateralized by loans. The average rate paid on FHLB
      borrowings for 2007 was 5.44%. Additionally, the Bank has an $11.7 million
      letter of credit secured by loans. At December 31, 2007, the Bank, under the
      FHLB programs, has a remaining borrowing capacity with existing collateral
      of
      approximately $106.3 million secured by loans and securities. See also Note
      8 of
      the Consolidated Financial Statements filed on this form 10-K for additional
      information related to the Bank’s borrowings from the FHLB.  The
      Bank
      utilizes securities sold under repurchase agreements as a source of funds.
      The
      Bank had $1.9 million in securities sold under repurchase agreements at December
      31, 2007 compared to $1.4 million at December 31, 2006.





*CAPITAL*





At
      December 31, 2007, stockholders’ equity was $69.5 million. When compared to the
      $49.5 million the Company reported at December 31, 2006, this represents an
      increase of approximately $20.0 million. Of this increase approximately $14.1
      million can be attributed to the issuance of 850,213 shares of the Company’s
      common stock to shareholders of Business First in connection with the
      acquisition. Additionally, the change in equity is attributable to 2007 net
      income of approximately $6.9 million, the payment of cash dividends in the
      amount of $2.1 million, $862 thousand in proceeds from the exercise of stock
      options, $361 thousand related to the expensing of share-based compensation,
      $215 thousand used in repurchases of the Company’s common stock, and an increase
      of $104 thousand in accumulated other comprehensive income during the
      year.




At
      December 31, 2007, 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, 2007, 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.





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.




41





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,
      2007.


**Minimum
                  Regulatory Capital Requirements**
              
              **Heritage
                  Oaks Bancorp**
              
              **Heritage
                  Oaks Bank**Leverage
                  ratio
              
              
              4.00
              %
              
              9.60
              %
              
              9.02
              %Tier
                  I risk weighted
              
              
              4.00
              %
              
              10.08
              %
              
              9.43
              %Total
                  risk based
              
              
              8.00
              %
              
              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,
      2007, these credit lines totaled $40.0 million and the Bank had no borrowings
      against those lines. The Bank is a member of the FHLB and has collateralized
      borrowing capacities remaining of $106.3 million at December 31, 2007.





The
      Bank
      manages liquidity by maintaining a majority of the investment portfolio in
      federal funds sold and other liquid investments. At December 31, 2007, the
      ratio
      of liquid assets not pledged for collateral and other purposes to deposits
      and
      other liabilities was 9.59% compared to 9.31% in 2006. The ratio of net loans
      to
      deposits (“LTD”), another key liquidity ratio, was 93.9% at December 31, 2007
      compared to 104.5% at December 31, 2006  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 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, in
      2006 the Bank implemented a tracking ratio of Loan-to-Funding
      (“LTF”).  This
      ratio is calculated by dividing gross loans by the sum of total deposits and
      alternative funding sources both available and used. At December 31, 2007 and
      2006, the LTF ratio was 80.6% and 84.0%.  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 results reported.
      Accounting policies are described in detail 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. The following is a brief
      description of our current accounting policies involving significant management
      valuation judgments.




·
              *Allowance
                  for Loan and Lease
                  Losses*





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




42





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




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





·
              *Securities
                  Available for Sale*





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




·
              *Goodwill
                  and Other Intangible
                  Assets*





As
      discussed in Note 6 of the Consolidated Financial Statements, we assess goodwill
      and other intangible assets each year for impairment. This assessment involves
      estimating cash flows for future periods. If the future cash flows were
      materially less than the recorded goodwill and other intangible assets balances,
      we would be required to take a charge against earnings to write down the assets
      to the lower value. The Company’s assessment at December 31, 2007 pursuant to
      its Goodwill Impairment Testing Policy resulted in no impairment.





·
              *Deferred
                  Tax Assets*





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





·
              *Supplemental
                  Employee Compensation Benefits Agreements*





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





See
      also
      Note 1 to the Consolidated Financial Statements for a listing of recently issued
      accounting pronouncements.





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




*OFF-BALANCE
      SHEET ARRANGEMENTS, CONTRACTUAL OBLIGATIONS AND CONTINGENT
      LIABILITIES*





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





*(dollar
                amounts in thousands)*
            
            **Less
                Than One Year**
            
            **One
                To Three Years**
            
            **Three
                To Five Years**
            
            **More
                Than Five Years**
            
            **Total**
            
            **December
                31,2006**Long-term
                debt obligations
            
            $
            -
            
            $
            -
            
            $
            -
            
            $
            13,403
            
            $
            13,403
            
            $
            16,496Operating
                lease obligations
            
            
            2,053
            
            
            3,644
            
            
            2,580
            
            
            8,596
            
            
            16,873
            
            
            3,788Totals
            
            $
            2,053
            
            $
            3,644
            
            $
            2,580
            
            $
            21,999
            
            $
            30,276
            
            $
            20,284




43





As
      noted
      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 $16.6 million at December 31, 2007, slightly lower from the
      $17.7 million reported at the end of 2006. Additionally, at December 31, 2007
      the Company had un-disbursed loan commitments, also made in the ordinary course
      of business, totaling approximately $245.9 million. When compared to the $166.5
      million reported at the end of 2006, this represents an increase of
      approximately $79.4 million, the majority of which can be attributed to the
      acquisition of Business First . The
      Company has an allowance for losses-unfunded commitments totaling $221 thousand
      at December 31, 2007, to cover losses inherent in its letter of credit
      accommodations and un-disbursed loan commitments.





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





As
      noted
      in Note 15 to the Consolidated Financial Statements, the Company does make
      loans
      to related parties (directors and officers) in the ordinary course of business
      at prevailing rates and terms. These loans totaled $18.9 million and $15.5
      million at the end of 2007 and 2006, 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.




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




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





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




The
      hypothetical impacts of sudden interest rate movements applied to the Company’s
      asset and liability balances are modeled monthly. The results of this movement
      indicate how much of the Company’s net interest income is “at risk” from various
      rate changes over a one year horizon. This exercise is valuable in identifying
      risk exposures. The results for the Company’s December 31, 2007 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.


44
  **Rate
                  Shock Scenarios***(dollar
                  amounts in thousands)*
              
              **-200bp**
              
              **-100bp**
              
              **Base**
              
              **+100bp**
              
              **+200bp**Net
                  interest income (NII)
              
              $
              31,987
              
              $
              33,545
              
              $
              35,199
              
              $
              36,927
              
              $
              38,669Dollar
                  change from base
              
              $
              (3,212
              )
              $
              (1,654
              )
              $
              -
              
              $
              1,728
              
              $
              3,470Percent
                  change from base
              
              
              -9.12
              %
              
              -4.70
              %
              
              0.00
              %
              
              4.91
              %
              
              9.86
              %


It
      is
      important to note that the above table is a summary of several forecasts and
      actual results may vary. The forecasts are based on estimates and assumptions
      of
      management that may turn out to be different and may change over time. Factors
      affecting these estimates and assumptions include, but are not limited to 1)
      competitor behavior, 2) economic conditions both locally and nationally, 3)
      actions taken by the Federal Reserve Board, 4) customer behavior and 5)
      management’s responses. Changes that vary significantly from the assumptions and
      estimates may have significant effects on the Company’s net interest income;
      therefore, the results of this analysis should not be relied upon as indicative
      of actual future results.





The
      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.





45




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







**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 
 Management's
                    Assessment of Internal Control Over Financial Reporting
                
                
                47Report
                    of Independent Registered Public Accounting Firm on Internal
                    ControlOver
                    Financial Reporting
                
                
                48Report
                    of Independent Registered Public Accounting Firm
                
                
                49Consolidated
                    Financial Statements:**CONSOLIDATED
                    BALANCE SHEETS**As
                    of December 31, 2007 and 2006
                
                
                50**CONSOLIDATED
                    STATEMENTS OF INCOME**For
                    the Years Ended December 31, 2007, 2006 and 2005
                
                
                51**CONSOLIDATED
                    STATEMENTS OF STOCKHOLDER'S EQUITY**As
                    of December 31, 2007, 2006 and 2005
                
                
                52**CONSOLIDATED
                    STATEMENTS OF CASH FLOWS**For
                    the Years Ended December 31, 2007, 2006 and 2005
                
                
                53Notes
                    to Consolidated Financial Statements
                
                
                55The
                    following un-audited supplementary financial data is included
                    in this
                    Annual Report on Form 10-K:
                  Quarterly
                    Financial Information
                
                
                87





46




**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, 2007, 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, 2007, 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, 2007. 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, 2007, is
      included below under the heading “Report of Independent Registered Public
      Accounting Firm.”




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





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


47




**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 Subsidiary (the “Company”) internal control
      over financial reporting as of December 31, 2007, 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 included obtaining an understanding of internal control
      over
      financial reporting, evaluating management’s assessment, testing and evaluating
      the design and operating effectiveness of internal control, and performing
      such
      other procedures as we considered necessary in the circumstances. We believe
      that our audit provides a reasonable basis for our opinion.





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





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





In
      our
      opinion, the Company maintained, in all material respects, effective internal
      control over financial reporting as of December 31, 2007, based on criteria
      established in Internal Control - Integrated Framework issued by the Committee
      of Sponsoring Organizations of the Treadway Commission (COSO).





We
      have
      also audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the consolidated balance sheets as of December
      31, 2007 and 2006, and the related consolidated statements of income,
      stockholders equity and cash flows for each of the three years in the period
      ended December 31, 2007 and our report dated February 29, 2008 expressed an
      unqualified opinion.




/s/ Vavrinek, Trine, Day & Co.,
              LLPRANCHO
                CUCAMONGA, CALIFORNIA
              FEBRUARY
                29, 2008




48




**REPORT
        OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**


Board
      of
      Directors


Heritage
      Oaks Bancorp


Paso
      Robles, California





We
      have
      audited the accompanying consolidated balance sheets of Heritage Oaks Bancorp
      and Subsidiaries (the “Company”) as of December 31, 2007 and 2006, 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, 2007.
      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, 2007 and 2006, 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, 2007, 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, 2007, based on criteria established in Internal
      Control - Integrated Framework issued by the Committee of Sponsoring
      Organizations of the Treadway Commission and our report dated February 29,
      2008
      expressed an unqualified opinion thereon.





/s/ Vavrinek, Trine, Day & Co.,
              LLPRANCHO
                CUCAMONGA, CALIFORNIA
              FEBRUARY
                29, 2008


49




**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **CONSOLIDATED
        BALANCE SHEETS**
 **DECEMBER
        31, 2007 AND 2006**
 *(dollar
        amounts in thousands except shares outstanding)*
  **2007**
                
                **2006****Assets**Cash
                    and due from banks
                
                $
                23,254
                
                $
                19,164Federal
                    funds sold
                
                
                23,165
                
                
                3,870Total
                    cash and cash equivalents
                
                
                46,419
                
                
                23,034Interest-bearing
                    deposits with other financial institutions
                
                
                330
                
                
                318Investment
                    securities, available-for-sale
                
                
                47,556
                
                
                38,445Federal
                    Home Loan Bank stock, at cost
                
                
                3,045
                
                
                2,350Loans
                    held for sale
                
                
                902
                
                
                1,764Loans,
                    net of deferred fees of $1,732 and $1,625 and allowance for loan
                    loss of
                    $6,143 and $4,081 at December 31, 2007 and 2006,
                    respectively
                
                
                605,342
                
                
                439,277Property
                    premises and equipment, net
                
                
                6,390
                
                
                14,581Net
                    deferred tax asset
                
                
                5,290
                
                
                2,414Bank
                    owned life insurance
                
                
                9,923
                
                
                9,435Goodwill
                
                
                10,911
                
                
                4,865Core
                    deposit intangible
                
                
                4,551
                
                
                1,148Other
                    assets
                
                
                4,895
                
                
                4,143Total
                    assets
                
                $
                745,554
                
                $
                541,774**Liabilities**Deposits:Demand,
                    non-interest bearing
                
                $
                153,684
                
                $
                153,005Savings,
                    NOW and money market deposits
                
                
                317,911
                
                
                146,110Time
                    deposits of $100 or more
                
                
                75,966
                
                
                30,630Time
                    deposits under $100
                
                
                97,247
                
                
                90,776Total
                    deposits
                
                
                644,808
                
                
                420,521FHLB
                    advances and other borrowings
                
                
                8,000
                
                
                50,000Securities
                    sold under agreement to repurchase
                
                
                1,936
                
                
                1,364Junior
                    subordinated debentures
                
                
                13,403
                
                
                16,496Other
                    liabilities
                
                
                7,957
                
                
                3,921Total
                    liabilities
                
                
                676,104
                
                
                492,302Commitments
                    and contingencies (Notes 5 and 10)
                
                
                -
                
                
                -**Stockholders'
                    Equity**Common
                    stock, no par value; 20,000,000 shares authorized; 7,317,932
                    and 6,345,639
                    shares issued and outstanding for 2007 and 2006,
                    respectively
                
                
                43,996
                
                
                29,247Additional
                    paid in capital
                
                
                672
                
                
                336Retained
                    earnings
                
                
                24,598
                
                
                19,809Accumulated
                    other comprehensive income, net of tax of $129 and $53 in 2007
                    and 2006,
                    respectively
                
                
                184
                
                
                80Total
                    stockholders' equity
                
                
                69,450
                
                
                49,472Total
                    liabilities and stockholders' equity
                
                $
                745,554
                
                $
                541,774




The
        accompanying notes are an integral part of these consolidated financial
        statements.
  50




**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **CONSOLIDATED
        STATEMENTS OF INCOME**
 **FOR
        THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005**
 *(dollar
        amounts in thousands except per share data)*
  **2007**
                
                **2006**
                
                **2005****Interest
                    Income**Interest
                    and fees on loans
                
                $
                42,425
                
                $
                33,897
                
                $
                27,399Interest
                    on investment securities:Obligations
                    of U.S. Government agencies
                
                
                1,042
                
                
                1,083
                
                
                1,389Obligations
                    of state and political subdivisions
                
                
                710
                
                
                702
                
                
                593Interest
                    on time deposits with other banks
                
                
                8
                
                
                9
                
                
                9Interest
                    on federal funds sold
                
                
                785
                
                
                539
                
                
                667Interest
                    on other securities
                
                
                204
                
                
                142
                
                
                118Total
                    interest income
                
                
                45,174
                
                
                36,372
                
                
                30,175**Interest
                    Expense**Interest
                    on savings, NOW and money market deposits
                
                
                4,911
                
                
                2,497
                
                
                1,695Interest
                    on time deposits in denominations of $100 or more
                
                
                2,046
                
                
                626
                
                
                413Interest
                    on time deposits under $100
                
                
                4,914
                
                
                3,845
                
                
                1,371Other
                    borrowings
                
                
                2,880
                
                
                2,348
                
                
                1,537Total
                    interest expense
                
                
                14,751
                
                
                9,316
                
                
                5,016Net
                    interest income before provision for possible loan losses
                
                
                30,423
                
                
                27,056
                
                
                25,159Provision
                    for possible loan losses
                
                
                660
                
                
                600
                
                
                710Net
                    interest income after provision for possible loan losses
                
                
                29,763
                
                
                26,456
                
                
                24,449**Non-Interest
                    Income**Fees
                    and service charges
                
                
                2,774
                
                
                2,427
                
                
                2,430Investment
                    securities gain/(loss), net
                
                
                6
                
                
                9
                
                
                -Gain
                    on sale of SBA loans, net
                
                
                36
                
                
                19
                
                
                84Gain/(loss)
                    on sale of premises, net
                
                
                -
                
                
                (38
                )
                
                4Other
                
                
                2,533
                
                
                2,535
                
                
                2,491Total
                    non-interest income
                
                
                5,349
                
                
                4,952
                
                
                5,009**Non-Interest
                    Expenses**Salaries
                    and employee benefits
                
                
                13,501
                
                
                11,573
                
                
                9,746Equipment
                    expenses
                
                
                1,089
                
                
                868
                
                
                824Occupancy
                    expenses
                
                
                2,292
                
                
                1,739
                
                
                1,667Other
                    expenses
                
                
                7,026
                
                
                6,775
                
                
                6,481Total
                    non-interest expenses
                
                
                23,908
                
                
                20,955
                
                
                18,718Income
                    before provision for income taxes
                
                
                11,204
                
                
                10,453
                
                
                10,740Provision
                    for income taxes
                
                
                4,287
                
                
                3,791
                
                
                4,103Net
                    income
                
                $
                6,917
                
                $
                6,662
                
                $
                6,637**Earnings
                    Per Share**Basic
                
                $
                1.04
                
                $
                1.05
                
                $
                1.08Diluted
                
                $
                1.00
                
                $
                1.01
                
                $
                1.01
 
 The
          accompanying notes are an integral part of these consolidated financial
          statements.
  51
  **HERITAGE
            OAKS BANCORP AND SUBSIDIARIES**
 **CONSOLIDATED
            STATEMENTS OF STOCKHOLDERS' EQUITY**
 **December
            31, 2007, 2006 and 2005**
 *(dollar
            amounts in thousands except shares outstanding)*
  **Common
                        Stock**
                    
                    **Additional**
                    
                    
                    
                    
                    
                    **Accumulated**
                      **Other**
                    
                    **Total****Number
                        of Shares**
                    
                    **Amount**
                    
                    **Paid-In**
                      **Capital**
                    
                    **Comprehensive
                        Income**
                    
                    **Retained
                        Earnings**
                    
                    **Comprehensive
                        Income/(loss)**
                    
                    **Stockholders**
                      **'Equity****Balance,
                        December 31, 2004**
                    
                    
                    3,817,943
                    
                    $
                    24,050
                    
                    $
                    -
                    
                    
                    
                    
                    $
                    13,053
                    
                    $
                    147
                    
                    $
                    37,250Exercise
                          of stock options(including
                          $588 tax benefit from exercise of stock options)
                    
                    
                    144,674
                    
                    
                    1,275
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    1,2755%
                        stock dividend
                    
                    
                    195,013
                    
                    
                    3,930
                    
                    
                    
                    
                    
                    
                    
                    
                    (3,930
                    )
                    
                    
                    
                    
                    -Cash
                        paid to stockholders in lieu of fractional shares on 5% stock
                        dividend
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (7)
                    
                    
                    
                    
                    
                    (7)3-for-2
                        stock split
                    
                    
                    2,074,352Cash
                        paid to stockholders in lieu of fractional shares on 3-for-2
                        stock
                        split
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (5)
                    
                    
                    
                    
                    
                    (5)Comprehensive
                        income:Net
                        income
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    6,637
                    
                    
                    6,637
                    
                    
                    
                    
                    
                    6,637Unrealized
                        security holding losses (net of $204 tax)
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (305
                    )
                    
                    
                    
                    
                    (305
                    )
                    
                    (305
                    )Total
                        comprehensive income
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    6,332**Balance,
                        December 31, 2005**
                    
                    
                    6,231,982
                    
                    $
                    29,255
                    
                    $
                    -
                    
                    
                    
                    
                    $
                    15,748
                    
                    $
                    (158
                    )
                    $
                    44,845Exercise
                        of stock options (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
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    6,900**Balance,
                        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
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    7,021**Balance,
                        December 31, 2007**
                    
                    
                    7,317,932
                    
                    $
                    43,996
                    
                    $
                    672
                    
                    
                    
                    
                    $
                    24,598
                    
                    $
                    184
                    
                    $
                    69,450
  The
              accompanying notes are an integral part of these consolidated financial
              statements.
  52
 **HERITAGE
                OAKS BANCORP AND SUBSIDIARIES**
 **CONSOLIDATED
                STATEMENTS OF CASH FLOWS**
 **FOR
                THE YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005**
 *(dollar
                amounts in thousands)*
  **2007**
                        
                        **2006**
                        
                        **2005****Cash
                            flows from operating activities:**Net
                            income
                        
                        $
                        6,917
                        
                        $
                        6,662
                        
                        $
                        6,637Adjustments
                            to reconcile net income to net cash provided by operating
                            activities:Depreciation
                            and amortization
                        
                        
                        984
                        
                        
                        958
                        
                        
                        897Provision
                            for possible loan losses
                        
                        
                        660
                        
                        
                        600
                        
                        
                        710Provision
                            for possible losses on unfunded loan commitments
                        
                        
                        -
                        
                        
                        -
                        
                        
                        10Realized
                            gain on sales of available-for-sale securities, net
                        
                        
                        (6
                        )
                        
                        (9
                        )
                        
                        -Amortization
                            of premiums/discounts on investment securities, net
                        
                        
                        (78
                        )
                        
                        (17
                        )
                        
                        184Amortization
                            of core deposit intangibles
                        
                        
                        393
                        
                        
                        300
                        
                        
                        573Share-based
                            compensation expense
                        
                        
                        361
                        
                        
                        336
                        
                        
                        -(Gain)/loss
                            on sale of property, premises and equipment, net
                        
                        
                        -
                        
                        
                        38
                        
                        
                        (4
                        )Net
                            decrease/(increase) in loans held for sale
                        
                        
                        862
                        
                        
                        1,628
                        
                        
                        (1,139
                        )Net
                            (increase) in bank owned life insurance
                        
                        
                        (378
                        )
                        
                        (343
                        )
                        
                        (276
                        )Federal
                            Home Loan Bank dividends received
                        
                        
                        (145
                        )
                        
                        (97
                        )
                        
                        (76
                        )(Increase)
                            in deferred tax asset
                        
                        
                        (2,746
                        )
                        
                        (220
                        )
                        
                        (236
                        )(Increase)
                            in other assets
                        
                        
                        (183
                        )
                        
                        (727
                        )
                        
                        (119
                        )Increase
                            in other liabilities
                        
                        
                        697
                        
                        
                        158
                        
                        
                        672Excess
                            tax benefit from share-based payment arrangements
                        
                        
                        (446
                        )
                        
                        (365
                        )
                        
                        -**Net
                            Cash Provided By Operating Activities**
                        
                        
                        6,892
                        
                        
                        8,902
                        
                        
                        7,833**Cash
                            flows from investing activities:**Purchase
                            of securities, available-for-sale
                        
                        
                        (1,103
                        )
                        
                        (1,190
                        )
                        
                        (2,588
                        )Proceeds
                            from principal reductions and maturities of securities,
                            available-for-sale
                        
                        
                        738
                        
                        
                        500
                        
                        
                        1,350Proceeds
                            from principal reductions and maturities of mortgage-backed
                            securities
                        
                        
                        5,450
                        
                        
                        7,071
                        
                        
                        13,537Net
                            change in interest-bearing deposits in other financial
                            institutions
                        
                        
                        -
                        
                        
                        (20
                        )
                        
                        200Redemption
                            of Federal Reserve Bank stock
                        
                        
                        361
                        
                        
                        -
                        
                        
                        -Redemption/(purchase)
                            of Federal Home Loan Bank stock
                        
                        
                        282
                        
                        
                        (368
                        )
                        
                        -Purchase
                            of bank owned life insurance
                        
                        
                        (110
                        )
                        
                        (1,386
                        )
                        
                        (300
                        )Recoveries
                            from loans previously charged off
                        
                        
                        270
                        
                        
                        161
                        
                        
                        25Increase
                            in loans, net
                        
                        
                        (46,217
                        )
                        
                        (77,403
                        )
                        
                        (28,406
                        )Proceeds
                            from sale of property, premises and equipment
                        
                        
                        12,810
                        
                        
                        -
                        
                        
                        900Increase
                            in cash from acquisition of Business First National Bank
                        
                        
                        12,467
                        
                        
                        -
                        
                        
                        -Purchase
                            of property, premises and equipment, net
                        
                        
                        (723
                        )
                        
                        (3,672
                        )
                        
                        (3,059
                        )**Net
                            Cash Used In Investing Activities**
                        
                        
                        (15,775
                        )
                        
                        (76,307
                        )
                        
                        (18,341
                        )**Cash
                            flows from financing activities:**Increase
                            in deposits, net
                        
                        
                        90,868
                        
                        
                        2,724
                        
                        
                        47,356Net
                            (decrease)/increase in Federal Home Loan Bank borrowings
                        
                        
                        (54,598
                        )
                        
                        40,000
                        
                        
                        (18,500
                        )Net
                            (decrease)/increase in junior subordinated debentures
                        
                        
                        (3,093
                        )
                        
                        8,248
                        
                        
                        -Net
                            increase/(decrease) in securities sold under agreement
                            to
                            repurchase
                        
                        
                        572
                        
                        
                        (2,483
                        )
                        
                        3,081Proceeds
                            from exercise of stock options
                        
                        
                        416
                        
                        
                        347
                        
                        
                        1,275Excess
                            tax benefit from share-based payment arrangements
                        
                        
                        446
                        
                        
                        365
                        
                        
                        -Cash
                            used in repurchases of common stock
                        
                        
                        (215
                        )
                        
                        (720
                        )
                        
                        -Cash
                            dividends paid
                        
                        
                        (2,128
                        )
                        
                        (2,601
                        )
                        
                        -Cash
                            paid in lieu of fractional shares
                        
                        
                        -
                        
                        
                        -
                        
                        
                        (12
                        )**Net
                            Cash Provided By Financing Activities**
                        
                        
                        32,268
                        
                        
                        45,880
                        
                        
                        33,200**Net
                            increase/(decrease) in cash and cash equivalents**
                        
                        
                        23,385
                        
                        
                        (21,525
                        )
                        
                        22,692**Cash
                            and cash equivalents, beginning of year**
                        
                        
                        23,034
                        
                        
                        44,559
                        
                        
                        21,867**Cash
                            and Cash Equivalents, End of Year**
                        
                        $
                        46,419
                        
                        $
                        23,034
                        
                        $
                        44,559
 53
  **Supplemental
                      Cash Flow Disclosures:****Cash
                      Flow Information**Interest
                      paid
                  
                  $
                  14,848
                  
                  $
                  8,976
                  
                  $
                  4,912Income
                      taxes paid
                  
                  $
                  6,856
                  
                  $
                  3,670
                  
                  $
                  3,825**Non-Cash
                      Flow Information**Change
                      in other valuation allowance for investment securities
                  
                  $
                  180
                  
                  $
                  397
                  
                  $
                  (509
                  )Tax
                      benefit of stock options exercised
                  
                  
                  
                  
                  
                  
                  
                  $
                  588**Net
                      change in assets and liabilities due to acquisition of Business
                      First**Increase
                      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.
  54
 **HERITAGE
            OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
            31, 2007, 2006, AND 2005**
 *(Dollars
            in thousands, except share and per share amounts)*


**NOTE
        1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**


The
      accounting and reporting policies of Heritage Oaks Bancorp (the Company) and
      subsidiaries conform to accounting principles generally accepted in the United
      States of America and to general practices within the banking industry. A
      summary of the Company's significant accounting and reporting policies
      consistently applied in the preparation of the accompanying financial statements
      follows:




*PRINCIPLES
        OF CONSOLIDATION*




The
      Consolidated Financial Statements include the Company and its wholly owned
      subsidiaries, Heritage Oaks Bank, (the “Bank”) and CCMS Systems, Inc.
      Inter-company balances and transactions have been eliminated.




*NATURE
        OF OPERATIONS*





The
      Company has been organized as a single operating segment. The Bank operates
      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 allowances for losses on loans and
      foreclosed real estate, management obtains independent appraisals for
      significant properties.





While
      management uses available information to recognize losses on loans and
      foreclosed real estate, future additions to the 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, 2007.




55




**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*


The
      Company maintains amounts due from banks that exceed federally insured limits.
      The Company has not experienced any losses in such accounts.




*CASH
        AND CASH EQUIVALENTS*





For
      purposes of reporting cash flows, cash and cash equivalents include cash, due
      from banks, federal funds sold and money market funds. Generally, federal funds
      are sold for one-day periods.




*INVESTMENT
        SECURITIES*





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





Declines
      in the fair values of individual held-to-maturity and available-for-sale
      securities below their cost that are other than temporary result in write-downs
      of individual securities to their fair value. The related write-downs are
      included in earnings as realized losses. In estimating other-than-temporary
      impairment losses, management considers (1) the length of time and the extent
      to
      which the fair value has been less than cost, (2) the financial condition and
      near-term prospects of the issuer, and (3) the intent and ability of the Company
      to retain its investment in the issuer for a period of time sufficient to allow
      for any anticipated recover in fair value.




*LOANS
        AND INTEREST ON LOANS*


Loans
      receivable that management has the intent and ability to hold for the
      foreseeable future or until maturity or payoff are reported at their outstanding
      unpaid principal balances reduced by any charge-offs of specific valuation
      accounts and net of any deferred fees or costs on originated loans, or
      unamortized premiums or discounts on purchased loans.





Loan
      origination fees and certain direct origination costs are capitalized and
      recognized as an adjustment of the yield of the related loan.





Loans
      on
      which the accrual of interest has been discontinued are designated as
      non-accrual loans. The accrual of interest on loans is discontinued when
      principal or interest is past due 90 days based on contractual terms of the
      loan
      or when, in the opinion of management, there is reasonable doubt as to
      collectibility. When loans are placed on non-accrual status, all interest
      previously accrued but not collected is reversed against current period interest
      income. Interest income generally is not recognized on specific impaired loans
      unless the likelihood of further loss is remote. Interest payments received
      on
      such loans are applied as a reduction to the loan principal balance. Interest
      accruals are resumed on such loans only when they are brought current with
      respect to interest and principal and when, in the judgment of management,
      the
      loans are estimated to be fully collectible as to all principal and
      interest.





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.





56




**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*


*LOANS
        HELD FOR SALE*





Loans
      held for sale are carried at the lower of aggregate cost or market value, which
      is determined by the specified value in the commitments. Net unrealized losses,
      if any, are recognized through a valuation allowance by charges to
      expense.




*ALLOWANCE
        FOR LOAN LOSSES*


The
      allowance for loan losses is maintained at a level which, in management's
      judgment, is adequate to absorb credit losses inherent in the loan portfolio.
      The amount of the allowance is based on management's evaluation of the
      collectibility of the loan portfolio, including the nature of the portfolio,
      credit concentrations, trends in historical loss experience, specific impaired
      loans, and economic conditions. Allowances for impaired loans are generally
      determined based on collateral values or the present value of estimated cash
      flows. The allowance is increased by a provision for loan losses, which is
      charged to expense and reduced by charge-offs, net of recoveries. Changes in
      the
      allowance relating to impaired loans are charged or credited to the provision
      for loan losses. Because of uncertainties inherent in the estimation process,
      management’s estimate of credit losses inherent in the loan portfolio and the
      related allowance may change.




*PROPERTY,
        PREMISES AND EQUIPMENT*


Land
      is
      carried at cost. Premises and equipment are carried at cost less accumulated
      depreciation and amortization. Depreciation is computed using the straight-line
      method over the estimated useful lives, which ranges from three to ten years
      for
      furniture and fixtures and forty years for buildings. Leasehold improvements
      are
      amortized using the straight-line method over the estimated useful lives of
      the
      improvements or the remaining lease term, whichever is shorter. Expenditures
      for
      betterments or major repairs are capitalized and those for ordinary repairs
      and
      maintenance are charged to operations as incurred. Total depreciation expenses
      for the reporting periods ending December 31, 2007, 2006, and 2005 were
      approximately $984, $958, and $897, respectively.




*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, 2007
      pursuant to its Goodwill Impairment Testing Policy resulted in no impairment.





Core
      deposit intangibles represent the intangible value of depositor relationships
      resulting from deposit liabilities assumed in acquisitions. Core deposit
      intangibles are being amortized over six and ten years. Intangibles are
      evaluated periodically for impairment. Should such an assessment indicate that
      the undiscounted value of an intangible may be impaired, the net book value
      of
      the intangible would be written down to the net estimated recoverable
      value.




57




**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*


*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."*




*ADVERTISING
        COSTS* ******


The
      Company expenses the costs of advertising in the period incurred.




*DISCLOSURE
        ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS*


Statement
      of Financial Accounting Standards (“SFAS”) No. 107, *“Fair
      Value Measurements,”* specifies the disclosure of the estimated fair value of financial instruments.
      The Company’s estimated fair value amounts have been determined by the Company
      using available market information and appropriate valuation methodologies.
      However, considerable judgment is required to develop the estimates of fair
      value. Accordingly, the estimates are not necessarily indicative of the amounts
      the Company could have realized in a current market exchange. The use of
      different market assumptions and/or estimation methodologies may have a material
      effect on the estimated fair value amounts.





Although
      management is not aware of any factors that would significantly affect the
      estimated fair value amounts, such amounts have not been comprehensively
      revalued for purposes of these financial statements since the balance sheet
      date
      and, therefore, current estimates of fair value may differ significantly from
      the amounts presented in the accompanying notes.




*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 Statement of Financial Accounting Standards (“SFAS”) No. 130,
“ *Reporting
      Comprehensive Income* ,”
the
      Company classifies items of other comprehensive income by their nature in the
      financial statements and displays the accumulated other comprehensive income
      separately from retained earnings in the equity section of the Balance
      Sheet *.* Changes
      in unrealized gain (loss) on available-for-sale securities net of income taxes
      is the only component of accumulated other comprehensive income for the
      Company.




*RECLASSIFICATIONS*


Certain
      amounts in the 2005 and 2006 financial statements have been reclassified to
      conform to the 2007 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.




58




**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*


*SHARE-BASED
        COMPENSATION*





Effective
      January 1, 2006, the Company adopted the provisions of Statement of
      Financial Accounting Standards (“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 is recognized only to the
      extent an option’s exercise price is less than the market value of the
      underlying stock on the date of grant. No share-based compensation expense
      was
      reflected in net income as all options are required by the plan to be granted
      with an exercise price equal to the estimated fair value of the underlying
      common stock on the date of grant. We also followed the disclosure requirements
      of SFAS No. 123, “ *Accounting
      for Stock-Based Compensation* ,”
as
      amended by SFAS No. 148, “ *Accounting
      for Stock-Based Compensation - Transition and Disclosure - An Amendment of
      FASB
      Statement 123.”* We
      adopted SFAS No. 123(R) under the *modified
      prospective* method
      which means that the unvested portion of previously granted awards and any
      awards that are granted or modified after the date of adoption will be measured
      and accounted for under the provisions of SFAS No. 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).





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, 2007
      and
      2006:


**For
                  The Years Ended,****2007**
              
              **2006**Share-based
                  compensation expense:Stock
                  option expense
              
              $
              114
              
              $
              113Restricted
                  stock expense
              
              
              247
              
              
              223Total
                  share-based compensation expense
              
              $
              361
              
              $
              336Total
                  share-based compensation expense, net of tax
              
              $
              246
              
              $
              198Diluted
                  shares outstanding
              
              
              6,884,575
              
              
              6,595,793Impact
                  on diluted earnings per share
              
              $
              0.036
              
              $
              0.030Unrecognized
                  compensation expense:Stock
                  option expense
              
              $
              364
              
              $
              227Restricted
                  stock expense
              
              
              787
              
              
              1,038Total
                  unrecognized share-based compensation expense
              
              $
              1,151
              
              $
              1,265Total
                  unrecognized share-based compensation expense, net of tax
              
              $
              719
              
              $
              819




59




**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*


Prior
      to
      January 1, 2006, had compensation cost for the Company’s stock option plans been
      determined based on the fair value at the grant dates for awards under those
      plans consistent with the method of SFAS No. 123, the Company’s net income and
      earnings per share would have been reduced to the pro forma amount indicated
      below:




**2005**Net
                  income as reported
              
              $
              6,637Stock-based
                  compensation using the intrinsic value method
              
              
              -Stock-based
                  compensation that would have been reported using the fair value
                  method of
                  SFAS 123
              
              
              (89
              )Pro
                  forma net income
              
              $
              6,548Basic
                  earnings per share:As
                  reported
              
              $
              1.08Pro
                  forma
              
              $
              1.06Diluted
                  earnings per share:As
                  reported
              
              $
              1.01Pro
                  forma
              
              $
              1.00




Prior
      to
      the adoption of SFAS No. 123(R), the Company presented the tax benefit of stock
      option exercises as operating cash flows, upon the adoption of SFAS No. 123(R),
      tax benefits resulting from tax deductions in excess of the compensation cost
      recognized for those options are classified as financing cash
      flows.




*RECENT
        ACCOUNTING PRONOUNCEMENTS*


In
      September 2006, the Financial Accounting Standards Board (“FASB”) ratified the
      consensus the Emerging Issues Task Force (“EITF”) reached regarding EITF No.
      06-5, *“Accounting
      for Purchases of Life Insurance - Determining the Amount That Could Be Realized
      in Accordance with FASB Technical Bulletin No. 85-4 (“EITF
      06-5”).”* The EITF
      concluded that a policy holder should consider any additional amounts included
      in the contractual terms of the life insurance policy in determining the amount
      that could be realized under the issuance contract. For group policies with
      multiple certificates or multiple policies with a group rider, the EITF also
      tentatively concluded that the amount that could be realized should be
      determined at the individual policy or certificate level, i.e, amounts that
      would be realized only upon surrendering all of the policies or certificates
      would not be included in measuring the assets. This interpretation is effective
      for fiscal years beginning after December 15, 2006. The adoption of EITF 06-5
      has not had a material impact on the Company’s financial position, results of
      operations, or cash flows.




In
      February 2006, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards (“SFAS”) No. 155, *"Accounting
      for Certain Hybrid Financial Instruments - an amendment of FASB Statements
      No.
      133 and 140."* SFAS No.
      155 simplifies accounting for certain hybrid instruments currently governed
      by
      SFAS No. 133, *"Accounting
      for Derivative Instruments and Hedging Activities,"* by
      allowing fair value re-measurement of hybrid instruments that contain an
      embedded derivative that otherwise would require bifurcation. SFAS No. 155
      also
      eliminates the guidance in SFAS No.133 Implementation Issue No. D1, *"Application
      of Statement 133 to Beneficial Interests in Securitized Financial
      Assets,"* which
      provides such beneficial interests are not subject to SFAS No.133. SFAS No.
      155
      amends SFAS No. 140, *"Accounting
      for Transfers and Servicing of Financial Assets and Extinguishments of
      Liabilities - a Replacement of FASB Statement No. 125,"* by
      eliminating the restriction on passive derivative instruments that a qualifying
      special-purpose entity may hold. This statement is effective for financial
      instruments acquired or issued after the beginning of the Company’s fiscal year
      2007. The Company adopted SFAS No. 155 effective January 1, 2007. The adoption
      of this statement did not have a material impact on the Company’s financial
      position, results of operations or cash flows.





In
      March
      2006, the Financial Accounting Standards Board (“FASB”) issued Statement of
      Financial Accounting Standards (“SFAS”) No. 156, *"Accounting
      for Servicing of Financial Assets- an amendment of FASB Statement No. 140."* SFAS
      No.156 requires an entity to recognize a servicing asset or servicing liability
      each time it undertakes an obligation to service a financial asset by entering
      into a servicing contract in specific situations. Additionally, the servicing
      asset or servicing liability shall be initially measured at fair value; however,
      an entity may elect the "amortization method" or "fair value method" for
      subsequent balance sheet reporting periods. SFAS No.156 is effective as of
      an
      entity's first fiscal year beginning after September 15, 2006. The Company
      adopted SFAS No. 156 effective January 1, 2007. The adoption of this statement
      did not have a material impact on the Company’s financial position, results of
      operations or cash flows.




60




**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*


In
      July
      2006, the Financial Accounting Standards Board (“FASB”) issued FASB
      Interpretation No. 48, *Accounting
      for Uncertainty in Income Taxes—an interpretation of FASB Statement No.
      109* (“FIN
      48”) which clarifies the accounting and disclosure for uncertainty in tax
      positions, as defined. FIN 48 seeks to reduce the diversity in practice
      associated with certain aspects of the recognition and measurement related
      to
      accounting for income taxes and provides that the tax effects from an uncertain
      tax position be recognized in the financial statements only if, based on its
      merits, the position is more likely than not to be sustained in audit by the
      taxing authorities. This interpretation is effective for fiscal years beginning
      after December 15, 2006. Effective January 1, 2007, the Company adopted FIN
      48.  Management believes that all tax positions taken as of December 31,
      2007 are highly certain and, accordingly, no accounting adjustments have been
      made to the financial statements. However, as part of the analysis of the impact
      of FIN 48 the Company’s CFO and tax accounting firm engaged in discussions
      surrounding a potential disclosure issue related to FIN 48. It was concluded
      that a previous position taken on the Company’s 2004 and 2005 tax returns in
      regard to deferred loan fees can not be supported and that amended returns
      will
      be filed for those periods. For income tax purposes, both Federal and Franchise,
      this is a “timing” issue and does not flow through the Income Statement. The
      Balance Sheet is impacted to the extent that current taxes payable is increased
      and offset by a deferred tax asset in the same amount. The 2004 and 2005 amended
      tax returns were filed in June 2007. Interest and penalties related to uncertain
      tax positions are recorded as part of other operating expense.





In
      September 2006, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards (“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 out 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. The
      Company has not determined the impact of adopting SFAS No. 157 will have on
      its
      financial position, results of operations or cash flows.





In
      September 2006, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards (“SFAS”) No. 158, “ *Employers’
      Accounting for Defined Benefit Pension and Other Postretirement Plans (an
      amendment of FASB Statements No. 87, 88, 106, and 132R).”
S* FAS
      No.
      158, requires an employer to: (1) Recognize in its statement of financial
      position an asset for a plan’s over funded status or a liability for a plan’s
      under funded status; (2) measure a plan’s assets and its obligations that
      determine its funded status as of the end of the employer’s fiscal year (with
      limited exceptions); and (3) recognize changes in the funded status of a
      defined benefit postretirement plan in the year in which the changes occur.
      Those changes will be reported in comprehensive income of a business entity
      and
      in changes in net assets of a not-for-profit organization. The requirement
      by
      SFAS No. 158 to recognize the funded status of a benefit plan and the disclosure
      requirements of SFAS No. 158 are effective as of the end of the fiscal year
      ending after December 15, 2006 for entities with publicly traded equity
      securities. The 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 Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards (“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 does not expect the adoption of
      SFAS
      No. 159 to have a material impact on its financial position, results of
      operations or cash flows.




61




**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*


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





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




**NOTE
        2. INVESTMENT SECURITIES**


At
      December 31, 2007 and 2006, the investment securities portfolio was comprised
      of
      securities classified as available-for-sale, in accordance with SFAS No. 115,
      resulting in investment securities available-for-sale being carried at fair
      value adjusted for amortization of premiums and accretions of discounts, and
      fair market value adjustments for securities transferred from
      available-for-sale.




62


**HERITAGE
      OAKS BANCORP AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006, AND 2005**


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


The
      tables below set forth the fair values of investment securities
      available-for-sale at December 31, 2007 and 2006:


**As
                  of December 31, 2007**
              
              **Amortized
                  C****ost**
              
              **Gross
                  Unrealized Gains**
              
              **Gross
                  Unrealized Losses**
              
              **Fair
                  Value**Obligations
                  of U.S. Government agencies and corporations
              
              $
              3,674
              
              $
              12
              
              $
              (6
              )
              $
              3,680Mortgage-backed
                  securities
              
              
              26,793
              
              
              71
              
              
              (206
              )
              
              26,658Obligations
                  of state and political subdivisions
              
              
              16,667
              
              
              478
              
              
              (36
              )
              
              17,109Other
                  securities
              
              
              109
              
              
              -
              
              
              -
              
              
              109Total
              
              $
              47,243
              
              $
              561
              
              $
              (248
              )
              $
              47,556
  **As
                  of December 31, 2006**
              
              **Amortized****Cost**
              
              **Gross
                  Unrealized Gains**
              
              **Gross
                  Unrealized Losses**
              
              **Fair
                  Value**Obligations
                  of U.S. Government agencies and corporations
              
              $
              205
              
              $
              -
              
              $
              (4
              )
              $
              201Mortgage-backed
                  securities
              
              
              21,959
              
              
              16
              
              
              (381
              )
              
              21,594Obligations
                  of state and political subdivisions
              
              
              16,139
              
              
              540
              
              
              (38
              )
              
              16,641Other
                  securities
              
              
              9
              
              
              -
              
              
              -
              
              
              9Total
              
              $
              38,312
              
              $
              556
              
              $
              (423
              )
              $
              38,445




There
      were no investment securities held-to-maturity at December 31, 2007 and December
      31, 2006.





The
      amortized cost and fair values of investment securities available-for-sale
      at
      December 31, 2007 and 2006, by contractual maturity are shown below. Actual
      maturities may differ from contractual maturities because borrowers may have
      the
      right to call or prepay obligations with or without call or prepayment
      penalties.




**2007**
              
              **2006****Amortized
                  Cost**
              
              **Fair
                  Value**
              
              **Amortized
                  Cost**
              
              **Fair
                  Value**Due
                  one year or less
              
              $
              7,737
              
              $
              7,704
              
              $
              583
              
              $
              581Due
                  after one year through five years
              
              
              21,993
              
              
              22,005
              
              
              20,445
              
              
              20,145Due
                  after five years through ten years
              
              
              8,689
              
              
              8,856
              
              
              7,775
              
              
              7,942Due
                  after ten years
              
              
              8,824
              
              
              8,991
              
              
              9,509
              
              
              9,777Total
                  securities
              
              $
              47,243
              
              $
              47,556
              
              $
              38,312
              
              $
              38,445


Proceeds
      from sales, maturities and principal reductions of investment securities
      available-for-sale during 2007, 2006, and 2005, were $738, $500, and $1,350,
      respectively.  For
      the
      years ended December 31, 2007 and 2006, the Company realized gross gains of
      approximately $6 and $9 related to the calls of certain available for sale
      securities. There were no gains or losses reported during 2005.





Securities
      having a carrying value and a fair value of approximately $33,503 and $21,645
      at
      December 31, 2007 and 2006, respectively, were pledged to secure public deposits
      and for other purposes as required by law.





63


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*


Those
      investment securities available for sale which have an unrealized loss position
      at December 31, 2007 and 2006 are detailed below:








**Securities
                In A Loss Position For Less Than Twelve Months**
            
            **Securities
                In A Loss Position For Twelve Months or More**
            
            **Total****As
                of December 31, 2007**
            
            **Fair
                Value**
            
            **Unrealized
                Loss**
            
            **Fair
                Value**
            
            **Unrealized
                Loss**
            
            **Fair
                Value**
            
            **Unrealized
                Loss**Obligations
                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
            )**As
                of December 31, 2006**Obligations
                of U.S. Government agencies and corporations
            
            $
            -
            
            $
            -
            
            $
            201
            
            $
            (4
            )
            $
            201
            
            $
            (4
            )Mortgage-backed
                securities
            
            
            379
            
            
            (4
            )
            
            19,603
            
            
            (377
            )
            
            19,982
            
            
            (381
            )Obligations
                of state and political subdivisions
            
            
            1,311
            
            
            (12
            )
            
            872
            
            
            (26
            )
            
            2,183
            
            
            (38
            )Other
                securities
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Total
            
            $
            1,690
            
            $
            (16
            )
            $
            20,676
            
            $
            (407
            )
            $
            22,366
            
            $
            (423
            )




There
      are
      sixteen securities that have been in a loss position for twelve months or longer
      as of December 31, 2007, compared to twenty two as of December 31, 2006. These
      securities are guaranteed by either the U.S. Government or other governmental
      agencies. These unrealized losses relate principally to current interest rates
      for similar types of securities. In analyzing an issuer’s financial condition,
      the Company considers whether the securities are issued by the federal
      government or its agencies, whether downgrades by bond rating agencies have
      occurred, and the results of reviews of the issuer’s financial condition. As the
      Company has the ability to hold these securities until maturity, or for the
      foreseeable future, no declines are deemed to be other-than-temporary.


**NOTE
        3. LOANS**


The
      following table sets forth the balance for each major loan category as of
      December 31, 2007 and 2006:


**2007**
              
              **2006**Commercial,
                  financial and agricultural
              
              $
              146,080
              
              $
              84,976Real
                  estate - construction
              
              
              118,200
              
              
              105,712Real
                  estate - commercial
              
              
              322,928
              
              
              237,401Home
                  equity lines of credit
              
              
              17,470
              
              
              10,792Installment
                  loans to individuals
              
              
              7,977
              
              
              5,598All
                  other loans (including overdrafts)
              
              
              562
              
              
              504Total
                  loans, gross
              
              
              613,217
              
              
              444,983Less:
                  Deferred loan fees
              
              
              1,732
              
              
              1,625Less:
                  Allowance for loan losses
              
              
              6,143
              
              
              4,081Total
                  loans, net
              
              $
              605,342
              
              $
              439,277Loans
                  held for sale
              
              $
              902
              
              $
              1,764


*CONCENTRATION
        OF CREDIT RISK*


At
      December 31, 2007 and 2006, approximately $458.6 million and $353.9 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 their concentration of
      credit risk by making loans which are diversified by project type. While
      management believes that the collateral presently securing this portfolio is
      adequate, there can be no assurances that significant deterioration in the
      California real-estate market would not expose the Bank to significantly greater
      credit risk.




64


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*


Loans
      serviced for others are not included in the accompanying balance sheets. The
      unpaid principal balance of loans serviced for others was
      $18.2
      million , $7.5
      million and $3.6 million at December 31, 2007, 2006 and 2005, respectively.





The
      following provides a summary of the investment in impaired loans, the related
      allowance for loan losses, and income recognized thereon as of December 31,
      2007, 2006 and 2005:




**2007**
              
              **2006**
              
              **2005**Impaired
                  loans with a valuation allowance
              
              $
              62
              
              $
              -
              
              $
              54Impaired
                  loans without a valuation allowance
              
              
              276
              
              
              55
              
              
              -Total
                  impaired loans
              
              $
              338
              
              $
              55
              
              $
              54Valuation
                  allowance related to impaired loans
              
              $
              31
              
              $
              -
              
              $
              16Average
                  recorded investment in impaired loans
              
              $
              419
              
              $
              131
              
              $
              374Cash
                  receipts applied to reduce principal balance
              
              $
              151
              
              $
              273
              
              $
              8Interest
                  income recognized for cash payments
              
              $
              -
              
              $
              -
              
              $
              -


The
      provisions of SFAS No. 114 and SFAS No. 118 permit the valuation allowance
      reported above to be determined on a loan-by-loan basis or by aggregating loans
      with similar risk characteristics. Because the loans currently identified as
      impaired have unique risk characteristics, the valuation allowance was
      determined on a loan-by-loan basis.





Non-accruing
      loans totaled approximately $338 and $55 at December 31, 2007 and 2006,
      respectively. As of December 31, 2007 and 2006, 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  $65,
      $63,
      and $87, in 2007, 2006, and 2005, respectively. No additional funds are
      committed to be advanced in connection with impaired loans.





At
      December 31, 2007 and 2006, the Bank had no loans past due 90 days or more
      and
      still accruing interest and there no loans classified as troubled debt
      restructurings.





The
      Bank
      also originates Small Business Administration (“SBA”) loans for sale to
      governmental agencies and institutional investors. At December 31, 2007 and
      2006, the unpaid principal balance of SBA loans serviced for others totaled
      $1,965 and $1,355, respectively. The Company recognized a gain on the sale
      of
      SBA loans in the approximate amounts of $36, $19, and $84 for the years ended
      December 31, 2007, 2006, and 2005, respectively.





65


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*


**NOTE
        4. ALLOWANCE FOR LOAN LOSSES**


The
      following table provides a summary of the transactions within the allowance
      for
      loan losses for the years ended December 31, 2007, 2006 and 2005:




**2007**
              
              **2006**
              
              **2005**Balance,
                  beginning of year
              
              $
              4,081
              
              $
              3,881
              
              $
              3,247Additions
                  charged to operating expense
              
              
              660
              
              
              600
              
              
              710Loans
                  charged off
              
              
              (249
              )
              
              (561
              )
              
              (100
              )Recoveries
                  of loans previously charged off
              
              
              270
              
              
              161
              
              
              24Credit
                  from purchase of Business First National Bank
              
              
              1,381
              
              
              -
              
              
              -Balance,
                  end of year
              
              $
              6,143
              
              $
              4,081
              
              $
              3,881


**NOTE
        5. PROPERTY, PREMISES AND EQUIPMENT**


At
      December 31, 2007 and 2006, property, premises and equipment consisted of the
      following:


**2007**
              
              **2006**Land
              
              $
              1,245
              
              $
              3,784Furniture
                  and equipment
              
              
              7,684
              
              
              5,759Building
                  and improvements
              
              
              5,179
              
              
              12,578Construction
                  in progress
              
              
              176
              
              
              -Total
                  cost
              
              
              14,284
              
              
              22,121Less:
                  accumulated depreciation and amortization
              
              
              7,894
              
              
              7,540Total
                  property, premises and equipment
              
              $
              6,390
              
              $
              14,581





During
      2003, the Bank purchased land for future development of a Paso Robles,
      California administrative facility for approximately $1,100. 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.”* Additionally,
      as of December 31, 2007, the Bank makes monthly payments in the aggregate amount
      of $75 to lease these facilities.





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.





66


**HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2007, 2006, AND 2005**
 *(Dollars
          in thousands, except share and per share amounts)*
 **NOTE
            6. INTANGIBLE ASSETS**


Intangible
      assets consisted of core deposit intangibles subject to amortization.
      Amortizations for 2007, 2006 and 2005 were $393, $300 and $574,
      respectively.





The
      following table summarizes the gross carrying amount, accumulated amortization
      and net carrying amount of core deposit intangibles as of December 31,
      2007:


**Gross
                  Carrying Amount**
              
              **Accumulated
                  Amortization**
              
              **Net
                  Carrying Amount**Core
                  deposit intangible asset
              
              $
              6,320
              
              $
              (1,769
              )
              $
              4,551


The
      following table summarizes the estimated future amortizations of core deposit
      intangibles as of December 31, 2007:


**Period**
              
              **Estimated
                  Amortization**2008
              
              $
              8612009
              
              
              1,0492010
              
              
              5142011
              
              
              6532012
              
              
              7572013
              
              
              717Total
                  estimated future amortization
              
              $
              4,551
  **NOTE
        7. TIME DEPOSIT LIABILITIES**





At
      December 31, 2007, the Bank had time certificates of deposit with maturity
      distributions as follows:


**Due
                  Year Ending**
                **December
                  31,**
              
              **Balance**2008
              
              $
              156,9752009
              
              
              14,1712010
              
              
              1,4302011
              
              
              2422012
              
              
              395Total
                  time deposits
              
              $
              173,213




67


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*
  **NOTE
        8. BORROWINGS**
 
 The
        Bank
        has borrowing lines with correspondent banks totaling $40.0 million. At December
        31, 2007 there were no balances outstanding on these borrowing
        lines.
 
 *FEDERAL
        HOME LOAN BANK (FHLB) ADVANCES*




The
      Bank
      has established borrowing lines with the Federal Home Loan Bank (“FHLB”). At
      December 31, 2007, the Bank had the following borrowings, all of which are
      collateralized by loans, with the FHLB:


**Amount**
              
              **Interest**
              
              **Maturity****Borrowed**
              
              **Rate**
              
              **Variable/Fixed**
              
              **Date**$
              4,000
              
              
              5.10
              %
              
              Fixed
              
              
              2/28/084,000
              
              
              4.93
              %
              
              Fixed
              
              
              2/27/09$
              8,000
              
              
              5.02
              %


At
      December 31, 2007, the Bank had a remaining borrowing capacity with existing
      collateral of approximately $106.3 million secured by loans and
      securities.  The
      Bank
      has pledged approximately $321.8 million in loans to the FHLB as of December
      31,
      2007.





Additionally,
      the Bank has an $11.7 million letter of credit secured by loans.


*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, 2007 and 2006, the Bank
      had
      $1,936 and $1,364 in securities sold under agreements to repurchase. Interest
      expense recorded was $91, $88, and $44 for the years ended December 31, 2007,
      2006, and 2005, respectively. The carrying value of underlying securities
      provided as collateral for these transactions was $4,350 and $4,330 at December
      31, 2007 and 2006, respectively.


*NOTES
        PAYABLE*





On
      October 10, 2007, the Company renewed a revolving line of credit in the amount
      of $3,500 through Pacific Coast Bankers Bank (PCBB). The line is secured by
      51%
      of the outstanding shares of the Bank’s stock. The line bears interest at the
      Wall Street Journal prime rate. Interest payments are due quarterly. The line
      is
      scheduled to mature on October 10, 2009 at which time the line converts to
      an
      eight-year term loan maturing on October 10, 2017 with principal and interest
      payments are due quarterly. Under the terms of the agreement, the Company will
      not incur any additional debt over $2,000 exclusive of the inter-company debt
      and existing debt without prior written consent of PCBB. In addition, the Bank
      must be “well” capitalized on an on-going basis as defined by the Regulators. At
      December 31, 2007, the outstanding balance owed was $0.


*JUNIOR
        SUBORDINATED DEBENTURES*





On
      October 27, 2006 the Company issued $8,248 of Floating Rate Junior Subordinated
      Debt Securities (“the debt securities”) to Heritage Oaks Capital Trust II, a
      statutory trust created under the laws of the State of Delaware. These debt
      securities are subordinated to effectively all borrowings of the Company. The
      Company intends to use the proceeds from the issuance of these securities for
      general corporate purposes, which may include capital contributions to the
      Bank,
      investments, payment of dividends, and repurchases of our common
      stock.





68


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*


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 $379 for the standard interest payment due April 22,
      2007, plus a payment of $8,248 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 $5,155 of Junior Subordinated Deferrable
      Interest Debentures (the “debt securities”) to Heritage Oaks Capital Trust III,
      a statutory trust created under the laws of the State of Delaware. These debt
      securities are subordinated to effectively all borrowings of the Company. The
      Company used the proceeds from the sale of the securities to assist in the
      acquisition of Business First, for general corporate purposes, and for capital
      contributions to the Bank for future growth.





At
      December 31, 2007, the Company had $13.4 million in Junior Subordinated
      Deferrable Interest Debentures (the “debt securities”) issued and outstanding.
      These securities have been issued to Heritage Oaks Capital Trusts II and III.
      The debt securities are subordinated to effectively all borrowings of the
      Company and can be redeemed at par if certain events occur that impact the
      tax
      treatment, regulatory treatment or the capital treatment of the issuance. Upon
      the issuance of the debt securities, the Company purchased a 3.1% minority
      interest in both Heritage Oaks Capital Trusts II and III, totaling $248 thousand
      and $155 thousand, respectively. The balance of the equity of Heritage Oaks
      Capital Trusts II and III is comprised of mandatory redeemable preferred
      securities and is included in other assets. Interest associated with the
      securities issued to Heritage Oaks Capital Trusts II and III is payable
      quarterly at 3-month LIBOR plus 1.71% variable rate and 6.888% fixed,
      respectively.





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


*(dollar
                  amounts in thousands)*
              
              **Amount
                  Borrowed**
              
              **Current
                  Rate**
              
              **Issue
                  Date**
              
              **Scheduled
                  Maturity**
              
              **Call
                  Date**
              
              **Rate
                  Type**Heritage
                  Oaks Capital Trust II
              
              
              8,248
              
              
              6.95
              %
              
              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
              
              
              6.93
              %


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





The
      Company has and or plans to use the proceeds from the issuance of these
      securities for general corporate purposes including, capital contributions
      to
      the Bank for future growth, acquisitions, payment of dividends and repurchases
      of common stock.





Under
      FASB Interpretation (“FIN”) No. 46, *“Consolidation
      of Variable Interest Entities, an interpretation of ARB No.
      51,”* the
      Company is not allowed to consolidate Heritage Oaks Capital Trusts II and III
      into the Company’s financial statements. Prior to the issuance of FIN No. 46,
      Bank holding companies typically consolidated these entities. On February 28,
      2005, the Federal Reserve Board issued a rule which provides that,
      notwithstanding the deconsolidation of such trusts, junior subordinated
      debentures, such as those issued by the Company, may continue to constitute
      up
      to 25% of a bank holding company's Tier I capital, subject to certain new
      limitations which will not become effective until March 31, 2009 and which,
      in
      any event, are not expected to affect the treatment of the Company's Junior
      Subordinated Debentures as Tier I capital for regulatory purposes. As of
      December 31, 2007, the Company has included $13.0 million of the net junior
      subordinated debt in its Tier I Capital for regulatory capital purposes.




69


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*


At
      December 31, 2007, the Company had sufficient cash to service the $13.4 million
      in junior subordinated debenture interest payments for approximately four years
      without dividends from subsidiaries. The Bank’s capacity to provide cash to the
      Company, while remaining “well-capitalized”, was approximately $2.5 million at
      December 31, 2007.


**NOTE
        9. INCOME TAXES**





The
      Company is subject to federal income taxation and income tax by the State of
      California. Our federal income tax returns for the years ended December 31,
      2006, 2005 and 2004 are open to audit by the federal authorities and our
      California state tax returns for the years ended December 31, 2006, 2005, 2004
      and 2003 are open to audit by state authorities.





The
      following table provides a summary of the current and deferred amounts for
      the
      Company’s income tax provision (benefit) for the years ended December 31, 2007,
      2006, and 2005:




**For
                  the Years Ended December 31,****2007**
              
              **2006**
              
              **2005**Federal
                  income taxCurrent
              
              $
              5,617
              
              $
              2,924
              
              $
              3,045Deferred
              
              
              (2,507
              )
              
              (191
              )
              
              (134
              )Total
                  federal taxes
              
              
              3,110
              
              
              2,733
              
              
              2,911State
                  franchise taxCurrent
              
              
              1,708
              
              
              1,087
              
              
              1,291Deferred
              
              
              (531
              )
              
              (29
              )
              
              (99
              )Total
                  state franchise tax
              
              
              1,177
              
              
              1,058
              
              
              1,192Total
                  income taxes
              
              $
              4,287
              
              $
              3,791
              
              $
              4,103


The
      provision for taxes on income differed from the amounts computed using the
      federal statutory tax rate of 34 percent is as follows:


**2007**
              
              **2006**
              
              **2005****Amount**
              
              **Percent**
              
              **Amount**
              
              **Percent**
              
              **Amount**
              
              **Percent**Tax
                  provision at federal statutory tax rate
              
              $
              3,809
              
              
              34.0
              
              $
              3,554
              
              
              34.0
              
              $
              3,652
              
              
              34.0State
                  income taxes, net of federal income tax benefit
              
              
              777
              
              
              6.9
              
              
              698
              
              
              7.2
              
              
              768
              
              
              7.2Tax
                  exempt income and other, Net
              
              
              (299
              )
              
              (2.6
              )
              
              (461
              )
              
              (4.9
              )
              
              (317
              )
              
              (3.0
              )Total
                  tax provision
              
              $
              4,287
              
              
              38.3
              
              $
              3,791
              
              
              36.3
              
              $
              4,103
              
              
              38.2





70


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*





The
      net
      deferred tax asset is determined as follows:


**2007**
              
              **2006**Deferred
                  tax assets:Reserves
                  for loan losses
              
              $
              2,470
              
              $
              1,605Fixed
                  assets
              
              
              35
              
              
              233Accruals
              
              
              1,717
              
              
              1,233Alternative
                  Minimum Tax Credit
              
              
              21
              
              
              -Deferred
                  income
              
              
              2,501
              
              
              84Net
                  operating loss carryforward
              
              
              743
              
              
              345Contribution
                  caryforward
              
              
              49
              
              
              -Total
                  deferred tax assets
              
              
              7,536
              
              
              3,500Deferred
                  tax liabilities:Fair
                  value adjustment for purchased assets
              
              
              1,242
              
              
              363Investment
                  securities valuation
              
              
              130
              
              
              55Deferred
                  costs, prepaids and FHLB advances
              
              
              874
              
              
              668Total
                  deferred tax liabilities
              
              
              2,246
              
              
              1,086Net
                  deferred tax assets
              
              $
              5,290
              
              $
              2,414


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, 2007.
      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 on various years through 2025 and 2015,
      respectively.





The
      Company records interest and penalties related to uncertain tax positions as
      part of other operating expense. As previously mentioned in Note 1 of these
      Consolidated Financial Statements, during 2007, the Company filed amended tax
      returns for the years 2004 and 2005. Although no penalties were paid during
      2007, the Company did pay approximately $96 in interest directly related to
      the
      amended returns for 2004 and 2005. As of December 31, 2007, we do not expect
      the
      total amount of unrecognized tax benefits to increase or decrease significantly
      within the next twelve months.


**NOTE
        10. COMMITMENTS AND CONTINGENCIES**





The
      Company is involved in various litigation. In the opinion of management and
      the
      Company’s legal counsel, the disposition of all such litigation pending will not
      have a material effect on the Company’s financial statements.





In
      the
      normal course of business, the Bank enters into financial commitments to meet
      the financing needs of their customers. These financial commitments include
      commitments to extend credit and standby letters of credit. Those instruments
      involve, to varying degrees, elements of credit and interest rate risk not
      recognized in the statement of financial position.





The
      Bank’s exposure to loan loss in the event of nonperformance on commitments to
      extend credit and standby letters of credit is represented by the contractual
      amount of those instruments. The Bank uses the same credit policies in making
      commitments as they do for loans reflected in the consolidated financial
      statements.





71


**HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2007, 2006, AND 2005**
 *(Dollars
          in thousands, except share and per share amounts)*





As
      of
      December 31, 2007 and 2006, the Bank had the following outstanding financial
      commitments whose contractual amount represents credit risk:


**2007**
              
              **2006**Commitments
                  to extend credit
              
              $
              245,894
              
              $
              166,540Standby
                  letters of credit
              
              
              16,629
              
              
              17,691Total
                  commitments and standby letters of credit
              
              $
              262,523
              
              $
              184,231





Commitments
      to extend credit are agreements to lend to a customer as long as there is no
      violation of any condition established in the contract. Standby letters of
      credit are conditional commitments to guarantee the performance of a Bank
      customer to a third party. Since many of the commitments and standby letters
      of
      credit are expected to expire without being drawn upon, the total amounts do
      not
      necessarily represent future cash requirements. The Bank evaluates each
      customer's credit worthiness on a case-by-case basis. The amount of collateral
      obtained if deemed necessary by the Bank is based on management's credit
      evaluation of the customer.





The
      following table provides a summary of the future minimum lease payments the
      Bank
      is expected to make based upon obligations at December 31, 2007:


**Due
                  2008**
              
              **Due
                  2009**
              
              **Due
                  2010**
              
              **Due
                  2011**
              
              **Due
                  2012**
              
              **Due
                  More**
                **Than
                  5 Years**
              
              **Total**Non-cancelable
                  operating leases
              
              $
              2,053
              
              $
              1,874
              
              $
              1,770
              
              $
              1,449
              
              $
              1,131
              
              $
              8,596
              
              $
              16,873




The
      leases contain options to extend for periods from five to twenty years. Options
      to extend which have been exercised and the related lease costs are included
      above.  Total
      expenditures charged for leases for the reporting periods ended December 31,
      2007, 2006, and 2005, were approximately $1,373, $628, and $663, respectively.
      The year over year increase in expense related to the Company’s leases 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 the Consolidated
      Financial Statements, as well as the acquisition of Business First National
      Bank.





The
      Company has six subleases in place, five of which are for additional space
      within existing branch offices and one is for an entire facility that was
      vacated as the result of consolidation from the 2003 Hacienda Bank acquisition.
      The subleases are for various terms and accounted for an approximate $212 credit
      to rental expense in 2007. The Company expects to receive sublease revenue
      for
      2008 and 2009 of approximately $215 and $93, respectively.


**NOTE
        11. REGULATORY MATTERS**





The
      Company (on a consolidated basis) and the Bank is subject to various regulatory
      capital requirements administered by federal banking agencies. Failure to meet
      minimum capital requirements can initiate certain mandatory, and possibly
      additional discretionary, actions by regulators that, if undertaken, could
      have
      a direct material effect on the Company’s and the Bank’s financial statements.
      Under capital adequacy guidelines and the regulatory framework for prompt
      corrective action, the Company and the Bank must meet specific capital
      guidelines that involve quantitative measures of the Company’s and the Bank’s
      assets, liabilities and certain off-balance sheet items as calculated under
      regulatory accounting practices. The Company’s and the Bank’s capital amounts
      and classification are also subject to qualitative judgments by the regulators
      about components, risk weightings and other factors. Prompt corrective action
      provisions are not applicable to bank holding companies.





Quantitative
      measures established by regulation to ensure capital adequacy require the
      Company and the Bank to maintain minimum amounts and ratios (set forth in the
      table below) of total and Tier 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, 2007, that the
      Company and the Bank meet all capital adequacy requirements to which it is
      subject.




72


**HERITAGE
            OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
            31, 2007, 2006, AND 2005**
 *(Dollars
            in thousands, except share and per share amounts)*


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 have changed the Bank's category. To
      be
      categorized as well-capitalized, the Bank must maintain minimum capital ratios
      as set forth in the table below.





The
      following table also sets forth the Company’s and the Bank’s actual regulatory
      capital amounts and ratios as of December 31, 2007 and 2006:


**Actual**
              
              **Capital
                  Needed For**
                **Adequacy
                  Purposes**
              
              **Capital
                  Needed**
                **To
                  Be Well Capitalized**
                **Under
                  Prompt Corrective**
                **Action
                  Provisions****Capital
                  Amount**
              
              **Ratio**
              
              **Capital
                  Amount**
              
              **Ratio**
              
              **Capital
                  Amount**
              
              **Ratio****As
                  of December 31, 2007**Total
                  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
                  1 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
                  1 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
                  of December 31, 2006**Total
                  capital to risk-weighted assets:Company
              
              $
              61,973
              
              
              12.36
              %
              $
              40,112
              
              
              8.0
              %
              
              N/A
              
              
              N/AHeritage
                  Oaks Bank
              
              $
              56,179
              
              
              11.21
              %
              $
              40,092
              
              
              8.0
              %
              $
              50,115
              
              
              10.0
              %Tier
                  1 capital to risk-weighted assets:Company
              
              $
              57,729
              
              
              11.51
              %
              $
              20,062
              
              
              4.0
              %
              
              N/A
              
              
              N/AHeritage
                  Oaks Bank
              
              $
              51,935
              
              
              10.37
              %
              $
              20,033
              
              
              4.0
              %
              $
              30,049
              
              
              6.0
              %Tier
                  1 capital to average assets:Company
              
              $
              57,729
              
              
              11.00
              %
              $
              20,993
              
              
              4.0
              %
              
              N/A
              
              
              N/AHeritage
                  Oaks Bank
              
              $
              51,935
              
              
              9.89
              %
              $
              21,005
              
              
              4.0
              %
              $
              26,256
              
              
              5.0
              %





As
      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,
      2007, the Company has included $13.0 million of proceeds from the issuance
      of
      Junior Subordinated Debentures 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.  The
      present values of the Company’s liability under these Agreements were
      approximately $1,978 and $1,617 at December 31, 2007 and 2006, respectively,
      and
      are included in other liabilities in the Company’s Consolidated Financial
      Statements. The Company maintains life insurance policies, which are intended
      to
      fund all costs of the agreements. The cash surrender values of these life
      insurance policies totaled approximately  $9,923
      and $9,435, at December 31, 2007 and 2006, respectively.




73


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*
  **NOTE
        13. EMPLOYEE BENEFIT PLANS**
 
 *401(K)
        PENSION PLAN*


During
      1994, the Company established a savings plan for employees that allow
      participants to make contributions by salary deduction equal to 15 percent
      or
      less of their salary pursuant to section 401(k) of the Internal Revenue Code.
      Employee contributions are matched up to 25 percent of the employee’s
      contribution. Employees vest immediately in their own contributions and they
      vest in the Company’s contribution based on years of service.  Expenses
      of the savings plan were approximately $168, $148, and $109, for the years
      ended
      December 31, 2007, 2006, and 2005, respectively.


*EMPLOYEE
        STOCK OWNERSHIP PLAN*
 
 The
        Company sponsors an employee stock ownership plan (“ESOP”) that covers all
        employees who have completed 12 consecutive months of service, are over 21
        years
        of age and work a minimum of 1,000 hours per year. The amount of the annual
        contribution to the ESOP is at the discretion of the Board of Directors.  The
        contributions made to this plan for the years ended December 31, 2007, 2006,
        and
        2005 were approximately $200, $364, and $216, respectively.
  **NOTE
        14. SHARE-BASED COMPENSATION PLANS**
 
 At
        December 31, 2007, the Company had two stock option plans, which are described
        below.
  *THE
        “1990 STOCK OPTION PLAN”*





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





The
      following table summarizes information about the 1990 Stock Option Plan for
      the
      years ended December 31, 2007, 2006, and 2005:


**2007**
              
              **2006**
              
              **2005****Shares**
              
              **Weighted
                  Average Exercise Price**
              
              **Shares**
              
              **Weighted
                  Average Exercise Price**
              
              **Shares**
              
              **Weighted
                  Average Exercise Price**Outstanding
                  at beginning of year
              
              
              3,136
              
              $
              2.55
              
              
              3,136
              
              $
              2.55
              
              
              3,136
              
              $
              2.55Granted
              
              
              -Cancelled
              
              
              (1
              )
              $
              -
              
              
              -
              
              $
              -
              
              
              -
              
              $
              -Exercised
              
              
              (3,135
              )
              $
              -
              
              
              -
              
              $
              -
              
              
              -
              
              $
              -Outstanding
                  at end of year
              
              
              -
              
              $
              -
              
              
              3,136
              
              $
              2.55
              
              
              3,136
              
              $
              2.55Options
                  available for grant at year-end
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -Options
                  exercisable at year-end
              
              
              -
              
              $
              -
              
              
              3,136
              
              $
              2.55
              
              
              3,136
              
              $
              2.55Weighted-average
                  fair value of options granted during year
              
              $
              -
              
              
              
              
              $
              -
              
              
              
              
              $
              -





74


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*


*THE
          “1997 STOCK OPTION PLAN”*


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





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





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





No
      Options were granted from the 1997 Stock Option Plan during 2007 or
      2006.





The
      following summarizes information about the 1997 stock option plan for the years
      ended December 31, 2007, 2006, and 2005:


**2007**
              
              **2006**
              
              **2005****Shares**
              
              **Weighted
                  Average Exercise Price**
              
              **Shares**
              
              **Weighted
                  Average Exercise Price**
              
              **Shares**
              
              **Weighted
                  Average Exercise Price**Outstanding
                  at beginning of year
              
              
              433,434
              
              $
              5.44
              
              
              522,780
              
              $
              5.20
              
              
              738,180
              
              $
              4.51Granted
              
              
              -
              
              $
              -
              
              
              -
              
              $
              -
              
              
              11,250
              
              $
              13.84Cancelled
              
              
              (996
              )
              $
              3.78
              
              
              (1,739
              )
              $
              6.48
              
              
              (7,079
              )
              $
              10.81Exercised
              
              
              (132,195
              )
              $
              3.09
              
              
              (87,607
              )
              $
              3.95
              
              
              (219,571
              )
              $
              3.13Outstanding
                  at end of year
              
              
              300,243
              
              $
              6.47
              
              
              433,434
              
              $
              5.45
              
              
              522,780
              
              $
              5.20Options
                  available for grant end of year
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -Options
                  exercisable at year-end
              
              
              260,906
              
              $
              5.75
              
              
              368,525
              
              $
              4.51
              
              
              429,023
              
              $
              4.07Weighted-average
                  fair value of options granted during year
              
              $
              -
              
              
              
              
              $
              -
              
              
              
              
              $
              5.24


*THE
        “2005 EQUITY BASED COMPENSATION PLAN”*


On
      May
      26, 2005, the stockholders of the Company approved the 2005 Equity Based
      Compensation Plan (the “2005 Plan”). Upon approval by stockholders, no further
      grants can be made from the 1997 Stock Option Plan. The 2005 Plan authorizes
      the
      granting of Incentive Stock Options, Non-Qualified Stock Options, Stock
      Appreciation Rights (“SARs”), Restricted Stock Awards, Restricted Stock Units
      and Performance Share Cash Only Awards. The 2005 Plan provides for a maximum
      of
      ten percent (10%) of the Company’s issued and outstanding shares of common stock
      as of March 25, 2005 and adjusted on each anniversary thereafter to be ten
      percent (10%) of the then issued and outstanding number of shares. As of
      December 31, 2007, the maximum number of shares that were available for issuance
      from the 2005 Plan was 432,830.





The
      Company grants restricted stock periodically as a part of the 2005 Plan for
      the
      benefit of employees. Restricted shares issued are typically new shares and
      currently vest in five years with a “cliff” vesting.





75


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*





The
      following tables summarize activity with respect to restricted share-based
      compensation for the years ended December 31, 2007 and 2006:


**For
                  the Year Ended**
                **December
                  31, 2007****Restricted
                  Shares Outstanding**
              
              **Average
                  Grant Date Fair Value**Balance,
                  beginning of period
              
              
              66,050
              
              $
              19.00Granted
              
              
              1,500
              
              $
              17.18Vested
              
              
              -
              
              $
              -Forfeited/expired
              
              
              (1,250
              )
              $
              19.20Balance,
                  end of period
              
              
              66,300
              
              $
              18.95
 **For
                    the Year Ended**
                  **December
                    31, 2006****Restricted
                    Shares Outstanding**
                
                **Average
                    Grant Date Fair Value**Balance,
                    beginning of period
                
                
                3,750
                
                $
                16.57Granted
                
                
                67,050
                
                $
                19.00Vested
                
                
                -
                
                $
                -Forfeited/expired
                
                
                (4,750
                )
                $
                17.11Balance,
                    end of period
                
                
                66,050
                
                $
                19.00





The
      compensation cost related to restricted stock that has been charged against
      income (included in salaries and employee benefits) was $247 and $223 for the
      years ended December 31, 2007 and 2006, respectively. The total income tax
      benefit recognized in the income statement related to restricted stock was
      $101
      and $91 for the years ended December 31, 2007 and 2006. During 2007, 1,500
      restricted shares were granted to employees of the Bank.  No
      restricted shares vested during 2007 and 2006.  At
      December 31, 2007, there was $787 of total unrecognized compensation cost
      related to non-vested restricted stock which is expected to be recognized over
      a
      weighted-average period of 3.38 years.





The
      following summarizes information about the 2005 equity based compensation plan
      for the years ended December 31, 2007, 2006 and 2005:


**2007**
              
              **2006**
              
              **2005****Shares**
              
              **Weighted
                  Average Exercise Price**
              
              **Shares**
              
              **Weighted
                  Average Exercise Price**
              
              **Shares**
              
              **Weighted
                  Average Exercise Price**Outstanding
                  at beginning of year
              
              
              -
              
              $
              -
              
              
              -
              
              $
              -
              
              
              -
              
              $
              -Granted
              
              
              140,851
              
              $
              13.68
              
              
              -
              
              $
              -
              
              
              -
              
              $
              -Cancelled
              
              
              -
              
              $
              -
              
              
              -
              
              $
              -
              
              
              -
              
              $
              -Exercised
              
              
              -
              
              $
              -
              
              
              -
              
              $
              -
              
              
              -
              
              $
              -Outstanding
                  at end of year
              
              
              140,851
              
              $
              13.68
              
              
              -
              
              
              -
              
              
              -
              
              $
              -Options
                  available for grant end of year
              
              
              432,830
              
              
              
              
              
              568,513
              
              
              
              
              
              611,697Options
                  exercisable at year-end
              
              
              100,851
              
              $
              12.76
              
              
              -
              
              $
              -
              
              
              -
              
              $
              -Weighted-average
                  fair value of options granted during year
              
              $
              6.05
              
              
              
              
              $
              -
              
              
              
              
              $
              -


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 2007, 2006 and 2005 was $1,083, $887 and $2,043, respectively.
      The
      intrinsic value of options outstanding in all plans at December 31, 2007 and
      2006 was approximately $1,840 and $5,444. Additionally, the total intrinsic
      value of options exercisable in all plans at December 31, 2007 and 2006 was
      approximately $1,792 and $4,983, respectively. The Company received income
      tax
      benefits of $446, $365 and $588 for the years ended December 31, 2007, 2006
      and
      2005, 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, 2007 was $446. As of December 31,
      2007,
      there was approximately $364 of total unrecognized compensation cost related
      to
      non-vested stock options. Of this total, approximately $126 and $238 is
      remaining under the 1997 and 2005 plans, respectively and is expected to be
      recognized over periods of 0.81 years and 1.84 years respectively.




76


**HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2007, 2006, AND 2005**
 *(Dollars
          in thousands, except share and per share amounts)*


In
      November 2007, 40,000 options were granted to various members of the Company’s
      board of directors from the 2005 Plan. The following table presents the
      assumptions used in the calculation of the weighted average fair value of those
      options on the date of grant using the Black-Scholes option pricing
      model:


**November**
                **2007**Expected
                  volatility
              
              
              34.32
              %Expected
                  term (years)
              
              
              10Dividend
                  yield
              
              
              2.00
              %Risk
                  free rate
              
              
              4.36
              %Weighted-average
                  grant date fair value
              
              $
              6.30




**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.





The
      following table sets forth loans made to directors and executive officers of
      the
      Company as of December 31, 2007 and 2006:




**2007**
            
            **2006**Outstanding
                balance, beginning of year
            
            $
            15,478
            
            $
            14,603Business
                First, at date of acquisition
            
            
            2,307
            
            
            -Additional
                loans made
            
            
            4,568
            
            
            3,715Repayments
            
            
            (3,470
            )
            
            (2,840
            )Outstanding
                balance, end of year
            
            $
            18,883
            
            $
            15,478




Deposits
      from related parties held by the Bank at December 31, 2007 and 2006 amounted
      to
      approximately $8,655 and $3,513, 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.
 
 77
 **HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2007, 2006, AND 2005**
 *(Dollars
          in thousands, except share and per share amounts)*
 
 **NOTE
        17. FAIR VALUE OF FINANCIAL INSTRUMENTS**




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





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





The
      estimated fair value of financial instruments at December 31, 2007 and 2006
      is
      summarized as follows:


**2007**
              
              **2006****Carrying
                  Amount**
              
              **Fair
                  Value**
              
              **Carrying
                  Amount**
              
              **Fair
                  Value**AssetsCash
                  and cash equivalents
              
              $
              46,419
              
              $
              46,419
              
              $
              23,034
              
              $
              23,034Interest-bearing
                  deposits
              
              
              330
              
              
              330
              
              
              318
              
              
              318Investments
                  and mortgage-backed securities
              
              
              47,556
              
              
              47,556
              
              
              38,445
              
              
              38,445Federal
                  Home Loan Bank and Federal Reserve Bank stock
              
              
              3,045
              
              
              3,045
              
              
              2,350
              
              
              2,350Loans
                  receivable, net of deferred fees and costs
              
              
              611,485
              
              
              615,533
              
              
              443,358
              
              
              444,396Loans
                  held for sale
              
              
              902
              
              
              902
              
              
              1,764
              
              
              1,764Bank
                  owned life insurance
              
              
              9,923
              
              
              9,923
              
              
              9,435
              
              
              9,435Accrued
                  interest receivable
              
              
              2,671
              
              
              2,671
              
              
              2,627
              
              
              2,627LiabilitiesNoninterest-bearing
                  deposits
              
              
              153,684
              
              
              153,684
              
              
              153,005
              
              
              153,005Interest-bearing
                  deposits
              
              
              491,124
              
              
              495,511
              
              
              267,516
              
              
              268,991Federal
                  Home Loan Bank advances
              
              
              8,000
              
              
              8,159
              
              
              50,000
              
              
              50,163Securities
                  sold under repurchase agreements
              
              
              1,936
              
              
              1,936
              
              
              1,364
              
              
              1,364Junior
                  subordinated debentures
              
              
              13,403
              
              
              13,328
              
              
              16,496
              
              
              16,352Accrued
                  interest payable
              
              
              667
              
              
              667
              
              
              851
              
              
              851
 **Notional
                    Amount**
                
                **Cost
                    to Cede**
                  **or
                    Assume**
                
                **Notional
                    Amount**
                
                **Cost
                    to Cede**
                  **or
                    Assume**Off-balance
                    sheet instruments, commitments to extend credit and standby letters
                    of
                    credit
                
                $
                262,523
                
                $
                2,625
                
                $
                184,231
                
                $
                1,842


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.





78


**HERITAGE
          OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
          31, 2007, 2006, AND 2005**
 *(Dollars
          in thousands, except share and per share amounts)*


·
            *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.





·
            *Loans
                and Loans Held for Sale*





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





·
            *Deposits*





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





·
            *FHLB
                Advances*





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





·
            *Securities
                Sold Under Agreement to
                Repurchase*





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





·
            *Junior
                Subordinated Debentures*





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





·
            *Off-Balance
                Sheet Instruments*





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





79




**HERITAGE
      OAKS BANCORP AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006, AND 2005**


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




**NOTE
      18. **EARNINGS PER SHARE** (EPS)**





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





**2007**
            
            **2006**
            
            **2005****Net**
            
            
            
            **Net**
            
            
            
            **Net****Income**
            
            **Shares**
            
            **Income**
            
            **Shares**
            
            **Income**
            
            **Shares**Net
                income as reported
            
            $
            6,917
            
            
            
            
            $
            6,662
            
            
            
            
            $
            6,637Shares
                outstanding at year-end
            
            
            
            
            
            7,317,932
            
            
            
            
            
            6,345,639
            
            
            
            
            
            6,231,982Impact
                of weighting sharespurchased
                during the year
            
            
            
            
            
            (666,338
            )
            
            
            
            
            (11,715
            )
            
            
            
            
            (64,045
            )Used
                in Basic EPS
            
            
            6,917
            
            
            6,651,594
            
            
            6,662
            
            
            6,333,924
            
            
            6,637
            
            
            6,167,937Dilutive
                effect of outstanding stock options
            
            
            
            
            
            232,981
            
            
            
            
            
            261,869
            
            
            
            
            
            383,452Used
                in Dilutive EPS
            
            $
            6,917
            
            
            6,884,575
            
            $
            6,662
            
            
            6,595,793
            
            $
            6,637
            
            
            6,551,389




**NOTE 
      19. **OTHER INCOME AND EXPENSE****




The
      following is a breakdown of fees and other income and expenses for the years
      ended December 31, 2007, 2006, and 2005:




**2007**
            
            **2006**
            
            **2005**Fees
                and Other Income:ATM/Debit
                card transaction/interchange fees
            
            $
            765
            
            $
            711
            
            $
            629Bankcard
                merchant fees
            
            
            224
            
            
            122
            
            
            160Mortgage
                origination fees
            
            
            461
            
            
            552
            
            
            897Earnings
                on cash surrender value of life insurance
            
            
            433
            
            
            393
            
            
            323Other
            
            
            650
            
            
            757
            
            
            482Total
                other income
            
            $
            2,533
            
            $
            2,535
            
            $
            2,491Other
                Expenses:Data
                processing
            
            $
            2,267
            
            $
            2,138
            
            $
            2,200Advertising
                and promotional
            
            
            718
            
            
            851
            
            
            582Regulatory
                fees
            
            
            146
            
            
            112
            
            
            106Other
                professional fees and outside services
            
            
            1,247
            
            
            1,207
            
            
            802Legal
                fees and other litigation expenses
            
            
            100
            
            
            154
            
            
            122Loan
                department costs
            
            
            129
            
            
            147
            
            
            182Stationery
                and supplies
            
            
            350
            
            
            327
            
            
            311Director
                fees
            
            
            289
            
            
            290
            
            
            247Core
                deposit amortization
            
            
            393
            
            
            300
            
            
            574Other
            
            
            1,387
            
            
            1,249
            
            
            1,355Total
                other expenses
            
            $
            7,026
            
            $
            6,775
            
            $
            6,481





80


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*





**NOTE 
      20. **CASH DIVIDENDS, STOCK DIVIDENDS AND STOCK
      SPLITS****




*STOCK
        DIVIDENDSAND STOCK SPLITS*





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





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





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





*CASH
        DIVIDENDS*





The
      following table provides a summary of dividends the Company has declared and
      paid on its common stock during 2007 and 2006:





**Dividend****Amount**
            
            **Declaration**
            
            **Record**
            
            **Payable****Dividend
                Type**
            
            **Per
                Share**
            
            **Date**
            
            **Date**
            
            **Date**Regular
                quarterly dividend
            
            $
            0.08
            
            
            17-Oct-07
            
            
            2-Nov-07
            
            
            16-Nov-07Regular
                quarterly dividend
            
            $
            0.08
            
            
            18-Jul-07
            
            
            3-Aug-07
            
            
            17-Aug-07Regular
                quarterly dividend
            
            $
            0.08
            
            
            20-Apr-07
            
            
            4-May-07
            
            
            18-May-07Regular
                quarterly dividend
            
            $
            0.08
            
            
            19-Jan-07
            
            
            2-Feb-07
            
            
            16-Feb-07Regular
                quarterly dividend
            
            $
            0.08
            
            
            20-Oct-06
            
            
            3-Nov-06
            
            
            17-Nov-06Regular
                quarterly dividend
            
            $
            0.08
            
            
            21-Jul-06
            
            
            11-Aug-06
            
            
            25-Aug-06Special
                cash dividend
            
            $
            0.25
            
            
            21-Apr-06
            
            
            8-May-06
            
            
            19-May-06




No
      cash
      dividends were paid in 2005.





**NOTE 
      21. **STOCK REPURCHASE PROGRAM****




In
      July
      2006, the Company adopted a stock repurchase program authorizing the repurchase
      of up to 40,000 shares of Company stock. In October 2006, the Board of Directors
      approved the authorization to repurchase an additional 60,000 shares of Company
      stock to its current stock repurchase program, which now provides for a total
      of
      up to 100,000 shares. Purchases are to be made, as conditions warrant, from
      time
      to time in the open market. The duration of the program is one year and the
      timing of purchases will depend on market conditions. In July of 2007, Board
      of
      Directors authorized an extension of the current stock repurchase program.





For
      the
      years ended December 31, 2007 and 2006, the Company repurchased and retired
      13,500 and 40,000 shares of its common stock under the current stock repurchase
      program. At December 31, 2007, under the current plan, the Company had the
      authority to repurchase up to 46,500 shares of its common stock through July
      2008.





81


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*


**NOTE 
      22. **BUSINESS COMBINATIONS****





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 $19,500, consisting of approximately 75% common stock and 25%
      cash. Business First shareholders received 0.5758 shares of Heritage Oaks
      Bancorp common stock for each share of Business First they owned and $3.44
      per
      share in cash. Upon the acquisition of Business First, the Company issued
      850,213 shares of Heritage Oaks Bancorp common stock and approximately $5,100
      in
      cash to the former shareholders of Business First. The value of the shares
      issued in connection with this acquisition was approximately $13,800 and was
      determined by multiplying the number of new shares issued times 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.





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:





**October****2007**Expected
                volatility
            
            
            33.48
            %Expected
                term (years)
            
            
            3.2Dividend
                yield
            
            
            1.97
            %Risk
                free rate
            
            
            4.35
            %Weighted-average
                grant date fair value
            
            $
            5.62




The
      following table provides a summary of the assets acquired and liabilities
      assumed as of the date of the acquisition:




**October
                12, 2007**Cash
                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
            
            $
            160,470Noninterest-bearing
                deposits
            
            $
            42,145Interest-bearing
                deposits
            
            
            91,274Federal
                Home Loan Bank borrowings
            
            
            12,598Other
                liabilities
            
            
            376Total
                liabilities assumed
            
            $
            146,393Net
                assets acquired
            
            $
            14,077





82


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2007, 2006, AND 2005**
 *(Dollars
        in thousands, except share and per share amounts)*





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,****2007**
            
            **2006**Revenues
            
            $
            39,820
            
            $
            37,534Net
                income
            
            $
            7,440
            
            $
            7,527Earnings
                per common share:Basic
            
            $
            1.02
            
            $
            1.05Diluted
            
            $
            0.98
            
            $
            1.01




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 has 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.





The
      Company’s Consolidated Statements of Income include the results of operations of
      Business First from October 12, 2007 through December 31, 2007.




83




**NOTE 
      23. **CONDENSED FINANCIAL INFORMATION OF HERITAGE OAKS BANCORP (PARENT
      COMPANY)****





**HERITAGE
                OAKS BANCORP****CONDENSED
                BALACE SHEETS (PARENT COMPANY)****DECEMBER
                31, 2007 AND 2006***(dollars
                amounts in thousands)*





**2007**
            
            **2006****Assets**Cash
            
            $
            215
            
            $
            7,276Federal
                funds sold
            
            
            4,000
            
            
            -Total
                cash and cash equivalents
            
            
            4,215
            
            
            7,276Prepaid
                and other assets
            
            
            493
            
            
            627Investment
                in subsidiaries
            
            
            78,453
            
            
            58,523Total
                assets
            
            $
            83,161
            
            $
            66,426**Liabilities**Junior
                subordinated debentures
            
            $
            13,403
            
            $
            16,496Other
                liabilities
            
            
            308
            
            
            458Total
                liabilities
            
            
            13,711
            
            
            16,954**Stockholders'
                Equity**Common
                stock
            
            
            43,996
            
            
            29,247Additional
                paid in capital
            
            
            672
            
            
            336Retained
                earnings
            
            
            24,598
            
            
            19,809Accumulated
                other comprehensive income
            
            
            184
            
            
            80Total
                stockholders' equity
            
            
            69,450
            
            
            49,472Total
                liabilities and stockholders' equity
            
            $
            83,161
            
            $
            66,426





84




**HERITAGE
                OAKS BANCORP****CONDENSED
                STATEMENTS OF INCOME (PARENT COMPANY)****FOR
                THE YEARS ENDED DECEMBER 31, 2007, 2006 AND
                2005***(dollar
                amounts in thousands)*





**2007**
            
            **2006**
            
            **2005****Income**Equity
                in undisbursed income of subsidiaries
            
            $
            7,512
            
            $
            7,297
            
            $
            7,201Interest
                income
            
            
            77
            
            
            73
            
            
            65Other
            
            
            -
            
            
            -
            
            
            31Total
                income
            
            
            7,589
            
            
            7,370
            
            
            7,297**Expense**Salary
                expense
            
            
            31
            
            
            114
            
            
            85Equipment
                expense
            
            
            (57
            )
            
            (57
            )
            
            (10
            )Other
                professional fees and outside services
            
            
            199
            
            
            254
            
            
            268Interest
                expense
            
            
            921
            
            
            839
            
            
            583Other
            
            
            -
            
            
            -
            
            
            126Total
                expense
            
            
            1,094
            
            
            1,150
            
            
            1,052Total
                operating income
            
            
            6,495
            
            
            6,220
            
            
            6,245Income
                tax benefit
            
            
            (422
            )
            
            (442
            )
            
            (392
            )Net
                income
            
            $
            6,917
            
            $
            6,662
            
            $
            6,637





85




**HERITAGE
                OAKS BANCORP****CONDENSED
                STATEMENTS OF CASH FLOWS (PARENT COMPANY)****FOR
                THE YEARS ENDED DECEMBER 31, 2007, 2006 AND
                2005***(dollar
                amounts in thousands)*





**2007**
            
            **2006**
            
            **2005****Cash
                flows from operating activities:**Net
                income
            
            $
            6,917
            
            $
            6,662
            
            $
            6,637Adjustments
                to reconcile net income to net cash provided by/(used in) operating
                activities:Depreciation
            
            
            -
            
            
            -
            
            
            8Decrease/(increase)
                in other assets
            
            
            226
            
            
            (981
            )
            
            (56
            )(Decrease)/increase
                in other liabilities
            
            
            (150
            )
            
            281
            
            
            18Share-based
                compensation expense
            
            
            32
            
            
            25
            
            
            -Undistributed
                income of subsidiaries
            
            
            (7,512
            )
            
            (7,297
            )
            
            (7,201
            )**Net
                Cash Used In Operating Activities**
            
            
            (487
            )
            
            (1,310
            )
            
            (594
            )**Cash
                flows from investing activities:**Net
                proceeds from sale of fixed assets
            
            
            -
            
            
            -
            
            
            900Contribution
                to subsidiary
            
            
            -
            
            
            311
            
            
            -**Net
                Cash Provided By Investing Activities**
            
            
            -
            
            
            311
            
            
            900**Cash
                flows from financing activities:**Cash
                dividends received
            
            
            2,000
            
            
            -
            
            
            -Cash
                paid in lieu of fractional shares
            
            
            -
            
            
            -
            
            
            (12
            )Cash
                dividends paid
            
            
            (2,128
            )
            
            (2,602
            )
            
            -(Decrease)/increase
                in junior subordinated debentures
            
            
            (3,093
            )
            
            8,248
            
            
            -Stock
                repurchased
            
            
            (215
            )
            
            (720
            )
            
            -Proceeds
                from the exercise of options
            
            
            862
            
            
            712
            
            
            1,275**Net
                Cash (Used In)/Provided by Financing Activities**
            
            
            (2,574
            )
            
            5,638
            
            
            1,263**Net
                (decrease)/increase in cash and cash equivalents**
            
            
            (3,061
            )
            
            4,639
            
            
            1,569**Cash
                and cash equivalents, beginning of year**
            
            
            7,276
            
            
            2,637
            
            
            1,068**Cash
                and Cash Equivalents, End of Year**
            
            $
            4,215
            
            $
            7,276
            
            $
            2,637





86




**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)*
            
            **2007**
            
            **2007**
            
            **2007**
            
            **2007**
            
            **2006**
            
            **2006**
            
            **2006**
            
            **2006**Interest
                income
            
            $
            13,155
            
            $
            10,870
            
            $
            10,823
            
            $
            10,303
            
            $
            9,932
            
            $
            9,568
            
            $
            8,666
            
            $
            8,206Net
                interest income
            
            
            8,781
            
            
            7,328
            
            
            7,258
            
            
            7,034
            
            
            6,951
            
            
            7,022
            
            
            6,635
            
            
            6,447Provision
                for credit losses
            
            
            140
            
            
            210
            
            
            170
            
            
            140
            
            
            120
            
            
            180
            
            
            180
            
            
            120Non-interest
                income
            
            
            1,439
            
            
            1,309
            
            
            1,391
            
            
            1,231
            
            
            1,301
            
            
            1,222
            
            
            1,211
            
            
            1,218Other
                expenses
            
            
            6,874
            
            
            5,777
            
            
            5,563
            
            
            5,694
            
            
            5,539
            
            
            5,384
            
            
            5,048
            
            
            4,984Income
                before provision for income taxes
            
            
            3,206
            
            
            2,650
            
            
            2,916
            
            
            2,431
            
            
            2,593
            
            
            2,680
            
            
            2,618
            
            
            2,561Net
                income
            
            $
            1,978
            
            $
            1,628
            
            $
            1,800
            
            $
            1,510
            
            $
            1,649
            
            $
            1,733
            
            $
            1,673
            
            $
            1,606Earnings
                per common share:Basic
            
            $
            0.27
            
            $
            0.25
            
            $
            0.28
            
            $
            0.24
            
            $
            0.26
            
            $
            0.27
            
            $
            0.26
            
            $
            0.26Diluted
            
            $
            0.26
            
            $
            0.24
            
            $
            0.27
            
            $
            0.23
            
            $
            0.25
            
            $
            0.26
            
            $
            0.25
            
            $
            0.24




**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 46 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 Exchange Act is recorded,
      processed, summarized and reported within the time periods specified in the
      SEC’s rules and forms. These controls and subsequent results are communicated to
      executive management providing the ability to make timely decisions regarding
      required disclosure.





**ITEM
      9B. OTHER INFORMATION**





None.




87




**PART
      III**





**ITEM
        10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE
        GOVERNANCE**




*CODEOF
        ETHICS*





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





There
      have been no material changes to the procedures by which security holders may
      recommend nominees to the Company’s Board during 2007.





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 2008 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 2008 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 2008 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 2008 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 2008 Annual
      Meeting of Shareholders which will be filed pursuant to Regulation
      14-A.





88




**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 91 for exhibits filed as part of this
      report.





(c)
            *ADDITIONAL
                  FINANCIAL STATEMENTS*




Not
      Applicable.





89




**SIGNATURES**


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




**THE
        COMPANY**
  /s/
                Lawrence P. Ward
              
              
              /s/
                Margaret A. TorresLAWRENCE
                  P. WARD
              
              
              MARGARET
                  A. TORRESPRESIDENT
                  AND CHIEF EXECUTIVE OFFICER
                DATED:FEBRUARY
                  29, 2008
              
              
              EXECUTIVE
                  VICE PRESIDENT, CHIEF FINANCIAL OFFICERAND
                  PRINCIPAL ACCOUNTING OFFICER
                DATED:
                      FEBRUARY 29, 2008


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
              
              FEBRUARY
                  29, 2008MICHAEL
                  MORRIS/s/
                  Donald H. Campbell
              
              VICE
                    CHAIRMAN OF THE BOARD OF DIRECTORS
              
              FEBRUARY
                  29, 2008DONALD
                  H. CAMPBELL/s/
                  Michael Behrman
              
              DIRECTOR
              
              FEBRUARY
                  29, 2008MICHAEL
                  BEHRMAN/s/
                  Kenneth Dewar
              
              DIRECTOR
              
              FEBRUARY
                  29, 2008KENNETH
                  DEWAR/s/
                  Mark C. Fugate
              
              DIRECTOR
              
              FEBRUARY
                  29, 2008MARK
                  C. FUGATE/s/
                  Dolores T. Lacey
              
              DIRECTOR
              
              FEBRUARY
                  29, 2008DOLORES
                  T. LACEY/s/
                  Merle F. Miller
              
              DIRECTOR
              
              FEBRUARY
                  29, 2008MERLE
                  F. MILLER/s/
                  Daniel J. O’Hare
              
              DIRECTOR
              
              FEBRUARY
                  29, 2008DANIEL
                  J. O’HARE/s/
                  Michael E. Pfau
              
              DIRECTOR
              
              FEBRUARY
                  29, 2008MICHAEL
                  E. PFAU/s/
                  Alex Simas
              
              DIRECTOR
              
              FEBRUARY
                  29, 2008ALEX
                  SIMAS/s/
                  Lawrence P. Ward
              
              DIRECTOR
              
              FEBRUARY
                  29, 2008LAWRENCE
                  P. WARD
  90





**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.




91




(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.(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.




92




(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.




93