Pacific Mercantile Bancorp (PMBC) 10-Q 2005 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10–Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2005

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                                to                                

Commission file number 0–30777

PACIFIC MERCANTILE BANCORP

(Exact name of Registrant as specified in its charter)

California	33–0898238
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification Number)

949 South Coast Drive, Suite 300, Costa Mesa, California	92626
(Address of principal executive offices)	(Zip Code)

(714) 438–2500

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed, since last year)

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. Yesx    No¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x    No ¨

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

10,176,008 shares of Common Stock as of August 3, 2005

PACIFIC MERCANTILE BANCORP

QUARTERLY REPORT ON FORM 10Q

FOR

THE QUARTER ENDED JUNE 30, 2005

TABLE OF CONTENTS

		Page No.
Part I	Financial Information
Item 1.	Financial Statements	1
	Consolidated Statements of Financial Condition at June 30, 2005 and December 31, 2004	1
	Consolidated Statements of Income for the Three and Six Months ended June 30, 2005 and 2004	2
	Consolidated Statement of Comprehensive Income for the Three and Six Months ended June 30, 2005 and 2004	3
	Consolidated Statements of Cash Flows for the Six Months ended June 30, 2005 and 2004	4
	Notes to Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	10
	Risks and Uncertainties That Could Affect Our Future Financial Performance	27
Item 3.	Market Risk	31
Item 4.	Controls and Procedures	31
Part II.
Item 4.	Submission of Matters to a Vote of Security Holders	32
Item 6.	Exhibits	32
Signatures		S–1
Exhibit Index		E–1
Exhibit 31.1 Certification of Chief Executive Officer under Section 302 of the Sarbanes–Oxley Act of 2002
Exhibit 31.2 Certification of Chief Financial Officer under Section 302 of the Sarbanes–Oxley Act of 2002
Exhibit 32.1 Certification of Chief Executive Officer under Section 906 of the Sarbanes–Oxley Act of 2002
Exhibit 32.2 Certification of Chief Financial Officer under Section 906 of the Sarbanes–Oxley Act of 2002

PART I. – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands)

(unaudited)

	June 30,     2005			December 31, 2004
ASSETS
Cash and due from banks	$	45,963		$	26,509
Federal funds sold		8,700			69,600
Cash and cash equivalents		54,663			96,109
Interest-bearing deposits with financial institutions		560			738
Federal Reserve Bank and Federal Home Loan Bank Stock, at cost		12,019			10,662
Securities available for sale, at fair value		234,724			169,412
Loans held for sale, at fair value		27,771			42,348
Loans (net of allowances of $4,350 and $4,032, respectively)		578,050			511,827
Investment in unconsolidated subsidiaries		837			837
Accrued interest receivable		3,297			2,539
Premises and equipment, net		2,760			2,987
Other assets		7,864			8,080
Total assets	$	922,545		$	845,539
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Noninterest-bearing	$	216,668		$	175,329
Interest-bearing		368,084			358,234
Total deposits		584,752			533,563
Borrowings		226,262			204,754
Accrued interest payable		1,661			1,259
Other liabilities		4,421			3,150
Junior subordinated debentures		27,837			27,837
Total liabilities		844,933			770,563
Commitments and contingencies		—			—
Shareholders’ equity:
Preferred stock, no par value, 2,000,000 shares authorized, none issued		—			—
Common stock, no par value, 20,000,000 shares authorized, 10,165,589 and 10,084,381 shares issued and outstanding at June 30, 2005 and December 31, 2004, respectively		69,071			69,028
Retained earnings		10,024			7,420
Accumulated other comprehensive (loss)		(1,483	)		(1,472	)
Total shareholders’ equity		77,612			74,976
Total liabilities and shareholders’ equity	$	922,545		$	845,539

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

1

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in thousands, except for per share data)

(Unaudited)

	Three Months Ended June 30,					Six Months Ended June 30,
	2005			2004		2005			2004
Interest income:
Loans, including fees	$	8,180		$	5,801	$	15,737		$	10,853
Federal funds sold		292			136		648			201
Securities available for sale and stock		2,240			1,834		4,063			4,368
Interest-bearing deposits with financial institutions		2			3		7			6
Total interest income		10,714			7,774		20,455			15,428
Interest expense:
Deposits		2,247			1,692		4,223			2,234
Borrowings		1,596			1,142		3,045			3,304
Total interest expense		3,843			2,834		7,268			5,538
Net interest income		6,871			4,940		13,187			9,890
Provision for loan losses		230			258		350			873
Net interest income after provision for loan losses		6,641			4,682		12,837			9,017
Noninterest income		517			388		910			1,075
Noninterest expense		4,598			3,635		8,821			7,437
Income before income taxes		2,560			1,435		4,926			2,655
Income tax expense		1,051			607		2,032			1,089
Income from continuing operations		1,509			828		2,894			1,566
(Loss) income from discontinued operations, net of taxes		(133	)		112		(290	)		158
Net income	$	1,376		$	940	$	2,604		$	1,724
Net income (loss) per share basic:
Income from continuing operations	$	0.15		$	0.08	$	0.29		$	0.15
(Loss) income from discontinued operations	$	(0.01	)	$	0.01	$	(0.03	)	$	0.02
Net income	$	0.14		$	0.09	$	0.26		$	0.17
Net income (loss) per share diluted:
Income from continuing operations	$	0.14		$	0.08	$	0.27		$	0.14
(Loss) income from discontinued operations	$	(0.01	)	$	0.01	$	(0.03	)	$	0.02
Net income	$	0.13		$	0.09	$	0.24		$	0.16
Weighted average number of shares:
Basic		10,162,511			10,081,567		10,136,463			10,081,407
Diluted		10,529,150			10,514,706		10,548,663			10,512,786

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

2

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME

(Dollars in thousands)

(Unaudited)

	Three Months Ended June 30,					Six Months Ended June 30,
	2005		2004			2005			2004
Net income	$	1,376	$	940		$	2,604		$	1,724
Other comprehensive gain, net of tax:
Change in unrealized gain (loss) on securities available for sale, net of tax effect		1,196		(2,234	)		(11	)		(1,513	)
Total comprehensive income	$	2,572	$	(1,294	)	$	2,593		$	211

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

3

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(unaudited)

	Six Months Ended June 30,
	2005			2004
Cash Flows From Operating Activities:
Income from continuing operations	$	2,894		$	1,566
(Loss) income from discontinued operations		(290	)		158
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
Depreciation and amortization		555			553
Provision for loan losses		350			873
Net amortization of premium (discount) on securities		679			1,145
Net gains on sales of securities available for sale		—			(369	)
Net gains on sales of loans held for sale		(903	)		(907	)
Net gain on sale of fixed assets		(15	)		—
Net increase in accrued interest receivable		(758	)		(297	)
Net increase in other assets		(24	)		(1,129	)
Net decrease (increase) in deferred taxes		246			(1,262	)
Net decrease in accrued interest payable		402			69
Net decrease in other liabilities		1,271			100
Proceeds from sales of loans held for sale		105,653			163,255
Originations and purchases of loans held for sale		(90,159	)		(166,875	)
Mark to market gain adjustment of loans held for sale		(14	)		(41	)
Mark to market gain adjustment of equity securities		(22	)		—
Net cash provided by (used in) operating activities		19,865			(3,161	)
Cash Flows From Investing Activities:
Net decrease (increase) in interest-bearing deposits with financial institutions		178			(3	)
Maturities of, proceeds from sales of and principal payments received for securities available for sale and other stock		27,640			97,308
Purchase of securities available for sale and other stock		(94,983	)		(66,499	)
Net increase in loans		(66,573	)		(104,739	)
Proceeds from sale of fixed assets		15			—
Purchases of premises and equipment		(328	)		(157	)
Net cash used in investing activities		(134,051	)		(74,090	)
Cash Flows From Financing Activities:
Net increase in deposits		51,189			39,695
Offering expenses from sale of common stock		—			(38	)
Proceeds from exercise of stock options		43			7
Net increase in borrowings		21,508			32,559
Net cash provided by financing activities		72,740			72,223
Net increase in cash and cash equivalents		(41,446	)		(5,028	)
Cash and Cash Equivalents, beginning of period		96,109			59,785
Cash and Cash Equivalents, end of period	$	54,663		$	54,757
Supplementary Cash Flow Information:
Cash paid for interest on deposits and other borrowings	$	7,346		$	5,574
Cash paid for income taxes	$	396		$	880
Non-Cash Investing Activities:
Transfer of loan to other real estate owned	$	—		$	1,517
Net decrease in net unrealized gains and losses on securities held for sale, net of income tax	$	(11	)	$	(1,513	)

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

4

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Unaudited)

1. Nature of Business

The consolidated financial statements include the accounts of Pacific Mercantile Bancorp (“PMBC”) and its wholly owned subsidiaries, which are Pacific Mercantile Bank (the “Bank”) and PMB Securities Corp. (which, together with PMBC, shall be referred to as the “Company” or as “we”, “us” or “our”). The Bank is chartered by the California Department of Financial Institutions (the “DFI”) and is a member of the Federal Reserve Bank of San Francisco (“FRB”). In addition, the deposit accounts of the Bank’s customers are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to the maximum amount allowed by law.

Substantially all of our operations are conducted and substantially all our assets are owned by the Bank, which accounts for substantially all of our consolidated revenues and expenses, and earnings. The Bank provides a full range of banking services to small and medium-size businesses, professionals and the general public in Orange, Los Angeles and San Diego Counties of California and is subject to competition from other financial institutions conducting operations in those same markets.

PMB Securities Corp. commenced operations in June 2002 as an SEC registered securities broker–dealer that is engaged in the retail securities brokerage business and is a member firm of the National Association of Securities Dealers.

During 2002, we organized three business trusts, under the names Pacific Mercantile Capital Trust I, PMB Capital Trust I, and PMB Statutory Trust III, respectively, to facilitate our issuance of $17 million principal amount of junior subordinated debentures, all with maturity dates in 2032. In October 2004, we organized PMB Capital Trust III to facilitate our issuance of $10 million principal amount of junior subordinated debentures, with a maturity date in 2034. In accordance with applicable accounting standards, the financial statements of these trusts are not included into the Company’s consolidated financial statements. See Note 2: “Significant Accounting Policies —Principles of Consolidation” below.

2. Significant Accounting Policies

The accompanying unaudited consolidated financial statements have been prepared in accordance with the instructions to Form 10–Q and, therefore, do not include all footnotes that would be necessary for a fair presentation of financial position, results of operations, changes in cash flows and comprehensive income (loss) in accordance with generally accepted accounting principles in the United States (“GAAP”). However, these interim financial statements reflect all adjustments (consisting of normal recurring adjustments and accruals) which, in the opinion of our management, are necessary for a fair presentation of our results for the interim periods presented.

These unaudited consolidated financial statements have been prepared in accordance with a basis consistent with prior periods, and should be read in conjunction with our audited consolidated financial statements as of and for the year ended December 31, 2004 and the notes thereto included in our Annual Report on Form 10–K for the fiscal year ended December 31, 2004, as filed with the Securities and Exchange Commission under the Securities Exchange Act of 1934.

However, as described below under the subcaption“Discontinued Operations” in this Note 2, in the second quarter of this year, the Company decided to discontinue its wholesale mortgage lending business and, therefore, the financial information for that segment of our business is presented as discontinued operations, separate from the financial information for our commercial banking and securities brokerage business, which comprise our continuing operations.

Our consolidated financial position at June 30, 2005, and the consolidated results of our operations for the three and six month periods ended June 30, 2005, are not necessarily indicative of what our financial position will be as of the end of, or of the results of operations that may be expected for any other interim period during or for the full year ending December 31, 2005.

5

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

2. Significant Accounting Policies (Cont.-)

Use of Estimates

The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make certain estimates and assumptions that affect the reported amounts of assets, liabilities, and contingencies 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.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries Pacific Mercantile Bank and PMB Securities Corp. All significant intercompany accounts and transactions have been eliminated in consolidation. Our wholly owned trust subsidiaries, Pacific Mercantile Capital Trust I, PMB Capital Trust I, PMB Statutory Trust III, and PMB Capital Trust III (the “Trust Subsidiaries”), are not included in our consolidated financial statements, in accordance with Financial Interpretation Number (FIN) 46 issued by the Financial Accounting Standards Board (“FASB”).

Nonperforming Loans and Other Assets

At June 30, 2005, we had $979,000 in nonaccrual and impaired loans, but we had no restructured loans and no loans that were past due as to principal for 90 days or more that were still accruing interest.

Income Per Share

Basic income per share for any fiscal period is computed by dividing net income for such period by the weighted average number of common shares outstanding during that period. Fully diluted income per share reflects the potential dilution that could have occurred assuming all outstanding options or warrants to purchase our shares of common stock at exercise prices that were less than the market price of our shares were exercised into common stock, thereby increasing the number of shares outstanding during the period.

Stock-Based Employee Compensation Plans

The Company accounts for stock-based employee compensation as prescribed by APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and has adopted the disclosure provisions of Statements of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock Based Compensation.” SFAS No. 123 requires pro-forma disclosures of the Company’s net income and net income per share as if the fair value based method of accounting for stock based awards had been applied. Under the fair value based method, compensation cost is recorded based on the value of the award at the grant date and is recognized over the employee’s period of service with the Company. The Financial Accounting Standards Board (“FASB”) issued SFAS No. 123(R), “Share-Based Payment” in December 2004, which requires entities that grant stock options and shares to employees to recognize the fair value of those options and shares as compensation cost over the service (vesting) period in their financial statements. SFAS No. 123(R) is effective beginning in the first quarter of fiscal years ending after June 15, 2005. Accordingly, in the Company’s case SFAS No. 123(R) will be effective as of January 1, 2006. SFAS No. 123(R) is expected to result in an increase in our reported compensation expense; however, the materiality of SFAS No. 123(R) on our results of operations cannot be accurately estimated at this time, as that will depend on the market values of our shares, and the amounts of share based awards that we may grant, in future periods.

Effective March 2, 1999, our Board of Directors adopted, and in January 2000 our shareholders approved, the 1999 Stock Option Plan (the “1999 Option Plan”). That Plan authorizes the granting of options to directors, officers and other key employees that entitle them to purchase shares of common stock of the Company at a price per share equal to or above the fair market value of the Company’s shares on the respective grant dates of the awards. Options may vest immediately or over various periods, generally ranging up to five years, as determined by the Company’s Compensation Committee at the time it approves the grant of options under the 1999 Option Plan. Options may be granted for terms of up to 10 years, but will terminate upon termination of service, if sooner. A total of 1,248,230 shares were authorized for issuance under the 1999 Option Plan (which number has been adjusted for stock splits effectuated subsequent to the Plan’s adoption).

6

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

2. Significant Accounting Policies (Cont.-)

Effective February 17, 2004, the Board of Directors adopted the Pacific Mercantile Bancorp 2004 Stock Incentive Plan (the “2004 Plan”), which was approved by the Company’s shareholders in May 2004. That Plan authorizes the granting of options and rights to purchase restricted stock to directors, officers and other key employees, that entitle them to purchase shares of common stock of the Company at a price per share equal to or above the fair market value of the Company’s shares on the date the option is granted or the stock purchase rights are awarded. Options and restricted stock purchase rights may vest immediately or over various periods of up to five years, determined by the Company’s Compensation Committee at the time the options are granted or the stock purchase rights are awarded. Options may be granted under the 2004 Plan for up to 10 years after the grant date, but will terminate upon termination of service, if sooner. In the case of restricted stock purchase rights, they generally will expire, if not exercised, within 15 days of the date of the award. Any unvested shares, subject to restricted purchase rights, will become subject to repurchase by the Company in the event of a termination of employment or service of the holder of the stock purchase right. A total of 400,000 shares were authorized for issuance under the 2004 Plan.

The Company continues to account for stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” under which no compensation cost for stock options is recognized in the accompanying financial statements for stock option or stock purchase awards granted at or above fair market value. Had compensation expense for the Company’s 1999 and 2004 Option Plans been determined based upon the fair value at the grant date for awards under those Plans in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company’s net income and income per share would have been reduced to the pro forma amounts indicated below:

	Three Months Ended June 30,				Six Months Ended June 30,
(Dollars in thousands, except per share data)	2005		2004		2005		2004
Net Income:
As reported	$	1,376	$	940	$	2,604	$	1,724
Deduct: Total stock-based employee compensation expense determined under Fair value based method for all awards, net of related tax effects		134		187		265		296
Pro forma	$	1,242	$	753	$	2,339	$	1,428
Income Per Share as Reported:
Basic	$	0.14	$	0.09	$	0.26	$	0.17
Diluted		0.13		0.09		0.24		0.16
Income Per Share Pro Forma:
Basic	$	0.12	$	0.07	$	0.23	$	0.14
Diluted		0.12		0.07		0.22		0.14
Weighted Average Number of Shares:
Basic		10,162,511		10,081,567		10,136,463		10,081,407
Diluted		10,529,150		10,514,706		10,548,663		10,512,786

The fair values of the options that were outstanding under the 1999 and 2004 Plans were estimated as of their respective dates of grant using the Black-Scholes option-pricing model. The following table summarizes the weighted average assumptions used for grants in the following periods:

	Three Months Ended June 30,				Six Months Ended June 30,
Assumptions with respect to:	2005		2004		2005		2004
Expected volatility	43.38	%	57.00	%	46.31	%	57.00	%
Risk-free interest rate	3.97	%	3.22	%	3.69	%	3.06	%
Expected dividend yield	1.04	%	1.22	%	1.04	%	1.22	%
Expected life of the option	5 years		5 years		5 years		5 years

7

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

2. Significant Accounting Policies (Cont.-)

Comprehensive Income

Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on securities available for sale, are reported as a separate component of the equity section of the balance sheet net of income taxes, such items, along with net income, are components of comprehensive income.

Recent Accounting Pronouncements

In December 2004, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 123, (revised 2004), “Share-Based Payment”. SFAS No. 123R, which supersedes Accounting Principle Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”, requires entities that grant stock options and shares to employees to recognize the fair value of those options and shares as compensation over the service (vesting) period in their financial statements; pro forma disclosure will no longer be permitted. The cost of the equity instruments is to be measured based on the fair value of the instruments on the date they are granted and is required to be recognized over the period during which the employees are required to provide services in exchange for the equity instruments. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. This statement becomes applicable for public entities on the first day of the first annual reporting period beginning after December 31, 2005, which in our case will be January 1, 2006.

In May 2005, the FASB issued FASB Statement No. 154, “Accounting Changes and Error Corrections” (“SFAS No. 154”). SFAS No. 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It requires, unless impracticable, retrospective application for reporting changes in accounting principle in the absence of explicit transition requirements specific to this newly adopted accounting principle. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We do not expect the adoption of SFAS No. 154 to have a material impact on our financial condition or operating results.

Reclassification

Certain amounts in the accompanying 2004 consolidated financial statements, including amounts related to discontinued business, have been reclassified to conform to 2005 presentation.

Commitments and Contingencies

To meet the financing needs of its customers in the normal course of business, the Company is party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated financial statements. At June 30, 2005, the Company was committed to fund loans totaling approximately $237 million (inclusive of $14 million of mortgage loans that, if funded, will be held for sale as part of our discontinued operations). The contractual amounts of credit-related financial instruments such as commitments to extend credit, credit-card arrangements, and letters of credit represent the amounts of potential accounting loss should the contract be fully drawn upon, the customer default, and the value of any existing collateral become worthless.

The Company uses the same credit policies in making commitments to extend credit and conditional obligations as it does for on-balance sheet instruments. Commitments generally have fixed expiration dates; however, since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s credit worthiness on a case-by-case basis, using the same credit underwriting standards that are employed in making commercial loans. The amount of collateral obtained, if deemed necessary by the Company upon an extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, real estate and income-producing commercial properties.

8

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

2. Significant Accounting Policies (Cont.-)

In the ordinary course of business, we are subject to legal actions normally associated with financial institutions. At June 30, 2005, we were not a party to any pending legal action that is expected to be material to our consolidated financial condition or results of operations.

Discontinued Business

In the second quarter this year, we decided to discontinue our wholesale mortgage lending business and to focus our capital and other resources on the growth of its commercial banking business. As a result, our commercial banking and retail brokerage business comprises our continuing operations with commercial banking the only reportable business segment; while the wholesale mortgage lending business has been classified as discontinued operations. We are in the process of winding down the operations of the wholesale mortgage lending business and expect to complete our exit from that business by the end of the third quarter of 2005.

The operating results of the discontinued wholesale mortgage lending business included in the accompanying consolidated statements of income, are as follows:

	Three Months Ended					Six Months Ended
	June 30, 2005			June 30, 2004		June 30, 2005			June 30, 2004
	(In thousands)
Income (loss) from discontinued operations, before income taxes	$	(225	)	$	190	$	(492	)	$	268
Income tax (expense) benefit		(92	)		78		(202	)		110
(Loss) income from discontinued operations, net of taxes(1)	$	(133	)	$	112	$	(290	)	$	158

⁽¹⁾ Contributing to the losses, before taxes, incurred by discontinued operations in the three and six month periods ended June 30, 2005, were charges aggregating $104,000 that were attributable to write downs in the carrying value of software used in that business and severance payments.

As of June 30, 2005 and December 31, 2004, loans held for sale by the wholesale mortgage lending division totaled $28 million and $42 million, respectively.

9

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

Pacific Mercantile Bancorp is a bank holding company that owns all of the stock of Pacific Mercantile Bank (the “Bank”), which is a commercial bank that provides a full range of banking services to small and medium-size businesses and to professionals and the general public in Orange, Los Angeles and San Diego counties, in Southern California. Substantially all of our operations are conducted and substantially all of our assets are owned by the Bank, which accounts for substantially all of our consolidated revenues and operating costs.

The following discussion presents information about our consolidated results of operations for the three and six month periods ended June 30, 2005 and 2004 and our consolidated financial condition, liquidity and capital resources at June 30, 2005 and should be read in conjunction with our consolidated financial statements and the notes thereto included elsewhere in this Report.

Additionally, except where otherwise noted, the following discussion of our results of operation and financial condition relates almost entirely to the results of operations and the assets and liabilities of our continuing operations, which consist primarily of the provision of commercial banking services and excludes our discontinued wholesale mortgage lending business, which is in the process of being wound down. See Note 2 of the Notes to our Consolidated Financial Statements included elsewhere in this Report for further information relating to our discontinued operations.

Forward-Looking Information

Statements contained in this Report that are not historical facts or that discuss our expectations or beliefs regarding our future operations or future financial performance, or financial or other trends in our business, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include the words “believe,” “expect,” “anticipate,” “intend,” “plan,” “estimate,” “project,” or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could,” or “may.” The information contained in such forward-looking statements is based on current information and assumptions about future events over which we do not have control and our business is subject to a number of risks and uncertainties that could cause our financial condition or actual operating results in the future to differ significantly from our expected financial condition or operating results that are set forth in those statements. Those risks and uncertainties are described in this Section of this Report, including in the subsection below entitled “Risks and Uncertainties That Could Affect Our Future Financial Performance” and readers of this Report are urged to read this Section in its entirety, including that subsection.

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) and general practices in the banking industry. The accounting policies we follow in determining the sufficiency of our allowance for loan losses and the fair value of derivative financial instruments involve judgments and assumptions which can have a material impact on the carrying value of our loans and those financial instruments, respectively, and, as a result, we consider these accounting policies to be critical accounting policies.

Allowance for Loan Losses. The accounting policies and practices we follow in determining the sufficiency of the allowance we establish for possible loan losses require us to make judgments and assumptions about economic and market trends that can affect the ability of our borrowers to meet their loan payment obligations. Accordingly, we use historical loss factors, adjusted for current economic market conditions and other economic indicators, to determine the losses inherent in our loan portfolio and the sufficiency of our allowance for loan losses. The actual loan losses could be greater than that predicted by those loss factors and our current assessments of current conditions and economic trends if unanticipated changes were to occur in those conditions. In such an event, it would be necessary for us to increase the allowance for loan losses by means of a charge to income referred to in our financial statements as the “provision for loan losses.” Such an increase would reduce the carrying value of our loans on our balance sheet, and the additional provision for loan losses taken to increase that allowance would reduce our income, in the period when it is determined that an increase in the allowance for loan losses is necessary. See the discussion in the subsections below entitled “—Provision for Loan Losses” and “—Allowance for Loan Losses and Nonperforming Loans” below.

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Derivative Financial Instruments. The derivative financial instruments that we enter into consist primarily of interest rate lock commitments that are designed to hedge mortgage loans held for sale that were originated by our wholesale mortgage loan division, the operations of which are classified in the consolidated financial statements in this Report as discontinued operations. At June 30, 2005, approximately $17 million, or 61%, of mortgage loans held for sale were hedged. We estimate the fair value of mortgage loans held for sale based on period end market interest rates obtained from various mortgage investors. The fluctuations in the fair values of the mortgage loans held for sale are reflected in our consolidated statements of financial condition and, correspondingly, as adjustments to our noninterest income. We also enter into non-designated derivative instruments relating to mortgage loan interest rate lock commitments with borrowers and investors in order to reduce our exposure to adverse fluctuations in interest rates. At June 30, 2005 we had $12 million of mortgage loan commitments identified as non-designated derivative instruments. We did not have any significant ineffective hedges at June 30, 2005. Due to the decision to discontinue the wholesale mortgage lending operations, we expect that the amount of these interest rate lock commitments will decline and will cease to be material to our operating results after this year.

Discontinued Business

The Bank decided in June 2005 to exit the wholesale mortgage banking business in order to concentrate its capital and other resources on expanding its successful commercial banking business. This was based on a number of factors, which included the steady growth achieved in, and the opportunities to further expand, the Bank’s commercial lending business; increases in the costs of operations of the wholesale mortgage banking business and, therefore, the prospect that, by exiting that business, we will be able to improve the efficiency of our operations; an anticipated increase in the variability of the period-to-period operating results of the wholesale mortgage banking business, which would make it more difficult to achieve consistency and predictability in our result of operations; and the amount of capital that would be required to grow and improve the profitability of the wholesale mortgage banking business, particularly in the face of the changing interest rate and market environment. The wholesale mortgage loan operations are in the process of being wound down and we expect to complete our exit from that business by the end of the third quarter of 2005.

Overview of Operating Results in the Three and Six Months ended June 30, 2005

The following table sets forth information regarding the interest income that we generated, the interest expense that we incurred, our net interest income, noninterest income, noninterest expense, and our net income and net income per share for the three and six months ended June 30, 2005 and 2004.

	Three Months Ended June 30,							Six Months Ended June 30,
	2005 Amount			2004 Amount		Percent Change		2005 Amount			2004 Amount		Percent Change
	(Unaudited)							(Unaudited)
	(Dollars in thousands except per share data)
Interest income	$	10,714		$	7,774	37.8	%	$	20,455		$	15,428	32.6	%
Interest expense		3,843			2,834	35.6	%		7,268			5,538	31.2	%
Net interest income	$	6,871		$	4,940	39.1	%	$	13,187		$	9,890	33.3	%
Noninterest income	$	517		$	388	33.3	%	$	910		$	1,075	(15.4	)%
Noninterest expense	$	4,598		$	3,635	26.5	%	$	8,821		$	7,437	18.6	%
Income from continuing business(1)	$	1,509		$	828	82.3	%	$	2,894		$	1,566	84.8	%
Income from discontinued business(1)	$	(133	)	$	112	(218.8	)%	$	(290	)	$	158	(283.5	)%
Net income	$	1,376		$	940	46.4	%	$	2,604		$	1,724	51.0	%
Net income per share—diluted
Income from continuing operations	$	0.14		$	0.08	75.0	%	$	0.27		$	0.14	92.9	%
Income from discontinued operations	$	(0.01	)	$	0.01	(200.0	)%	$	(0.03	)	$	0.02	(250.0	)%
Net income per share—diluted	$	0.13		$	0.09	44.4	%	$	0.24		$	0.16	50.0	%
Weighted average number of diluted shares		10,529,150			10,514,706	0.1	%		10,548,663			10,512,786	0.3	%

⁽¹⁾ Net of taxes

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Key Factors Affecting Operating Results in the Three and Six Months Ended June 30, 2005

• Increase in Net Interest Income. The increases in net interest income in the three and six month periods ended June 30, 2005, as compared to the corresponding periods of 2004, were primarily the result of growth in the volume of our core loans (loans exclusive of those held for sale). Core loans grew by $123 million, or 27%, to $578 million at June 30, 2005 from $455 million at June 30, 2004.

• Improvement in Net Interest Margin. Net interest margin improved to 3.35% and 3.31%, respectively, in the three and six month periods ended June 30, 2005, as compared to 2.81% and 2.90%, respectively, in the corresponding three and six month periods of 2004. This improvement was due largely to (i) an increase in the volume of core loans, which generated higher yields than our other earning assets, and (ii) an increase in the yield on federal funds sold for the three and six month periods ended June 30, 2005, which improved to 2.80% and 2.55%, respectively, from 0.96% in both of the same periods of 2004 as a result of an increase, by the Federal Reserve Board (“FRB”), of 2.25% in the overnight funds rates over the last 12 months.

• Increase in Noninterest Income in the Quarter Ended June 30, 2005. Noninterest income increased by $129,000, or 33%, to $517,000 in the quarter ended June 30, 2005, as compared to the corresponding quarter of 2004. That increase was primarily attributable to increases in service charges and fees and in other items of noninterest income such as commissions earned on brokerage services.

• Decrease in Noninterest Income in the Six Months Ended June 30, 2005. Noninterest income decreased by $165,000, or 15%, in the six month period ended June 30, 2005. This decrease was primarily attributable to a decline during the first quarter this year, as compared to the first quarter of 2004, in gains on sale of securities available for sale (consisting primarily of mortgage backed securities).

• Increase in Noninterest Expense, while improved Efficiency Ratio. Our noninterest expenses increased by $963,000, or 27%, and $1.4 million, or 19%, respectively, in the three and six month periods ended June 30, 2005, in each case as compared to the corresponding period of 2004. However, due to the increases in net interest income of 39% and 33%, respectively in those same three and six month periods, which more than offset the growth in operating expenses, our efficiency ratio (operating expenses as a percentage to total revenues) in the second quarter and six months ended June 30, 2005 improved to 62% and 63%, respectively, as compared to 68% in the same three and six month periods of 2004.

Set forth below are certain key financial performance ratios and other financial data from continuing operations for the periods indicated:

	Three Months Ended June 30,				Six Months Ended June 30,
	2005		2004		2005		2004
	(Unaudited)				(Unaudited)
Return on average assets(1)	0.68	%	0.48	%	0.67	%	0.46	%
Return on average shareholders’ equity(1)	7.87	%	5.29	%	7.66	%	4.86	%
Net interest margin(2)	3.35	%	2.81	%	3.31	%	2.90	%

⁽¹⁾ Annualized.

⁽²⁾ Net interest income expressed as a percentage of total average interest earning assets.

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Results of Operations

Net Interest Income

One of the principal determinants of a bank’s income is its net interest income, which is the difference between (i) the interest that a bank earns on loans, investment securities and other interest earning assets, on the one hand, and (ii) its interest expense, which consists primarily of the interest it must pay to attract and retain deposits and the interest that it pays on borrowings and other interest-bearing liabilities, on the other hand. A bank’s interest income and interest expense are, in turn, affected by a number of factors, some of which are outside of its control, including national and local economic conditions and the FRB’s monetary policies, which affect interest rates, the demand for loans, and the ability of borrowers to meet their loan payment obligations.

The following table sets forth our interest income, interest expense, net interest income and net interest margin from continuing operations in the three and six month periods ended June 30, 2005 and 2004, respectively:

	Three Months Ended June 30,								Six Months Ended June 30,
(Dollars in thousands except per share data)	2005 Amount			2004 Amount			Percent Change		2005 Amount			2004 Amount			Percent Change
	(Unaudited)								(Unaudited)
Interest income	$	10,714		$	7,774		37.8	%	$	20,455		$	15,428		32.6	%
Interest expense		3,843			2,834		35.6	%		7,268			5,538		31.2	%
Net interest income	$	6,871		$	4,940		39.1	%	$	13,187		$	9,890		33.3	%
Net interest margin		3.35	%		2.81	%				3.31	%		2.90	%

As the table above indicates, the net interest income increased by $1.9 million, or 39%, in the second quarter of 2005, and $3.3 million, or 33%, in the six months ended June 30, 2005, as compared to the same respective periods of 2004. Those increases were attributable to increases in interest income of $2.9 million, or 38%, and $5.0 million, or 33%, respectively, in the three and six month periods of 2005, as compared to the same periods of 2004. By contrast, our interest expense increased $1.0 million, or 36%, and $1.7 million, or 31%, respectively in the three and six months periods ended June 30, 2005 over the corresponding periods of 2004.

The increase in interest income in the three and six month periods ended June 30, 2005, was primarily attributable to (i) an increase in the volume of average interest earning assets, including increases of $108 million and $132 million, respectively, in the average volume of outstanding loans (exclusive of mortgages held for sale) over the corresponding periods of 2004, and (ii) to a lesser extent, the increase in market rates of interest over the last 12 months.

The increases in interest expense in the second quarter and six months ended June 30, 2005, as compared to the same respective periods last year, were primarily attributable to increases of $74 million and $79 million in the average volume of interest bearing liabilities and the rise in market rates of interest rates subsequent to June 2004, which required us to increase the interest we pay to attract and retain deposits and led to increases in interest rates on our outstanding borrowings.

Our net interest margin improved to 3.35% in the second quarter of 2005 from 2.81% in the second quarter ended June 30, 2004, and to 3.31% in the six months ended June 30, 2005, from 2.90% in the same six months of 2004. In the three months ended June 30, 2005 the yield on interest earning assets improved to 5.29%, while the average rate of interest paid on our interest bearing liabilities increased to 2.70%, as compared to a yield on interest earning assets of 4.37% and an average rate of interest paid on interest bearing liabilities of 2.15%, in the same three months of 2004. In the six months ended June 2005, the yield on interest earning assets improved to 5.18%, and the average rate of interest paid on our interest bearing liabilities increase to 2.59%, as compared to a yield on interest earning assets of 4.47%, and an average rate of interest paid of 2.17%, in the same six months of 2004.

This improvement in the average yield on interest earning assets was due primarily to the substantial increase in the volume of core loans on which we generate greater yields than on our other interest earning assets and, to a lesser extent, the rise of interest rates over the last 12 months.

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The following table sets forth changes in interest income, including loan fees, and interest paid in the three and six month periods ended June 30, 2005, as compared to the same respective periods in 2004 and the extent to which those changes were attributable to changes in the volume and rates of interest earned on interest earning assets and interest paid on interest-bearing liabilities.

	Three Months Ended June 30, 2005 vs 2004 Increase (decrease) due to:							Six Months Ended June 30, 2005 vs 2004 Increase (decrease) due to:
	Volume(1)			Rate(1)		Total		Volume(1)			Rate(1)		Total
	(Dollars in thousands)							(Dollars in thousands)
Interest income:
Short-term investments(2)	$	(286	)	$	436	$	150	$	35		$	405	$	440
Securities available for sale and stock		38			368		406		(1,214	)		908		(306	)
Loans		1,835			782		2,617		4,241			1,054		5,295
Total earning assets		1,587			1,586		3,173		3,062			2,367		5,429
Interest expense:
Interest-bearing checking accounts		0			14		14		3			26		29
Money market and savings accounts		26			255		281		85			475		560
Certificates of deposit		17			244		261		49			283		332
Borrowings		332			117		449		612			167		779
Junior subordinated debentures		157			71		228		302			103		405
Total interest-bearing liabilities		532			701		1,233		1,051			1,054		2,105
Net interest income	$	1,055		$	885	$	1,940	$	2,011		$	1,313	$	3,324

⁽¹⁾ Changes in interest earned and interest paid due to changes in the mix of interest earning assets and interest bearing liabilities have been allocated to the change due to volume and the change due to interest rates in proportion to the relationship of the absolute dollar amounts of the changes in each.

⁽²⁾ Short-term investments consist of federal funds sold and interest bearing deposits with financial institutions.

The above table indicates that the increases of $1.9 million and $3.3 million, respectively, in our net interest income in the three and six month periods ended June 30, 2005, as compared to the like periods in 2004, were the result of increases of $1.0 million and $2.0 million, respectively, in volume variance and of $885,000 and $1.3 million, respectively, in interest rate variance, for the three and six month periods ended June 30, 2005, as compared to the same periods in 2004. The increases in the volume variance reflect the increases in average earning assets of $110 million and $115 million, respectively, and in average interest-bearing liabilities of $74 million and $79 million, respectively, in the three and six month periods ended June 30, 2005, as compared to the corresponding periods of 2004. The increases in the rate variance reflect the increases in interest rates earned on average earning assets of 92 basis points and 71 basis points, respectively, offset by increases in interest rates paid on average interest-bearing liabilities of 55 basis points and 42 basis points, respectively, in the three and six month periods ended June 30, 2005, as compared to the corresponding periods of 2004.

Provision for Loan Losses

Like virtually all banks and other financial institutions, we follow the practice of maintaining a reserve or allowance (the “Allowance”) for possible loan losses that occur from time to time as an incidental part of the banking business. When it is determined that the payment in full of a loan has become unlikely, the carrying value of the loan is reduced to what management believes is its realizable value. This reduction, which is referred to as a loan “charge-off,” or “write-down” is charged against that Allowance. The amount of the Allowance for Loan Losses is increased periodically (i) to replenish the Allowance after it has been reduced due to loan charge-offs, (ii) to reflect changes in the volume of outstanding loans, and (iii) to take account of changes in the risk of potential losses due to a deterioration in the condition of borrowers or in the

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value of property securing non–performing loans or changes in economic conditions. See “—Financial Condition—Allowance for Loan Losses and Nonperforming Loans” below in this Section of this Report. Increases in the Allowance for Loan Losses are made through a charge, recorded as an expense in the statement of income referred to as the “provision for loan losses.” Recoveries of loans previously charged-off are added back to the Allowance and, therefore, have the effect of increasing the Allowance for Loan Losses and reducing the amount of the provision that might otherwise be made to replenish or increase the Allowance.

Although we employ economic models that are based on bank regulatory guidelines, industry standards and historical loss experience to evaluate and determine the sufficiency of the Allowance for Loan Losses and, thereby, the amount of the provisions required to be made for potential loan losses, those determinations involve judgments about trends in current economic conditions and other events that can affect the ability of borrowers to meet their loan obligations. The duration and effects of current economic trends are subject to a number of uncertainties and changes that are outside of our ability to control. See the discussion below in this Section under the caption “Risks and Uncertainties That Could Affect our Future Financial Performance — we could incur losses on the loans we make.” In the event of unexpected subsequent events or changes in circumstances, it could become necessary in the future to incur additional charges to increase the Allowance, which would have the effect of reducing our income or could cause us to incur losses.

In addition, the Federal Reserve Board and the California Department of Financial Institutions, as an integral part of their examination processes, periodically review the Bank’s Allowance for Loan Losses. These agencies may require the Bank to make additional provisions, over and above that which we have already made, the effect of which would be to reduce our income.

Noninterest Income

Noninterest income consists primarily of fees charged for services provided by the bank on deposit accounts and commissions earned on brokerage services. The following table identifies the components of and the percentage changes in noninterest income in the three and six month periods ended June 30, 2005, as compared to the same respective periods of 2004.

	Three Months Ended June 30,						Six Months Ended June 30,
	Amount				Percentage Change 2005 vs. 2004		Amount				Percentage Change 2005 vs. 2004
	2005		2004				2005		2004
	(Dollars in thousands						(Dollars in thousands)
Service fees on deposits	$	174	$	155	12.3	%	$	338	$	340	(0.6	)%
Net gains on sales of securities available for sale		—		50	NM			—		369	NM
Brokerage commissions		176		93	89.2	%		319		204	56.4	%
Other		167		90	85.6	%		253		162	56.2	%
Total noninterest income	$	517	$	388	33.2	%	$	910	$	1,075	(15.4	)%

Noninterest income increased by $129,000, or 33%, in the second quarter of 2005, as compared to the same quarter in 2004, primarily as a result of increases in brokerage commissions, service charges and fees and increases in other items of noninterest income such as fees on loan documentation. In the six months ended June 30, 2005, noninterest income declined by $165,000, or 15%, as compared to the like period of 2004, due primarily to the fact that noninterest income in the six months ended June 30, 2004 included $369,000 of gains from sales of securities; whereas there were no sales of, and hence no gains from, sales of securities in the six months ended June 30, 2005.

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Noninterest Expense

The following table sets forth the principal components and amounts of noninterest expense in the three and six months periods ended June 30, 2005 and 2004.

	Three Months Ended June 30,						Six Months Ended June 30,
	Amount				Percentage Change 2005 vs. 2004		Amount				Percentage Change 2005 vs. 2004
	2005		2004				2005		2004
	(Dollars in thousands)						(Dollars in thousands)
Salaries and employee benefits	$	2,374	$	1,751	35.6	%	$	4,662	$	3,672	27.0	%
Occupancy		599		510	17.5	%		1,131		1,016	11.3	%
Equipment and depreciation		366		344	6.4	%		743		687	8.2	%
Data processing		122		158	(22.8	)%		239		322	(25.8	)%
Professional fees		313		188	66.5	%		525		425	23.5	%
Other operating expense(1)		824		684	20.5	%		1,521		1,315	15.7	%
Total noninterest expense	$	4,598	$	3,635	26.5	%	$	8,821	$	7,437	18.6	%

⁽¹⁾ Other operating expense primarily consists of telephone, stationery and office supplies, regulatory expenses, investor relations, insurance premiums, postage, and correspondent bank fees.

Noninterest expense increased by $963,000, or 27%, in the quarter ended June 30, 2005 and by $1.4 million, or 19%, in the six months ended June 30, 2005, in each case as compared to the corresponding period of 2004. These increases were primarily the result of expenses attributable to the September 2004 opening of, and the subsequent growth of our commercial banking business at, our Long Beach Financial Center and the opening of our new Ontario Financial Center in June of 2005.

A measure of our ability to control noninterest expense in relation to the level of our net revenue (net interest income plus noninterest income) is our efficiency ratio, which is the ratio of noninterest expense to net revenue. As a general rule, all other things being equal, a lower efficiency ratio indicates an ability to generate increased revenue without a commensurate increase in the staffing and equipment and third party services and, therefore, would indicate greater efficiencies in our operations. However, a bank’s efficiency ratio can be adversely affected by factors such as the opening of new banking offices, the revenues of which usually lag behind the expenses that a bank must incur to staff and open the new offices.

Notwithstanding the increase in the dollar amounts of our noninterest expense in the second quarter and six months ended June 30, 2005, as compared to the like periods of last year, we were able to improve our efficiency ratio in the quarter and six months ended June 30, 2005 to 62% and 63%, respectively, as compared to 68% in each of the same three and six month periods of 2004, due primarily to the increases we generated in net interest income.

We anticipate that noninterest expense also will be higher during the second half of this year, as compared to the second half of 2004, due primarily to the expansion of our banking franchise resulting from the growth of our Long Beach Financial Center and the opening of our Ontario Financial Center.

Asset/Liability Management

The primary objective of asset/liability management is to reduce our exposure to interest rate fluctuations, which can affect our net interest margins and, therefore, our net interest income and net earnings. We seek to achieve this objective by matching interest rate sensitive assets and liabilities, and maintaining the maturities and the repricing of these assets and liabilities at appropriate levels in response to the changes in the interest rate environment. Generally, if rate sensitive assets exceed rate sensitive liabilities, net interest income will be positively impacted during a rising interest rate environment and negatively impacted during a declining interest rate environment. When rate sensitive liabilities exceed rate sensitive assets,

16

net interest income generally will be positively impacted during a declining interest rate environment and negatively impacted during a rising interest rate environment. However, because interest rates for different asset and liability products offered by depository institutions respond differently to changes in the interest rate environment, the relationship or “gap” between interest sensitive assets and interest sensitive liabilities is only a general indicator of interest rate sensitivity and how our net interest income might be affected by changing rates of interest.

For example, rates on certain assets or liabilities typically lag behind changes in market rates of interest. Additionally, prepayments of loans and securities available for sale, and early withdrawals of certificates of deposit, could cause the interest sensitivities to vary.

The table below sets forth information concerning our rate sensitive assets and liabilities at June 30, 2005. The assets and liabilities are classified by the earlier of maturity or repricing dates in accordance with their contractual terms. As is described above, certain shortcomings are inherent in the method of analysis presented in this table.

	Three Months or Less			Over Three Through Twelve Months			Over One Year Through Five Years			Over Five Years			Non - Interest- Bearing			Total
	(Dollars in thousands)
Assets
Interest-bearing deposits in other financial institutions	$	560		$	—		$	—		$	—		$	—		$	560
Investment in unconsolidated trust subsidiaries		—			—			—						837			837
Securities available for sale		17,621			44,446			121,528			51,129			—			234,724
Federal Reserve Bank and Federal Home Loan Bank stock		12,019			—			—			—			—			12,019
Federal funds sold		8,700			—			—			—			—			8,700
Loans, gross		279,142			60,329			244,451			21,899			—			605,821
Non-interest earning assets, net		—			—			—			—			59,884			59,884
Total assets	$	318,042		$	104,775		$	365,979		$	73,028		$	60,721		$	922,545
Liabilities and Shareholders Equity
Noninterest-bearing deposits	$	—		$	—		$	—		$	—		$	216,668		$	216,668
Interest-bearing deposits		220,0211			106,6282			41,435			—			—			368,084
Borrowings		35,262			117,000			74,000			—			—			226,262
Junior subordinated debentures		27,837			—			—			—			—			27,837
Other liabilities		—			—			—			—			6,082			6,082
Shareholders’ equity		—			—			—			—			77,612			77,612
Total liabilities and shareholders equity	$	283,120		$	223,628		$	115,435		$	0		$	300,362		$	922,545
Interest rate sensitivity gap	$	34,922		$	(118,853	)	$	250,544		$	73,028		$	(239,641	)
Cumulative interest rate sensitivity gap	$	34,922		$	(83,931	)	$	166,613		$	239,641		$	—
Cumulative % of rate sensitive assets in maturity period		34	%		46	%		86	%		93	%		100	%
Rate sensitive assets to rate sensitive liabilities		112	%		47	%		317	%		N/A			N/A
Cumulative ratio		112	%		83	%		127	%		139	%		N/A

¹ Net of Bancorp’s money market demand account of $25.1 million and certificate of deposit of $250,000

² Net of Bancorp’s certificate of deposit of $5.0 million

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At June 30, 2005, our rate sensitive balance sheet was shown to be in a negative twelve-month gap position. This implies that our net interest margin would decrease in the short–term if interest rates rise and would increase in the short-term if interest rates were to fall. However, as noted above, the extent to which our net interest margin will be impacted by changes in prevailing interests rates will depend on a number of factors, including how quickly rate sensitive assets and liabilities react to interest rate changes, the mix of our interest earning assets (loans versus other lower yielding interest earning assets, such as securities) and the mix of our interest bearing deposits (between for example, lower interest core deposits and higher cost time certificates of deposit) and our other interest bearing liabilities.

Derivative Financial Instruments Relating to Loans Held for Sale by our Discontinued Mortgage Lending Operations

In connection with our wholesale mortgage lending business, which now comprises discontinued operations, we have used derivative instruments to reduce our exposure to adverse fluctuations in interest rates in accordance with our risk management policy. Generally, if interest rates increase, the value of our mortgage loan commitments to borrowers and mortgage loans held for sale are adversely impacted. We attempt to economically hedge 100% of the risk of the overall change in the fair value of loan commitments to borrowers and mortgage loans held for sale by entering into rate lock commitments with investors in mortgage loans at the date loan commitments are made to the individual borrowers. These rate lock commitments are entered into at the same terms as those extended to borrowers to be delivered to the investors at a future date.

Mortgage loan commitments to borrowers and rate lock commitments with investors in mortgage loans are non-designated as derivative instruments and are included in mortgage loans held for sale in our balance sheets, and gains and losses resulting from these derivative instruments are included in the loss (income) from our discontinued operations in our statements of operations. As we wind down the wholesale mortgage lending business, the amount of such derivative will be reduced and, once we have exited that business, we will no longer have a need for such instruments.

Financial Condition

Assets

Our total consolidated assets increased by $77 million, or 9%, to $923 million at June 30, 2005 from $846 million at December 31, 2004, primarily as a result of increases in loan volume. Those increases were funded by increases in deposits and, to a lesser extent, increases in borrowings.

The following table sets forth the composition of our interest earning assets at:

	June 30, 2005		December 31, 2004
	(In thousands)
Federal funds sold	$	8,700	$	69,600
Interest-bearing deposits with financial institutions		560		738
Federal Reserve Bank and Federal Home Loan Bank Stock, at cost		12,019		10,662
Securities available for sale, at fair value		234,724		169,412
Loans (net of allowances of $4,350 and $4,032, respectively)		578,050		511,827
Loans held for sale, at fair value(1)		27,771		42,348

⁽¹⁾ Loans held for sale comprise substantially all of the assets of our discontinued wholesale mortgage lending operations.

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Loans

The following table sets forth the composition, by loan category, of our loan portfolio, excluding mortgage loans held for sale, at June 30, 2005 and December 31, 2004:

	June 30, 2005					December 31, 2004
	Amount			Percent		Amount			Percent
	(Dollars in thousands)
Commercial loans	$	152,250		26.2	%	$	132,964		25.8	%
Real estate loans		210,738		36.2	%		174,520		33.7	%
Residential mortgage loans		179,504		30.8	%		173,194		33.6	%
Construction loans		33,914		5.8	%		29,731		5.8	%
Consumer loans		6,020		1.0	%		5,471		1.1	%
Gross loans		582,426		100.0	%		515,880		100.0	%
Deferred fee (income) costs, net		(26	)				(21	)
Allowance for loan losses		(4,350	)				(4,032	)
Loans, net	$	578,050				$	511,827

Commercial loans are loans to businesses to finance capital purchases or improvements, or to provide cash flow for operations. Real estate and residential mortgage loans are loans secured by trust deeds on real property, including commercial property and single family and multi-family residences. Construction loans are interim loans to finance specific construction projects. Consumer loans include installment loans to consumers.

The following tables set forth the maturity distribution of our loan portfolio (excluding consumer and residential mortgage loans and mortgage loans held for sale) at June 30, 2005:

	June 30, 2005
	One Year or Less		Over One Year Through Five Years		Over Five Years		Total
	(Dollars in thousands)
Real estate and construction loans(1)
Floating rate	$	60,348	$	31,567	$	130,616	$	222,531
Fixed rate		179		15,535		6,407		22,121
Commercial loans
Floating rate		89,139		28,601		9,148		126,888
Fixed rate		6,533		17,311		1,518		25,362
Total	$	156,199	$	93,014	$	147,689	$	396,902

⁽¹⁾ Does not include mortgage loans on single and multi-family residences and consumer loans, which totaled $179.5 million and $6.0 million, respectively, at June 30, 2005.

Allowance for Loan Losses and Nonperforming Loans

Allowance for Loan Losses. The allowance for loan losses (the “Allowance”) at June 30, 2005 was $4.4 million, which represented about 0.75% of the loans outstanding at June 30, 2005, as compared to $4.0 million, or 0.78%, of the loans outstanding at December 31, 2004, in each case exclusive of loans held for sale.

We carefully monitor changing economic conditions, the loan portfolio by category, the financial condition of borrowers, the history of the loan portfolio, and we follow bank regulatory guidelines in determining the adequacy of the Allowance. We believe that the Allowance at June 30, 2005 is adequate to provide for losses inherent in the loan portfolio. However, as the volume of loans increases, additional provisions for loan losses will be required to maintain the Allowance at adequate levels. Additionally, the Allowance was established on the basis of assumptions and judgments regarding such

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matters as economic conditions and trends and the condition of borrowers, historical industry loan loss data and regulatory guidelines, and actual loan losses in the future could vary from the losses predicted on the basis of those assumptions, judgments and guidelines. For example, if economic conditions were to deteriorate, or interest rates were to increase significantly, which would have the effect of increasing the risk that borrowers would encounter difficulties meeting their loan payment obligations, it could become necessary to increase the Allowance by means of additional provisions for loan losses. See “—Results of Operations—Provision for Loan Losses” above.

Set forth below is a summary of the transactions in the allowance for loan losses for the six months ended June 30, 2005 and the year ended December 31, 2004:

	June 30, 2005			December 31, 2004
	(In thousands)
Balance, beginning of period	$	4,032		$	3,943
Provision for loan losses		350			973
Amounts charged off		(32	)		(884	)
Balance, end of period	$	4,350		$	4,032

The $884,000 charge off during fiscal year ended December 31, 2004, primarily represents one loan that had been fully reserved and included in the Allowance at December 31, 2003.

Non-Performing Loans. We also measure and establish reserves for loan impairments on a loan-by-loan basis using either the present value of expected future cash flows discounted at a loan’s effective interest rate, or the fair value of the collateral if the loan is collateral-dependent. We exclude from our impairment calculations smaller, homogeneous loans such as consumer installment loans and lines of credit. Also, loans that experience insignificant payment delays or shortfalls are generally not considered impaired. We cease accruing interest, and therefore classify as nonaccrual, any loan as to which principal or interest has been in default for a period of 90 days or more, or if repayment in full of interest or principal is not expected.

At June 30, 2005 and December 31, 2004, we had $979,000 and $11,000, respectively, loans that was delinquent 90 days or more and which was classified as a nonaccrual and impaired loans. We had no loans delinquent 90 days or more with principal still accruing interest or any restructured loans at June 30, 2005 or December 31, 2004. At June 30, 2005, our average investment in impaired loans, on a year-to-date basis, was $671,000. The interest that we would have earned in the six months ended June 30, 2005, had the impaired loans remained current in accordance with their original terms was $30,000.

Loans Held for Sale

Loans held for sale in the secondary market, which consist primarily of mortgage loans, totaled $28 million at June 30, 2005, a decrease of $14 million from $42 million at December 31, 2004. Loans held for sale are carried at the lower of cost or estimated fair value in the aggregate except for those designated as fair value hedges, which are carried at fair value. There were $17 million of loans held for sale designated as fair value hedges at June 30, 2005, and there were no ineffective hedges. Net unrealized losses on loans held for sale, if any, are recognized through a valuation allowance by charges to income. As of June 30, 2005, we had a valuation allowance of approximately $135,000 representing net unrealized losses related to these loans held for sale and unfunded commitments to make such loans.

The loans held for sale were originated by our wholesale mortgage lending business, which is being wound down and is classified in the accompanying financial statements as discontinued operations. We expect to have exited that business by the end of the third quarter of the current year, by which time all of these loans will have been sold or transferred to the commercial loan portfolio at lower of cost or market.

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Deposits

Average Balances of and Average Interest Rates Paid on Deposits. Set forth below are the average amounts (in thousands) of, and the average rates paid on, deposits for the six months ended June 30, 2005:

	Six Months Ended June 30, 2005
	Average Balance		Average Rate
	(Dollars in thousands)
Noninterest-bearing demand deposits	$	194,560	—
Interest-bearing checking accounts		21,745	0.55	%
Money market and savings deposits		137,044	1.80	%
Time deposits		205,612	2.89	%
Total deposits	$	558,961	1.52	%

Deposit Totals. Deposits totaled $584 million at June 30, 2005 as compared to $534 million at December 31, 2004. At June 30, 2005, noninterest-bearing deposits totaled $217 million and represented 37% of total deposits, as compared to $175 million and 33% of total deposits at December 31, 2004. By comparison, at June 30, 2005, certificates of deposit in denominations of $100,000 or more totaled $114 million and represented 19% of total deposits, as compared to $99 million and 19% of total deposits at December 31, 2004. Set forth below is a maturity schedule of domestic time certificates of deposit outstanding at June 30, 2005:

	At June 30, 2005
	Certificates of Deposit Under $100,000		Certificates of Deposit of $100,000 or More
	(In thousands)
Maturities
Three months or less	$	23,788	$	36,137
Over three and through twelve months		44,593		62,034
Over twelve months		25,748		15,688
Total	$	94,129	$	113,859

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Liquidity

We actively manage our liquidity needs to insure sufficient funds are available to meet the ongoing needs of our customers. We project the future sources and uses of funds and maintain sufficient liquid funds for unanticipated events. Our primary sources of cash include payments on loans, the sale or maturity of investments and growth in deposits. The primary uses of cash include funding new loans and making advances on existing lines of credit, purchasing investments, including securities available for sale, funding deposit withdrawals and paying operating expenses. We maintain funds in overnight federal funds and other short-term investments to provide for short-term liquidity needs. We also have obtained credit lines from the Federal Home Loan Bank and other financial institutions to meet any additional liquidity requirements.

Cash flow Provided by Financing Activities. Cash flow of $73 million was provided by financing activities during the six months ended June 30, 2005, the source of which consisted primarily of net increases of $51 million in deposits and $22 million in net borrowings.

Cash flow From Operating Activities. Cash flow of $5 million was provided by our continuing operations, while the activities of our discontinued mortgage lending operations provided an additional $15 million of cash during the six months ended June 30, 2005.

Cash flow Used in Investing. Cash flow used in investing activities in the six months ended June 30, 2005 was $134 million, primarily to fund an increase of $67 million in loans and $95 million of purchases of investment securities available for sale, offset somewhat by $28 million proceeds from principal payments received on investment securities available for sale in the six months ended June 30, 2005.

Our liquid assets, which included cash and due from banks, federal funds sold, interest earning deposits with financial institutions and unpledged securities available for sale (excluding Federal Reserve Bank and Federal Home Loan Bank stock) totaled $128 million or 14% of total assets at June 30, 2005.

The relationship between gross loans and total deposits provides a useful measure of our liquidity. Since repayment of loans tends to be less predictable than the maturity of investments and other liquid resources, the higher the loan-to-deposit ratio the less liquid are our assets. On the other hand, since we realize greater yields and higher interest income on loans than we do on investments, a lower loan-to-deposit ratio can adversely affect interest income and earnings. As a result, our goal is to achieve a loan-to-deposit ratio that appropriately balances the requirements of liquidity and the need to generate a fair return on assets. At June 30, 2005, the ratio of loans-to-deposits (excluding loans held for sale) was 99%, compared to 96% at December 31, 2004.

Off Balance Sheet Arrangements

Loan Commitments and Standby Letters of Credit. In order to meet the financing needs of our customers in the normal course of business, we make commitments to extend credit and issue standby commercial letters of credit to or for our customers. At June 30, 2005 and December 31, 2004, we were committed to fund certain loans (inclusive of mortgages held for sale) amounting to approximately $237 million and $167 million, respectively.

Commitments to extend credit and standby letters of credit generally have fixed expiration dates or other termination clauses and the customer may be required to pay a fee and meet other conditions in order to draw on those commitments or standby letters of credit. We expect, based on historical experience, that many of the commitments will expire without being drawn upon and, therefore, the total commitment amounts do not necessarily represent future cash requirements.

To varying degrees, commitments to extend credit involve elements of credit and interest rate risk for us that are in excess of the amounts recognized in our balance sheets. Our maximum exposure to credit loss in the event of nonperformance by the customers to whom such commitments are made is equal to the amount of those commitments. As a result, before making such a commitment to a customer, we evaluate the customer’s creditworthiness using the same

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underwriting standards that we would apply if we were approving loans to the customer. In addition, we often require the customer to secure its payment obligations for amounts drawn on such commitments with collateral such as accounts receivable, inventory, property, plant and equipment, income-producing commercial properties, residential properties and properties under construction. As a consequence, our exposure to credit and interest rate risk on such commitments is not different in character or amount than risks inherent in the outstanding loans in our loan portfolio.

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers.

We believe that our cash and cash equivalent resources, together with available borrowings under our credit facilities, will be sufficient to enable us to meet any increases in demand for loans or in the utilization of outstanding loan commitments or standby letters of credit and any increase in deposit withdrawals that might occur in the foreseeable future.

Contractual Obligations

Borrowings. As of June 30, 2005, we had $74 million of outstanding long-term borrowings and $145 million of outstanding short-term borrowings that we had obtained from the Federal Home Loan Bank. The table below sets forth the amounts, in thousands of dollars, the interest rates we pay on, and the maturity dates of these Federal Home Loan Bank borrowings. These borrowings, along with the securities sold under agreements to repurchase, have a weighted-average annualized interest rate of 2.82%.

Principal Amounts	Interest Rate	Maturity Dates	Principal Amounts	Interest Rate	Maturity Dates
(Dollars in thousands)			(Dollars in thousands)
$  5,000	2.95%	August 15, 2005	$7,000	3.63%	June 7, 2006
5,000	2.24%	August 29, 2005	5,000	3.63%	June 9, 2006
10,000	2.70%	September 19, 2005	5,000	3.13%	June 19, 2006
3,000	1.93%	September 19, 2005	5,000	2.76%	July 10, 2006
5,000	1.76%	September 30, 2005	7,000	3.72%	July 10, 2006
5,000	2.34%	October 13, 2005	5,000	2.76%	August 9, 2006
7,000	2.34%	November 14, 2005	2,000	2.94%	August 28, 2006
5,000	2.35%	November 14, 2005	3,000	2.56%	September 18, 2006
5,000	2.33%	November 17, 2005	3,000	2.49%	September 25, 2006
5,000	2.33%	November 21, 2005	5,000	2.39%	October 2, 2006
7,000	2.41%	January 9, 2006	2,000	2.40%	October 2, 2006
6,000	1.94%	January 23, 2006	7,000	3.18%	November 12, 2006
10,000	2.74%	January 30, 2006	5,000	2.69%	December 12, 2006
5,000	2.66%	February 2, 2006	5,000	2.67%	December 18, 2006
7,000	3.18%	February 3, 2006	4,000	2.50%	January 22, 2007
5,000	2.00%	February 13, 2006	5,000	2.57%	February 12, 2007
5,000	2.50%	February 21, 2006	5,000	3.62%	May 18, 2007
6,000	2.34%	February 28, 2006	3,000	3.14%	September 18, 2007
5,000	3.50%	March 16, 2006	2,000	3.06%	September 24, 2007
5,000	3.26%	April 10, 2006	1,000	2.91%	October 1, 2007
7,000	3.59%	May 1,2006	5,000	3.45%	February 11, 2009
5,000	3.87%	May 18, 2006

At June 30, 2005, U.S. Agency and Mortgage Backed securities, U.S. Government agency securities and collateralized mortgage obligations with an aggregate fair market value of $153 million and $102 million of residential mortgage and other real estate secured loans were pledged to secure these Federal Home Loan Bank borrowings, repurchase agreements, local agency deposits, and Treasury, tax and loan accounts.

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The highest amount of borrowings outstanding at any month end during the six months ended June 30, 2005 consisted of $219 million of borrowings from the Federal Home Loan Bank and $15 million of overnight borrowings in the form of securities sold under repurchase agreements. During 2004, the highest amount of borrowings outstanding at any month end consisted of $191 million of advances from the Federal Home Loan Bank and $17 million of overnight borrowings in the form of securities sold under repurchase agreements.

Junior Subordinated Debentures. Pursuant to rulings of the Federal Reserve Board, bank holding companies have been permitted to issue long term subordinated debt instruments that will, subject to certain conditions, qualify as and, therefore, augment capital for regulatory purposes. Pursuant to those rulings, in 2002, we formed subsidiary grantor trusts to sell and issue to institutional investors a total of $17 million principal amount of floating junior trust preferred securities (“trust preferred securities”). We received the net proceeds from the sale of the trust preferred securities in exchange for our issuance to the grantor trusts, of a total $17 million principal amount of our junior subordinated floating rate debentures (the “Debentures”), the payment terms of which mirror those of the trust preferred securities. In October 2004, we established another grantor trust that sold an additional $10 million of trust preferred securities to an institutional investor and, in connection therewith, we sold and issued an additional $10 million principal amount junior subordinated floating rate debentures in exchange for the proceeds raised from the sale of those trust preferred securities. The payments that we make of interest and principal on the Debentures are used by the grantor trusts to make the payments that come due to the holders of the trust preferred securities pursuant to the terms of those securities.

Set forth below is certain information regarding the terms of the Debentures that were outstanding as of June 30, 2005:

Original Issue Dates	Principal Amount		Interest Rate	Maturity Date
	(In thousands)
June 2002	$	5,155	LIBOR plus 3.75%(1)	June 2032
August 2002	$	5,155	LIBOR plus 3.625%(2)	August 2032
September 2002	$	7,217	LIBOR plus 3.40%(1)	September 2032
October 2004	$	10,310	LIBOR plus 2.00%(1)	October 2034
Total	$	27,837

⁽¹⁾ Interest rate resets quarterly.

⁽²⁾ Interest rate resets semi-annually.

These Debentures have quarterly or semi-annual interest payments, which may be deferred until the first redeemable date, and are redeemable at our option beginning 5 years after their respective original issue dates.

Under the Federal Reserve Board rulings, the borrowings evidenced by the Debentures, which are subordinated to all of our other borrowings that are outstanding or which we may obtain in the future, are eligible (subject to certain dollar limitations) to qualify and, at June 30, 2005, $26.3 million of those Debentures qualified as Tier I capital, for regulatory purposes. The remaining $1.5 million qualified as Tier II capital for regulatory purposes. See discussion below under the subcaption “—Regulatory Capital Requirements.”

Investment Policy and Securities Available for Sale

Our investment policy is designed to provide for our liquidity needs and to generate a favorable return on investments without undue interest rate risk, credit risk or asset concentrations.

Our investment policy:

• authorizes us to invest in obligations issued or fully guaranteed by the United States Government, certain federal agency obligations, time deposits issued by federally insured depository institutions, municipal securities and in federal funds sold;

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• provides that the weighted average maturities of U.S. Government obligations and federal agency securities cannot exceed 10 years and municipal obligations cannot exceed 25 years;

• provides that time deposits must be placed with federally insured financial institutions, cannot exceed $100,000 in any one institution and may not have a maturity exceeding 60 months; and

• prohibits engaging in securities trading activities.

Securities available for sale are those that we intend to hold for an indefinite period of time, but which may be sold in response to changes in liquidity needs, changes in interest rates, changes in prepayment risks or other similar factors. Such securities are recorded at fair value. Any unrealized gains and losses are reported as “Other Comprehensive Income (Loss)” rather than included in or deducted from earnings.

The following is a summary of the major components of securities available for sale and a comparison of the amortized cost, estimated fair values and gross unrealized gains and losses as of June 30, 2005 and December 31, 2004:

	Amortized Cost		Gross Unrealized Gain		Gross Unrealized Loss		Estimated Fair Value
	(Dollars in thousands)
June 30, 2005
Securities Available For Sale:
Mortgage Backed Securities	$	210,979	$	177	$	2,489	$	208,667
Collateralized Mortgage Obligations		22,268		13		222		22,059
Total Government and Agencies Securities		233,247		190		2,711		230,726
Municipal Securities		2,462		15		1		2,476
Mutual Fund		1,522		0		0		1,522
Total Securities Available For Sale	$	237,231	$	205	$	2,712	$	234,724
December 31, 2004
Securities Available For Sale:
U.S. Agencies and Mortgage Backed Securities	$	160,405	$	14	$	2,383	$	158,036
Collateralized Mortgage Obligations		10,487		3		122		10,368
Total Government and Agencies Securities		170,892		17		2,505		168,404
Fannie Mae Trust Preferred Stock		1,008		0		0		1,008
Total Securities Available For Sale	$	171,900	$	17	$	2,505	$	169,412

At June 30, 2005, U.S. Agencies and Mortgage Backed securities, U.S. Government agency securities and collateralized mortgage obligations with an aggregate fair market value of $162 million were pledged to secure Federal Home Loan Bank borrowings, repurchase agreements, local agency deposits and Treasury, tax and loan accounts.

The amortized cost and estimated fair value, at June 30, 2005, of securities available for sale are shown in the table below by contractual maturities and historical prepayments based on the prior three months of principal payments. Expected

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maturities will differ from contractual maturities and historical prepayments, particularly with respect to collateralized mortgage obligations, because borrowers may react to interest rate market conditions differently than the historical prepayment rates.

	Maturing in
	One year or less			Over one year through five years			Over five years through ten years			Over ten years			Total
(Dollars in thousands)
Securities available for sale, amortized cost	$	55,594		$	110,529		$	53,211		$	17,897		$	237,231
Securities available for sale, estimated fair value		55,004			109,505			52,837			17,378			234,724
Weighted average yield		3.57	%		3.77	%		4.04	%		4.14	%		3.81	%

The table below shows as of June 30, 2005, the gross unrealized losses and fair values of our investments, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position.

	Securities With Unrealized Loss as of June 30, 2005
	Less than 12 months				12 months or more				Total
(Dollars In thousands)	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
US Agencies and Mortgage Backed Securities	$	69,957	$	498	$	107,112	$	1,991	$	177,069	$	2,489
Collateralized Mortgage Obligations		10,065		99		3,939		123		14,004		222
Municipal Securities		503		1		0		0		503		1
Total Temporarily impaired securities	$	80,525	$	598	$	111,051	$	2,114	$	191,576	$	2,712

We regularly monitor investments for significant declines in fair value. We have determined that the declines in the fair values of these investments below their amortized costs, as set forth in the table above, are temporary based on the following: (i) those declines are due to interest rate changes and not due to a deterioration in the creditworthiness of the issuers of those investment securities, and (ii) we have the ability to hold those securities until there is a recovery in their values.

Capital Resources

Capital Regulatory Requirements Applicable to Banking Institutions. Under federal banking regulations that apply to all United States based bank holding companies and federally insured banks, the Company (on a consolidated basis) and the Bank (on a stand-alone basis) must meet specific capital adequacy requirements that, for the most part, involve quantitative measures that determine the ratios of their capital to their assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. Under those regulations, based primarily on those quantitative measures each bank holding company and each federally insured bank is determined by its primary federal bank regulatory agency to come within one of the following categories.

• well capitalized

• adequately capitalized

• undercapitalized

• significantly undercapitalized; or

• critically undercapitalized

Certain qualitative assessments also are made by a banking institution’s primary federal regulatory agency that could lead the agency to determine that the banking institution should be assigned to a lower capital category than the one indicated by the quantitative measures used to assess the institution’s capital adequacy. At each successive lower capital category, a bank and its bank holding company are subject to greater operating restrictions and increased regulatory supervision by their federal bank regulatory agencies.

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The following table sets forth the amounts of capital and capital ratios of the Company (on a consolidated basis) and the Bank (on a stand alone basis) at June 30, 2005, as compared to the respective minimum regulatory requirements applicable to them.

					Applicable Federal Regulatory Requirement
	Amount		Ratio		Capital Adequacy Purposes				Amount		Ratio
	(Dollars in thousands)
Total Capital to Risk Weighted Assets:
Company	$	111,281	17.0	%	$	52,430	At least 8.0	%	$	65,537	At least 10.0	%
Bank		71,721	11.1	%		51,726	At least 8.0	%		64,657	At least 10.0	%
Tier 1 Capital to Risk Weighted Assets:
Company	$	105,440	16.1	%	$	26,215	At least 4.0	%	$	39,322	At least 6.0	%
Bank		67,394	10.4	%		25,863	At least 4.0	%		38,794	At least 6.0	%
Tier 1 Capital to Average Assets:
Company	$	105,440	11.8	%	$	35,818	At least 4.0	%	$	44,772	At least 5.0	%
Bank		67,394	7.5	%		35,749	At least 4.0	%		44,687	At least 5.0	%

As of June 30, 2005, based on applicable capital regulations, the Company (on a consolidated basis) and the Bank (on a stand-alone basis) qualified as well capitalized institutions under the capital adequacy guidelines described above.

Our consolidated total capital and Tier 1 capital of the Company, at June 30, 2005, include approximately $26.3 million of long term indebtedness evidenced by the Junior Subordinated Debentures that we issued in 2002 and 2004 in connection with the sale of trust preferred securities. The remaining $1.5 million was classified as Tier II capital. See “—Financial Condition—Contractual Obligations” above. We contributed $24 million of the net proceeds from the sale of the trust preferred securities to the Bank, thereby, increasing its total capital and Tier 1 capital.

Dividend Policy and Share Repurchase Program. The Company intends to retain earnings to support future growth and, therefore, does not expect to pay dividends for at least for the next 6-12 months.

In July 2005, our Board of Directors concluded that, at prevailing market prices, the Company’s shares represented an attractive investment opportunity and, therefore, that repurchases of Company shares would be a good use of Company funds. As a result, the Board of Directors approved a share repurchase program, which authorizes Company purchases of up to two percent (2%) of the Company’s outstanding common shares, which is approximately 200,000 shares in total. Purchases will be made in the open market or in private transactions, in accordance with applicable Securities and Exchange Commission rules, when opportunities become available to purchase shares at prices believed to be attractive. The Company is under no obligation to repurchase shares under the share repurchase program and the timing, actual number and value of shares that are repurchased by the Company under this program will depend on a number of factors, including the Company’s future financial performance and available cash resources, competing uses for its corporate funds, prevailing market prices of its common stock and the number of shares that become available for sale at prices that the Company believes are attractive, as well as any regulatory requirements applicable to the Company.

Risks and Uncertainties That Could Affect Our Future Financial Performance

This Report, including the discussion and analysis of our financial condition and results of operations set forth above, contains certain forward-looking statements. Forward-looking statements are estimates of, or expectations or beliefs regarding our future financial performance that are based on current information and that are subject to a number of risks and uncertainties that could cause our actual operating results and financial performance in the future to differ significantly from those expected at the current time. Those risks and uncertainties include, although they are not limited to, the following:

Risks Related to Our Business

We face intense competition from other banks and financial institutions that could hurt our business

We conduct our business operations in Southern California, where the banking business is highly competitive and is dominated by a relatively small number of large multi-state banks with offices operating over wide geographical areas. We also compete with other financial service businesses, mutual fund companies, and securities brokerage and investment banking firms that offer competitive banking and financial products and services. The larger banks, and some of those other financial

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institutions, have greater resources that enable them to conduct extensive advertising campaigns and to shift resources to regions or activities of greater potential profitability. Some of these banks and institutions also have substantially more capital and higher lending limits that could enable them to attract larger clients, and offer financial products and services that we are unable to offer, as a means of also attracting loans and deposits.

Increased competition may prevent us from (i) achieving increases, or could even result in a decrease, in our loan volume or deposit accounts or (ii) increasing interest rates on loans or reducing interest rates we pay to attract or retain deposits, any of which could cause a decline in interest income or an increase in interest expense, that could cause our net interest income and our earnings to decline.

Adverse changes in economic conditions in Southern California could disproportionately harm our business

The large majority of our customers and the properties securing a large proportion of our loans are located in Southern California. A worsening of economic conditions in Southern California could harm our business by:

• reducing loan demand which, in turn, would lead to reduced net interest margins and net interest income;

• affecting the financial capability of borrowers to meet their loan obligations which could, in turn, result in increases in loan losses and require increases in provisions made for possible loan losses, thereby reducing our earnings; and

• leading to reductions in real property values that, due to our reliance on real property to secure many of our loans, could make it more difficult for us to prevent losses from being incurred on non-performing loans through the sale of such real properties.

Additionally, real estate values in California have been increasing rapidly in recent years. In the event that these values are not sustained or other events, such as earthquakes or fires, that may be more prevalent in Southern California than other geographic areas, cause a decline in real estate values, our collateral coverage for our loans will be reduced and we may suffer increased loan losses.

National economic conditions and changes in Federal Reserve Board monetary policies could affect our operating result.

Our ability to achieve and sustain our profitability is substantially dependent on our net interest income. Like most banking organizations and other depository institutions, our interest income is affected by a number of factors outside of our control, including changes in market rates of interest, which in turn are affected by changes in national economic conditions and national monetary policies adopted by the Federal Reserve Board. From 2001 and continuing until June 30, 2004, the Federal Reserve Board followed a policy of reducing interest rates in an effort to stimulate the national economy. Those interest rate reductions, coupled with sluggishness in the economy, led to decreases in our net interest margin during 2003 and made it more difficult to increase earnings. We cannot predict whether the improvement in the economy will continue or whether the Federal Reserve Board’s recent increases in interest rates, which have totaled 225 basis points since June 2004, will succeed in lessening the downward pressure on net interest margins that was prevalent through most of the last three years.

On the other hand, the benefits of increased market rates of interest may be offset, partially or in whole, because those increases will increase the costs of attracting deposits and obtaining borrowings. If we are unable to effectuate commensurate increases in the rates we are able to charge on existing or new loans due to competitive pressures or contractual restrictions on our ability to increase interest rates on existing loans, our net interest margin may suffer despite the increase in interest rates. Changes in economic conditions and increasing rates of interest also could cause prospective borrowers to fail to qualify for our loan products and reduce loan demand, thereby reducing our net interest margins. In addition, if economic conditions were to worsen, that could adversely affect the financial capability of borrowers to meet their loan obligations, which could result in loan losses and require increases in provisions made for possible loan losses.

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Rapid growth could strain our resources and lead to operating problems or inefficiencies

We have grown substantially in the past five years by opening new financial centers. We intend to continue to evaluate the opening of new financial centers, primarily in Southern California, either by opening new offices or acquiring one or more community banks. The opening of new offices or the acquisition of another bank will result in increased operating expenses until new banking offices or acquired banking operations attract sufficient business to cover operating expenses, which usually takes at least six to twelve months. There is no assurance, however, as to how long it would take for new financial centers to begin generating positive cash flow and earnings. Also, we cannot assure that we will be able to adequately manage our growth, which will make substantial demands on the time and attention of management and on our capital resources. The failure to prepare appropriately and on a timely basis for growth could cause us to experience inefficiencies or failures in our service delivery systems, regulatory problems, and erosion in customer confidence, unexpected expenses or other problems.

Additionally, acquisitions of banks are extremely time consuming and expensive, and, in the case of bank acquisitions, subject to regulatory control. Expansion through the acquisition of other banks may also have the following consequences:

• expenses of any undisclosed or potential legal liabilities of the acquired bank;

• costs, delays and difficulties of integrating the acquired bank’s operations, technologies and personnel into our existing operations, organization and culture;

• possible regulatory agency required divestiture of certain assets; and

• issuances of equity securities to pay for acquisitions which may be dilutive to existing shareholders.

We could incur losses on the loans we make

The failure or inability of borrowers to repay their loans is an inherent risk in the banking business. We take a number of measures designed to reduce this risk, including the maintenance of stringent loan underwriting policies and the establishment of reserves for possible loan losses and the requirement that borrowers provide collateral that we could sell in the event they fail to pay their loans. However, the ability of borrowers to repay their loans, the adequacy of our reserves and our ability to sell collateral for amounts sufficient to offset loan losses are affected by a number of factors outside of our control, such as changes in economic conditions, increases in market rates of interest and changes in the condition or value of the collateral securing our loans. As a result, we could incur losses on the loans we make that will hurt our operating results and weaken our financial condition.

Government regulations may impair our operations or restrict our growth

We are subject to extensive supervision and regulation by federal and state bank regulatory agencies. The primary objective of these agencies is to protect bank depositors and other customers and not shareholders, whose respective interests will often differ. The regulatory agencies have the legal authority to impose restrictions which they believe are needed to protect depositors and customers of banking institutions, even if such restrictions would adversely affect the ability of the banking institution to expand its business, or result in increases in its costs of doing business or hinder its ability to compete with financial services companies that are not regulated or banks or financial service organizations that are less regulated. Additionally, due to the complex and technical nature of many of the government regulations to which banking organizations are subject, inadvertent violations may occur. In such an event, we would be required to correct or implement measures to prevent a recurrence of such violations. If more serious violations were to occur, the regulatory agencies could limit our activities or growth, fine us or ultimately put us out of business.

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Our computer and network systems may be vulnerable to unforeseen problems and security risks

The computer systems and network infrastructure that we use to provide automated and Internet banking services could be vulnerable to unforeseen problems. Our operations are dependent upon our ability to protect our computer equipment against damage from fire, power loss, telecommunications failure, earthquakes and similar catastrophic events and from security breaches. Any of those occurrences could result in damage to or a failure of our computer systems that could cause an interruption in our banking services and, therefore, harm our business, operating results and financial condition.

Additionally, interruptions in service and security breaches could lead existing customers to terminate their banking relationships with us and could make it more difficult for us to attract new banking customers.

The loss of key personnel could hurt our financial performance

Our success depends to a great extent on the continued availability of our existing management, in particular on Raymond E. Dellerba, President and Chief Executive Officer. In addition to their skills and experience as bankers, our executive officers provide us with extensive community ties upon which our competitive strategy is partially based. We do not maintain key-man life insurance on these executives, other than Mr. Dellerba. As a result, the loss of the services of any of these officers could harm our ability to implement our business strategy.

Evolving regulation of corporate governance and public disclosure may result in additional expenses and continuing uncertainty

Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and NASDAQ Stock Market rules are creating uncertainty for companies such as ours. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, we intend to invest resources to comply with evolving laws, regulations and standards, and this investment may result in increased general and administrative expenses and a diversion of management time and attention from revenue generating activities to compliance activities. If our efforts to comply with new or changed laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to our practices, our reputation may be harmed or we may be subject to litigation.

Business Decision to Exit the Wholesale Lending Business might not met the expectation of Management

The risk that our decision to concentrate our capital and other resources on our commercial banking business by, among other things, exiting the mortgage banking business, will not turn out to be successful, in terms of the objectives underlying that decision, including growing our commercial banking business and increasing the efficiency of our operations.

Other Risks

Other risks that could affect our future financial performance are described in the Section entitled “Risk Factors” in the Prospectus dated December 8, 2003, included in our S-2 Registration Statement filed with the Securities and Exchange Commission under the Securities Act of 1933, as amended, and in our Annual Report on Form 10-K for the year ended December 31, 2004 filed with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended, and readers are urged to review those risks as well.

Due to these and other possible uncertainties and risks, readers are cautioned not to place undue reliance on the forward looking statements, which speak only as of the date of this Report. We also disclaim any obligation to update forward-looking statements contained in this Report or in the above-referenced S-2 Registration Statement or Annual Report on Form 10-K.

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ITEM 3. MARKET RISK

We are exposed to market risk as a consequence of the normal course of conducting our business activities. The primary market risk to which we are exposed is interest rate risk. Our interest rate risk arises from the instruments, positions and transactions entered into for purposes other than trading. They include loans, securities, deposit liabilities, and short-term borrowings. Interest rate risk occurs when assets and liabilities reprice at different times as market interest rates change. Interest rate risk is managed within an overall asset/liability framework for the Company.

ITEM 4. CONTROLS AND PROCEDURES

Our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) are designed to provide reasonable assurance that information required to be disclosed in our reports filed under that Act (the Exchange Act), such as this Quarterly Report on Form 10-Q, is recorded, processed, summarized and reported within the time periods specified in the rules of the Securities and Exchange Commission. Our disclosure controls and procedures also are designed to provide reasonable assurance that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosures.

Our management, under the supervision and with the participation of our Chief Executive Officer and the Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures in effect as of June 30, 2005. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of June 30, 2005, our disclosure controls and procedures were effective to provide reasonable assurance that material information, relating to the Company and its consolidated subsidiaries, required to be included in our Exchange Act reports, including this Quarterly Report on Form 10-Q, is made known to management, including the Chief Executive Officer and Chief Financial Officer, on a timely basis.

There were no changes in our internal control over financial reporting that occurred during the quarter ended June 30, 2005 that has materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II

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

The Annual Meeting of Shareholders of the Company was held on May 17, 2005. At that Meeting, the shareholders elected the Directors of the Company for a term of one year, ending at the next Annual Meeting of Shareholders to be held in 2006.

(1) Directors Elected at the Annual Meeting. Set forth below is the name of each Director that was nominated and elected at the Annual Meeting and the respective numbers of votes cast for their election and the respective number of votes withheld. As the election was uncontested, there were no broker non-votes.

	Votes Cast
Nominee/Director	For	Withheld
Raymond E. Dellerba	8,287,714	1,319,956
George H. Wells	8,589,339	1,018,331
Ronald W. Chrislip	8,593,719	1,013,951
Julia M. DiGiovanni	8,586,339	1,021,331
Warren T. Finley	8,582,899	1,024,771
John Thomas, M.D.	8,601,719	1,005,951
Robert E. Williams	8,582,652	1,025,018

ITEM 6. EXHIBITS

The following documents are filed Exhibits to the Quarterly Report on Form 10-Q:

Exhibits:
Exhibit 31.1	Certification of Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 31.2	Certification of Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 32.1	Certification of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002
Exhibit 32.2	Certification of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002

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SIGNATURES

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

	PACIFIC MERCANTILE BANCORP
Date: August 8, 2005	By:	/S/ NANCY A. GRAY
		Nancy A. Gray, Chief Financial Officer

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EXHIBIT INDEX

Exhibit No.	Description of Exhibit
31.1	Certification of Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002

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