Pacific Mercantile Bancorp (PMBC) 10-Q 2006 Q1 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 March 31, 2006

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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.)

(Check one):

Large accelerated filer¨                 Accelerated filerx                 Non-accelerated filer¨

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

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.

10,247,690 shares of Common Stock as of May 3, 2006

PACIFIC MERCANTILE BANCORP

QUARTERLY REPORT ON FORM 10Q

FOR

THE QUARTER ENDED MARCH 31, 2006

TABLE OF CONTENTS

		Page No.
Part I	Financial Information
Item 1.	Financial Statements	1
	Consolidated Statements of Financial Condition at March 31, 2006 and December 31, 2005	1
	Consolidated Statements of Income for the Three Months ended March 31, 2006	2
	Consolidated Statement of Comprehensive Income for the Three Months ended March 31, 2006	3
	Consolidated Statements of Cash Flows for the Three Months ended March 31, 2006	4
	Notes to Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11
Item 3.	Market Risk	29
Item 4.	Controls and Procedures	29
Part II.
Item 1A	Risk Factors	30
Item 6.	Exhibits	30
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)

	March 31, 2006			December 31, 2005
ASSETS
Cash and due from banks	$	16,739		$	23,422
Federal funds sold		26,500			11,400
Cash and cash equivalents		43,239			34,822
Interest-bearing deposits with financial institutions		341			441
Federal Reserve Bank and Federal Home Loan Bank Stock, at cost		14,712			13,349
Securities available for sale, at fair value		251,199			265,556
Loans (net of allowances of $5,339 and $5,126, respectively)		675,691			650,027
Investment in unconsolidated subsidiaries		837			837
Accrued interest receivable		4,376			4,040
Premises and equipment, net		2,504			2,570
Other assets		11,187			9,514
Total assets	$	1,004,086		$	981,156
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Noninterest-bearing	$	193,631		$	200,688
Interest-bearing		431,531			379,661
Total deposits		625,162			580,349
Borrowings		264,537			288,684
Accrued interest payable		1,798			2,214
Other liabilities		4,584			3,555
Junior subordinated debentures		27,837			27,837
Total liabilities		923,918			902,639
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, 10,218,690 and 10,176,008 shares issued and outstanding at March 31, 2006 and December 31, 2005, respectively		69,688			69,078
Retained earnings		14,903			13,144
Accumulated other comprehensive loss		(4,423	)		(3,705	)
Total shareholders’ equity		80,168			78,517
Total liabilities and shareholders’ equity	$	1,004,086		$	981,156

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 March 31,
	2006		2005
Interest income:
Loans, including fees	$	11,485	$	7,558
Federal funds sold		108		356
Securities available for sale and stock		2,999		1,822
Interest-bearing deposits with financial institutions		4		5
Total interest income		14,596		9,741
Interest expense:
Deposits		3,271		1,975
Borrowings		3,171		1,450
Total interest expense		6,442		3,425
Net interest income		8,154		6,316
Provision for loan losses		225		120
Net interest income after provision for loan losses		7,929		6,196
Noninterest income		336		393
Noninterest expense		5,342		4,223
Income before income taxes		2,923		2,366
Income tax expense		1,163		981
Income from continuing operations		1,760		1,385
(Loss) income from discontinued operations, net of taxes		—		(157	)
Net income	$	1,760	$	1,228
Net income (loss) per share basic:
Income from continuing operations	$	0.17	$	0.14
Income (loss) from discontinued operations	$	0.00	$	(0.02	)
Net income	$	0.17	$	0.12
Net income (loss) per share diluted:
Income from continuing operations	$	0.16	$	0.13
Income (loss) from discontinued operations	$	0.00	$	(0.02	)
Net income	$	0.16	$	0.11
Weighted average number of shares:
Basic		10,187,688		10,110,125
Diluted		10,838,782		10,856,945

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 March 31,
	2006			2005
Net income	$	1,760		$	1,228
Other comprehensive loss, net of tax:
Change in unrealized loss on securities available for sale, net of tax effect		(718	)		(1,207	)
Total comprehensive income	$	1,042		$	21

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)

	Three Months ended March 31,
	2006			2005
Cash Flows From Operating Activities:
Income from continuing operations	$	1,760		$	1,385
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		248			291
Provision for loan losses		225			120
Net amortization of premium (discount) on securities		180			349
Mark to market loss adjustment of equity securities		43			5
Net gain on sale of fixed assets		—			(15	)
Net increase in accrued interest receivable		(336	)		(398	)
Stock-based compensation expense		175			—
Net decrease (increase) in other assets		726			1,482
Net (increase) decrease in deferred taxes		(1,777	)		(452	)
Net increase in accrued interest payable		(416	)		(454	)
Net increase (decrease) in other liabilities		1,029			14,788
Net cash provided by operating activities		1,857			17,101
Cash Flows From Investing Activities:
Net decrease in interest-bearing deposits with financial institutions		100			265
Maturities of, proceeds from sales of and principal payments received for securities available for sale and other stock		12,800			12,898
Purchase of securities available for sale and other stock		(1,369	)		(59,302	)
Net increase in loans		(25,889	)		(13,604	)
Proceeds from sale of fixed assets		—			15
Purchases of premises and equipment		(183	)		(56	)
Net cash used in investing activities		(14,541	)		(59,784	)
Cash Flows From Financing Activities:
Net increase in deposits		44,813			37,827
Proceeds from exercise of stock options		167			43
Tax benefits from exercise of stock options		268			—
Net decrease in borrowings		(24,147	)		(3,900	)
Net cash provided by financing activities		21,101			33,970
Discontinued Operations:
Cash Flows From Operating Activities
(Loss) income from discontinued operations		—			(157	)
Proceeds from sales of loans held for sale		—			62,132
Originations and purchases of loans held for sale		—			(49,503	)
Net gains on sales of loans held for sale		—			(545	)
Mark to market (gain) loss adjustment of loans held for sale		—			120
Net cash provided by operating activities		—			12,047
Net increase in cash and cash equivalents		8,417			3,334
Cash and Cash Equivalents, beginning of period		34,822			96,109
Cash and Cash Equivalents, end of period	$	43,239		$	99,443
Supplementary Cash Flow Information:
Cash paid for interest on deposits and other borrowings	$	6,858		$	4,082
Cash paid for income taxes	$	710		$	96
Non-Cash Investing Activities:
Net increase in net unrealized losses on securities held for sale, net of income tax	$	(718	)	$	(1,207	)

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, San Bernardino and San Diego Counties of California and is subject to competition from other financial institutions conducting operations in those same markets.

PMB Securities Corp., which commenced operations in June 2002, is 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 an aggregate 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 an additional $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 in 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, 2005 and the notes thereto included in our Annual Report on Form 10–K for the fiscal year ended December 31, 2005, 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 2005, 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.

5

Our consolidated financial position at March 31, 2006, and the consolidated results of our operations for the three month period ended March 31, 2006, 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, 2006.

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. The estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the fair value of securities available for sale, and the valuation of deferred tax assets. Actual amounts or results could differ from those estimates.

Principles of Consolidation

The consolidated financial statements include the accounts of PMBC and its wholly owned subsidiaries Pacific Mercantile Bank and PMB Securities Corp. All significant intercompany accounts and transactions have been eliminated in consolidation.

Nonperforming Loans and Other Assets

At March 31, 2006 and December 31, 2005, we had $449,000 and $1.3 million, respectively, 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. 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

In December 2004, Financial Accounting Standards Board (“FASB”) issued SFAS No. 123(R), “Share-Based Payment”, which requires entities that grant stock options or other equity compensation awards to employees to recognize the fair value of those options and shares as compensation cost over their respective service (vesting) periods in their financial statements. SFAS No. 123(R) is effective beginning in the first quarter of fiscal years ending after June 15, 2005. As a result, effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123(R), using the modified-prospective-transition method. Under this transition method, equity compensation costs that will be recognized in fiscal 2006 will include: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on their grant date fair values estimated in accordance with the original provisions of SFAS No. 123, and (b) compensation cost for all share-based payments granted subsequent to December 31, 2005, based on their grant date fair values estimated in accordance with the provisions of SFAS No. 123(R). Since stock-based compensation that is recognized in the statement of income is to be determined based on the equity compensation awards that we expect will ultimately vest, that compensation expense has been reduced for estimated forfeitures of unvested options that typically occur due to terminations of employment of optionees. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. For purposes of the determination of stock-based compensation expense for the quarter ended March 31, 2006, we estimated forfeitures to be 15% of the unvested options issued.

Prior to January 1, 2006 we had accounted for stock-based employee compensation as prescribed by APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Pursuant to APB No. 25, no stock-based compensation was recognized for income statement purposes, as all of the options that we granted under our stock incentive plans were granted at exercise prices at least equal to the market prices of the underlying shares on their respective dates of grant. Accordingly, our operating results for periods prior to January 1, 2006 will not, to that extent, be comparable to our reported results of operations in periods ending after December 31, 2005.

6

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 Compensation Committee of our Board of Directors 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).

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, in the case of stock options, 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, in case of stock purchase rights, at prices and on such terms as are fixed by the Compensation Committee of the Board of Directors at the time the rights are granted. Options and restricted stock purchase rights may vest immediately or over various periods of up to five years, or based on the achievement of specified performance goals, as 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 terms of up to 10 years after the grant date, but will terminate upon termination of service, if sooner. The Company will become entitled to repurchase any unvested shares subject to restricted purchase rights in the event of a termination of employment or service of the holder of the stock purchase right or in the event the holder fails to achieve any goals that are required to be met as a condition of vesting. A total of 400,000 shares were authorized for issuance under the 2004 Plan.

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 March 31,
Assumptions with respect to:	2006			2005
Expected volatility		35	%		47	%
Risk-free interest rate		4.57	%		3.61	%
Expected dividends		1.07	%		1.04	%
Expected term (years)		6.5			5
Weighted average fair value of option granted during period	$	7.06		$	6.42

The following tables summarize the share option activity under the plans for the three months ended March 31 2006 and 2005.

	Number of Shares	Weighted-Average Exercise Price Per Share		Number of Shares	Weighted-Average Exercise Price Per Share
	2006			2005
Outstanding - January 1,	1,470,698	$	8.51	1,353,848	$	7.73
Granted	32,500		18.05	128,500		15.37
Exercised	43,212		4.34	6,050		7.17
Forfeited/Canceled	9,800		16.24	11,700		9.18
Outstanding - March 31,	1,450,186	$	8.79	1,464,598	$	8.39
Options Exercisable - March 31,	1,050,351	$	7.25	953,083	$	6.61

The aggregate intrinsic values of options exercised for the three months ended March 31, 2006 and 2005 were $653,000 and $52,000, respectively. Total fair values of vested options for the same periods were $214,000 and $254,000, respectively.

7

Outstanding as of March 31, 2006						Exercisable as of March 31, 2006
Range of Exercise Price	Vested	Unvested	Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Life (Years)	Shares	Weighted- Average Exercise Price
$  4.00 –   5.99	237,810		$	4.00	2.92	237,810	$	4.00
$  6.00 –   9.99	646,936	26,140		7.30	4.46	646,936		7.28
$10.00 – 12.99	141,671	228,129		11.27	7.94	141,671		11.25
$13.00 – 17.99	23,934	100,566		15.23	8.91	23,934		15.30
$18.00 – 18.84	—	45,000		18.23	9.78	—		—
	1,050,351	399,835	$	8.79	5.64	1,050,351	$	7.25

The aggregate intrinsic values of options that were outstanding and those that were exercisable under the plans at March 31, 2006 were $14.3 million and $12.0 million, respectively.

A summary of the status of the unvested shares as of December 31, 2005, and changes during the quarter ended March 31, 2006, is set forth in the following table.

	Shares		Weighted-Average Grant Date Fair Value
Unvested at December 31, 2005	416,436		$	12.44
Granted	32,500			18.05
Vested	(39,301	)		12.13
Forfeited/Canceled	(9,800	)		6.57
Unvested at March 31, 2006	399,835		$	12.83

The aggregate amount charged against income in relation to the stock-based awards was $175,000 for the three months ended March 31, 2006. At March 31, 2006, compensation expense related to non-vested stock option grants aggregated $2 million, which is expected to be recognized as follows:

	Stock Option Compensation Expense
	(In thousands)
Remainder of 2006	$	487
For the year ended December 31,
2007		624
2008		582
2009		268
2010		74
2011		4
Total	$	2,039

As a result of SFAS No. 123(R), our income before income taxes for the three months ended March 31, 2006 was $175,000 lower, and our basic and diluted net income per share for the three months ended March 31, 2006 were $0.02 lower, than if it had continued to account for share-based compensation under APB Opinion 25.

8

Comprehensive Income

Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. 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, and such items, along with net income, are components of comprehensive income.

Recent Accounting Pronouncements

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 2005 consolidated financial statements, including amounts related to discontinued operations, have been reclassified to conform to 2006 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 March 31, 2006, the Company was committed to $206 million in loan commitments and $7.4 million in letters of credit. The contractual amount of a credit-related financial instrument such as a commitment to extend credit, a credit-card arrangement or a letter of credit represents the amounts of potential accounting loss should the contract be fully drawn upon, the customer default, and the value of any existing collateral securing the contract 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 creditworthiness 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.

9

In the ordinary course of business, we are subject to legal actions normally associated with financial institutions. At March 31, 2006, 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.

3. Discontinued Business

In the second quarter of 2005, 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 businesses comprise our continuing operations with commercial banking the only reportable business segment; while, in 2005, the wholesale mortgage lending business was classified as discontinued operations. We completed our exit from the wholesale lending business during the fourth 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
	March 31, 2006		March 31, 2005
	(In thousands)
Income (loss) from discontinued operations, before income taxes	$	—	$	(267	)
Income tax (expense) benefit		—		(110	)
(Loss) income from discontinued operations, net of taxes	$	—	$	(157	)

As of March 31, 2006 and December 31, 2005, there were no loans held for sale by the wholesale mortgage lending division.

4. Subsequent Event

On April 7, 2006, we entered into a stock purchase agreement that provides for the sale by us of all of the stock of PMB Securities Corp. (“PMB Securities”), our wholly-owned retail securities brokerage subsidiary, to its President, Gary D. Cohee. The purchase price that is payable to us for PMB Securities is $220,000, which is subject to certain closing adjustments that are not expected to materially change that price. Consummation of the sale of PMB Securities is subject to satisfaction of certain conditions, including the obtaining of any required third party consents. It is currently anticipated that the sale will be consummated in the second quarter of this year. We do not expect this transaction to result in any material gain or loss. We do not expect to offer retail brokerage services following completion of this sale, at least for the foreseeable future.

As a result of our decision to sell PMB Securities, for accounting purposes that business will be classified in our financial statements, for periods prior to the consummation of the sale, as discontinued operations.

10

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, San Bernardino 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 month period ended March 31, 2006 and 2005 and our consolidated financial condition, liquidity and capital resources at March 31, 2006 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. 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 factors 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. Certain of those risks factors are summarized below, in this Item 2, under the caption “Risks that could Affect our Future Financial Performance” and those, as well as other, risks are discussed in detail in Item 1A, “Risk Factors,” in our 2005 Form 10-K and readers of this Report are urged to that summary below and read Item 1A in the 2005 Form 10-K in conjunction with this Report.

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. Certain of those accounting policies are considered critical accounting policies, because they require us to make estimates and assumptions regarding circumstances or trends that could affect the value of those assets, such as economic conditions or trends in those conditions that could impact our ability to fully collect our loans or ultimately realize the carrying value of certain of our other assets. Those estimates and assumptions are made based on current information available to us regarding those economic conditions or trends or other circumstances. Many of those conditions, trends and circumstances, however, are outside of our control and, if changes were to occur in the events, trends or other circumstances on which our estimates or assumptions were based, or other unanticipated events were to happen that might affect our operations, we may be required under GAAP to adjust our earlier estimates that are affected by those changes or events; and such adjustments may require that we reduce the carrying value of the affected assets on our balance sheet. Our critical accounting policies relate to the determination of our allowance for loan losses, the fair value of securities available for sale and the valuation of deferred tax assets.

11

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 conditions and trends that can affect the ability of our borrowers to meet their loan payment obligations to us. 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. If, however, unanticipated changes were to occur in those conditions or trends, actual loan losses could be greater than those predicted by those loss factors and our prior assessments of current conditions and economic trends. In such an event, it could 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 the 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 entitled “—Provision for Loan Losses” and “—Allowance for Loan Losses and Nonperforming Loans” below.

Fair Value of Securities Available for Sale. We determine the fair value of our securities by obtaining quotes from third party vendors and securities brokers. When quotes are not available, a reasonable fair value is determined by using a variety of industry standard pricing techniques including, but not limited to, discounted cash flow analysis, matrix pricing, option adjusted spread models, as well as fundamental analysis. These pricing techniques are based on various assumptions such as, but not limited to, future prepayment speeds, yield, duration, monetary policy and demand and supply for the individual securities.

Utilization of Deferred Income Tax Benefits. The provision that we make for income taxes is based on, among other things, our ability to use certain income tax benefits available under state and federal income tax laws to reduce our income tax liability. As of March 31, 2006, the total of the unused income tax benefits (referred to in our consolidated financial statements as a “deferred tax asset”), available to reduce our income taxes in future periods was $5.9 million. Unless used, such tax benefits expire over time. Therefore, the realization of those benefits is dependent on our generating taxable income in the future in amounts sufficient to enable us to use those tax benefits prior to their expiration. We have made a judgment, based on historical experience and current and anticipated market and economic conditions and trends, that it is more likely than not that we will generate taxable income in future years sufficient to fully utilize those benefits. In the event that our income were to decline in future periods making it less likely that those benefits could be fully utilized, we could be required to establish a valuation reserve to cover the potential loss of those tax benefits by increasing the provision we make for income taxes, which would have the effect of reducing our net income in the period when that valuation reserve is established.

Discontinued Business

In June 2005, we decided to exit the wholesale mortgage lending business in order to concentrate our capital and management resources on expanding our commercial banking business. This decision was based on a number of factors, which included the steady growth achieved in, and the opportunities to further expand, our 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 could 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 lending business, which would make it more difficult to achieve consistency and predictability in our results of operations; and the amount of capital that would be required to grow and improve the profitability of the wholesale mortgage lending business, particularly in the face of the changing interest rate and market environment. The exit of the wholesale mortgage loan operations was completed in the in the fourth quarter of 2005.

In accordance with Statement of Financial Accounting Standard (“SFAS”) 144, the operating results of the wholesale mortgage lending business have been classified as discontinued operations and prior period financial statements have been restated on that same basis.

Additionally, as a result of exit from our wholesale mortgage lending business, our commercial banking business, together with our retail securities brokerage business that is conducted by PMB Securities Corp. constitute our continuing operations and the discussion that follows focuses almost entirely on those continuing operations.

12

Overview of Operating Results in the Three Months Ended March 31, 2006

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 months ended March 31, 2006 and 2005.

	Three Months Ended March 31,
	2006 Amounts		2005 Amounts			Percent Change
	(Unaudited)
	(Dollars in thousands except per share data)
Interest income	$	14,596	$	9,741		49.8	%
Interest expense		6,442		3,425		88.1	%
Net interest income	$	8,154	$	6,316		29.1	%
Noninterest income	$	336	$	393		(14.5	)%
Noninterest expense	$	5,342	$	4,223		26.5	%
Income from continuing operations(1)	$	1,760	$	1,385		27.1	%
Loss from discontinued operations(1)	$	—	$	(157	)	N/M
Net income	$	1,760	$	1,228		43.3	%
Net income per share — diluted
Income from continuing operations	$	0.16	$	0.13		23.1	%
Income (loss) from discontinued operations	$	—	$	(0.02	)	N/M
Net income per share — diluted	$	0.16	$	0.11		45.5	%
Weighted average number of diluted shares		10,838,782		10,856,945		(0.2	)%

⁽¹⁾ Net of taxes

Key Factors Affecting Operating Results in the Three Months Ended March 31, 2006

During the first quarter of 2006, we generated income from continuing operations of $1,760,000, an increase of $375,000, or 27%, as compared to the same quarter of 2005. That increase was principally the result of an increase of $4,855,000, or nearly 50%, in interest income in the first quarter this year, as compared to the same quarter last year, primarily as a result of the growth in our loan volume. Loans grew by $151 million, or 29%, to $676 million at March 31, 2006 from $525 million at March 31, 2005. That increase in loan volume also contributed, and the resulting increase in interest income led to an improvement in our net interest margin to 3.46% for this year’s first quarter from 3.26% for the same quarter of 2005.

The increase in interest income more than offset a $3,017,000, or 88%, increase in interest expense in the quarter ended March 31, 2006, and as a result, our net interest income increased by $1,838,000, or 29% in that quarter to $8,154,000 from $6,196,000 in the first quarter of 2005.

The increase in net interest income more than offset a $1,119,000 increase in noninterest expense in the quarter ended March 31, 2006. That increase in noninterest expense was due primarily to (i) growth-related expenses incurred in connection with the opening, in June 2005, of our Ontario, California Financial Center, and the addition of experienced commercial banking officers at our Financial Centers and our new Corporate Banking Division during the 12 months ended March 31, 2006, and (ii) the recognition of $175,000 of stock-based compensation stock that was attributable to the adoption of SFAS No. 123R (“Share based Payments”) effective January 1, 2006. Stock-based compensation was not required to be recognized in the same period of 2005.

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

	Three Months Ended March 31,
	2006		2005
	(Unaudited)
Return on average assets(1)	0.73	%	0.66	%
Return on average shareholders’ equity(1)	8.91	%	7.45	%
Net interest margin(2)	3.46	%	3.26	%

⁽¹⁾ Annualized.

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

13

Results of Operations

Net Interest Income

One of the principal determinants of a bank’s income is 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 monetary policies of the Federal Reserve Board which affect interest rates, the demand for loans, and the ability of borrowers to meet their loan payment obligations. Net interest income, when expressed as a percentage of total average interest earning assets, is a banking organization’s “net interest margin.”

The following table sets forth our interest income, interest expense, net interest income (in thousands of dollars) and net interest margin in the three months ended March 31, 2006 and 2005, respectively:

	Three Months Ended March 31,
(Dollars in thousands except per share data)	2006 Amount			2005 Amount			Percent Change
	(Unaudited)
Interest income	$	14,596		$	9,741		49.8	%
Interest expense		6,442			3,425		88.1	%
Net interest income	$	8,154		$	6,316		29.1	%
Net interest margin		3.46	%		3.26	%

As the table above indicates, our net interest income increased by $1.8 million, or 29%, in the first quarter of 2006, as compared to the same period of 2005. This increase was primarily attributable to an increase in interest income of $4.8 million, or 50%, in the three month period of 2006, as compared to the same period of 2005, which more than offset an increase in interest expense of $3 million, or 88% in the three month period ended March 31, 2006 over the corresponding period of 2005.

The increase in interest income in the three month period ended March 31, 2006, was primarily attributable to (i) an increase in the volume of average interest earning assets, including an increase of $147 million in the average volume of outstanding loans (exclusive of mortgages held for sale) over the corresponding period of 2005, and (ii) to a lesser extent, the increase in market rates of interest since March 31, 2005.

The increase in interest expense in the three months ended March 31, 2006, as compared to the same period last year, was primarily attributable to increases of $157 million in the average volume of interest bearing liabilities and the rise in market rates of interest subsequent to March 31, 2005, 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 3.46% in the first quarter of 2006 from 3.26% in the same quarter of 2005. In the three months ended March 31, 2006 the yield on average interest earning assets improved to 6.21%, while the average rate of interest paid on our average interest bearing liabilities increased to 3.65%, as compared to a yield on average interest earning assets of 5.05% and an average rate of interest paid on average interest bearing liabilities of 2.49%, in the same three months of 2005.

This improvement in the average yield on interest earning assets was due primarily to the substantial increase in the volume of loans on which we generate greater yields than on our other interest earning assets and, to a lesser extent, the increase in interest rates during the 12 months ended March 31, 2006.

The following table sets forth changes in interest income, including loan fees, and interest paid in the three month period ended March 31, 2006, as compared to the same period in 2005 and the extent to which those changes were

14

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 March 31, 2006 vs 2005 Increase (decrease) due to:
	Volume(1)			Rate(1)		Total
	(Unaudited)
	(Dollars in thousands)
Interest income:
Short-term investments(2)	$	(424	)	$	176	$	(248	)
Securities available for sale and stock		765			411		1,176
Loans		2,370			1,557		3,927
Total earning assets		2,711			2,144		4,855
Interest expense:
Interest-bearing checking accounts		9			2		11
Money market and savings accounts		(10	)		209		199
Certificates of deposit		300			787		1,087
Borrowings		919			672		1,591
Junior subordinated debentures		—			129		129
Total interest-bearing liabilities		1,218			1,799		3,017
Net interest income	$	1,493		$	345	$	1,838

⁽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 increase of $1.8 million in our net interest income in the three month period ended March 31, 2006, as compared to the like period in 2005, was the result of increases of $1.5 million and $345,000, respectively, in volume and rate variance, respectively, for the three month period ended March 31, 2006, as compared to the same period in 2005. The increases in the volume variance reflect the increases in average earning assets of $170 million and in average interest-bearing liabilities of $157 million in the three month period ended March 31, 2006, as compared to the corresponding period of 2005.

Provision for Loan Losses

The failure or inability of borrowers to repay their loans is an inherent risk of the banking business. Therefore, 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 the Allowance. The amount of the Allowance 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 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 have to be made to replenish or increase the Allowance.

15

During the first quarter of 2006, we made provisions, totaling $225,000, for potential loan losses, as compared to $120,000 in the same quarter of 2005. That increase was primarily due to the increase in outstanding loans at March 31, 2006 as compared to March 31, 2005. At March 31, 2006, the Allowance for Loan Losses totaled $5.3 million, or 0.78% of loans then outstanding, as compared to $4.2 million, or 0.78% of loans outstanding, at March 31, 2005.

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 That Could Affect our Future Financial Performance—we could incur losses on the loans we make.” If changes in economic or market conditions or unexpected subsequent events were to occur, it could become necessary to incur additional charges to increase the Allowance, which would have the effect of reducing our income or causing 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 adequacy of our Allowance for Loan Losses. These agencies may require us to make additional provisions, over and above the provisions that 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 securities brokerage services.

The following table identifies the components of and the percentage changes in noninterest income in the three month period ended March 31, 2006, as compared to the same respective periods of 2005. As indicated below noninterest income decreased by $57,000, or 15%, in the first quarter of 2006, as compared to the same quarter in 2005, primarily as a result of a decline in securities brokerage commission earned by PMB Securities Corp., our retail securities brokerage subsidiary.

	Three Months Ended March 31,
	Amount				Percentage Change 2006 vs. 2005
	2006		2005
	Unaudited
	(Dollars in thousands)
Service fees on deposits	$	163	$	164	(0.6	)%
Brokerage commissions		51		146	(65.1	)%
Other		122		83	47.0	%
Total noninterest income	$	336	$	393	(14.5	)%

16

Noninterest Expense

The following table compares the amounts (in thousands of dollars) of the principal components of noninterest expense in the three months ended March 31, 2006 to the same three months of 2005.

	Three Months Ended March 31,
	Amount				Percentage Change 2006 vs. 2005
	2006		2005
	Unaudited
	(Dollars in thousands)
Salaries and employee benefits	$	3,036	$	2,288	32.7	%
Occupancy		658		532	23.7	%
Equipment and depreciation		334		377	(11.4	)%
Data processing		163		117	39.3	%
Professional fees		351		212	65.6	%
Customer expense		156		99	57.6	%
Other operating expense(1)		644		598	7.7	%
	$	5,342	$	4,223	26.5	%

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

Due primarily to the growth of our commercial banking operations, non-interest expense increased by $1.1 million, or 27%, to $5.3 million in the quarter ended March 31, 2006 from approximately $4.2 million in the same quarter of 2005. The increases in non-interest expense were primarily attributable to (i) the June 2005 opening of our new Inland Empire Financial Center in Ontario, along with the addition of commercial loan officers in our Southern California Financial Centers and our new Corporate Banking Division, located in Costa Mesa during the last 12 months ended March 31, 2006, and (ii) the recognition of $175,000 of stock-based compensation as a result of the adoption, effective as of January 1, 2006, of SFAS 123R, “Share-Based Payment.” Stock based compensation was not required to be recognized in any years prior to 2006.

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 growth related expenses and the recognition of stock based compensation for the first time in the quarter ended March 31, 2006, our efficiency ratio (operating expenses as a percentage of total revenues from continuing operations) in that quarter remained unchanged from the same quarter of 2005, at 63%.

We anticipate that noninterest expense also will be higher during the remainder of this year, as compared to the same period of 2005, due primarily to the expansion of our banking franchise resulting from the opening of our Ontario Financial Center in mid-year 2005 and the expansion of our lending staff that occurred during 2005 and the first quarter of 2006.

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, 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

17

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 March 31, 2006. 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
	Unaudited
	(Dollars in thousands)
Assets
Interest-bearing deposits in other financial institutions	$	341		$	—		$	—		$	—		$	—		$	341
Investment in unconsolidated trust subsidiaries		—			—			—			—			837			837
Securities available for sale		20,374			36,842			127,928			66,055			—			251,199
Federal Reserve Bank and Federal Home Loan Bank stock		13,066			—			—			1,646			—			14,712
Federal funds sold		26,500			—			—			—			—			26,500
Loans, gross		312,109			66,097			229,365			73,459			—			681,030
Non-interest earning assets, net		—			—			—			—			29,467			29,467
Total assets	$	372,390		$	102,939		$	357,293		$	141,160		$	30,304		$	1,004,086
Liabilities and Shareholders Equity
Noninterest-bearing deposits	$	—		$	—		$	—		$	—		$	193,631		$	193,631
Interest-bearing deposits		232,204	(1)		124,888	(2)		74,439	(3)		—			—			431,531
Borrowings		85,537			156,000			23,000			—			—			264,537
Junior subordinated debentures		22,682			5,155			—			—			—			27,837
Other liabilities		—			—			—			—			6,382			6,382
Shareholders’ equity		—			—			—			—			80,168			80,168
Total liabilities and shareholders equity	$	340,423		$	286,043		$	97,439		$	0		$	280,181		$	1,004,086
Interest rate sensitivity gap	$	31,967		$	(183,104	)	$	259,854		$	141,160		$	(249,877	)
Cumulative interest rate sensitivity gap	$	31,967		$	(151,137	)	$	108,717		$	249,877		$	—
Cumulative % of rate sensitive assets in maturity period		37	%		47	%		83	%		97	%		100	%
Rate sensitive assets to rate sensitive liabilities		109	%		36	%		367	%		N/A			N/A
Cumulative ratio		109	%		76	%		115	%		135	%		N/A

¹ Net of Bancorp’s money market demand account of $14.8 million

² Net of Bancorp’s certificate of deposit of $250,000

³ Net of Bancorp’s certificate of deposit of $5,000,000

At March 31, 2006, our rate sensitive balance sheet was shown to be in a negative twelve-month gap position. This would imply that our net interest margin would decrease in the short–term if interest rates rise and would increase in the

18

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.

Financial Condition

Assets

Our total consolidated assets increased by $23 million, or 2%, to $1 billion at March 31, 2006 from $981 million at December 31, 2005, primarily as a result of increases in loan volume. Those increases were funded by increases in deposits and in borrowings.

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

	March 31, 2006		December 31, 2005
	Unaudited
	(In thousands)
Federal funds sold	$	26,500	$	11,400
Interest-bearing deposits with financial institutions		341		441
Federal Reserve Bank and Federal Home Loan Bank Stock, at cost		14,712		13,349
Securities available for sale, at fair value		251,199		265,556
Loans (net of allowances of $5,339 and $5,126, respectively)		675,691		650,027

Loans

The following table sets forth the composition, by loan category, of our loan portfolio, at March 31, 2006 and December 31, 2005:

	March 31, 2006					December 31, 2005
	Amount			Percent		Amount			Percent
	Unaudited
	(Dollars in thousands)
Commercial loans	$	181,839		26.7	%	$	187,246		28.6	%
Real estate loans		259,798		38.1	%		241,866		36.9	%
Residential mortgage loans		181,798		26.7	%		173,685		26.5	%
Construction loans		53,828		7.9	%		47,056		7.2	%
Consumer loans		4,403		0.6	%		5,523		0.8	%
Gross loans		681,666		100.0	%		655,376		100.0	%
Deferred fee (income) costs, net		(636	)				(223	)
Allowance for loan losses		(5,339	)				(5,126	)
Loans, net	$	675,691				$	650,027

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.

19

The following tables set forth the maturity distribution of our loan portfolio (excluding consumer and residential mortgage loans) at March 31, 2006:

	March 31, 2006
	One Year or Less		Over One Year Through Five Years		Over Five Years		Total
	Unaudited
	(Dollars in thousands)
Real estate and construction loans(1)
Floating rate	$	120,850	$	98,385	$	10,982	$	230,217
Fixed rate		4,788		23,833		54,788		83,409
Commercial loans
Floating rate		126,180		10,389		0		136,569
Fixed rate		22,274		19,305		3,691		45,270
Total	$	274,092	$	151,912	$	69,461	$	495,465

⁽¹⁾ Does not include mortgage loans on single and multi-family residences and consumer loans, which totaled $181.8 million and $4.4 million, respectively, at March 31, 2006.

Allowance for Loan Losses and Nonperforming Loans

Allowance for Loan Losses. The allowance for loan losses (the “Allowance”) at March 31, 2006 was $5.3 million, which represented approximately 0.78% of the loans outstanding at March 31, 2006, as compared to $5.1 million, or 0.78%, of the loans outstanding at December 31, 2005, 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 bank regulatory guidelines in determining the adequacy of the Allowance. We believe that the Allowance at March 31, 2006 was 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 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 three months ended March 31, 2006 and the year ended December 31, 2005:

	March 31, 2006			December 31, 2005
	Unaudited
	(In thousands)
Balance, beginning of period	$	5,126		$	4,032
Provision for loan losses		225			1,145
Amounts charged off		(12	)		(51	)
Balance, end of period	$	5,339		$	5,126

20

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 March 31, 2006 and December 31, 2005, we had $449,000 and $1.3 million, respectively, of fully collateralized loans that were delinquent 90 days or more and which were 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 March 31, 2006 or December 31, 2005. At March 31, 2006, our average investment in impaired loans, on a year-to-date basis, was $1.3 million, which included a nonaccrual loan that was paid prior to the quarter end. The interest that we would have earned in the three months ended March 31, 2006, had the impaired loans remained current in accordance with their original terms was $25,000.

Deposits

Average Balances of and Average Interest Rates Paid on Deposits. Set forth below are the average amounts (in thousands of dollars) of, and the average rates paid on, deposits for the three months ended March 31, 2006:

	Three Months Ended March 31, 2006
	Unaudited
	Average Balance		Average Rate
	(Dollars in thousands)
Noninterest-bearing demand deposits	$	186,239	—
Interest-bearing checking accounts		27,892	0.58	%
Money market and savings deposits		134,464	2.39	%
Time deposits		241,407	4.10	%
Average total deposits	$	590,002	2.25	%

Deposit Totals. Deposits totaled $625 million at March 31, 2006 as compared to $580 million at December 31, 2005. At March 31, 2006, noninterest-bearing deposits totaled $194 million and represented 31% of total deposits, as compared to $201 million and 35% of total deposits at December 31, 2005. At March 31, 2006, certificates of deposit in denominations of $100,000 or more totaled $153 million and represented 24% of total deposits, as compared to $136 million and 23% of total deposits at December 31, 2005. Set forth below is a maturity schedule of domestic time certificates of deposit outstanding at March 31, 2006:

	At March 31, 2006
	Certificates of Deposit Under $100,000		Certificates of Deposit of $100,000 or More
	Unaudited
	(In thousands)
Maturities
Three months or less	$	11,196	$	45,953
Over three and through twelve months		47,455		77,433
Over twelve months		44,684		29,756
Total certificates of deposit	$	103,335	$	153,142

21

Liquidity

We actively manage our liquidity needs to ensure that 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, and 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 $21 million was provided by financing activities during the three months ended March 31, 2006, the source of which consisted primarily of net increases of $45 million in deposits offset by a net decrease of $24 million in net borrowings.

Cash flow From Operating Activities. Cash flow of $2 million was provided by our continuing operations during the three months ended March 31, 2006.

Cash flow Used in Investing. In the three months ended March 31, 2006, we used cash flow of $15 million in investing activities, primarily to fund an increase of $26 million in loans, partially offset by $13 million of proceeds from principal payments received on investment securities available for sale.

Cash flow From Discontinued Operations. The exit from our discontinued wholesale mortgage lending operations was completed in the fourth quarter of 2005, therefore, there were no cash flow activity from discontinued operations during the quarter ended March 31, 2006.

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 $112 million or 11% of total assets at March 31, 2006.

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 March 31, 2006, the ratio of loans-to-deposits was 108%, compared to 112% at December 31, 2005. Even though our loans-to-deposits ratio was 108%, the Company maintained adequate liquidity supported by Federal Home Loan Bank advances and securities sold under agreement to repurchase.

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 March 31, 2006 and December 31, 2005, we were committed to fund certain loans amounting to approximately $206 million and $156 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 underwriting standards that we would apply if we were approving loans to the customer. In addition, we often require the

22

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 March 31, 2006, we had $23 million of outstanding long-term borrowings and $236 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) of, 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 4.09%.

Principal Amounts	Interest Rate		Maturity Dates	Principal Amounts		Interest Rate		Maturity Dates
(Dollars in thousands)				(Dollars in thousands)
$10,000	4.38	%	April 10, 2006	$	12,000	4.86	%	September 7, 2006
5,000	4.18	%	April 10, 2006		11,000	4.94	%	September 14, 2006
5,000	3.26	%	April 10, 2006		3,000	2.56	%	September 18, 2006
7,000	3.59	%	May 1, 2006		3,000	2.49	%	September 25, 2006
7,000	4.73	%	May 4, 2006		5,000	2.39	%	October 2, 2006
5,000	4.21	%	May 10, 2006		2,000	2.4	%	October 2, 2006
5,000	3.62	%	May 18, 2006		7,000	4.83	%	October 10, 2006
5,000	4.73	%	May 25, 2006		5,000	4.96	%	October 19, 2006
7,000	4.78	%	June 2, 2006		5,000	4.96	%	November 9, 2006
7,000	3.62	%	June 7, 2006		10,000	5.04	%	November 16, 2006
4,000	4.9	%	June 15, 2006		7,000	3.18	%	November 22, 2006
8,000	4.85	%	June 16, 2006		5,000	2.69	%	December 12, 2006
5,000	3.13	%	June 19, 2006		10,000	5.03	%	December 14, 2006
3,000	4.65	%	July 5, 2006		5,000	2.67	%	December 18, 2006
5,000	3.78	%	July 6, 2006		10,000	5.03	%	January 18, 2007
7,000	3.72	%	July 6, 2006		4,000	2.5	%	January 22, 2007
5,000	3.63	%	July 10, 2006		5,000	2.57	%	February 12, 2007
3,000	4.67	%	July 20, 2006		5,000	3.87	%	May 18, 2007
5,000	4.8	%	August 3, 2006		7,000	4.71	%	June 20, 2007
5,000	2.76	%	August 9, 2006		3,000	3.14	%	September 18, 2007
7,000	4.19	%	August 10, 2006		2,000	3.06	%	September 24, 2007
5,000	4.13	%	August 15, 2006		1,000	2.91	%	October 1, 2007
2,000	2.94	%	August 28, 2006		5,000	3.45	%	February 11, 2009

At March 31, 2006, U.S. Agency and Mortgage Backed securities, U.S. Government agency securities and collateralized mortgage obligations with an aggregate fair market value of $182 million and $156 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.

The highest amount of borrowings outstanding at any month end during the three months ended March 31, 2006 consisted of $263 million of borrowings from the Federal Home Loan Bank and $20 million of overnight borrowings in the form of securities sold under repurchase agreements. During 2005, the highest amount of borrowings outstanding at any month end consisted of $249 million of advances from the Federal Home Loan Bank and $40 million of overnight borrowings in the form of securities sold under repurchase agreements.

23

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. The Debentures also were pledged by the grantor trusts as security for their payment obligations under 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 of 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 March 31, 2006:

Original Issue Dates	Principal Amount		Interest Rates		Maturity Dates
	(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, which are redeemable at our option, without premium or penalty, beginning five years after their respective original issue dates, require quarterly or semi-annual interest payments. Subject to certain conditions, we have the right, at our discretion, to defer those interest payments for up to five years. However, we have no plans to exercise this deferrable right.

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 March 31, 2006, a total amount of $27.8 million principal amount of those Debentures qualified, as Tier I capital for regulatory purposes.

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;

• 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;

24

• 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 March 31, 2006 and December 31, 2005:

	Amortized Cost		Gross Unrealized Gain		Gross Unrealized Loss		Estimated Fair Value
	Unaudited
	(Dollars in thousands)
March 31, 2006
Securities Available For Sale:
Mortgage-backed securities	$	221,095	$	—	$	6,839	$	214,256
Collateralized mortgage obligations		24,513		—		702		23,811
Total government and agencies securities		245,608		—		7,541		238,067
Municipal securities		11,651		49		25		11,675
Mutual fund		1,457		—		—		1,457
Total Securities Available For Sale	$	258,716	$	49	$	7,566	$	251,199
December 31, 2005
Securities Available For Sale:
U.S. agencies and mortgage-backed securities	$	233,405	$	10		5,621	$	227,794
Collateralized mortgage obligations		25,190		—		583		24,607
Total government and agencies securities		258,595		10		6,204		252,401
Municipal securities		11,651		56		38		11,669
Mutual fund		1,486		—		—		1,486
Total Securities Available For Sale	$	271,732	$	66	$	6,242	$	265,556

At March 31, 2006, U.S. Agencies and Mortgage Backed securities, U.S. Government Agency securities and collateralized mortgage obligations with an aggregate fair market value of $182 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 March 31, 2006, 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 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
(Dollars in thousands)	One year or less			Over one year through five years			Over five years through ten years			Over ten years			Total
	Unaudited
Securities available for sale, amortized cost	$	46,863		$	114,502		$	58,263		$	39,088		$	258,716
Securities available for sale, estimated fair value		45,547			110,907			56,369			38,376			251,199
Weighted average yield		4.05	%		4.15	%		4.45	%		4.57	%		4.26	%

25

The table below shows as of March 31, 2006, 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 March 31, 2006
	Less than 12 months				12 months or more				Total
(Dollars In thousands)	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
	Unaudited
US agencies and mortgage backed securities	$	86,625	$	1,735	$	127,631	$	5,104	$	214,256	$	6,839
Collateralized mortgage obligations		13,552		258		10,259		444		23,811		702
Municipal securities		4,228		25		—		—		4,228		25
Total temporarily impaired securities	$	104,405	$	2,018	$	137,890	$	5,548	$	242,295	$	7,566

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.

26

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 March 31, 2006, as compared to the respective minimum regulatory requirements applicable to them.

					Applicable Federal Regulatory Requirement
	Actual				Capital Adequacy Purposes					To be Categorized Well Capitalized
	Amount		Ratio		Amount		Ratio			Amount	Ratio
	(Dollars in thousands)
Total Capital to Risk Weighted Assets:
Company	$	117,500	15.4	%	$	60,900	At least 8.0	%	$76,125		At least 10.0	%
Bank		80,631	10.9	%		59,341	At least 8.0	%	74,176		At least 10.0	%
Tier 1 Capital to Risk Weighted Assets:
Company	$	112,161	14.8	%	$	30,450	At least 4.0	%	$45,675		At least 6.0	%
Bank		75,000	10.1	%		29,670	At least 4.0	%	44,505		At least 6.0	%
Tier 1 Capital to Average Assets:
Company	$	112,161	11.8	%	$	38,120	At least 4.0	%	$47,650		At least 5.0	%
Bank		75,000	7.7	%		39,136	At least 4.0	%	48,920		At least 5.0	%

As of March 31, 2006, 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 March 31, 2006, include an aggregate of $27.8 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. We contributed $26 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 analyze the cash flow requirements in order to determine if we will pay dividends in the next three to twelve 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 to purchase up to two percent (2%) of the Company’s outstanding common shares, which are approximately 200,000 shares in total. Purchases may 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. To date the Company has not purchased any stock under this program.

Risks 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 set forth are estimates of, or our expectations, beliefs or views 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:

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. 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.

27

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. For example, adverse changes in economic conditions, and increasing rates of interest as a result of the Federal Reserve Board’s monetary policies, could cause prospective borrowers to fail to qualify for our loan products and reduce loan demand, thereby reducing our net interest margins. In addition, such conditions 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.

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.

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.

28

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.

Other Risks

Other risks that could affect our future financial performance are described in Item 1A , entitled “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2005 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 our Annual Report on Form 10-K.

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 March 31, 2006. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of March 31, 2006, 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 March 31, 2006 that has materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

29

PART II

ITEM 1A.  RISK FACTORS

There have been no material changes from the risk factors previously disclosed in Item 1A, “Risk Factors,” in our Annual Report on Form 10K for the fiscal year ended December 31, 2005.

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

30

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: May 9, 2006	By:	/s/ NANCY A. GRAY
		Nancy A. Gray, Chief Financial Officer

S-1

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

E-1