Pacific Mercantile Bancorp (PMBC) 10-Q 2007 Q3 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 September 30, 2007

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.    Yes  x    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 filer  x                    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  ¨    No  x

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.

10,505,899 shares of Common Stock as of November 6, 2007

PACIFIC MERCANTILE BANCORP

QUARTERLY REPORT ON FORM 10Q

FOR

THE QUARTER ENDED SEPTEMBER 30, 2007

TABLE OF CONTENTS

		Page No.
Part I.	Financial Information
Item 1.	Financial Statements	1
	Consolidated Statements of Financial Condition at September 30, 2007 and December 31, 2006	1
	Consolidated Statements of Income for the Three and Nine Months ended September 30, 2007 and 2006	2
	Consolidated Statement of Comprehensive Income for the Three and Nine Months ended September 30, 2007 and 2006	3
	Consolidated Statements of Cash Flows for the Nine Months ended September 30, 2007 and 2006	4
	Notes to Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3.	Market Risk	32
Item 4.	Controls and Procedures	32
Part II.
Item 1A.	Risk Factors	33
Item 6.	Exhibits	33
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)

	September 30, 2007			December 31, 2006
ASSETS
Cash and due from banks	$	16,775		$	13,304
Federal funds sold		89,785			13,000
Cash and cash equivalents		106,560			26,304
Interest-bearing deposits with financial institutions		198			198
Federal Reserve Bank and Federal Home Loan Bank Stock, at cost		13,362			13,792
Securities available for sale, at fair value		249,781			241,912
Loans (net of allowances of $5,556 and $5,929, respectively)		739,202			740,957
Investment in unconsolidated subsidiaries		682			837
Accrued interest receivable		4,862			4,877
Premises and equipment, net		1,669			2,152
Other assets		11,894			11,500
Total assets	$	1,128,210		$	1,042,529
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Noninterest-bearing	$	205,274		$	189,444
Interest-bearing		572,012			528,349
Total deposits		777,286			717,793
Borrowings		201,404			201,797
Accrued interest payable		3,012			2,930
Other liabilities		34,566			4,246
Junior subordinated debentures		17,527			27,837
Total liabilities		1,033,795			954,603
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, and 10,505,899 and 10,308,364 shares issued and outstanding at September 30, 2007 and December 31, 2006, respectively		71,992			70,790
Retained earnings		24,644			20,076
Accumulated other comprehensive loss		(2,221	)		(2,940	)
Total shareholders’ equity		94,415			87,926
Total liabilities and shareholders’ equity	$	1,128,210		$	1,042,529

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 September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006
Interest income:
Loans, including fees	$	13,952	$	13,287	$	41,622	$	37,361
Federal funds sold		1,385		532		3,138		888
Securities available for sale and stock		2,718		2,782		8,342		8,626
Interest-bearing deposits with financial institutions		2		3		7		7
Total interest income		18,057		16,604		53,109		46,882
Interest expense:
Deposits		6,908		5,073		19,544		12,386
Borrowings		3,056		3,536		9,855		10,078
Total interest expense		9,964		8,609		29,399		22,464
Net interest income		8,093		7,995		23,710		24,418
Provision for loan losses		300		270		925		830
Net interest income after provision for loan losses		7,793		7,725		22,785		23,588
Noninterest income		369		389		1,036		993
Noninterest expense		5,864		5,261		16,357		15,618
Income before income taxes		2,298		2,853		7,464		8,963
Income tax expense		867		1,151		2,896		3,626
Income from continuing operations		1,431		1,702		4,568		5,337
Loss from discontinued operations, net of taxes		—		—		—		(189	)
Net income	$	1,431	$	1,702	$	4,568	$	5,148
Net income (loss) per share basic:
Income from continuing operations	$	0.14	$	0.17	$	0.44	$	0.52
Income (loss) from discontinued operations	$	0.00	$	0.00	$	0.00	$	(0.02	)
Net income	$	0.14	$	0.17	$	0.44	$	0.50
Net income (loss) per share diluted:
Income from continuing operations	$	0.13	$	0.16	$	0.42	$	0.50
Income (loss) from discontinued operations	$	0.00	$	0.00	$	0.00	$	(0.02	)
Net income	$	0.13	$	0.16	$	0.42	$	0.48
Weighted average number of shares:
Basic		10,466,389		10,293,566		10,396,778		10,249,112
Diluted		10,905,721		10,762,436		10,867,763		10,765,657

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 September 30,				Nine Months Ended September 30,
	2007		2006		2007			2006
Net income	$	1,431	$	1,702	$	4,568		$	5,148
Other comprehensive loss, net of tax:
Change in unrealized gain (loss) on securities available for sale, net of tax effect		1,436		2,547		800			464
Change in net unrealized gain (loss) and prior service benefit (cost) on supplemental executive retirement plan, net of tax effect		11		—		(81	)		—
Total comprehensive income	$	2,878	$	4,249	$	5,287		$	5,612

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)

	Nine Months Ended September 30,
	2007			2006
Cash Flows From Continuing Operating Activities:
Income from continuing operations	$	4,568		$	5,337
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		598			700
Provision for loan losses		925			830
Net amortization of premium (discount) on securities		352			540
Mark to market loss adjustment of equity securities		6			13
Net gain on sale of fixed assets		—			(3	)
Stock-based compensation expense		429			461
Net decrease (increase) in accrued interest receivable		15			(427	)
Net increase in other assets		(572	)		(2,637	)
Net (increase) decrease in deferred taxes		(324	)		1,296
Net decrease in accrued interest payable		82			452
Net decrease in other liabilities		(42	)		(87	)
Net cash provided by operating activities		6,037			6,475
Cash Flows From Investing Activities:
Net decrease in interest-bearing deposits with financial institutions		—			101
Maturities of and principal payments received for securities available for sale and other stock		30,988			37,981
Purchase of securities available for sale and other stock		(7,356	)		(3,720	)
Proceeds from sale of subsidiary		—			134
Gain on sale of subsidiary		—			(2	)
Net decrease (increase) in loans		830			(56,568	)
Proceeds from dissolution of trust preferred securities		155			—
Purchases of premises and equipment		(115	)		(503	)
Net cash provided by (used) in investing activities		24,502			(22,577	)
Cash Flows From Financing Activities:
Net increase in deposits		59,493			123,572
Proceeds from exercise of stock options		1,460			415
Tax benefits from exercise of stock options		—			580
Net decrease from share buyback		(688	)		—
Redemption of junior subordinated debentures		(10,155	)		—
Net decrease in borrowings		(393	)		(68,568	)
Net cash provided by financing activities		49,717			55,999
Cash Flows provided by continuing operations	$	80,256		$	39,897

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

4

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS—continued

(Dollars in thousands)

(Unaudited)

	Nine Months Ended September 30,
	2007			2006
Discontinued Operations:
Cash Flows From Operating Activities
Loss from discontinued operations		—			(189	)
Depreciation and Amortization		—			2
Net decrease in other assets		—			181
Net decrease in fixed assets		—			11
Net decrease in other liabilities		—			(49	)
Net cash used by operating activities		—			(44	)
Cash Flows From Investing Activities:
Net decrease in interest-bearing deposits with financial institutions		—			142
Net cash flow provided in investing activities		—			142
Cash Flows used by discontinued operations		—			98
Net increase in cash and cash equivalents		80,256			39,995
Cash and Cash Equivalents, beginning of period		26,304			34,822
Cash and Cash Equivalents, end of period	$	106,560		$	74,817
Supplementary Cash Flow Information:
Cash paid for interest on deposits and other borrowings	$	29,316		$	22,023
Cash paid for income taxes	$	4,050		$	4,200
Non-Cash Investing Activities:
Net increase (decrease) in net unrealized losses on securities held for sale, net of income tax	$	(800	)	$	464
Net increase in net unrealized losses and prior year service cost on supplemental executive retirement, net of income tax		(81	)		—

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

5

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Unaudited)

1. Nature of Business

Pacific Mercantile Bancorp (“PMBC”) is a bank holding company which, through its wholly owned subsidiary, Pacific Mercantile Bank (the “Bank”) is engaged in the commercial banking business in Southern California. PMBC is registered as a one bank holding company under the United States Bank Holding Company Act of 1956, as amended. 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. PMBC and the Bank, together, shall sometimes be referred to in this report as the “Company” or as “we”, “us” or “our”.

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 and from financial services organizations conducting operations in those same markets.

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 $5.155 million, $5.155 million and $7.217 million, respectively, 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.

In July 2007, we redeemed the $5.155 million principal amount of junior subordinated debentures issued in conjunction with the organization of Pacific Mercantile Capital Trust I and in August 2007, we redeemed the $5.155 million principal amount of junior subordinated debentures issued in conjunction with the organization of PMB Capital Trust I. Those trusts were dissolved as a result of those redemptions.

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 required for a full 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 period presented.

These unaudited consolidated financial statements have been prepared on 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, 2006, and the notes thereto included in our Annual Report on Form 10–K for the fiscal year ended December 31, 2006, as filed with the Securities and Exchange Commission under the Securities Exchange Act of 1934.

As described below under the subcaption“Discontinued Operations” in this Note 2, in the second quarter of fiscal 2006, we sold one of our subsidiaries, PMB Securities Corp., which was an SEC—registered securities broker/dealer engaged in the retail securities brokerage business. Therefore, the results of operations of that business are presented as discontinued operations, separate from the results of our continuing operations, in our financial statements for the nine months ended September 30, 2006. Because that business was sold in second quarter of 2006, those discontinued operations had no financial impact on our operating results in either of the three month periods ended September 30, 2007 and 2006 nor in the nine months ended September 20, 2007 and also will not have any financial impact on our operating results during the remainder of 2007.

Our consolidated financial position at September 30, 2007, and the consolidated results of operations for the three and nine month periods ended September 30, 2007, are not necessarily indicative of what our financial position will be as of the end of, or of the results of our operations that may be expected for any other interim period during or for, the full year ending December 31, 2007.

6

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. For the periods in this Report, those estimates related primarily to the determination of the allowance for loan losses, the fair value of securities available for sale, and the valuation of deferred tax assets. If circumstances or financial trends on which those estimates were based were to change in the future or there were to occur any currently unanticipated events affecting the amounts of those estimates, our future financial position or results of operation could differ, possibly materially, from those expected at the current time.

Principles of Consolidation

The consolidated financial statements for the three month periods ended September 30, 2007 and 2006 and for the nine months ended September 20, 2007, include the accounts of PMBC and its wholly owned subsidiary, Pacific Mercantile Bank. The consolidated financial statements for nine months ended September 30, 2006 also include the accounts of PMB Securities Corp., as discontinued operations, to the date of its sale on June 1, 2006. All significant intercompany accounts and transactions have been eliminated in consolidation.

Nonperforming Loans and Other Assets

At September 30, 2007 and December 31, 2006, we had $6.2 million and $1.8 million, respectively, in nonaccrual and impaired loans. As of those same dates, we had no restructured loans and no loan that was past due as to principal for 90 days or more and that were still accruing interest.

Earnings Per Share (“EPS”)

Basic EPS excludes dilution and is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if stock options or other contracts to issue common stock were exercised or converted to common stock that would then share in our earnings. For the three and nine month periods ended September 30, 2007, stock options to purchase up to 200,343 and 209,843 shares, respectively, were not considered in computing diluted earnings per common share because they were antidilutive.

The following table shows how we computed basic and diluted EPS for the three and nine month periods ended September 30, 2007 and 2006.

	For the three months ended September 30,				For the nine months ended September 30,
(In thousands, except earnings per share data)	2007		2006		2007		2006
Net income available for common shareholders (A)	$	1,431	$	1,702	$	4,568	$	5,148
Weighted average outstanding shares of common stock (B)		10,466		10,294		10,397		10,249
Dilutive effect of employee stock options and warrants		440		468		471		517
Common stock and common stock equivalents (C)		10,906		10,762		10,868		10,766
Earnings per share:
Basic (A/B)	$	0.14	$	0.17	$	0.44	$	0.50
Diluted (A/C)	$	0.13	$	0.16	$	0.42	$	0.48

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 and unrealized actuarial gains and losses on the supplemental executive compensation plan, 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.

7

Recent Accounting Pronouncements

In July 2006, the FASB also issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109,” (FIN 48). FIN 48 clarifies the accounting for uncertain tax positions in accordance with SFAS 109, “Accounting For Income Taxes,” by prescribing a minimum recognition threshold that a tax position is required to meet before being recognized in the financial statements. The minimum recognition threshold will require us to recognize, in our financial statements, the impact of a tax position if it is more likely than not that the tax position is valid and would be sustained on audit, including resolution of related appeals or litigation processes, if any. Only tax positions that meet the “more likely than not” recognition criteria at the effective date may be recognized or continue to be recognized in the financial statements upon the adoption of FIN 48. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition requirements in accounting for uncertain tax positions. Changes in the amount of tax benefits recognized resulting from the application of the provisions of this Interpretation would result in a one-time non-cash charge to be recognized as a change in accounting principle via a cumulative adjustment to the opening balance of retained earnings in the period of adoption. FIN 48 is effective for fiscal years beginning after December 15, 2006. Accordingly, we adopted the provisions of FIN 48 in the first quarter 2007. The adoption of FIN 48 has not had an impact on our results of operations or financial condition. See “Note 5: Income Taxes” below.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value, and therefore, does not expand the use of fair value in any new circumstances. SFAS 157 clarifies that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices in active markets and lowest priority to unobservable data. SFAS 157 is effective for fiscal years beginning after November 15, 2007. We do not expect that the adoption of FAS 157 will have a material effect on our consolidated financial statements.

On September 29, 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106, and 132(R),” (SFAS 158). SFAS 158 represent the first phase of the FASB’s project on pension and post-retirement benefits. The next phase will consider potential changes in determining net periodic benefit cost and measuring plan assets and obligations. A company with publicly traded equity securities is required to initially recognize the funded status of a defined benefit post-retirement plan and to provide the required disclosures as of the end of the fiscal year ending after December 15, 2006. The disclosures required by SFAS 158 are included in Note 15 (Employee Benefit Plans) to our Consolidated Financial Statements for the fiscal year ended December 31, 2006 in our 2006 Annual Report on Form 10-K.

On February 15, 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115,” (SFAS 159). SFAS 159 provides an alternative measurement treatment for certain financial assets and financial liabilities, under an instrument-by-instrument election, that permits fair value to be used for both initial and subsequent measurement, with changes in fair value recognized in earnings. SFAS 159 is effective beginning January 1, 2008. However, we do not expect that the adoption of SFAS 159 will have a material effect on our consolidated financial condition or results of operations.

Commitments and Contingencies

To meet the financing needs of our customers in the normal course of business, we are a 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 September 30, 2007, loan commitments and letters of credits totaled $219 million and $11 million, respectively. 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 commitment be fully drawn upon, the customer default, and the value of any existing collateral securing the customer’s payment obligation become worthless.

As a result, 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.

8

In the ordinary course of business, we are subject to legal actions normally associated with financial institutions. At September 30, 2007, 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. Stock-Based Employee Compensation Plans

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 sooner upon or shortly after a termination of service occurring prior to the expiration of the term of the option. 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 Stock Incentive 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 generally ranging up to five years, or based on the achievement of specified performance goals, as determined by the Compensation Committee at the time it grants the options or the stock purchase rights. Options may be granted under the 2004 Stock Incentive Plan for terms of up to 10 years after the grant date, but will terminate sooner upon or shortly after a termination of service occurring prior to the expiration of the term of the option. 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 Stock Incentive Plan.

In December 2004, Financial Accounting Standards Board (“FASB”) issued SFAS No. 123(R), “Share-Based Payment”, which requires companies or other organizations that grant stock options or other equity compensation awards to employees to recognize, in their financial statements, the fair value of those options and shares as compensation cost over their respective service (vesting) periods. In the case of the Company, SFAS No. 123(R) became effective January 1, 2006 and, as of that date, we adopted the fair value recognition provisions of SFAS No. 123(R), using the modified-prospective-transition method. Under this transition method, equity compensation expense includes: (a) compensation expense 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 in the event actual forfeitures differ from those estimates. For purposes of determining stock-based compensation expense for the quarter ended September 30, 2007, we estimated no forfeitures of options held by the Company’s directors and all other forfeitures to be 21% of the unvested options issued.

The fair values of the options that were outstanding under the 1999 and 2004 Stock 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 September 30,						Nine Months Ended September 30,
Assumptions with respect to:	2007			2006			2007			2006
Expected volatility		28	%		35	%		29	%		35	%
Risk-free interest rate		5.01	%		5.10	%		4.81	%		4.69	%
Expected dividends		1.07	%		1.07	%		1.19	%		1.07	%
Expected term (years)		6.5			6.5			6.5			6.5
Weighted average fair value of options granted during period	$	4.92		$	6.96		$	5.09		$	7.13

9

The following tables summarize the share option activity under the Company’s 1999 Option Plan and the 2004 Stock Incentive Plan during the nine month period ended September 30, 2007 and 2006.

	Nine Months Ended September 30,
	2007			2006
	Number of Shares Subject to Options	Weighted- Average Exercise Price Per Share		Number of Shares Subject to Options	Weighted- Average Exercise Price Per Share
Outstanding—January 1,	1,366,924	$	9.11	1,470,698	$	8.51
Granted	41,800		14.64	46,500		18.12
Exercised	247,535		5.90	122,174		5.21
Forfeited/Canceled	28,500		17.11	41,400		15.58
Outstanding—September 30,	1,132,689		9.81	1,353,624		8.91
Options Exercisable—September 30,	876,832	$	8.66	1,029,155	$	7.59

The aggregate intrinsic values of options exercised at September 30, 2007 and 2006 were $2.1 million and $1.5 million, respectively. Total fair values of vested options at September 30, 2007 and 2006 were $495,000 and $514,000, respectively.

	Options Outstanding as of September 30, 2007					Options Exercisable as of September 30, 2007
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	44,312		$	4.00	1.42	44,312	$	4.00
$ 6.00 – $9.99	547,731	3,820		7.31	3.02	547,731		7.31
$10.00 – $12.99	231,557	104,926		11.23	6.41	231,557		11.23
$13.00 – $17.99	46,632	120,711		15.12	8.20	46,632		14.97
$18.00 – $18.84	6,600	26,400		18.16	8.32	6,600		18.16
	876,832	255,857	$	9.81	4.88	876,832	$	8.66

The aggregate intrinsic values of options that were outstanding and exercisable under the 1999 and 2004 Stock Plans at September 30, 2007 and 2006, were $6.2 million and $10.0 million, respectively.

A summary of the status of the unvested options as of December 31, 2006, and changes during the nine month period ended September 30, 2007, are set forth in the following table.

	Number of Shares Subject to Options		Weighted- Average Grant Date Fair Value
Unvested at December 31, 2006	331,287		$	5.80
Granted	41,800			5.09
Vested	(88,730	)		5.58
Forfeited/Canceled	(28,500	)		6.74
Unvested at September 30, 2007	255,857		$	5.74

10

The aggregate amounts charged against income in relation to stock-based awards were $151,000 and $429,000 for the three and nine months ended September 30, 2007, respectively. At September 30, 2007, compensation expense related to non-vested stock option grants were expected to be recognized in the respective amounts set forth in the table below:

	Stock Option Compensation Expense
	(In thousands)
Remainder of 2007	$	150
For the year ended December 31,
2008		597
2009		221
2010		96
2011		48
2012		7
Total	$	1,119

4. Employee Benefit Plan

The Company has established a Supplemental Retirement Plan (SERP) for its Chief Executive Officer. Net periodic benefit costs are charged to “employee benefits expense” in the consolidated statements of income to recognize the Company’s expense in respect of that Plan. The components of net periodic benefit cost for the SERP are set forth in the table below:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006
	(In thousands)				(In thousands)
Service cost	$	42	$	34	$	126	$	102
Interest cost		24		17		65		48
Expected return on plan assets		—		—		—		—
Amortization of prior service cost		4		4		12		11
Amortization of net actuarial loss		14		6		42		17
Net periodic SERP cost	$	84	$	61	$	245	$	178

5. Income Taxes

The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109,” (“FIN 48”) on January 1, 2007. We did not have any unrecognized tax benefits and there was no effect on our financial condition or results of operations as a result of implementing FIN 48.

We file income tax returns with the U.S. federal government and the state of California. As of September 30 and January 1, 2007, we were subject to examination by the Internal Revenue Service with respect to our U.S. federal tax returns for the 2004-2006 tax years. We were also subject to examination in California of our state income tax returns for the 2002-2006 tax years. We do not believe there will be any material changes in our unrecognized tax positions over the next 12 months.

Our policy is that we recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. As of the date of adoption of FIN 48, we did not have any accrued interest or penalties associated with any unrecognized tax benefits, and no interest expense was recognized during the quarter. Our effective tax rate differs from the federal statutory rate primarily due to the non-deductibility of certain expenses recognized for financial reporting purposes and state taxes.

6. Discontinued Operations

As previously reported, in the second quarter of 2006 we sold our securities brokerage business and, accordingly, for financial reporting purposes that business was classified as discontinued operations in our consolidated financial statements for the period from January 1, 2006 to the date of its sale on June 1, 2006. Those discontinued operations had no financial impact on our operating results for last two quarters of 2006 or for the first three quarters of 2007 and also will not have any financial impact on our operating results during the fourth quarter of 2007. By comparison, those discontinued operations sustained losses of $73,000 and $116,000, respectively, in the first and second quarters of 2006.

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The operating results of the discontinued securities brokerage business included in the accompanying consolidated statements of income are set forth below:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006
	(In thousands)				(In thousands)
Loss from discontinued operations, before income taxes	$	—	$	—	$	—	$	(313	)
Income tax benefit		—		—		—		(124	)
Loss from discontinued operations, net of taxes	$	—	$		$	—	$	(189	)

As of September 30, 2007 and December 31, 2006, there were no accounts included in the consolidated statement of financial condition from the discontinued securities brokerage business.

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

Introduction

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, operating income and expenses.

The following discussion presents information about our consolidated results of operations for the three and nine month periods ended September 30, 2007 and 2006 and our consolidated financial condition, liquidity and capital resources at September 30, 2007 and should be read in conjunction with our interim consolidated financial statements and the notes thereto included elsewhere in this Report.

Additionally, except where otherwise noted below, the following discussion of our results of operation and financial condition relates to the results of operations and the assets and liabilities of our commercial banking business, which comprises our continuing operations and excludes our discontinued securities brokerage business, which was sold in June 2006. See Note 6 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, beliefs or views 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 Annual Report on Form 10-K for our fiscal year ended December 31, 2006 and readers of this Report are urged to read that summary below and the information contained in Item 1A of the 2006 Annual Report on Form 10-K in conjunction with this Report.

Due to those uncertainties and risks, readers are cautioned not to place undue reliance on the forward-looking statements contained in this Report, which speak only as of the date of this Report, or to make predictions about future performance based solely on historical financial performance. We also disclaim any obligation to update forward-looking statements contained in this Report or in our Annual Report on Form 10-K or any other prior filings with Securities and Exchange Commission.

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Overview of Operating Results in the Three and Nine Months Ended September 30, 2007

The following table sets forth information regarding the interest income that we generated, the interest expense that we incurred, our net interest income, noninterest income, noninterest expense, and our net income and net income per share for the three and nine months ended September 30, 2007 and 2006.

	Three Months Ended September 30, (Unaudited)						Nine Months Ended September 30, (Unaudited)
	2007 Amounts		2006 Amounts		Percent Change		2007 Amounts		2006 Amounts			Percent Change
	( Dollars in thousands, except per share data)
Interest income	$	18,057	$	16,604	8.8	%	$	53,109	$	46,882		13.3	%
Interest expense		9,964		8,609	15.7	%		29,399		22,464		30.9	%
Net interest income	$	8,093	$	7,995	1.2	%	$	23,710	$	24,418		(2.9	)%
Noninterest income	$	369	$	389	(5.1	)%	$	1,036	$	993		4.3	%
Noninterest expense	$	5,864	$	5,261	11.5	%	$	16,357	$	15,618		4.7	%
Income from continuing operations(1)	$	1,431	$	1,702	(15.9	)%	$	4,568	$	5,337		(14.4	)%
Loss from discontinued operations(1)	$	—	$	—	NM	%	$	—	$	(189	)	NM	%
Net income	$	1,431	$	1,702	(15.9	)%	$	4,568	$	5,148		(11.3	)%
Net income (loss) per share diluted
Income from continuing operations	$	0.13	$	0.16	(18.8	)%	$	0.42	$	0.50		(16.0	)%
Income (loss) from discontinued operations	$	0.00	$	0.00	NM	%	$	0.00	$	(0.02	)	NM	%
Net income diluted per share	$	0.13	$	0.16	(18.8	)%	$	0.42	$	0.48		(12.5	)%
Weighted average number of diluted shares		10,905,721		10,762,436	1.3	%		10,867,763		10,765,657		0.9	%

⁽¹⁾ Net of taxes

Key Factors Affecting Operating Results in the Three and Nine Months Ended September 30, 2007

As the table above indicates, income from continuing operations in the three and nine months ended September 30, 2007 declined by $271,000, or 15.9%, and $769,000, or 14.4%, respectively, as compared to the respective corresponding periods of 2006. On a diluted per share basis, income from continuing operations declined to $0.13 and $0.42 in the three and nine months ended September 30, 2007, respectively, from $0.16 and $0.50 in the respective corresponding periods of 2006.

Three Months Ended September 30, 2007. The decline in income from continuing operations in this year’s third quarter was due primarily to a $603,000, or 12%, increase in non-interest expense that was primarily attributable to a non-cash charge of $443,000 recognized as a result of the redemption, during this year’s third quarter of $10.3 million of our junior subordinated debentures. That charge represented the accelerated recognition of costs incurred in connection with the original issuance of those debentures which, until that redemption, were being amortized over their original 30 year term. Also contributing to that increase in non-interest expense was an increase in federal deposit insurance assessments on federally insured banking institutions that was attributable to a change in assessment formulas, mandated by the Federal Deposit Insurance Reform Act of 2005.

Nine Months Ended September 30, 2007. The decline in income from continuing operations in the first nine months of 2007 was primarily due to (i) a $708,000, or 3%, decrease in net interest income that was attributable to an increase in interest expense that more than offset an increase in interest income during that nine month period, and (ii) a $739,000, or 5%, increase in non-interest expense that was primarily attributable to the above-described charge that resulted from the redemption of the junior subordinated debentures and the increase in federal deposit insurance assessments.

14

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

	Three Months Ended September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006
	(Unaudited)				(Unaudited)
Return on average assets(1)	0.51	%	0.66	%	0.56	%	0.71	%
Return on average shareholders’ equity(2)	6.13	%	7.87	%	6.71	%	8.41	%
Net interest margin(2)	2.94	%	3.17	%	2.97	%	3.34	%

⁽¹⁾ Annualized.

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

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, for example, assumptions regarding economic conditions or trends 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. 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 operating results, under GAAP it could become necessary to reduce the carrying values 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.

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 estimate the potential losses inherent in our loan portfolio and assess the sufficiency of our allowance for loan losses. If 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 economic conditions and 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 “Results of Operations—Provision for Loan Losses” and “Financial Condition—Allowance for Loan Losses and Nonperforming Loans” below.

Fair Value of Securities Available for Sale. We determine the fair value of those of our investment securities that are available for sale (as opposed to those which we intend to hold to maturity) by obtaining price quotations from third party vendors and securities brokers. When such quotations are not available, a reasonable fair value is determined by using a variety of industry standard pricing methodologies including, but not limited to, discounted cash flow analysis, matrix pricing, option adjusted spread models, as well as fundamental analysis. These pricing methodologies require us to make various assumptions relating to such matters as future prepayment speeds, yield, duration, monetary policy and demand and supply for the individual securities. Consequently, if changes were to occur in the market or other conditions on which those assumptions were based, it could become necessary for us to make adjustments to the fair values of those securities, which would have the effect of changing our accumulated other comprehensive gain/(loss) in our consolidated statements of financial condition.

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 September 30, 2007, the total of the unused income tax benefits (included in “Other Assets” in our consolidated balance sheet), available to reduce our income taxes in future periods was $4.9 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

15

utilize those benefits before they expire. In the event that market or economic conditions or our results of operation were to change in a manner that would lead us to conclude that it would be less likely that those benefits could be fully utilized, it could become necessary for us to establish a valuation reserve to cover any 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 Operations

As previously reported, in the second quarter of 2006 we sold our retail securities brokerage subsidiary, PMB Securities Corp. In accordance with Statement of Financial Accounting Standard No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”), the operating results of that business were classified as discontinued operations in 2006 and prior period financial statements have been restated on that same basis. Since we were able to sell that business in the second quarter of 2006, those discontinued operations had no financial impact on our operating results in either of the three month periods ended September 30, 2007 and September 30, 2006 or in the nine months ended September 30, 2007, and will not have any financial impact on our operating results for any subsequent periods.

Additionally, as a result of our sale of our retail securities brokerage business, our commercial banking business constitutes our continuing operations and the discussion that follows focuses almost entirely on those continuing operations.

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 and net interest income (in thousands of dollars) and our net interest margin in the three and nine months ended September 30, 2007 and 2006, respectively:

	Three Months Ended September 30,								Nine Months Ended September 30,
	2007 Amount			2006 Amount			Percent Change		2007 Amount			2006 Amount			Percent Change
	(Unaudited)
Interest income	$	18,057		$	16,604		8.8	%	$	53,109		$	46,882		13.3	%
Interest expense		9,964			8,609		15.7	%		29,399			22,464		30.9	%
Net interest income	$	8,093		$	7,995		1.2	%	$	23,710		$	24,418		(2.9	)%
Net interest margin		2.94	%		3.17	%				2.97	%		3.34	%

As the table above indicates, our net interest income increased by $98,000, or 1%, in the third quarter of 2007, and decreased by $708,000, or 3%, in the nine months ended September 30, 2007, in each case as compared to the respective corresponding period of 2006. The increase in net interest income for the three months ended September 30, 2007, was due to a $1.5 million increase in interest income, which more than offset a $1.4 million increase in interest expense. The decrease in net interest income for the nine months ended September 30, 2007 was due to a $6.9 million, or 31%, increase in interest expense, which more than offset a $6.2 million, or 13%, increase in interest income.

Our net interest margin decreased to 2.94% in the third quarter of 2007 from 3.17% in the same quarter of 2006, and to 2.97% in the nine months ended September 30, 2007 from 3.34% in the same nine months of 2006. Contributing to that decline in the three months ended September 30, 2007 was a decrease in the yield on interest-earning assets to 6.57% from 6.59% in the same period of 2006%. In the nine months ended September 30, 2007, the yield on interest-earning assets improved to 6.66%, from 6.42% in the same period of 2006; however, the average rate of interest paid on our interest-bearing liabilities increased to 4.80%, from 4.08% in the same nine months of 2006.

16

Average Balances

Information Regarding Average Assets and Average Liabilities

The following table sets forth information regarding our average balance sheet, yields on interest earning assets, interest expense on interest-bearing liabilities, the interest rate spread and the interest rate margin for the three months ended September 30, 2007 and 2006.

	Three Months Ended September 30,
	2007						2006
	Average Balance		Interest Earned/ Paid		Average Yield/ Rate		Average Balance		Interest Earned/ Paid		Average Yield/ Rate
	(Dollars in thousands)
	(Unaudited)
Interest earning assets:
Short-term investments(1)	$	109,456	$	1,387	5.03	%	$	40,741	$	535	5.21	%
Securities available for sale and stock(2)		237,731		2,718	4.54	%		247,111		2,782	4.47	%
Loans		743,916		13,952	7.44	%		711,895		13,287	7.41	%
Total earning assets		1,091,103		18,057	6.57	%		999,747		16,604	6.59	%
Noninterest earning assets		27,797						31,066
Total Assets	$	1,118,900					$	1,030,813
Interest-bearing liabilities:
Interest-bearing checking accounts	$	23,568		42	0.71	%	$	22,409		44	0.78	%
Money market and savings accounts		160,558		1,455	3.60	%		146,819		1,248	3.37	%
Certificates of deposit		413,594		5,411	5.19	%		313,978		3,781	4.78	%
Other borrowings		209,951		2,624	4.96	%		251,465		2,952	4.66	%
Junior subordinated debentures		19,367		432	8.85	%		27,837		584	8.32	%
Total interest-bearing liabilities		827,038		9,964	4.78	%		762,508		8,609	4.48	%
Noninterest-bearing liabilities		199,371						182,493
Total Liabilities		1,026,409						945,001
Shareholders’ equity		92,491						85,812
Total Liabilities and Shareholders’ Equity	$	1,118,900					$	1,030,813
Net interest income			$	8,093					$	7,995
Interest rate spread					1.79	%					2.11	%
Net interest margin					2.94	%					3.17	%

⁽¹⁾ Short-term investments consist of federal funds sold and interest bearing deposits with financial institutions.

⁽²⁾ Stock consists of Federal Home Loan Bank Stock and Federal Reserve Bank Stock.

17

The following table sets forth information regarding our average balance sheet, yields on interest earning assets, interest expense on interest-bearing liabilities, the interest rate spread and the interest rate margin for the nine months ended September 30, 2007 and 2006.

	Nine Months Ended September 30,
	2007						2006
	Average Balance		Interest Earned/ Paid		Average Yield/ Rate		Average Balance		Interest Earned/ Paid		Average Yield/ Rate
	(Dollars in thousands)
	(Unaudited)
Interest earning assets:
Short-term investments(1)	$	82,116	$	3,145	5.12	%	$	24,033	$	895	4.98	%
Securities available for sale and stock(2)		243,828		8,342	4.57	%		260,384		8,626	4.43	%
Loans		739,797		41,622	7.52	%		691,284		37,361	7.23	%
Total earning assets		1,065,741		53,109	6.66	%		975,701		46,882	6.42	%
Noninterest earning assets		28,033						32,285
Total Assets	$	1,093,774					$	1,007,986
Interest-bearing liabilities:
Interest-bearing checking accounts	$	22,617		123	0.73	%	$	25,451		125	0.66	%
Money market and savings accounts		149,632		3,958	3.54	%		141,378		3,067	2.90	%
Certificates of deposit		399,720		15,463	5.17	%		274,385		9,194	4.48	%
Other borrowings		221,341		8,251	4.98	%		267,360		8,411	4.21	%
Junior subordinated debentures		24,983		1,604	8.58	%		27,837		1,667	8.01	%
Total interest-bearing liabilities		818,293		29,399	4.80	%		736,411		22,464	4.08	%
Noninterest-bearing liabilities		184,422						186,772
Total Liabilities		1,002,715						923,183
Shareholders’ equity		91,059						84,803
Total Liabilities and Shareholders’ Equity	$	1,093,774					$	1,007,986
Net interest income			$	23,710					$	24,418
Interest rate spread					1.86	%					2.34	%
Net interest margin					2.97	%					3.34	%

⁽¹⁾ Short-term investments consist of federal funds sold and interest bearing deposits with financial institutions.

⁽²⁾ Stock consists of Federal Home Loan Bank Stock and Federal Reserve Bank Stock.

18

The following table sets forth the changes in interest income, including loan fees, and interest paid in the three and nine month periods ended September 30, 2007, as compared to the same periods in 2006 and the extent to which those changes were attributable to changes in the volume of and rates of interest earned on interest-earning assets and the volume of and interest paid on interest-bearing liabilities.

	Three Months Ended September 30, 2007 vs 2006 Increase (decrease) due to:									Nine Months Ended September 30, 2007 vs 2006 Increase (decrease) due to:
	Volume(1)			Rate(1)			Total			Volume(1)			Rate(1)			Total
	(Unaudited) (Dollars in thousands)									(Unaudited) (Dollars in thousands)
Interest income:
Short-term investments(2)	$	980		$	(128	)	$	852		$	2,224		$	26		$	2,250
Securities available for sale and stock		(289	)		225			(64	)		(560	)		276			(284	)
Loans		600			65			665			2,690			1,571			4,261
Total earning assets		1,291			162			1,453			4,354			1,873			6,227
Interest expense:
Interest-bearing checking accounts		11			(13	)		(2	)		(15	)		13			(2	)
Money market and savings accounts		121			86			207			187			704			891
Certificates of deposit		1,281			349			1,630			4,684			1,585			6,269
Borrowings		(1,324	)		996			(328	)		(1,577	)		1,417			(160	)
Junior subordinated debentures		(368	)		216			(152	)		(178	)		115			(63	)
Total interest-bearing liabilities		(279	)		1,634			1,355			3,101			3,834			6,935
Net interest income	$	1,570		$	(1,472	)	$	98		$	1,253		$	(1,961	)	$	(708	)

⁽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 $98,000 in our net interest income in the three months ended September 30, 2007, as compared to the like period in 2006, was primarily the result of a $1.6 million increase in our volume variance, which more than offset a decrease of $1.5 million in the rate variance. The increase in the volume variance reflects the increases in average interest earning assets of $91 million and interest bearing liabilities of $64 million, while the decline in the rate variance was a result of an increase of 30 basis points in interest rates paid on interest bearing liabilities and a decrease in interest rates on average earning assets of 2 basis points

The decline of $708,000 in net interest income in the nine months ended September 30, 2007, as compared to the same nine months of 2006, was due to an increase in interest expense that was attributable to an increase in the interest rates paid on and in the volume of interest-bearing liabilities. Those increases more than offset increases in the interest earned on interest-earning assets resulting from increases in both interest rates and in the volume of those assets. The increase in the rate variance in the nine months ended September 30, 2007 reflects an increase in interest rates paid on average interest-bearing liabilities of 72 basis points, somewhat offset by an increase in interest rates on average interest-earning assets of 24 basis points, in the nine months ended September 30, 2007, as compared to the same period of 2006.

Provision for Loan Losses

The failure 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 an allowance for possible loan losses that occur from time to time as an incidental part of the banking business. When it is determined that the payment in full of a loan has become unlikely, the carrying value of the loan is reduced to what management believes is its realizable value. This reduction, which is referred to as a loan “charge-off,” or “write-down” is charged against that allowance. The amount of the allowance for loan losses is increased periodically (i) to replenish the allowance after it has been reduced due to loan charge-offs, (ii) to reflect changes in the volume of outstanding loans, and (iii) to take account of changes in the risk of potential losses due to a deterioration in the condition of borrowers or in the 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 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 and reducing the amount of the provision that might otherwise have had to be made to replenish or increase the allowance.

19

During the third quarter of 2007, we made provisions, totaling $300,000, for potential loan losses, as compared to $270,000 in the same quarter of 2006. At September 30, 2007, the Allowance for Loan Losses totaled $5.6 million, or 0.75% of loans then outstanding, as compared to $5.9 million, or 0.79% of loans outstanding, at December 31, 2006.

We employ economic models that are based on bank regulatory guidelines, industry standards and historical loss experience to evaluate and determine both the sufficiency of the allowance for loan losses and the amount of the provisions that are 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 to us. The duration and effects of current economic trends are subject to a number of risks and 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 for loan losses, which would have the effect of reducing our income.

In addition, the Federal Reserve Bank 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. The following table identifies the components, (in thousands of dollars) of, and sets forth the percentage changes in, noninterest income in the three and nine month periods ended September 30, 2007, as compared to the same respective periods of 2006.

	Three Months Ended September 30,						Nine Months Ended September 30,
	Amount				Percentage Change 2007 vs. 2006		Amount				Percentage Change 2007 vs. 2006
	2007		2006				2007		2006
	Unaudited
Service fees on deposits	$	190	$	174	9.2	%	$	575	$	542	6.1	%
Other		179		215	(16.7	)%		461		451	2.2	%
Total	$	369	$	389	(5.1	)%	$	1,036	$	993	4.3	%

Noninterest Expense

The following table compares the amounts (in thousands of dollars) of the principal components of noninterest expense in the three and nine months ended September 30, 2007 and in the same three and nine month periods of 2006.

	Three Months Ended September 30,						Nine Months Ended September 30,
	Amount				Percentage Change 2007 vs. 2006		Amount				Percentage Change 2007 vs. 2006
	2007		2006				2007		2006
	Unaudited (Dollars in thousands)						Unaudited (Dollars in thousands)
Salaries and employee benefits	$	2,919	$	2,894	0.9	%	$	8,694	$	8,635	0.7	%
Occupancy		670		670	—			2,036		1,926	5.7	%
Equipment and depreciation		313		343	(8.7	)%		954		1,027	(7.1	)%
Data processing		183		165	10.9	%		506		503	0.6	%
Professional fees		269		213	26.3	%		669		780	(14.2	)%
Customer expense		167		221	(24.4	)%		512		636	(19.5	)%
FDIC insurance		144		—	NM			343		—	NM
Amortization of debt issuance cost		457		14	NM			486		43	NM
Other operating expense(1)		742		741	0.1	%		2,157		2,068	4.3	%
Total	$	5,864	$	5,261	11.5	%	$	16,357	$	15,618	4.7	%

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

20

The increases in non-interest expense in the three and nine months ended September 30, 2007 were primarily attributable to (i) a $443,000 charge, recognized in connection with our voluntary redemption, in this year’s third quarter, of $10.3 million principal amount of junior subordinated debentures and (ii) an increase in Federal Deposit Insurance assessments on federally insured banking institutions that resulted from a change, mandated by the Federal Deposit Insurance Reform Act of 2005, in assessment formulas. The charge arising as a result of our redemption of the junior subordinated debentures represented the costs we incurred, in 2002, in connection with the issuance of those debentures. We had previously been amortizing those costs over the original 30 year term of those debentures.

The increase in non-interest expense in the three months ended September 30, 2007, caused our efficiency ratio (operating expenses as a percentage of total revenues from continuing operations) to rise to approximately 69% from 63% for the same three months of 2006. For the nine months ended September 30, 2007, our efficiency ratio was approximately 66%, as compared to approximately 61% in the same nine months of 2006, as a result of the combined effects of the decrease in net interest income and the increase in non-interest expense in the nine months ended September 30, 2007.

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 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.

21

The table below sets forth information concerning our rate sensitive assets and liabilities at September 30, 2007. The assets and liabilities are classified by the earlier of maturity or repricing dates in accordance with their contractual terms. As 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	$	—		$	99		$	99		$	—		$	—		$	198
Investment in unconsolidated trust subsidiaries		—			—			—			682			—			682
Securities available for sale		14,860			35,131			123,987			75,803			—			249,781
Federal Reserve Bank and Federal Home Loan Bank stock		13,362			—			—			—			—			13,362
Federal funds sold		89,785			—			—			—			—			89,785
Loans, gross		331,905			98,665			247,286			66,902			—			744,758
Non-interest earning assets, net		—			—			—			—			29,644			29,644
Total assets	$	449,912		$	133,895		$	371,372		$	143,387		$	29,644		$	1,128,210
Liabilities and Shareholders Equity
Noninterest-bearing deposits	$	—		$	—		$	—		$	—		$	205,274		$	205,274
Interest-bearing deposits		271,268	(1)		233,822	(2)		66,922			—			—			572,012
Borrowings		15,404			53,000			133,000			—			—			201,404
Junior subordinated debentures		17,527			—			—			—			—			17,527
Other liabilities		—			—			—			—			37,578			37,578
Shareholders’ equity		—			—			—			—			94,415			94,415
Total liabilities and shareholders equity	$	304,199		$	286,822		$	199,922		$	—		$	337,267		$	1,128,210
Interest rate sensitivity gap	$	145,713		$	(152,927	)	$	171,450		$	143,387		$	(307,623	)	$	—
Cumulative interest rate sensitivity gap	$	145,713		$	(7,214	)	$	164,236		$	307,623		$	—		$	—
Cumulative % of rate sensitive assets in maturity period		40	%		52	%		85	%		97	%		100	%
Rate sensitive assets to rate sensitive liabilities and shareholders’ equity		148	%		47	%		186	%		N/A			N/A
Cumulative ratio		148	%		99	%		121	%		139	%		N/A

¹ Net of Bancorp’s savings accounts of $16.8 million

² Net of Bancorp’s certificate of deposits of $5.3 million

At September 30, 2007, 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 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.

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Financial Condition

Assets

Our total consolidated assets increased by $85 million, or 8%, to $1.128 billion at September 30, 2007 from $1.043 billion at December 31, 2006, as we used increases in deposits during the nine months ended September 30, 2007 to primarily increase federal funds sold.

The following table sets forth the composition of our interest earning assets (in thousands of dollars) at:

	September 30, 2007		December 31, 2006
	Unaudited
Federal funds sold	$	89,785	$	13,000
Interest-bearing deposits with financial institutions		198		198
Federal Reserve Bank and Federal Home Loan Bank Stock, at cost		13,362		13,792
Securities available for sale, at fair value		249,781		241,912
Loans (net of allowances of $5,556 and $5,929, respectively)		739,202		740,957

Loans

The following table sets forth, in thousands of dollars, the composition, by loan category, of our loan portfolio, at September 30, 2007 and December 31, 2006:

	September 30, 2007					December 31, 2006
	Amount			Percent		Amount			Percent
	Unaudited
Commercial loans	$	249,616		33.5	%	$	230,960		30.9	%
Commercial real estate loans - owner occupied		159,877		21.5	%		128,632		17.2	%
Commercial real estate loans - all other		107,726		14.5	%		125,851		16.9	%
Residential mortgage loans - single family		66,639		8.9	%		76,117		10.2	%
Residential mortgage loans - multi-family		90,156		12.1	%		98,678		13.2	%
Construction loans		49,068		6.6	%		65,120		8.7	%
Land development loans		14,988		2.0	%		16,733		2.2	%
Consumer loans		6,700		0.9	%		5,401		0.7	%
Gross loans		744,770		100.0	%		747,492		100.0	%
Deferred fee (income) costs, net		(12	)				(606	)
Allowance for loan losses		(5,556	)				(5,929	)
Loans, net	$	739,202				$	740,957

Commercial loans are loans to businesses to finance capital purchases or improvements, or to provide cash flow for operations. Commercial 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 and land development loans are interim loans to finance specific construction projects. Consumer loans include installment loans to consumers.

23

The following table sets forth, in thousands of dollars, the maturity distribution of our loan portfolio (excluding consumer and residential mortgage loans) at September 30, 2007:

	September 30, 2007
	One Year or Less		Over One Year Through Five Years		Over Five Years		Total
			Unaudited
Real estate and construction loans(1)
Floating rate	$	64,084	$	17,959	$	149,975	$	232,018
Fixed rate		20,243		43,070		36,328		99,641
Commercial loans
Floating rate		173,671		30,411		4,729		208,811
Fixed rate		13,917		22,180		4,708		40,805
Total	$	271,915	$	113,620	$	195,740	$	581,275

⁽¹⁾ Does not include mortgage loans on single and multi-family residences and consumer loans, which totaled $156.8 million and $6.7 million, respectively, at September 30, 2007.

Allowance for Loan Losses and Nonperforming Loans

Allowance for Loan Losses. The allowance for loan losses (the “Allowance”) at September 30, 2007 was $5.6 million, which represented approximately 0.75% of the loans outstanding at September 30, 2007, as compared to $5.9 million, or 0.79%, of the loans outstanding at December 31, 2006.

We carefully monitor changing economic conditions, the loan portfolio by category, the financial condition of borrowers, the history of the loan portfolio, and we follow bank regulatory guidelines in determining the adequacy of the allowance. We believe that the allowance at September 30, 2007 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, if there were changes in those conditions or trends, actual loan losses in the future could vary from the losses that were predicted on the basis of those earlier 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, in thousands of dollars, of the transactions in the allowance for loan losses for the nine months ended September 30, 2007 and the year ended December 31, 2006:

	Nine Months Ended September 30, 2007			Year Ended December 31, 2006
	Unaudited
Balance, beginning of period	$	5,929		$	5,126
Provision for loan losses		925			1,105
Net, amounts charged off		(1,298	)		(302	)
Balance, end of period	$	5,556		$	5,929

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 smaller, homogeneous loans, such as consumer installment loans and lines of credit, from our impairment calculations. 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.

24

At September 30, 2007 and December 31, 2006, we had $6.2 million and $1.8 million, respectively, of collateralized or adequately reserved loans that were delinquent and which were classified as nonaccrual and impaired loans. The increase in non-performing loans at September 30, 2007, as compared to December 31, 2006, was attributable to a net increase of $3.2 million of commercial loans and $1.2 million of residential mortgage loans that had become delinquent and were placed on nonaccrual status during the first nine months of 2007. However, we believe that all of these loans are well-collateralized or have been adequately reserved for.

We had no loans with delinquent balances of 90 days or more that were still accruing interest as of September 30, 2007 or December 31, 2006. There were no restructured loans at September 30, 2007 or December 31, 2006. At September 30, 2007, our average investment in impaired loans, on a year-to-date basis, was $3.1 million. The interest that we would have earned during the nine months ended September 30, 2007, had the impaired loans remained current in accordance with their original terms was $398,000.

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 nine months ended September 30, 2007:

	Nine Months Ended September 30, 2007
	Unaudited
	Average Balance		Average Rate
Noninterest-bearing demand deposits	$	172,894	—
Interest-bearing checking accounts		22,617	0.73	%
Money market and savings deposits		149,632	3.54	%
Time deposits		399,720	5.17	%
Average total deposits	$	744,863	3.51	%

Deposit Totals. Deposits totaled $777 million at September 30, 2007 as compared to $718 million at December 31, 2006. At September 30, 2007, noninterest-bearing deposits totaled $205 million and represented 26% of total deposits, as compared to $189 million and 26% of total deposits at December 31, 2006. At September 30, 2007, certificates of deposit in denominations of $100,000 or more totaled $242 million and represented 31% of total deposits, as compared to $219 million and 31% of total deposits at December 31, 2006. Set forth below, in thousands of dollars, is a maturity schedule of domestic time certificates of deposit outstanding at September 30, 2007:

	At September 30, 2007
	Certificates of Deposit Under $100,000		Certificates of Deposit of $100,000 or More
	Unaudited
Maturities
Three months or less	$	27,814	$	74,228
Over three and through twelve months		97,118		131,704
Over twelve months		35,295		31,680
Total certificates of deposit	$	160,227	$	237,612

Liquidity

We actively manage our liquidity needs to ensure that sufficient funds are available to meet our needs for cash, including to fund new loans to and deposit withdrawals by 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, proceeds from the sale or maturity of investments, increases in deposits and increases in borrowings principally from the Federal Home Loan Bank. 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.

25

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 $223 million or 20% of total assets at September 30, 2007.

Cash flow From Operating Activities. Cash flow of $6 million was provided by our continuing operations during the nine months ended September 30, 2007, the source of which consisted primarily of net income of $5 million.

Cash flow Provided by Investing Activities. In the nine months ended September 30, 2007, $25 million was provided in investing activities, the source of which was $31 million from maturities or principal payments received on investment securities available for sale, offset by $7 million in purchases of securities available for sale and other stock.

Cash flow Provided by Financing Activities. Cash flow of $50 million was provided by financing activities during the nine months ended September 30, 2007, the source of which consisted primarily of a net increase of $60 million in deposits, partially offset by $10.3 million used to fund the redemption of junior subordinated debentures.

Ratio of Loans to Deposits.The relationship between gross loans and total deposits can provide a useful measure of a bank’s 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 September 30, 2007, the ratio of loans-to-deposits was 95%, compared to 103% at December 31, 2006.

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 September 30, 2007 and December 31, 2006, we were committed to fund certain loans amounting to approximately $219 million and $224 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 could potentially be 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 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 a source of additional funds that we have used primarily to fund loans and to purchase other interest earning assets, we have obtained long and short term borrowings from the Federal Home Loan Bank (the “FHLB”). As of September 30, 2007, we had $133 million of outstanding long-term borrowings, with maturities ranging from October 2008 to March 2010, and $61

26

million of outstanding short-term borrowings, with maturities ranging from October 2007 to August 2008, that we had obtained from the Federal Home Loan Bank. These borrowings, together with securities sold under agreements to repurchase, have a weighted-average annualized interest rate of 4.97%. By comparison, as of December 31, 2006, we had $116 million of outstanding long-term borrowings and $81 million of outstanding short-term borrowings that we had obtained from the Federal Home Loan Bank, which, together with the securities sold under agreements to repurchase, had a weighted-average annualized interest rate of 4.54%

At September 30, 2007, U.S. Agency and Mortgage Backed securities, U.S. Government agency securities and collateralized mortgage obligations with an aggregate fair market value of $134 million and $154 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 nine months ended September 30, 2007 consisted of $231 million of borrowings from the Federal Home Loan Bank and $10 million of overnight borrowings in the form of securities sold under repurchase agreements. During 2006, the highest amount of borrowings outstanding at any month end consisted of $274 million of advances from the Federal Home Loan Bank and $33 million of overnight borrowings in the form of securities sold under repurchase agreements.

Junior Subordinated Debentures. Pursuant to rulings of the Federal Reserve Board, bank holding companies have been permitted to issue long term subordinated debt instruments that will, subject to certain conditions, qualify as and, therefore, augment capital for regulatory purposes. Pursuant to those rulings, in 2002, we formed subsidiary grantor trusts to sell and issue to institutional investors a total of approximately $17.5 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 $17.5 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 $10.3 million of trust preferred securities to an institutional investor and, in connection therewith, we sold and issued an additional $10.3 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.

During the quarter ended September 2007, we voluntarily redeemed, at par, $10.3 million principal amount of the Debentures that we issued in 2002.

Set forth below are the respective principal amounts, in thousands of dollars, and certain other information regarding the terms, of the Debentures that remained outstanding as of September 30, 2007:

Original Issue Dates	Principal Amount		Interest Rate(1)		Maturity Dates
September 2002	$	7,217	LIBOR plus 3.40	%	September 2032
October 2004		10,310	LIBOR plus 2.00	%	October 2034
Total	$	17,527

⁽¹⁾ Interest rate resets quarterly.

These Debentures require quarterly 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 deferral 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 September 30, 2007, a total amount of $17.5 million principal amount of those Debentures qualified as Tier I capital for regulatory purposes.

These Debentures are redeemable, at our option, without premium or penalty, beginning five years after their respective original issue dates. As noted above, we exercised this voluntary redemption right to redeem $10.3 million principal amount of the Debentures that we issued in 2002.

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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;

• 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, in thousands of dollars, as of September 30, 2007 and December 31, 2006:

	Amortized Cost		Gross Unrealized Gain		Gross Unrealized Loss		Estimated Fair Value
			Unaudited
September 30, 2007
Securities Available For Sale:
US Agencies/Mortgage-backed securities	$	209,121	$	77	$	2,915	$	206,283
Collateralized mortgage obligations		19,441		—		376		19,065
Total government and agencies securities		228,562		77		3,291		225,348
Municipal securities		22,893		67		247		22,713
Mutual fund		1,720		—		—		1, 720
Total Securities Available For Sale	$	253,175	$	144	$	3,538	$	249,781
December 31, 2006
Securities Available For Sale:
U.S. agencies and mortgage-backed securities	$	211,790	$	91	$	4,608	$	207,273
Collateralized mortgage obligations		21,751		—		437		21,314
Total government and agencies securities		233,541		91		5,045		228,587
Municipal securities		11,651		201		—		11,852
Mutual fund		1,473		—		—		1,473
Total Securities Available For Sale	$	246,665	$	292	$	5,045	$	241,912

At September 30, 2007, U.S. Agencies and Mortgage Backed securities, U.S. Government Agency securities and collateralized mortgage obligations with an aggregate fair market value of $134 million were pledged to secure Federal Home Loan Bank borrowings, repurchase agreements, local agency deposits and Treasury, Tax and Loan accounts.

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The amortized cost and estimated fair value, at September 30, 2007, of securities available for sale are shown, in thousands of dollars in the following table, 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
	One year or less			Over one year through five years			Over five years through ten years			Over ten years			Total
(Dollars in thousands)	Unaudited
Securities available for sale, amortized cost	$	41,118		$	108,011		$	54,428		$	49,618		$	253,175
Securities available for sale, estimated fair value		40,465			106,353			53,709			49,254			249,781
Weighted average yield		4.32	%		4.39	%		4.62	%		4.68	%		4.49	%

The table below shows as of September 30, 2007, the gross unrealized losses and fair values (in thousands of dollars) 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 September 30, 2007
	Less than 12 months					12 months or more					Total
	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
(Dollars In thousands)	Unaudited
US agencies and mortgage backed securities	$	25,161	$	(110	)	$	126,375	$	(2,805	)	$	151,536	$	(2,915	)
Collateralized mortgage obligations		5,930		(36	)		13,137		(340	)		19,067		(376	)
Municipal securities		11,782		(247	)		—		—			11,782		(247	)
Total temporarily impaired securities	$	42,873	$	(393	)	$	139,512	$	(3,145	)	$	182,385	$	(3,538	)

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 or until their maturity.

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 primarily in terms of the ratios of their capital to their assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. Under those regulations, based primarily on those quantitative measures each bank holding company and each federally insured bank is determined by its primary federal bank regulatory agency to come within one of the following categories.

• well capitalized

• adequately capitalized

• undercapitalized

• significantly undercapitalized; or

• critically undercapitalized

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

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The following table sets forth the capital and capital ratios of the Company (on a consolidated basis) and the Bank (on a stand alone basis) at September 30, 2007, 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	$	119,331	14.6	%	$	65,617	At least 8.0	%	$	82,022	At least 10.0	%
Bank		92,418	11.3	%		65,232	At least 8.0	%		81,540	At least 10.0	%
Tier 1 Capital to Risk Weighted Assets:
Company	$	113,480	13.8	%	$	32,809	At least 4.0	%	$	49,213	At least 6.0	%
Bank		86,605	10.6	%		32,616	At least 4.0	%		48,924	At least 6.0	%
Tier 1 Capital to Average Assets:
Company	$	113,480	10.4	%	$	43,751	At least 4.0	%	$	54,689	At least 5.0	%
Bank		86,605	7.7	%		44,768	At least 4.0	%		55,960	At least 5.0	%

As of September 30, 2007, 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.

The consolidated total capital and Tier 1 capital of the Company, at September 30, 2007, include an aggregate of $17.5 million principal amount of Junior Subordinated Debentures that we issued in 2002 and 2004 in connection with the sale of trust preferred securities. We contributed $17.5 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 current dividend policy is to retain earnings to support the future growth of the Company. However, the Board of Directors periodically reviews this policy and the Company’s cash flow requirements in order to determine whether to modify this policy to provide for the payment of cash dividends.

In September 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 the Company to purchase up to two percent (2%) of the Company’s outstanding common shares, which are approximates 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.

During June 2007, the Company made open market purchases of an aggregate of 50,000 shares of its common stock pursuant to this program for an aggregate purchase price of $687,500, which results in an average per share price of $13.75. No shares were repurchased during the quarter ended September 30, 2007.

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

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

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

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

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

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

Additionally, real estate values in California, as well as in many other parts of the country, have begun to decrease, after several years of significant increases. If real estate values continue to decline, or other events (such as earthquakes or fires, that are more prevalent in Southern California than most 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 events that can adversely affect the credit markets, such as the recent increase in real estate mortgage loan foreclosures, 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 interest income and net interest margins. Increases in interest rates as a result of the Federal Reserve Board’s monetary policies also could lead depositors to transfer funds from noninterest bearing demand deposits to higher cost certificates of deposit or to mutual funds, which would cause an increase in our interest expense. 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.

We could incur losses on the loans we make

The failure or inability of borrowers to repay their loans in full 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.

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 an 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

31

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.

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.

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, 2006 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 Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures in effect as of September 30, 2007. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that, as of September 30, 2007, 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 September 30, 2007 that has materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II

ITEM 1A. RISK FACTORS

There have been no material changes from the risk factors that were disclosed under the caption “Risk Factors” in Item 1A of Part I of our Annual Report on Form 10-K for the fiscal year ended December 31, 2006, except as may otherwise be set forth above under the caption “Risks That Could Affect Our Future Financial Performance” in Item 2 of Part I of this Report and except as follows:

There has been a recent increase in mortgage loan foreclosures throughout the United States, due primarily to increasing market rates of interest and declining property values. Although the vast majority of these foreclosures appear to involve borrowers who had financed home purchases or refinanced existing home mortgage loans with so-called subprime mortgage loans, mortgage loan foreclosures can result in increases in loan losses and require mortgage lenders to take ownership of the foreclosed real properties in order to mitigate potential loan losses, which can result in increased non-interest expenses. Moreover, some economists have expressed concerns that the recent increase in mortgage loan foreclosures could lead to increases in interest rates that could adversely affect loan demand in general and even adversely affect national economic conditions. We began to reduce our exposure to these risks when we discontinued our residential mortgage lending business in 2005 and, more recently, have begun reducing the volume of real estate loans that we make. However, there is no assurance that these conditions will not have a broader impact on prevailing market rates of interest or economic conditions that could adversely affect our operating results in the future.

ITEM 6. EXHIBITS

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

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

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SIGNATURES

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

	PACIFIC MERCANTILE BANCORP
Date: November 8, 2007	By:	/s/ NANCY A. GRAY
		Nancy A. Gray, Chief Financial Officer

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EXHIBIT INDEX

Exhibit No.	Description of Exhibit
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

E-1