Heritage Oaks Bancorp 10Q 2006 Q3 Quarterly report

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

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

For the Transition Period from _____ to _____

Commission File No. 0-25020

HERITAGE OAKS BANCORP

(Exact name of registrant as specified in charter)

STATE OF CALIFORNIA

(State or other jurisdiction of incorporation or organization)

77-0388249

(I.R.S. Employer Identification Code)

545 12th STREET, PASO ROBLES, CA 93446

(Address of principal office)

(805) 239-5200

(Registrant's telephone number, including area code)

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 twelve (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 ninety (90) days.

YES x NO o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or is 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 o Accelerated filer o Non-accelerated filer x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x

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

As of October 11, 2006 there were approximately 6,356,021 shares outstanding of the Registrant’s common stock.

TABLE OF CONTENTS

Part 1. Financial Information	3

Item 1. Consolidated Financial Statements (Un-audited)	3

Consolidated Balance Sheets	3
Consolidated Statements of Operations	4
Consolidated Statements of Other Comprehensive Income	5
Consolidated Statement of Changes in Stockholders’ Equity	6
Consolidated Statements of Cash Flows	7
Notes to Consolidated Financial Statements	8

Item 2. Management’s Discussion and Analysis of
Financial Condition and Results of Operations	16

Item 3. Quantitative and Qualitative Disclosure about Market Risk	35

Item 4. Controls and Procedures	37

Part 2. Other Information	37

Item 1. Legal Proceedings	37

Item 1. A. Risk Factors	37

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	37

Item 3. Defaults Upon Senior Securities	38

Item 4. Submission of Matters to a Vote of Security Holders	38

Item 5. Other Information	38

Item 6.Exhibits	38

Signatures	39

Certifications

Exhibits	40

PART 1. FINANCIAL INFORMATION

Item 1. Financial Statements

HERITAGE OAKS BANCORP

CONSOLIDATED BALANCE SHEETS

(in thousands)	September 30,		December 31,
	2006		2005
ASSETS		(Unaudited)		(1)
Cash and due from banks	$	17,972	$	18,279
Federal funds sold		14,195		26,280
Total cash and cash equivalents		32,167		44,559
Interest bearing deposits other banks		318		298
Securities Available for sale		40,294		44,402
Federal Home Loan Bank Stock, at cost		1,955		1,885
Loans Held For Sale		2,069		3,392
Loans, net		419,314		362,635
Property, premises and equipment, net		14,801		11,905
Cash surrender value life insurance		9,344		7,706
Deferred Tax Assets		2,515		2,358
Goodwill		4,864		4,865
Core Deposit Intangible		1,223		1,448
Other assets		3,517		3,048
TOTAL ASSETS	$	532,381	$	488,501

LIABILITIES
Deposits:
Demand, non-interest bearing	$	157,180	$	164,014
Savings, NOW, and money market deposits		152,033		170,106
Time deposits of $100 or more		31,782		17,414
Time deposits under $100		89,277		66,263
Total deposits		430,272		417,797
FHLB advances and other borrowed money		40,000		10,000
Securities Sold under Agreement to Repurchase		1,219		3,847
Junior subordinated debentures		8,248		8,248
Other liabilities		4,215		3,764
Total liabilities		483,954		443,656

STOCKHOLDERS' EQUITY
Common stock, no par value;
20,000,000 shares authorized; issued and outstanding
6,356,021 and 6,231,982 as of September 30, 2006
and December 31, 2005, respectively.		29,648		29,255
Retained earnings		18,668		15,748
Accumulated other comprehensive income/(loss)		111		(158	)
Total stockholders' equity		48,427		44,845
TOTAL LIABILITIES & STOCKHOLDERS' EQUITY	$	532,381	$	488,501

(1) These numbers have been derived from the audited financial statements.

See notes to condensed consolidated financial statements

HERITAGE OAKS BANCORP

CONSOLIDATED STATEMENTS OF INCOME

(in thousands except per share date)

	For the three months				For the nine months
	ended September 30,				ended September 30,
	2006		2005		2006		2005
	(Unaudited)		(Unaudited)		(Unaudited)		(Unaudited)
Interest Income:

Interest and fees on loans	$	8,968	$	7,179	$	24,475	$	19,794
Investment securities		467		489		1,446		1,586
Federal funds sold and commercial paper		131		270		513		440
Time certificates of deposit		2		2		6		7
Total interest income		9,568		7,940		26,440		21,827

Interest Expense:

Now accounts		22		25		66		67
MMDA accounts		567		442		1,687		983
Savings accounts		25		29		78		71
Time deposits of $100 or more		172		103		428		276
Other time deposits		1,132		350		2,671		856
Other borrowed funds		628		398		1,406		1,201
Total interest expense		2,546		1,347		6,336		3,454

Net Interest Income Before Prov. for Possible Loan Losses		7,022		6,593		20,104		18,373
Provision for loan losses		180		170		480		530
Net interest income after provision for loan losses		6,842		6,423		19,624		17,843

Non-interest Income:
Service charges on deposit accounts		644		655		1,826		1,825
Other income		578		734		1,826		1,962
Total Non-interest Income		1,222		1,389		3,652		3,787

Non-interest Expense:
Salaries and employee benefits		2,965		2,532		8,534		7,188
Occupancy and equipment		633		600		1,901		1,853
Other expenses		1,786		1,743		4,982		4,820
Total Noninterest Expenses		5,384		4,875		15,417		13,861
Income before provision for income taxes		2,680		2,937		7,859		7,769
Provision for applicable income taxes		947		1,132		2,846		2,940
Net Income	$	1,733	$	1,805	$	5,013	$	4,829

Earnings per share: (See note #4)
Basic	$	0.27	$	0.29	$	0.79	$	0.79
Fully Diluted	$	0.26	$	0.28	$	0.76	$	0.74

See notes to condensed consolidated financial statements

HERITAGE OAKS BANCORP

Consolidated Statements of Comprehensive Income

(Unaudited, in thousands)	Three Month Period						Nine Month Period
	Ended September 30,						Ended September 30,
	2006			2005			2006			2005
Net Income	$	1,733		$	1,805		$	5,013		$	4,829
Other Comprehensive Income (Loss) Before Taxes:
Unrealized gains (losses) on securities available for sale:
Unrealized holding gains (losses) arising during period		(1,043	)		(291	)		448			(240	)
Reclassification adjustments for (gains) included in net income		-			-			-			-
Other comprehensive income (loss), before taxes		(1,043	)		(291	)		448			(240	)
Income tax expense (benefit) related to items in comprehensive income		418			118			(179	)		96
Income tax expense (benefit) related to realized gain in comprehensive income		-			-			-			-
Other Comprehensive Income (Loss), Net of Taxes		(625	)		(173	)		269			(144	)
Comprehensive Income	$	1,108		$	1,632		$	5,282		$	4,685

See notes to condensed consolidated financial statements

HERITAGE OAKS BANCORP

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

September 30, 2006 and September 30, 2005

(Unaudited)

( in thousands except shares outstanding)

										Accumulated
										Other			Total
	Shares			Common			Retained			Comprehensive			Stockholders'
	Outstanding			Stock			Earnings			Income/(Loss)			Equity

Balance January 1, 2006		6,231,982		$	29,255		$	15,748		$	(158	)	$	44,845

Exercise of Stock Options (including $160 tax benefit from exercise of stock options)		72,989			559									559

Cash Dividend of $.25 per share paid May 19, 2006								(1,585	)					(1,585	)
Cash Dividend of $.08 per share paid August 25, 2006								(508	)					(508	)
Stock-based compensation expense					83									83
Issuance of Restricted Stock Awards		66,050
Stock Repurchased		(15,000	)		(249	)								(249	)
Comprehensive Income
Net Income								5,013						5,013
Unrealized security holding gains (net of $179 tax)											269			269
Total other comprehensive Income														5,282

Balance September 30, 2006		6,356,021		$	29,648		$	18,668		$	111		$	48,427


											Other			Total
		Shares			Common			Retained			Comprehensive			Stockholders'
		Outstanding			Stock			Earnings			Income			Equity

Balance January 1, 2005		3,817,943		$	24,050		$	13,053		$	147		$	37,250

Exercise of Stock Options		133,980			945									945
Stock dividend- 5%		195,013			3,930			(3,930	)					0
Cash paid to Shareholders' in Lieu of
fractional shares on 5% Stock Dividend								(8	)					(8	)
Comprehensive Income
Net Income								4,829						4,829
Unrealized Security Holding Gains
(net of $96 tax )											(144	)		(144	)
Total other comprehensive Income														4,685

Balance September 30, 2005		4,146,936		$	28,925		$	13,944		$	3		$	42,872

See notes to condensed consolidated financial statements

HERITAGE OAKS BANCORP

CONSOLIDATED STATEMENTS OF CASHFLOWS

(in thousands)

	Periods ended September 30,
	2006			2005
	(Unaudited)			(Unaudited)
Cash Flows from Operating Activities
Net income	$	5,013		$	4,829
Adjustments to reconcile net income to
net cash provided by operating activities
Net cash provided by operating activities
Depreciation and amortization		690			688
Provision for possible loan losses		480			530
Provision for possible unfunded loan commitment		-			(10	)
Amortization of premiums/discounts on
Investment securities, net		(3	)		170
FHLB stock dividends received		(70	)		(55	)
Amortization of intangible assets		225			431
Stock based compensation expense		83			-
(Increase) in loans held for sale		1,323			(5,441	)
Net increase in cash surrender value of life insurance		(252	)		(205	)
(Increase) in other assets		(805	)		(73	)
Excess tax benefit related to stock based compensation expense		-			-
Increase in other liabilities		452			626
NET CASH PROVIDED BY/(USED IN) OPERATING ACTIVITIES		7,136			1,490
Cash Flows From Investing Activities
Net Change in time deposits		(20	)		200
Purchase of securities available-for-sale		(1,190	)		(1,393	)
Maturity/Call AFS securities		-			850
Proceeds from principal reductions and maturities
of mortgage backed securities available-for-sale		5,749			11,065
Purchase of life insurance policies		(1,386	)		(300	)
Increase in loans, net		(57,180	)		(31,746	)
Net ALLL Recoveries		21			22
Proceeds from disposal of property		-			617
Purchase of property, premises and equipment, net		(3,586	)		(1,660	)
NET CASH USED IN INVESTING ACTIVITIES		(57,592	)		(22,345	)
Cash Flows From Financing Activities
Increase in deposits, net	$	12,475		$	73,328
Increase in FHLB borrowing		30,000			(500	)
Increase/(Decrease) in Repurchase agreements		(2,628	)		1,291
Proceeds from exercise of stock options		270			945
Excess tax benefit related to stock based compensation		289			-
Repurchase of stock		(249	)		-
Cash Dividend paid		(2,093	)		-
Cash paid in lieu of fractional shares		-			(8	)
NET CASH PROVIDED BY FINANCING ACTIVITIES		38,064			75,056
Net Increase in Cash and Cash Equivalents		(12,392	)		54,201
Cash and Cash Equivalents, Beginning of year		44,559			21,867
Cash and Cash Equivalents, End of period	$	32,167		$	76,068
Supplemental Disclosures of Cash Flow Information
Interest paid	$	5,939		$	3,456
Income taxes paid	$	2,290		$	3,132

See notes to condensed consolidated financial statements

Note 1. CONSOLIDATED FINANCIAL STATEMENTS

The accompanying un-audited condensed consolidated financial statements of Heritage Oaks Bancorp and subsidiaries (the “Company”) have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and notes required by accounting principles generally accepted in the United States of America for annual financial statements are not included herein. In the opinion of Management, all adjustments (which consist solely of normal recurring accruals) considered necessary for a fair presentation of results for the interim periods presented have been included. These interim condensed consolidated financial statements should be read in conjunction with the financial statements and related notes contained in the Company’s 2005 Annual Report on Form 10-K.

The condensed consolidated financial statements include the accounts of the Company and its wholly-owned financial subsidiary, Heritage Oaks Bank (the “Bank”). All significant inter-company balances and transactions have been eliminated. Heritage Oaks Capital Trust I is an unconsolidated subsidiary formed solely for the purpose of issuing trust preferred securities. Operating results for the three and nine months ended September 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. Certain amounts in the consolidated financial statements for the year ended December 31, 2005 and the three and nine month period ended September 30, 2005 may have been reclassified to conform to the presentation of the consolidated financial statement in 2006.

The preparation of consolidated financial statements in conformity with the accounting principles generally accepted in the United States of America requires Management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

Note 2. INVESTMENT SECURITIES

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

The amortized cost and fair values of investment securities available for sale at September 30, 2006 and December 31, 2005:

(in thousands)			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
Balance September 30, 2006	Cost		Gains		Losses			Value

Obligations of U.S. government agencies and corporations	$	759	$	-	$	(8	)	$	751
Mortgage-backed securities		23,243		10		(461	)		22,792
Obligations of State and Political Subdivisions		16,100		670		(28	)		16,742
Other Securities		9		-		-			9
TOTAL	$	40,111	$	680	$	(497	)	$	40,294


				Gross		Gross
		Amortized		Unrealized		Unrealized			Fair
As of December 31, 2005		Cost		Gains		Losses			Value

Obligations of U.S. government agencies and corporations	$	826	$	-	$	(20	)	$	806
Mortgage-backed securities		28,795		13		(518	)		28,290
Obligations of State and Political Subdivisions		15,036		364		(103	)		15,297
Other Securities		9		-		-			9
TOTAL	$	44,666	$	377	$	(641	)	$	44,402

Note 3. LOANS AND ALLOWANCE FOR LOAN LOSSES

Major classifications of loans were:

	September 30,			December 31,
(in thousands)	2006			2005

Commercial, financial, and agricultural	$	75,627		$	60,050
Real estate-construction/land		101,665			76,981
Real estate - other		229,070			210,690
Home equity lines of credit		11,777			14,398
Installment loans to individuals		5,660			5,620
All other loans (including overdrafts)		867			394
		424,666			368,133

Less - deferred loan fees, net		(1,489	)		(1,617	)
Less - reserve for possible loan losses		(3,863	)		(3,881	)

Total loans		419,314			362,635

Loans Held For Sale	$	2,069		$	3,392

Concentration of Credit Risk

At September 30, 2006, approximately $342.5 million of the Bank’s loan portfolio was collateralized by various forms of real estate. Such loans are generally made to borrowers located in San Luis Obispo and Santa Barbara Counties. The Bank attempts to reduce its concentration of credit risk by making loans which are diversified by project type. While Management believes that the collateral presently securing this portfolio is adequate, there can be no assurances that significant deterioration in the California real estate market would not expose the Bank to significantly greater credit risk.

At September 30, 2006, the Bank was contingently liable for letters of credit accommodations made to its customers totaling approximately $20.1 million and un-disbursed loan commitments in the approximate amount of $160 million. The Bank makes commitments to extend credit in the normal course of business to meet the financing needs of its customers. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total outstanding commitment amount does not necessarily represent future cash requirements. Standby letters of credit written 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 those involved in extending loan facilities to customers. The Bank anticipates no losses as a result of such transactions.

Allowance for Loan Losses

An allowance for loan losses has been established by management to provide for those loans that may not be repaid in their entirety for a variety of reasons. The allowance is maintained at a level considered by management to be adequate to provide for probable incurred losses. The allowance is increased by provisions charged to earnings and is reduced by charge-offs, net of recoveries. The provision for loan losses is based upon past loan loss experience and management’s evaluation of the loan portfolio under current economic conditions. Loans are charged to the allowance for loan losses when, and to the extent, they are deemed by management to be un-collectible. The allowance for loan losses is composed of allocations for specific loans and a historical portion for all other loans.

An analysis of the changes in the reserve for possible loan losses is as follows:

(in thousands)	September 30,			December 31,
	2006			2005

Balance at beginning of year	$	3,881		$	3,247
Additions charged to operating expense		480			710
Loans charged off		(519	)		(100	)
Recoveries of loans previously charged off		21			24
Balance at end of year	$	3,863		$	3,881

The Bank recognizes that credit losses will be experienced and the risk of loss will vary with, among other things, general economic conditions; the type of loan being made; the creditworthiness of the borrower over the term of the loan and in the case of a collateralized loan, the quality of the collateral for such loan. The allowance for loan loss represents the Bank’s estimate of the allowance necessary to provide for probable incurred losses in the portfolio. In making this determination, the Bank analyzes the ultimate ability to collect the loans in its portfolio by incorporating feedback provided by internal loan staff, an independent loan review function, and information provided by examinations performed by regulatory agencies. The Bank makes monthly evaluations as to the adequacy of the allowance for loan losses.

The analysis of the allowance for loan losses is comprised of three components: specific credit allocation; general portfolio allocation; and subjectively by determined allocation. Effective January 1, 1995, the Bank adopted SFAS No.114, Accounting by Creditors for Impairment of a Loan (SFAS 114), as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures. These pronouncements provide that when it is probable that a creditor will be unable to collect all amounts due in accordance with the terms of the loan that such loan is deemed impaired. Impaired loans are accounted for differently in that the amount of the impairment is measured and reflected in the records of the creditor. The allowance for credit losses related to loans that are identified for evaluation in accordance with Statement 114 is based on discounted cash flows using the loan’s initial effect interest rate or the fair value of the collateral for certain collateral dependent loans. The general portfolio allocation consists of an assigned reserve percentage based on the credit rating of the loan. The subjective portion is determined based on loan history and the Bank’s evaluation of various factors including current economic conditions and trends in the portfolio including delinquencies and impairment, as well as changes in the composition of the portfolio.

The allowance for loan losses is based on estimates, and ultimate losses will vary from current estimates. These estimates are reviewed monthly, and as adjustments, either positive or negative, become necessary, a corresponding increase or decrease is made in the provision for loan losses. The methodology used to determine the adequacy of the allowance for possible loan losses for the three and nine months ended September 30, 2006 is consistent with prior periods.

The allowance for loan losses as a percentage of total net loans was .92% as of September 30, 2006 and 1.07% as of December 31, 2005. Management believes that the allowance for credit losses at September 30, 2006 is prudent and warranted, based on information currently available.

Note 4. EARNINGS PER SHARE

Basic earnings per share are based on the weighted average number of shares outstanding before any dilution from common stock equivalents. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shares in the earnings of the entity.

On March 25, 2005, the Company’s Board of Directors declared a 5% stock dividend. The record date for the stock dividend was April 8, 2005 and the pay date was April 22, 2005. In addition, on October 21, 2005, the Board of Directors declared a 3 for 2 stock split payable on December 2, 2005 to stockholders of record on November 10, 2005. Share information has been retroactively adjusted for the stock split and dividend.

On April 21, 2006 the Board of Directors declared a special $0.25 per share cash dividend that was paid on May 19, 2006 to shareholders of record on May 8, 2006.

On July 21, 2006, the Board of Directors declared a quarterly cash dividend of $.08 to be paid on August 25, 2006 to shareholders of record on August 11, 2006. In addition, the Board of Directors adopted a resolution authorizing the repurchase of up to 40,000 shares of Company stock. Purchases are to be made, as conditions warrant, from time to time in the open market. The duration of the program is one year and the timing of purchases will depend on market conditions. During the three months ending September 30, 2006, 15,000 shares of the Company’s stock was repurchased.

On October 20, 2006, the Board of Directors declared a quarterly cash dividend of $.08 to be paid on November 17, 2006 to shareholders of record on November 3, 2006. In addition, the Board of Directors adopted a resolution to increase the number of shares to 100,000 for the repurchase plan that was adopted in July 2006. Purchases are to be made, as conditions warrant, from time to time in the open market. The duration of the program is one year and the timing of purchases will depend on market conditions.

The following table shows the number of shares used to calculate and the earnings per share for the three and nine months ending September 30, 2006 and 2005:

	For the Three Months Ending				For the Nine Months Ending
	September 30,				September 30,
	2006		2005		2006		2005

Net Income	$	1,733,149	$	1,804,918	$	5,012,872	$	4,828,627
Basic	$	0.27	$	0.29	$	0.79	$	0.79
Diluted	$	0.26	$	0.28	$	0.76	$	0.74
Shares:
Basic		6,350,727		6,186,045		6,326,743		6,147,243
Diluted		6,594,626		6,499,178		6,594,800		6,514,980

Note 5. RECENT ACCOUNTING PRONOUNCEMENTS

In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109 (FIN 48) which clarifies the accounting and disclosure for uncertainty in tax positions, as defined. FIN 48 seeks to reduce the diversity in practice associated with certain aspects of the recognition and measurement related to accounting for income taxes. This interpretation is effective for fiscal years beginning after December 15, 2006. The Company has not yet determined the impact this interpretation will have on our results from operations or financial position.

SHARE-BASED PAYMENT: Effective January 1, 2006, we adopted the fair value recognition provisions of statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), "Share-Based Payment" (SFAS No.123(R)), using the modified prospective transition method and, therefore, have not restated results for prior periods. Under this transition method, stock-based compensation expense for the nine months ending September 30, 2006 included compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provision of SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS No.123"). Stock-based compensation expense for all stock-based compensation awards granted after January 1, 2006 is based on the grant-date fair value estimated in accordance with the provisions of SFAS No.123(R). The Company recognizes these compensation costs on a straight-line basis over the requisite service period of the award. Prior to the January 1, 2006 adoption of SFAS No.123(R), the Company recognized stock-based compensation expense in accordance with Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees" (APB No. 25). In March 2005, the Securities and Exchange Commission (the SEC) issued Staff Accounting Bulletin No. 107 (SAB No. 107) regarding the SEC's interpretation of SFAS No.123(R) and the valuation of share-based payments for public companies. The Company has applied the provisions of SAB No. 107 in its adoption of SFAS No. 123(R). See Note 6 to the Un-audited Consolidated Financial Statements for a further discussion on stock-based compensation.

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

ACCOUNTING FOR SERVICING OF FINANCIAL ASSETS: In March 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 156, "Accounting for Servicing of Financial Assets- an amendment of FASB Statement No. 140." SFAS No.156 requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in specific situations. Additionally, the servicing asset or servicing liability shall be initially measured at fair value; however, an entity may elect the "amortization method" or "fair value method" for subsequent balance sheet reporting periods. SFAS No.156 is effective as of an entity's first fiscal year beginning after September 15, 2006. Early adoption is permitted as of the beginning of an entity's fiscal year, provided the entity has not yet issued financial statements, including interim financial statements, for any period of that fiscal year. The Company does not expect the adoption of this statement to have a material impact on its financial condition, results of operations or cash flows.

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

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (an amendment of FASB Statements No. 87, 88, 106, and 132R) (FAS 158), requires an employer to: (a) Recognize in its statement of financial position an asset for a plan’s over funded status or a liability for a plan’s under funded status; (b) measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year (with limited exceptions); and (c) recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur. Those changes will be reported in comprehensive income of a business entity and in changes in net assets of a not-for-profit organization. The requirement by FAS 158 to recognize the funded status of a benefit plan and the disclosure requirements of FAS 158 are effective as of the end of the fiscal year ending after December 15, 2006 for entities with publicly traded equity securities. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end statement of financial position is effective for fiscal years ending after December 15, 2008. The Company does not expect the adoption of FAS 158 to have a material effect on the financial position of the company at December 31, 2006.

Note 6. Stock-Based Compensation

As of September 30, 2006, the Company had three stock-based employee compensation plans, which are more fully described in Note 14 of the Consolidated Financial Statements in the Company's Annual Report on Form 10-K for the year ended December 31, 2005. These plans include two stock option plans and the 2005 Equity Based Compensation Plan.

Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123(R), using the modified prospective transition method and, therefore, have not restated results for prior periods. Under this transition method, stock-based compensation expense for the first nine months of 2006 included compensation expense for all stock-based compensation awards granted prior to, but that remained unvested as of, January 1, 2006. Compensation expense was based on the grant date fair value estimated in accordance with the original provision of SFAS No. 123.

Prior to January 1, 2006, the Company accounted for stock-based compensation under the recognition, measurement and pro forma disclosure provisions of APB No. 25, the original provisions of SFAS No. 123, and SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure" (SFAS 148). No stock-based compensation expense was reflected in net income as all options are required by the plan to be granted with an exercise price equal to the estimated fair value of the underlying common stock on the date of grant.

Stock-based compensation expense for all stock-based compensation awards granted after January 1, 2006, is based on the grant-date fair value. For all awards except stock option awards, the grant date fair value is either the fair market value per share or book value per share (corresponding to the type of stock awarded) as of the grant date. For stock option awards, the grant date fair value is estimated using the Black-Scholes option pricing model. For all awards the Company recognizes these compensation costs only for those shares expected to vest on a straight-line basis over the requisite service period of the award, for which we use the related vesting term. The Company estimates forfeiture rates based on historical employee option exercise and employee termination experience.

As a result of the Company’s January 1, 2006, adoption of SFAS No.123(R), the impact to the Consolidated Financial Statements for the nine months ended September 30, 2006 on income before income taxes and on net income were reductions of $83 thousand and $50 thousand, respectively. The cumulative effect of the change in accounting was $83 thousand before income taxes and $50 thousand, after income taxes. The change had no impact on basic and $.0076 on diluted earnings per share for the three months ended September 30, 2006. In addition, prior to the adoption of SFAS No. 123(R), the Company presented the tax benefit of stock option exercises as operating cash flows, upon the adoption of SFAS No. 123(R), tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options are classified as financing cash flows.

PRO FORMA INFORMATION UNDER SFAS NO. 123

Pro forma information regarding the effect on the net income and basic and diluted income per share for the three and nine months ended September 30, 2005, had the Company applied the fair value recognition provisions of SFAS No. 123, are as follows:

	For the Three			For the Nine
	Months Ended			Months Ended
	30-Sep-05			30-Sep-05
Net income:
As reported	$	1,804,918		$	4,828,627
Stock-based compensation using the intrinsic value method		-			-
Stock-based compensation that would have been reported
using the fair value method of SFAS 123		(6,607	)		(77,541	)
Pro forma net income	$	1,798,311		$	4,751,086

Weighted Average Shares Outstanding - Basic		6,186,045			6,147,243
Weighted Average Shares Outstanding - Diluted		6,499,178			6,514,980

Basic Earnings per share
As reported	$	0.29		$	0.79
Pro forma	$	0.29		$	0.77

Earnings per share - assuming dilution
As reported	$	0.28		$	0.74
Pro forma	$	0.28		$	0.73

The stock-based compensation expense recognized in the condensed consolidated statement of operations for the nine months ended September 30, 2006 is based on awards ultimately expected to vest, and accordingly has been adjusted by the amount of estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based partially on historical experience.

The aggregate intrinsic value in the table below represents the total pretax intrinsic value (the difference between the Company’s closing stock price on the last trading day of the third quarter of 2006 (September 30, 2006) and the exercise price, multiplied by the number of in-the-money options that would have been received by the option holders had all option holders exercised their options on September 30, 2006, this amount changes based on the fair market value of the Company's stock. Total intrinsic value of options exercised for the three and nine months ended September 30, 2006 was $330 thousand and $1,033 thousand, respectively. Total fair value of options vested and expensed was $50 thousand, net of tax, for the nine months ended September 30, 2006. No options were granted during the nine months ended September 30, 2006 and there were 11,250 options issued during the same period in 2005.

						Average
				Weighted		Remaining		Total
				Average		Contractual		Intrinsic
	Number of			Exercise		Term		Value
	Shares			Price		(in years)		(in 000's)

Options outstanding, January 1, 2006		525,915		$	5.19
Granted		-			-
Exercised		(72,989	)		3.66
Forfeited		(3	)		4.35

Options outstanding, September 30, 2006		452,923		$	5.43		3.9	$	4,924

Exercisable at September 30, 2006		383,837		$	4.49		3.7	$	4,534

As of September 30, 2006, there was $256,012 of total unrecognized compensation cost related to non-vested share-based compensation arrangements. That cost is expected to be recognized over a weighted-average period of 4.4 years.

The following table summarizes information about stock options outstanding at September 30, 2006:

Weighted

Average

Weighted

Range of

Number

Remaining

Average

Number

Average

Exercise

of shares

Contractual

Exercise

of shares

Exercise

Prices

Outstanding

Life (years)

Price

Exercisable

Price

$2.56 to $5.74

326,376

2.67

3.67

326,376

3.67

$5.75 to $10.27

37,047

5.95

6.94

25,140

6.70

$10.28 to $13.84

89,500

7.60

11.22

32,321

11.02

Totals

452,923

3.91

5.43

383,837

4.49

The fair value of each stock option was estimated on the date of grant using the Black-Scholes option-pricing model with the weighed average assumptions included on the table above, under the header "Stock Based Option Valuation and Expense Information under SFAS No.123(R)".

The Company grants restricted share awards periodically for the benefit of employees. These restricted shares generally “cliff vest” after five years of issuance. Recipients of restricted shares have the right to vote all shares subject to such grant, and receive all dividends with respect to such shares, whether or not the shares have vested. Recipients do not pay any cash consideration for the shares. The Company records compensation expense relating to restricted share awards. For the three and nine months ended September 30, 2006, the Company recorded compensation of $32 thousand and $101 thousand, net of tax, respectively.

Note 7. Reclassifications

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

Forward Looking Statements

Certain statements contained in this Quarterly Report on Form 10-Q (“Quarterly Report”), including, without limitation, statements containing the words “believes”, “anticipates”, “intends”, “expects”, and words of similar impact, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities and Exchange Act of 1934. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others, the following: general economic and business conditions in those areas in which the Company operates, demographic changes, competition, fluctuations in interest rates, changes in business strategy or development plans, changes in governmental regulation, credit quality, the availability of capital to fund the expansion of the Company’s business, as well as economic, political and global changes arising from the war on terrorism. (Refer to the Company’s December 31, 2005 10-K, ITEM 1A. Risk Factors.) The Company disclaims any obligation to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements contained herein to reflect future events or developments.

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

The following is an analysis of the results of operations and financial condition of the Company for the periods ending September 30, 2006 and 2005. The analysis should be read in connection with the consolidated financial statements and notes thereto appearing elsewhere in this report.

THE COMPANY

Heritage Oaks Bancorp (the "Company") is a California corporation organized in 1994 to act as a holding company of Heritage Oaks Bank ("Bank"), an 11 branch bank serving San Luis Obispo and northern Santa Barbara Counties. In 1994, the Company acquired all of the outstanding common stock of the Bank in a holding company formation transaction.

In October 2006, the Company formed Heritage Oaks Capital Trust II (the “Trust”). The Trust is a statutory business trust formed under the laws of the State of Delaware. The Trust is a wholly-owned, non-financial, non-consolidated subsidiary of the Company.

Other than holding the shares of the Bank, the Company conducts no significant activities, although it is authorized, with the prior approval of the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"), the Company's principal regulator, to engage in a variety of activities which are deemed closely related to the business of banking. The Company has also caused to be incorporated a subsidiary, CCMS Systems, Inc. which is currently inactive and has not been capitalized. The Company has no present plans to activate the proposed subsidiary.

Where You Can Find More Information

Under the Securities Exchange Act of 1934 Sections 13 and 15(d), periodic and current reports must be filed with the SEC. The Company electronically files the following reports with the SEC: Form 10-K (Annual Report), Form 10-Q (Quarterly Report), Form 8-K (Current Report), and Form DEF 14A (Proxy Statement). The Company may file additional forms. The SEC maintains an Internet site, www.sec.gov, in which all forms filed electronically may be accessed. Additionally, all forms filed with the SEC and additional shareholder information is available free of charge on the Company’s website: www.heritageoaksbancorp.com

The Company posts these reports to its website as soon as reasonably practicable after filing them with the SEC. None of the information on or hyperlinked from the Company’s website is incorporated into this Quarterly Report on Form 10-Q.

Executive Summary and Recent Developments

On October 27, 2006, the Company issued $8,248,000 of Floating Rate Junior Subordinated Deferrable Interest Debentures (the “debt securities”) to Heritage Oaks Capital Trust II, a statutory trust created under the laws of the State of Delaware. These debt securities are subordinated to effectively all borrowings of the Company and are due and payable on January 1, 2037. Interest is payable quarterly on these debt securities at 3-Month LIBOR plus 1.72% for an effective rate of 7.10% as of September 30, 2006. The debt securities can be called at any time commencing on January 1, 2012, at par. The Company also purchased a 3% minority interest totaling $248 thousand in Heritage Oaks Capital Trust II. The balance of the equity of Heritage Oaks Capital Trust II is comprised of mandatorily redeemable preferred securities and is included in other assets.

The Company intends to use the proceeds of the sale of the Trust Preferred Securities for general corporate purposes which may include investment in the Bank, acquisitions, investments, payment of dividends and repurchased of our outstanding common stock.

On April 21, 2006 the Company declared a $0.25 per share special cash dividend that paid on May 19, 2006 to shareholders of record on May 8, 2006. The special dividend was declared in lieu of recent annual stock dividends the Company has declared.

In July 2003, the Bank purchased a property immediately adjacent to its Headquarters facility. Construction was completed in May 2006 on the approximate 20 thousand square feet of office space. This facility houses all administrative functions of the Company and has enabled the Company to vacate two leased facilities.

The table below provides selected financial data that highlights the Company’s quarterly performance results:

Selected Financial Data

For the Quarter Ended,

	Sep-06			Jun-06			Mar-06			Dec-05			Sep-05			Jun-05			Mar-05			Dec-04

Return on Average Assets		1.35	%		1.37	%		1.33	%		1.47	%		1.44	%		1.37	%		1.24	%		1.18	%

Return on Average Equity		14.54	%		14.33	%		13.92	%		16.38	%		17.03	%		15.94	%		14.74	%		14.77	%

Average Equity to Average Assets		9.25	%		9.59	%		9.58	%		8.97	%		8.47	%		8.60	%		8.40	%		6.76	%

Net Interest Margin		6.07	%		6.04	%		5.90	%		6.06	%		5.80	%		5.68	%		5.55	%		5.40	%

Efficiency Ratio*		65.31	%		64.34	%		65.02	%		60.65	%		61.08	%		62.66	%		64.14	%		67.64	%

Average Loans to Average Deposits		97.15	%		94.37	%		90.15	%		89.84	%		89.60	%		91.91	%		92.82	%		85.65	%

Net Income	$	1,733		$	1,673		$	1,606		$	1,808		$	1,805		$	1,606		$	1,417		$	1,353

Earnings Per Share:
Basic	$	0.27		$	0.26		$	0.26		$	0.29		$	0.29		$	0.26		$	0.23		$	0.23
Diluted	$	0.26		$	0.25		$	0.24		$	0.27		$	0.28		$	0.25		$	0.22		$	0.21
Outstanding Shares:
Basic		6,350,727			6,337,712			6,283,890			6,223,500			6,186,045			6,167,571			6,080,805			6,010,964
Diluted		6,594,626			6,670,942			6,643,432			6,592,000			6,499,178			6,524,849			6,458,433			6,460,174

* The efficiency ratio is defined as total non-interest expense as a percent of the combined net interest income plus non-interest income.

The Company’s earnings are highly influenced by changes in short term interest rates. The nature of the Company’s balance sheet can be summarily described as of short duration and asset sensitive. The balance sheet is of short duration because a large percentage of its interest sensitive assets and liabilities re-price immediately with changes in the Federal Funds and Prime interest rates. The Company is asset sensitive, primarily due to its large volume of non-interest bearing demand deposit accounts which effectively never re-price. Therefore, an upward movement in short term interest rates will generally result in higher net interest margin and, conversely, a reduction in short term interest rates will result in reduced net interest margin.

Historically, the largest and most variable source of income for the Company is net interest income. The results of operations for the three and nine months ended September 30, 2006 and September 30, 2005 reflect the impact of increases in short term rates as well as growth in the volume of both interest earning assets and interest bearing liabilities during these periods.

Local Economy

The economy in the Company’s service area is based primarily on agriculture, tourism, light industry, oil and retail trade. Services supporting these industries have also developed in the areas of medical, financial and educational services. The population of San Luis Obispo County and the City of Santa Maria (in Northern Santa Barbara County) in 2005 totaled approximately 260,000 and 90,000, respectively, according to economic data provided by local county and title company sources. The moderate climate allows a year round growing season for numerous vegetables and fruits. Vineyards and cattle ranches also contribute largely to the local economy. The Central Coast’s leading agricultural industry is the production of high quality wine grapes and production of premium quality wines. Vineyards in production have grown significantly over the past several years throughout the Company’s service area. Access to numerous recreational activities, including lakes, mountains and beaches, provide a relatively stable tourist industry from many areas including the Los Angeles/Orange County basin, the San Francisco Bay area and the San Joaquin Valley. Principally due to the diversity of the various industries in the Company’s service area, the area, while not immune from economic fluctuations, does tend to enjoy a more stable level of economic activity than many other areas of California.

Critical Accounting Policies

The Company’s significant accounting policies are set forth in the 2005 Annual Report, Note 1 of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, which was filed on Form 10-K.

The following is a brief description of the Company’s current accounting policies involving significant management valuation judgments.

Allowance for Loan and Lease Losses

The Company considers its policy regarding the allowance for loan losses to be its most critical accounting policy, because it requires management's most subjective and complex judgments. In addition, changes in economic conditions can have a significant impact on the allowance for loan losses and therefore the provision for loan losses and results of operations. The Company has developed appropriate policies and procedures for assessing the adequacy of the allowance for loan losses, recognizing that this process requires a number of assumptions and estimates with respect to its loan portfolio. The Company's assessments may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers, which is not known to management at the time of the issuance of the consolidated financial statements.

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

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

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

See Note 3 to the Consolidated Financial Statements for further discussion on Allowance for Loan Losses.

Securities Available for Sale

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

Goodwill and Other Intangible Assets

As discussed in the 2005 Annual Report, Note 6 of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, we assess goodwill and other intangible assets each year for impairment. This assessment involves estimating cash flows for future periods. If the future cash flows were materially less than the recorded goodwill and other intangible assets balances, the Company would be required to take a charge against earnings to write down the assets to the lower value. The Company determined that there was no impairment at December 31, 2005.

RESULTS OF OPERATIONS

Earnings Overview

The Company reported net income for the three months ended September 30, 2006 of $1.7 million compared to $1.8 million during the same period in 2005. This represents a decrease of 4%. Basic earnings per share for the three months ended September 30, 2006 and September 30, 2005, were $0.27 and $0.29, respectively. Diluted earnings per share for the three months ended September 30, 2006 and September 30, 2005, were $0.26 and $0.28, respectively.

The Company reported net income for the nine months ended September 30, 2006 of $5.0 million compared to $4.8 million during the same period in 2005. This represents an increase of 4%. Basic earnings per share for the both the nine months ended September 30, 2006 and September 30, 2005, were $0.79. Diluted earnings per share for the nine months ended September 30, 2006 and September 30, 2005, were $0.76 and $0.74, respectively.

Year-to-date, non-interest expense increased to $15.4 million, compared to $13.9 million in the same period a year ago. At the end of 2005 the Company began a branding initiative which included an extensive assessment, both internally and externally of all bank delivery channels. Recommended actions were incorporated into a comprehensive Marketing Strategic Plan which is currently in process of implementation. The increase in non-interest expense has been primarily the result of expenses related to the branding project, the addition of staff including the EVP / Human Resources and EVP/Product Delivery and full service branch expansion within the bank’s existing footprint in the town of Templeton. The Company has invested significant resources in these new initiatives throughout 2006 in an effort to improve our service delivery and image and expect to continue the investment with the expectation of returns on these investments adding to shareholder value this year.

As a result of the increase in expenses, the efficiency ratio was 65.31% for the third quarter of 2006 compared to 61.08% for the same period in 2005. On a linked quarter basis, the efficiency ratio was 65.02% and 64.34% for the first and second quarter of 2006, respectively. The efficiency ratio measures non-interest expenses as a percent of revenues.

While earnings increased year over year for the nine months ended 2006 compared to the same period in 2005, earnings performance compared to quarter three and four in 2005 has been impacted by the above noted strategic issues that have been implemented by the Company. These new initiatives are designed to improve future profitability through enhanced customer relationship management, service delivery and branding.

Net Interest Income and Interest Margin

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

The table below sets forth changes for the three and nine months ended September 30, 2006 compared to the same period in 2005 in regard to volume and rate associated with interest earning assets and interest bearing deposits.

Analysis of Changes in Net Interest Income (in thousands)

	Three months ended									Nine months ended
	September 30. 2006 over 2005									September 30. 2006 over 2005
	Volume			Rate			Total			Volume			Rate			Total
Interest income:
Loans (1)	$	746		$	1,043		$	1,789		$	1,711		$	2,970		$	4,681
Investment securities taxable		(129	)		73			(56	)		(426	)		176			(250	)
Investment securities non-taxable (2):		44			1			45			144			(2	)		142
Taxable equivalent adjustment (2):		(15	)		(0	)		(16	)		(49	)		1			(49	)
Interest-bearing deposits		(0	)		5			5			(1	)		16			15
Federal funds sold		(554	)		415			(139	)		(59	)		132			73
Net increase (decrease)		91			1,537			1,628			1,319			3,294			4,613
Interest expense:
Savings, now, money market		(37	)		155			118			(17	)		727			710
Time deposits		536			315			851			980			987			1,967
Other borrowings		33			158			191			(92	)		172			80
Long term borrowings		-			39			39			-			125			125
Net increase (decrease)		532			667			1,199			871			2,011			2,882
Total net increase (decrease)	$	(441	)	$	870		$	429		$	448		$	1,283		$	1,731

(1) Loan fees of $303 and $347 for the three months ending September 30, 2006 and 2005 , respectively, and loan fees of $960 and $1,033 for the nine months ending September 30, 2006 and 2005, respectively been included in the interest income computation.

(2) Adjusted to a fully taxable equivalent basis using a tax rate of 34%.

Note A: Average balances of all categories in each period were included in the volume computations.

Note B: Average yield rates in each period were used in rate computations. Change attributable to both volume and rate have been allocated in proportion to the relationship between their absolute dollar amounts.

The table below sets forth the average balance sheet information, interest income and expense, average yields and rates and net interest income and margin for the three and nine months ended September 30, 2006 and September 30, 2005. The average balance of non-accruing loans has been included in loan totals.

AVERAGE BALANCE SHEET INFORMATION


(dollars in thousands)	For the three months ending September 30,																For the nine months ending September 30,
				2006								2005								2006								2005
	Avg.			Yield/			Amt.		Avg.			Yield/			Amt.		Avg.			Yield/			Amt.		Avg.			Yield/			Amt.
Interest Earning Assets:	Balance			Rate			Interest		Balance			Rate			Interest		Balance			Rate			Interest		Balance			Rate			Interest
Investments with other banks	$	318			8.81	%	$	7	$	396			2.02	%	$	2	$	314			9.32	%	$	22	$	943			0.99	%	$	7
Investment securities taxable		26,366			4.32	%		285		36,457			3.74	%		341		28,161			4.27	%		905		40,461			3.80	%		1,155
Investment securities non-taxable		16,467			4.30	%		177		13,684			4.33	%		148		16,209			4.31	%		525		13,265			4.32	%		431
Federal funds sold		9,966			5.26	%		131		31,250			3.46	%		270		14,217			4.80	%		513		18,606			3.15	%		440
Loans (1) (2)		409,897			8.75	%		8,968		373,200			7.69	%		7,179		387,627			8.40	%		24,475		358,233			7.35	%		19,794
Total interest earning assets		463,014			8.27	%		9,568		454,987			6.98	%		7,940		446,528			7.88	%		26,440		431,508			6.73	%		21,827

Allowance for possible loan losses		(3,767	)							(3,664	)							(3,928	)							(3,491	)
Other assets		56,073								48,876								52,319								47,988
TOTAL ASSETS	$	515,320							$	500,199							$	494,919							$	476,005
Interest -bearing liabilities:
Savings/NOW/money market		154,539			1.59	%		614		168,734			1.18	%		496		163,506			1.49	%		1,831		166,131			0.90	%		1,121
Time deposits		119,162			4.38	%		1,304		63,050			2.87	%		453		101,354			4.07	%		3,099		61,372			2.45	%		1,132
Other borrowings		32,195			5.33	%		429		29,251			3.39	%		248		22,577			5.01	%		851		31,439			3.30	%		779
FF Purchased		652			6.13	%		10		-			0.00	%		-		305			5.67	%		13		193			3.45	%		5
Long Term Debt		8,248			9.17	%		189		8,248			7.27	%		150		8,248			8.74	%		542		8,248			6.72	%		417
Total interest-bearing liabilities		314,796			3.24	%		2,546		269,283			2.00	%		1,347		295,990			2.85	%		6,336		267,383			1.72	%		3,454
Demand deposits		148,215								184,756								147,908								164,940
Other liabilities		4,646								3,774								4,178								3,286
Stockholders' equity
Common stock		29,589								28,909								29,506								27,717
Retained earnings		18,336								13,414								17,562								12,609
Valuation Allowance Investments		(262	)							63								(225	)							70
Total stockholders' equity		47,663								42,386								46,843								40,396
TOTAL LIABILITIES AND STOCKHOLDERS'
EQUITY	$	515,320							$	500,199							$	494,919							$	476,005

Net Interest Income							$	7,022							$	6,593							$	20,104							$	18,373
Net Interest Margin (3)					6.07	%							5.80	%							6.00	%							5.68	%

(1) Nonaccrual loans have been included in total loans.

(2) Loan fees of $303 and $347 for the three months ending September 30, 2006 and 2005, respectively, and loan fees of $960 and $1,033 for the nine months ending September 30, 2006 and 2005, respectively been included in the interest income computation.

(3) Net interest income has been calculated by dividing the net interest income by total average earning assets.

The tables below set forth changes for the three and nine months ending September 30, 2006 compared to the same periods in 2005 for average interest earning assets and their respective average yields.

The Company has been able to increase the loan portfolio with continued market penetration by a team of seasoned loan officers who are compensated for production. Additions to the loan portfolio for both the three and nine months ending September 30, 2006 were achieved under the Company’s established Loan Policy.

For the three and nine months ending September 30, 2006 compared to the same period in 2005, the average yield on loans improved by 106 and 105 basis points, respectively. This has been primarily due to action by the Federal Reserve Bank of raising rates by 225 basis points from June 2005 through September 2006. See “Item 3. Quantitative and Qualitative Disclosure about Market Risk” for further discussion.

The tax-exempt portion of the investment portfolio also increased as the Company selectively purchased securities available in the marketplace. The Company has significant ability to increase its holdings of tax-exempt securities before becoming subject to the Alternative Minimum Tax. The taxable investment portfolio gained in average yield due to extension of average life as the result of rising rates. Taxable investment securities decreased due to regular principal reductions on Mortgage Backed Securities (MBS).

	Average Balance										Average Yield
	for the three months ending										for the three months ending
(dollars in thousands)	September 30,				$			%			September 30,
Interest Earning Assets:	2006		2005		Variance			Variance			2006			2005			Variance
Time deposits with other banks	$	318	$	396	$	(78	)		-19.70	%		8.81	%		2.02	%		6.79	%
Investment securities taxable		26,366		36,457		(10,091	)		-27.68	%		4.32	%		3.74	%		0.58	%
Investment securities non-taxable		16,467		13,684		2,783			20.34	%		4.30	%		4.33	%		-0.03	%
Federal funds sold		9,966		31,250		(21,284	)		-68.11	%		5.26	%		3.46	%		1.80	%
Loans (1) (2)		409,897		373,200		36,697			9.83	%		8.75	%		7.69	%		1.06	%

Total interest earning assets	$	463,014	$	454,987	$	8,027			1.76	%		8.27	%		6.98	%		1.29	%

	Average Balance										Average Yield
	for the nine months ending										for the nine months ending
(dollars in thousands)	September 30,				$			%			September 30,
Interest Earning Assets:	2006		2005		Variance			Variance			2006			2005			Variance
Time deposits with other banks	$	314	$	943	$	(629	)		-66.70	%		9.32	%		0.99	%		8.33	%
Investment securities taxable		28,161		40,461		(12,300	)		-30.40	%		4.27	%		3.80	%		0.48	%
Investment securities non-taxable		16,209		13,265		2,944			22.19	%		4.31	%		4.32	%		-0.01	%
Federal funds sold		14,217		18,606		(4,389	)		-23.59	%		4.80	%		3.15	%		1.65	%
Loans (1) (2)		387,627		358,233		29,394			8.21	%		8.40	%		7.35	%		1.05	%

Total interest earning assets	$	446,528	$	431,508	$	15,020			3.48	%		7.88	%		6.73	%		1.15	%

(1) Nonaccrual loans have been included in total loans.

From June 2004 through September 2006, the Federal Reserve Bank increased rates by a total of 425 basis points. Due to the asset sensitive nature of the Company’s balance sheet, these increases, coupled with the Company’s substantial volume of non-interest bearing deposits and low average rates on interest bearing deposits, are the primary factors for the increase in net interest margin.

The tables below sets forth changes for the three and nine months ending September 30, 2006 compared to the same periods in 2005 for average interest bearing liabilities and their respective average rates paid.

	Average Balance										Average Rate
	for the three months ending										for the three months ending
(dollars in thousands)	September 30,				$			%			September 30,
Interest bearing liabilities:	2006		2005		Variance			Variance			2006			2005			Variance
Savings/NOW/money market	$	154,539	$	168,734	$	(14,195	)		-8.41	%		1.59	%		1.18	%		0.41	%
Time deposits		119,162		63,050		56,112			89.00	%		4.38	%		2.87	%		1.51	%
Other borrowings		32,195		29,251		2,944			10.06	%		5.33	%		3.39	%		1.94	%
FF Purchased		652		-		652			100.00	%		6.13	%		0.00	%		6.13	%
Long Term Debt		8,248		8,248		-			0.00	%		9.17	%		7.27	%		1.89	%

Total interest-bearing liabilities	$	314,796	$	269,283	$	45,513			16.90	%		3.24	%		2.00	%		1.24	%

	Average Balance										Average Rate
	for the nine months ending										for the nine months ending
(dollars in thousands)	September 30,				$			%			September 30,
Interest bearing liabilities:	2006		2005		Variance			Variance			2006			2005			Variance
Savings/NOW/money market	$	163,506	$	166,131	$	(2,625	)		-1.58	%		1.49	%		0.90	%		0.59	%
Time deposits		101,354		61,372		39,982			65.15	%		4.07	%		2.45	%		1.62	%
Other borrowings		22,577		31,439		(8,862	)		-28.19	%		5.01	%		3.30	%		1.71	%
FF Purchased		305		193		112			58.03	%		5.67	%		3.45	%		2.22	%
Long Term Debt		8,248		8,248		-			0.00	%		8.74	%		6.72	%		2.02	%

Total interest-bearing liabilities	$	295,990	$	267,383	$	28,607			10.70	%		2.85	%		1.72	%		1.13	%

The ability to attract low cost deposits is part of the Company’s marketing plans that have been in place for numerous years. While this remains Management’s main objective, in 2005, due to intensified competition, the Company implemented a Time Deposit/Money Market promotion that continues today. This has resulted in an increase in interest bearing deposits as well as an increase in deposit costs.

For the three months ending September 30, 2006 compared to the same period in 2005, the Company’s average yield on average interest earnings assets and average yield on average interest bearing liabilities increased by 128 basis points and 123 basis points, respectively. For the nine months ending September 30, 2006 compared to the same period in 2005, the Company’s average yield on average interest earnings assets and average yield on average interest bearing liabilities increased by 115 basis points and 113 basis points, respectively.

The Company’s net interest margin improved as a result of the larger balances of interest earning assets as compared to interest bearing liabilities during both periods. This result is primarily driven by the presence of non-interest bearing deposits that also fund earning assets.

Non-Interest Income

The tables below set forth changes for the three and nine months ending September 30, 2006 compared to the same period in 2005 for non-interest income.

Non-Interest Income Components
	For Three Months Ended
	September 30,
(dollars in thousands)	2006		2005		$ Variance			% Variance
Service Charges on Deposit Accounts	$	644	$	655	$	(11	)		-1.7	%
ATM/Debit Card Transaction/Interchange Fees		183		170		13			7.6	%
Bancard		35		34		1			2.9	%
Mortgage Origination Fees		110		296		(186	)		-62.8	%
Earnings on Cash Surrender Value Life Ins		113		88		25			28.4	%
Other		137		146		(9	)		-6.2	%
Total	$	1,222	$	1,389	$	(167	)		-12.0	%

	For Nine Months Ended
	September 30,
(dollars in thousands)	2006		2005		$ Variance			% Variance
Service Charges on Deposit Accounts	$	1,826	$	1,825	$	1			0.1	%
ATM/Debit Card Transaction/Interchange Fees		542		464		78			16.8	%
Bancard		89		105		(16	)		-15.2	%
Mortgage Origination Fees		410		719		(309	)		-43.0	%
Earnings on Cash Surrender Value Life Ins		289		239		50			20.9	%
Other		496		435		61			14.0	%
Total	$	3,652	$	3,787	$	(135	)		-3.6	%

For both the three months ending September 30, 2006 as compared to the same period in 2005, non-interest income excluding Mortgage Origination Fees has remained relatively flat. The Company has experienced a modest increase in the electronic activity category of ATM/Debit Card Transaction/Interchange Fees due to the continuing migration of consumers to paperless transactions.

For both the three and nine months ended September 30, 2006 compared to the same period in 2005, Mortgage Origination Fees have been negatively impacted by reduced mortgage volumes as the result of a slowdown in both purchase and refinance activity. Home sales have slowed with builders beginning to offer additional buyer incentives and lower prices. The area still remains desirable with prices considerably lower than the major metropolitan areas to the Company’s North and South. Reasonable mortgage rates and financing options such as interest only mortgages and 40 year loans have kept many in the market. The table below illustrates the decline in activity in both number of loans and dollars.

Mortgage Origination Activity
($ in 000's)
	For the 3 months								For the 9 months
	ending September 30,								ending September 30,
	2006		2005		Variance				2006		2005		Variance
$ Volume	$	18,185	$	33,612		-46	%	$Volume	$	48,916	$	75,538		-35	%

# Loans		31		66		-53	%	# Loans		147		224		-34	%

Non-Interest Expenses

The tables below set forth changes for the three and nine months ending September 30, 2006 compared to the same period in 2005 for non-interest expense.

Non-Interest Expense Components
	For Three Months Ended
	September 30,
(dollars in thousands)	2006		2005		$ Variance			% Variance
Salaries and Employee Benefits	$	2,965	$	2,532	$	433			17.1	%
Occupany and Equipment		633		600		33			5.5	%
Data Processing		517		561		(44	)		-7.8	%
Advertising and promotional		278		175		103			58.9	%
Regulatory fees		28		27		1			3.7	%
Other professional fees and outside services		286		156		130			83.3	%
Legal fees and other litigation expense		30		22		8			36.4	%
Loan Department Costs		30		45		(15	)		-33.3	%
Stationery and supplies		84		72		12			16.7	%
Director fees		69		70		(1	)		-1.4	%
Core Deposit Intangible Amortization		75		143		(68	)		-47.6	%
Other		389		472		(83	)		-17.6	%
Total	$	5,384	$	4,875	$	509			10.4	%

	For Nine Months Ended
	September 30,
(dollars in thousands)	2006		2005		$ Variance			% Variance
Salaries and Employee Benefits	$	8,534	$	7,188	$	1,346			18.7	%
Occupany and Equipment		1,901		1,853		48			2.6	%
Data Processing		1,579		1,678		(99	)		-5.9	%
Advertising and promotional		632		438		194			44.3	%
Regulatory fees		85		77		8			10.4	%
Other professional fees and outside services		694		399		295			73.9	%
Legal fees and other litigation expense		90		80		10			12.5	%
Loan Department Costs		112		116		(4	)		-3.4	%
Stationery and supplies		221		238		(17	)		-7.1	%
Director fees		217		175		42			24.0	%
Core Deposit Intangible Amortization		225		430		(205	)		-47.7	%
Other		1,127		1,189		(62	)		-5.2	%
Total	$	15,417	$	13,861	$	1,556			11.2	%

Salary and Employee Benefits

Salaries and employee related expense incurred the greatest dollar increase of any non-interest expense category for the three and nine months ending September 30, 2006 and 2005. The increase was primarily a result of increased expenses related to the addition of staff to enhance relationship management and the expansion of a full service branch within the bank’s existing footprint in the town of Templeton. The Bank hired the four Templeton staff members in April and May to allow time for intense training. In addition, the Bank instituted two new executive positions, one in Human Resources and one in Marketing. The HR position was filled in June 2006. The Marketing executive began the oversight of the branding initiatives in late 2005. Both executives are seasoned professionals in the banking industry.

Other Professional Fees and Outside Services

Other professional fees and outside services expenses increased for the quarter as a result of increases in a number of sub-categories including executive search expenses, consulting fees, audit fees, compliance and insurance costs. As competition within the primary market area has intensified, the Company has found it necessary to use the service of executive search firms when looking to either replace or add staff. In addition to this, during the second quarter of 2006, the Company engaged a consulting firm to assist with compensation programs including base salary and bonus program assessment.

Advertising and Promotional

The increase in advertising and promotional expenses was primarily a result of increases in professional fees related to the new marketing initiatives designed to enhance customer relationship management, service delivery and branding.

Provision for Income Taxes

The provision for income taxes was 35.3% and 38.5% of net pre-tax income for the three months ending September 30, 2006, and 2005, respectively. The provision for income taxes was 36.2% and 37.8% of net pre-tax income for the nine months ending September 30 2006, and 2005, respectively.

FINANCIAL CONDITION ANALYSIS

Total assets of the Company were $488.5 million at December 31, 2005 compared to $532.4 million at September 30, 2006. This represents an increase of $43.9 million or approximately 9%.

Loans

The table below sets forth changes from December 31, 2005 to September 30, 2006 for the composition of the loan portfolio.

Major classifications of loans were:
	September 30,			December 30,
	2006			2005			$ Variance			% Variance
(in thousands)
Commercial, financial, and agricultural	$	75,627		$	60,050			15,577			25.94	%
Real estate-construction/land		101,665			76,981			24,684			32.07	%
Real estate - other		229,070			210,690			18,380			8.72	%
Home equity lines of credit		11,777			14,398			(2,621	)		-18.20	%
Installment loans to individuals		5,660			5,620			40			0.71	%
All other loans (including overdrafts)		867			394			473			120.05	%
		424,666			368,133			56,533			15.36	%

Less - deferred loan fees, net		(1,489	)		(1,617	)		128			-7.92	%
Less - reserve for possible loan losses		(3,863	)		(3,881	)		18			-0.46	%

Total loans		419,314			362,635			56,679			15.63	%

Loans Held For Sale	$	2,069		$	3,392			(1,323	)		-39.00	%

The increase in commercial, financial and agricultural loans is attributed primarily to a $2.3 million new line of credit to a winery, a $5 million line of credit to a financial services company, an $8 million line of credit to a title company that is collateralized by marketable securities, a $1.9 million agriculture property loan, $3.4 million to acquire 3 restaurants and several other new $.5 to $1 million business credit lines to medical groups, contractors and others.

The increase in real estate-construction and land loans can be attributed to several large new construction projects and the funding of existing construction projects. New loans include a strip center for $4.0 million, a $6.7 million medical office complex, an office complex for $1.7 million, an office building for $1.2 million, a $1.2 million hotel site land loan, a spec residence for $1.6 million, an apartment construction loan increase of $1.8 million, a meat processing facility for $1.2 million, a 4 home development for $2.2 million, a spec residence for $1.2 million, 4 loans on land for tract development of $2.4, $1.3, $1.2 & $1.2 million and numerous other smaller projects. Construction loans are typically granted for a one year period and then, with income properties, are amortized over not more than 25 years with 10 to 15 year maturities.

The increase in real estate-mortgage loans is attributed to several new loans including a hotel for $5.4 million, a theatre complex for $7.3 million, restaurant properties for $2.6 million, a medical office for $1 million, a gas station for $2 million, an auto dealership for $1.2 million, a RV park for $1.2 million, an office building for $1.0 million and several smaller real estate loans. During the period, numerous loans were also refinanced and paid off through out of area lenders and mortgage brokers.

The Bank presently has a concentration of loans in construction/land in the amount of $101.7 million which represents 188% of the Bank’s Total Risk Based capital. Of this, 57% are owner occupied thus the concentration is 131% net of owner occupied. Un-disbursed commitments total $48.6 million which combined with disbursed represent 278.6% of the Bank’s Total Risk based Capital with 86% owner occupied. At September 30, 2006 there were 85 construction loans with outstanding balances and remaining commitments of approximately $76.6 million and $48.6 million, respectively. The single largest construction loan, an office complex in San Luis Obispo, has a commitment amount of approximately $10.7 million with a balance of approximately $3.9 million at September 30, 2006. A portion of the project has been sold with a $5.1 million principal reduction. At September 30, 2006, there were 61 land loans with balances of approximately $25.0 million. The single largest land loan accounts for approximately $1.6 million of the total and is for a mixed use development. While these loans may be considered somewhat riskier than certain other real estate loans, the construction/land loans are spread throughout the Company’s market area and have consistently performed in a satisfactory manner.

Single family residence construction loans represent 15.48% of the total construction and land loan commitments. Land loans account for 17.61%, tract for .22%, multiple family income properties for 11.04%, owner occupied commercial for 31.06% and non-owner occupied commercial properties for 24.60%.

Hotel loans disbursed are not considered to be a concentration with balances of $41.9 million which represents 78% of the Bank’s Total Risk Based Capital. However, there are several hotel construction loans that increase total outstanding to $58.6 million and total commitments to $62.4 million which represents a concentration at 115.54% of the Bank’s Total Risk Based Capital. At September 30, 2006, there were 34 motel loans. The single largest loan has a commitment of approximately $6.3 million, was made to a nationally known chain and is located in Paso Robles, California. The hotel loans are also made to clients throughout the Company’s markets. These loans have also typically paid as agreed.

In September 2004, the Bank issued an $11.7 million irrevocable standby letter of credit to guarantee the payment of Taxable Variable Rate Demand Bonds. The primary purpose of the bond issue was to refinance existing debt and provide funds for the expansion of an assisted living facility in San Luis Obispo. Approximately $6.6 million of the funds were deposited with the Bank with $.8 million remaining at September 30, 2006. These funds are being used for capital improvements to the assisted living facility. The project is complete and lease-up is under way. The letter of credit will expire in September 2007.

Construction loan demand for both single family and commercial real estate moderated during the first quarter of 2006 and then increased during the second and third quarters. Increased interest rates and construction costs impacted commercial real estate activity. Home sales have slowed with builders beginning to offer additional buyer incentives and lower prices. The area still remains desirable with prices considerably lower than the major metropolitan areas to the Company’s North and South. Reasonable mortgage rates and financing options such as interest only mortgages and 40 year loans have kept many in the market. The continued availability of land for subdivision use also continued to drive the market in the North San Luis Obispo County and Santa Maria markets. Builders are moving to the more rural communities in order to construct more affordable homes.

Business properties are also in demand with low vacancies and competitive but increasing loan rates. Commercial property values and rental rates increased substantially during 2005 and have slowed somewhat thus far in 2006. Investors, many seeking exchange properties, continue to seek properties in the Company’s market area. Capitalization rates have steadily decreased with increased demand. Capitalization rate (the rate at which a stream of future cash flows is discounted to find the present value) ranges over the last three years are: 2003- 7.0% to 8.0%, 2004- 6.5% to 7.5% and 2005- 5.5% to 6.5%. Commercial properties typically require larger down payments in order to satisfy bank debt coverage requirements. The Bank expects to experience continued growth in commercial real estate loans during 2006. Interest rate margins are expected to decrease somewhat do to competitive pressures and increasing cost of funds.

Loans held for sale consist of mortgage originations that have already been sold pursuant to Correspondent Mortgage Loan Agreements. There is no interest rate risk associated with these loans as the commitments are in place at the time that the Bank funds them. Settlement from the correspondents is typically within 30 to 45 days.

At September 30, 2006, the Bank had no foreign loans outstanding. The Bank did not have any concentrations of loans except as disclosed above.

The Bank’s management is responsible for monitoring loan performance that is done through various methods, including a review of loan delinquencies and personal knowledge of customers. Additionally, the Bank maintains both a “watch” list of loans that, for a variety of reasons, management believes requires regular review as well as an internal loan classification process. Annually, the loan portfolio is also reviewed by an experienced, outside loan reviewer not affiliated with the Bank. A list of delinquencies, the watch list, loan grades and the outside loan review are reviewed regularly by the Bank’s Board of Directors.

The Bank’s provision for loan losses was $180 thousand for the three months ended September 30, 2006 compared to $170 thousand for the same period in 2005. The provision amount is based on the Bank’s monthly allowance for loan losses calculation including current plans for recovery collection.

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

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

During the second quarter of 2006, the Bank recognized a $500,000 write down on a single account receivable loan. The bank has identified this as not indicative of a deterioration of overall loan quality. Management believes that the allowance for credit losses at September 30, 2006 is adequate based on information currently available.

Loans on non-accrual status totaled $54 thousand and $183 thousand at December 31, 2005 and September 30, 2006, respectively. Typically, these loans have adequate collateral protection and/or personal guaranties to provide a source of repayment to the Bank. Loans on non-accrual consist of six loans most of which are related to commercial loans that are being addressed by specific workout plans at this time. Interest income that would have been recognized on non-accrual loans if they had performed in accordance with the terms of the loans was approximately $87 thousand and $47 thousand for the period ended December 31, 2005 and September 30, 2006, respectively.

Non-performing loans include non-accrual loans, restructured loans and accruing loans that are 90 days or more delinquent. Non-performing loans totaled $52 thousand at December 31, 2005 and $183 thousand at September 30, 2006. There were no loans past due 90 days or more and still accruing interest at September 30, 2006.

Non-performing loans were 0.01% and 0.04% of total assets as of December 31, 2005 and September 30, 2006, respectively. The allowance for loan loss to non-performing loans was 74.3x and 21.2x at December 31, 2005 and September 30, 2006, respectively.

Total Cash and Due from Banks

Total cash and due from banks were $18.3 million and $18.0 million at December 31, 2005 and September 30, 2006, respectively. This line item will vary depending on cash letters from the previous night and actual cash on hand in the branches.

Investment Securities and Other Earning Assets

Other earning assets are comprised of Federal Home Loan Bank, Federal Funds sold (funds lent on a short-term basis to other banks), investments in securities and short-term interest bearing deposits at other financial institutions. These assets are maintained for liquidity needs of the Bank, collateralization of public deposits, and diversification of the earning asset mix.

The table below sets forth changes from December 31, 2005 to September 30, 2006 for the composition of other earning assets. Investments available-for-sale decreased due to cash flow on Mortgage Backed Securities (MBS) and Collateralized Mortgage Obligations (CMO). Overnight liquidity in the form of Federal Funds Sold decreased due to loan demand outpacing deposit growth.

COMPOSITION OF OTHER EARNING ASSETS

	September 30,		December 31,
	2006		2005		$ Variance			% Variance
(in thousands)
Federal Home Loan Bank, and other stock	$	1,955	$	1,885	$	70			3.71	%

Available-for-Sale Investments		40,294		44,402	$	(4,108	)		-9.25	%

Federal Funds Sold		14,195		26,280	$	(12,085	)		-45.99	%

Interest Bearing Deposits other fin inst.		318		298		20			6.71	%

Total Other Earning Assets	$	56,762	$	72,865	$	(16,103	)		-22.10	%

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

Securities available-for-sale are carried at fair value, with related unrealized net gains or losses, net of deferred income taxes, recorded as an adjustment to equity capital. As of December 31, 2005, net unrealized losses in the portfolio were $158 thousand compared to a net unrealized gain of $183 thousand at September 30, 2006. This change in market value was driven by the slope of the yield curve becoming more inverted with long term rates, the 30-Year T-Bill as much as 26bp lower than the 6 month T-Bill at September 30, 2006. The portfolio decreased in size due to principle reductions on MBS and CMOs.

At September 30, 2006, available-for-sale securities in the portfolio included obligations of state and political subdivisions, obligations of US government agencies and corporations and mortgaged backed securities issued by various agencies.

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

Deposits and Borrowed Funds

The table below sets forth changes from December 31, 2005 to September 30, 2006 for the composition of deposit categories.

											% of Total
	September 30,		December 31,								Deposits
(in thousands)	2006		2005		$ Variance			% Variance			30-Sep-06
Deposits:
Demand, non-interest bearing	$	157,180	$	164,014		(6,834	)		-4.17	%		36.5	%
Interest bearing demand		46,100		50,598		(4,498	)		-8.89	%		10.7	%
Savings		24,755		29,386		(4,631	)		-15.76	%		5.8	%
Money market		81,178		90,122		(8,944	)		-9.92	%		18.9	%
Time deposits of $100 or more		31,782		17,414		14,368			82.51	%		7.4	%
Time deposits under $100		89,277		66,263		23,014			34.73	%		20.7	%
Total deposits	$	430,272	$	417,797	$	12,475			2.99	%		100	%

Acquisition of core, low cost deposits has become the single biggest challenge facing the Company. Still, the Company has been able to increase deposits due to a well planned marketing strategy and incentive based compensation that has been in place for several years. Like all good strategies, this one is fluid and is subject to the changing dynamics within the Company’s balance sheet and staffing along with changes in its primary market area. A shift to higher balances in time deposits is the result of fierce competition for deposits coupled with funding requirements for loans.

For the Company, at September 30, 2006, non-interest bearing demand deposits provide 37% of total deposits compared to 39% at December 31, 2005. At December 31, 2005 and September 30, 2006, the Bank had three deposit relationships that it considers to be volatile. These deposits are held by three customers of the Bank that engage in mortgage related activities. As a percentage of total deposits, these accounts represented 12.5% or $52.2 million at December 31, 2005 compared to 10.1% or $43.6 million at September 30, 2006. These volatile account relationships are included in the volatile liability dependency report that the Bank produces on a monthly basis. Typically, a material increase in balances held by these three customers is reflected in Federal Funds Sold and is recognized by Management to potentially be short term in nature. Therefore, any material increase in these balances is not considered to be a funding source for any form of long-term investment. Management and the Board of Directors of the Bank are keenly aware that as the mortgage market conditions change, these relationships will be impacted.

Core deposits (time deposits less than $100 thousand, demand, and savings) gathered in the local communities served by the Company continue to be the primary source of funds for loans and investments. Core deposits of $398.5 million represented 92.6% of total deposits at September 30, 2006. The Company does not purchase funds through deposit brokers.

In October 2005, the Company renewed a Promissory Note with Pacific Coast Bankers Bank (PCBB) for a revolving line of credit in the amount of $3.5 million. At September 30, 2006, the Company had a zero balance outstanding on this note. The Company pledged 646,598 shares (51%) of the Bank’s stock as collateral for the loan. The note is revolving in nature for the first two years. The terms of the note call for quarterly interest only payments for the first two years with subsequent principal and interest payments for eight years on a fully amortized basis. At September 30, 2006, the interest rate on the note was 8.25% and is variable and moves with prime. Under the terms of the agreement, the Company will not incur any additional debt over $2 million exclusive of inter-company debt and existing debt without the prior written consent of PCBB. In addition, the Bank must be “well” capitalized on an on-going basis as defined by bank regulators.

The Bank has established borrowing lines with the Federal Home Loan Bank (FHLB). At September 30, 2006, the Bank had borrowings with the FHLB of $40.0 million collateralized by loans. The table below sets forth the various advances:

Amount	Interest				Maturity
Borrowed	Rate		Variable/Fixed		Date
$ 10,000		5.39		Variable- Daily		28-Sep-07
$ 10,000		5.44		Fixed		26-Feb-07
$ 10,000		5.50		Fixed		25-Jul-07
$ 10,000		5.28		Fixed		24-Nov-06

At maturity, Management will assess balance sheet needs and determine how much if any and at what term it will borrow from the FHLB.

On September 17, 2004, the Bank issued a Letter of Credit in the amount of approximately $11.7 million to a customer in regard to a senior care facility. The Letter of Credit was issued pursuant to a Letter of Credit Reimbursement Agreement between the Bank and the FHLB. It is collateralized by a blanket lien with the FHLB that includes all qualifying loans on the Bank’s balance sheet.

At September 30, 2006, the Bank has a remaining borrowing capacity with existing collateral of approximately $57.6 million and $9.7 million secured by loans and securities, respectively.

The Bank utilizes securities sold under repurchase agreements as a source of funds. The Bank had $3.8 million in securities sold under repurchase agreements at December 31, 2005 compared to $1.2 million at September 30, 2006.

Capital

The Company's total stockholders equity was $44.8 million at December 31, 2005 compared to $48.4 million at September 30, 2006. The increase in capital was due to net income of $5.0 million, stock options exercised in the amount of $559 thousand, the capital impact of stock options expense of $83 thousand, $2.1 million paid for a cash dividend, $249 thousand paid to repurchase the Company’s stock and an increase in accumulated other comprehensive income of $269 thousand.

On July 21, 2006, the Board of Directors declared a quarterly cash dividend of $.08 to be paid on August 25, 2006 to shareholders of record on August 11, 2006. In addition, the Board of Directors adopted a resolution authorizing the repurchase of up to 40,000 shares of Company stock. Purchases are to be made, as conditions warrant, from time to time in the open market. The duration of the program is one year and the timing of purchases will depend on market conditions. Under this program, during the third quarter of 2006, the Company purchased 15,000 shares at an average price of $16.56 per share.

On April 21, 2006 the Company declared a $0.25 per share special cash dividend to be paid on May 19, 2006 to shareholders of record on May 8, 2006. The special dividend was declared in lieu of recent annual stock dividends the Company has declared.

On March 25, 2005 the Board of Directors of the Company announced a 5% stock dividend to shareholders of record on April 8, 2005 that was distributed on April 22, 2005. On October 21, 2005, the Board of Directors declared a 50% stock split payable on December 2, 2005 to stockholders of record on November 10, 2005. The Consolidated Statements of Stockholders’ Equity found under “Item 1. Financial Statements” in this document reflects the 5% stock dividend and the 50% stock split.

On April 10, 2002, the Company issued $8,248,000 of Floating Rate Junior Subordinated Deferrable Interest Debentures (the “debt securities”) to Heritage Oaks Capital Trust I, a statutory trust created under the laws of the State of Delaware. These debt securities are subordinated to effectively all borrowings of the Company and are due and payable on April 22, 2032. Interest is payable semi-annually on these debt securities at 6-Month LIBOR plus 3.7% for an effective rate of 8.99% as of September 30, 2006. The debt securities can be called at any time commencing on April 22, 2007, at par. The debt securities can also be redeemed at par if certain events occur that impact the tax treatment, regulatory treatment or the capital treatment of the issuance. The Company also purchased a 3% minority interest totaling $248 thousand in Heritage Oaks Capital Trust I. The balance of the equity of Heritage Oaks Capital Trust I is comprised of mandatorily redeemable preferred securities and is included in other assets.

If the Company elects to defer interest payments pursuant to terms of the agreement, then the Company may not (i) declare or pay any dividends or distributions on, or redeem, purchase, acquire or make a liquidation payment with respect to any of the Company’s capital stock, or (ii) make any payment of principal of or premium, if any, or interest on or repay, repurchase or redeem any debt securities of the Company that rank pari passu with or junior in interest to the Debt Securities, other than, among other items, a dividend in the form of stock, warrants, options or other rights in the same stock as that on which the dividend is being paid or ranks pari passu with or junior to such stock. The prohibition on payment of dividends and payments on pari passu or junior debt also applies in the case of an event of default under the agreements.

The Company used the proceeds from the sale of the securities for general corporate purposes, including the repayment of outstanding indebtedness of $1.9 million on April 11, 2002 and capital contributions to the Bank for future growth.

Under FASB Interpretation (FIN) No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51,” the Company is not allowed to consolidate Heritage Oaks Capital Trust I into the Company’s financial statements. Prior to the issuance of FIN No. 46, Bank holding companies typically consolidated these entities. On February 28, 2005, the Federal Reserve Board issued a new rule which provides that, notwithstanding the deconsolidation of such trusts, junior subordinated debentures, such as those issued by the Company, may continue to constitute up to 25% of a bank holding company's Tier 1 capital, subject to certain new limitations which will not become effective until March 31, 2009 and which, in any event, are not expected to affect the treatment of the Company's Junior Subordinated Debentures as Tier 1 capital for regulatory purposes. At September 30, 2006, the Company has included the net junior subordinated debt in its Tier1 Capital for regulatory capital purposes.

At September 30, 2006, the Company had sufficient cash to service the existing $8.2 million in junior subordinated debenture interest payments for approximately two quarters without dividends from subsidiaries. The Bank’s capacity to provide cash to the Company, while remaining “well-capitalized”, was $5.4 million at September 30, 2006.

It is widely known in the banking and investment community that pricing on these debt securities has changed dramatically since the Company issued $8 million in 2002. As the market’s appetite for these debt securities grew from 2002 through 2005, pricing eased as well as costs associated with the transactions. With the opportunity to call the existing debt securities in April 2007 and given the fact that pricing has been tightening since late 2005 due to the significant amount of debt securities that are becoming callable, the Company has determined that early in the fourth quarter of 2006, it will issue an additional $8 million in debt securities. The cost of the debt, net of income generated on the proceeds is estimated to have less than a $.01 impact to EPS for the remainder of 2006. It is anticipated that the cost for the newly issued debt securities will be approximately 200bp less than those issued in 2002. Management will review whether to use these proceeds to eliminate or reduce the existing debt securities in April 2007. Costs in the amount of $282 thousand that were associated with the original issuance were amortized to the call date of April 2007 thereby eliminating any write-down if the securities are called. The cost associated with the potential new issue of debt securities is anticipated to be less than $15 thousand. To this end, on October 27, 2006, the Company issued $8,248,000 of Floating Rate Junior Subordinated Deferrable Interest Debentures (the “debt securities”) to Heritage Oaks Capital Trust II, a statutory trust created under the laws of the State of Delaware. These debt securities are subordinated to effectively all borrowings of the Company and are due and payable on January 1, 2037. Interest is payable quarterly on these debt securities at 3-Month LIBOR plus 1.72% for an effective rate of 7.10% as of September 30, 2006. The debt securities can be called at any time commencing on January 1, 2012, at par. The Company also purchased a 3% minority interest totaling $248 thousand in Heritage Oaks Capital Trust II. The balance of the equity of Heritage Oaks Capital Trust II is comprised of mandatorily redeemable preferred securities and is included in other assets.

Capital ratios for commercial banks in the United States are generally calculated using three different formulas. These calculations are referred to as the “Leverage Ratio” and two “risk based” calculations known as: “Tier One Risk Based Capital Ratio” and the “Total Risk Based Capital Ratio.” These standards were developed through joint efforts of banking authorities from 12 different countries around the world. The standards essentially take into account the fact that different types of assets have different levels of risk associated with them. Furthermore, they take into account the off-balance sheet exposures of banks when assessing capital adequacy.

The Leverage Ratio calculation simply divides common stockholders’ equity (reduced by any goodwill a bank may have) by the total assets. In the Tier One Risk Based Capital Ratio, the numerator is the same as the leverage ratio, but the denominator is the total “risk-weighted assets”. Risk weighted assets are determined by segregating all the assets and off balance sheet exposures into different risk categories and weighting them by a percentage ranging from 0% (lowest risk) to 100% (highest risk). The Total Risk Based Capital Ratio again uses “risk-weighted assets” in the denominator, but expands the numerator to include other capital items besides equity such as a limited amount of the loan loss reserve, long-term capital debt, preferred stock and other instruments.

Summarized below are the Company’s and the Bank’s capital ratios at September 30, 2006.

	Regulatory Standard
	Adequately			Well			Heritage Oaks			Heritage Oaks
	Capitalized			Capitalized			Bancorp			Bank
Leverage Ratio		4.00	%		5.00	%		9.86	%		9.94	%

Tier One Risk Based Captial Ratio		4.00	%		6.00	%		10.35	%		10.27	%

Total Risk Based Captial Ratio		8.00	%		10.00	%		11.18	%		11.10	%

Liquidity

The objective of liquidity management is to ensure the continuous availability of funds to meet the demands of depositors, investors and borrowers. Asset liquidity is primarily derived from loan payments and the maturity of other earning assets. Liquidity from liabilities is obtained primarily from the receipt of new deposits. The Bank’s Asset Liability Committee (ALCO) is responsible for managing the on and off-balance sheet commitments to meet the needs of customers while achieving the Bank’s financial objectives. ALCO meets regularly to assess the projected funding requirements by reviewing historical funding patterns, current and forecasted economic conditions and individual customer funding needs. Deposits generated from Bank customers serve as the primary source of liquidity. The Bank has credit arrangements with correspondent banks that serve as a secondary liquidity source in the amount of $13.4 million. At September 30, 2006, the Bank had no borrowings against credit arrangements with these correspondent banks. The Bank is a member of the FHLB and has a collateralized borrowing capacity remaining of approximately $67 million.

The Bank manages liquidity by maintaining a majority of the investment portfolio in federal funds sold and other liquid investments. At September 30, 2006, the ratio of liquid assets not pledged for collateral and other purposes to deposits and other liabilities was 11.6% compared to 16.1% at December 31, 2005. The ratio of net loans to deposits, another key liquidity ratio, was 97.5% at September 30, 2006 compared to 86.8% at December 31, 2005

Inflation

The assets and liabilities of a financial institution are primarily monetary in nature. As such they represent obligations to pay or receive fixed and determinable amounts of money that are not affected by future changes in prices. Generally, the impact of inflation on a financial institution is reflected by fluctuations in interest rates, the ability of customers to repay debt and upward pressure on operating expenses. The effect of inflation during the four-year period ended September 30, 2006 has been significant to the Company’s financial position and results of operations in regard to fluctuation in interest rates creating in the decreasing rate environment a narrowing of the net interest margin and in the increasing rate environment for the past two years, a widening of the net interest margin. However, inflation has not been a factor in the customer’s ability to repay debt.

Off-Balance Sheet Arrangements

Off-balance sheet arrangements are any contractual arrangement to which an unconsolidated entity is a party, under which the Company has: (1) any obligation under a guarantee contract; (2) a retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement that serves as credit, liquidity or market risk support to that entity for such assets; (3) any obligation under certain derivative instruments; or (4) any obligation under a material variable interest held by the Company in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support to the Company, or engages in leasing, hedging or research and development services with the Company.

In the ordinary course of business, the Company has entered into off-balance sheet financial instruments consisting of commitments to extend credit, commercial letter of credit, and standby letter of credit. Such financial instruments are recorded in the financial statement when they are funded or related fees are incurred or received. For a fuller discussion of these financial instruments, refer to Note 10 of the Company’s consolidated financial statements contained in Item 7 of Part II of the Company’s December 31, 2005 10-K.

In the ordinary course of business, the Bank is a party to various operating leases. For a fuller discussion of these financial instruments, refer to Note 5 of the Company’s consolidated financial statements contained in Item 7 of Part II of the Company’s December 31, 2005 10-K.

In connection with the $8.2 million in debt securities discussed in “Capital,” the Company issued the full and unconditional payment guarantee of certain accrued distributions.

Item 3. Quantitative and Qualitative Disclosure about Market Risk

As a financial institution, the Company’s primary component of market risk is interest rate volatility. Fluctuations in interest rates will ultimately impact both the level of interest income and interest expense recorded on a large portion of the Company’s assets and liabilities, and the market value of all interest earning assets and interest bearing liabilities, other than those which possess a short term to maturity. Virtually all of the Company’s interest earning assets and interest bearing liabilities are located at the banking subsidiary level. Thus, virtually all of the Company’s interest rate risk exposure lies at the banking subsidiary level other than $8.2 million in subordinated debentures issued by the Company’s subsidiary grantor trust. As a result, all significant interest rate risk procedures are performed at the banking subsidiary level. The subsidiary bank’s real estate loan portfolio, concentrated primarily within Northern Santa Barbara County and San Luis Obispo County, California, are subject to risks associated with the local economy.

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

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

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

The hypothetical impacts of sudden interest rate movements applied to the Company’s asset and liability balances are modeled monthly. The results of this movement indicate how much of the Company’s net interest income is “at risk” from various rate changes over a one year horizon. This exercise is valuable in identifying risk exposures. Management believes the results for the Company’s September 30, 2006 balances indicate that the net interest income at risk over a one year time horizon for a 1% and 2% rate increase and decrease is acceptable at this time.

(dollars in thousands)

	Shock Rate Scenarios
	-200bp			-100bp			Base			+100bp			+200bp
Net Interest
Income (NII)	$	24,954		$	26,053		$	27,221		$	28,239		$	29,264

$ Change from Base	$	(2,267	)	$	(1,168	)	$	-		$	1,018		$	2,043

% Change from Base		-8.33	%		-4.29	%		0.00	%		3.74	%		7.50	%

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

The following tables show Management’s estimates of how the loan portfolio is broken out between variable-daily, variable at various time lines, fixed rate loans and estimates of re-pricing opportunities for the entire loan portfolio.

(dollars in thousands)

			% of
Loans	Balance		Total
Variable-Daily	$	182,855		43	%
Variable Other than Daily		192,068		45	%
Fixed		49,743		12	%
Total Gross Loans	$	424,666		100	%

Total Gross Loans			% of
Re-Pricing	Balance		Total
< 1 Year	$	260,095		61	%
1-3 Years		98,298		23	%
3-5 Years		51,716		12	%
> 5 Years		14,557		4	%
	$	424,666		100	%

The table above identifies approximately 43% of the loan portfolio that will re-price immediately in a changing rate environment.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of its management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective to provide reasonable assurances that information required to be disclosed in the reports the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

There was no change in the Company’s internal controls over financial reporting during the quarter ended September 30, 2006 that has materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting.

In designing and evaluating disclosure controls and procedures, the Company’s management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable, not absolute, assurances of achieving the desired control objectives and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

PART 2. OTHER INFORMATION

Item 1. Legal Proceedings

The Company is not a party to any material legal proceeding.

Item 1A.Risk Factors

During the period covered by this report there were no material changes from risk factors as previously disclosed in the Company’s December 31, 2005 10k in response to Item A to Part I of Form 10k.

Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

Unregistered Sale of Equity Securities

None

Purchases of Equity Securities

On July 21, 2006, the Company adopted a one year stock repurchase program in the initial amount of 40,000 shares. In October 2006, the Company approved an increase in the stock repurchase program to a total of 100,000 shares. Under the publicly announced stock repurchase program, the Company has been acquiring our common stock shares in the open market from time to time.

The table below summarizes our monthly repurchases and redemptions of our common equity securities during the three months ended September 30, 2006.

					Total Number of Shares
					that may yet be
	Total Number		Average		Purchased Under the
	of Shares		Price Paid		Publicly Announced
Period	Purchased		Per Share		Plan
July 1 - 31, 2006		N/A		N/A		40,000
August 1 - 31, 2006		15,000	$	16.56		25,000
September 1 - 30, 2006		-	$	-		25,000
Total		15,000	$	16.56		85,000	⁽¹⁾