Heritage Oaks Bancorp (HEOP) 10-Q 2008 Q2 Quarterly report

UNITED STATES

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 JUNE 30, 2008.

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _______ to _______.

COMMISSION FILE NUMBER: 000-25020

HERITAGE OAKS BANCORP

(Exact name of registrant as specified in charter)

STATE OF CALIFORNIA	77-0388249
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

545 12th STREET, PASO ROBLES, CA 93446

(Address of principal office) (Zip Code)

(805) 369-5200

(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 ¨

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

Large Accelerated filer ¨         Accelerated filer x         Non-accelerated filer ¨         Smaller Reporting Company ¨

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

YES ¨ 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 July 29, 2008 there were approximately 7,709,600 shares outstanding of the Registrant’s common stock.

Heritage Oaks Bancorp and Subsidiaries

Table of Contents

Part 1. Financial Information	3
Item 1. Consolidated Financial Statements (Un-audited, except for Balance Sheet as of 12/31/2007)	3
Consolidated Balance Sheets	4
Consolidated Statements of Income	5
Consolidated Statements of Stockholders’ Equity	6
Consolidated Statements of Comprehensive Income	7
Consolidated Statements of Cash Flows	8
Notes to Consolidated Financial Statements	9
Note 1 – Consolidated Financial Statements	9
Note 2 – Investment Securities	10
Note 3 – Loans and the Allowance for Loan Losses	11
Note 4 – Earnings Per Share	12
Note 5 – Recent Accounting Pronouncements	13
Note 6 – Share Based Compensation	15
Note 7 – Fair Value of Financial Instruments	17
Note 8 – Goodwill	19
Note 9 – Reclassifications	19
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	20
The Company	20
Where You Can Find More Information	20
Earnings and Financial Condition Overview	21
Recent Developments	22
Stock Repurchases and Dividends	23
Selected Financial Data	24
Local Economy	24
Critical Accounting Policies	24
Results of Operations	26
Net Interest Income and Margin	26
Non-Interest Income	31
Non-Interest Expenses	32
Financial Condition Analysis	34
Loans	34
Non-Performing Assets	38
Total Cash and Due From Banks	39
Investment Securities and Other Earning Assets	39
Deposits and Borrowed Funds	41
Capital	42
Liquidity	45
Inflation	45
Off-Balance Sheet Arrangements	46
Item 3. Quantitative and Qualitative Disclosure about Market Risk	46
Item 4. Controls and Procedures	48
Part 2. Other Information	48
Item 1. Legal Proceedings	48
Item 1.A. Risk Factors	48
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	48
Item 3. Defaults Upon Senior Securities	49
Item 4. Submission of Matters to a Vote of Security Holders	49
Item 5. Other Information	49
Item 6. Exhibits	50
Signatures	51
Certifications
Exhibits

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Part 1. Financial Information

Item 1. Consolidated Financial Statements

The financial statements and the notes thereto begin on next page.

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HERITAGE OAKS BANCORP

CONSOLIDATED BALANCE SHEETS

(dollar amounts in thousands)

	(Unaudited)			(1)
	June 30,			December 31,
	2008			2007
Assets
Cash and due from banks	$	27,346		$	23,254
Federal funds sold		15,660			23,165
Total cash and cash equivalents		43,006			46,419
Interest bearing deposits with other banks		131			330
Securities available for sale		57,064			47,556
Federal Home Loan Bank stock, at cost		5,401			3,045
Loans held for sale		1,246			902
Loans, net (2)		649,928			605,342
Property, premises and equipment, net		6,524			6,390
Bank owned life insurance		10,527			9,923
Deferred tax assets		5,799			5,290
Goodwill		11,541			10,911
Core deposit intangible		4,121			4,551
Other real estate owned		197			-
Other assets		4,600			4,895
Total assets	$	800,085		$	745,554
Liabilities
Demand, non-interest bearing	$	168,589		$	153,684
Savings, NOW, and money market deposits		293,799			317,911
Time deposits of $100 or more		79,756			75,966
Time deposits under $100		92,374			97,247
Total deposits		634,518			644,808
FHLB advances and other borrowed money		71,500			8,000
Securities sold under agreement to repurchase		2,718			1,936
Junior subordinated debentures		13,403			13,403
Other liabilities		7,074			7,957
Total liabilities		729,213			676,104
Commitments and contingencies		-			-
Stockholders' Equity
Common stock, no par value; 20,000,000 shares authorized; issued and outstanding 7,709,929 and 7,683,829 as of June 30, 2008 and December 31, 2007, respectively.		48,456			43,996
Additional paid in capital		839			672
Retained earnings		22,140			24,598
Accumulated other comprehensive income		(563	)		184
Total stockholders' equity		70,872			69,450
Total liabilities and stockholders' equity	$	800,085		$	745,554

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

(2) Loans net of deferred fees of $1,756 and $1,732 and allowance for loan losses of $8,128 and $6,143 at June 30, 2008 and December 31, 2007, respectively.

See notes to condensed consolidated financial statements.

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HERITAGE OAKS BANCORP

CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

(dollar amounts in thousands except per share data)

	For the three months				For the six months
	ended June 30,				ended June 30,
	2008		2007		2008		2007
Interest Income:
Interest and fees on loans	$	11,732	$	10,214	$	23,823	$	20,029
Investment securities		794		437		1,450		885
Federal funds sold and commercial paper		45		162		112		193
Time certificates of deposit		3		10		6		18
Total interest income		12,574		10,823		25,391		21,125
Interest Expense:
Now accounts		162		43		255		71
MMDA accounts		823		946		2,105		1,613
Savings accounts		35		23		166		47
Time deposits of $100 or more		525		301		1,205		510
Other time deposits		674		1,276		1,574		2,488
Other borrowed funds		766		976		1,377		2,105
Total interest expense		2,985		3,565		6,682		6,834
Net interest income before provision for possible loan losses		9,589		7,258		18,709		14,291
Provision for loan losses		2,775		170		3,015		310
Net interest income after provision for loan losses		6,814		7,088		15,694		13,981
Non-Interest Income:
Service charges on deposit accounts		837		686		1,609		1,299
Other income		882		705		1,549		1,324
Gain on sale of investment securities		37		-		37		-
Total non-interest income		1,756		1,391		3,195		2,623
Non-Interest Expense:
Salaries and employee benefits		4,021		3,194		8,246		6,444
Occupancy and equipment		1,129		706		2,268		1,421
Other expenses		2,348		1,663		4,604		3,391
Total non-interest expenses		7,498		5,563		15,118		11,256
Income before provision for income taxes		1,072		2,916		3,771		5,348
Provision for applicable income taxes		381		1,116		1,405		2,037
Net income	$	691	$	1,800	$	2,366	$	3,311
Earnings Per Share:
Basic	$	0.09	$	0.27	$	0.31	$	0.49
Fully diluted	$	0.09	$	0.26	$	0.30	$	0.47

See notes to condensed consolidated financial statements.

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HERITAGE OAKS BANCORP

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (UNAUDITED)

June 30, 2008 and 2007

(amounts in thousands except shares outstanding)

														Accumulated
	Common Stock					Additional								Other			Total
	Number of					Paid-In		Comprehensive			Retained			Comprehensive			Stockholders'
	Shares			Amount		Capital		Income			Earnings			Income			Equity
Balance, December 31, 2007		7,317,932		$	43,996	$	672				$	24,598		$	184		$	69,450
Exercise of stock options (including $88 excess tax benefit from exercise of stock options)		31,228			228													228
5% Stock Dividend distributed May 16, 2008		366,344			4,232							(4,232	)					-
Cash paid in lieu of fractional shares												(5	)					(5	)
Cash dividend - $0.08 per share paid on February 15, 2008												(587	)					(587	)
Share-based compensation expense							167											167
Issuance of restricted stock awards		1,000																-
Retirement of restricted share awards		(6,575	)															-
Comprehensive income:
Net income								$	2,366			2,366						2,366
Unrealized security holding losses (net of $537 tax benefit)									(769	)					(769	)		(769	)
Realized gains on sale of securities (net of $15 tax)									22						22			22
Total comprehensive income								$	1,619
Balance, June 30, 2008		7,709,929		$	48,456	$	839				$	22,140		$	(563	)	$	70,872
Balance, December 31, 2006		6,345,639		$	29,247	$	336				$	19,809		$	80		$	49,472
Exercise of stock options (including $440 excess tax benefit from exercise of stock options)		129,764			825													825
Cash dividend - $0.08 per share paid on February 16, 2007												(510	)					(510	)
Cash dividend - $0.08 per share paid on May 18, 2007												(514	)					(514	)
Share-based compensation expense							184											184
Issuance of restricted stock awards		1,000																-
Comprehensive income:
Net income								$	3,311			3,311						3,311
Unrealized security holding losses (net of $164 tax benefit)									(247	)					(247	)		(247	)
Total comprehensive income								$	3,064
Balance, June 30, 2007		6,476,403		$	30,072	$	520				$	22,096		$	(167	)	$	52,521

See notes to condensed consolidated financial statements.

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HERITAGE OAKS BANCORP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)

(dollar amounts in thousands)

	For the three months						For the six months
	ended June 30,						ended June 30,
	2008			2007			2008			2007
Net Income	$	691		$	1,800		$	2,366		$	3,311
Other comprehensive income / (loss) before taxes:
Unrealized losses on securities available for sale arising during the period		(1,611	)		(488	)		(1,307	)		(411	)
Realized gains on sale of availavle for sale securities during the period		37			-			37			-
Total other comprehensive (loss) before taxes		(1,574	)		(488	)		(1,270	)		(411	)
Unrealized income tax benefit related to items in comprehensive (loss)		663			195			538			164
Income tax related to the sale of available for sale securities		(15	)		-			(15	)		-
Total other comprehensive (loss), net of taxes		(926	)		(293	)		(747	)		(247	)
Comprehensive (loss) / income	$	(235	)	$	1,507		$	1,619		$	3,064

See notes to condensed consolidated financial statements.

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HERITAGE OAKS BANCORP

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(dollar amounts in thousands)

	For the six month periods
	ended June 30,
	2008			2007
Cash flows from operating activities:
Net income	$	2,366		$	3,311
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		537			509
Provision for possible loan losses		3,015			310
Amortization of premiums/discounts on investment securities, net		(66	)		(41	)
Federal Home Loan Bank stock dividends received		(84	)		(64	)
Amortization of intangible assets		430			177
Gain on sale of available-for-sale securities		(37	)		-
Share-based compensation expense		167			184
(Increase) in loans held for sale		(344	)		(1,565	)
Net (increase) in bank owned life insurance		(204	)		(186	)
Decrease/(increase) in deferred tax asset		14			(2,078	)
Increase/(decrease) in other assets		(483	)		582
(Decrease)/increase in other liabilities		(795	)		1,741
Excess tax benefit related to share-based compensation expense		(88	)		(440	)
NET CASH PROVIDED IN OPERATING ACTIVITIES		4,428			2,440
Cash flows from investing activities:
Purchase of available-for-sale securities		(18,417	)		-
Proceeds from principal reductions and maturities of available-for-sale mortgage backed securities		5,193			2,057
Maturities and calls of available-for-sale securities		1,012			-
Sale of available-for-sale-securities		1,537			-
Maturities of time deposits with other banks		199			-
Purchase of Federal Home Loan Bank stock		(2,272	)		(705	)
Purchase of bank owned life insurance policies		(400	)		-
(Increase) in loans, net		(47,673	)		(15,082	)
Allowance for loan and lease loss recoveries		72			149
Purchase of property, premises and equipment, net		(720	)		(386	)
Proceeds from sale of property, premises and equipment		-			12,810
NET CASH (USED) IN INVESTING ACTIVITIES		(61,469	)		(1,157	)
Cash flows from financing activities:
(Decrease)/increase in deposits, net		(10,290	)		68,586
Increases in Federal Home Loan Bank borrowing		240,000			55,000
Paydowns in Federal Home Loan Bank borrowing		(176,500	)		(75,000	)
Increase/(decrease) in repurchase agreements		782			(6	)
Decrease in junior subordinated debentures		-			(8,248	)
Excess tax benefit related to share-based compensation expense		88			440
Proceeds from exercise of stock options		140			385
Cash paid in lieu of fractional shares		(5	)		-
Cash dividends paid		(587	)		(1,024	)
NET CASH PROVIDED BY FINANCING ACTIVITIES		53,628			40,133
Net (decrease)/increase in cash and cash equivalents		(3,413	)		41,416
Cash and cash equivalents, beginning of period		46,419			23,034
CASH AND CASH EQUIVALENTS, END OF PERIOD	$	43,006		$	64,450
Supplemental disclosures of cash flow information:
Interest paid	$	6,819		$	7,000
Income taxes paid	$	1,405		$	2,030
Transfer of loans to other real estate owned	$	197		$	-

See notes to condensed consolidated financial statements.

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Heritage Oaks Bancorp and Subsidiaries

Notes To Consolidated Financial Statements (Un-audited)

June 30, 2008

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 2007 annual report filed 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 Trusts II and III are unconsolidated subsidiaries formed solely for the purpose of issuing trust preferred securities. Operating results for the three and six months ended June 30, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008. Certain amounts in the consolidated financial statements for the year ended December 31, 2007 and for the three and six months ended June 30, 2007 may have been reclassified to conform to the presentation of the consolidated financial statements in 2008.

On October 12, 2007 the Company acquired Business First National Bank (“Business First”). Business First was merged with and into Heritage Oaks Bank, a wholly owned subsidiary of the Company. The consideration paid for Business First was approximately $19.5 million, consisting of approximately 75% common stock and 25% cash. Business First shareholders received 0.5758 shares of Heritage Oaks Bancorp common stock for each share of Business First they owned and $3.44 per share in cash. Upon the acquisition of Business First, the Company issued 850,213 shares of Heritage Oaks Bancorp common stock and approximately $5.1 million in cash to the former shareholders of Business First. Upon the date of the acquisition, the Company added approximately $160.5 million in assets and approximately $133.4 million in deposits. The financial position, results of operations and cash flows of the Company as of and for the three and six month periods ended June 30, 2008 reflect the acquisition of Business First.

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.

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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: debt and mortgage-backed securities that the Company has the positive intent and ability to hold to maturity are classified as held-to-maturity and are measured at amortized cost; debt and equity securities bought and held principally for the purpose of selling in the near term are classified as trading securities and are measured at fair value, with 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. Premiums and discounts are amortized or accreted using the interest method over the lives of the related securities.

The following table sets forth the amortized cost and fair values of investment securities available for sale at June 30, 2008 and December 31, 2007:

(dollars in thousands)			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
As of June 30, 2008	Cost		Gains		Losses			Value
Obligations of U.S. government agencies and corporations	$	1,170	$	2	$	(1	)	$	1,171
Mortgage-backed securities		39,743		39		(1,005	)		38,777
Obligations of state and political subdivisions		16,999		223		(215	)		17,007
Other securities		109		-		-			109
Total	$	58,021	$	264	$	(1,221	)	$	57,064

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

At June 30, 2008, the fair value of the securities portfolio was approximately $57.1 million. This, when compared to the $47.6 million reported at December 31, 2007, represents an increase of approximately $9.5 million. The change in the fair value of the portfolio can be attributed in large part to purchases of securities in the amount of $18.4 million, proceeds from principal reductions of mortgage-backed securities in the amount of $5.2 million, and sales and maturities totaling $2.5 million. During the quarter ended June 30, 2008, the Bank recognized a gain of approximately $37 thousand related to the sale of securities previously mentioned. At June 30, 2008, the securities portfolio had a net unrealized loss of approximately $1.0 million or $563 thousand, net of tax. This, when compared to the net unrealized gain of approximately $313 thousand or $184 thousand, net of tax the portfolio had at December 31, 2007, represents a decline in market value of approximately $1.3 million or $747 thousand, net of tax. The year to date decline in market value of the securities portfolio can be attributed in large part to a rise in market interest rates during the second quarter of 2008, as well as a continued concerns surrounding mortgage related securities.

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Note 3. Loans and the Allowance for Loan Losses

The following table provides a summary of outstanding loan balances as of June 30, 2008 compared to December 31, 2007:

	June 30,		December 31,
(dollars in thousands)	2008		2007
Real Estate Secured:
Multi-family residential	$	14,457	$	12,779
Residential 1 to 4 family		26,466		24,326
Home equity lines of credit		19,220		17,470
Commercial		268,612		274,266
Farmland		10,652		11,557
Commercial:
Commercial and industrial		154,456		133,981
Agriculture		12,747		11,367
Other		814		732
Construction:
Single family residential		9,708		10,239
Single family residential - Spec.		16,565		18,718
Tract		2,317		1,664
Multi-family		9,482		9,054
Hospitality		21,401		16,784
Commercial		27,565		30,677
Land		55,555		31,064
Installment loans to individuals		7,792		7,977
All other loans (including overdrafts)		2,003		562
Total loans, gross		659,812		613,217
Deferred loan fees		1,756		1,732
Reserve for possible loan losses		8,128		6,143
Total loans, net	$	649,928	$	605,342
Loans held for sale	$	1,246	$	902

Concentration of Credit Risk

At June 30, 2008, approximately $482.7 million or 73.2% of the Bank’s loan portfolio was collateralized by various forms of real estate, this represents an increase of approximately $24.1 million when compared to the $458.6 million or 74.8% reported at December 31, 2007. 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 June 30, 2008, the Bank was contingently liable for letters of credit accommodations made to its customers totaling approximately $17.9 million and un-disbursed loan commitments in the approximate amount of $173.1 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.

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An analysis of the changes in the allowance for possible loan losses for the periods indicated below is as follows:

	For the three months ended						For the six months ended						For the year ended
(dollars in thousands)	June 30, 2008			June 30, 2007			June 30, 2008			June 30, 2007			December 31, 2007
Balance at beginning of period	$	6,305		$	4,312		$	6,143		$	4,081		$	4,081
Credit from purchase of Business First National Bank		-			-			-			-			1,381
Additions charged to operating expense		2,775			170			3,015			310			660
Loans charged off		(1,024	)		(19	)		(1,102	)		(20	)		(249	)
Recoveries of loans previously charged off		72			57			72			149			270
Balance at end of period	$	8,128		$	4,520		$	8,128		$	4,520		$	6,143

For the three and six month periods ended June 30, 2008, the Company had net charge-offs of approximately $952 thousand and $1.0 million, respectively. During the same periods ended in 2007, the Company had a net recoveries of loans previously charged off in the approximate amounts of $38 thousand and $129 thousand, respectively. During the second quarter of 2008, the Bank wrote down the value of certain non-performing loans in the approximate amount of $1.0 million. For a more detailed discussion concerning the loans the Bank has placed on non-accrual status, see “Non Performing Assets” under Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations in this Form 10-Q.

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

The analysis of the allowance for loan losses is comprised of three components: specific credit allocation; general portfolio allocation; and subjectively by determined allocation. The Bank accounts for problem loans in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 114, “Accounting by Creditors for Impairment of a Loan,” as amended by SFAS No. 118, “Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures.” These pronouncements provide that when it is probable that a creditor will be unable to collect all amounts due in accordance with the terms of the loan that such loan is deemed impaired. Impaired loans are accounted for differently in that the amount of the impairment is measured and reflected in the records of the creditor. The allowance for loan losses related to loans that are identified for evaluation in accordance with SFAS No. 114 is based on discounted cash flows using the loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. The general portfolio allocation consists of an assigned reserve percentage based on the credit rating of the loan. The subjective portion is determined based on loan history and the 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 six months ended June 30, 2008 is consistent with prior periods. The allowance for loan losses as a percentage of total gross loans was 1.23% and 1.00% at June 30, 2008 and December 31, 2007, respectively. Management believes that the allowance for loan losses as of June 30, 2008 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 would then share in the earnings of the entity.

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The following table sets forth the number of shares used in the calculation of both basic and diluted earnings per share for the three and six months ended June 30, 2008 and 2007:

	For the three months ending				For the six months ending
	June 30,				June 30,
(dollars in thousands except per share data)	2008		2007		2008		2007
Net Income	$	691	$	1,800	$	2,366	$	3,311
Basic	$	0.09	$	0.27	$	0.31	$	0.49
Diluted	$	0.09	$	0.26	$	0.30	$	0.47
Shares:
Basic		7,705,174		6,754,321		7,699,860		6,728,840
Diluted		7,830,390		7,027,090		7,841,144		7,018,270

On October 12, 2007, the Company issued 850,213 shares of common stock to the former shareholders of Business First National Bank in connection with its acquisition. Additionally, on April 24, 2008, the Company’s Board of Directors declared a 5% stock dividend to be paid on May 16, 2008. As a result of this dividend, the Company issued 366,344 shares of its common stock to holders of record on May 2, 2008. The basic and diluted shares presented in the table above for the three and six months ended June 30, 2008 fully reflect the shares issued in connection with the acquisition of Business First National Bank as well as the stock dividend paid in May 2008. Additionally, earnings per share for all prior periods have been adjusted to fully reflect the May 2008 stock dividend.

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 and provides that the tax effects from an uncertain tax position be recognized in the financial statements only if, based on its merits, the position is more likely than not to be sustained in audit by the taxing authorities. This interpretation is effective for fiscal years beginning after December 15, 2006. Effective January 1, 2007, the Company adopted FIN 48.  Management believes that all tax positions taken as of June 30, 2008 are highly certain and, accordingly, no accounting adjustments have been made to the financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 enhances existing guidance for measuring assets and liabilities using fair value. Prior to the issuance of SFAS No. 157, guidance for applying fair value was incorporated in several accounting pronouncements. SFAS No. 157 provides a single definition of fair value, together with a framework for measuring it, and requires additional disclosure about the use of fair value to measure assets and liabilities. SFAS No. 157 also emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and sets forth a fair value hierarchy with the highest priority being quoted prices in active markets. Under SFAS No. 157, fair value measurements are disclosed by level within that hierarchy. While SFAS No. 157 does not add any new fair value measurements, it does change current practice. Changes to practice include: (1) a requirement for an entity to include its own credit standing in the measurement of its liabilities; (2) a modification of the transaction price presumption; (3) a prohibition on the use of block discounts when valuing large blocks of securities for broker-dealers and investment companies; and (4) a requirement to adjust the value of restricted stock for the effect of the restriction even if the restriction lapses within one year. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Effective January 1, 2008, the Company adopted SFAS No. 157. The adoption of this standard has not had a material impact on the Company’s financial position, results of operations or cash flows.

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (an amendment of FASB Statements No. 87, 88, 106, and 132R).” SFAS No. 158, requires an employer to: (1) Recognize in its statement of financial position an asset for a plan’s over funded status or a liability for a plan’s under funded status; (2) measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year (with limited exceptions); and (3) recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur. Those changes will be reported in comprehensive income of a business entity and in changes in net assets of a not-for-profit organization. The requirement by SFAS No. 158 to recognize the funded status of a benefit plan and the disclosure requirements of SFAS No. 158 are effective as of the end of the fiscal year ending after December 15, 2006 for entities with publicly traded equity securities. The Company adopted this portion of the pronouncement effective January 1, 2007. The adoption of this portion has not had a material impact on the financial position, results of operation or cash flows of the Company. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end statement of financial position is effective for fiscal years ending after December 15, 2008. The adoption of SFAS No. 158 did not have a material effect on the financial position of the company.

In February 2007, the FASB issued SFAS No. 159,“Establishing the Fair Value Option for Financial Assets and Liabilities.” The FASB has issued SFAS No. 159 to permit all entities to choose to elect, at specified election dates, to measure eligible financial instruments at fair value. An entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date, and recognize upfront costs and fees related to those items in earnings as incurred and not deferred. SFAS No. 159 applies to fiscal years beginning after November 15, 2007, with early adoption permitted for an entity that has also elected to apply the provisions of SFAS No. 157, Fair Value Measurements. An entity is prohibited from retrospectively applying SFAS No. 159, unless it chooses early adoption. SFAS No. 159 also applies to eligible items existing at November 15, 2007 (or early adoption date). The Company adopted SFAS No. 159 on January 1, 2008 and chose not to measure certain eligible financial instruments at their fair values and as a result the adoption of SFAS No. 159 did not have a material impact on its financial position, results of operations or cash flows.

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

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

In February 2008, the FASB issued FASB Staff Position (“FSP”) FAS 157-1, “Application of FASB Statement No. 157 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement Under Statement 13,” and FSP FAS 157-2, “Effective Date of FASB Statement No. 157.” FSP FAS 157-1 removes leasing from the scope of SFAS No. 157, “Fair Value Measurements.” FSP FAS 157-2 delays the effective date of SFAS No. 157 from 2008 to 2009 for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). The Company does not expect the implementation of FSP 157-1 to have a material impact on its financial position, results of operations, or cash flows. Additionally, in accordance with FSP 157-2 the Company will delay the application of SFAS No. 157 for non-financial assets and non-financial liabilities until January 1, 2009 and does not expect the application to have a material impact on the Company’s financial position, results of operations, or cash flows.

In March 2008, the FASB issued SFAS No. 161,“Disclosures about Derivative Instruments and Hedging Activities - an amendment of FASB Statement No. 133,” which amends and expands the disclosure requirements of SFAS No. 133 with the intent to provide users of financial statements with an enhanced understanding of: how and why an entity uses derivative instruments; how derivative instruments and related hedged items are accounted for under SFAS No. 133 and its related interpretations; and how derivative instruments and related hedged items affect an entity’s financial position, results of operations, and cash flows. To meet those objectives, this Statement requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. This Statement is effective for fiscal and interim periods after November 15, 2008 with earlier adoption encouraged. Disclosures will not be required retrospectively to prior reporting periods. The Company has elected to adopt SFAS No. 161 effective January 1, 2009. We have not yet determined the impact that the adoption of SFAS No. 161 may have on our financial position, results of operations and cash flows.

In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles.” SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of the financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (“GAAP”) in the Unites States. The FASB issued SFAS No. 162, because the current GAAP hierarchy, as set forth in the American Institute of Certified Public Accountants (“AICPA”) Statement on Auditing Standards No. 69, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles,” is directed to the auditor and not the entity, it is complex, and it ranks FASB Statements of Financial Accounting Concepts below industry practices that are widely recognized as generally accepted but that are not subject to due process. This statement is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board (“PCAOB”) amendments to AU Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles.” The Company does not anticipate the adoption of SFAS No. 162 to have a material impact of its financial position, results of operations or cash flows.

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In May 2008, the FASB issued SFAS No. 163, “Accounting for Financial Guarantee Insurance Contracts, an interpretation of FASB Statement No. 60.” SFAS No. 163 seeks to bring consistency in the recognition and measurement of claim liabilities. This statement also clarifies how SFAS No. 60 applies to financial guarantee contracts, including the recognition and measurement to be used to account for premium revenue and claim liabilities, increasing the comparability in financial reporting of financial guarantee contracts by insurance enterprises. The Company must adopt SFAS No. 163 no later than January 1, 2009. The Company does not anticipate the adoption of SFAS No. 163 to have a material impact on its financial position, results of operations or cash flows.

Note 6. Share-Based Compensation

As of June 30, 2008, the Company had two share-based employee compensation plans, which are more fully described in Note 14 of the Consolidated Financial Statements in the Company's Annual Report filed on Form 10-K for the year ended December 31, 2007. These plans include the “1997 Stock Option Plan” 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.

Share-based compensation expense for all share-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.

The share-based compensation expense recognized in the condensed consolidated statements of income for the three and six month periods ended June 30, 2008 and 2007 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 following table provides a summary of the expenses the Company has recognized related to share-based compensation as well as the impact those expenses have had on diluted earnings per share for the periods indicated below:

	For the three months ended				For the six months ended
	June 30,				June 30,
(dollars in thousands except per share data)	2008		2007		2008		2007
Share-based compensation expense:
Stock option expense	$	52	$	28	$	101	$	56
Restricted stock expense		3		64		66		127
Total share-based compensation expense	$	55	$	92	$	167	$	183
Total share-based compensation expense, net of tax	$	40	$	63	$	114	$	126
Diluted shares outstanding		7,830,390		7,027,090		7,841,144		7,018,270
Impact on diluted earnings per share	$	0.005	$	0.009	$	0.015	$	0.018
Unrecognized compensation expense:
Stock option expense	$	367	$	171
Restricted stock expense		604		921
Total unrecognized share-based compensation expense	$	971	$	1,092
Total unrecognized share-based compensation expense, net of tax	$	597	$	699

At June 30, 2008, there was a total of $367 thousand of unrecognized compensation expense related to non-vested stock option awards. That expense is expected to be recognized over a weighted-average period of 1.8 years.

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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 total unrecognized compensation expense related to restricted share awards at June 30, 2008 was $604 thousand. That expense is expected to be recognized over the next 2.7 years.

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 second quarter of 2008 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 June 30, 2008). The aggregate pretax intrinsic value is subject to change based on the fair market value of the Company's stock. The aggregate intrinsic value of options exercised for the three and six month periods ended June 30, 2008 and 2007 was $72 thousand and $214 thousand and $249 thousand and $1.1 million, respectively.

The following table provides a summary of the aggregate intrinsic value of options outstanding and exercisable as well as options granted, exercised, and forfeited during the year-to-date period ended June 30, 2008 and 2007:

						Average
				Weighted		Remaining		Total
				Average		Contractual		Intrinsic
	Number of			Exercise		Term		Value
	Shares			Price		(in years)		(in 000's)
Options outstanding, January 1, 2008		463,160		$	8.36
Granted		26,250			11.48
Exercised		(32,090	)		4.37
Forfeited		(4,437	)		6.58
Expired		(2	)		4.42
Options outstanding, June 30, 2008		452,881		$	8.84		4.41	$	906
Exercisable at June 30, 2008		362,146		$	7.78		3.37	$	904
Options outstanding, January 1, 2007		458,395		$	5.16
Granted		-			-
Exercised		(136,252	)		2.82
Forfeited		(1,047	)		10.23
Options outstanding, June 30, 2007		321,096		$	6.14		4.24	$	3,545
Exercisable at June 30, 2007		277,230		$	5.42		3.82	$	3,257

During the first quarter of 2008, 26,250 options were granted to members of the Company’s Board of Directors excluding the one inside Director. The following table presents the assumptions used in the calculation of the weighted average fair value of those options on the date of grant using the Black-Scholes options pricing model:

	February
	2008
Expected volatility		35.07	%
Expected term (years)		10
Dividend yield		2.66	%
Risk free rate		3.62	%
Weighted-average grant date fair value	$	3.93

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Note 7. Fair Value of Financial Instruments

Effective January 1, 2008, the Company determines the fair market values of certain financial instruments based on the fair value hierarchy established in SFAS No. 157,“Fair Value Measurements,” which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value.

The following provides a summary of the hierarchical levels, as defined by SFAS No. 157, used to measure fair value:

Level 1 - Quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 1 assets and liabilities may include debt and equity securities that are traded in an active exchange market and that are highly liquid and are actively traded in over-the-counter markets.

Level 2 - Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities may include debt securities with quoted prices that are traded less frequently than exchange-traded instruments and other instruments whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. This category generally includes U.S. Government and agency mortgage-backed debt securities, corporate debt securities, derivative contracts, residential mortgage and loans held-for-sale.

Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. This category generally includes certain private equity investments, retained residual interests in securitizations, residential MSRs, asset-backed securities (ABS), highly structured or long-term derivative contracts and certain collateralized debt obligations (CDO) where independent pricing information was not able to be obtained for a significant portion of the underlying assets.

Fair Value Measurements

The Company used the following methods and significant assumptions to estimate fair value:

· Securities

The fair value of securities available-for-sale are determined by obtaining quoted prices on nationally recognized exchanges or matrix pricing which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather relying on the security’s relationship to other benchmark quoted securities.

· Loans Held For Sale

The fair value of loans held for sale is determined, when possible, using quoted secondary market prices. If no such quoted price exists, the fair value of the loan is determined using quoted prices for a similar asset or assets, adjusted for the specific attributes of that loan.

· Impaired Loans

A loan is considered impaired when it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement. Impairment is measured based on the fair value of the underlying collateral or the discounted expected future cash flows. The Company measures impairment on all non-accrual loans for which it has established specific reserves as part of the specific allocated allowance component of the allowance for loan losses. As such, the Company records impaired loans as non-recurring Level 2 when the fair value of the underlying collateral is based on an observable market price or current appraised value. When current market prices are not available or the Company determines that the fair value of the underlying collateral is further impaired below appraised values, the Company records impaired loans as non-recurring Level 3. At June 30, 2008, substantially all of the Company’s impaired loans were evaluated based on the fair value of their underlying collateral based upon the most recent appraisal available to Management.

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· Other Real Estate Owned and Foreclosed Collateral

Other real estate owned and foreclosed collateral are adjusted to the lower of cost or fair value, less any estimated costs to sell, at the time the loans are transferred into this category. The fair value of these assets is based on independent appraisals, observable market prices for similar assets, or Management’s estimation of value. When the fair value is based on independent appraisals or observable market prices for similar assets, the Company records other real estate owned or foreclosed collateral as non-recurring Level 2. When appraised values are not available, there is no observable market price for similar assets, or Management determines the fair value of the asset is further impaired below appraised values or observable market prices, the Company records other real estate owned or foreclosed collateral as non-recurring Level 3.

The following table provides a summary of the financial instruments the Company measures at fair value on a recurring basis as of June 30, 2008:

	Fair Value Measurments Using
							Assets At
(dollars in thousands)	Level 1		Level 2		Level 3		Fair Value
Assets:
Available for sale investment securities	$	-	$	56,352	$	712	$	57,064
Total assets measured on a recurring basis	$	-	$	56,352	$	712	$	57,064

The following table provides a summary of the changes in balance sheet carrying values associated with Level 3 financial instruments during the six months ended June 30, 2008:

	Available For
	Sale Investment
(dollars in thousands)	Securities
Beginning balance	$	739
Total gains or losses (realized/unrealized)(1):
Included in earnings		-
Included in other comprehensive income		(27	)
Purchases		-
Transfers in and/or out of Level 3		-
Ending balance	$	712

⁽¹⁾ Realized or unrealized gains from the changes in values of Level 3 financial instruments represent gains from changes in values of financial instruments only for the period(s) in which the instruments were classified as Level 3.

The assets presented under level 3 of the fair value hierarchy described in SFAS No. 157 represent available for sale investment securities in the form of certificates of participation where an active market for such securities is not currently available.

The following table provides a summary of the financial instruments the Company measures at fair value on a non-recurring basis as of June 30, 2008:

	Fair Value Measurments Using
							Assets At
(dollars in thousands)	Level 1		Level 2		Level 3		Fair Value
Assets:
Impaired loans	$	-	$	13,507	$	-	$	13,507
Loans held for sale		-		1,246		-		1,246
Other real estate owned		-		197		-		197
Other assets(1)		-		30		-		30
Total assets measured on a non-recurring basis	$	-	$	14,980	$	-	$	14,980

⁽¹⁾ Other assets represent foreclosed collateral carried at fair value.

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In addition to the assets presented in the table above, the Company uses fair value measurements on a non-recurring basis in its assessment of assets classified as Goodwill. These assets are recorded at fair value initially and assessed for impairment periodically thereafter. During the fiscal year ended December 31, 2007, the carrying amount of goodwill assets were compared to their fair value. No change in carrying amount resulted in accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets.” Additionally, the Company has certain other loans that are measured at fair value on a non-recurring basis such as loans that were acquired in the acquisition of Business First National Bank.

Note 8. Goodwill

As of June 30, 2008, the balance of good will was approximately $11.5 million. This, when compared to the $10.9 million the Company reported at December 31, 2007, represents an increase of approximately $0.6 million. The increase in the balance of goodwill can be attributed exclusively to expenses the Company incurred and capitalized, directly related to the acquisition of Business First National Bank.

Note 9. Reclassifications

Certain amounts in the 2007 financial statements have been reclassified to conform to the 2008 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: the recent fluctuations in U.S. markets resulting, in part, from problems related to sub-prime lending, the recent downturn in the California real-estate market, 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, 2007 10K, 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.

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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 as of and for the three and six month periods ending June 30, 2008 and 2007. 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"), a 15 branch bank serving San Luis Obispo and 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.

In September 2007, the Company formed Heritage Oaks Capital Trust III (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.

On October 12, 2007, the Company acquired Business First National Bank (“Business First”). Business First was merged with and into Heritage Oaks Bank, a wholly owned subsidiary of the Company. In connection with the acquisition, two additional branches were added to the Bank’s network. For additional information regarding this acquisition, please see Note 1 to the consolidated financial statements filed on this Form 10-Q as well as Note 22 to the consolidated financial statements of the Company’s 2007 annual report, which was filed on Form 10-K.

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.

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Executive Summary and Recent Developments

Earnings and Financial Condition Overview

For the three and six months ended June 30, 2008, the Company earned $0.7 million and $2.4 million, respectively. This represents declines of 61.6% and 28.5% for the three and six months ended June 30, 2008 when compared to the same periods ended a year earlier. During the second quarter of 2008, the Company made additions to the allowance for loan losses in the approximate amount of $2.8 million. The Company felt it necessary to make additions to the allowance, given the weakened economic environment, and changes in the trend of delinquent loans. The Company’s analysis of the allowance for loan losses indicates that as of June 30, 2008, the allowance was sufficient to cover potential credit losses inherent in the loan portfolio. With respect to earnings per share, the Company earned $0.09 and $0.30 per diluted share for the quarter and year to date periods ended June 30, 2008. When compared to the same periods ended a year earlier, diluted earnings per share declined approximately 65.5% and 36.0%, respectively. The year over year decline in diluted earnings per share can be attributed in part to shares the Company issued during the fourth quarter of 2007 in connection with the acquisition of Business First. For additional information related to the Company’s 2007 acquisition of Business First, see Note 1 to the consolidated financial statements filed on this Form 10-Q as well as Note 22 to the consolidated financial statements of the Company’s 2007 annual report filed on Form 10-K. Additionally, when viewing data as of and for the periods ended June 30, 2008, it is important to consider that Business First was acquired on October 12, 2007. Therefore, the Company’s financial position and results of operations will not reflect the acquisition as of and for the periods ended June 30, 2007.

The following provides financial highlights as of and for the three and six months ended June 30, 2008:

· Total interest income increased approximately $1.8 million and $4.3 million or 16.2% and 20.2% when compared to the same three and six month periods ended a year earlier. This can be attributed to higher loan balances in connection with the acquisition of Business First as well as organic loan growth. At June 30, 2008 gross loan balances were approximately $199.0 million higher than a year ago. The Bank obtained approximately $120.8 million in new loan balances upon the acquisition of Business First.

· Interest expense declined approximately $0.6 million and $0.2 million or 16.3% and 2.2% when compared to the same three and six month periods ended a year earlier. The declines in interest expense can be attributed in large part to the dramatic declines seen in the overnight Fed Funds rate during the first six months of 2008, leading Management to significantly re-price its deposits.

· Net interest income increased approximately $2.3 million or 32.1% and $4.4 million or 30.9% when compared to the same three and six month periods ended a year earlier. The increase in net interest income is attributable in large part to the items mentioned above.

· Non-interest income increased approximately $0.4 million or 26.2% and $0.6 million or 21.8% when compared to the same three and six month periods ended a year earlier. The quarter and year to date increases are largely attributable to increased service charges on deposit accounts stemming from the additional deposit relationships the Bank obtained from promotional activities during 2007 as well as the acquisition of Business First. Additionally, during the second quarter, the Bank recognized income in the approximate amount of $0.3 million related to the Visa, Inc. initial public offering.

· Non-interest expenses increased approximately $1.9 million or 34.8% and $3.9 million or 34.3% from the same three and six month periods ended a year earlier. The increases in this category can be attributable in large part to higher salaries and employee benefits stemming from branch expansion and additional staff from the acquisition of Business First. Additionally, higher occupancy and equipment expenses contributed to the increase within this category as a result of branch expansion and the Business First acquisition.

· The acquisition of Business First accounted for the addition of nearly $160.5 million in assets along with approximately $13.8 million in equity over that which was reported at June 30, 2007. It is because of these additional balances in addition to the additional loan loss provision the Bank booked during the second quarter of 2008, that return on average assets for the three and six months ended June 30, 2008 was 0.35% and 0.62%, respectively compared to 1.25% and 1.17% for the same periods ended a year earlier. Return on average equity was 3.84% and 6.66% for the three and six months ended June 30, 2008 compared to 13.84% and 12.99% for the same periods ended a year earlier.

· The Company’s net interest margin for the three and six months ended June 30, 2008 was 5.28% and 5.31%, respectively. This, when compared to the 5.56% and 5.61% the Company reported for the same periods ended a year earlier, represents declines of approximately 28 and 30 basis points, respectively. The Company was able to mitigate margin compression by aggressively re-pricing its deposits and borrowings during the declining rate environment.

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· For the three and six months ended June 30, 2008 the Company’s operating efficiency ratio was 66.31% and 69.14%, respectively. This, when compared to the 64.32% and 66.55% the Company reported for the same periods ended a year earlier, represents increases of approximately 199 and 259 basis points, respectively. The increases in the efficiency ratio can be attributed in large part to the increases in non-interest expenses previously mentioned.

At June 30, 2008, total assets were $800.1 million. This represents an increase of approximately $54.5 million or 7.3% when compared to the $745.6 million reported at December 31, 2007.

· Net loan balances were $649.9 million at June 30, 2008. This, when compared to the $605.3 million reported at the end of 2007, represents an increase of approximately $44.6 million or 7.4%.

· Total deposit balances were $634.5 million at June 30, 2008, which represents a decline of approximately $10.3 million or 1.6% from the $644.8 million reported at December 31, 2007. The year to date decline in deposit balances can be attributable in large part to the dramatic decline in interest rates seen during the first half of 2008. As the Bank moved to match the declines in the overnight Fed Funds rate made by the Federal Open Market Committee (“FOMC”), we experienced declines in deposit balances, particularly with respect to non-core promotional deposit products and money market balances. See also “Deposits” under Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations on this Form 10-Q for additional information related to deposits.

· Federal Home Loan Bank and other borrowings were $71.5 million at June 30, 2008. When compared to the $8.0 million reported at the end of 2007, this represents an increase of approximately $63.5 million. The large increase in wholesale borrowing is attributed in large part to the strategy by Management to replace higher cost non-core deposits with lower cost FHLB borrowing.

· At June 30, 2008, the allowance for loan losses was $8.1 million. As a percentage of total gross and non-performing loan balances, the allowance for loan losses was 1.23% and 60.18%, respectively. For the three and six month periods ended June 30, 2008, provision for loan losses was approximately $2.8 million and $3.0 million, respectively. When compared to the same periods ended a year earlier, this represents increases of approximately $2.6 million and $2.7 million, respectively. The increased provision of loan losses can be attributed in part to weakened economic conditions, increases in the balance of non-performing loans, as well as loans the Bank charged off during the second quarter of 2008.

· As of June 30, 2008, the balance of loans placed on non-accrual status was approximately $13.4 million. This represents an increase of approximately $13.1 million from that reported at December 31, 2007. During the quarter, the Bank also moved to foreclose on real-estate securing a loan previously placed on non-accrual. The value of this property was recorded at $197 thousand as of June 30, 2008. See also “Non Performing Assets” under Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations on this Form 10-Q for additional information related to non-performing assets.

Recent Developments

On October 12, 2007, the Company acquired Business First National Bank (“Business First”). Business First was merged with and into Heritage Oaks Bank, a wholly owned subsidiary of Heritage Oaks Bancorp. The consideration paid for Business First was approximately $19.5 million, consisting of approximately 75% common stock and 25% cash. Business First shareholders received 0.5758 shares of Heritage Oaks Bancorp common stock for each share of Business First they owned and $3.44 per share in cash. Upon the acquisition, the Company issued 850,213 shares of common stock and $5.1 million in cash to the former shareholders of Business First. For additional information regarding the acquisition of Business First, see Note 1 to the consolidated financial statements filed on this Form 10-Q as well as Note 22 to the consolidated financial statements of the Company’s 2007 annual report filed on Form 10-K.

On September 20, 2007, the Company issued $5.2 million in Junior Subordinated Debt Securities (the “Debt Securities”) to Heritage Oaks Capital Trust III, a statutory trust created under the laws of the State of Delaware. The Debt Securities are subordinated to effectively all borrowings of the Company and are due and payable in September 2037. Interest is payable quarterly on these securities based on the five year SWAP rate (a rate that may be converted to a floating rate at a later date) plus 2.00% for an effective rate of 6.888%. Interest on the Debt Securities is fixed for five years and at the end of such time will convert to a floating rate of the five year SWAP rate plus 2.00%. The Company has the right under the Indenture to defer payment of interest on the Debt Securities at any time for a period not to exceed twenty consecutive quarterly periods (each an “Extension Period”) provided that no Extension Period may extend beyond the maturity of the Debt Securities. In the event the Company exercises the right to defer payment of interest on the Debt Securities, it may not declare or pay any dividends on its common stock. The Company presently has no intention to defer interest payments on the Debt Securities, and it considers the likelihood of such a deferral to be remote. The securities can be called at any time commencing on December 15, 2012, at par. The Company also purchased a 3.1% minority interest totaling $155 thousand in Heritage Oaks Capital Trust III. The balance of the equity of Heritage Oaks Capital Trust III is comprised of mandatorily redeemable preferred securities and is included in other assets. The company used the proceeds from the sale of the securities to assist in the acquisition in Business First, for general corporate purposes, and for capital contributions to the Bank for future growth.

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On May 11, 2007 the Company entered into a material definitive agreement to sell four of the Bank’s properties to First States Group, L.P. (“First States”) in a sale/leaseback transaction for $12.8 million. In connection with the sale, the Bank entered into four separate lease agreements with First States Investors, LLC to lease back three branches and one administrative facility under which the Bank will continue to utilize the properties for the normal course of business. Each of the four leases contain an annual rent escalation clause equal to the lower of CPI-U (Consumer Price Index for all Urban Consumers) or 2.5 percent, commencing in the second year of the lease term. Each of the four leases provide for an initial term of 15 years with the option to renew for two 10 year terms. As of June 30, 2008, the Bank makes monthly payments in the aggregate amount of $75 thousand to lease these facilities.

In connection with the sale of the properties mentioned, the Bank will recognize a gain of approximately $3.4 million. This gain will be recognized over a fifteen year period in accordance with SFAS No. 13 “Accounting For Leases.” For the three and six months ended June 30, 2008, the Bank recognized a gain of approximately $57 thousand or $33 thousand net of tax and $114 thousand or $67 thousand net of tax, respectively. This gain was recorded as an offset to rental expense for the period mentioned. In addition to deferring the gain on sale, the Bank recorded an income tax liability and a deferred tax asset in the approximate amounts of $1.4 million, directly related to the deferred gain on sale.

On April 23, 2007 the Company redeemed all of the Floating Rate Junior Subordinated Debt Securities it held associated with Heritage Oaks Capital Trust I, a wholly-owned subsidiary of Heritage Oaks Bancorp. The redemption price was 100% of the principal amount redeemed plus accrued and unpaid interest as of the Redemption Date. The Company paid $0.4 million for the standard interest payment due April 22, 2007, plus a payment of $8.2 million for the principal amount to be redeemed on that date. These amounts were funded from the Company’s general corporate reserves. As a result of the redemption of the securities the Company held associated with Heritage Oaks Capital Trust I, the Trust was dissolved on June 1, 2007.

Stock Repurchases and Dividends

On July 18, 2007, the Board of Directors authorized a one year extension of the stock repurchase program that was adopted in July 2006. Under the one year extension the Company may repurchase up to 100,000 shares of its common stock. As of June 30, 2008, the Company repurchased 53,500 shares of its common stock under the current plan. No repurchases were made during the first six months of 2008.

On April 24, 2008, the Board of Directors declared a 5% stock divided to be paid on May 16, 2008 to shareholders of record on May 2, 2008. This stock dividend represents a change in the form of dividend payment to the Company’s shareholders away from cash dividends in order to retain the Company’s capital for future growth.

On January 24, 2008, the Board of Directors declared a quarterly cash dividend of $0.08 per share to be paid on February 15, 2008 to shareholders of record on February 1, 2008.

On October 17, 2007, the Board of Directors declared a quarterly cash dividend of $0.08 per share to be paid on November 16, 2007 to shareholders of record on November 2, 2007.

On July 18, 2007, the Board of Directors declared a quarterly cash dividend of $0.08 per share to be paid on August 17, 2007 to shareholders of record on August 3, 2007.

On April 20, 2007, the Board of Directors declared a quarterly cash dividend of $0.08 per share to be paid on May 18, 2007 to shareholders of record on May 4, 2007.

On January 19, 2007, the Board of Directors declared a quarterly cash dividend of $0.08 per share to be paid on February 16, 2007 to shareholders of record on February 2, 2007.

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Selected Financial Data

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

	For the quarters ended
(dollars in thousands except share data)	06/30/08			03/31/08			12/31/07			09/30/07			06/30/07			03/31/07			12/31/06			09/30/06
Return on average assets		0.35	%		0.91	%		1.11	%		1.12	%		1.25	%		1.10	%		1.24	%		1.33	%
Return on average equity		3.84	%		9.55	%		11.65	%		12.09	%		13.84	%		12.10	%		13.64	%		14.43	%
Average equity to average assets		9.14	%		9.48	%		9.49	%		9.27	%		9.02	%		9.07	%		9.11	%		9.25	%
Net interest margin		5.28	%		5.33	%		5.33	%		5.44	%		5.56	%		5.66	%		5.77	%		6.02	%
Efficiency ratio*		66.31	%		72.17	%		67.26	%		66.89	%		64.32	%		68.89	%		67.12	%		65.31	%
Average loans to average deposits		109.26	%		103.64	%		96.40	%		95.79	%		103.52	%		108.23	%		105.03	%		97.15	%
Net Income	$	691		$	1,675		$	1,978		$	1,628		$	1,800		$	1,510		$	1,649		$	1,733
Earnings Per Share:
Basic	$	0.09		$	0.22		$	0.26		$	0.24		$	0.27		$	0.23		$	0.25		$	0.26
Diluted	$	0.09		$	0.21		$	0.25		$	0.23		$	0.26		$	0.22		$	0.24		$	0.25
Outstanding Shares:
Basic		7,705,174			7,694,546			7,682,730			6,796,286			6,754,321			6,703,358			6,673,239			6,668,263
Diluted		7,830,390			7,851,831			7,887,206			7,013,070			7,027,090			6,936,239			6,928,273			6,924,357

* The efficiency ratio is defined as total non-interest expense as a percent of the combined net interest income plus non-interest income, exclusive of gains and losses on the sale of investment securities.

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, the City of Santa Maria (in Northern Santa Barbara County) and the City of Santa Barbara totaled approximately 260,000 and 92,000 and 90,000, respectively, according to economic data provided by local county and title company sources. The moderate climate allows a year round growing season for numerous 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, has historically experienced a more stable level of economic activity when compared to many other areas of California.

Critical Accounting Policies

The Company’s significant accounting policies are set forth in the 2007 Annual Report, Note 1 of the 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.

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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 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 also Note 3 to the consolidated financial statements for further discussion on Allowance for Loan Losses.

· Securities Available for Sale

The fair values 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 2007 Annual Report, Note 1 of the consolidated financial statements, which was filed on Form 10-K, we assess goodwill and other intangible assets each year for impairment. This assessment involves a “carrying amount comparison” that compares the fair value of the reporting unit to its carrying value (stated shareholders’ equity, including goodwill). If the carrying value of a reporting unit materially exceeds its fair value, 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, 2007.

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Results of Operations

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 Federal Funds and Prime interest rates. This was evidenced during the first six months of 2008, as the FOMC cut the overnight Fed Funds rate by 225 basis points. The result was sequential declines in interest income and interest expense in the first and second quarters of 2008 from that reported for the three months ended December 31, 2007. The Company has historically been 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. However, during 2007 and the first half of 2008, the Bank engaged in promotional activities designed to attract lower cost core deposits. As a result of these promotions, the balance of floating rate money market accounts increased dramatically. This proved to be beneficial during the first and second quarters of 2008, as the Bank had the ability to re-price those funds in conjunction with the moves in interest rates made by the FOMC. The ability to rapidly re-price significant portions of the balance sheet allowed for a relatively stable net interest margin. For the three and six months ended June 30, 2008 the Bank’s net interest margin was 5.28% and 5.31%, respectively. This, when compared to the 5.33% reported for the first quarter of 2008 and fourth quarter of 2007, represents minimal declines of 5 and 2 basis points, respectively. Given that interest rates are considerably lower on a year over year basis, the net interest margin contracted approximately 28 and 30 basis points when compared to the same three and six month periods ended June 30^th a year earlier.

Historically, the largest and most variable source of income for the Company is net interest income. The results of operations for the three and six months ended June 30, 2008 and 2007 reflect the impact of a rising rate environment that covered the majority of 2004 through the third quarter of 2007 as well as a dramatic decline in interest rates from the fourth quarter of 2007 through April of 2008.

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 volume and rate variances table below sets forth the dollar difference in interest earned and paid for each major category of interest-earning assets and interest-bearing liabilities for the three and six month periods ended June 30, 2008 over the same period ended in 2007, and the amount of such change attributable to changes in average balances (volume) or changes in average yields and rates.

	For the three months ended									For the six months ended
	June 30, 2008 over 2007									June 30, 2008 over 2007
(dollars in thousands)	Volume			Rate			Total			Volume			Rate			Total
Interest Income:
Loans (1)	$	2,722		$	(1,204	)	$	1,518		$	5,996		$	(2,202	)	$	3,794
Investment securities taxable		293			49			342			465			73			538
Investment securities non-taxable (2)		13			(2	)		11			21			-			21
Taxable equivalent adjustment (2)		(5	)		1			(4	)		(7	)		-			(7	)
Interest-bearing deposits		-			1			1			-			1			1
Federal funds sold		(39	)		(78	)		(117	)		23			(104	)		(81	)
Net increase (decrease)		2,984			(1,233	)		1,751			6,498			(2,232	)		4,266
Interest Expense:
Savings, now, money market		20			(12	)		8			1,030			(235	)		795
Time deposits		289			(667	)		(378	)		1,122			(1,341	)		(219	)
Other borrowings		(1,004	)		805			(199	)		582			(1,189	)		(607	)
Long term borrowings		(108	)		97			(11	)		2			(123	)		(121	)
Net increase (decrease)		(803	)		223			(580	)		2,736			(2,888	)		(152	)
Total net increase (decrease)	$	3,787		$	(1,456	)	$	2,331		$	3,762		$	656		$	4,418

(1) Loan fees of $369 and $353 for the three months ending June 30, 2008 and 2007, respectively and $724 and $641 for the six months ending June 30, 2008 and 2007, respectively have been included in interest income computation.

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

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The tables below set forth average balance sheet information, interest income and expense, average yields and rates and net interest income and margin for the three and six month periods ended June 30, 2008 and 2007. The average balance of non-accruing loans has been included in loan totals.

	For the three months ending								For the three months ending
	June 30, 2008								June 30, 2007
				Yield/			Income/					Yield/			Income/
(dollars in thousands)	Balance			Rate (4)			Expense		Balance			Rate (4)			Expense
Interest Earning Assets:
Investments with other banks	$	281			4.29	%	$	3	$	318			2.52	%	$	2
Investment securities taxable		46,594			5.26	%		609		23,636			4.53	%		267
Investment securities non-taxable		17,423			4.27	%		185		16,621			4.30	%		178
Federal funds sold		9,249			1.96	%		45		13,198			4.92	%		162
Loans (1) (2)		656,917			7.18	%		11,732		469,719			8.72	%		10,214
Total interest earning assets		730,464			6.92	%		12,574		523,492			8.29	%		10,823
Allowance for possible loan losses		(6,475	)							(4,417	)
Other assets		67,083								59,619
Total assets	$	791,072							$	578,694
Interest Bearing Liabilities:
Savings/NOW/money market		295,713			1.39	%		1,020		181,654			2.23	%		1,012
Time deposits		152,628			3.16	%		1,199		133,377			4.74	%		1,577
Other borrowings		92,825			2.45	%		565		55,607			5.55	%		769
Federal funds purchased		3,439			2.46	%		21		1,130			5.68	%		16
Long-term debt		13,403			5.40	%		180		10,242			7.48	%		191
Total interest-bearing liabilities		558,008			2.15	%		2,985		382,010			3.74	%		3,565
Demand deposits		152,927								138,696
Other liabilities		7,856								5,818
Total liabilities		718,791								526,524
Stockholders' Equity:
Common stock		46,291								29,833
Additional paid in capital		824								467
Retained earnings		25,129								21,801
Valuation allowance investments		37								69
Total stockholders' equity		72,281								52,170
Total liabilities and stockholders' equity	$	791,072							$	578,694
Net interest income							$	9,589							$	7,258
Net interest margin (3)					5.28	%							5.56	%

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

(2) Loan fees of $369 and $353 for the three months ending June 30, 2008 and 2007, respectively have been included in interest income computation.

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

(4) Yield/Rate is annualized using actual number of days in period.

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	For the six months ending								For the six months ending
	June 30, 2008								June 30, 2007
				Yield/			Income/					Yield/			Income/
(dollars in thousands)	Balance			Rate (4)			Expense		Balance			Rate (4)			Expense
Interest Earning Assets:
Investments with other banks	$	306			3.94	%	$	6	$	318			3.17	%	$	5
Investment securities taxable		42,370			5.13	%		1,081		23,924			4.58	%		543
Investment securities non-taxable		17,273			4.30	%		369		16,636			4.30	%		355
Federal funds sold		8,631			2.61	%		112		7,834			4.97	%		193
Loans (1) (2)		640,449			7.48	%		23,823		465,297			8.68	%		20,029
Total interest earning assets		709,029			7.20	%		25,391		514,009			8.29	%		21,125
Allowance for possible loan losses		(6,339	)							(4,299	)
Other assets		64,924								58,630
Total assets	$	767,614							$	568,340
Interest Bearing Liabilities:
Savings/NOW/money market		299,808			1.69	%		2,526		170,263			2.05	%		1,731
Time deposits		153,334			3.64	%		2,779		129,695			4.66	%		2,998
Other borrowings		69,250			2.67	%		918		56,420			5.44	%		1,521
Federal funds purchased		3,824			2.94	%		56		2,123			5.70	%		60
Long-term debt		13,403			6.05	%		403		13,352			7.91	%		524
Total interest-bearing liabilities		539,619			2.49	%		6,682		371,853			3.71	%		6,834
Demand deposits		148,518								139,878
Other liabilities		8,051								5,218
Total liabilities		696,188								516,949
Stockholders' Equity:
Common stock		45,164								29,587
Additional paid in capital		768								419
Retained earnings		25,416								21,316
Valuation allowance investments		78								69
Total stockholders' equity		71,426								51,391
Total liabilities and stockholders' equity	$	767,614							$	568,340
Net interest income							$	18,709							$	14,291
Net interest margin (3)					5.31	%							5.61	%

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

(2) Loan fees of $724 and $641 for the six months ending June 30, 2008 and 2007, respectively have been included in interest income computation.

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

(4) Yield/Rate is annualized using actual number of days in period.

- 28 -

The tables below set forth changes in average interest earning assets and their respective yields for the three and six month periods ending June 30, 2008 compared to the same periods ended in 2007.

	Average Balance										Average Yield
	for the three months ending										for the three months ending
	June 30,				Variance						June 30,
(dollars in thousands)	2008		2007		dollar			percentage			2008			2007			Variance
Time deposits with other banks	$	281	$	318	$	(37	)		-11.64	%		4.29	%		2.52	%		1.77	%
Investment securities taxable		46,594		23,636		22,958			97.13	%		5.26	%		4.53	%		0.73	%
Investment securities non-taxable		17,423		16,621		802			4.83	%		4.27	%		4.30	%		-0.03	%
Federal funds sold		9,249		13,198		(3,949	)		-29.92	%		1.96	%		4.92	%		-2.96	%
Loans (1) (2)		656,917		469,719		187,198			39.85	%		7.18	%		8.72	%		-1.54	%
Total interest earning assets	$	730,464	$	523,492	$	206,972			39.54	%		6.92	%		8.29	%		-1.37	%

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

(2) Loan fees of $369 and $353 for the three months ending June 30, 2008 and 2007, respectively have been included in the interest income computation.

	Average Balance										Average Yield
	for the six months ending										for the six months ending
	June 30,				Variance						June 30,
(dollars in thousands)	2008		2007		dollar			percentage			2008			2007			Variance
Time deposits with other banks	$	306	$	318	$	(12	)		-3.77	%		3.94	%		3.17	%		0.77	%
Investment securities taxable		42,370		23,924		18,446			77.10	%		5.13	%		4.58	%		0.55	%
Investment securities non-taxable		17,273		16,636		637			3.83	%		4.30	%		4.30	%		0.00	%
Federal funds sold		8,631		7,834		797			10.17	%		2.61	%		4.97	%		-2.36	%
Loans (1) (2)		640,449		465,297		175,152			37.64	%		7.48	%		8.68	%		-1.20	%
Total interest earning assets	$	709,029	$	514,009	$	195,020			37.94	%		7.20	%		8.29	%		-1.09	%

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

(2) Loan fees of $724 and $641 for the six months ending June 30, 2008 and 2007, respectively have been included in the interest income computation.

As of June 30, 2008, total earning assets were approximately $207.0 million higher than when reported a year earlier. The primary factor for the increase in interest earning assets can be attributed to the acquisition of Business First, organic loan growth, and the purchase of approximately $18.4 million in investment securities during the first six months of 2008. At June 30, 2008, Business First accounted for approximately $167.5 million and $158.7 million of the quarter and year to date increases in interest earning assets. Additionally, the Company continues to increase the loan portfolio organically with continued market penetration by a team of seasoned loan officers. Additions to the loan portfolio for the three and six months ending June 30, 2008 were achieved under the Company’s established loan policy.

For the three and six month periods ended June 30, 2008, the average yield on loans was 7.18% and 7.48%, respectively. This represents declines of 154 and 120 basis points from the 8.72% and 8.68% reported for the same periods ended a year earlier. As conditions in the credit markets and specifically the financial services industry have worsened over the last nine months, the FOMC has moved to cut the overnight Fed Funds rate in aggregate by 325 basis points since late in the third quarter of 2007. This has had a direct impact in the average yield of the loan portfolio, as corresponding declines in the Prime rate have brought yields in the portfolio down. The decline in the average yield of the loan portfolio is the primary contributory factor in the year over declines in the yield on earning assets. For the three and six month periods ended June 30, 2008, the yield on earning assets declined approximately 137 and 109 basis points, respectively when compared to the same periods ended a year ago.

Also contributing to the decline in the yield on earning assets were declines in the yield on federal funds sold of approximately 296 and 236 basis points for the three and six months ended June 30, 2008. The declines in the yield earned on federal funds sold are a direct result of the moves made by the FOMC since late in the third quarter to cut the overnight Fed Funds rate.

As evidenced in the tables above, the yield on taxable investment securities increased approximately 73 and 55 basis points for the three and six month periods ended June 30, 2008 when compared to the same periods ended a year earlier. During the first six months of 2008, the Bank purchased approximately $18.2 million in mortgage backed securities with yields somewhat higher than other securities in the portfolio, contributing significantly to the rise in yield of the portfolio overall. See also “Item 3. Quantitative and Qualitative Disclosure About Market Risk” for additional discussion.

- 29 -

The tables below set forth changes in average interest bearing liabilities and their respective rates for the three and six month periods ending June 30, 2008 compared to the same periods ended in 2007.

	Average Balance									Average Rate
	for the three months ending									for the three months ending
	June 30,				Variance					June 30,
(dollars in thousands)	2008		2007		dollar		percentage			2008			2007			Variance
Savings/NOW/money market	$	295,713	$	181,654	$	114,059		62.79	%		1.39	%		2.23	%		-0.84	%
Time deposits		152,628		133,377		19,251		14.43	%		3.16	%		4.74	%		-1.58	%
Other borrowings		92,825		55,607		37,218		66.93	%		2.45	%		5.55	%		-3.10	%
Federal funds purchased		3,439		1,130		2,309		204.34	%		2.46	%		5.68	%		-3.22	%
Long term debt		13,403		10,242		3,161		30.86	%		5.40	%		7.48	%		-2.08	%
Total interest-bearing liabilities	$	558,008	$	382,010	$	175,998		46.07	%		2.15	%		3.74	%		-1.59	%

	Average Balance									Average Rate
	for the six months ending									for the six months ending
	June 30,				Variance					June 30,
(dollars in thousands)	2008		2007		dollar		percentage			2008			2007			Variance
Savings/NOW/money market	$	299,808	$	170,263	$	129,545		76.09	%		1.69	%		2.05	%		-0.36	%
Time deposits		153,334		129,695		23,639		18.23	%		3.64	%		4.66	%		-1.02	%
Other borrowings		69,250		56,420		12,830		22.74	%		2.67	%		5.44	%		-2.77	%
Federal funds purchased		3,824		2,123		1,701		80.12	%		2.94	%		5.70	%		-2.76	%
Long term debt		13,403		13,352		51		0.38	%		6.05	%		7.91	%		-1.86	%
Total interest-bearing liabilities	$	539,619	$	371,853	$	167,766		45.12	%		2.49	%		3.71	%		-1.22	%

At June 30, 2008 the balance of average interest bearing liabilities was approximately $176.0 million and $167.8 million higher than that reported for the same three and six month periods ended a year earlier. The primary factor contributing to the increase was the acquisition of Business First as well as promotions the Bank engaged in during the majority of 2007 and early 2008 designed to attract lower cost core deposits. This is evidenced by the $114.1 million or 62.8% and $129.5 million or 76.1% increases in Savings, NOW and Money Market account balances for the three and six month periods ended June 30, 2008 when compared to the same periods ended a year earlier. The quarter and year to date increases in interest bearing deposit balances, of approximately $75.8 million and $72.2 million can be attributed to core deposit balances the Bank obtained in the acquisition of Business First.

The average balance of floating rate deposits represented approximately 66.0% and 57.7% and 66.2% and 56.8% of total interest bearing deposit accounts for the three and six month periods ended June 30, 2008 and 2007 respectively. The increase in floating rate deposit balances allowed the Bank to re-price its interest bearing deposits more rapidly in conjunction with the moves in the over night Fed Funds made by the FOMC during the first six months of 2008. The ability to rapidly re-price these funds was a contributing factor in stabilizing the net interest margin at 5.28% and 5.31% for the three and six months ended June 30, 2008 when compared to the 5.33% reported for the three month periods ended March 31, 2008 and December 31, 2007. The declines in the average rates paid on interest bearing liabilities for the three and six month periods ended June 30, 2008 when compared to the same periods ended a year earlier can be attributed almost exclusively to the 325 basis point decline in the overnight Fed Funds rate since late in the third quarter of 2007.

- 30 -

Non-Interest Income

The tables below set forth changes in non-interest income for the three and six month periods ended June 30, 2008 compared to the same periods ended in 2007.

	For the three months ended
	June 30,				Variance
(dollars in thousands)	2008		2007		dollar			percentage
Service charges on deposit accounts	$	837	$	684	$	153			22.4	%
ATM/Debit Card transaction/interchange fees		218		201		17			8.5	%
Bancard		70		59		11			18.6	%
Mortgage origination fees		83		110		(27	)		-24.5	%
Earnings on bank owned life insurance		119		107		12			11.2	%
Gain on sale of investment securities		37		-		37			0.0	%
Other		392		230		162			70.4	%
Total non-interest income	$	1,756	$	1,391	$	365			26.2	%

	For the six months ended
	June 30,				Variance
(dollars in thousands)	2008		2007		dollar			percentage
Service charges on deposit accounts	$	1,609	$	1,295	$	314			24.2	%
ATM/Debit Card transaction/interchange fees		413		378		35			9.3	%
Bancard		113		117		(4	)		-3.4	%
Mortgage origination fees		249		259		(10	)		-3.9	%
Earnings on bank owned life insurance		231		213		18			8.5	%
Gain on sale of investment securities		37		-		37			0.0	%
Other		543		361		182			50.4	%
Total non-interest income	$	3,195	$	2,623	$	572			21.8	%

Non-interest income increased approximately $365 thousand or 26.2% and $572 thousand or 21.8% for the three and six month periods ended June 30, 2008 when compared to the same periods ended a year earlier. As evidenced in the tables above, one of the primary factors behind the overall increase in non-interest income can be attributed to higher service charges on deposit accounts. Of the quarter and year to date increases in this category, approximately $94 thousand and $229 thousand can be attributed to the acquisition of Business First. The additional deposit relationships obtained resulting from the promotional activities the Bank engaged in during the majority of 2007 and early 2008 have also contributed to the year over year increase within this category.

The primary factor behind the year over year increase in debit card interchange income can be attributed to the acquisition of Business First, the additional accounts the Bank added over the prior year related to promotional activities, and a stronger emphasis being placed on customer debit card usage.

Other non-interest income for the three and six months ended June 30, 2008 increased approximately $162 thousand and $182 thousand, respectively. The primary factor behind the year over year increases in this category can be attributed to proceeds the Bank received from the Visa, Inc. initial public offering in the approximate amount of $272 thousand.

Mortgage origination fee income was approximately $27 thousand and $10 thousand lower for the three and six months ended June 30, 2008, when compared to the same periods ended a year earlier. Origination volumes declined during the second quarter of 2008, as concerns over the values of real-estate, a rise in interest rates when compared to the first quarter, and buyers being less eager to purchase homes led to weaker volumes. However, the decline in interest rates on a year over year basis has contributed to the number of home owners seeking to re-finance. This was evidenced in the first quarter of 2008, contributing greatly to the minimal decline in volumes the Bank saw on a year to date basis when compared to a year ago. Additionally, since the fourth quarter of 2007, the Bank has moved to strengthen the origination team with additional high quality, seasoned professionals. Management believes these additions will help to strengthen the Bank’s position to become one of the preferred originators within its current market footprint.

- 31 -

The table below illustrates the change in the number and total dollar volume of mortgage loans originated during the three and six months ended June 30, 2008 when compared to the same periods ended in 2007.

	For the three months ended June 30,
(dollars in thousands)	2008		2007		Variance
Dollar volume	$	12,973	$	14,477		-10.4	%
Number of loans		38		43		-11.6	%

	For the six months ended June 30,
(dollars in thousands)	2008		2007		Variance
Dollar volume	$	29,377	$	29,620		-0.8	%
Number of loans		83		84		-1.2	%

Non-Interest Expenses

The tables below set forth changes in non-interest expenses for the three and six month periods ended June 30, 2008 compared to the same periods ended in 2007.

	For the three months ended
	June 30,				Variance
(dollars in thousands)	2008		2007		dollar		percentage
Salaries and employee benefits	$	4,021	$	3,194	$	827		25.9	%
Occupancy and equipment		1,129		706		423		59.9	%
Data processing		672		571		101		17.7	%
Advertising and promotional		235		213		22		10.3	%
Regulatory fees		117		28		89		317.9	%
Other professional fees and outside services		311		281		30		10.7	%
Legal fees and other litigation expense		26		18		8		44.4	%
Loan department costs		39		28		11		39.3	%
Stationery and supplies		105		78		27		34.6	%
Director fees		80		77		3		3.9	%
Core deposit intangible amortization		215		88		127		144.3	%
Other		548		281		267		95.0	%
Total non-interest expense	$	7,498	$	5,563	$	1,935		34.8	%

	For the six months ended
	June 30,				Variance
(dollars in thousands)	2008		2007		dollar			percentage
Salaries and employee benefits	$	8,247	$	6,444	$	1,803			28.0	%
Occupany and equipment		2,268		1,421		847			59.6	%
Data processing		1,326		1,105		221			20.0	%
Advertising and promotional		481		427		54			12.6	%
Regulatory fees		225		55		170			309.1	%
Other professional fees and outside services		597		625		(28	)		-4.5	%
Legal fees and other litigation expense		63		46		17			37.0	%
Loan department costs		71		70		1			1.4	%
Stationery and supplies		224		172		52			30.2	%
Director fees		158		147		11			7.5	%
Core deposit intangible amortization		430		177		253			142.9	%
Other		1,028		567		461			81.3	%
Total non-interest expense	$	15,118	$	11,256	$	3,862			34.3	%

- 32 -

· Salary and Employee Benefits

Salaries and employee related expense incurred the greatest dollar increase of any non-interest expense category for the three and six months ended June 30, 2008 when compared to the same periods ended in 2007. The primary factor driving the increase within this category can be attributed to the acquisition of Business First. Of the quarter and year to date increases within this category, approximately $507 thousand and $1,128 thousand can be attributed to acquired staff costs. Additionally, the Bank opened a new full service branch in the town of San Miguel, which has also contributed to the increase within this category. 

· Occupancy and Equipment

Expenses related to occupancy and equipment increased significantly for the three and six months ended June 30, 2008 when compared to the same periods ended a year earlier. Late in the second quarter of 2007, the Bank sold four of its properties in a sale-leaseback transaction. While this contributed significantly to the year over year increase in occupancy and equipment expenses, the Bank benefited to the extent that approximately $12.8 million in additional liquidity was available for investment in earning assets. Additionally, the addition of two branches related to the acquisition of Business First contributed to the increase with this category. For the three and six months ended June 30, 2008 the additional expense incurred within this category attributable to Business First was approximately $201 thousand and $415 thousand, respectively. Additionally, the opening of a new branch in the town of San Miguel, as previously mentioned, also contributed to the quarter and year to date increases within this category.

· Data Processing

Expenses within this category increased approximately $101 thousand and $221 thousand for the three and six month periods ended June 30, 2008 when compared to the same period ended a year earlier. The primary factor behind the increase within this category can be attributed to higher transaction processing volumes related to the acquisition of Business First. Also, the additional deposit relationships the Bank obtained over the last year have also contributed to the increase within this category.

· Regulatory Fees

For the three and six months ended June 30, 2008 regulatory fees increased approximately $89 thousand and $170 thousand, respectively. During 2007 the Bank received a one-time assessment credit under the Federal Deposit Insurance Reform Act of 2005 to recognize its past contributions to the insurance fund. It is the absence of this one-time credit during the three and six months ended June 30, 2008 that contributed substantially to the year over year increases within this category.

· Core Deposit Intangible (“CDI”) Amortization

Upon the acquisition of Business First the Company booked CDI in the approximate amount of $3.8 million. The remaining balance of this intangible will be amortized over a six year period. For the three and six months ended June 30, 2008 CDI amortization was approximately $127 thousand and $253 thousand higher than that reported for the same periods ended in 2007. Of the quarter and year to date increases approximately $119 thousand and $239 thousand can be attributed to the acquisition of Business First.

· Provision for Income Taxes

For the three and six month periods ended June 30, 2008, the provision for income taxes was 35.5% and 37.3% of pre tax income. For the same periods ended a year earlier, the provision for income taxes was 38.3% and 38.1% of pre tax income.

- 33 -

Financial Condition Analysis

At June 30, 2008 total assets were $800.1 million compared to $745.6 million at December 31, 2007. This represents an increase of $54.5 million or approximately 7.3%. During the first six months of 2008, the Bank saw gross loan growth in the approximate amount of $46.6 million. The majority of the increase in loan balances can be attributed to increases in the commercial and industrial and land segments of the portfolio.

The Bank also saw declines in deposit balances during the first six months of 2008 and consequently lower balances of Federal Funds sold and higher balances of Federal Home Loan Bank borrowing. The large decline in the overnight Fed Funds rate during the first quarter prompted the Bank to reduce the rate paid on its interest bearing deposits and as a result total deposit balances declined approximately $10.3 million or 1.6% from the balance reported at December 31, 2007. During the second quarter of 2008, the Bank purchased approximately $30.0 million in brokered deposits in an effort to rely less on Federal Home Loan Bank borrowing. Net of brokered deposits, total deposits declined approximately $40.3 million from that reported at December 31, 2007. For the quarter, total deposits, net of brokered, increased approximately $14.1 million. 

Loans

At June 30, 2008, total gross loan balances were $659.8 million. This represents an increase of approximately $46.6 million or 7.6% from the balance reported at December 31, 2007. As previously mentioned, the primary factor behind the year to date increase in total gross loans can be attributed to higher commercial and industrial and land loan balances in the approximate amount of $45.0 million.

The table below sets forth changes from December 31, 2007 to June 30, 2008 for the composition of the loan portfolio:

	June 30,		December 31,		Variance
(dollars in thousands)	2008		2007		dollar			percentage
Real Estate Secured:
Multi-family residential	$	14,457	$	12,779	$	1,678			13.13	%
Residential 1 to 4 family		26,466		24,326		2,140			8.80	%
Home equity lines of credit		19,220		17,470		1,750			10.02	%
Commercial		268,612		274,266		(5,654	)		-2.06	%
Farmland		10,652		11,557		(905	)		-7.83	%
Commercial:
Commercial and industrial		154,456		133,981		20,475			15.28	%
Agriculture		12,747		11,367		1,380			12.14	%
Other		814		732		82			11.20	%
Construction:
Single family residential		9,708		10,239		(531	)		-5.19	%
Single family residential - Spec.		16,565		18,718		(2,153	)		-11.50	%
Tract		2,317		1,664		653			39.24	%
Multi-family		9,482		9,054		428			4.73	%
Hospitality		21,401		16,784		4,617			27.51	%
Commercial		27,565		30,677		(3,112	)		-10.14	%
Land		55,555		31,064		24,491			78.84	%
Installment loans to individuals		7,792		7,977		(185	)		-2.32	%
All other loans (including overdrafts)		2,003		562		1,441			256.41	%
Total loans, gross		659,812		613,217		46,595			7.60	%
Deferred loan fees		1,756		1,732		24			1.39	%
Reserve for possible loan losses		8,128		6,143		1,985			32.31	%
Total loans, net	$	649,928	$	605,342	$	44,586			7.37	%
Loans held for sale	$	1,246	$	902	$	344			38.14	%

- 34 -

· Real-Estate Secured

Real-Estate secured loan balances declined approximately $1.0 million from that reported at December 31, 2007. Contributing to the overall decline were lower commercial real-estate balances. This is primarily the result of several large loan pay-downs during the second quarter totaling approximately $7.7 million. Additionally, several other loans in amounts less than $1.0 million were also paid down during the quarter. Mitigating the decline, were the funding of several new loans in amounts between $0.5 million and $1.0 million during the quarter.

Hotel loans disbursed are not considered a concentration with balances of approximately $50.5 million, representing 75.6% of the Bank’s Tier I capital. However, there are several hotel construction and land loans that increase total outstanding balances to $75.7 million as well as un-disbursed commitments of approximately $16.8 million, which in aggregate represent a concentration at 138.6% of the Bank’s Tier I capital. These loans are made to clients throughout our market area and have historically performed in a satisfactory manner.

As of June 30, 2008, approximately $139.2 million or 40.9% of real-estate secured loans are considered owner occupied.

In September 2004, the Bank issued an $11.7 million irrevocable standby letter of credit to guarantee the payment of taxable variable rate demand bonds that has since been reduced to $11.4 million. The primary purpose of the bond issue was to refinance existing debt and provide funds for capital improvement and expansion of an assisted living facility. The project is 100% complete and fully leased. The letter of credit will expire in September 2009.

· Commercial

Loans within this category increased $21.9 million or 15.0% from the year ended December 31, 2007. Increases in commercial and industrial loan balances in the approximate amount $20.5 million are the primary factor behind the increase within this category. During the first six months of 2008, the Bank funded thirteen new loans in excess of $1.0 million within this category with an aggregate balance of approximately $26.4 million, with the majority of these fundings taking place during the second quarter.  Additionally, many other smaller loans with balances of $0.5 million or less were made during the first six months of the year. New loans within this category were made to medical groups, contractors, hotel operators, farmers and others within the Bank’s primary market area. At June 30, 2008, the aggregate balance of loans within this category was approximately $168.0 million, representing 251.8% of the Bank’s Tier I Capital. Additionally, approximately $1.0 million of commercial loans were SBA guaranteed at June 30, 2008.

· Construction

At June 30, 2008, construction loan balances were approximately $87.0 million or $0.1 million less than that reported at December 31, 2007. During the second quarter, loan pay-downs out paced new fundings as the Bank has become very selective in the loans it originates within this category. During the first six months of the year the Bank funded approximately $5.1 million of new loans within this category and at the same time saw several sizable pay-offs in the aggregate amount of $6.6 million. At June 30, 2008, total construction balances represented 130.5% of the Bank’s Tier I Capital. Un-disbursed commitments within this category totaled approximately $49.2 million and when combined with disbursed represent 204.3% of the Bank’s Tier I Capital. As of June 30, 2008, approximately $22.3 million or 25.6% of the construction portfolio is considered owner occupied. Construction loans are typically granted for a one year period and then, with income properties, are amortized over a period not more than 30 years with 10 to 15 year maturities.  

During the second quarter of 2008, the Bank placed approximately $9.2 million in single family spec construction loans on non-accrual status. The Bank also charged-off approximately $206 thousand in construction balances. For a more detailed discussion related to the loans the Bank has placed on non-accrual status, please see “Non Performing Assets” under Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations on this Form 10-Q. The Bank continues to closely monitor this segment of the loan portfolio for additional signs of deterioration and has devoted additional resources to this effort.

- 35 -

· Land

At June 30, 2008 the balance of loans within this category was approximately $55.6 million. When compared to the $31.1 million reported at December 31, 2007, land balances increased approximately $24.5 million. The year to date increase within this category can be attributed in large part to the funding of six loans in excess of $1.0 million with an aggregate balance of $18.1 million. Two of the largest new loans made within this category consist of loans for residential tract developments in the aggregate amount of $13.4 million. These projects are located in the California Central Valley in Kern County. One project is approved for 314 single family lots. This project, located in Bakersfield, California, has also been approved for approximately 8.6 acres of commercial development and 13.5 acres for recreational purposes. The project was funded in the first quarter of 2008 and has an approximate loan to value of 50.0%, based on an appraisal conducted earlier in the year. The borrower is in the process of grading the project site and anticipates cash flow will be obtained in this process from the excavation of rock at the site that will later be sold. The Bank anticipates the cash flow obtained from the grading/excavation of the site will be used to pay-down the loan and that the borrower will begin to see cash flow from the project early in the third quarter. At June 30, 2008, the balance of this loan was approximately $10.6 million, with approximately $1.6 million un-disbursed. The second project, located in McFarland, California, consists of 17 finished homes, 38 finished lots and is the only new housing development in its area. The purpose of the project is to provide affordable housing to a market that generally consists of renters. This loan funded in March 2008 at approximately $4.1 million and has subsequently been paid down by approximately $1.4 million from proceeds of sold homes. The borrower is actively marketing the remaining finished homes and sales continue to occur at a rate of two homes per month. Currently there are four homes under contract to be sold within the third quarter of 2008. The Bank anticipates the additional sale of these homes to further reduce the outstanding balance of this loan. Although the Bank continues to closely monitor both of these particular loans, the borrowers have continued to perform under the contractual terms of their respective loan agreements. At June 30, 2008, land balances combined with un-disbursed commitments totaled approximately $61.1 million or 91.6% of the Bank’s Tier I Capital. Additionally, as of June 30, 2008, approximately $10.8 million or 19.4% of the land portfolio was considered owner occupied.

· Installment

At June 30, 2008, the balance of installment loans was approximately $7.8 million. This, when compared to the $8.0 million reported at December 31, 2007, represents a decline of approximately $0.2 million. Installment loans include revolving credit plans, consumer loans, Money Plus loans, as well as credit card balances obtained in the acquisition of Business First.

· Loans Held For Sale

Loans held for sale consist of mortgage originations that have already been sold pursuant to correspondent mortgage loan agreements. There is no interest rate risk associated with these loans as the commitments are in place at the time the Bank funds them. Settlement from the correspondents is typically within 30 to 45 days. At June 30, 2008 and December 31, 2007 mortgage correspondent loans (loans held for sale) totaled approximately $1.2 million and $0.9 million, respectively.

· Foreign Loans

At June 30, 2008, the Bank had no foreign loans outstanding.

· Summary of Market Condition

The local residential real-estate market came under significant pressure during 2007 and continues to remain under pressure thus far in 2008. The market was negatively impacted by rising interest rates during the majority of 2007, negative sentiment surrounding market values of real-estate, an over supply of newly constructed homes and inflationary pressures. As more and more home owners began to see interest rate resets on adjustable rate mortgages, the number of non-performing loans and defaults began to rise in the industry as a whole. This trend has continued thus far in 2008. These factors eventually led to the tightening of credit and further downturn in real-estate markets. Sales of single family homes have significantly fallen year over year in the Company’s market area and California as a whole, with recent indications showing price declines of close to 20%. The Bank continues to employ stringent lending standards and remains very selective with regard to any additional real-estate construction and land loans it chooses to originate in an effort to effectively manage risk in this difficult credit environment. Along with other segments in the real-estate environment, commercial real-estate prices in the Company’s market area have experienced some pressure during 2008, though not to the extent of the residential real-estate market. During 2007 the demand for business and professional properties in the Company’s market area remained relatively strong, with low vacancies, competitive loan rates, and many investors seeking exchange properties. This helped to provide some insulation against a significant downturn in prices as well as the volume of sales. Demand for these properties have experienced little to moderate pressure thus far in 2008, and vacancy rates, in some of the Company’s market areas, appear to be increasing with respect to retail and office segments. Capitalization rates, the rate at which a stream of cash flows are discounted to find their present value, for the last three years were as follows: 5.5% to 6.5% in 2005, 5.0% to 6.5% in 2006, and 6.0% to 7.0% in 2007.

Although, the Company’s market footprint has historically enjoyed a more stable level of economic growth, we are not completely immune from the effects of a slowdown on a state or national level. As the availability of credit significantly diminished and the effects of inflation as well as interest rate resets on mortgages placed more pressure on borrowers throughout the U.S. economy, the ability of consumers to satisfy outstanding obligations to the financial sector has begun to languish. We believe that within certain areas of our local economy these more macro level concerns have started to become more evident, specifically with respect to real-estate development in the single family residential market. This has no doubt had an impact on the level of and type of loans the Bank has placed on non accrual during the first six months of 2008. However, the desirability of the Company’s market footprint and diversity of the loan portfolio, we believe will continue to provide some insulation against a significant slowdown in growth relative to many other areas within California. Additionally, the Company has devoted considerable resources to the monitoring of credits within the loan portfolio in order to take any appropriate steps when and if necessary to mitigate any material adverse impact the slowing of the single family residential and commercial real-estate markets may have on the Bank overall.

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The following table provides a break-down of the Bank’s construction, land, and real-estate secured loan portfolios as of June 30, 2008:

	June 30, 2008									Percent of					Single
			Undisbursed		Total Bank		Percent			Bank's Tier 1			Number		Largest
(dollars in thousands)	Balance		Commitment		Exposure		Composition			Capital			of Loans		Loan
Construction:
Single family residential	$	9,708	$	7,560	$	17,268		12.7	%		25.9	%		25	$	1,396
Single family residential - Spec.		16,565		7,046		23,611		17.3	%		35.4	%		15		2,551
Tract		2,317		455		2,772		2.0	%		4.2	%		5		539
Multi-family		9,482		9,867		19,349		14.2	%		29.0	%		7		3,650
Commercial		27,565		7,798		35,363		26.0	%		53.0	%		30		4,000
Hospitality		21,401		16,468		37,869		27.8	%		56.8	%		5		10,891
Total construction	$	87,038	$	49,194	$	136,232		100.0	%		204.3	%		87	$	23,027
Land:
Single family residential	$	8,896	$	-	$	8,896		14.6	%		13.3	%		24	$	1,400
Single family residential - Spec.		1,073		240		1,313		2.1	%		2.0	%		6		400
Tract		31,408		5,059		36,467		59.7	%		54.7	%		10		10,609
Multi-family		1,393		69		1,462		2.4	%		2.2	%		3		675
Commercial		8,978		174		9,152		15.0	%		13.7	%		18		1,500
Hospitality		3,807		-		3,807		6.2	%		5.7	%		3		2,340
Total land	$	55,555	$	5,542	$	61,097		100.0	%		91.6	%		64	$	16,924
Real-Estate Secured:
Retail	$	41,088	$	1,569	$	42,657		11.4	%		63.9	%		64	$	3,323
Professional		72,069		2,425		74,494		20.1	%		111.7	%		107		8,597
Hospitality		50,450		362		50,812		13.7	%		76.2	%		40		5,251
Multi-family		14,457		1,029		15,486		4.2	%		23.2	%		19		4,809
Home equity lines of credit		19,220		21,995		41,215		11.1	%		61.8	%		266		865
Residential 1 to 4 family		26,466		1,365		27,831		7.5	%		41.7	%		87		2,769
Farmland		10,652		645		11,297		3.0	%		16.9	%		26		1,937
Healthcare / medical		16,785		-		16,785		4.5	%		25.2	%		34		2,176
Restaurants / food establishments		7,978		94		8,072		2.2	%		12.1	%		15		2,554
Commercial		67,123		996		68,119		18.4	%		102.1	%		111		4,750
Other		13,855		594		14,449		3.9	%		21.7	%		29		3,380
Total real-estate secured	$	340,143	$	31,074	$	371,217		100.0	%		556.5	%		798	$	40,411

The following table provides a break-down for some of the Bank’s largest segments of the loan portfolio: commercial real-estate secured, construction, and land by region as of June 30, 2008:

	Commercial
	Real Estate
Geographic Distribution	Secured			Construction			Land
Northern San Luis Obispo County		28.1	%		41.8	%		23.5	%
Southern San Luis Obispo County		16.5	%		15.2	%		19.9	%
Coastal Regions - San Luis Obispo County		9.2	%		7.2	%		2.3	%
Northern Santa Barbara County		21.1	%		12.8	%		2.9	%
Southern Santa Barbara County		19.2	%		13.4	%		14.5	%
Other		5.9	%		9.6	%		36.9	%
Totals		100.0	%		100.0	%		100.0	%

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Non Performing Assets

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

The Bank has a non-accrual policy that requires a loan greater than 90 days past due and/or is specifically determined to be impaired to be placed on non-accrual status unless such loan is well-collateralized and in the process of collection. When loans are placed on non-accrual status, all uncollected interest accrued is reversed from earnings. Once on non-accrual status, interest on a loan is only recognized on a cash basis and is generally not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on such loans are applied as a reduction of the loan principal balance. Loans may be returned to accrual status if Management believes that all remaining principal and interest is fully collectible and there has been at least six months of sustained repayment performance since the loan was placed on non-accrual.

However, 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.

Non-performing loans include non-accrual loans, restructured loans and accruing loans that are 90 days or more delinquent. As of June 30, 2008, the Bank had one such loan with an approximate balance of $93 thousand that was 90 days past due and still accruing. Loans on non-accrual status totaled $13.4 million at June 30, 2008 compared to $1.5 million at March 31, 2008 and $0.3 million at December 31, 2007. In May 2008, the Company reported in an 8-K filing with the Securities and Exchange Commission, an increase in non-accrual loans of approximately $11.0 million. All loans on non-accrual are carried at fair value pursuant to SFAS No. 114. As of June 30, 2008, non-accruing loans consist of the following:

· Nine loans in the approximate amount of $10.4 million to three borrowers all representing single family spec construction loans located in various costal communities along the Central Coast of California.

· Five loans in the approximate amount of $2.3 million all secured by commercial real-estate and single family residences.

· Eight loans in the approximate amount of $0.7 million to five borrowers that are collateralized by various business assets and personal collateral.

Credit quality is consistently monitored and Management has implemented additional precautionary actions that include but are not limited to pro-actively identifying credit weaknesses earlier in the collection cycle, increasing the oversight frequency of watch list credits and devoting additional internal resources to monitoring those credits. During the second quarter of 2008, the Bank formed a “Special Assets” division to oversee all problem credits and to aid in the identification of any additional credits that exhibit signs of deterioration.

Interest income that would have been recognized on non-accruing loan balances if they had performed in accordance with the terms of the loans was approximately $276 thousand and $65 thousand at June 30, 2008 and December 31, 2007, respectively.

During the second quarter of 2008, the Bank moved to foreclose on a commercial real-estate loan that was placed on non-accrual status during the first quarter. The value of the asset that was securing the loan was valued at approximately $197 thousand and is reflected in the Company’s financial statements as other real estate owned (“OREO”). No additional charge off was required at the time the asset moved into OREO. In addition, the Bank moved to foreclose on property securing an installment loan previously placed on non-accrual status during the first quarter. This loan had a balance of approximately $50 thousand of which $20 thousand was charged off at foreclosure. The value of this property is reflected in the Company’s financial statements under other assets. Subsequent to the closing of the quarter and the date of the financial statements filed on this Form 10-Q, the Bank received a cash offer to sell the foreclosed property in July and on July 21, 2008 the Bank closed on the sale and recorded a net recovery of approximately $15 thousand.

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At June 30, 2008, non-performing assets were approximately $13.7 million, or 1.71% of total assets. When compared to the $0.3 million or 0.05% of total assets reported at December 31, 2007, this represents an increase of approximately $13.4 million. As previously mentioned the increase in non performing assets can be attributed in large part to nine single family spec construction loans placed on non accrual during the second quarter of 2008.

At June 30, 2008, the allowance for loan losses was approximately $8.1 million, or 1.23% of total gross loans. This, when compared to the $6.1 million or 1.00% of total gross loans reported at December 31, 2007, represents an increase of approximately $2.0 million. The year to date change in the allowance can be attributed to net charge offs in the amount of $1.0 million as well as additions to the allowance in the amount of $3.0 million. During the second quarter of 2008, the Bank wrote down the values of certain loans previously placed on non accrual status. This, in conjunction with the weakened economic environment, as well as the large year to date increase in non accrual balances, prompted the Bank to make substantial additions to the allowance during the second quarter of 2008. As of June 30, 2008, Management believes that the allowance for loan losses is prudent and warranted, based on information currently available. 

The following table provides a summary of non-performing assets at June 30, 2008 compared to December 31, 2007 as well as key asset quality ratios:

	June 30,			December 31,
(dollars in thousands)	2008			2007
Loans delinquent 90 days or more and still accruing	$	93		$	-
Non Accruing Loans:
Real-estate secured		1,564			261
Commercial		1,236			62
Construction		10,009			-
Land		591			-
Installment loans		14			15
Total non-accruing loans	$	13,414		$	338
Other real-estate owned	$	197		$	-
Total non-performing assets	$	13,704		$	338
Ratio of allowance for credit losses to total gross loans		1.23	%		1.00	%
Ratio of allowance for credit losses to total non-performing loans		60.18	%		1817	%
Ratio of non-performing loans to total gross loans		2.05	%		0.06	%
Ratio of non-performing assets to total assets		1.71	%		0.05	%

Total Cash and Cash Equivalents

Total cash and due from banks was $43.0 million and $46.4 million at June 30, 2008 and December 31, 2007, respectively. This line item will vary depending on cash letters from the previous night and actual cash on hand in the branches. Additionally, lower deposit balance during the first quarter of 2008 when compared to that reported at December 31, 2007 have contributed to fewer Federal Funds sold.

Investment Securities and Other Earning Assets

Other earning assets are comprised of Federal Home Loan Bank stock, Federal Funds sold (funds the bank lends 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.

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The table below sets forth the change in balances of other earning assets as of June 30, 2008 from that reported at December 31, 2007.

	June 30,		December 31,		Variance
(dollars in thousands)	2008		2007		dollar			percentage
Federal Home Loan Bank stock	$	5,401	$	3,045	$	2,356			77.37	%
Available-for-sale securities		57,064		47,556		9,508			19.99	%
Federal funds sold		15,660		23,165		(7,505	)		-32.40	%
Interest bearing deposits other financial institutions		131		330		(199	)		-60.30	%
Total other earning assets	$	78,256	$	74,096	$	4,160			5.61	%

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 board of directors on a regular basis.

At June 30, 2008, total other earning assets increased approximately $4.2 million from that reported at December 31, 2007, due primarily to increases in available for sale securities and Federal Home Loan Bank stock. The increase in the balance of Federal Home Loan Bank stock can be attributable to the year to date increases in Federal Home Loan Bank borrowing, resulting from lower deposit balances. The decline in the balance of Federal Funds sold can also be attributed to lower deposit balances, resulting in fewer excess funds available for overnight investment. Additionally, the amount of Federal Funds sold can vary widely on a daily basis depending on the cash position of the bank which is affected by numerous variables such as cash letters, incoming and outgoing wire activity, and loan funding needs.

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 shareholders’ equity. At June 30, 2008, net unrealized losses in the portfolio were $957 thousand or $563 thousand, net of tax. This, when compared to the net unrealized gain of approximately $313 thousand or $184 thousand, net of tax the portfolio had at December 31, 2007, represents a decline in market value of approximately $1,270 thousand or $747 thousand, net of tax. The decline in the market value can be attributed in large part to continued concerns surrounding mortgage related securities as well as increases in market interest rates during the later part of the second quarter of 2008. In addition to changes in market values, the year to date change in the securities portfolio can be attributed to purchases in the amount $18.4 million, proceeds from principal reduction in mortgage-backed securities in the amount of $5.2 million, as well as sales and maturities totaling $2.5 million.

During the second quarter of 2008, the Bank sold two mortgage backed securities with total proceeds of approximately $1.5 million. In connection with this sale the Bank recognized a gain of approximately $37 thousand or $22 thousand net of tax.

During the third and fourth quarters of 2007, fixed income markets saw a significant re-pricing of credit risk, which caused the values of certain classes of fixed income instruments to fall, specifically those related to Collateralized Debt Obligations (“CDO”) and Mortgage-Backed Securities (“MBS”). Concerns surrounding these asset classes continued to overhang the market during the first half of 2008 and the Bank’s securities portfolio was not completely immune to market fluctuations.  

As part of the acquisition of Business First, the Bank acquired five whole loan CMO (“Collateralized Mortgage Obligation”) securities with a remaining principle balance of approximately $4.0 million and a net unrealized loss of approximately $150 thousand or $88 thousand net of tax. Additionally, the Bank purchased four additional whole loan CMOs in the approximate amount of $17.0 million in the first six months of 2008. Management performs extensive review of the underlying collateral for these securities, including but not limited to updates on: credit enhancements, loan-to-values, credit scores, delinquency rates and default rates. At June 30, 2008, the market value of these securities had a net unrealized loss of approximately $753 thousand or $443 thousand net of tax.

At June 30, 2008, other than the nine whole loan CMOs discussed in the paragraph above, the remaining MBS and CMOs in the Bank’s investment portfolio were issued by: The Government National Mortgage Association (“Ginnie Mae”), The Federal National Mortgage Association (“Fannie Mae”), and The Federal Home Loan Mortgage Corporation (“Freddie Mac”). These securities carry the guarantee of the issuing agencies.

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

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Deposits and Borrowed Funds

The table below sets forth the change in the various categories of deposits from December 31, 2007 to June 30, 2008:

											% of Total
	June 30,		December 31,		Variance						Deposits
(dollars in thousands)	2008		2007		dollar			percentage			6/30/08
Non-interest bearing demand	$	168,589	$	153,684	$	14,905			9.70	%		26.6	%
Interest bearing demand		83,387		69,558		13,829			19.88	%		13.1	%
Savings		23,067		41,599		(18,532	)		-44.55	%		3.6	%
Money market		187,345		206,754		(19,409	)		-9.39	%		29.5	%
Time deposits of $100 or more		79,756		75,966		3,790			4.99	%		12.6	%
Time deposits under $100		92,374		97,247		(4,873	)		-5.01	%		14.6	%
Total deposits	$	634,518	$	644,808	$	(10,290	)		-1.60	%		100.0	%

Acquisition of core deposits has remained the single biggest challenge facing the Company. Still, the Company has been able to increase deposits on a year over year basis due to the acquisition of Business First, 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.

At June 30, 2008, total deposit balances were approximately $10.3 million lower than that reported at December 31, 2007. The moves by the FOMC during the first half of 2008 to cut the overnight Fed Funds rate by an aggregate 225 basis points has had a direct impact on the Bank’s total deposit balances. The Bank moved aggressively to lower rates paid on interest bearing accounts in response to the actions taken by the FOMC and as a result, we began to see some expected deposit run-off. In particular, deposit run-off was most evident in time deposit balances. Contributing to the year to date decline in time deposits was the call of approximately $10.7 million in higher cost brokered funds the Bank assumed upon the acquisition of Business First. However, during the second quarter of 2008, the Bank purchased approximately $30.0 million in brokered deposits, which is fully reflected in the table above. The Bank purchased these funds in an effort to rely less on Federal Home Loan Bank borrowings and to maintain an appropriate mix of secondary funding. Net of brokered funds, total time deposit balances declined approximately $31.1 million during the first six months of 2008 and increased approximately $10.3 million over that reported at March 31, 2008. Declines in savings and money market balances, resulting from the re-pricing of deposits, also contributed to the year to date decline in total deposit balances. Mitigating the decline in overall deposits were increases in non-interest and interest bearing demand balances. Increases in these categories can be attributed in part to increased balances of those deposits classified as public funds as well as promotions the Bank currently has in place to attract lower cost core deposits. Management has been keenly aware of the need for lower cost core deposits in order to rely less on secondary funding sources, but has chosen not to engage in irrational deposit pricing in an effort to not only maintain the net interest margin, but also to build a deposit base based on customer relationship.

As of June 30, 2008, core deposit balances (demand, savings, and money market) represented 72.9% of total deposits compared to 73.1% of total deposits at December 31, 2007. Non-interest bearing demand accounts represent approximately 26.6% of total deposits at June 30, 2008. Of this balance, approximately $22.7 million consist of deposit relationships that the Bank considers to be volatile in nature. This when compared to the $15.7 million reported at December 31, 2007, represents an increase of approximately $7.0 million. The customers that hold these deposits engage in mortgage related activities. These volatile account relationships are included in the volatile liability dependency report that the Bank produces on a monthly basis. Typically, a material change in balances held by these customers is reflected in the balance of 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 aware that as conditions in the mortgage market change, these relationships will be impacted. Additionally, the Bank closely monitors three additional deposit relationships that it also considers to be volatile. At June 30, 2008, the balances of these accounts were approximately $45.5 million. This when compared to the $42.6 million reported at December 31, 2007, represents an increase of approximately $2.9 million. At June 30, 2008, two of these accounts are classified as money market accounts with balances of approximately $28.9 million, while the other is classified as an interest bearing demand account with a balance of approximately $16.5 million and is considered public funds.

Additionally, the Bank has a policy in place that permits the purchase of brokered funds as a secondary source for funding. This policy permits the Bank to purchase brokered funds in an amount not to exceed 10% of total assets. As previously mentioned, the Bank purchased approximately $30.0 million in brokered funds during the second quarter of 2008.

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The following table provides a summary of the Federal Home Loan Bank (“FHLB”) borrowings the Bank had as of June 30, 2008:

(dollars in thousands)
	Amount		Interest					Maturity
	Borrowed		Rate			Variable/Fixed		Date
	$	22,500		2.16	%		Fixed		9/22/08
		10,000		2.85	%		Fixed		1/26/09
		10,000		2.60	%		Fixed		2/6/09
		4,000		4.93	%		Fixed		2/27/09
		25,000		2.57	%		Variable/Fixed		6/22/09
	$	71,500		2.62	%

As evidenced in the table above, the balance of FHLB borrowing as of June 30, 2008 was $71.5 million. This represents an increase of approximately $63.5 million from the balance reported at December 31, 2007. The increase in FHLB borrowing is primarily attributable to the $10.3 million decline in deposit balances in addition to the $44.6 million increase in net loan balances the Bank saw during the first six months of 2008. Additionally, during the first quarter of 2008, the Bank borrowed $10.0 million from the FHLB and securitized that borrowing with securities it purchased in the approximate amount of $9.9 million. Management makes regular assessments of balance sheet needs to determine how much if any and at what term it will borrow from the FHLB.

The Bank utilizes securities sold under repurchase agreements as a source of funds. The Bank had $2.7 million and $1.9 million in securities sold under agreements to repurchase at June 30, 2008 and December 31, 2007, respectively.

In the fourth quarter of 2007, the Company renewed a promissory note with Pacific Coast Bankers Bank (“PCBB”) for a revolving line of credit in the amount of $3.5 million. At June 30, 2008, the Company had no balance outstanding on this note. The Company pledged 646,598 shares (51.0%) 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 June 30, 2008 the interest rate on the note was 5.00% and is variable, moving with prime. Under the terms of the agreement, the Company will not incur any additional debt over $2.0 million exclusive of inter-company debt and existing debt without the prior written consent of PCBB. In addition, the Bank must be “well” capitalized on an on-going basis as defined by bank regulators.

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. The letter of credit will expire in September 2009.

Capital

The Company's total stockholders’ equity was $70.9 million at June 30, 2008 compared to $69.5 million at December 31, 2007. The change in capital was due to net income of $2.4 million, stock options exercised in the amount of $228 thousand, the capital impact of year-to-date share-based compensation expense of $167 thousand, $587 thousand paid year-to-date in cash dividends, cash paid in lieu of fractional shares issued in connection with a 5% stock dividend the Company paid to stockholders in May 2008, and a decline in accumulated other comprehensive income of $747 thousand.

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· Dividends

The following table provides a summary of dividends the Company has paid over the last two years:

	Dividend
	Amount			Declaration		Record		Payable
Dividend Type	Per Share			Date		Date		Date
Stock dividend		5	%		4/24/2008		5/2/2008		5/16/2008
Cash dividend	$	0.08			24-Jan-08		1-Feb-08		15-Feb-08
Cash dividend	$	0.08			17-Oct-07		2-Nov-07		16-Nov-07
Cash dividend	$	0.08			18-Jul-07		3-Aug-07		17-Aug-07
Cash dividend	$	0.08			20-Apr-07		4-May-07		18-May-07
Cash dividend	$	0.08			19-Jan-07		2-Feb-07		16-Feb-07
Cash dividend	$	0.08			20-Oct-06		3-Nov-06		17-Nov-06
Cash dividend	$	0.08			21-Jul-06		11-Aug-06		25-Aug-06

As evidenced in the table above, on April 24, 2008, the Board of Directors declared a stock dividend in the amount of 5% to be paid on May 16, 2008 to shareholders of record on May 2, 2008. Shares and earnings per share for all prior periods have been adjusted to fully reflect the impact of the May 2008 stock dividend. The stock dividend represents a change in the form of dividend payment to the Company’s shareholders away from a cash dividend, which the Company has paid out over the past seven consecutive quarters. The Company had previously paid a stock dividend on an annual basis to shareholders for 10 consecutive years prior to switching to a cash dividend in 2006. At this time of economic uncertainty, the Board of Directors believes that retention of capital for future growth is in the best interest of the Company.

· Stock Repurchases

On July 21, 2006, the Board of Directors adopted a resolution authorizing the repurchase of up to 40,000 shares of the Company’s common stock. Purchases are to be made, as conditions warrant, from time to time in the open market or through privately negotiated transactions. The duration of the program is one year and the timing of purchases will depend on market conditions. Subsequently, on October 20, 2006, the Board of Directors adopted a resolution to increase the number of shares available for repurchase under the current plan to 100,000. In July 2007, the Board of Directors authorized a one year extension of this plan, which is set to expire in August 2008.

As of June 30, 2008, the Company repurchased and retired approximately 53,500 shares of its common stock under the current plan at a weighted average price of $17.44. The Company made no repurchases of its common stock during the six month period ended June 30, 2008. Under the current plan, the Company has the authority to repurchase 46,500 shares through July 2008.

· Trust Preferred Securities

On October 27, 2006 the Company issued $8.2 million of Floating Rate Junior Subordinated Debt Securities (“the debt securities”) to Heritage Oaks Capital Trust II, a statutory trust created under the laws of the State of Delaware. These debt securities are subordinated to effectively all borrowings of the Company. The Company intends to use the proceeds from the issuance of these securities for general corporate purposes, which may include capital contributions to the Bank, investments, payment of dividends, and repurchases of our common stock.

On April 23, 2007, the Company redeemed all of the Floating Rate Junior Subordinated Debt Securities it held associated with Heritage Oaks Capital Trust I, a wholly owned subsidiary of Heritage Oaks Bancorp. The redemption price was 100% of the principal amount redeemed plus accrued and unpaid interest as of the redemption date. The Company paid $0.4 million for the standard interest payment due April 22, 2007, plus a payment of $8.2 million for the principal amount to be redeemed on that date. These amounts were funded from the Company’s general corporate reserves. As a result of the redemption of the securities associated with Heritage Oaks Capital Trust I, the Trust was dissolved on June 1, 2007.

On September 20, 2007, the Company issued $5.2 million of Junior Subordinated Deferrable Interest Debentures (the “debt securities”) to Heritage Oaks Capital Trust III, a statutory trust created under the laws of the State of Delaware. These debt securities are subordinated to effectively all borrowings of the Company. The Company used the proceeds from the sale of the securities to assist in the acquisition of Business First, for general corporate purposes, and for capital contributions to the Bank for future growth.

At June 30, 2008, the Company had $13.4 million in Junior Subordinated Deferrable Interest Debentures (the “debt securities”) issued and outstanding. These securities have been issued to Heritage Oaks Capital Trusts II and III. The debt securities are subordinated to effectively all borrowings of the Company and can be redeemed at par if certain events occur that impact the tax treatment, regulatory treatment or the capital treatment of the issuance. Upon the issuance of the debt securities, the Company purchased a 3.1% minority interest in both Heritage Oaks Capital Trusts II and III, totaling $248 thousand and $155 thousand, respectively. The balance of the equity of Heritage Oaks Capital Trusts II and III is comprised of mandatory redeemable preferred securities and is included in other assets. Interest associated with the securities issued to Heritage Oaks Capital Trusts II and III is payable quarterly at 3-month LIBOR plus 1.71% variable rate and 6.888% fixed, respectively.

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The following table provides a summary of the securities the Company has issued to Heritage Oaks Capital Trusts II and III as of June 30, 2008:

Amount

Current

Issue

Scheduled

Call

(dollars in thousands)

Issued

Rate

Date

Maturity

Date

Rate Type

Heritage Oaks Capital Trust II

$

8,248

4.42

%

27-Oct-06

Aug-37

Nov-11

Varibale 3-month LIBOR + 1.71

%

Heritage Oaks Capital Trust III

5,155

6.89

%

20-Sep-07

Sep-37

Dec-12

5-year Fixed SWAP + 2.00

%

Total Issued

$

13,403

5.37

%

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

Under FIN No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51,” the Company is not allowed to consolidate Heritage Oaks Capital Trusts II and III into the Company’s financial statements. Prior to the issuance of FIN No. 46, Bank holding companies typically consolidated these entities. On February 28, 2005, the Federal Reserve Board issued a rule which provides that, notwithstanding the deconsolidation of such trusts, junior subordinated debentures, such as those issued by the Company, may continue to constitute up to 25% of a bank holding company's Tier I capital, subject to certain new limitations which will not become effective until March 31, 2009 and which, in any event, are not expected to affect the treatment of the Company's Junior Subordinated Debentures as Tier I capital for regulatory purposes. As of June 30, 2008, the Company has included $13.0 million of the net junior subordinated debt in its Tier I Capital for regulatory capital purposes.

At June 30, 2008, the Company had sufficient cash to service the $13.4 million in junior subordinated debenture interest payments for approximately 2.5 years without dividends from subsidiaries. The Bank’s capacity to provide cash to the Company, while remaining “well-capitalized”, was approximately $4.0 million at June 30, 2008.

· Regulatory Capital Requirements

Capital ratios for commercial banks in the United States are generally calculated using three different formulas. These calculations are referred to as the “Leverage Ratio” and two “risk-based” calculations known as: “Tier One Risk Based Capital Ratio” and the “Total Risk Based Capital Ratio.” These standards were developed through joint efforts of banking authorities from different countries around the world. The standards essentially take into account 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.

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The following table provides a Summary of the Company’s and the Bank’s regulatory capital ratios at June 30, 2008 and 2007:

	Regulatory Standard						June 30, 2008						June 30, 2007
	Adequately			Well			Heritage Oaks			Heritage Oaks			Heritage Oaks			Heritage Oaks
	Capitalized			Capitalized			Bancorp			Bank			Bancorp			Bank
Leverage Ratio		4.00	%		5.00	%		8.87	%		8.64	%		9.58	%		9.43	%
Tier I Risk Based Captial Ratio		4.00	%		6.00	%		9.66	%		9.38	%		10.64	%		10.48	%
Total Risk Based Captial Ratio		8.00	%		10.00	%		10.83	%		10.55	%		11.55	%		11.39	%

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 and or other borrowed funds. 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. As of June 30, 2008 the Bank had no balance drawn against these credit arrangements. The Bank is also a member of the FHLB and as of June 30, 2008 had approximately $71.5 million in outstanding borrowing from the FHLB.

The following table provides a summary of the remaining borrowing capacity the Company has with various secondary liquidity sources as of June 30, 2008:

(dollars in thousands)	June 30, 2008
Federal Home Loan Bank remaining borrowing capacity	$	84,421
Correspondent bank credit arrangements - Bank		40,000
Revolving line of credit - Holding Company		3,500
Brokered funds availability		49,782
Total available secondary liquidity source	$	177,703

As previously mentioned, the Company has a policy that permits the purchase of brokered funds in an amount not to exceed 10% of total assets. During the second quarter, the Bank called approximately $1.8 million in brokered funds that were assumed in the acquisition of Business First. Subsequently, the Bank purchased approximately $30.0 million in lower cost brokered funds. This was in an effort to rely less on FHLB borrowing as a source of funding.

The Bank manages liquidity by maintaining an investment portfolio of federal funds sold and other liquid investments. At June 30, 2008, the ratio of liquid assets not pledged for collateral and other purposes to deposits and other liabilities was 7.53% compared to 9.59% at December 31, 2007. The ratio of net loans to deposits was 102.4% at June 30, 2008 compared to 93.9% at December 31, 2007. Net of brokered deposits, the net loan to deposit ratio was 107.5% at June 30, 2008. The year to decline in deposit balances of $10.3 million and $40.3 million, net of brokered during the first six months of 2008 in addition to the $44.6 million increase in net loan balances from December 31, 2007 contributed to the increase in the loan deposit ratio. The ratio of total gross loans to available funding sources, which takes into account all funding sources including those other than deposits such as FHLB advances and Fed Funds purchased, was 92.9% at June 30, 2008 compared to 80.6% at December 31, 2007.

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. Although, the Company’s market footprint has historically enjoyed a more stable level of economic growth, we are not completely immune to the effects of a slowdown on a state or national level. As the availability of credit significantly diminished and the effects of inflation as well as interest rate resets on mortgages placed more pressure on borrowers throughout the U.S. economy, the ability of consumers to satisfy outstanding obligations to the financial sector has begun to languish. We believe that within certain areas of our local economy these more macro level concerns have started to become more evident, specifically with respect to real-estate development in the single family residential market. This has no doubt had an impact on the level of and type of loans the Bank has placed on non accrual during the first six months of 2008.

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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 statements when they are funded or related fees are incurred or received. For a more detailed discussion of these financial instruments, refer to Note 10 of the Company’s Consolidated Financial Statements contained in Item 8 of Part II of the Company’s December 31, 2007 10-K.

In the ordinary course of business, the Bank is a party to various operating leases. For a more detailed discussion of these financial instruments, refer to Note 10 of the Company’s Consolidated Financial Statements contained in Item 8 of Part II of the Company’s December 31, 2007 10-K.

In connection with the $13.4 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 $13.4 million in subordinated debentures issued by the Company’s subsidiary grantor trusts. As a result, all significant interest rate risk procedures are performed at the banking subsidiary level. The subsidiary bank’s real estate loan portfolio, concentrated primarily within Santa Barbara and San Luis Obispo Counties, 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.

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The hypothetical impacts of sudden interest rate movements applied to the Company’s asset and liability balances are modeled monthly. The results of these models 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 June 30, 2008 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 and within policy guidelines at this time.

The results in the table below indicate the change in net interest income the Company would expect to see as of June 30, 2008, if interest rates were to change in the amounts set forth:

	Rate Shock Scenarios
(dollars in thousands)	-200bp			-100bp			Base			+100bp			+200bp
Net interest income (NII)	$	35,453		$	37,063		$	38,588		$	40,336		$	42,520
$ Change from base	$	(3,135	)	$	(1,525	)	$	-		$	1,748		$	3,932
% Change from base		-8.12	%		-3.95	%		0.00	%		4.53	%		10.19	%

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 at June 30, 2008. 

(dollars in thousands)
			Percent of
Rate Type	Balance		Total
Variable - daily	$	298,086		45.2	%
Variable other than daily		203,544		30.8	%
Fixed rate		158,182		24.0	%
Total gross loans	$	659,812		100.0	%

The table above identifies approximately 45.2% of the loan portfolio that will re-price immediately in a changing rate environment. At June 30, 2008, approximately $501.6 million or 76.0% of the Bank’s loan portfolio is variable and of this balance approximately $152.7 million are currently at their floor.

(dollars in thousands)
			Percent of
Re-Pricing	Balance		Total
< 1 Year	$	397,374		60.2	%
1-3 Years		136,602		20.7	%
3-5 Years		70,749		10.7	%
> 5 Years		55,087		8.4	%
Total gross loans	$	659,812		100.0	%

The table above indicates that as of June 30, 2008, approximately 60.2% of the Bank’s loan portfolio will re-price within one year.

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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 Rules 13a-15 and 15d-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.

Changes in Internal Control Over Financial Reporting

There was no change in the Company’s internal controls over financial reporting during the quarter ended June 30, 2008 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, 2007 annual report filed on Form 10-K in response to Item A to Part I of Form 10-K.

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 Board of Directors adopted a resolution authorizing the repurchase of up to 40,000 shares of the Company’s common stock. Purchases are to be made, as conditions warrant, from time to time in the open market or through privately negotiated transactions. The duration of the program is one year and the timing of purchases will depend on market conditions. Subsequently, on October 20, 2006, the Board of Directors adopted a resolution to increase the number of shares available for repurchase under the current plan to 100,000. In July 2007, the Board of Directors authorized a one year extension of this plan, which is set to expire in July 2008.

As of June 30, 2008, the Company repurchased and retired approximately 53,500 shares of its common stock under the current plan at a weighted average price of $17.44. The Company made no repurchases of its common stock during the six months ended June 30, 2008. Under the current plan, the Company has the authority to repurchase 46,500 shares through July 2008.

- 48 -

Item 3. Defaults upon Senior Securities

Not applicable.

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

The following items were submitted to the security holders for approval at the Company’s annual meeting held on May 22, 2008:

1. Election of Directors.

To elect eleven (11) persons to the Board of Directors of the Company to serve until the 2008 Annual Meeting of Shareholders and until their successors are elected and have qualified. The following persons were elected on the following votes:

Directors	Votes For		Votes Withheld		% Votes For
Michael J. Morris		5,283,744		531,198		72.02	%
Don Campbell		5,275,852		539,090		71.92	%
Michael Behrman		5,681,822		133,120		77.45	%
Kenneth Dewar		5,279,744		535,198		71.97	%
Mark C. Fugate		5,685,716		129,226		77.50	%
Dolores T. Lacey		5,277,493		537,449		71.94	%
Merle F. Miller		5,275,021		539,921		71.90	%
Daniel J. O'Hare		5,283,544		531,398		72.02	%
Michael E. Pfau		5,069,213		745,729		69.10	%
Alexander F. Simas		5,283,321		531,621		72.02	%
Lawrence P. Ward		5,280,842		534,100		71.98	%

2. Ratification of Independent Accountants.

To ratify the appointment of Vavrinek, Trine, Day & Co., LLP as the Company’s independent accountants for the 2008 fiscal year.

	Votes For		Votes Against		Votes Abstain		% Votes For
Ratification of VTD		5,698,290		95,416		21,236		77.67	%

Item 5. Other Information

Not applicable.

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Item 6. Exhibits

(a) Exhibits:

Exhibit (31.1) Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit (31.2) Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit (32.1) Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit (32.2) Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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Signatures

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

Heritage Oaks Bancorp

DATE: August 5, 2008

/s/ Lawrence P. Ward

Lawrence P. Ward

President

Chief Executive Officer

/s/ Margaret A. Torres

Margaret A. Torres

Executive Vice President

Chief Financial Officer

(Principal Financial and Accounting Officer)

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