Heritage Oaks Bancorp (HEOP) 10-Q 2009 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, 2009.

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 its charter)

California	77-0388249
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification No.)
545 12th Street,
Paso Robles, California	93446
(Address of principal offices)	(Zip Code)

(805) 369-5200

(Registrant's telephone number, including area code)

Not Applicable

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

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 90 days.

YES x     NO ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

YES ¨     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 Exchange 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 August 5, 2009 there were 7,761,554 shares outstanding of the Registrant’s common stock.

	Page
Part I.  Financial Information	3
Item 1.  Consolidated Financial Statements (un-audited, except for Balance Sheet as of 12/31/2008)	3
Consolidated Balance Sheets	4
Consolidated Income Statements	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	9
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	16
Note 7.  Fair Value Disclosures	19
Note 8.  Fair Value of Financial Instruments	21
Note 9.  Preferred Stock	23
Note 10.  Subsequent Events	24
Note 11.  Reclassifications	24
Forward Looking Statements	25
Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations	26
The Company	26
Where You Can Find More Information	26
Executive Summary	27
Recent Developments	29
Dividends and Stock Repurchases	29
Selected Financial Data	30
Local Economy	30
Critical Accounting Policies	31
Results of Operations	33
Net Interest Income and Margin	33
Non-Interest Income	38
Non-Interest Expenses	40
Provision for Income Taxes	41
Provision for Loan Losses	41
Financial Condition Analysis	43
Loans	43
Non-Performing Assets	48
Total Cash and Cash Equivalents	51
Investment Securities and Other Earning Assets	52
Deposits and Borrowed Funds	53
Capital	55
Liquidity	57
Inflation	58
Off-Balance Sheet Arrangements	58
Item 3.  Quantative and Qualitative Disclosure About Market Risk	59
Item 4.  Controls and Procedures	60
Part II.  Other Information	61
Item 1.  Legal Proceedings	61
Item 1A.  Risk Factors	61
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds	61
Item 3.  Defaults upon Senior Securities	61
Item 4.  Submission of Matters to a Vote of Security Holders	62
Item 5.  Other Information1	62
Item 6.  Exhibits	62
Signatures	63

- 2 - -

Part I.  Financial Information

Item 1. Consolidated Financial Statements

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

- 3 - -

Heritage Oaks Bancorp

and Subsidiaries

Consolidated Balance Sheets

				(audited)
	June 30,			December 31,
(dollars in thousands except per share data)	2009			2008
Assets
Cash and due from banks	$	15,667		$	17,921
Federal funds sold		32,675			6,650
Total cash and cash equivalents		48,342			24,571
Interest bearing deposits with other banks		119			119
Securities available for sale		75,726			50,762
Federal Home Loan Bank stock, at cost		5,828			5,123
Loans held for sale		11,692			7,939
Loans, net of deferred fees of $1,555 and $1,701 and allowance for loan loss of $11,106 and $10,412 at June 30, 2009 and December 31, 2008, respectively		685,193			668,034
Property, premises and equipment, net		6,848			6,827
Deferred tax assets		8,673			7,708
Bank owned life insurance		10,949			10,737
Goodwill		11,049			11,049
Core deposit intangible		3,166			3,691
Other real estate owned		6,669			1,337
Other assets		7,101			7,691
Total assets	$	881,355		$	805,588
Liabilities
Deposits
Demand, non-interest bearing	$	178,600		$	147,044
Savings, NOW, and money market deposits		290,178			296,488
Time deposits of $100 or more		125,325			75,111
Time deposits under $100		109,886			84,878
Total deposits		703,989			603,521
Short term FHLB borrowing		55,000			99,000
Long term FHLB borrowing		10,000			10,000
Securities sold under agreement to repurchase		-			2,796
Junior subordinated debentures		13,403			13,403
Other liabilities		7,649			6,836
Total liabilities		790,041			735,556
Commitments and contingencies		-			-
Stockholders' Equity
Senior preferred stock, no par value; $1,000 per share stated value 5,000,000 shares authorized, 21,000 and 0 issued and outstanding as of June 30, 2009 and December 31, 2008, respectively.		19,253			-
Common stock, no par value; 20,000,000 shares authorized, issued and outstanding 7,761,554 and 7,753,078 as of June 30, 2009 and December 31, 2008, respectively.		48,695			48,649
Additional paid in capital		3,087			1,055
Retained earnings		22,768			21,420
Accumulated other comprehensive loss, net of tax benefit of $1,740 and $763 as of June 30, 2009 and December 31, 2008, respectively.		(2,489	)		(1,092	)
Total stockholders' equity		91,314			70,032
Total liabilities and stockholders' equity	$	881,355		$	805,588

See notes to condensed consolidated financial statements.

- 4 - -

Heritage Oaks Bancorp

and Subsidiaries

Consolidated Statements of Income

	For the three months					For the six months
	ended June 30,					ended June 30,
(dollars in thousands except per share data)	2009			2008		2009			2008
Interest Income
Interest and fees on loans	$	11,416		$	11,732	$	22,563		$	23,823
Interest on investment securities
Mortgage backed securities		625			546		1,173			966
Obligations of state and political subdivisions		208			185		394			369
Interest on time deposits with other banks		1			3		2			6
Interest on federal funds sold		10			45		17			112
Interest on other securities		9			63		16			115
Total interest income		12,269			12,574		24,165			25,391
Interest Expense
Interest on savings, NOW and money market deposits		839			1,020		1,656			2,526
Interest on time deposits in denominations of $100 or more		631			525		1,175			1,205
Interest on time deposits under $100		664			674		1,228			1,574
Other borrowings		293			766		697			1,377
Total interest expense		2,427			2,985		4,756			6,682
Net interest income before provision for possible loan losses		9,842			9,589		19,409			18,709
Provision for possible loan losses		2,700			2,775		4,810			3,015
Net interest income after provision for possible loan losses		7,142			6,814		14,599			15,694
Non Interest Income
Fees and service charges		752			837		1,464			1,609
Gain on sale of investment securities		-			37		122			37
Loss on sale of OREO		(104	)		-		(131	)		-
Other		852			882		1,705			1,549
Total non-interest income		1,500			1,756		3,160			3,195
Non Interest Expenses
Salaries and employee benefits		3,745			4,021		7,548			8,246
Equipment		376			351		701			717
Occupancy		826			778		1,678			1,551
Other		3,067			2,348		5,512			4,604
Total non-interest expenses		8,014			7,498		15,439			15,118
Income before provision for income taxes		628			1,072		2,320			3,771
Provision for income taxes		121			381		711			1,405
Net income		507			691		1,609			2,366
Dividends and accretion on preferred stock		250			-		261			-
Net income available to common shareholders	$	257		$	691	$	1,348		$	2,366
Earnings Per Common Share
Basic	$	0.03		$	0.09	$	0.17		$	0.31
Diluted	$	0.03		$	0.09	$	0.17		$	0.30

See notes to condensed consolidated financial statements.

- 5 - -

Heritage Oaks Bancorp

and Subsidiaries

Consolidated Statements of Stockholders' Equity

																		Accumulated
	Preferred Stock				Common Stock					Additional								Other			Total
	Number of				Number of					Paid-In		Comprehensive			Retained			Comprehensive			Stockholders'
(dollars in thousands)	Shares		Amount		Shares			Amount		Capital		Income			Earnings			Income			Equity
Balance, December 31, 2008		-	$	-		7,753,078		$	48,649	$	1,055				$	21,420		$	(1,092	)	$	70,032
Issuance of preferred stock and common stock warrant		21,000		19,152							1,848											21,000
Amortization of discount on preferred stock				101												(101	)					-
Dividends paid on preferred stock																(160	)					(160	)
Exercise of stock options																						-
(including $9 excess tax benefit																						-
from exercise of stock options)						10,050			46													46
Share-based compensation expense											184											184
Retirement of restricted share awards						(1,575	)
Comprehensive income:
Net income												$	1,609			1,609						1,609
Unrealized security holding gains (net of $1,027 tax benefit)													(1,469	)					(1,469	)		(1,469	)
Realized gains on sale of securities (net of $50 tax)													72						72			72
Total comprehensive income												$	212
Balance, June 30, 2009		21,000	$	19,253		7,761,553		$	48,695	$	3,087				$	22,768		$	(2,489	)	$	91,314
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 dividends - $0.08 per share																(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 gains (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

See notes to condensed consolidated financial statements.

- 6 - -

Heritage Oaks Bancorp

and Subsidiaries

Consolidated Statements of Comprehensive Income

	For the three months						For the six months
	ended June 30,						ended June 30,
(dollars in thousands)	2009			2008			2009			2008
Net income	$	507		$	691		$	1,609		$	2,366
Other comprehensive loss before taxes
Unrealized losses on securities available for sale		(1,370	)		(1,611	)		(2,496	)		(1,307	)
Realized gains on sale of available for sale securities		-			37			122			37
Total other comprehensive loss before taxes		(1,370	)		(1,574	)		(2,374	)		(1,270	)
Unrealized income tax benefit related to items in comprehensive loss		564			663			1,027			538
Income tax related to the sale of available for sale securities		-			(15	)		(50	)		(15	)
Total other comprehensive loss, net of taxes		(806	)		(926	)		(1,397	)		(747	)
Total comprehensive (loss) / income	$	(299	)	$	(235	)	$	212		$	1,619

See notes to condensed consolidated financial statements.

- 7 - -

Heritage Oaks Bancorp

and Subsidiaries

Consolidated Statements of Cash Flows

	For the six month periods
	ended June 30,
(dollars in thousands)	2009			2008
Cash flows from operating activities:
Net income	$	1,609		$	2,366
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		547			537
Provision for possible loan losses		4,810			3,015
Amortization of premiums / discounts on investment securities, net		29			(66	)
Amortization of intangible assets		525			430
Share-based compensation expense		184			167
Federal Home Loan Bank dividends received		-			(84	)
Gain on sale of available for sale securities		(122	)		(37	)
Increase in loans held for sale		(3,753	)		(344	)
Net increase in bank owned life insurance		(212	)		(204	)
Decrease in deferred tax asset		12			14
Loss on sale and write-downs on other real estate owned		204			-
Increase in other assets		(7,799	)		(483	)
Increase / (decrease) in other liabilities		822			(795	)
Excess tax benefit related to share-based compensation expense		(9	)		(88	)
NET CASH (USED) / PROVIDED IN OPERATING ACTIVITIES		(3,153	)		4,428
Cash flows from investing activities:
Purchase of securities, available for sale		(38,553	)		(18,417	)
Sale of available for sale securities		4,762			1,537
Maturities and calls of available for sale securities		1,136			1,012
Maturities of time deposits with other banks		-			199
Proceeds from principal reductions and maturities of available for sale securities		5,410			5,193
Purchase of Federal Home Loan Bank stock		(705	)		(2,272	)
Increase in loans, net		(21,991	)		(47,673	)
Allowance for loan and lease loss recoveries		22			72
Purchase of property, premises and equipment, net		(578	)		(720	)
Purchase of bank owned life insurance		-			(400	)
Proceeds from sale of other real estate owned		2,863			-
NET CASH (USED) IN INVESTING ACTIVITIES		(47,634	)		(61,469	)
Cash flows from financing activities:
Increase / (decrease) in deposits, net		100,468			(10,290	)
Proceeds from Federal Home Loan Bank borrowing		75,000			240,000
Repayments of Federal Home Loan Bank borrowing		(119,000	)		(176,500	)
(Decrease) / increase in repurchase agreements		(2,796	)		782
Excess tax benefit related to share-based compensation expense		9			88
Proceeds from exercise of stock options		37			140
Cash dividends paid		(160	)		(587	)
Cash paid in lieu of fractional shares		-			(5	)
Proceeds from issuance of preferred stock and common stock warrants, net		21,000			-
NET CASH PROVIDED BY FINANCING ACTIVITIES		74,558			53,628
Net increase / (decrease) in cash and cash equivalents		23,771			(3,413	)
Cash and cash equivalents, beginning of period		24,571			46,419
Cash and cash equivalents, end of period	$	48,342		$	43,006
Supplemental Cash Flow Disclosures:
Cash Flow information
Interest paid	$	4,836		$	6,819
Income taxes paid	$	220		$	1,405
Non-Cash Flow Information
Change in other valuation allowance for investment securities	$	(2,374	)	$	(1,270	)
Loans transferred to OREO or foreclosed collateral	$	8,403		$	197
See notes to condensed consolidated financial statements.

- 8 - -

Notes to Consolidated Financial Statements

Note 1.  Consolidated Financial Statements

The accompanying un-audited condensed consolidated financial statements of Heritage Oaks Bancorp and subsidiaries (the “Company”) have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and notes required by accounting principles generally accepted in the United States of America for annual financial statements are not included herein. In the opinion of Management, all adjustments (which consist solely of normal recurring accruals) considered necessary for a fair presentation of results for the interim periods presented have been included. These interim condensed consolidated financial statements should be read in conjunction with the financial statements and related notes contained in the Company’s 2008 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, 2009 are not necessarily indicative of the results that may be expected for the year ending December 31, 2009. Certain amounts in the consolidated financial statements for the year ended December 31, 2008 and for the three and six months ended June 30, 2008 may have been reclassified to conform to the presentation of the consolidated financial statements in 2009.

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.

Management evaluated subsequent events through July 28, 2009, the date the financial statements were available to be issued.  Events or transactions occurring after June 30, 2009, but prior to July 28, 2009 that provided additional evidence about conditions that existed at June 30, 2009, have been recognized in the financial statements for the quarter ended June 30, 2009.  Events or transactions that provided evidence about conditions that did not exist at June 30, 2009, but arose before the financial statements were available to be issued have not been recognized in the financial statements for the period ended June 30, 2009.

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.

- 9 - -

Notes to Consolidated Financial Statements

The following table sets forth the amortized cost and fair values of investment securities available for sale at June 30, 2009 and December 31, 2008:

(dollars in thousands)			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
As of June 30, 2009	Cost		Gains		Losses			Value
Obligations of U.S. government agencies and corporations	$	145	$	-	$	(2	)	$	143
Mortgage backed securities		58,629		256		(4,598	)		54,287
Obligations of state and political subdivisions		21,072		361		(246	)		21,187
Other securities		109		-		-			109
Total	$	79,955	$	617	$	(4,846	)	$	75,726
As of December 31, 2008
Obligations of U.S. government agencies and corporations	$	149	$	-	$	(1	)	$	148
Mortgage-backed securities		35,339		166		(2,102	)		33,403
Obligations of state and political subdivisions		17,020		373		(291	)		17,102
Other securities		109		-		-			109
Total	$	52,617	$	539	$	(2,394	)	$	50,762

During the first quarter of 2009, the Company sold five securities in the aggregate amount of $4.8 million.  In connection with the sale, the Company recognized a pre tax gain of $122 thousand.  During the second quarter of 2008, the Bank sold approximately $5.2 million in securities and recognized a pre tax gain of $37 thousand.  No securities were sold during the three months ended June 30, 2009.

Management periodically evaluates investments in the portfolio for other than temporary impairment and more specifically when conditions warrant such an evaluation.  When evaluating whether impairment is other than temporary, Management considers, among other things, the following: (1) the length of time the security has been in an unrealized loss position, (2) the extent to which the security’s fair value is less than its cost, (3) the financial condition of the issuer, (4) any adverse changes in ratings issued by various rating agencies, (5) the intent and ability of the Bank to hold such securities for a period of time sufficient to allow for any anticipated recovery in fair value and (6) in the case of mortgage related securities, credit enhancements, loan-to-values, credit scores, delinquency and default rates, cash flows and the extent to which those cash flows are within Management’s initial expectations based on pre-purchase analyses.

As of June 30, 2009, Management does not believe unrealized losses in the investment portfolio are other than temporary.

- 10 - -

Notes to Consolidated Financial Statements

Note 3.  Loans and the Allowance for Loan Losses

The following table provides a summary of outstanding loan balances as of June 30, 2009 compared to December 31, 2008:

	June 30,		December 31,
(dollars in thousands)	2009		2008
Real Estate Secured
Multi-family residential	$	17,414	$	16,206
Residential 1 to 4 family		23,626		23,910
Home equity lines of credit		29,049		26,409
Commercial		302,735		285,631
Farmland		9,639		10,723
Commercial
Commercial and industrial		171,208		157,674
Agriculture		14,231		13,744
Other		491		620
Construction
Single family residential		14,710		11,414
Single family residential - Spec.		10,338		15,395
Tract		3,202		2,431
Multi-family		5,648		5,808
Hospitality		12,388		18,630
Commercial		17,215		21,484
Land		57,149		61,681
Installment loans to individuals		8,428		7,851
All other loans (including overdrafts)		383		536
Total loans, gross		697,854		680,147
Deferred loan fees		1,555		1,701
Reserve for possible loan losses		11,106		10,412
Total loans, net	$	685,193	$	668,034
Loans held for sale		11,692		7,939

Concentration of Credit Risk

At June 30, 2009, approximately $503.1 million or 72.1% of the Bank’s loan portfolio was collateralized by various forms of real estate, this represents an increase of approximately $3.4 million when compared to the $499.7 million or 73.5% reported at December 31, 2008.  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 industry and project type. While Management believes that the collateral presently securing this portfolio is adequate, there can be no assurances that further significant deterioration in the California real estate market would not expose the Bank to significantly greater credit risk.  At June 30, 2009, the Bank was contingently liable for letters of credit accommodations made to its customers totaling approximately $18.1 million and un-disbursed loan commitments in the approximate amount of $201.2 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. For more detailed information on Concentration of Credit Risk, please refer to “Loans” of “Financial Condition” under “Management’s Discussion and Analysis of Results and Operations” contained within this document.

- 11 - -

Notes to Consolidated Financial Statements

Allowance for Loan Losses

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

The following table provides a summary for the activity in the allowance for loan losses during the periods indicated:

	For the three months ended				For the six months ended				For the year ended
(dollars in thousands)	June 30, 2009		June 30, 2008		June 30, 2009		June 30, 2008		December 31, 2008
Balance at beginning of period	$	10,429	$	6,305	$	10,412	$	6,143	$	6,143
Provision expense		2,700		2,775		4,810		3,015		12,215
Loans charged-off:
Commercial real estate		-		305		-		305		340
1-4 family residential		-		-		-		-		555
Commercial and industrial		942		492		1,225		568		3,854
Construction		415		206		1,821		206		1,837
Land		681		-		991		-		1,434
Other		4		21		101		23		56
Total charge-offs		2,042		1,024		4,138		1,102		8,076
Recoveries of loans previously charged off		19		72		22		72		130
Balance at end of period	$	11,106	$	8,128	$	11,106	$	8,128	$	10,412

During the three and six months ended June 30, 2009, the Company made provisions to the allowance for loan losses in the amounts of $2.7 million and $4.8 million, respectively.  This when compared to the $2.8 million and $3.0 million reported for the same periods ended a year earlier, represents a decline of approximately $0.1 million for the quarter and an increase of approximately $1.8 million on a year to date basis.  Elevated provision expenses are reflective of, among other things, additional loan balances charged-off during the first six months of 2009, continued weakness in local, state and national economic conditions and the number and dollar volume of loans placed on non-accruing status when compared to the same period ended in 2008.

Note 4.  Earnings Per Share

Basic earnings per common share are computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding.  Diluted earnings per common share are computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding adjusted to include the effect of potentially dilutive common shares.  Potentially dilutive common shares are calculated using the Treasury Stock Method and include incremental shares issuable upon exercise of outstanding stock options and other share-based compensation awards, exclusive of any award that may have an anti-dilutive affect on earnings per common share.  As disclosed in Note 9 of these consolidated financial statements, the Company issued a warrant to the U.S. Treasury to purchase 611,650 shares of its common stock.  The warrant was included in the Company’s calculation of diluted earnings per common share for the three months ended June 30, 2009, but excluded from the calculation on a year to date basis, since it was anti-dilutive for that period.  

- 12 - -

Notes to Consolidated Financial Statements

The following table sets forth the number of shares used in the calculation of both basic and diluted earnings per share for the three months ended June 30, 2009 and 2008:

	For the three months ending,
	June 30, 2009					June 30, 2008
	Net					Net
(dollar amounts in thousands except per share data)	Income			Shares		Income		Shares
Net income	$	507				$	691
Dividends and accretion on preferred stock		(250	)				-
Net income available to common shareholders	$	257				$	691
Weighted average shares outstanding					7,696,027				7,705,174
Basic earnings per common share	$	0.03				$	0.09
Dilutive effect of share-based compensation awards					94,681				125,216
Dilutive effect of common stock warrant					76,254				-
Weighted average diluted shares outstanding					7,866,962				7,830,390
Diluted earnings per common share	$	0.03				$	0.09

The following table sets forth the number of shares used in the calculation of both basic and diluted earnings per share for the six months ended June 30, 2009 and 2008:

	For the six months ending,
	June 30, 2009					June 30, 2008
	Net					Net
(dollar amounts in thousands except per share data)	Income			Shares		Income		Shares
Net income	$	1,609				$	2,366
Dividends and accretion on preferred stock		(261	)				-
Net income available to common shareholders	$	1,348				$	2,366
Weighted average shares outstanding					7,692,765				7,699,860
Basic earnings per common share	$	0.17				$	0.31
Dilutive effect of share-based compensation awards					85,606				141,284
Dilutive effect of common stock warrant					-				-
Weighted average diluted shares outstanding					7,778,371				7,841,144
Diluted earnings per common share	$	0.17				$	0.30

On April 24, 2008, the Company’s Board of Directors declared a 5% stock dividend which was paid on May 16, 2008.  As a result of this dividend, the Company issued 366,294 shares of its common stock to holders of record on May 2, 2008.  The basic and diluted shares presented in the tables above as well as shares for all prior periods have been adjusted to fully reflect the May 2008 stock dividend.

Note 5.  Recent Accounting Pronouncements

In June 2009, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 168, “The FASB Accounting Standards Codification™ and the Hierarchy of Generally Accepted Accounting Principles, a replacement of FASB Statement No. 162.”  The FASB Accounting Standards CodificationTM (“Codification”) will become the source of authoritative U.S. generally accepted accounting principles (“GAAP”) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants.  On the effective date of this Statement, all interim and annual reporting periods ending after September 15, 2009, the Codification will supersede all then-existing non-SEC accounting and reporting standards. All other non-grandfathered non-SEC accounting literature not included in the Codification will become non-authoritative.  The Company does not currently believe the adoption of this statement will have a material impact on its financial statements.  

- 13 - -

Notes to Consolidated Financial Statements

In June 2009, the FASB issued SFAS No. 167, “Amendments to FASB Interpretation No. 46(R).”  SFAS No. 167 seeks to improve financial reporting by companies involved with variable interest entities. SFAS No. 167 addresses concerns about the application of certain key provisions of Interpretation No. 46(R), including those in which the accounting and disclosures under the Interpretation do not always provide timely and useful information about a company’s involvement in a variable interest entity.  SFAS No. 167 requires a company to perform analyses to determine if its variable interest(s) give it a controlling financial interest in a variable interest entity.  These analyses identify the primary beneficiary of the a variable interest entity as the company that has both of the following characteristics: (a) the power to direct the activities of a variable interest entity that most significantly impact the company’s economic performance; and (b) the obligation to absorb losses of the entity that could potentially be significant to the variable interest entity or the right to receive benefits from the entity that could potentially be significant to the variable interest entity.  This statement is effective for all annual and interim reporting periods beginning after November 15, 2009 with earlier application prohibited.  The Company has not yet determined the impact that SFAS No. 167 will have on its financial statements.

In June 2009, the FASB issued SFAS No. 166, “Accounting for Transfers of Financial Assets, an Amendment of FASB Statement 140.”  SFAS No. 166 seeks to improve the relevance, representational faithfulness and comparability of the information that a reporting entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets.  The Company is required to adopt SFAS No. 166 for all interim and annual reporting periods beginning after November 15, 2009.  The Company does not currently expect the adoption of this standard to have a material impact on its financial statements.

In May 2009, the FASB issued SFAS No. 165, “Subsequent Events.”  SFAS No. 165 sets forth principles and requirements for disclosing and recognizing subsequent events in the financial statements.  SFAS No. 165 also outlines circumstances under which an entity shall recognize those events or transactions occurring after the balance sheet date.  The Company is required to adopt SFAS No. 165 for all interim and annual reporting periods after June 15, 2009, prospectively.  The Company’s adoption of this pronouncement did not have a material impact on its financial statements.

In April 2009, the FASB issued the following new accounting standards:

The FASB issued FASB Staff Position (“FSP”) FAS 157-4, “Determining Whether a Market Is Not Active and a Transaction Is Not Distressed,” FSP FAS 157-4 provides guidelines for making fair value measurements more consistent with the principles presented in SFAS 157. FSP FAS 157-4 provides additional authoritative guidance in determining whether a market is active or inactive, and whether a transaction is distressed, is applicable to all assets and liabilities (i.e. financial and nonfinancial) and will require enhanced disclosures.

The FASB issued FSP FAS 115-2, FAS 124-2, and EITF 99-20-2, “Recognition and Presentation of Other-Than-Temporary Impairments,”  The FSP amends FASB Statements No. 115, Accounting for Certain Investments in Debt and Equity Securities, No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations, and EITF Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets,” to make the other-than-temporary impairment guidance more operational and to improve the presentation of other-than-temporary impairments in the financial statements.  This statement applies to other-than-temporary impairments of debt and equity securities and requires a company to assert that (a) it does not have the intent to sell the security in question and (b) it is more likely than not that it will not have to sell the security in question before recovery of its cost basis to avoid an impairment being considered other-than-temporary.  This FSP also changes the amount of impairment losses recognized in earnings.  Under this FSP impairments are separated into two components: (i) the amount of impairments related to credit losses and (ii) and the amount related to other factors.  The amount of impairment related to credit losses is reflected as a charge to earnings, while the amount deemed to be related to other factors is reflected as an adjustment to shareholders’ equity through other comprehensive income.

The FASB issued FSP FAS 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instrument.” FSP FAS 107-1 and APB 28-1, amends FASB Statement No. 107, “Disclosures about Fair Value of Financial Instruments,” to require disclosures about fair value of financial instruments in interim as well as in annual financial statements. This FSP also amends APB Opinion No. 28, “Interim Financial Reporting,” to require those disclosures in all interim financial statements.

The standards summarized in the preceding paragraphs are effective for periods ending after June 15, 2009.  The adoption of these standards has not had a material impact in the Company’s financial statements.

- 14 - -

Notes to Consolidated Financial Statements

On April 1, 2009, the FASB issued FSP FAS 141(R)-1, “Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies.”  FSP 141(R)-1 provides additional guidance regarding the recognition, measurement and disclosure of assets and liabilities arising from contingencies in a business combination.  FSP 141(R)-1 is effective for assets or liabilities arising from contingencies in business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008.  The impact of adopting FSP 141(R)-1 will depend on the timing of future acquisitions, as well as the nature and existence of contingencies associated with such acquisitions.

In December 2008, the FASB issued FSP FAS 132(R)-1, “Employers’ Disclosures about Postretirement Benefit Plan Assets.”  FSP FAS 132(R)-1 amends FASB Statement No. 132(R) to provide guidance on an employer’s disclosures about plan assets of a defined benefit pension or other postretirement plan.  FSP FAS 132(R)-1 seeks to provide users of financial statements with an understanding of: how investment allocation decisions are made, the major categories of plan assets, the inputs and valuations techniques used to measure the fair value of those assets, the effect of fair value measurements using unobservable inputs on changes in plan assets during a reporting period, and significant concentrations of risk within plan assets.  The Company is required to adopt FSP FAS 132(R)-1 no later than January 1, 2010.  The Company does not believe the adoption of this FSP will have a material impact on its financial statements.

On October 10, 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active.” The FSP clarifies the application of SFAS No. 157, “Fair Value Measurements”, in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. The FSP is effective immediately, and includes prior periods for which financial statements have not been issued, and therefore the Company is subject to the provisions under the FSP effective September 30, 2008. The implementation of FSP FAS 157-3 did not affect the Company's fair value measurements as of June 30, 2009.

In June 2008, the FASB issued Staff Position No. EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities ("FSP EITF 03-6-1"). The FSP addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing EPS under the two-class method. The FSP affects entities that accrue cash dividends on share-based payment awards during the awards' service period when the dividends do not need to be returned if the employees forfeit the awards.  FSP EITF 03-6-1 is effective for fiscal years beginning after December 15, 2008.  The adoption of FSP EITF 03-6-1 did not have material impact on the Company’s 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 adoption of SFAS No. 162 did not have a material impact on the Company’s financial position, results of operations or cash flows.

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’s adoption of SFAS No. 163 did not have a material impact on its 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 years and interim periods beginning 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. The Company’s adoption of this standard did not have a material impact on its financial position, results of operations or cash flows.

- 15 - -

Notes to Consolidated Financial Statements

In February 2008, the FASB issued 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 was required to adopt FSP FAS 157-1 no later than January 1, 2009.  The adoption of this pronouncement did not have a material impact on the Company’s financial position, results of operations and cash flows.

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 adoption of SFAS No. 141(R) did not have a material impact on the Company’s 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 adoption of SFAS No. 160 did not have a material impact on the Company’s financial position, results of operations or cash flows.

Note 6.  Share-Based Compensation

As of June 30, 2009, 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, 2008. 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 consolidated statements of income for the three and six month periods ended June 30, 2009 and 2008 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.

- 16 - -

Notes to Consolidated Financial Statements

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 share and per share data)	2009		2008		2009		2008
Share-based compensation expense:
Stock option expense	$	42	$	52	$	86	$	101
Restricted stock expense		52		3		98		66
Total share-based compensation expense		94	$	55		184	$	167
Total share-based compensation expense, net of tax	$	57	$	40	$	113	$	114
Diluted shares outstanding		7,866,962		7,830,390		7,778,371		7,841,144
Impact on diluted earnings per share	$	0.007	$	0.005	$	0.015	$	0.015
Unrecognized compensation expense:
Stock option expense	$	258	$	367
Restricted stock expense		368		604
Total unrecognized share-based compensation expense	$	626	$	971
Total unrecognized share-based compensation expense, net of tax	$	380	$	597

At June 30, 2009, there was a total of $258 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.

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, 2009 was $368 thousand. That expense is expected to be recognized over the next 1.7 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 2009 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, 2009).  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, 2009 was $22 thousand.  The aggregate intrinsic value of options exercised during the three and six month periods ended June 30, 2008 was $72 thousand and $214 thousand, respectively.

- 17 - -

Notes to Consolidated Financial Statements

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 periods ended June 30, 2009 and 2008:

						Average
				Weighted		Remaining		Total
				Average		Contractual		Intrinsic
	Number of			Exercise		Term		Value
	Shares			Price		(in years)		(in 000's)
Options outstanding, January 1, 2009		408,830		$	9.34
Granted		30,324			4.81
Exercised		(10,050	)		3.73
Forfeited		-			-
Options outstanding, June 30, 2009		429,104		$	9.15		4.34	$	288
Exercisable at June 30, 2009		347,172		$	8.92		3.28	$	245
Options outstanding, January 1, 2008		463,160		$	8.36
Granted		26,250			11.48
Exercised		(32,090	)		4.37
Forfeited		(4,439	)		6.58
Options outstanding, June 30, 2008		452,881		$	8.84		4.41	$	906
Exercisable at June 30, 2008		362,146		$	7.78		3.37	$	904

During the first quarter of 2009, the Company granted 25,000 options to various non-management members of the Company’s Board of Directors.  Similar grants were made to the Company’s Board of Directors during the first quarter of 2008.  The following table presents the assumptions used in the calculation of the weighted average fair value of options granted during 2009 and 2008 on the date of grant using the Black-Scholes options pricing model:

	2009			2008
Expected volatility		42.26	%		35.07	%
Expected term (years)		10			10
Dividend yield		0.00	%		2.66	%
Risk free rate		2.84	%		3.62	%
Weighted-average grant date fair value	$	2.74		$	3.93

The Black-Scholes model incorporates a range of assumptions for inputs that are disclosed in the table above.  Expected volatilities are based on, among other things, the daily historical stock price over the expected life of the option.  The expected term of options granted is derived from the output of the model and represents the period of time that options granted are expected to be outstanding.  Dividend yields are estimated based on the dividend yield on the Company’s common stock at the time of grant.  The risk-free rate for periods within the contractual life of the stock option is based on the U.S. Treasury yield curve in effect at the time of grant.

Estimates of fair value derived from the Company’s use of the Black-Scholes pricing model are theoretical values for stock options and changes in the assumptions used in the models could result in different fair value estimates.  The actual value of the stock options granted will depend on the market value of the Company’s common stock when the options are exercised.

- 18 - -

Notes to Consolidated Financial Statements

Note 7.  Fair Value Disclosures

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-accruing 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, 2009, substantially all of the Company’s impaired loans were evaluated based on the fair value of their underlying collateral with the most recent appraisal available to Management.

- 19 - -

Notes to Consolidated Financial Statements

Other Real Estate Owned and Foreclosed Collateral

Other real estate owned and foreclosed collateral are adjusted to 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, 2009:

	Fair Value Measurments Using
							Assets At
(dollars in thousands)	Level 1		Level 2		Level 3		Fair Value
Assets:
Available for sale investment securities	$	-	$	74,988	$	738	$	75,726
Total assets measured on a recurring basis	$	-	$	74,988	$	738	$	75,726

The following table provides a summary of the changes in balance sheet carrying values associated with Level 3 financial instruments during the three months ended June 30, 2009:

	Available For
	Sale Investment
(dollars in thousands)	Securities
Beginning balance	$	774
Total gains or losses (realized/unrealized)(1):
Included in earnings		-
Included in other comprehensive loss		(36	)
Purchases		-
Transfers in and/or out of Level 3		-
Ending balance	$	738

(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, 2009:

	Fair Value Measurments Using
							Assets At
(dollars in thousands)	Level 1		Level 2		Level 3		Fair Value
Assets:
Impaired loans	$	-	$	12,151	$	-	$	12,151
Loans held for sale		-		11,692		-		11,692
Other real estate owned		-		6,669		-		6,669
Total assets measured on a non-recurring basis	$	-	$	30,512	$	-	$	30,512

- 20 - -

Notes to Consolidated Financial Statements

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, 2008, 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.  Fair Value of Financial Instruments

The fair value of a financial instrument is the amount at which the asset or obligation could be exchanged in a current transaction between willing parties, other than a forced or liquidation sale.  Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instrument.  These estimates do not reflect any premium or discount that could result from offering for sale at one time the entire holdings or a particular financial instrument.  Because no market value exists for a significant portion of the financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors.  These estimates are subjective in nature, involve uncertainties and matters of judgment and, therefore, cannot be determined with precision.  Changes in assumptions could significantly affect these estimates.

Fair value estimates are based on financial instruments both on and off the balance sheet without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments.  Additionally, tax consequences related to the realization of the unrealized gains and losses can have a potential effect on fair value estimates and have not been considered in many of the estimates.

The following table provides a summary of the estimated fair value of financial instruments at June 30, 2009:

	June 30, 2009
	Carrying
(dollars in thousands)	Amount		Fair Value
Assets
Cash and cash equivalents	$	48,342	$	48,342
Interest bearing deposits		119		119
Investments and mortgage-backed securities		75,726		75,726
Federal Home Loan Bank and Federal Reserve Bank stock		5,828		5,828
Loans receivable, net of deferred fees and costs		696,299		704,558
Loans held for sale		11,692		11,692
Bank owned life insurance		10,949		10,949
Accrued interest receivable		3,298		3,298
Liabilities
Non-interest bearing deposits		178,600		178,600
Interest bearing deposits		525,389		522,268
Federal Home Loan Bank advances		65,000		65,246
Junior subordinated debentures		13,403		12,252
Accrued interest payable		608		608
	Notional		Cost to Cede
	Amount		or Assume
Off-balance sheet instruments, commitments to extend credit and standby letters of credit	$	219,315	$	2,193

The following methods and assumptions were used by the Company in estimating fair values of financial instruments:

Cash and Cash Equivalents

The carrying amounts reported in the balance sheet for cash and cash equivalents approximate the fair values of those assets due to the short-term nature of the assets.

- 21 - -

Notes to Consolidated Financial Statements

Interest Bearing Deposits and Accrued Interest Payable

The fair values disclosed for interest bearing deposits (for example, interest-bearing checking accounts and passbook accounts) are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts).  The fair values for certificates of deposit are estimated using a discounted cash flow analysis that applies interest rates currently being offered on certificates to a schedule of aggregated contractual maturities on such time deposits.

The carrying amount of accrued interest payable approximates its fair value.

Investments Including Federal Home Loan Bank Stock, Federal Reserve Bank Stock and Mortgage-Backed Securities

Fair values are based upon quoted market prices, where available. If quoted market prices are not available, fair values are extrapolated from the quoted prices of similar instruments or through the use of other observable data supporting a valuation model.  Fair values for holdings of Federal Home Loan Bank and Federal Reserve Bank stock are based on carrying amounts.

Loans, Loans Held for Sale, and Accrued Interest Receivable

For variable-rate loans that re-price frequently and with no significant change in credit risk, fair values are based on carrying amounts.  The fair values for other loans (for example, fixed rate commercial real estate and rental property mortgage loans and commercial and industrial loans) are estimated using discounted cash flow analysis, based on interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.  Loan fair value estimates include judgments regarding future expected loss experience and risk characteristics.

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.

The carrying amount of accrued interest receivable approximates its fair value.

Bank Owned Life Insurance

Fair values are based on current cash surrender values at each reporting date provided by the underlying insurers.

Federal Home Loan Bank Advances

The fair value disclosed for FHLB advances is determined by discounting contractual cash flows at current market interest rates for similar instruments.

Junior Subordinated Debentures

The fair value disclosed for junior subordinated debentures is based on contractual cash flows at current market interest rates for similar instruments.

Off-Balance Sheet Instruments

Fair values of commitments to extend credit and standby letters of credit are based upon fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreement and the counterparties' credit standing.

- 22 - -

Notes to Consolidated Financial Statements

Note 9.  Preferred Stock

On February 27, 2009, the Company received shareholder approval for an amendment of its Articles of Incorporation to add a class of preferred stock, which ultimately allowed it to participate in the U.S Treasury’s Capital Purchase Program (“CPP”).

Under its Amended Articles of Incorporation, The Company is authorized to issue up to 5,000,000 shares of preferred stock, in one or more series, having such voting powers, designations, preferences, rights, qualifications, limitations and restrictions as determined by the Board of Directors.  

On March 20, 2009, the Company issued 21,000 shares of Senior Preferred Stock to the U.S. Treasury under the terms of the CPP for $21.0 million with a liquidation preference of $1,000 per share.  The preferred stock will carry a coupon of 5% for five years and 9% thereafter.  Senior preferred issued to the U.S. Treasury will be non-voting, cumulative, and perpetual and may be redeemed at 100% of their liquidation preference plus accrued and unpaid dividends following three years from the date of issue.  In addition, the Company issued a warrant to the U.S. treasury to purchase shares of the Company’s common stock in an amount equal to 15% of the preferred equity issuance or approximately $3.2 million (611,650 shares).  The warrant is exercisable immediately at a price of $5.15 per share, will expire after a period of 10 years from issuance and is transferable by the U.S. Treasury.  The Company expects the warrant to be dilutive to earnings per common share.

The U.S. Treasury may not transfer a portion or portions of the warrant with respect to, and/or exercise the warrant for more than one-half of, the 611,650 common shares issuable upon exercise of the warrant, in the aggregate, until the earlier of (i) the date on which the Company has received aggregate gross proceeds of not less than $21.0 million from one or more Qualified Equity Offerings and (ii) December 31, 2009.  However, if the Company were to redeem all of the Senior Preferred Stock as permitted by and in accordance with the provisions set forth under the CPP, the U.S. Treasury will be permitted, subject to compliance with applicable securities laws, to transfer all or a portion of the warrant with respect to, and/or exercise the warrant for, all or a portion of the number of common shares issuable thereunder, at any time and without limitation.  In the event the Company completes one or more Qualified Equity Offerings on or prior to December 31, 2009, that result in the Company receiving aggregate gross proceeds of not less than $21.0 million, the number of the common shares underlying the portion of the warrant then held by the U.S. Treasury will be reduced by one-half of the common shares originally covered by the warrant.  The U.S. Treasury has agreed not to exercise voting power with respect to any common shares issued to it upon exercise of the warrant.   At June 30, 2009, there had been no changes to the number of common shares covered by the warrant nor had the U.S. Treasury exercised any portion of the warrant.

The proceeds received from the U.S. Treasury were allocated to the Senior Preferred Stock and the warrant based on their relative fair values.  The fair value of the Senior Preferred Stock was determined through a discounted future cash flow model at a discount rate of 10%.  The fair value of the warrant was calculated using the Black-Scholes option pricing model, which includes assumptions regarding the Company’s dividend yield, stock price volatility, and the risk-free interest rate.  As a result the Company recorded the Senior Preferred Stock and the warrant at approximately $19.2 million and $1.8 million, respectively.  The Company will accrete the discount on the Senior Preferred Stock over a period of five years with corresponding charges to retained earnings.

It is also important to note that net income available to common shareholders will be impacted to the extent the Company charges retained earnings for the accretion of the discount on the Senior Preferred Stock and any dividends paid from retained earnings on the Senior Preferred Stock.  For the three and six month periods ended June 30, 2009, dividends and accretion on the Senior Preferred Stock totaled approximately $250 thousand and $261 thousand, respectively.

Additionally, the Company is subject to certain limitations during its participation in the CPP including:

· The requirement to obtain consent from the U.S. Treasury for any proposed increases in common stock dividends prior to the third anniversary date of the preferred equity issuance.

· The Senior Preferred Stock cannot be redeemed for three years unless the Company obtains proceeds to replace the Senior Preferred Stock through a qualified equity offering.

· The U.S. Treasury must consent to any buy back of our common stock.

· The Company must adhere to restrictions placed on the amount of and type of compensation paid to its executives while participating in the CPP, pursuant to section 111 of the Emergency Economic Stabilization Act of 2008, as amended (“EESA”).

- 23 - -

Notes to Consolidated Financial Statements

Note 10.  Subsequent Events

During the last few days of July 2009, the Bank finalized the sale of three OREO properties and received proceeds of approximately $2.5 million.  In connection with the sale of these properties, the Bank recognized an aggregate pre tax loss on sale of approximately $0.3 million in the month of July.

Note 11.  Reclassifications

Certain amounts in the 2008 financial statements have been reclassified to conform to the 2009 presentation.

- 24 - -

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 ongoing financial crisis in the United States, and the response of the federal and state government and our regulators thereto, general economic conditions and California’s energy crisis, 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, 2008 10-K, ITEM 1A. Risk Factors). The Company disclaims any obligation to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements contained herein to reflect future events or developments.

- 25 - -

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, 2009 and 2008.  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 (“Trust II”). Trust II is a statutory business trust formed under the laws of the State of Delaware and is a wholly-owned, non-financial, non-consolidated subsidiary of the Company.

In September 2007, the Company formed Heritage Oaks Capital Trust III (“Trust III”). Trust III is a statutory business trust formed under the laws of the State of Delaware and 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 23 to the consolidated financial statements of the Company’s 2008 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.

- 26 - -

Management’s Discussion and Analysis

Executive Summary

For the three and six month periods ended June 30, 2009, earnings available to common shareholders were approximately $0.3 million and $1.3 million, respectively.  This when compared to the same periods ended a year earlier represents a decline of approximately $0.4 million and $1.0 million, respectively.  Earnings per diluted common share for the three and six month periods ended June 30, 2009 were $0.03 and $0.17, respectively, representing respective declines of $0.06 and $0.13 when compared to the same periods ended a year earlier.  Year over year declines in earnings can be attributed to elevated provisions for loan losses, a one time assessment imposed by the FDIC and several one time charges incurred as a result of OREO properties the Bank acquired.  The FDIC assessment was imposed on all insured institutions with the intent to replenish the Deposit Insurance Fund.  Additionally, during the second quarter of 2008 the Bank recognized income related to the Visa, Inc. IPO in the approximate amount of $0.3 million.  The absence of this income in the second quarter of 2009 is another factor behind the year over year decline in earnings.

One time charges during the first six months of 2009 include the special FDIC assessment in the amount of $0.4 million, booked during the second quarter, and expenses incurred related to OREO properties the Bank acquired in the amount of $0.2 million and $0.3 million for the three and six months ended June 30, 2009, respectively.  Absent these charges, non-interest expenses would have been approximately $0.1 million and $0.4 million lower that that reported for the same three and six month periods ended a year earlier.  Management has and will continue to focus on cost controls and efficiency gains while navigating through this difficult economic environment.

Net interest income for the three and six month periods ended June 30, 2009 showed slight increases of $0.3 million and $0.7 million, respectively, when compared to year ago levels.  Although interest income fell approximately $0.3 million and $1.2 million for the three and six month periods ended June 30, 2009 when compared to year ago levels, interest expenses fell at a faster pace, allowing for the increases seen in net interest income.  Throughout 2008 and early 2009, the Bank stayed relatively short with respect to maturities on various interest bearing liabilities, allowing the Bank the opportunity to take advantage of lower rates in a rates down environment.  Additionally, floors within the loan portfolio were instrumental in abating any substantial year over year decline in interest income.

Non-performing assets at June 30, 2009 were approximately $18.9 million or $4.3 million lower than that reported at March 31, 2009 and $1.1 million lower that that reported at December 31, 2008.  Although approximately $6.7 million in loan balances moved to OREO status during the second quarter, the Bank saw pay-downs of approximately $1.2 million on non-accruing credits, the result of proceeds obtained from the liquidation of collateral and principal guarantees.  During the second quarter the Bank sold three spec construction properties acquired through foreclosure for approximately $2.9 million.  In connection with the sale of these properties, the Bank recognized a loss of approximately $104 thousand.  For the first six months of 2009, losses on the sale of OREO totaled approximately $131 thousand. As discussed in Note 10. Subsequent Events, to the consolidated financial statements, the Bank closed escrow for the sale of three additional OREO properties in late July 2009.  In connection with the sale of these properties, the Bank received aggregate proceeds of approximately $2.5 million and recognized an aggregate pre-tax loss of approximately $0.3 million in July 2009.

Deposit growth was strong during the first six months of the year, with total deposits of $704.0 million at June 30, 2009, representing a $100.5 million or 16.6% increase from that reported at December 31, 2008.  Net of brokered, retail deposits grew approximately $110.6 million or 19.9% from that reported at December 31, 2008.  Growth in deposit balances was driven in large part by increases in non-interest bearing demand, retail money market deposits and time certificates.  As a result of increased deposits, the Bank was able to pay down approximately $46.0 million in brokered funds during the second quarter and approximately $10.1 million on a year to date basis.  Borrowings with the Federal Home Loan Bank (“FHLB”) declined $44.0 million during the first six months of 2009, directly attributable to growth in retail deposit balances.

The following provides a summary of operating results for the three and six month periods ended June 30, 2009 and 2008:

· Interest income for the three and six month periods ended June 30, 2009 was approximately $12.3 million and $24.2 million, respectively.  This, when compared to the $12.6 million and $25.4 million reported for the same periods ended a year earlier, represents declines of approximately $0.3 million and $1.2 million or 2.4% and 4.8%, respectively.  The year over year decline is primarily attributable to the actions taken by the Federal Reserve within the fourth quarter of 2008 to lower the overnight Fed Funds rate from 2.00%, as of June 30, 2008, to within a range of 0.00% and 0.25%.  However, as previously mentioned, floors in the loan portfolio were instrumental in mitigating any substantial year over year decline in interest income.

· Interest expenses for the three and six month periods ended June 30, 2009 were approximately $2.4 million and $4.8 million, respectively.  This, when compared to the $3.0 million and $6.7 million reported for the same periods ended a year earlier, represents declines of approximately $0.6 million and $1.9 million or 18.7% and 28.8%, respectively.  The year over year decline is mainly attributable to the dramatic declines in the overnight Fed Funds rate previously referred to above and the ability of the Bank to re-price a significant portion of its interest bearing liabilities over the last year.

- 27 - -

Management’s Discussion and Analysis

· Net interest income for the three and six months ended June 30, 2009 was approximately $9.8 million and $19.4 million, respectively.  When compared to the same periods ended a year earlier, this represents increases of approximately $0.3 million and $0.7 million or 2.6% and 3.7%, respectively.  As previously mentioned, the ability of the Bank to re-price a significant portion of its interest bearing liabilities in a rates down environment contributed greatly to the year over year increases seen in net interest income.

· The net interest margin for the second quarter and the first six months of 2009 was 4.91% and 4.97%, respectively.  When compared to the same periods a year earlier, this represents declines of approximately 37 and 34 basis points, respectively.  Declines in the yields on earning assets when compared to year ago levels, contributed to the decline in the net interest margin.

· Non-interest income for the three and six months ended June 30, 2009 was approximately $1.5 million and $3.2 million, respectively.  This, when compared to the same periods ended a year earlier, represents declines of  $0.3 million and $35 thousand, respectively.  The year over year decline in the second quarter of 2009 can be attributed to income the Bank recognized in the second quarter of 2008 related to the Visa, Inc. IPO, totaling approximately $0.3 million.

· Non-interest expenses for the three and six months ended June 30, 2009 were approximately $8.0 million and $15.4 million, respectively.  This, when compared to the $7.5 million and $15.1 million reported for the same periods ended a year earlier, represents increases of approximately $0.5 million and $0.3 million or 6.9% and 2.1%, respectively.  As previously mentioned the Bank incurred several one time charges related to the special FDIC assessment and expenses related to OREO properties the Bank acquired.  Exclusive of these one time items, non-interest expenses would have been approximately $0.1 million and $0.4 million lower that that reported for the three and six month periods ended a year earlier, respectively.

The following provides a summary for significant year to date changes in balances as of June 30, 2009:

· At June 30, 2009, net loan balances were approximately $685.2 million or approximately $17.2 million and 2.6% higher than the $668.0 million reported at December 31, 2008.  See also “Loans” under “Financial Condition” of this discussion and analysis for additional information regarding the Bank’s loan portfolio.

· At June 30, 2009, total deposits were approximately $704.0 million or approximately $100.5 million and 16.7% higher than the $603.5 million reported at December 31, 2008.  Deposits, exclusive of brokered were approximately $665.5 million or $110.6 million higher than the $554.9 million reported at December 31, 2008.  See also “Deposits and Borrowed Funds” under “Financial Condition” of this discussion and analysis for information regarding the Bank’s deposit liabilities.

· At June 30, 2009, borrowings with the FHLB were $65.0 million or approximately $44.0 million lower than the $109.0 million reported at December 31, 2008.  Higher retail deposit balances during the first six months of 2009 resulted in fewer borrowings with the FHLB.

The following provides an overview of asset quality as of June 30, 2009:

· At June 30, 2009, the balance of non-performing loans was approximately $12.2 million or $6.5 million lower than the $18.7 million reported at December 31, 2008.  As of June 30, 2009 the balance of non-performing loans as a percentage of total gross loans was 1.75% compared to 2.75% as of December 31, 2008.

· As of June 30, 2009, the allowance for loan losses represented 1.59% of total gross loans and 1.53% of total gross loans as of December 31, 2008.

· During the three and six months ended June 30, 2009, the Bank made provisions to the allowance for loan losses in the approximate amount of $2.7 million and $4.8 million, respectively.  Charge-offs during the same periods were approximately $2.0 million and $4.1 million, respectively.

· For the three and six months ended June 30, 2009, net charge-offs to average gross loans were 0.29% and 0.59%, respectively.  When compared to the 0.14% and 0.16% reported for the same periods ended a year earlier, represents increases 15 and 43 basis points, respectively.

- 28 - -

Management’s Discussion and Analysis

· During the first six months of 2009, the Bank moved approximately $8.4 million in loan balances to OREO status of which approximately $6.7 million occurred during the second quarter of 2009.  As of June 30, 2009, the balance of OREO was $6.7 million compared to the $1.3 million reported at December 31, 2008.  In spite of the year to date increase in OREO balances, the Bank sold three spec construction properties during the second quarter in the aggregate amount of $2.9 million.  See also “Non Performing Assets” under “Financial Condition” of this discussion analysis for additional information related asset quality.

Recent Developments

As previously mentioned and as discussed in Note 10. Subsequent Events, to the consolidated financial statements, the Bank closed escrow for the sale of three additional OREO properties in late July 2009.  In connection with the sale of these properties, the Bank received aggregate proceeds of approximately $2.5 million and recognized an aggregate pre-tax loss of approximately $0.3 million in July 2009.

During the third and fourth quarters of 2008, the credit and equity markets came under significant duress as confidence by many in the U.S. financial system began to wane.  During the later part of 2007 and throughout 2008, many U.S. financial institutions were forced to significantly write-down the values of certain classes of assets in response to the weakened real estate market.  These losses lead to strained capital levels, impairing the confidence of many depositors and others providing funding to the nation’s banks, which in turn lead to a crisis of liquidity.  With liquidity levels of many financial institutions significantly weakened, borrowing costs began to rise considerably and the flow of credit to consumers and between banks all but came to a halt.  In response to this, the weakened economy and other factors, the U.S. Congress passes the Emergency Economic Stabilization Act of 2008 (the “EESA”) in October of 2008.  Under the EESA, the Department of the U.S. Treasury formed the Troubled Asset Relief Program (the “TARP”).  The TARP gives the U.S. Treasury the power to make purchases of certain troubled assets as well as the direct purchase of equity from U.S. financial institutions under the CPP.  Although the Company’s liquidity levels remained adequate and the Bank and Company were well capitalized throughout 2008, the Company applied to participate in the CPP to keep all capital raising options available.  On February 27, 2009, the Company received shareholder approval to add an authorized class of preferred stock to the Company’s Articles of Incorporation that allowed the Company to participate in the CPP and will also allow for more flexibility in capital raising efforts in general.  On March 20, 2009, the Company issued 21,000 shares of Senior Preferred Stock to the U.S. Treasury under the terms of the CPP for $21.0 million.  Additionally, the Company issued a warrant to the U.S. Treasury to purchase 611,650 shares of its common stock at a price of $5.15 per share, representing 15% of the preferred issuance or approximately $3.2 million.  For a more detailed discussion regarding the Company’s participation in the CPP, see Note 9. Preferred Stock, to the consolidated financial statements filed on this Form 10-Q.

Dividends and Stock Repurchases

During the second quarter of 2009, the Company paid approximately $160 thousand in dividends on its Senior Preferred Stock issued to the U.S. Treasury under the CPP.  See also Note 9. Preferred Stock, to the consolidated financial statements filed on this form 10-Q for additional information about dividends on the Company’s Senior Preferred Stock.

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 represented 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.

The Company paid no dividends on or made repurchases of its common stock during the three and six months ended June 30, 2009.

- 29 - -

Management’s Discussion and Analysis

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 per share data)	06/30/09			03/31/09			12/31/08			09/30/08			06/30/08			03/31/08			12/31/07			09/30/07
Return on average assets		0.23	%		0.54	%		-0.63	%		0.27	%		0.35	%		0.91	%		1.11	%		1.12	%
Return on average equity		2.20	%		6.04	%		-6.93	%		2.94	%		3.84	%		9.55	%		11.65	%		12.09	%
Return on average common equity		1.41	%		6.19	%		-6.93	%		2.94	%		3.84	%		9.55	%		11.65	%		12.09	%
Average equity to average assets		10.68	%		8.95	%		9.06	%		9.16	%		9.14	%		9.48	%		9.49	%		9.27	%
Average common equity to average assets		8.47	%		8.64	%		9.06	%		9.16	%		9.14	%		9.48	%		9.49	%		9.27	%
Net interest margin		4.91	%		5.03	%		5.04	%		5.18	%		5.28	%		5.33	%		5.33	%		5.44	%
Efficiency ratio*		70.02	%		66.71	%		66.43	%		64.40	%		66.31	%		72.17	%		67.26	%		66.89	%
Average loans to average deposits		103.58	%		112.39	%		109.95	%		111.54	%		109.26	%		103.64	%		96.40	%		95.79	%
Net Income	$	507		$	1,102		$	(1,254	)	$	534		$	691		$	1,675		$	1,978		$	1,628
Net income available to common shareholders	$	257		$	1,091		$	(1,254	)	$	534		$	691		$	1,675		$	1,978		$	1,628
Earnings Per Common Share:
Basic	$	0.03		$	0.14		$	(0.16	)	$	0.07		$	0.09		$	0.22		$	0.26		$	0.24
Diluted	$	0.03		$	0.14		$	(0.16	)	$	0.07		$	0.09		$	0.21		$	0.25		$	0.23
Outstanding Shares:
Basic		7,696,027			7,689,317			7,660,342			7,709,600			7,705,174			7,694,546			7,682,730			6,796,286
Diluted		7,866,962			7,824,377			7,721,460			7,798,321			7,830,390			7,851,831			7,887,206			7,013,070

* 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 and sale of other real estate owned.

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 262,000, 86,000, and 86,000 respectively, according to the most recent economic data provided by the U.S. Census Bureau.  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 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. While the economy in the Company’s primary markets of San Luis Obispo and Santa Barbara counties have not been immune to the negative impacts of both the national and state economies, the abundant tourism that has developed over the past decade in our market area, especially in the wine industry and coastal communities, has helped sustain our local economy in previous economic downturns.  According to a recent publication by Smith Travel Research in regard to hotel occupancy rates comparing May 2009 to May 2008, there was a decline in occupancy of 2.6%, 4.9% and 12.3% for Paso Robles/San Luis Obispo, Santa Barbara/Santa Maria and the State of California, respectively.

- 30 - -

Management’s Discussion and Analysis

2008 proved to be a challenging year not only on the national level, but within the state of California and more specifically our primary market area.  As the U.S. housing market continued to wane throughout 2008 and economic growth began to significantly slow, the ability of borrowers to satisfy their obligations to the financial sector began to languish.  These among other factors placed severe stress on the U.S. financial system, leading to a crisis of confidence, further downturn in economic growth and unprecedented volatility in the U.S. equity and credit markets.  As mentioned, our primary market area has historically enjoyed a more stable level of economic activity; however we believe these more macro level concerns have started to become more evident within our market area.  Recent indications show the unemployment rate within California to be approximately 11.5%.  Within the Company’s primary market area, recent indications show the unemployment rate within San Luis Obispo and Santa Barbara major metropolitan areas to be approximately 8.4% and 7.6%, respectively.  Additionally, housing prices have fallen significantly year over year within California, showing an approximate 42% year over year decline as of December 2008.  Within the Company’s primary market, housing prices have fallen in San Luis Obispo and Santa Barbara counties from year ago levels by approximately 17% and 27%, respectively.  However, sales have been relatively strong within the State of California and the Company’s primary market area, climbing over 30% compared to 2008, the majority of which can be attributed to sales of distressed properties.  That said, the lack of oversupply in the Company’s market, desirable climate, close proximity to beaches, lakes and the wine industry, for both San Luis Obispo and Santa Barbara Counties have resulted in lower percentage declines in prices for the local real-estate market, relative to other areas of California.

Critical Accounting Policies

The Company’s significant accounting policies are set forth in the 2008 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.

Loans and Interest on Loans

Loans receivable that Management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at their outstanding unpaid principal balances reduced by any charge-offs of specific valuation accounts and net of any deferred fees or costs on originated loans, or unamortized premiums or discounts on purchased loans.

Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment in yield of the related loan.

Loans on which the accrual of interest has been discontinued are designated as non-accrual loans.  The accrual of interest on loans is discontinued when principal or interest is past due 90 days based on contractual terms of the loan or when, in the opinion of Management, there is reasonable doubt as to collectibility.  When loans are placed on non-accrual status, all interest previously accrued but not collected is reversed against current period interest income.  Interest income generally is 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 to the loan principal balance.  Interest accruals are resumed on such loans only when they are brought current with respect to interest and principal and when, in the judgment of Management, the loans are estimated to be fully collectible as to all principal and interest.

The Company considers a loan to be impaired when it is probable that the Company will be unable to collect all amounts due (principal and interest) according to the contractual terms of the loan agreement.  Measurement of impairment is based on the expected future cash flows of an impaired loan which are to be discounted at the loan’s effective interest rate, or measured by reference to an observable market value, if one exists, or the fair value of the collateral for a collateral-dependent loan.  The Company selects the measurement method on a loan-by-loan basis except that collateral-dependent loans for which foreclosure is probable are measured at the fair value of the collateral.  The Bank recognizes interest income on impaired loans based on its existing methods of recognizing interest income on non-accrual loans.  All loans are generally charged off at such time the loan is classified as a loss.

Allowance for Loan Losses

The allowance for loan losses is maintained at a level which, in Management's judgment, is adequate to absorb credit losses inherent in the loan portfolio.  The amount of the allowance is based on Management's evaluation of the collectibility of the loan portfolio, including the nature and volume of the portfolio, credit concentrations, trends in historical loss experience, the level of certain classified balances and specific impaired loans, and economic conditions and the related impact on specific borrowers and industry groups.  The allowance is increased by a provision for loan losses, which is charged to earnings and reduced by charge-offs, net of recoveries.  Changes in the allowance relating to impaired loans are charged or credited to the provision for loan losses.  Because of uncertainties inherent in the estimation process, Management’s estimate of credit losses inherent in the loan portfolio and the related allowance may change.

- 31 - -

Management’s Discussion and Analysis

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.  Allowances for impaired loans are generally determined based on collateral values or the present value of estimated cash flows.

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

Other Real Estate Owned

Real estate and other property acquired in full or partial settlement of loan obligations is referred to as other real estate owned (“OREO”).  OREO is originally recorded in the Company’s financial statements at fair value less any estimated costs to sell.  When property is acquired through foreclosure or surrendered in lieu of foreclosure, the Company measures the fair value of the property acquired against its recorded investment in the loan.  If the fair value of the property at the time of acquisition is less than the recorded investment in the loan, the difference is charged to the allowance for loan losses.  Any subsequent fluctuations in the fair value of OREO are recorded against a valuation allowance for foreclosed assets, established through a charge to non-interest expense.  All related operating or maintenance costs are charged to non-interest expense as incurred. Any subsequent gains or losses on the sale of OREO are recorded in other income or expense as incurred.

Securities Available for Sale

In accordance with 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 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 unrealized gains and losses, net of applicable taxes, reported in a separate component of stockholders' equity.  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 or through the use of other observable data supporting a valuation model.  Gains or losses on sales of investment securities are determined on the specific identification method.  Premiums and discounts are amortized or accreted using the interest method over the expected lives of the related securities.

Declines in the fair values of individual held-to-maturity and available-for-sale securities below their cost that are other than temporary result in write-downs of individual securities to their fair value.  The related write-downs are included in earnings as realized losses. In estimating other-than-temporary impairment losses, Management considers: (1) the length of time the security has been in an unrealized loss position, (2) the extent to which the security’s fair value is less than its cost, (3) the financial condition of the issuer, (4) any adverse changes in ratings issued by various rating agencies, (5) the intent and ability of the Bank to hold such securities for a period of time sufficient to allow for any anticipated recovery in fair value and (6) in the case of mortgage related securities, current cash flows, credit enhancements, loan-to-values, credit scores, delinquency and default rates.

Goodwill and Other Intangible Assets

As discussed in the 2008 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.  The Company’s assessment at December 31, 2008, pursuant to its Goodwill Impairment Testing Policy, was performed with the assistance of an independent third party and resulted in no impairment.

- 32 - -

Management’s Discussion and Analysis

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 2008, as the Federal Open Market Committee (“FOMC”) cut the overnight Fed Funds rate by over 400 basis points, placing pressure on the level of and growth in net interest income.

Contributing significantly to an asset sensitive balance sheet is a relatively 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, as a result of promotions in the last two years designed to attract lower cost core deposits, the Bank was able to significantly increase the level of floating rate liabilities in the form of money market and short term certificate accounts, bringing the balance sheet to a more neutral position regarding interest rate sensitivity.  This was instrumental in mitigating substantial year over year declines in the net interest margin as a result of dramatic declines in the overnight Fed Funds and Prime rates during 2008.

For the three and six months ended June 30, 2009 and 2008, the net interest margin was 4.91%, 4.97%, 5.28% and 5.31%, respectively.  The year over year declines in the net interest margin can be attributed to reductions in the overnight Fed Funds rate as well as higher average balances of federal funds sold, resulting from substantial increases in core deposit balances during the first six months of 2009.  Although higher average balances of federal funds sold significantly enhanced the Bank’s liquidity position, it did contribute somewhat to a lower yield on earning assets. On a year-over-year rate/volume basis, the decrease in yield on earning assets overall was the driver in regard to margin compression.

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, 2009 and 2008 reflect the impact of dramatically lower interest rates throughout the majority of 2008 as the result of a significantly weakened economy.

Net Interest Income and 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.

- 33 - -

Management’s Discussion and Analysis

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, 2009 and 2008. 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, 2009								June 30, 2008
				Yield/			Income/					Yield/			Income/
(dollars in thousands)	Balance			Rate (4)			Expense		Balance			Rate (4)			Expense
Interest Earning Assets:
Investments with other banks	$	119			3.37	%	$	1	$	281			4.29	%	$	3
Federal funds sold		20,816			0.19	%		10		9,249			1.96	%		45
Investment securities taxable		57,746			4.40	%		634		46,594			5.26	%		609
Investment securities non taxable		19,412			4.30	%		208		17,423			4.27	%		185
Loans (1) (2)		705,779			6.49	%		11,416		656,917			7.18	%		11,732
Total interest earning assets		803,872			6.12	%		12,269		730,464			6.92	%		12,574
Allowance for possible loan losses		(10,121	)							(6,475	)
Other assets		71,936								67,083
Total assets	$	865,687							$	791,072
Interest Bearing Liabilities:
Interest bearing demand	$	61,084			0.69	%	$	105	$	83,754			0.78	%	$	160
Savings		23,819			0.19	%		11		24,343			0.59	%		36
Money market		177,585			1.48	%		656		187,616			1.76	%		824
Time deposits		185,078			2.52	%		1,161		136,709			3.14	%		1,068
Brokered money market funds		32,893			0.82	%		67		-			0.00	%		-
Brokered time deposits		36,907			1.46	%		134		15,919			3.28	%		131
Total interest bearing deposits		517,366			1.65	%		2,134		448,341			1.99	%		2,219
Federal funds purchased		109			1.10	%		-		3,439			2.46	%		21
Securities sold under agreement to repurchase		-			0.00	%		-		2,094			1.92	%		10
Federal Home Loan Bank borrowing		68,956			0.83	%		143		90,731			2.46	%		555
Junior subordinated debentures		13,403			4.49	%		150		13,403			5.40	%		180
Total borrowed funds		82,468			1.43	%		293		109,667			2.81	%		766
Total interest bearing liabilities		599,834			1.62	%		2,427		558,008			2.15	%		2,985
Non interest bearing demand		163,994								152,927
Total funding		763,828			1.27	%		2,427		710,935			1.69	%		2,985
Other liabilities		9,372								7,856
Total liabilities	$	773,200							$	718,791
Stockholders' Equity:
Preferred stock	$	19,197							$	-
Common stock		48,674								46,291
Additional paid in capital		3,032								824
Retained earnings		23,543								25,129
Valuation allowance investments		(1,959	)							37
Total stockholders' equity		92,487								72,281
Total liabilities and stockholders' equity	$	865,687							$	791,072
Net interest income							$	9,842							$	9,589
Net interest margin (3)					4.91	%							5.28	%

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

(2) Loan fees of $225 and $369 for the three months ending June 30, 2009 and 2008, 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.

- 34 - -

Management’s Discussion and Analysis 

	For the six months ending								For the six months ending
	June 30, 2009								June 30, 2008
				Yield/			Income/					Yield/			Income/
(dollars in thousands)	Balance			Rate (4)			Expense		Balance			Rate (4)			Expense
Interest Earning Assets:
Investments with other banks	$	119			3.39	%	$	2	$	306			3.94	%	$	6
Federal funds sold		16,852			0.20	%		17		8,631			2.61	%		112
Investment securities taxable		51,507			4.66	%		1,189		42,370			5.13	%		1,081
Investment securities non taxable		18,293			4.34	%		394		17,273			4.30	%		369
Loans (1) (2)		700,804			6.49	%		22,563		640,449			7.48	%		23,823
Total interest earning assets		787,575			6.19	%		24,165		709,029			7.20	%		25,391
Allowance for possible loan losses		(10,370	)							(6,339	)
Other assets		69,431								64,924
Total assets	$	846,636							$	767,614
Interest Bearing Liabilities:
Interest bearing demand	$	62,845			0.61	%	$	189	$	75,314			0.68	%	$	255
Savings		22,949			0.18	%		20		28,634			1.17	%		166
Money market		175,378			1.51	%		1,316		195,860			2.16	%		2,105
Time deposits		164,228			2.60	%		2,116		142,125			3.62	%		2,561
Brokered money market funds		36,854			0.72	%		131		-			0.00	%		-
Brokered time deposits		33,169			1.74	%		287		11,209			3.91	%		218
Total interest bearing deposits		495,423			1.65	%		4,059		453,142			2.35	%		5,305
Federal funds purchased		378			1.07	%		2		3,824			2.94	%		56
Securities sold under agreement to repurchase		1,312			0.31	%		2		2,080			2.61	%		27
Federal Home Loan Bank borrowing		89,105			0.88	%		388		67,170			2.67	%		891
Junior subordinated debentures		13,403			4.59	%		305		13,403			6.05	%		403
Total borrowed funds		104,198			1.35	%		697		86,477			3.20	%		1,377
Total interest bearing liabilities		599,621			1.60	%		4,756		539,619			2.49	%		6,682
Non interest bearing demand		154,971								148,518
Total funding		754,592			1.27	%		4,756		688,137			1.95	%		6,682
Other liabilities		8,733								8,051
Total liabilities	$	763,325							$	696,188
Stockholders' Equity:
Preferred stock	$	10,921							$	-
Common stock		48,661								45,164
Additional paid in capital		2,190								768
Retained earnings		23,162								25,416
Valuation allowance investments		(1,623	)							78
Total stockholders' equity		83,311								71,426
Total liabilities and stockholders' equity	$	846,636							$	767,614
Net interest income							$	19,409							$	18,709
Net interest margin (3)					4.97	%							5.31	%

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

(2) Loan fees of $483 and $724 for the six months ending June 30, 2009 and 2008, 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.          

- 35 - -

Management’s Discussion and Analysis 

The table below sets forth changes in average interest earning assets and their respective yields for the three and six month periods ending June 30, 2009 compared to the same period ended in 2008:

	Average Balance										Average Yield
	for the three months ending										for the three months ending
	June 30,				Variance						June 30,
(dollars in thousands)	2009		2008		dollar			percentage			2009			2008			Variance
Time deposits with other banks	$	119	$	281	$	(162	)		-57.65	%		3.37	%		4.29	%		-0.92	%
Federal funds sold		20,816		9,249		11,567			125.06	%		0.19	%		1.96	%		-1.77	%
Investment securities taxable		57,746		46,594		11,152			23.93	%		4.40	%		5.26	%		-0.86	%
Investment securities non-taxable		19,412		17,423		1,989			11.42	%		4.30	%		4.27	%		0.03	%
Loans (1) (2)		705,779		656,917		48,862			7.44	%		6.49	%		7.18	%		-0.69	%
Total interest earning assets	$	803,872	$	730,464	$	73,408			10.05	%		6.12	%		6.92	%		-0.80	%

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

(2) Loan fees of $225 and $369 for the three months ending June 30, 2009 and 2008, 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)	2009		2008		dollar			percentage			2009			2008			Variance
Time deposits with other banks	$	119	$	306	$	(187	)		-61.11	%		3.39	%		3.94	%		-0.55	%
Federal funds sold		16,852		8,631		8,221			95.25	%		0.20	%		2.61	%		-2.41	%
Investment securities taxable		51,507		42,370		9,137			21.56	%		4.66	%		5.13	%		-0.47	%
Investment securities non-taxable		18,293		17,273		1,020			5.91	%		4.34	%		4.30	%		0.04	%
Loans (1) (2)		700,804		640,449		60,355			9.42	%		6.49	%		7.48	%		-0.99	%
Total interest earning assets	$	787,575	$	709,029	$	78,546			11.08	%		6.19	%		7.20	%		-1.01	%

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

(2) Loan fees of $483 and $724 for the six months ending June 30, 2009 and 2008, respectively have been included in the interest income computation.

At June 30, 2009, average interest earning assets were approximately $73.4 million and $78.5 million higher than that reported over the same three and six month periods ended a year earlier.  Organic loan growth as well as higher balances of federal funds sold and investment securities are the primary factors behind the increase.

For the three and six month periods ended June 30, 2009, the average yield on loans was 6.49% and 6.49%, respectively.  This represents declines of 69 and 99 basis points from the 7.18% and 7.48% reported for the same periods ended a year earlier.  As economic conditions worsened throughout 2008, the FOMC moved to cut the overnight Fed Funds rate by over 400 basis points, which had a direct impact on yields in the loan portfolio.  The decline in the yield of the loan portfolio is the primary factor contributing to the year over year decline in the yield on earning assets.  Additionally, higher average balances of federal funds sold, resulting from substantial deposit growth during the first half of 2009, placed further pressure on the yield on earning assets.  For the three and six month periods ended June 30, 2009, the yield on earning assets declined approximately 80 and 101 basis points when compared to the same periods ended a year ago.

Year over year increases in the average balance of taxable investment securities can be attributable to purchases the Bank made in a mix of collateralized mortgage obligations from government sponsored agencies and private issuers.

- 36 - -

Management’s Discussion and Analysis 

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, 2009 compared to the same periods ended in 2008:

	Average Balance										Average Rate
	for the three months ending										for the three months ending
	June 30,				Variance						June 30,
(dollars in thousands)	2009		2008		dollar			percentage			2009			2008			Variance
Interest bearing demand	$	61,084	$	83,754	$	(22,670	)		-27.07	%		0.69	%		0.78	%		-0.09	%
Savings		23,819		24,343		(524	)		-2.15	%		0.19	%		0.59	%		-0.40	%
Money market		177,585		187,616		(10,031	)		-5.35	%		1.48	%		1.76	%		-0.28	%
Time deposits		185,078		136,709		48,369			35.38	%		2.52	%		3.14	%		-0.62	%
Brokered money market funds		32,893		-		32,893			100.00	%		0.82	%		0.00	%		0.82	%
Brokered time deposits		36,907		15,919		20,988			131.84	%		1.46	%		3.28	%		-1.82	%
Federal funds purchased		109		3,439		(3,330	)		-96.83	%		1.10	%		2.46	%		-1.36	%
Securities sold under repurchase agreements		-		2,094		(2,094	)		-100.00	%		0.00	%		1.92	%		-1.92	%
Federal Home Loan Bank borrowing		68,956		90,731		(21,775	)		-24.00	%		0.83	%		2.46	%		-1.63	%
Junior subordinated debentures		13,403		13,403		-			0.00	%		4.49	%		5.40	%		-0.91	%
Total interest bearing liabilities	$	599,834	$	558,008	$	41,826			7.50	%		1.62	%		2.15	%		-0.53	%

	Average Balance										Average Rate
	for the six months ending										for the six months ending
	June 30,				Variance						June 30,
(dollars in thousands)	2009		2008		dollar			percentage			2009			2008			Variance
Interest bearing demand	$	62,845	$	75,314	$	(12,469	)		-16.56	%		0.61	%		0.68	%		-0.07	%
Savings		22,949		28,634		(5,685	)		-19.85	%		0.18	%		1.17	%		-0.99	%
Money market		175,378		195,860		(20,482	)		-10.46	%		1.51	%		2.16	%		-0.65	%
Time deposits		164,228		142,125		22,103			15.55	%		2.60	%		3.62	%		-1.02	%
Brokered money market funds		36,854		-		36,854			100.00	%		0.72	%		0.00	%		0.72	%
Brokered time deposits		33,169		11,209		21,960			195.91	%		1.74	%		3.91	%		-2.17	%
Federal funds purchased		378		3,824		(3,446	)		-90.12	%		1.07	%		2.94	%		-1.87	%
Securities sold under repurchase agreements		1,312		2,080		(768	)		-36.92	%		0.31	%		2.61	%		-2.30	%
Federal Home Loan Bank borrowing		89,105		67,170		21,935			32.66	%		0.88	%		2.67	%		-1.79	%
Junior subordinated debentures		13,403		13,403		-			0.00	%		4.59	%		6.05	%		-1.46	%
Total interest bearing liabilities	$	599,621	$	539,619	$	60,002			11.12	%		1.60	%		2.49	%		-0.89	%

At June 30, 2009, the balance of interest bearing liabilities was approximately $41.8 million and $60.0 million higher than that reported over the same three and six month periods ended a year earlier.  During the majority of 2008 and into the first six months of 2009, the Bank experienced continued strong loan demand.  Meeting this demand with appropriately priced funding proved to be challenging, resulting in higher year over year average balances from alternative funding sources.  This is evidenced in the table above, with increases in, brokered time deposits and additional money market deposits obtained from the Reserve.  As conditions in the financial services industry worsened dramatically throughout 2008, many financial institutions in severe need of liquidity engaged in irrational deposit pricing, making it difficult for the Bank to attract and retain core deposits.  Management chose not to engage in this type of pricing and instead pursued other inexpensive sources of funding to meet the demands of borrowers and mitigate any substantial year over year decline in the net interest margin.  However, as deposit pricing began to normalize during 2009, the Bank was able to attract additional core deposits. The Bank attributes deposit growth to several factors including work in making its two bank brands top of mind in both of the Bank’s primary markets.  Growth can also be attributed to the continued focus on providing excellent customer service provided by the Bank’s staff.  Marketing and promotional activities have also been beneficial in increasing core deposit balances as the Bank has seen a flight to quality from some of the larger institutions in our marketplace.  These events have proved to be successful, especially within the second quarter of 2009, as the Bank was able to significantly increase demand deposit, time certificate and money market balances to further pay down FHLB borrowings and begin to reduce its reliance on brokered funds.

Additionally, the Bank stayed relatively short with respect to its interest bearing liabilities during 2008 and into the first quarter of 2009.  This proved to be beneficial with respect to the cost of its interest bearing liabilities as the Federal Reserve moved aggressively to lower the overnight Fed Funds rate by over 400 basis during 2008.  The Bank’s ability to rapidly re-price a significant portion of its interest bearing liabilities in a declining rates environment helped to keep funding costs relatively low and reduce the impact of falling rates on the net interest margin.

- 37 - -

Management’s Discussion and Analysis 

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, 2009 over the same period ended in 2008, 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, 2009 over 2008									June 30, 2009 over 2008
(dollars in thousands)	Volume			Rate			Total			Volume			Rate			Total
Interest Income:
Investments with other banks	$	(1	)	$	(1	)	$	(2	)	$	(4	)	$	-		$	(4	)
Federal funds sold		(125	)		90			(35	)		(3,357	)		3,262			(95	)
Investment securities taxable		78			(53	)		25			190			(82	)		108
Investment securities non-taxable (2)		33			2			35			32			6			38
Taxable equivalent adjustment (2)		(11	)		(1	)		(12	)		(11	)		(2	)		(13	)
Loans (1)		1,068			(1,384	)		(316	)		3,145			(4,405	)		(1,260	)
Net increase (decrease)		1,042			(1,347	)		(305	)		(5	)		(1,221	)		(1,226	)
Interest Expense:
Savings, NOW, money market		(81	)		(167	)		(248	)		(272	)		(729	)		(1,001	)
Time deposits		212			(119	)		93			542			(987	)		(445	)
Brokered funds		5			65			70			96			104			200
Other borrowings		(128	)		(315	)		(443	)		439			(1,021	)		(582	)
Long term debt		-			(30	)		(30	)		-			(98	)		(98	)
Net increase (decrease)		8			(566	)		(558	)		805			(2,731	)		(1,926	)
Total net increase (decrease)	$	1,034		$	(781	)	$	253		$	(810	)	$	1,510		$	700

(1) Loan fees of $225 and $369 for the three months ending June 30, 2009 and 2008 and $483 and $724 for the six months ending June 30, 2009 and 2008, respectively.              

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

Non-Interest Income

The table below sets forth changes in non-interest income for the three and six month periods ended June 30, 2009 compared to the same periods ended in 2008:

	For the three months ended
	June 30,					Variance
(dollars in thousands)	2009			2008		dollar			percentage
Service charges on deposit accounts	$	752		$	837	$	(85	)		-10.16	%
ATM/Debit and credit card transaction/interchange fees		254			232		22			9.48	%
Bancard		55			70		(15	)		-21.43	%
Mortgage origination fees		336			83		253			304.82	%
Earnings on bank owned life insurance		124			119		5			4.20	%
Other commissions and fees		83			378		(295	)		-78.04	%
Gain on sale of investment securities		-			37		(37	)		-100.00	%
Loss on sale of OREO		(104	)		-		(104	)		100.00	%
Total non interest income	$	1,500		$	1,756	$	(256	)		-14.58	%

- 38 - -

Management’s Discussion and Analysis 

	For the six months ended
	June 30,					Variance
(dollars in thousands)	2009			2008		dollar			percentage
Service charges on deposit accounts	$	1,464		$	1,609	$	(145	)		-9.01	%
ATM/Debit and credit card transaction/interchange fees		470			440		30			6.82	%
Bancard		92			113		(21	)		-18.58	%
Mortgage origination fees		665			249		416			167.07	%
Earnings on bank owned life insurance		246			231		15			6.49	%
Other commissions and fees		232			516		(284	)		-55.04	%
Gain on sale of investment securities		122			37		85			229.73	%
Loss on sale of OREO		(131	)		-		(131	)		100.00	%
Total non interest income	$	3,160		$	3,195	$	(35	)		-1.10	%

Non-interest income for the three and six months ended June 30, 2009 decreased approximately $256 thousand or 14.58% and $35 thousand or 1.10%, respectively when compared to the same periods ended in 2008.  Contributing substantially to the year over year declines is the absence of income the Bank recognized in the approximate amount of $272 thousand during the second quarter of 2008 in connection with the Visa, Inc. IPO.  Additionally, losses recognized on the sale of OREO properties during the second quarter of 2009 contributed further to the year over year declines in interest income.

Gains recognized from the sale of five investment securities during the first quarter of 2009 in the approximate amount of $122 thousand helped to offset the year to date decline in non-interest income.

Further offsetting the declines in non-interest income was the substantial year over year increase in mortgage origination fee income.  Income within this category increased approximately $253 thousand or 304.82% and $416 thousand or 167.07% when compared to the same periods ended a year earlier.  The Bank witnessed a significant increase in the number of home loan re-financings during the first six months of 2009 when compared to the same period ended a year earlier as a result of a significantly lower rate environment.

As the result of a significant reduction in the number of competitors in mortgage origination within the Bank’s market, the Bank recognized the opportunity to expand the mortgage origination department. The Bank hired a well seasoned mortgage manager who has been able to expand the Bank’s penetration into the origination market both in San Luis Obispo and Santa Barbara counties. This strategy has performed well at this point as is exhibited by the revenue generation of the department.

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, 2009 when compared to the same period ended in 2008:

	For the three months ended June 30,
(dollars in thousands)	2009		2008		Variance
Dollar volume	$	46,622	$	12,973		259.4	%
Number of loans		149		38		292.1	%

	For the six months ended June 30,
(dollars in thousands)	2009		2008		Variance
Dollar volume	$	88,687	$	29,377		201.9	%
Number of loans		278		83		234.9	%

- 39 - -

Management’s Discussion and Analysis 

Non-Interest Expenses

The table below sets forth changes in non-interest expenses for the three and six month periods ended June 30, 2009 compared to the same periods ended in 2008:

	For the three months ended
	June 30,				Variance
(dollars in thousands)	2009		2008		dollar			percentage
Salaries and employee benefits	$	3,745	$	4,021	$	(276	)		-6.86	%
Occupancy		826		778		48			6.17	%
Equipment		376		351		25			7.12	%
Promotional		225		235		(10	)		-4.26	%
Data processing		691		672		19			2.83	%
Stationery and supplies		99		105		(6	)		-5.71	%
Regulatory fees		537		117		420			358.97	%
Audit and tax costs		147		114		33			28.95	%
Amortization of core deposit intangible		262		215		47			21.86	%
Director fees		80		80		-			0.00	%
Communications		61		79		(18	)		-22.78	%
Other		965		731		234			32.01	%
Total non interest expense	$	8,014	$	7,498	$	516			6.88	%

	For the six months ended
	June 30,				Variance
(dollars in thousands)	2009		2008		dollar			percentage
Salaries and employee benefits	$	7,548	$	8,247	$	(699	)		-8.48	%
Occupancy		1,678		1,551		127			8.19	%
Equipment		701		717		(16	)		-2.23	%
Promotional		326		481		(155	)		-32.22	%
Data processing		1,361		1,326		35			2.64	%
Stationery and supplies		203		224		(21	)		-9.38	%
Regulatory fees		680		225		455			202.22	%
Audit and tax costs		295		228		67			29.39	%
Amortization of core deposit intangible		525		430		95			22.09	%
Director fees		163		158		5			3.16	%
Communications		123		152		(29	)		-19.08	%
Other		1,836		1,379		457			33.14	%
Total non-interest expense	$	15,439	$	15,118	$	321			2.12	%

Salary and Employee Benefits

Salaries and employee related expenses declined approximately $276 thousand and $699 thousand for the three and six month periods ended June 30, 2009 when compared to the same periods ended a year earlier.  Efficiencies the Bank gained with respect to staffing during the later part of 2008 and into 2009 contributed to the majority of the year over year decline within this category.

Occupancy Expenses

Year over year increases within this category are primarily attributable to annual increases in rental expense.

Promotion Expenses

Year over year declines within this category are primarily attributable to cost cutting measures Management implemented during the first quarter of 2009.

- 40 - -

Management’s Discussion and Analysis 

Regulatory Fees

For the three and six months ended June 30, 2009, regulatory fees were approximately $420 thousand and $455 thousand higher than that reported for the same periods ended a year earlier.  During the second quarter of 2009 the Bank took a one time charge in the approximate amount of $388 thousand related to a special assessment imposed by the FDIC on all lending institutions with the intent to replenish the Deposit Insurance Fund. Regular quarterly assessment fees imposed by the FDIC have also increased from year ago levels and may increase further throughout 2009.

Core Deposit Intangible (“CDI”) Amortization

Upon the acquisition of Business First the Company booked CDI in the approximate amount of $3.8 million.  The balance of this intangible will be amortized over a six year period pursuant to a schedule provided in the initial valuation process.  For the three and six months ended June 30, 2009 CDI amortization was approximately $47 thousand and $95 thousand higher than that reported for the same periods ended in 2008 of which substantially all can be attributed to the Business First acquisition.

Other Expenses

Expenses within this category increased approximately $234 thousand and $457 thousand during the three and six months ended June 30, 2009 when compared to the same periods ended a year ago.  The majority of the increase within this category can be attributed to expenses incurred related to the acquisition, write-down and maintenance of foreclosed collateral in the approximate amounts of $193 thousand and $337 thousand for the three and six month periods ended June 30, 2009, respectively.

Year over year increases within this category can also be attributed to increased loan department costs related to strong mortgage origination volume as well as expenses incurred related to collection efforts.  Loan department costs increased approximately $58 thousand and $105 thousand during the three and six month periods ended June 30, 2009 when compared to the same periods ended a year ago.

Management continues to utilize various cost cutting measures in an effort to mitigate the declines seen in net income, resulting in large part from the elevated provisions made to the allowance for loan losses and declines in yields on earning assets. As evidenced in the tables and discussion above, non-interest expenses have declined or remained relatively unchanged in a number of categories, exclusive of one time items such as the special assessment imposed by the FDIC and various OREO related expenses.  Exclusive of these one time items, non-interest expenses for the three and six month periods ended June 30, 2009 would have declined approximately $65 thousand and $404 thousand, respectively.

Provision for Income Taxes

For the three and six month periods ended June 30, 2009 the provision for income taxes was 19.3% and 30.6% of pre tax income compared to 35.5% and 37.3% for the same periods ended a year earlier.  The primary reason behind the year over year decline in the Company’s effective tax rate when compared to the same periods ended a year earlier is attributable to substantial increases in the provision for loan losses and the permanent difference associated with tax exempt interest income the Company earned on municipal securities and income from holdings of bank owned life insurance becoming a larger percentage of overall taxable income.

Provision 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 for loan losses is comprised of three components: specific credit allocation, general portfolio allocation, and subjectively determined allocation.  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.

- 41 - -

Management’s Discussion and Analysis 

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 as of the balance sheet date.  In making this determination, the Bank analyzes the ultimate collectibility of the loans in the portfolio by incorporating feedback provided by internal loan staff, an independent loan review function, and information provided by examinations performed by regulatory agencies.  The Bank makes monthly evaluations as to the adequacy of the allowance for loan losses.

The Bank accounts for problem loans in accordance with 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 credit 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 of the allowance 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 by the Bank’s Directors, Loan Committee and full Board of Directors, 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 loan losses for the three and six months ended June 30, 2009 is consistent with prior periods.

The Bank’s provision for loan losses was $2.7 million and $4.8 million for the three and six month periods ended June 30, 2009 compared to provisions of $2.8 million and $3.0 million for the same periods ended a year earlier.  Provisions made to the allowance for loan losses during the first six months of 2009, were approximately $1.8 million higher than that reported for the same period a year earlier.  As economic conditions throughout 2008 and 2009 worsened on national, state and local levels, the Bank moved to increase the allowance as required by monthly analyses the Bank conducts in determining its adequacy to cover potential losses in the loan portfolio.  The Bank employs the use of a “watch list” and loan grading system to assist in monitoring the quality of certain credits in the loan portfolio.  As loans on the watch list and any other loan within the portfolio experience deterioration, the Bank typically moves to downgrade such loans, resulting in an increase in the required allowance to cover any potential losses.  Management believes the significant economic downturn witnessed during 2008 and that has continued into 2009 has had a considerable impact on the ability of certain borrowers to satisfy their obligations to the Bank, resulting in watch list expansion, loan downgrades and corresponding increases in loan loss provisions.  Additionally, the Bank makes estimates as to the impact that certain economic factors will have on various credits within the portfolio.  Negative economic trends witnessed during 2008 have continued thus far into 2009 and contributed substantially to increases in the required allowance to cover potential losses in the loan portfolio, resulting in year over year increases in loan loss provisions.

Losses in the commercial and industrial, construction and land segments of the loan portfolio during the first six months of 2009 compared to the same period a year earlier increased significantly, contributing to the additional provisions the Bank made to the allowance for loan losses.  Although the majority of losses within these segments of the portfolio were the result of several large write-downs, the Bank has witnessed an increase in the number and total dollar volume of past due loans within the commercial and industrial, construction and land segments.  Additionally, while the Bank saw a decline in the balance of non-accruing loans when compared to that reported a year ago, non-accruing balances remain elevated relative to historical periods, also contributing to increased loan loss provisions.  Continued increases in the level of charge-offs and the number and dollar volume of past due and non-performing loans may result in further provisions to the allowance for loan losses.

Looking forward into 2009, Management anticipates there to be further weakness in economic conditions on national, state and local levels.  Many economic forecasts suggest further increases in the national unemployment rate, which will undoubtedly place continued pressure on conditions within the Bank’s primary market area.  Continued economic pressures may negatively impact the financial condition of borrowers to whom the Bank has extended credit and as a result the Bank may be required to make further significant provisions to the allowance for loan losses during 2009.  That said, Management has been and will continue to be proactive in looking for signs of deterioration within the loan portfolio in an effort to manage credit quality and work with borrowers where possible to mitigate any further losses.

As of June 30, 2009, Management believes, based on all current and available information, the allowance for loan losses is adequate to absorb current estimable losses within the loan portfolio.

- 42 - -

Management’s Discussion and Analysis 

Financial Condition

At June 30, 2009, total assets were $881.4 million.  This when compared to the $805.6 million reported at December 31, 2008, represents an increase of approximately $75.8 million or 9.4%.  Increases in investment securities, federal funds sold, and the net balance of the loan portfolio were primary factors behind the year to date increase in total assets.  An increase of $26.0 million in the balance of federal funds sold are attributable in part to the dramatic increases we saw in deposit balances during the first six months of 2009.  Net increases in the investment portfolio of approximately $25.0 million are the result of purchases the Bank made during 2009 to take advantage of increased credit spreads on investment securities.  During the first six months of 2009, the loan portfolio grew approximately $17.2 million, contributing to overall growth in total assets.

At June 30, 2009, total deposits were approximately $704.0 million or approximately $100.5 million higher than the $603.5 million reported at December 31, 2008.  Increases in non-interest bearing demand and retail time deposits contributed to the year to date increase in deposits.  Deposit growth during the first six months of 2009 allowed the Bank to pay down brokered funds as well as borrowings with the FHLB.  Net of the pay down in brokered funds, total deposits grew approximately $110.6 million from that reported at December 31, 2008.  During the first six month of 2009, FHLB borrowings declined $44.0 million.  See also “Deposits and Borrowed Funds” of this discussion and analysis for additional information related to the changes in deposit balances and wholesale borrowings.

Loans

At June 30, 2009 total gross loan balances were $697.8 million.  This represents an increase of approximately $17.7 million or 2.6% from the $680.1 million reported at December 31, 2008.  Higher real estate secured and commercial loan balances contributed to the majority of the year to date increase in the portfolio.

The following table provides a summary of year to date variances in the loan portfolio as of June 30, 2009:

	June 30,		December 31,		Variance
(dollars in thousands)	2009		2008		dollar			percentage
Real Estate Secured
Multi-family residential	$	17,414	$	16,206	$	1,208			7.45	%
Residential 1 to 4 family		23,626		23,910		(284	)		-1.19	%
Home equity line of credit		29,049		26,409		2,640			10.00	%
Commercial		302,735		285,631		17,104			5.99	%
Farmland		9,639		10,723		(1,084	)		-10.11	%
Commercial
Commercial and industrial		171,208		157,674		13,534			8.58	%
Agriculture		14,231		13,744		487			3.54	%
Other		491		620		(129	)		-20.81	%
Construction
Single family residential		14,710		11,414		3,296			28.88	%
Single family residential - Spec.		10,338		15,395		(5,057	)		-32.85	%
Tract		3,202		2,431		771			31.72	%
Multi-family		5,648		5,808		(160	)		-2.75	%
Hospitality		12,388		18,630		(6,242	)		-33.51	%
Commercial		17,215		21,484		(4,269	)		-19.87	%
Land		57,149		61,681		(4,532	)		-7.35	%
Installment loans to individuals		8,428		7,851		577			7.35	%
All other loans (including overdrafts)		383		536		(153	)		-28.54	%
Total loans, gross		697,854		680,147		17,707			2.60	%
Deferred loan fees		1,555		1,701		(146	)		-8.58	%
Reserve for possible loan losses		11,106		10,412		694			6.67	%
Total loans, net	$	685,193	$	668,034	$	17,159			2.57	%
Loans held for sale	$	11,692	$	7,939	$	3,753			47.27	%

- 43 - -

Management’s Discussion and Analysis 

Real Estate Secured

The following table provides a break-down of the real estate secured segment of the Bank’s loan portfolio as of June 30, 2009:

	June 30, 2009									Percent of					Single
			Undisbursed		Total Bank		Percent			Bank's Risk			Number		Largest
(dollars in thousands)	Balance		Commitment		Exposure		Composition			Based Capital			of Loans		Loan
Retail	$	45,270	$	3,528	$	48,798		11.9	%		50.5	%		67	$	5,000
Professional		70,208		864		71,072		17.3	%		73.6	%		101		8,875
Hospitality		70,540		120		70,660		17.2	%		73.2	%		41		10,891
Multi-family		17,414		-		17,414		4.2	%		18.0	%		19		4,131
Home equity lines of credit		29,049		20,629		49,678		12.1	%		51.5	%		308		1,250
Residential 1 to 4 family		23,626		615		24,241		5.9	%		25.1	%		65		3,000
Farmland		9,639		1,465		11,104		2.7	%		11.5	%		23		1,937
Healthcare / medical		16,005		-		16,005		3.9	%		16.6	%		29		2,155
Restaurants / food establishments		7,173		-		7,173		1.7	%		7.4	%		13		2,541
Commercial		76,198		1,396		77,594		18.9	%		80.4	%		108		4,714
Other		17,341		71		17,412		4.2	%		18.0	%		32		2,100
Total real estate secured	$	382,463	$	28,688	$	411,151		100.0	%		425.8	%		806	$	46,594

As of June 30, 2009, real estate secured balances represented approximately $382.5 million of total gross loans.  This when compared to the $362.9 million reported at December 31, 2008, represents an increase of approximately $19.6 million or 5.4%.  The primary factor behind the year to date increase can be attributed to higher commercial real estate balances.  Year to date increases within this category can be attributed to the completion of several large construction projects and their subsequent reclassification from construction to commercial real estate.  The aggregate balance of these large loans was approximately $14.9 million at June 30, 2009.  During the first six months of the year the Bank also made several new loans in excess of $1.0 million.  The aggregate balance of these loans was approximately $7.3 million as of June 30, 2009.  These new loans were made to borrowers in the industries of commercial and hospitality.  The Bank also had several large payoffs and pay downs in excess of $0.5 million during the first six months of the year, totaling approximately $3.7 million.

Loans classified as multi-family residential also contributed to the year to date increase within the real estate secured portfolio.  Contributing substantially to the year to date increase was the funding of one loan in the aggregate amount of $2.3 million.  This loan was made to a non profit organization within the Bank’s primary market.  Notable pay downs within this category include the pay down of one loan in the aggregate amount of $1.4 million.

HELOC disbursements also contributed to the year to date increase within the real estate secured portfolio, rising approximately $2.6 million from the $26.4 million reported at December 31, 2008.

At June 30, 2009, real estate secured commitments represented approximately 425.8% of the Bank’s total risk based capital.  This when compared to the 510.7% reported at December 31, 2008, represents a decline of 84.9 percentage points.  The additional capital obtained under the U.S. Treasury’s CPP is the primary factor behind the year to date decline.  While the real estate secured portfolio in aggregate represents a concentration, no single category within this segment of the portfolio is considered a concentration as of June 30, 2009.

At June 30, 2009, approximately $160.2 million or 41.9% of the real estate secured segment of the loan portfolio was considered owner occupied.

Capitalization rates, the rate at which a stream of cash flows are discounted to find their present value, on commercial properties in our primary market area for the last three years were as follows: 5.0% to 6.5% in 2006, 6.0% to 7.0% in 2007, and 4.5% to 8.0% in 2008.  A recent uptick in capitalization rates would indicate that we are seeing some pressure on commercial real estate prices within our market, primarily resulting from weakened economic conditions.

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 was renewed in July 2009 and will expire in September 2010.

- 44 - -

Management’s Discussion and Analysis 

Commercial

The following table provides a break-down of the commercial and industrial segment of the Bank’s commercial loan portfolio as of June 30, 2009:

	June 30, 2009									Percent of					Single
			Undisbursed		Total Bank		Percent			Bank's Risk			Number		Largest
(dollars in thousands)	Balance		Commitment		Exposure		Composition			Based Capital			of Loans		Loan
Agriculture	$	3,827	$	2,732	$	6,559		2.5	%		6.8	%		29	$	2,000
Oil, gas and utilities		2,129		1,133		3,262		1.3	%		3.4	%		12		1,200
Construction		19,751		15,138		34,889		13.4	%		36.1	%		173		2,750
Manufacturing		11,218		9,989		21,207		8.2	%		22.0	%		111		2,100
Wholesale and retail		16,379		6,453		22,832		8.8	%		23.6	%		126		1,250
Transportation and warehousing		2,796		659		3,455		1.3	%		3.6	%		35		596
Media and information services		10,702		2,191		12,893		5.0	%		13.4	%		27		8,000
Financial services		17,931		7,483		25,414		9.8	%		26.3	%		51		6,000
Real estate / rental and leasing		16,985		10,430		27,415		10.5	%		28.4	%		95		3,500
Professional services		18,350		8,657		27,007		10.4	%		28.0	%		144		2,000
Healthcare / medical & social services		19,976		19,758		39,734		15.3	%		41.2	%		120		11,355
Restaurants and hospitality		23,024		3,291		26,315		10.1	%		27.3	%		113		6,000
All other		8,140		757		8,897		3.4	%		9.2	%		60		2,062
Total commercial and industrial	$	171,208	$	88,671	$	259,879		100.0	%		269.3	%		1,096	$	48,813

At June 30, 2009, commercial loans represented approximately $185.9 million of total gross loan balances.  This when compared to the $172.0 million reported at December 31, 2008, represents an increase of approximately $13.9 million or 8.1%.  Increases in the commercial and industrial category were the primary factor behind the year to date increase.

During the first six months of the year the Bank made several new loans as well as notable disbursements in amounts in excess of $1.0 million, totaling approximately $9.5 million.  These new loans and disbursements were made to borrowers in the following industries: healthcare / medical, wholesale and retail, real estate / rental and leasing, oil / gas and utilities, and construction.

Although the commercial and industrial category as a whole does represent a concentration at 269.3% of the Bank’s total risk based capital, there was no one particular industry to which the Bank has extended credit within the commercial and industrial category that represented a concentration as of June 30, 2009.  At June 30, 2009, commercial and industrial commitments as a percent of the Bank’s total risk based capital were approximately 269.3% or 54.7 percentage points lower than the 324.0% reported at December 31, 2008.  The additional capital obtained under the U.S. Treasury’s CPP is the primary factor behind the year to date decline.

Construction

The following table provides a break-down of the construction segment of the Bank’s loan portfolio as of June 30, 2009:

	June 30, 2009									Percent of					Single
			Undisbursed		Total Bank		Percent			Bank's Risk			Number		Largest
(dollars in thousands)	Balance		Commitment		Exposure		Composition			Based Capital			of Loans		Loan
Single family residential	$	14,710	$	6,139	$	20,849		23.9	%		21.6	%		24	$	4,600
Single family residential - Spec.		10,338		725		11,063		12.7	%		11.5	%		9		3,480
Tract		3,202		188		3,390		3.9	%		3.5	%		15		532
Multi-family		5,648		1,611		7,259		8.3	%		7.5	%		5		3,584
Commercial		17,215		13,255		30,470		34.9	%		31.6	%		24		6,100
Hospitality		12,388		1,928		14,316		16.3	%		14.8	%		3		7,359
Total construction	$	63,501	$	23,846	$	87,347		100.0	%		90.5	%		80	$	25,655

At June 30, 2009, construction balances represented approximately $63.5 million or 9.1% of total gross loan balances.  This when compared to the $75.2 million reported at December 31, 2008, represents a decline of approximately $11.7 million or 15.6%.

- 45 - -

Management’s Discussion and Analysis

As previously stated the primary factor behind the year to date decline can be attributed to construction loans moving into amortizing loans under the commercial real estate category as well as a general decline in demand for loans of this type in the current economic environment.

Year to date declines in the category of single family residential – spec can be attributed in large part to the charge off of several loans and their subsequent movement into OREO status, totaling approximately $6.0 million.

Declines in the categories of commercial and hospitality are attributable in large part to balances moving to commercial real estate upon completion of underlying projects as well as pay downs.

At June 30, 2009 total construction commitments represented approximately 90.5% of the Bank’s total risk based capital.  This when compared to the 135.9% reported at December 31, 2008, represents a decline of approximately 45.4 percentage points.  The additional capital obtained under the Company’s participation in the U.S. Treasury’s CPP contributed substantially to the year to date decline.  Approximately $25.1 million or 39.5% of the Bank’s construction portfolio was considered owner occupied as of June 30, 2009.

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.

Land

The following table provides a break-down of the land segment of the Bank’s loan portfolio as of June 30, 2009:

	June 30, 2009									Percent of					Single
			Undisbursed		Total Bank		Percent			Bank's Risk			Number		Largest
(dollars in thousands)	Balance		Commitment		Exposure		Composition			Based Capital			of Loans		Loan
Single family residential	$	8,201	$	92	$	8,293		13.8	%		8.6	%		26	$	1,200
Single family residential - Spec.		2,067		-		2,067		3.4	%		2.1	%		8		618
Tract		30,495		1,616		32,111		53.5	%		33.3	%		11		12,208
Multi-family		1,509		3		1,512		2.5	%		1.6	%		3		675
Commercial		10,796		1,119		11,915		19.9	%		12.3	%		21		1,500
Hospitality		4,081		-		4,081		6.9	%		4.2	%		4		2,340
Total land	$	57,149	$	2,830	$	59,979		100.0	%		62.1	%		73	$	18,541

At June 30, 2009, land balances represented approximately $57.1 million or 8.2% of total gross loan balances.  When compared to the $61.7 million reported at December 31, 2008, land balances declined approximately $4.6 million.  The year to date decline can be attributed to the pay down / payoff of several loans in the aggregate amount of $2.7 million.  Additionally, during the first six months of the year the Bank charged off and subsequently moved to OREO approximately $3.3 million in land balances, contributing to the year to date decline.

New loans within this category include five loans to five borrowers in the aggregate amount of $1.3 million.  The majority of these loans are classified as land – commercial as of June 30, 2009 and were made to borrowers within the Bank’s primary market area.

Two of the largest existing loans within this category consist of loans for residential tract developments in the aggregate amount of $11.8 million.  These projects are located in Kern County of the California Central Valley.  One project is approved for 314 single family lots.  This project 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 had an approximate loan to value of 50.0%, based on an appraisal conducted at the time.  At June 30, 2009 the balance of this loan was approximately $11.3 million, with approximately $0.9 million un-disbursed.  However, given the current economic environment, the borrower intends to delay commercial and residential development of the property and instead has begun to develop the project site into a rock quarry operation, with limited competition for this business in the borrower’s market.   The borrower has begun to receive cash flows from these operations and it is anticipated that it will provide significant cash flows in future periods to help pay down the loan.  To that end, the Bank intends to order a new appraisal of the property, including the quarry, during the third quarter of 2009 and require, if necessary, the borrower to provide a principal reduction in order to maintain a maximum LTV of 50.0% based on new appraisals.  Additionally, the Bank anticipates this loan to be reclassified from land tract development to commercial and industrial.

- 46 - -

Management’s Discussion and Analysis

The purpose of the second project is to provide affordable housing to a market that generally consists of renters and is the only new housing development in its area.  This loan funded in March 2008 at approximately $4.1 million and has subsequently been paid down by approximately $3.6 million from proceeds of sold homes, with approximately $1.7 million in pay downs occurring during the first six months of 2009.  The borrower is actively marketing the remaining finished homes and sales continue to occur at a rate of one to two homes per month.  Additionally, the housing in this project qualifies for the USDA Direct Loan program whereby individuals or families receive financial assistance directly from the Housing and Community Facilities Programs (“HCFP”) in the form of a home loan at an affordable interest rate.  As of June 30, 2009, these loans were performing under the contractual terms of their respective loan agreements.

The Bank does not typically make loans outside of its market footprint unless the potential for a long term relationship, including the acquisition of additional core deposits, exists.  Kern County, while contiguous to San Luis Obispo County is somewhat outside of the Company’s market footprint, has a population of approximately 800,000 and depends on agriculture, oil, light industry, warehousing and distribution, and educational services to support its economy.  This region of California’s Central Valley has experienced significant population growth in recent years relative to other areas of the state.  Affordable housing, compared to other metropolitan areas within California, has been a significant factor behind the growth in Kern County’s population.  However, like many other areas within California, real estate prices within the California Central Valley have fallen significantly, with recent indications showing year over year declines of 30% - 40% within Kern County, specifically.  Management acknowledges that as economic conditions worsen across the state, the level of growth previously experienced within the California Central Valley as well the purchasing power of consumers within that market will no doubt be negatively impacted.  As such, Management continues to carefully monitor loans made to borrowers in the Central Valley for any sign of deterioration.

At June 30, 2009 total land commitments represented 62.1% of the Bank’s total risk based capital.  When compared to the 85.2% reported at December 31, 2008, this represents a decline of approximately 23.1 percentage points.  The additional capital obtained under the Company’s participation in the U.S. Treasury’s CPP contributed substantially to the year to date decline.

At June 30, 2009 approximately $9.4 million or 16.5% of total land balances were considered owner occupied.

Installment

At June 30, 2009, the installment loan balances were approximately $8.4 million.  This, when compared to the $7.9 million reported at December 31, 2008, represents an increase of approximately $0.5 million.  Installment loans include revolving credit plans, consumer 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, 2009 mortgage correspondent loans (loans held for sale) totaled approximately $11.7 million.  This when compared to the $7.9 million reported at December 31, 2008, represents an increase of approximately $3.8 million.  The dramatic year over year decline in interest rates has lead to significantly higher mortgage re-financing volumes, which combined with the Bank's expansion of its mortgage origination department to further the Bank's penetration its market, have contributed substantially to the year to date increase within this category.

Foreign Loans

At June 30, 2009 the Bank had no foreign loans outstanding.

- 47 - -

Management’s Discussion and Analysis

Summary of Market Condition

The residential real estate market came under significant pressure during 2008 and has shown no significant signs of improvement thus far in 2009.  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.  Additionally, as conditions in the credit markets worsened during 2008, financial institutions became more reluctant to extend new credit to borrowers, pushing the cost of certain types of credit higher in a rates down environment and contributing further to the decline in real estate prices.  As more and more home owners began to see interest rates reset higher on adjustable rate mortgages late in 2007 and into 2008, the number of delinquent and non-performing loans rose significantly in the industry as a whole and have remained at elevated levels thus far in 2009.  During the later part of 2008, the credit markets came under increasingly intense pressure, specifically during the third and fourth quarters. This was fueled in part by a widespread lack of confidence in the U.S. financial system, which led many financial institutions to further tighten the extension of new credit given concerns over the lack of liquidity, asset quality, and the conservation of capital.  Also contributing significantly to the troubles seen in the housing market and U.S. financial system have been a weakened economy and consequently higher levels of unemployment, placing considerable pressure on the U.S. consumer’s ability to satisfy their outstanding obligations to the financial sector.  The Company believes these factors have placed pressure on certain borrowers in the Bank’s market, contributing to the increased level of non-performing assets the Bank experienced during 2008 and thus far into 2009.

Prices of single family homes have fallen significantly year over year in the Company's market area and California as a whole, with recent indications showing price declines in excess of 30% to 40% statewide and 29% to 34% within the Company's market area.  Along with other segments in the real estate sector, commercial real estate prices in the Company's market area experienced some pressure during 2008 and the Company has begun to see increases in vacancy rates in certain retail, industrial and office segments.  The most recent data available to the Company shows vacancy rates within retail, industrial and office segments to be approximately 3.0%, 5.4% and 6.1%, respectively as of the third quarter of 2008.  When compared to levels in the year ago period, this represents respective increases of approximately 160, 310 and 260 basis points.  The Company realizes that any prolonged and significant downturn in the national and local economies may further impact the values of commercial real estate within its market footprint as well as the borrowers to whom the Bank has extended such credit.  As such, Management continues to closely monitor the credits within this segment of the loan portfolio for potential signs of deterioration.  Additionally, the Bank is aware that as economic conditions worsen and levels of unemployment continue to rise, borrowers to whom the Bank has extended commercial lines of credit may come under additional pressure to satisfy their outstanding obligations.  That said, the Bank continues to employ stringent lending standards and remains very selective with regard to any additional commercial real estate, real estate construction, land and commercial loans it chooses to originate in an effort to effectively manage risk in this difficult credit environment.

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 previously mentioned, with the effects of a weakened economy placing more pressure on borrowers, the ability of consumers to satisfy outstanding obligations to the financial sector, as a whole, 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.  This has no doubt had an impact on the level of and type of loans the Bank has placed on non-accrual and charged-off during 2008 and into 2009.  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 effects of weakened economic conditions may have on the Bank overall.

As of June 30, 2009, substantially all loans the Bank originated within the major categories of commercial real estate, construction, land, and commercial and industrial were made to borrowers within our current market footprint.

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.  Semi-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, internal loan classifications 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 accrued but uncollected interest income is reversed from earnings.  Once on non-accrual status payments received on such loans are applied as a reduction of the loan principal balance.  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.  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.

- 48 - -

Management’s Discussion and Analysis

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 collateral is recognized by a charge to the allowance for loan losses.  When collateral is held for sale after foreclosure, it is subject to a periodic appraisal.  If the appraisal indicates that the collateral will sell for less than its recorded value, the Bank recognizes the loss by a charge to non-interest expense.

Management acknowledges that due to negative undertones associated with the economy and real estate markets, the internal watch list has expanded over the last twelve months.  While credit quality is consistently monitored, 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 monitor those credits.  Although the Bank believes these actions will serve to potentially minimize any future losses the Bank may incur related to problem loans, we cannot guarantee that the Bank will not experience an increase in non-performing loans.

The following table provides a summary of non-accruing loans as of June 30, 2009 and December 31, 2008:

	June 30,			December 31,
(dollars in thousands)	2009			2008
Loans delinquent 90 days or more and still accruing	$	140		$	348
Non-Accruing Loans:
Commercial real estate	$	2,776			1,961
Residential 1-4 family		392			265
Home equity lines of credit		320			320
Commercial		5,316			7,060
Agriculture		384			-
Construction		2,267			5,990
Land		511			2,720
Installment loans		132			11
Total non-accruing loans	$	12,098		$	18,327
Other real estate owned	$	6,669		$	1,337
Total non-performing assets	$	18,907		$	20,012
Ratio of allowance for credit losses to total gross loans		1.59	%		1.53	%
Ratio of allowance for credit losses to total non-performing loans		90.75	%		55.75	%
Ratio of non-performing loans to total gross loans		1.75	%		2.75	%
Ratio of non-performing assets to total assets		2.15	%		2.48	%

At June 30, 2009 the balance of non-accruing loans was approximately $12.1 million or $6.2 million lower than the $18.3 million reported at December 31, 2008.  Notable changes in the balance of non-accruing loans occurred within the categories of commercial real estate, commercial and industrial, construction and land.  Contributing substantially to the year to date decline in non-accruing balances were pay downs the Bank received on non-accruing loans of approximately $1.3 million, charge-offs of approximately $4.1 million, and approximately $8.4 million in balances moving to OREO status.  Additionally, the Bank returned two loans totaling approximately $1.3 million to accruing status after working with the respective borrowers.  Offsetting these factors was the addition of $8.8 million in loans to non-accruing status during the first six months of 2009.

Non performing assets totaled approximately $18.9 million at June 30, 2009, approximately $1.1 million lower than that reported at December 31, 2008.  At June 30, 2009, the allowance for loan losses was approximately $11.1 million or 1.59% of total gross loans.  When compared to the $10.4 million or 1.53% reported at December 31, 2008, the allowance increased approximately $0.7 million.  During the three and six months ended June 30, 2009, the Bank made provisions to the allowance for loan losses in the amounts of $2.7 million and $4.8 million, respectively.  Net charge-offs for the three and six months ended June 30, 2009 totaled approximately $2.0 million and $4.1 million, respectively.

- 49 - -

Management’s Discussion and Analysis

The following table reconciles the change in non accruing balances for the six months ended June 30, 2009:

	Balance		Additions to											Transfers			Balance
	December 31,		Non-Accruing		Net						Returns to			to OREO			June 30,
(dollars in thousands)	2008		Balances		Paydowns			Charge-offs			Accrual			Status			2009
Real Estate Secured
Multi-family residential	$	-	$	-	$	-		$	-		$	-		$	-		$	-
Residential 1 to 4 family		265		146		(19	)		-			-			-			392
Home equity line of credit		320		-		-			-			-			-			320
Commercial		1,961		1,398		(548	)		-			-			(35	)		2,776
Farmland		-		-		-			-			-			-			-
Commercial
Commercial and industrial		7,060		1,584		(347	)		(1,225	)		(14	)		(1,742	)		5,316
Agriculture		-		385		(1	)		-			-			-			384
Other		-		-		-			-			-			-			-
Construction
Single family residential		-		823		-			(145	)		-			-			678
Single family residential - Spec.		5,990		2,839		-			(1,676	)		(1,250	)		(4,314	)		1,589
Tract		-		-		-			-			-			-			-
Multi-family		-		-		-			-			-			-			-
Hospitality		-		-		-			-			-			-			-
Commercial		-		-		-			-			-			-			-
Land		2,720		1,421		(362	)		(991	)		-			(2,277	)		511
Installment loans to individuals		11		224		(2	)		(101	)		-			-			132
All other loans		-		-		-			-			-			-			-
Totals	$	18,327	$	8,820	$	(1,279	)	$	(4,138	)	$	(1,264	)	$	(8,368	)	$	12,098

The following table reconciles the change in balances classified as 90 days past due and still accruing for the six months ended June 30, 2009:

	Balance		Additions to		Transfers to					Transfers		Balance
	December 31,		90 Day Plus		Non-Accruing					to OREO		June 30,
(dollars in thousands)	2008		Balances		Status			Charge-offs		Status		2009
Loans 90 days deliquent or  more and still accruing	$	348	$	582	$	(790	)	$	-	$	-	$	140

The following provides additional information regarding non-accruing loans and OREO balances as of June 30, 2009:

Real Estate Secured Commercial

Comprising a considerable portion of balances within this category are two loans to one borrower in the aggregate amount of $1.1 million.  Both of these loans are well secured and the Bank is working with the borrower to liquidate the collateral and expects no loss to be incurred at this time.  During the second quarter of 2009, the Bank received proceeds in the amount of $0.5 million from the sale of collateral securing one loan as well as approximately $42 thousand in principal pay downs on two other credits, bringing the balance of CRE non-accruing loans down slightly from that reported at March 31, 2009.  However, balances within this category increased approximately $0.8 million when compared to that reported at December 31, 2008.

Commercial and Industrial

During the first six months of 2009, the Bank added approximately $1.6 million to non-accruing status within the commercial and industrial segment.  Of the $1.2 million in charge-offs occurring within this segment, approximately $0.7 million can be attributed to three loans, while $0.4 million can be attributed to several smaller loans added to non-accruing status during the second quarter and subsequently charged-off.  The Bank also moved two loans to one borrower in the aggregate amount of $1.7 million to OREO status during the second quarter of 2009.  These loans are secured by commercial property within the Bank’s primary market.  At June 30, 2009, the majority of balances on non-accrual within this segment consisted of one loan to one borrower in the approximate amount of $3.6 million.  This loan is secured by property within the Bank’s primary market.

- 50 - -

Management’s Discussion and Analysis

Construction Single Family Residential

Balances within this category consist of two loans to two borrowers.  The Bank is currently working with the borrowers to liquidate the collateral.  Collateral securing these loans is located in the Bank’s primary market.

Single Family Residential- Spec

At June 30, 2009 the balance of non-accruing loans within this category consisted of one loan to one borrower and is secured by real estate in the Bank’s primary market.  The Bank is currently working with the borrower to liquidate the collateral.  Additions to this category during the first six months of 2009 include the loan previously mentioned as well as another loan in the amount of $1.3 million.  After working with the borrower, the loan was brought current and subsequently returned to accruing status during the second quarter of 2009.  During the first six month of 2009, the Bank moved four loans to two borrowers to OREO status, totaling approximately $4.3 million.  During the second quarter of 2009 the Bank sold two of these properties for $2.4 million as well as another single family residential – spec property, previously booked to OREO, for approximately $0.5 million.  In connection with the sale of these properties the Bank recorded aggregate losses of approximately $104 thousand.

Additionally, more recent indications obtained from prospective buyers of these distressed assets have given Management a more refined picture of how the market expects to price certain types of properties in the current environment. This has provided more evidence to extrapolate fair values for similar types of collateral.

Land

At June 30, 2009, the balance of non-accruing land loans was approximately $0.5 million or $2.2 million lower than that reported at December 31, 2008.  During the first six months of 2009, the Bank moved approximately $2.3 million in balances within this segment to OREO status following charge-offs of approximately $1.0 million.  The Bank also received approximately $0.4 million in principal payments, the majority of which can be attributed to proceeds received from the guaranteed portion of one loan.

At June 30, 2009, all non accruing balances were carried at their current fair values.

Other Real Estate Owned (“OREO”)

The following table provides a summary for the year to date change in the balance of OREO as of June 30, 2009:

	For the six months ended
(dollars in thousands)	June 30, 2009
Balance December 31, 2008	$	1,337
Additions		8,403
Dispositions		(2,998	)
Write-downs		(73	)
Balance June 30, 2009	$	6,669

As of June 30, 2009, the balance of OREO was approximately $6.7 million, an increase of approximately $3.8 million from the first quarter and $5.3 million higher than that reported at December 31, 2008.  During the first six months of 2009, the Bank sold four properties, resulting in a reduction in the balance of OREO of approximately $3.0 million, as represented in the table above.  The majority of OREO sales occurred during the second quarter, with approximately $2.9 million moving out of OREO.

As discussed in Note 10. Subsequent Events, to the consolidated financial statements, the Bank closed escrow for the sale of three additional OREO properties in late July 2009.  In connection with the sale of these properties, the Bank received aggregate proceeds of approximately $2.5 million and recognized an aggregate pre-tax loss of approximately $0.3 million in July 2009.  Two of these properties were classified as single family residential  - spec and one property was classified as land.

Total Cash and Cash Equivalents

Total cash and due from banks was $48.3 million and $24.6 million at June 30, 2009 and December 31, 2008, respectively. This line item will vary depending on cash letters from the previous night and actual cash on hand in the branches.  Additionally, increased deposit balances are reflected in higher balances of federal funds sold.

- 51 - -

Management’s Discussion and Analysis

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.

The table below summarizes the year to date change in the balances of other earning assets as of June 30, 2009:

	June 30,		December 31,		Variance
(dollars in thousands)	2009		2008		dollar		percentage
Federal Home Loan Bank stock	$	5,828	$	5,123	$	705		13.76	%
Available for sale securities		75,726		50,762		24,964		49.18	%
Federal funds sold		32,675		6,650		26,025		391.35	%
Interest bearing deposits other financial institutions		119		119		-		0.00	%
Total other earning assets	$	114,348	$	62,654	$	51,694		82.51	%

Federal Home Loan Bank (“FHLB”) Stock

As a member of the Federal Home Loan Bank of San Francisco, the Bank is required to hold a specified amount of FHLB capital stock based on the level of borrowings the Bank has obtained from the FHLB.  As such, the amount of FHLB stock the Bank carries can vary from one period to another based on among other things the current liquidity needs of the Bank.  At June 30, 2009, the Bank held approximately $5.8 million in FHLB stock, an increase of approximately $0.7 million from that reported at December 31, 2008.

Available for Sale Investment Securities

At June 30, 2009 the balance of available for sale investment securities was approximately $75.7 million, $25.0 million or 49.2% higher than that reported at December 31, 2008.  The change in the balance of the portfolio can be attributed in large part to purchases the Bank made in the aggregate amount $38.6 million, sales, calls and maturities of securities in the aggregate amount of $5.9 million and principal pay downs totaling approximately $5.4 million.

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.

Securities available-for-sale are carried at fair value, with related unrealized net gains or losses, net of deferred income taxes, recorded as an adjustment to equity capital.  At June 30, 2009 the securities portfolio had a net unrealized loss, net of income taxes of approximately $2.5 million.  This represents an increase in the net unrealized loss position of approximately $1.4 million when compared to that reported at December 31, 2008.  The year to date decline in the fair value of the securities portfolio can be attributed in large part to the decline in the value of several mortgage related securities as a result of downgrades and continued market concerns surrounding such investments.

The Bank had a total of nine whole loan CMO’s in the investment portfolio as of June 30, 2009 with a remaining principal balance of approximately $17.2 million.  This when compared to the $18.9 million in remaining principal reported at December 31, 2008, represents a decline of approximately $1.7 million or 9.0%.  These securities had a net unrealized loss of approximately $4.4 million at June 30, 2009.  This represents an increase in the net unrealized loss of approximately $2.3 million or 91.3% from that reported at December 31, 2008.

The Bank continues to perform extensive analyses on the underlying tranches associated with all CMOs in the portfolio.  By analyzing the tranche separate from the “mother” security, the Bank has determined that there is no impairment and as such, is not taking any action to write-down these securities. These investment securities continue to demonstrate cash flows as expected, based on pre-purchase analyses, and the credit support component of these tranches has actually increased from the origination date.  As of June 30, 2009, Management does not believe the decline in market value of these securities is other than temporary.

- 52 - -

Management’s Discussion and Analysis

During the third and fourth quarters of 2008, the credit markets came under significant duress as investor and consumer confidence in the U.S. financial system became significantly destabilized.  As a result, many financial institutions in severe need of liquidity were forced to de-leverage for a variety of reasons, selling significant portions of their investment holdings which in turn placed considerable pressure on the values of many classes of investment securities.  In particular, mortgage related securities came under substantial pressure and the Bank’s portfolio was not completely immune to this.  Although substantially all of the Bank’s mortgage related securities are considered “investment grade,” overall lack of confidence in the housing market, the inability of many consumers to meet their mortgage related obligations, and the strong need for liquidity have, among other things, been influential in placing pressure on the prices of these types of securities.

The majority of the Bank’s mortgage securities 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.

Federal Funds Sold

The year to date increase in the balance of federal funds sold can be attributed in large part to higher deposit balances.  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. Management  continues to implement strategies for deployment of excess funds, including the origination of  high quality loans and investments in securities, while ensuring the Bank continues to maintain appropriate levels of liquidity.

Deposits and Borrowed Funds

The following table provides a summary for the year to date change in various categories of deposit balances as of June 30, 2009:

											Variance Exclusive of
	June 30,		December 31,		Variance						Volatile Balances
(dollars in thousands)	2009		2008		dollar			percentage			dollar			percentage
Non-interest bearing demand	$	178,600	$	147,044	$	31,556			21.46	%	$	13,108			8.91	%
Interest bearing demand		64,723		72,952		(8,229	)		-11.28	%		10,982			15.05	%
Savings		24,792		21,835		2,957			13.54	%		2,957			13.54	%
Money market		190,661		173,199		17,462			10.08	%		18,134			10.47	%
Time deposits		206,708		139,872		66,836			47.78	%		66,836			47.78	%
Total retail deposits		665,484		554,902		110,582			19.93	%		112,017			20.19	%
Brokered time deposits		28,503		20,117		8,386			41.69	%		8,386			41.69	%
Brokered money market funds		10,002		28,502		(18,500	)		-64.91	%		(18,500	)		-64.91	%
Total brokered deposits		38,505		48,619		(10,114	)		-20.80	%		(10,114	)		-20.80	%
Total deposits	$	703,989	$	603,521	$	100,468			16.65	%	$	101,903			16.88	%

Deposits

During the first six months of 2009, the Bank placed considerable emphasis on the acquisition of additional core deposits.  The focus on this initiative proved to be successful as the Bank saw core deposit balances (non-interest and interest bearing demand, savings, money market and time certificate accounts with balances less than $100 thousand) increase approximately $68.8 million during the first six months of 2009 from that reported at December 31, 2008, with significant increases in non-interest bearing demand, money market and time certificate of deposit accounts.

- 53 - -

Management’s Discussion and Analysis

In an effort to rely less on FHLB borrowings and maintain an appropriate mix of secondary funding, the Bank purchased brokered deposits to assist in the funding of balance sheet growth and to provide an additional source of liquidity.  At June 30, 2009, brokered deposit balances totaled approximately $38.5 million, a decline of approximately $10.1 million from that reported at December 31, 2008 and a decline $46.0 million from that reported at March 31, 2009.  Declines in brokered funds can be attributed to the significant growth in core deposits.

Volatile Deposits

The Bank monitors the balance of various accounts that it considers to be volatile for a variety of reasons and provides this data to the Board of Directors on a regular basis.  Accounts may be added to or removed from the volatile liability dependency report when, based on Management’s judgment, it is determined that these funds are not suitable for any form of long term investment or that the risk associated with these funds leaving the Bank has become minimal.  Typically a material change in the balances of these accounts is reflected in the balance of federal funds sold.  At June 30, 2009, the aggregate balance of deposits the Bank considers to be volatile was approximately $59.9 million or $1.6 million lower that that reported at December 31, 2008.

The following table provides a summary of the deposit balances the Bank considers to be volatile as of June 30, 2009 and December 31, 2008:

			Percent of					Percent of
	June 30,		Total			December 31,		Total			Dollar
(dollars in thousands)	2009		Deposits			2008		Deposits			Variance
Non-interest bearing demand	$	29,641		4.2	%	$	11,193		1.9	%	$	18,448
Interest bearing demand		2,484		0.4	%		21,695		3.6	%		(19,211	)
Savings		-		0.0	%		196		0.0	%		(196	)
Money market deposits		27,810		3.9	%		28,482		4.7	%		(672	)
Total volatile deposits	$	59,935		8.5	%	$	61,566		10.2	%	$	(1,631	)

The year to date decline in balances the Bank considers to be volatile can be attributed in large part to declines in volatile interest bearing demand balances of approximately $19.2 million.  The year to date decline within this category is the result of two relationships leaving the Bank, the majority of which are considered public funds.  These declines were partially offset by a dramatic increase in volatile non-interest bearing demand balances.  The customers that hold these deposits engage in mortgage related activities.  As more and more home owners have moved to re-finance existing mortgages, given the current rate environment, deposit balances related to these customers have increased.  Management and the Board of Directors are aware that as conditions in the market change these relationships will be impacted.

Borrowed Funds

The Bank has a variety of sources from which it may obtain secondary funding.  These sources include, among others, the FHLB, credit lines established with correspondent banks and various sources that provide brokered funds.  Borrowings are obtained for a variety of reasons which include, but are not limited to, funding loan growth and the purchase of investments in the absence of core deposits and to provide additional liquidity to meet the demands of depositors.

At June 30, 2009, borrowings obtained from the FHLB comprised the majority of borrowed funds.  The following table provides a summary of FHLB borrowings the Bank had outstanding as of June 30, 2009:

(dollars in thousands)

Amount		Interest				Maturity
Borrowed		Rate			Variable/Fixed	Date
$	55,000		0.14	%	Variable	Open
	10,000		2.89	%	Fixed	9/16/10
$	65,000		0.56	%

As evidenced in the table above, the balance of FHLB borrowing as of June 30, 2009 was $65.0 million.  This represents a decline of approximately $44.0 million from the balance reported at December 31, 2008.  The year to date decline can be attributed to higher deposit balances during the first six months of 2009.

- 54 - -

Management’s Discussion and Analysis

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.  The Company pledged 646,598 shares (51%) of the Bank’s stock as collateral for the loan. The note is revolving in nature for the first two years. The terms of the note call for quarterly interest only payments for the first two years with subsequent principal and interest payments for eight years on a fully amortized basis.  At June 30, 2009 the interest rate on the note was 3.25% 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.  At June 30, 2009, the Company had no balance outstanding on this note.

On September 17, 2004, the Bank issued a Letter of Credit in the amount of approximately $11.7 million, which has since been reduced to $11.4 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 was renewed in July 2009 and will expire in September 2010.

Capital

At June 30, 2009, the balance of stockholders’ equity was approximately $91.3 million.  This, when compared to the $70.0 million at December 31, 2008, represents an increase of approximately $21.3 million. The year to date change in capital is due primarily to $21.0 million in Senior Preferred Stock the Company issued to the U.S. Treasury as part of its participation in the CPP.   Additionally, the year to date change is also attributed to net income of $1.6 million, the impact of year-to-date share-based compensation expense in the amount of $0.2 million, dividends paid and accretion on senior preferred stock in the amount of $0.2 million, proceeds from the exercise of options in the amount of $46 thousand and a decline in the balance of accumulated other comprehensive income in the amount of $1.4 million.

Senior Preferred Stock

On March 20, 2009, the Company issued $21.0 million in Senior Preferred Stock to the U.S. Treasury as part of its participation in the CPP.  Pursuant to the terms under the CPP, the Company is required to pay dividends on the Senior Preferred Stock in an amount equal to 5% per annum for five years and 9% per annum thereafter.  Dividends are cumulative and payable quarterly. Pursuant to an interim rule issued by the Federal Reserve Board, effective October 17, 2008, all $21.0 million of preferred stock the Company issued under the CPP qualifies as Tier I Capital.

Pursuant to the terms outlined under the CPP, the Company issued a warrant to the U.S. Treasury in an amount equal to 15% of the preferred issuance or approximately $3.2 million (611,650 shares).  The warrant is exercisable immediately for a period of ten years at a price equal to the average closing price of the Company’s common stock over the twenty day period ending the day prior to the Company’s preliminary approval to participate in the CPP ($5.15 per share).

For additional information regarding the Company’s Senior Preferred Stock and its participation in the CPP, see Note 9 of the consolidated financial statements filed on this Form 10-Q.

Dividends

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

	Dividend
	Amount			Declaration	Record	Payable
Dividend Type	Per Share			Date	Date	Date
Stock dividend		5	%	04/24/08	05/02/08	05/16/08
Cash dividend	$	0.08		01/24/08	02/01/08	02/15/08
Cash dividend	$	0.08		10/17/07	11/02/07	11/16/07
Cash dividend	$	0.08		07/18/07	08/03/07	08/17/07
Cash dividend	$	0.08		04/20/07	05/04/07	05/18/07

As evidenced in the table above, on April 24, 2008, the Board of Directors declared a stock dividend in the amount of 5% which was 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 Company paid no dividends on its common stock during the first six months of 2009 and as part of its participation in the U.S. Treasury’s CPP, must seek the approval of the Treasury before doing so.

- 55 - -

Management’s Discussion and Analysis

Trust Preferred Securities

On October 27, 2006 the Company issued $8.2 million of Floating Rate Junior Subordinated Debt Securities to Heritage Oaks Capital Trust II (“Trust II”), a statutory trust created under the laws of the State of Delaware.  The debt securities issued to Trust II are subordinated to effectively all borrowings of the Company.  The Company used the proceeds from the issuance for general corporate purposes, which included, but not limited: 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 to Heritage Oaks Capital Trust III (“Trust III”), a statutory trust created under the laws of the State of Delaware. The debt securities issued to Trust III are subordinated to effectively all borrowings of the Company. The Company used the proceeds from the issuance 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, 2009, the Company had at total of $13.4 million in Junior Subordinated Deferrable Interest Debentures issued and outstanding.  As mentioned in the preceding paragraphs, these securities have been issued to 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 Trusts II and III, totaling $248 thousand and $155 thousand, respectively.  The balance of the equity of Trusts II and III is comprised of mandatory redeemable preferred securities and is included in other assets.  Interest associated with the securities issued to both Trusts II and III is payable quarterly at 3-month LIBOR plus 1.72% variable rate and 6.888% fixed, respectively.

The following table provides a summary of the securities the Company has issued to Trusts II and III as of June 30, 2009:

	Amount		Current			Issue	Scheduled	Call
(dollars in thousands)	Issued		Rate			Date	Maturity	Date	Rate Type
Heritage Oaks Capital Trust II	$	8,248		2.928	%	27-Oct-06	Aug-37	Nov-11	Variable 3-month LIBOR + 1.72%
Heritage Oaks Capital Trust III		5,155		6.888	%	20-Sep-07	Sep-37	Dec-12	5-year Fixed SWAP + 2.00%
Total Issued	$	13,403		4.45	%

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 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 limitations which were to become effective on March 31, 2009.  However, on March 17, 2009, the Federal Reserve Board issued a ruling to delay the effective date of limitations on trust preferred securities until March 31, 2011.    At June 30, 2009, the Company included $13.0 million of the net junior subordinated debt in its Tier I Capital for regulatory capital purposes.

- 56 - -

Management’s Discussion and Analysis

At June 30, 2009, the Company had sufficient cash to service the $13.4 million in junior subordinated debenture interest payments for approximately 9 years without dividends from subsidiaries. The Bank’s capacity to provide cash to the Company, while remaining “well-capitalized”, was approximately $19.2 million at June 30, 2009.

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.

The following table provides a Summary of Company and Bank regulatory capital ratios at June 30, 2009 and 2008:

	Regulatory Standard						June 30, 2009						June 30, 2008
	Adequately			Well			Heritage Oaks						Heritage Oaks
Ratio	Capitalized			Capitalized			Bancorp			Bank			Bancorp			Bank
Leverage ratio		4.00	%		5.00	%		10.87	%		10.33	%		8.87	%		8.64	%
Tier I capital to risk weighted assets		4.00	%		6.00	%		11.95	%		11.23	%		9.66	%		9.38	%
Total risk based capital to risk weighted assets		8.00	%		10.00	%		13.20	%		12.49	%		10.83	%		10.55	%

Regulatory capital ratios as of June 30, 2009 fully reflect the issuance of $21.0 million in Senior Preferred Stock issued to the U.S. Treasury under the terms of the CPP.  During the first six month of 2009, the holding company down-streamed $17.0 million in capital to the Bank.  As previously mentioned, pursuant to an interim rule issued by the Federal Reserve Board, effective October 17, 2008, all $21.0 million of preferred stock the Company issued qualifies as Tier I Capital, thus the Company’s and Bank’s capital ratios as of June 30, 2009 increased significantly from that reported a year earlier.

Liquidity

The objective of liquidity management is to ensure the continuous availability of funds to meet the demands of depositors, investors and borrowers.  Asset liquidity is primarily derived from loan payments and the maturity of other earning assets.  Liquidity from liabilities is obtained primarily from the receipt of new deposits.  The Bank’s Asset Liability Committee (“ALCO”) is responsible for managing the on and off-balance sheet commitments to meet the needs of customers while achieving the Bank’s financial objectives.  ALCO meets regularly to assess the projected funding requirements by reviewing historical funding patterns, current and forecasted economic conditions and individual customer funding needs.  Deposits generated from the Bank’s customers serve as the primary source of liquidity.  The Bank has credit arrangements with correspondent banks that serve as a secondary liquidity source.  At June 30, 2009, these credit lines totaled $20.0 million and the Bank had no borrowings against those lines.  As previously mentioned the Bank is a member of the FHLB and has collateralized borrowing capacities remaining of $115.7 million at June 30, 2009.

The Bank manages liquidity by maintaining a majority of the investment portfolio in Federal Funds sold and other liquid investments.  The majority of these investments include obligations of state and political subdivisions (municipal bonds) and mortgage related securities that provide a relatively steady stream of cash flows.  As of June 30, 2009, the Company believes investments in the portfolio can be liquidated at their current fair values in the event they are needed to provide liquidity.  The ratio of liquid assets not pledged for collateral and other purposes to deposits and other liabilities was 16.36% at June 30, 2009 compared to 6.79% at December 31, 2008.   At June 30, 2009, the Bank was within its internal guideline for liquidity.  The ratio of net loans to deposits (“LTD”), another key liquidity ratio, was 97.3% at June 30, 2009 compared to 110.7% at December 31, 2008 both of which are and were within the Bank’s policy guidelines.  While the Bank still provides the majority of loan funding with core deposits, due to the highly competitive nature of deposit gathering and given the current economic environment, the Bank has found it necessary to rely on borrowed funds from time to time.  With the banking industry’s common use of alternative funding sources, i.e. FHLB borrowing, the Bank implemented a tracking ratio of Loan-to-Funding (“LTF”) in 2006.  This ratio is calculated by dividing gross loans by the sum of total deposits and alternative funding sources both available and used.  At June 30, 2009, the LTF ratio was 78.9%, compared to 87.2% at December 31, 2008.  The Bank’s key focus has been and remains to increase core deposits and minimize alternative funding sources.

- 57 - -

Management’s Discussion and Analysis

The following table provides a summary of the remaining borrowing capacity the Company has with various secondary liquidity sources as of June 30, 2009:

(dollars in thousands)	June 30, 2009
Federal Home Loan Bank remaining borrowing capacity	$	115,741
Correspondent bank credit arrangements		20,000
Brokered funds availability		127,866
Revolving line of credit - Holding Company		3,500
Total available secondary liquidity source	$	267,107

During the fourth quarter of 2008, a credit line previously established with a correspondent bank in the amount of $20.0 million was temporarily suspended.  Due to overall instability in the financial markets this particular correspondent bank determined it necessary to re-assess all lines of credit.  Management is currently in the process of working with this and other correspondent banks in an effort to re-establish the line.

The Bank has a policy that permits the purchase of brokered funds in an amount not to exceed 20% of total deposits.  As previously mentioned, Management has purchased brokered funds in an effort to rely less on FHLB borrowings and maintain an appropriate mix of secondary funding.  At June 30, 2009, the balance of brokered funds was approximately $38.5 million or $10.1million lower than that reported at December 31, 2008.  Brokered funds represented 5.5% and 8.1% of total deposits as of June 30, 2009 and December 31, 2008, respectively.   Year to date increases in core deposits has allowed the Bank to pay down brokered funds.

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 their obligations and upward pressure on operating expenses.  Although inflationary pressures are not considered to be of any particular hindrance in the current economic environment, they may however have an impact on the Company’s future earnings in the event those pressures do become more prevalent.

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 arrangements consisting of commitments to extend credit, commercial letters of credit, and standby letters 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 to the Company’s Consolidated Financial Statements under Item 8 of Part II of the Company’s December 31, 2008 Annual Report filed on Form 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 to the Company’s Consolidated Financial Statements under Item 8 of Part II of the Company’s December 31, 2008 Annual Report filed on Form 10-K.

In connection with the $13.4 million in debt securities discussed under “Capital,” the Company issued the full and unconditional payment guarantee of certain accrued distributions.

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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 and 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 rate sensitivity.  Based on the results of this model, Management believes the Bank’s balance sheet is to a large extent “asset sensitive.”  This means the Company expects (all other things being equal) to expand its net interest income if rates rise and expects it conversely to contract if rates fall.  The level of potential or expected contraction indicated by the tables below is considered acceptable by Management and is compliant with the Bank’s ALCO policies.  Management will continue to perform this analysis each quarter to further validate the expected results against actual data.

The hypothetical impacts of sudden interest rate movements applied to the Company’s asset and liability balances are modeled monthly. The results of 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, 2009 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, 2009, 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)	$	39,280		$	40,673		$	41,484		$	42,334		$	43,360
$ Change from base	$	(2,204	)	$	(811	)	$	-		$	850		$	1,876
% Change from base		-5.31	%		-1.95	%		0.00	%		2.05	%		4.52	%

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.

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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, 2009: 

(dollars in thousands)
			Percent of
Rate Type	Balance		Total
Variable - daily		275,892		39.5	%
Variable other than daily		263,717		37.8	%
Fixed rate		158,245		22.7	%
Total gross loans	$	697,854		100.0	%

The table above identifies approximately 39.5% of the loan portfolio that will re-price immediately in a changing rate environment.  At June 30, 2009, approximately $539.6 million or 77.3% of the Bank’s loan portfolio is considered variable.

(dollars in thousands)
			Percent of
Re-Pricing	Balance		Total
< 1 Year	$	403,798		57.9	%
1-3 Years		171,065		24.5	%
3-5 Years		72,470		10.4	%
> 5 Years		50,521		7.2	%
Total gross loans	$	697,854		100.0	%

The following table provides a summary of the loans the Bank can expect to see come off their floors if the prime rate were to increase by the amounts identified below as of June 30, 2009:

	Move in Prime Rate (bps)
(dollars in thousands)	+200		+250		+300		+350
Variable daily	$	575	$	18,106	$	41,346	$	111,562
Variable other than daily		2,647		4,908		50,962		106,200
Cumulative total variable at floor	$	3,222	$	23,014	$	92,308	$	217,762

Given the significant year over year decline in Prime rate, many loans in the portfolio possess floors significantly higher than the current prime rate.  Therefore, the Bank will need to see rates increase significantly before the majority of loans in the portfolio start to come off their floors.

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.

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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, 2009 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 II.  Other Information

Item 1.  Legal Proceedings

The Company is party to the following litigation:

Alpert, et al v. Cuesta Title Company, et al.  San Luis Obispo County Sup. Ct. Case no. CV 098220.  Plaintiffs have sued a title company, title insurer, Hurst Financial and related individuals on a variety of claims related to Hurst Financial's lending practices.  The Bank, which made a commercial loan to a developer which also borrowed from Hurst Financial, is named in two causes of action alleging (1) negligence and (2) aiding and abetting Hurst Financial's allegedly illegal lending practices.  The Bank did not lend to any of the plaintiffs or to Hurst Financial, nor did the Bank have any contact whatsoever with the plaintiffs in relation to their transactions with Hurst Financial.  The Bank has foreclosed upon and now owns one of the properties Hurst Financial purportedly financed for the developer using funds raised from the plaintiffs.  The Company believes the action against it is without merit.  The matter has been tendered to the Company's insurance carrier, and the Company is actively defending the case.  The Company anticipates a favorable outcome to the case and does not expect the litigation to have any significant financial impact to the Company.

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, 2008 Annual Report filed on Form 10-K in response to Item A to Part I of Form 10-K.

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

Unregistered Sale of Equity Securities

None.

Purchases of Equity Securities

None.

Item 3.  Defaults upon Senior Securities

None.

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

The annual meeting of shareholders of the Company was held on May 21, 2009, and three matters were considered at the meeting:

1. The election of eleven persons to the Board of Directors of the Company to serve until the 2010 Annual Meeting of Shareholders and until their successors are elected and have qualified.  The following persons were elected with the following votes:

Directors	Votes For	Votes Withheld	% Votes For
Michael J. Morris	6,238,014	517,033	80.47%
Don Campbell	6,148,288	606,759	79.31%
Michael Behrman	6,236,224	518,823	80.45%
Kenneth Dewar	6,244,995	510,052	80.56%
Mark C. Fugate	6,244,767	510,280	80.56%
Dolores T. Lacey	6,143,123	611,924	79.25%
Merle F. Miller	6,152,915	602,132	79.37%
Daniel J. O'Hare	6,244,995	510,052	80.56%
Michael E. Pfau	6,236,252	518,795	80.45%
Alexander F. Simas	6,244,995	510,052	80.56%
Lawrence P. Ward	6,198,365	556,682	79.96%

2. To adopt a non-binding resolution approving the Executive Compensation disclosed in the Proxy statement for the 2009 Annual Meeting of Shareholders dated April 24, 2009.  The resolution was adopted with the following votes:

Votes For	Votes Against	Votes Abstain	% Votes For
5,787,759	843,736	123,554	74.66%

3. To ratify the appointment of Vavrinek, Trine, Day & Co., LLP as the Company’s independent accountants for the 2009 fiscal year.

Votes For	Votes Against	Votes Abstain	% Votes For
6,613,807	68,711	72,529	85.32%

Item 5.  Other Information

Not applicable.

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 10, 2009

/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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