Edgar Filing: PACIFIC MERCANTILE BANCORP

Form 10-Q for the quarterly period ended September 30, 2006

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2006

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

For the transition period from to

Commission file number 0-30777

PACIFIC MERCANTILE BANCORP

(Exact name of Registrant as specified in its charter)


California		33–0898238
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

949 South Coast Drive, Suite 300, Costa Mesa, California		92626
(Address of principal executive offices)		(Zip Code)

(714) 438–2500

(Registrant’s telephone number, including area code)

Not Applicable

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports); and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

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

(Check one):

Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨

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

APPLICABLE ONLY TO CORPORATE ISSUERS:

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

10,298,364 shares of Common Stock as of November 4, 2006

PACIFIC MERCANTILE BANCORP

QUARTERLY REPORT ON FORM 10Q

FOR

THE QUARTER ENDED SEPTEMBER 30, 2006

TABLE OF CONTENTS


		Page No.
Part I	Financial Information

Item 1.	Financial Statements	1

	Consolidated Statements of Financial Condition at September 30, 2006 and December 31, 2005	1

	Consolidated Statements of Income for the Three and Nine Months ended September 30, 2006 and 2005	2

	Consolidated Statement of Comprehensive Income for the Three and Nine Months ended September 30, 2006 and 2005	3

	Consolidated Statements of Cash Flows for the Nine Months ended September 30, 2006 and 2005	4

	Notes to Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13

Item 3.	Market Risk	31

Item 4.	Controls and Procedures	31

Part II.

Item 1A	Risk Factors	32

Item 6.	Exhibits	32

Signatures		S–1

Exhibit Index		E–1

Exhibit 31.1 Certification of Chief Executive Officer under Section 302 of the Sarbanes–Oxley Act of 2002

Exhibit 31.2 Certification of Chief Financial Officer under Section 302 of the Sarbanes–Oxley Act of 2002

Exhibit 32.1 Certification of Chief Executive Officer under Section 906 of the Sarbanes–Oxley Act of 2002

Exhibit 32.2 Certification of Chief Financial Officer under Section 906 of the Sarbanes–Oxley Act of 2002

PART I. – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands)

(Unaudited)


	September 30, 2006			December 31, 2005
ASSETS
Cash and due from banks	$	16,017		$	23,422
Federal funds sold		58,800			11,400

Cash and cash equivalents		74,817			34,822
Interest-bearing deposits with financial institutions		198			441
Federal Reserve Bank and Federal Home Loan Bank Stock, at cost		15,291			13,349
Securities available for sale, at fair value		229,471			265,556
Loans (net of allowances of $5,869 and $5,126, respectively)		705,764			650,027
Investment in unconsolidated subsidiaries		837			837
Accrued interest receivable		4,467			4,040
Premises and equipment, net		2,365			2,570
Other assets		10,468			9,514

Total assets	$	1,043,678		$	981,156

LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Noninterest-bearing	$	186,275		$	200,688
Interest-bearing		517,778			379,661

Total deposits		704,053			580,349
Borrowings		220,116			288,684
Accrued interest payable		2,667			2,214
Other liabilities		3,419			3,555
Junior subordinated debentures		27,837			27,837

Total liabilities		958,092			902,639

Commitments and contingencies		—			—
Shareholders’ equity:
Preferred stock, no par value, 2,000,000 shares authorized, none issued		—			—
Common stock, no par value, 20,000,000 shares authorized, 10,298,364 and 10,176,008 shares issued and outstanding at September 30, 2006 and December 31, 2005, respectively		68,910			69,078
Retained earnings		19,917			13,144
Accumulated other comprehensive loss		(3,241	)		(3,705	)

Total shareholders’ equity		85,586			78,517

Total liabilities and shareholders’ equity	$	1,043,678		$	981,156

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

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in thousands, except for per share data)

(Unaudited)


	Three Months Ended September 30,					Nine Months Ended September 30,
	2006		2005			2006			2005
Interest income:
Loans, including fees	$	13,287	$	9,436		$	37,361		$	25,174
Federal funds sold		532		360			888			1,008
Securities available for sale and stock		2,782		2,345			8,626			6,408
Interest-bearing deposits with financial institutions		3		3			7			4

Total interest income		16,604		12,144			46,882			32,594
Interest expense:
Deposits		5,073		2,553			12,386			6,776
Borrowings		3,536		2,025			10,078			5,071

Total interest expense		8,609		4,578			22,464			11,847

Net interest income		7,995		7,566			24,418			20,747
Provision for loan losses		270		340			830			690

Net interest income after provision for loan losses		7,725		7,226			23,588			20,057

Noninterest income		389		236			993			817
Noninterest expense		5,261		4,524			15,618			12,709

Income before income taxes		2,853		2,938			8,963			8,165
Income tax expense		1,151		1,196			3,626			3,348

Income from continuing operations		1,702		1,742			5,337			4,817
(Loss) income from discontinued operations, net of taxes		0		(259	)		(189	)		(730	)

Net income	$	1,702	$	1,483		$	5,148		$	4,087
Net income (loss) per share basic:
Income from continuing operations	$	0.17	$	0.18		$	0.52		$	0.47
Income (loss) from discontinued operations	$	0.00	$	(0.03	)	$	(0.02	)	$	(0.07	)

Net income	$	0.17	$	0.15		$	0.50		$	0.40
Net income (loss) per share diluted:
Income from continuing operations	$	0.16	$	0.16		$	0.50		$	0.45
Income (loss) from discontinued operations	$	0.00	$	(0.02	)	$	(0.02	)	$	(0.07	)

Net income	$	0.16	$	0.14		$	0.48		$	0.38
Weighted average number of shares:
Basic		10,293,566		10,175,505			10,249,112			10,149,525
Diluted		10,762,436		10,648,392			10,765,657			10,582,888

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

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME

(Dollars in thousands)

(Unaudited)


	Three Months Ended September 30,					Nine Months Ended September 30,
	2006		2005			2006		2005
Net income	$	1,702	$	1,483		$	5,148	$	4,087
Other comprehensive loss, net of tax:
Change in unrealized gain (loss) on securities available for sale, net of tax effect		2,547		(982	)		464		(993	)

Total comprehensive income	$	4,249	$	501		$	5,612	$	3,094

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

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)


	Nine Months Ended September 30,
	2006			2005
Cash Flows From Continuing Operating Activities:
Income from continuing operations	$	5,337		$	4,817
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		700			829
Provision for loan losses		830			690
Net amortization of premium (discount) on securities		540			1,049
Mark to market loss (gain) adjustment of equity securities		13			6
Net gain on sale of fixed assets		(3	)		(15	)
Net increase in accrued interest receivable		(427	)		(1,004	)
Stock-based compensation expense		461			—
Net (increase) decrease in other assets		(2,637	)		2,187
Net decrease (increase) in deferred taxes		1,296			(481	)
Net increase in accrued interest payable		452			205
Net (decrease) increase in other liabilities		(87	)		638

Net cash provided by operating activities		6,475			8,921
Cash Flows From Investing Activities:
Net decrease in interest-bearing deposits with financial institutions		101			212
Maturities of, proceeds from sales of and principal payments received for securities available for sale and other stock		37,981			47,187
Purchase of securities available for sale and other stock		(3,720	)		(120,544	)
Proceeds from sale of subsidiary		134			—
Gain on sale of subsidiary		(2	)		—
Net increase in loans		(56,568	)		(79,180	)
Proceeds from sale of fixed assets		—			15
Purchases of premises and equipment		(503	)		(499	)

Net cash used in investing activities		(22,577	)		(152,809	)
Cash Flows From Financing Activities:
Net increase in deposits		123,572			28,933
Proceeds from exercise of stock options		415			50
Tax benefits from exercise of stock options		580			—
Net decrease in borrowings		(68,568	)		54,952

Net cash provided by financing activities		55,999			83,935

Cash Flows provided (used) by continuing operations		39,897			(59,953	)

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

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS—continued

(Dollars in thousands)

(Unaudited)


	Nine Months Ended September 30,
	2006			2005
Discontinued Operations:
Cash Flows From Operating Activities
Loss from discontinued operations		(189	)		(730	)
Depreciation and Amortization		2			18
Net decrease (increase) in other assets		181			(110	)
Net decrease in fixed assets		11			—
Net (decrease) increase in other liabilities		(49	)		19
Proceeds from sales of loans held for sale		—			141,124
Originations and purchases of loans held for sale		—			(98,255	)
Net gains on sales of loans held for sale		—			(1,133	)
Mark to market gain adjustment of loans held for sale		—			(216	)

Net cash (used) provided by operating activities		(44	)		40,717
Cash Flows From Investing Activities:
Net decrease in interest-bearing deposits with financial institutions		142			100
Purchases of premises and equipment		—			(3	)

Net cash flow provided by investing activities		142			97

Cash Flows provided by discontinued operations		98			40,814
Net increase (decrease) in cash and cash equivalents		39,995			(19,139	)
Cash and Cash Equivalents, beginning of period		34,822			96,095

Cash and Cash Equivalents, end of period	$	74,817		$	76,956

Supplementary Cash Flow Information:
Cash paid for interest on deposits and other borrowings	$	22,023		$	7,346

Cash paid for income taxes	$	4,200		$	396

Non-Cash Investing Activities:
Net increase in net unrealized losses on securities held for sale, net of income tax	$	464		$	(11	)

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

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Unaudited)

1. Nature of Business

Pacific Mercantile Bancorp (“PMBC”) is a bank holding company which, through its wholly owned subsidiary, Pacific Mercantile Bank (the “Bank”) is engaged in the commercial banking business in Southern California. PMBC is registered as a one bank holding company under the United States Bank Holding Company Act of 1956, as amended. The Bank is chartered by the California Department of Financial Institutions (the “DFI”) and is a member of the Federal Reserve Bank of San Francisco (“FRB”). In addition, the deposit accounts of the Bank’s customers are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to the maximum amount allowed by law. PMBC and the Bank, together, shall sometimes be referred to in this report as the “Company” or as “we”, “us” or “our”.

Substantially all of our operations are conducted and substantially all our assets are owned by the Bank, which accounts for substantially all of our consolidated revenues and expenses, and earnings. The Bank provides a full range of banking services to small and medium-size businesses, professionals and the general public in Orange, Los Angeles, San Bernardino and San Diego Counties of California and is subject to competition from other financial institutions conducting operations in those same markets.

During 2002, we organized three business trusts, under the names Pacific Mercantile Capital Trust I, PMB Capital Trust I, and PMB Statutory Trust III, respectively, to facilitate our issuance of an aggregate of $17 million principal amount of junior subordinated debentures, all with maturity dates in 2032. In October 2004, we organized PMB Capital Trust III to facilitate our issuance of an additional $10 million principal amount of junior subordinated debentures, with a maturity date in 2034. In accordance with applicable accounting standards, the financial statements of these trusts are not included in the Company’s consolidated financial statements. See Note 2: “Significant Accounting Policies — Principles of Consolidation” below.

2. Significant Accounting Policies

The accompanying unaudited consolidated financial statements have been prepared in accordance with the instructions to Form 10–Q and, therefore, do not include all footnotes that would be necessary for a fair presentation of financial position, results of operations, changes in cash flows and comprehensive income (loss) in accordance with generally accepted accounting principles in the United States (“GAAP”). However, these interim financial statements reflect all adjustments (consisting of normal recurring adjustments and accruals) which, in the opinion of our management, are necessary for a fair presentation of our results for the interim periods presented.

These unaudited consolidated financial statements have been prepared in accordance with a basis consistent with prior periods, and should be read in conjunction with our audited consolidated financial statements as of and for the year ended December 31, 2005 and the notes thereto included in our Annual Report on Form 10–K for the fiscal year ended December 31, 2005, as filed with the Securities and Exchange Commission under the Securities Exchange Act of 1934.

However, as described below under the subcaption “Discontinued Operations” in this Note 2, in the second quarter of 2005, the Company decided to discontinue its wholesale mortgage lending business and completed its exit from that business at the end of 2005. Accordingly, the results of operations of that business are presented as discontinued operations, separate from our financial statements for the three and nine month periods ended September 30, 2005. In the second quarter of 2006, the Company sold one of its subsidiaries, PMB Securities Corp., which was a securities broker/dealer engaged in the securities brokerage business. Therefore, the results of operations of that business are presented as discontinued operations, separate from the results of our continuing operations in our financial statements for the three and nine month periods ended September 30, 2005 and the nine month period ended September 30, 2006.

Our consolidated financial position at September 30, 2006, is not necessarily indicative of what our financial position will be as of the end of and our consolidated results of operations for the three and nine month periods then ended and is not necessarily indicative of the results of our operations that may be expected for, any other interim period during or for the full year ending December 31, 2006.

Use of Estimates

The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make certain estimates and assumptions that affect the reported amounts of assets, liabilities, and contingencies at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the fair value of securities available for sale, and the valuation of deferred tax assets. Actual amounts or results could differ from those estimates.

Principles of Consolidation

The consolidated financial statements for the three and nine month periods ended September 30, 2006 and 2005, include the accounts of PMBC and its wholly owned subsidiary, Pacific Mercantile Bank. The accounts of PMB Securities Corp., as discontinued operations are included in the nine months ended September 30, 2006, until the date of its sale in the second quarter of 2006 and for the entirety of the three and nine month periods ended September 30, 2005. All significant intercompany accounts and transactions have been eliminated in consolidation.

Nonperforming Loans and Other Assets

At September 30, 2006 and December 31, 2005, we had $781,000 and $1.3 million, respectively, in nonaccrual and impaired loans, but we had no restructured loans and no loans that were past due as to principal for 90 days or more that were still accruing interest.

Stock-Based Employee Compensation Plans

In December 2004, Financial Accounting Standards Board (“FASB”) issued SFAS No. 123(R), “Share-Based Payment”, which requires entities that grant stock options or other equity compensation awards to employees to recognize the fair value of those options and shares as compensation cost over their respective service (vesting) periods in their financial statements. SFAS No. 123(R) is effective beginning in the first quarter of fiscal years ending after June 15, 2005. As a result, effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123(R), using the modified-prospective-transition method. Under this transition method, equity compensation expense that will be recognized in fiscal 2006 will include: (a) compensation expense for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on their grant date fair values estimated in accordance with the original provisions of SFAS No. 123, and (b) compensation cost for all share-based payments granted subsequent to December 31, 2005, based on their grant date fair values estimated in accordance with the provisions of SFAS No. 123(R). Since stock-based compensation that is recognized in the statement of income is to be determined based on the equity compensation awards that we expect will ultimately vest, that compensation expense has been reduced for estimated forfeitures of unvested options that typically occur due to terminations of employment of optionees. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. For purposes of the determination of stock-based compensation expense for the quarter ended September 30, 2006, we estimated no forfeitures for Directors of the Board and all other forfeitures to be 20% of the unvested options issued.

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

Effective March 2, 1999, our Board of Directors adopted, and in January 2000 our shareholders approved, the 1999 Stock Option Plan (the “1999 Option Plan”). That Plan authorizes the granting of options to directors, officers and other key employees that entitle them to purchase shares of common stock of the Company at a price per share equal to or above the fair market value of the Company’s shares on the respective grant dates of the awards. Options may vest immediately or over various periods, generally ranging up to five years, as determined by the Compensation Committee of our Board of Directors at the time it approves the grant of options under the 1999 Option Plan. Options may be granted for terms of up to 10 years, but will terminate upon termination of service, if sooner. A total of 1,248,230 shares were authorized for issuance under the 1999 Option Plan (which number has been adjusted for stock splits effectuated subsequent to the Plan’s adoption).

Effective February 17, 2004, the Board of Directors adopted the Pacific Mercantile Bancorp 2004 Stock Incentive Plan (the “2004 Plan”), which was approved by the Company’s shareholders in May 2004. That Plan authorizes the granting of options and rights to purchase restricted stock to directors, officers and other key employees, that entitle them to purchase shares of common stock of the Company at, in the case of stock options, a price per share equal to or above the fair market value of the Company’s shares on the date the option is granted or, in case of stock purchase rights, at prices and on such terms as are fixed by the Compensation Committee of the Board of Directors at the time the rights are granted. Options and restricted stock purchase rights may vest immediately or over various periods of up to five years, or based on the achievement of specified performance goals, as determined by the Company’s Compensation Committee at the time the options are granted or the stock purchase rights are awarded. Options may be granted under the 2004 Plan for terms of up to 10 years after the grant date, but will terminate upon termination of service, if sooner. The Company will become entitled to repurchase any unvested shares subject to restricted purchase rights in the event of a termination of employment or service of the holder of the stock purchase right or in the event the holder fails to achieve any goals that are required to be met as a condition of vesting. A total of 400,000 shares were authorized for issuance under the 2004 Plan.

The fair values of the options that were outstanding under the 1999 and 2004 Plans were estimated as of their respective dates of grant using the Black-Scholes option-pricing model. The following table summarizes the weighted average assumptions used for grants in the following periods:


	Three Months Ended September 30,						Nine Months Ended September 30,
Assumptions with respect to:	2006			2005			2006			2005
Expected volatility		35	%		41	%		35	%		46	%
Risk-free interest rate		5.10	%		4.03	%		4.69	%		3.72	%
Expected dividends		1.07	%		1.04	%		1.07	%		1.04	%
Expected term (years)		6.5			5			6.5			5
Weighted average fair value of option granted during period	$	6.96		$	6.09		$	7.13		$	6.25

The following tables summarize the share option activity under the plans for the nine months ended September 30, 2006 and 2005.


	Number of Shares	Weighted- Average Exercise Price Per Share		Number of Shares	Weighted- Average Exercise Price Per Share
	2006			2005
Outstanding - January 1,	1,470,698	$	8.51	1,353,848	$	7.73
Granted	46,500		18.12	169,000		14.91
Exercised	122,174		5.21	7,927		7.15
Forfeited/Canceled	41,400		15.58	45,023		11.01

Outstanding - September 30, 2006	1,353,624		8.91	1,469,898		8.46

Options Exercisable - September 30, 2006	1,029,155	$	7.59	1,029,681	$	6.85

The aggregate intrinsic values of options exercised for the nine months ended September 30, 2006 and 2005 were $1.5 million and $63,000, respectively. Total fair values of vested options for the same periods were $514,000 and $658,000, respectively.


Outstanding as of September 30, 2006						Exercisable as of September 30, 2006
Range of Exercise Price	Vested	Unvested	Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Life (Years)	Shares	Weighted- Average Exercise Price
$ 4.00 – 5.99	176,998		$	4.00	2.42	176,998	$	4.00
$ 6.00 – 9.99	650,136	14,940		7.29	3.94	650,136		7.28
$10.00 – 12.99	173,989	180,061		11.25	7.41	173,989		11.23
$13.00 – 17.99	27,532	82,968		15.11	8.48	27,532		15.00
$18.00 – 18.84	500	46,500		18.31	9.34	500		18.10

	1,029,155	324,469	$	8.91	5.21	1,029,155	$	7.59

The aggregate intrinsic values of options that were outstanding and those that were exercisable under the plans at September 30, 2006 were $10.0 million and $8.8 million, respectively.

A summary of the status of the unvested shares as of December 31, 2005, and changes during the nine month period ended September 30, 2006, are set forth in the following table.


	Shares	Weighted- Average Grant Date Fair Value
Unvested at December 31, 2005	416,436	$	5.54
Granted	46,500		7.13
Vested	97,067		5.30
Forfeited/Canceled	41,400		6.41

Unvested at September 30, 2006	324,469	$	5.73

The aggregate amounts charged against income in relation to stock-based awards were $122,000 and $461,000 for the three and nine months ended September 30, 2006, respectively. At September 30, 2006, compensation expense related to non-vested stock option grants aggregated $1.4 million, which is expected to be recognized as follows:


	Stock Option Compensation Expense
	(In thousands)
Remainder of 2006	$	126
For the year ended December 31,
2007		530
2008		544
2009		171
2010		51
2011		6

Total	$	1,428

Earnings Per Share (“EPS”)

Basic EPS excludes dilution and is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if stock options or other contracts to issue common stock were exercised or converted to common stock that would then share in our earnings. For the three and nine months ended September 30, 2006, stock options for 148,076 and 125,709 shares, respectively, were not considered in computing diluted earnings per common share because they were antidilutive.

The following table shows how we computed basic and diluted EPS for the three and nine months ended September 30, 2006 and 2005.


	For the three months ended September 30,
	2006						2005
	Net Income (Numerator)		Shares (Denominator)	Per Share (Amount)			Net Income (Numerator)		Shares (Denominator)	Per Share (Amount)
	(Dollars in thousands, except share and per share data)
Basic EPS	$	1,702	10,293,566	$	0.17		$	1,483	10,175,505	$	0.15
Effect of Dilutive Securities:
Stock Options		—	468,870		(0.01	)		—	472,887		(0.01	)

Diluted EPS	$	1,702	10,762,436	$	0.16		$	1,483	10,648,392	$	0.14


	For the nine months ended September 30,
	2006						2005
	Net Income (Numerator)		Shares (Denominator)	Per Share (Amount)			Net Income (Numerator)		Shares (Denominator)	Per Share (Amount)
	(Dollars in thousands, except share and per share data)
Basic EPS	$	5,148	10,249,112	$	0.50		$	4,087	10,149,525	$	0.40
Effect of Dilutive Securities:
Stock Options		—	516,545		(0.02	)		—	433,363		(0.02	)

Diluted EPS	$	5,148	10,765,657	$	0.48		$	4,087	10,582,888	$	0.38

Comprehensive Income

Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Certain changes in assets and liabilities, such as unrealized gains and losses on securities available for sale, are reported as a separate component of the equity section of the balance sheet net of income taxes, and such items, along with net income, are components of comprehensive income.

Recent Accounting Pronouncements

In May 2005, the FASB issued FASB Statement No. 154, “Accounting Changes and Error Corrections” (“SFAS No. 154”). SFAS No. 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It requires, unless impracticable, retrospective application for reporting changes in accounting principle in the absence of explicit transition requirements specific to this newly adopted accounting principle. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We do not expect the adoption of SFAS No. 154 to have a material impact on our financial condition or operating results.

The U.S. Securities and Exchange Commission in September 2006, released Staff Accounting Bulletin (SAB) 108, “Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements”, that provides guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a potential current year misstatement. SAB 108 is effective for fiscal years beginning after November 15, 2006. We do not expect the adoption of SAB 108 to have a material impact on our financial condition or operating results.

In July 2006, the FASB also issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109,” (FIN 48). FIN 48 clarifies the accounting for uncertain tax positions in accordance with SFAS 109, “Accounting For Income Taxes,” by prescribing a minimum recognition threshold that a tax position is required to meet before being recognized in the financial statements. The minimum recognition threshold requires the Corporation to recognize, in its financial statements, the impact of a tax position if it is more likely than not that the tax

position is valid and would be sustained on audit, including resolution of related appeals or litigation processes, if any. Only tax positions that meet the “more likely than not” recognition criteria at the effective date may be recognized or continue to be recognized in the financial statements upon the adoption of FIN 48. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition requirements in accounting for uncertain tax positions. Changes in the amount of tax benefits recognized resulting from the application of the provisions of this Interpretation would result in a one-time non-cash charge to be recognized as a change in accounting principle via a cumulative adjustment to the opening balance of retained earnings in the period of adoption. FIN 48 is effective for fiscal years beginning after December 15, 2006. Accordingly, we will adopt the provisions of FIN 48 in the first quarter 2007. We are currently evaluating the guidance contained in FIN 48 and we do not expect the non-cash charge to be material to beginning retained earnings. However, the amount charged to beginning retained earnings upon adoption could be impacted by events in the fourth quarter 2006 and further clarification and interpretation of the provisions of FIN 48.

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

Reclassification

Certain amounts in the accompanying 2005 consolidated financial statements, including amounts related to discontinued operations, have been reclassified to conform to 2006 presentation.

Commitments and Contingencies

To meet the financing needs of its customers in the normal course of business, the Company is party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated financial statements. At September 30, 2006, loan commitments and letters of credits totaled $210 million and $9 million, respectively. The contractual amount of a credit-related financial instrument such as a commitment to extend credit, a credit-card arrangement or a letter of credit represents the amounts of potential loss should the commitment be fully drawn upon, the customer default, and the value of any existing collateral securing the customer’s payment obligation become worthless.

The Company uses the same credit policies in making commitments to extend credit and conditional obligations as it does for on-balance sheet instruments. Commitments generally have fixed expiration dates; however, since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis, using the same credit underwriting standards that are employed in making commercial loans. The amount of collateral obtained, if deemed necessary by the Company upon an extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, real estate and income-producing commercial properties.

In the ordinary course of business, we are subject to legal actions normally associated with financial institutions. At September 30, 2006, we were not a party to any pending legal action that is expected to be material to our consolidated financial condition or results of operations.

3. Discontinued Businesses

In the second quarter of 2005, we decided to discontinue our wholesale mortgage lending business and to focus our capital and other resources primarily on the growth of our commercial banking business. In the second quarter of 2006, we sold our securities brokerage business. As a result, our commercial banking business comprises our continuing operations; the wholesale mortgage lending and the securities brokerage businesses have been classified as discontinued operations in our financial statements for the three and nine month periods ended September 30, 2005; and, since we were able to complete our exit from the wholesale mortgage lending business during fourth quarter of 2005 and the exit from our securities brokerage business in the second quarter of 2006, the securities brokerage business comprised our discontinued operations in the nine month period ended September 30, 2006 to the date in the second quarter of 2006 when that business was sold.

The statement of financial condition related to discontinued operations is below. As of September 30, 2006 and December 31, 2005, there were no loans held for sale by the wholesale mortgage lending division.


	September 30 2006		December 31 2005
	(Dollars in thousands)
Assets
Due from banks and interest-bearing deposits with financial institutions	$	—	$	172
Premises and equipment, net		—		11
Other assets		—		181

Total assets	$	—	$	364

Liabilities and Shareholders’ Equity
Liabilities	$	—	$	49
Shareholders’ equity		—		315

Total liabilities and shareholders’ equity	$	—	$	364

The operating results of the discontinued wholesale mortgage lending and the securities brokerage businesses included in the accompanying consolidated statements of income are set forth below:


	Three Months Ended					Nine Months Ended
	September 30, 2006		September 30, 2005			September 30, 2006			September 30, 2005
	(In thousands)					(In thousands)
Loss from discontinued operations, before income taxes	$	—	$	(437	)	$	(313	)	$	(1,230	)
Income tax benefit		—		178			124			500

Loss from discontinued operations, net of taxes	$	—	$	(259	)	$	(189	)	$	(730	)

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

OVERVIEW

Pacific Mercantile Bancorp is a bank holding company that owns all of the stock of Pacific Mercantile Bank (the “Bank”), which is a commercial bank that provides a full range of banking services to small and medium-size businesses and to professionals and the general public in Orange, Los Angeles, San Bernardino and San Diego counties, in Southern California. Substantially all of our operations are conducted and substantially all of our assets are owned by the Bank, which accounts for substantially all of our consolidated revenues and operating costs.

The following discussion presents information about our consolidated results of operations for the three and nine month periods ended September 30, 2006 and 2005 and our consolidated financial condition, liquidity and capital resources at September 30, 2006 and should be read in conjunction with our consolidated financial statements and the notes thereto included elsewhere in this Report.

Additionally, except where otherwise noted, the following discussion of our results of operation and financial condition relates primarily to the results of operations and the assets and liabilities of our commercial banking business, which comprises our continuing operations and which excludes our discontinued wholesale mortgage lending and securities brokerage businesses. See Note 3 of the Notes to our Consolidated Financial Statements included elsewhere in this Report for further information relating to our discontinued operations.

Forward-Looking Information

Statements contained in this Report that are not historical facts or that discuss our expectations or beliefs regarding our future operations or future financial performance, or financial or other trends in our business, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include the words “believe,” “expect,” “anticipate,” “intend,” “plan,” “estimate,” “project,” or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could,” or “may.” The information contained in such forward-looking statements is based on current information and assumptions about future events over which we do not have control and our business is subject to a number of risk factors that could cause our financial condition or actual operating results in the future to differ significantly from our expected financial condition or operating results that are set forth in those statements. Certain of those risks factors are summarized below, in this Item 2, under the caption “Risks that could Affect our Future Financial Performance” and those, as well as other, risks are discussed in detail in Item 1A, “Risk Factors,” in our 2005 Form 10-K and readers of this Report are urged to read that summary below and Item 1A in the 2005 Form 10-K in conjunction with this Report.

Overview of Operating Results in the Three and Nine Months Ended September 30, 2006

The following table sets forth information regarding the interest income that we generated, the interest expense that we incurred, our net interest income, noninterest income, noninterest expense, and our net income and net income per share for the three and nine months ended September 30, 2006 and 2005.


	Three Months Ended September 30,							Nine Months Ended September 30,
	2006 Amounts		2005 Amounts			Percent Change		2006 Amounts			2005 Amounts			Percent Change
	(Unaudited) (Dollars in thousands except per share data)
Interest income	$	16,604	$	12,144		36.7	%	$	46,882		$	32,594		43.8	%
Interest expense		8,609		4,578		88.1	%		22,464			11,847		89.6	%

Net interest income	$	7,995	$	7,566		5.7	%	$	24,418		$	20,747		17.7	%
Noninterest income	$	389	$	236		64.8	%	$	993		$	817		21.5	%
Noninterest expense	$	5,261	$	4,524		16.3	%	$	15,618		$	12,709		22.9	%
Income from continuing operations⁽¹⁾	$	1,702	$	1,742		(2.3	)%	$	5,337		$	4,817		10.8	%
Loss from discontinued operations⁽¹⁾	$	—	$	(259	)	(100.0	)%	$	(189	)	$	(730	)	(74.1	)%
Net income	$	1,702	$	1,483		14.8	%	$	5,148		$	4,087		26.0	%

Net income (loss) per share diluted
Income from continuing operations	$	0.16	$	0.16		—		$	0. 50		$	0.45		11.1	%
Income (loss) from discontinued operations	$	0.00	$	(0.02	)	(100.0	)%	$	(0.02	)	$	(0.07	)	(71.4	)%
Net income per share	$	0.16	$	0.14		14.29	%	$	0.48		$	0.38		26.3	%
Weighted average number of diluted shares		10,762,436		10,648,392		1.1	%		10,765,657			10,582,888		1.7	%

⁽¹⁾	Net of taxes

Key Factors Affecting Operating Results in the Three and Nine Months Ended September 30, 2006

•

Increase in Net Interest Income. The increases in net interest income of 6% and 18% in the three and nine month periods ended September 30, 2006, respectively, were primarily the result of growth in the volume of our core loans (loans exclusive of those held for sale). Core loans grew by $116 million, or 20%, to $706 million at September 30, 2006 from $590 million at September 30, 2005.

•

Change in Net Interest Margin. Net interest margin declined to 3.17% and 3.34%, respectively, in the three and nine month periods ended September 30, 2006, from 3.42% and 3.35%, respectively, in the corresponding three and nine month periods of 2005 due in a large part to the current flat interest rate yield curve and the competitive market for deposits which contributed to compression in our net interest margins.

•

Increase in Noninterest Expense. Noninterest expense increased by $737,000 and $2.9 million in the third quarter and nine months ended September 30, 2006 respectively. Those increases were due primarily to (i) growth-related expenses incurred in connection with the opening, in June 2005, of our Ontario, California Financial Center, and the addition of experienced commercial banking officers at our Financial Centers and our new Corporate Banking Division during the 12 months ended September 30, 2006, and (ii) the recognition of $122,000 and $461,000 of stock-based compensation in the three and nine months ended September 30, 2006, respectively, that was attributable to the adoption of SFAS No. 123R (“Share based Payments”) effective January 1, 2006. Stock-based compensation was not required to be recognized in the same periods of 2005.

•

Changes in Income from Continuing Operations. The increases in noninterest expense more than offset the increase in net interest income in the three months ended September 30, 2006, but only partially offset the increase in net interest income in the nine months ended September 30, 2006. As a result, we generated income from continuing operations of $1.7 million, or $0.16 per diluted share, and $5.3 million, or $0.50 per diluted share, in the three and nine month periods ended September 30, 2006, respectively, which represented a decrease of 2% and an increase of 11%, respectively, as compared to income from continuing operations in the same respective periods of 2005.

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


	Three Months Ended September 30,				Nine Months Ended September 30,
	2006		2005		2006		2005
	(Unaudited)				(Unaudited)
Return on average assets ⁽¹⁾	0.66	%	0.74	%	0.71	%	0.72	%
Return on average shareholders’ equity ⁽¹⁾	7.87	%	8.90	%	8.41	%	8.40	%
Net interest margin ⁽²⁾	3.17	%	3.42	%	3.34	%	3.35	%

⁽¹⁾	Annualized.

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

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) and general practices in the banking industry. Certain of those accounting policies are considered critical accounting policies, because they require us to make estimates and assumptions regarding circumstances or trends that could affect the value of those assets, such as economic conditions or trends in those conditions that could impact our ability to fully collect our loans or ultimately realize the carrying value of certain of our other assets. Those estimates and assumptions are made based on current information available to us regarding those economic conditions or trends or other circumstances. If changes were to occur in the events, trends or other circumstances on which our estimates or assumptions were based, or other unanticipated events were to happen that might affect our operations, we may be required under GAAP to adjust our earlier estimates that are affected by those changes or events and to reduce the carrying value of the affected assets on our balance sheet. Our critical accounting policies relate to the determination of our allowance for loan losses, the fair value of securities available for sale and the valuation of deferred tax assets.

Allowance for Loan Losses. The accounting policies and practices we follow in determining the sufficiency of the allowance we establish for possible loan losses require us to make judgments and assumptions about economic and market conditions and trends that can affect the ability of our borrowers to meet their loan payment obligations to us. Accordingly, we use historical loss factors, adjusted for current economic market conditions and other economic indicators, to determine the losses inherent in our loan portfolio and the sufficiency of our allowance for loan losses. If unanticipated changes were to occur in those conditions or trends, actual loan losses could be greater than those predicted by those loss factors and our prior assessments of economic conditions and trends. In such an event, it could be necessary for us to increase the allowance for loan losses by means of a charge to income referred to in our financial statements as the “provision for loan losses.” Such an increase would reduce the carrying value of the loans on our balance sheet, and the additional provision for loan losses taken to increase that allowance would reduce our income in the period when it is determined that an increase in the allowance for loan losses is necessary. See the discussion in the subsections entitled “—Provision for Loan Losses” and “—Allowance for Loan Losses and Nonperforming Loans” below.

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

Utilization of Deferred Income Tax Benefits. The provision that we make for income taxes is based on, among other things, our ability to use certain income tax benefits available under state and federal income tax laws to reduce our income tax liability. As of September 30, 2006, the total of the unused income tax benefits (included in “Other Assets” in our consolidated balance sheet), available to reduce our income taxes in future periods was $5.4 million. Unless used, such tax benefits expire over time. Therefore, the realization of those benefits is dependent on our generating taxable income in the future in amounts sufficient to enable us to use those tax benefits prior to their expiration. We have made a judgment,

based on historical experience and current and anticipated market and economic conditions and trends, that it is more likely than not that we will generate taxable income in future years sufficient to fully utilize those benefits. In the event that our income were to decline in future periods making it less likely that those benefits could be fully utilized, we could be required to establish a valuation reserve to cover the potential loss of those tax benefits by increasing the provision we make for income taxes, which would have the effect of reducing our net income in the period when that valuation reserve is established.

Discontinued Businesses

As previously announced, in the second quarter of 2005 we decided to exit the wholesale mortgage lending business, which we completed in the fourth quarter of 2005. In the second quarter of 2006 we sold our securities brokerage subsidiary, PMB Securities Corp. Accordingly, our discontinued operations in 2006 consisted of our securities brokerage business; whereas, in 2005 they consisted of the wholesale mortgage lending business and our securities brokerage business.

In accordance with Statement of Financial Accounting Standard No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”), the operating results of the wholesale mortgage lending and retail securities brokerage businesses have been classified as discontinued operations and prior period financial statements have been restated on that same basis.

Additionally, as a result of our exit from our wholesale mortgage lending business and sale of our brokerage business, our commercial banking business constitutes our continuing operations and the discussion that follows focuses almost entirely on this continuing operation.

Results of Operations

Net Interest Income

One of the principal determinants of a bank’s income is net interest income, which is the difference between (i) the interest that a bank earns on loans, investment securities and other interest-earning assets, on the one hand, and (ii) its interest expense, which consists primarily of the interest it must pay to attract and retain deposits and the interest that it pays on borrowings and other interest-bearing liabilities, on the other hand. A bank’s interest income and interest expense are, in turn, affected by a number of factors, some of which are outside of its control, including national and local economic conditions and the monetary policies of the Federal Reserve Board which affect interest rates, the demand for loans, and the ability of borrowers to meet their loan payment obligations. Net interest income, when expressed as a percentage of total average interest earning assets, is a banking organization’s “net interest margin.”

The following table sets forth our interest income, interest expense and net interest income (in thousands of dollars) and our net interest margin in the three and nine months ended September 30, 2006 and 2005, respectively:


	Three Months Ended September 30								Nine Months Ended September 30
(Dollars in thousands except per share data)	2006 Amount			2005 Amount			Percent Change		2006 Amount			2005 Amount			Percent Change
	(Unaudited)
Interest income	$	16,604		$	12,144		36.7	%	$	46,882		$	32,594		43.8	%
Interest expense		8,609			4,578		88.1	%		22,464			11,847		89.6	%

Net interest income	$	7,995		$	7,566		5.7	%	$	24,418		$	20,747		17.7	%
Net interest margin		3.17	%		3.42	%				3.34	%		3.35	%

As the table above indicates, our net interest income increased by $429,000, or 6%, in the third quarter of 2006, and by $3.7 million, or 18%, in the nine months ended September 30, 2006, as compared to the same respective periods of 2005. Those increases were primarily attributable to increases in interest income of $4.5 million, or 37%, and $14.3 million, or 44%, respectively, in the three and nine month periods of 2006, as compared to the same respective corresponding periods of 2005. Interest expense increased $4.0 million, or 88%, and $10.7 million, or 90%, respectively in the three and nine month periods ended September 30, 2006 over the corresponding periods of 2005.

The increases in interest income in the three and nine month periods ended September 30, 2006, were primarily attributable to (i) an increase in the volume of average interest-earning assets, including increases of $114 million and $115 million, respectively, in the average volume of outstanding loans (exclusive of mortgages held for sale) over the corresponding periods of 2005, and (ii) to a lesser extent, the increase in market rates of interest over the last 18 months due primarily to FRB aggregated increases of 2.5% in the overnight funds rates, which impacted market rates of interest in general.

Our net interest margin declined to 3.17% in the third quarter of 2006 from 3.42% in the same quarter of 2005, but remained substantially unchanged at 3.34% in the nine months ended September 30, 2006, as compared to 3.35% in the same nine months of 2005. In the three months ended September 30, 2006 the yield on interest-earning assets improved to 6.59%, while the average rate of interest paid on our interest-bearing liabilities increased to 4.17%, as compared to a yield on interest-earning assets of 5.54% and an average rate of interest paid on interest-bearing liabilities of 2.69%, in the same three months of 2005. In the nine months ended September 2006, the yield on interest-earning assets improved to 6.42%, and the average rate of interest paid on our interest-bearing liabilities increased to 3.75%, as compared to a yield on interest-earning assets of 5.31%, and an average rate of interest paid of 2.46% on interest-bearing liabilities in the same nine months of 2005.

This improvement in the average yield on interest-earning assets was due primarily to the substantial increase in the volume of loans on which we generate higher yields than on our other interest-earning assets and, to a lesser extent, the increase in interest rates during the 12 months ended September 30, 2006.

The increase in interest paid on interest bearing liabilities was due primarily to increases (i) in the volume of and interest rates on time certificates of deposit and (ii) in the interest rates on and, to a lesser extent, in the volume of outstanding borrowings.

The following table sets forth the changes in interest income, including loan fees, and interest paid in the three and nine month periods ended September 30, 2006, as compared to the same periods in 2005 and the extent to which those changes were attributable to changes in the volume and rates of interest earned on interest-earning assets and interest paid on interest-bearing liabilities.


	Three Months Ended September 30, 2006 vs 2005 Increase (decrease) due to:								Nine Months Ended September 30, 2006 vs 2005 Increase (decrease) due to:
	Volume⁽¹⁾			Rate⁽¹⁾			Total		Volume⁽¹⁾			Rate⁽¹⁾			Total
	(Unaudited) (Dollars in thousands)								(Unaudited) (Dollars in thousands)
Interest income:
Short-term investments⁽²⁾	$	(146	)	$	319		$	173	$	(668	)	$	552		$	(116	)
Securities available for sale and stock		(45	)		481			436		989			1,229			2,218
Loans		2,365			1,486			3,851		7,391			4,795			12,186

Total earning assets		2,174			2,286			4,460		7,712			6,576			14,288
Interest expense:
Interest-bearing checking accounts		(10	)		20			10		14			17			31
Money market and savings accounts		36			649			685		52			1,232			1,284
Certificates of deposit		1,067			759			1,826		1,821			2,475			4,296
Borrowings		268			1,108			1,376		1,945			2,661			4,606
Junior subordinated debentures		—			134			134		—			400			400

Total interest-bearing liabilities		1,361			2,670			4,031		3,832			6,785			10,617

Net interest income	$	813		$	(384	)	$	429	$	3,880		$	(209	)	$	3,671

⁽¹⁾

Changes in interest earned and interest paid due to changes in the mix of interest-earning assets and interest-bearing liabilities have been allocated to the change due to volume and the change due to interest rates in proportion to the relationship of the absolute dollar amounts of the changes in each.

⁽²⁾	Short-term investments consist of federal funds sold and interest bearing deposits with financial institutions.

The above table indicates that the increases of $429,000 and $3.7 million, respectively, in our net interest income in the three and nine month periods ended September 30, 2006, as compared to the like periods in 2005, were the result of increases of $813,000 and $3.9 million, respectively, in volume variance and offset by decreases of $384,000 and $209,000, respectively, in interest rate variance, for the three and nine month periods ended September 30, 2006, as compared to the same periods in 2005. The increases in the volume variance reflect the increases in average interest-earning assets of $130

million and $153 million, respectively, and in average interest-bearing liabilities of $139 million and $151 million, respectively, in the three and nine month periods ended September 30, 2006, as compared to the corresponding periods of 2005. The decreases in rate variance reflect the increases in interest rates paid on average interest-bearing liabilities of 156 basis points and 137 basis points, respectively, offset by increases in interest rates on average interest earning assets of 105 basis points and 112 basis points, respectively, in the three and nine month periods ended September 30, 2006, as compared to the corresponding periods of 2005.

Provision for Loan Losses

The failure or inability of borrowers to repay their loans is an inherent risk of the banking business. Therefore, like virtually all banks and other financial institutions, we follow the practice of maintaining a reserve or allowance (the “Allowance”) for possible loan losses that occur from time to time as an incidental part of the banking business. When it is determined that the payment in full of a loan has become unlikely, the carrying value of the loan is reduced to what management believes is its realizable value. This reduction, which is referred to as a loan “charge-off,” or “write-down” is charged against the Allowance. The amount of the Allowance is increased periodically (i) to replenish the Allowance after it has been reduced due to loan charge-offs, (ii) to reflect changes in the volume of outstanding loans, and (iii) to take account of changes in the risk of potential losses due to a deterioration in the condition of borrowers or in the value of property securing non–performing loans or changes in economic conditions. See “—Financial Condition—Allowance for Loan Losses and Nonperforming Loans” below in this Section of this Report. Increases in the Allowance for Loan Losses are made through a charge, recorded as an expense in the statement of income, referred to as the “provision for loan losses.” Recoveries of loans previously charged-off are added back to the Allowance and, therefore, have the effect of increasing the Allowance and reducing the amount of the provision that might otherwise have to be made to replenish or increase it.

During the third quarter of 2006, we made provisions, totaling $270,000, for potential loan losses, as compared to $340,000 in the same quarter of 2005. At September 30, 2006, the Allowance for Loan Losses totaled $5.9 million, or 0.82% of loans then outstanding, as compared to $4.7 million, or 0.79% of loans outstanding, at September 30, 2005.

Although we employ economic models that are based on bank regulatory guidelines, industry standards and historical loss experience to evaluate and determine the sufficiency of the Allowance for Loan Losses and, thereby, the amount of the provisions required to be made for potential loan losses, those determinations involve judgments about trends in current economic conditions and other events that can affect the ability of borrowers to meet their loan obligations. The duration and effects of current economic trends are subject to a number of uncertainties and changes that are outside of our ability to control. See the discussion below in this Section under the caption “Risks That Could Affect our Future Financial Performance—we could incur losses on the loans we make.” If changes in economic or market conditions or unexpected subsequent events were to occur, it could become necessary to incur additional charges to increase the Allowance, which would have the effect of reducing our income or causing us to incur losses.

In addition, the Federal Reserve Board and the California Department of Financial Institutions, as an integral part of their examination processes, periodically review the adequacy of our Allowance for Loan Losses. These agencies may require us to make additional provisions, over and above the provisions that we have already made, the effect of which would be to reduce our income.

Noninterest Income

Noninterest income consists primarily of fees charged for services provided by the Bank on deposit accounts. The following table identifies the components of, and sets forth the percentage changes in, noninterest income in the three and nine month periods ended September 30, 2006, as compared to the same respective periods of 2005.


	Three Months Ended September 30,						Nine Months Ended September 30,
	Amount				Percentage Change 2006 vs. 2005		Amount				Percentage Change 2006 vs. 2005
	2006		2005		Percentage Change 2006 vs. 2005		2006		2005		Percentage Change 2006 vs. 2005
	Unaudited (Dollars in thousands)						Unaudited (Dollars in thousands)
Service fees on deposits	$	174	$	164	6.1	%	$	542	$	502	8.0	%
Other		215		72	198.6	%		451		315	43.2	%

Total	$	389	$	236	64.8	%	$	993	$	817	21.5	%

Noninterest Expense

The following table compares the amounts (in thousands of dollars) of the principal components of noninterest expense in the three and nine months ended September 30, 2006 and in the same three and nine month periods of 2005.


	Three Months Ended September 30,						Nine Months Ended September 30,
	Amount				Percentage Change 2006 vs. 2005		Amount				Percentage Change 2006 vs. 2005
	2006		2005		Percentage Change 2006 vs. 2005		2006		2005		Percentage Change 2006 vs. 2005
	Unaudited (Dollars in thousands)						Unaudited (Dollars in thousands)
Salaries and employee benefits	$	2,894	$	2,313	25.1	%	$	8,635	$	6,590	31.0	%
Occupancy		670		624	7.4	%		1,926		1,695	13.6	%
Equipment and depreciation		343		350	(2.0	)%		1,027		1,180	(12.97	)%
Data processing		165		137	20.4	%		503		369	36.3	%
Professional fees		239		368	(35.1	)%		878		861	2.0	%
Customer expense		221		155	42.6	%		636		370	71.9	%
Other operating expense⁽¹⁾		729		577	26.3	%		2,013		1,644	22.4	%

Total	$	5,261	$	4,524	16.3	%	$	15,618	$	12,709	22.9	%

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

Due primarily to the continued growth of our commercial banking business, non-interest expense increased by $737,000, or 16%, to $5.3 million in this year’s third quarter, and by $2.9 million, or 23%, to $15.6 million in the nine months ended September 30, 2006, in each case as compared to the respective corresponding period of 2005. Those increases were primarily attributable to (i) the addition of commercial loan officers in our Southern California Financial Centers, beginning in the second half of 2005, and (ii) the recognition, in accordance with SFAS No. 123R, of stock-based compensation in the amounts of $122,000 and $461,000, respectively, in the quarter and nine months ended September 30, 2006. By contrast, stock based compensation was not required to be recognized in prior years. Also contributing to the increase in non-interest expense in the nine months ended September 30, 2006 was the opening, in June 2005, of our new Inland Empire Financial Center in Ontario.

A measure of our ability to control noninterest expense in relation to the level of our net revenue (net interest income plus noninterest income) is our efficiency ratio, which is the ratio of noninterest expense to net revenue. As a general rule, all other things being equal, a lower efficiency ratio indicates an ability to generate increased revenue without a commensurate increase in the staffing and equipment and third party services and, therefore, would indicate greater efficiencies in our operations. However, a bank’s efficiency ratio can be adversely affected by factors such as the opening of new banking offices, the revenues of which usually lag behind the expenses that a bank must incur to staff and open the new offices.

Due primarily to the growth related increases in noninterest expense, our efficiency ratio (operating expenses as a percentage of total revenues from continuing operations) in the three and nine month periods ended September 30, 2006 was 63% and 61%, respectively, as compared to 58% and 59% in the same respective periods of 2005.

Asset/Liability Management

The primary objective of asset/liability management is to reduce our exposure to interest rate fluctuations, which can affect our net interest margins and, therefore, our net interest income and net earnings. We seek to achieve this objective by matching interest rate sensitive assets and liabilities, and maintaining the maturities and the repricing of these assets and liabilities at appropriate levels in response to the changes in the interest rate environment. Generally, if rate sensitive assets exceed rate sensitive liabilities, net interest income will be positively impacted during a rising interest rate environment and negatively impacted during a declining interest rate environment. When rate sensitive liabilities exceed rate sensitive assets, net interest income generally will be positively impacted during a declining interest rate environment and negatively impacted during a rising interest rate environment. However, because interest rates for different asset and liability products offered by depository institutions respond differently to changes in the interest rate environment, the relationship or “gap” between interest sensitive assets and interest sensitive liabilities is only a general indicator of interest rate sensitivity and how our net interest income might be affected by changing rates of interest.

For example, rates on certain assets or liabilities typically lag behind changes in market rates of interest. Additionally, prepayments of loans and securities available for sale, and early withdrawals of certificates of deposit, could cause the interest sensitivities to vary.

The table below sets forth information concerning our rate sensitive assets and liabilities at September 30, 2006. The assets and liabilities are classified by the earlier of maturity or repricing dates in accordance with their contractual terms. As is described above, certain shortcomings are inherent in the method of analysis presented in this table.


	Three Months or Less			Over Three Through Twelve Months			Over One Year Through Five Years			Over Five Years			Non- Interest- Bearing			Total
	Unaudited (Dollars in thousands)
Assets
Interest-bearing deposits in other financial institutions	$	198		$	—		$	—		$	—		$	—		$	198
Investment in unconsolidated trust subsidiaries		—			—			—			—			837			837
Securities available for sale		14,365			35,195			122,840			57,071			—			229,471
Federal Reserve Bank and Federal Home Loan Bank stock		13,585			—			—			1,706			—			15,291
Federal funds sold		58,800			—			—			—			—			58,800
Loans, gross		305,054			66,773			254,833			84,973			—			711,633
Non-interest earning assets, net		—			—			—			—			27,448			27,448

Total assets	$	392,002		$	101,968		$	377,673		$	143,750		$	28,285		$	1,043,678

Liabilities and Shareholders Equity
Noninterest-bearing deposits	$	—		$	—		$	—		$	—		$	186,275		$	186,275
Interest-bearing deposits		246,352	⁽¹⁾		183,047	⁽²⁾		88,379	⁽³⁾		—			—			517,778
Borrowings		72,116			68,000			80,000			—			—			220,116
Junior subordinated debentures		27,837			—			—			—			—			27,837
Other liabilities		—			—			—			—			6,086			6,086
Shareholders’ equity		—			—			—			—			85,586			85,586

Total liabilities and shareholders equity	$	346,305		$	251,047		$	168,379		$	0		$	277,947		$	1,043,678

Interest rate sensitivity gap	$	45,697		$	(149,079	)	$	209,294		$	143,750		$	(249,662	)

Cumulative interest rate sensitivity gap	$	45,697		$	(103,382	)	$	105,912		$	249,662		$	—

Cumulative % of rate sensitive assets in maturity period		38	%		47	%		84	%		97	%		100	%

Rate sensitive assets to rate sensitive liabilities and shareholders’ equity		113	%		41	%		224	%		N/A			N/A

Cumulative ratio		113	%		83	%		114	%		133	%		N/A

¹	Net of Bancorp’s savings account of $19.3 million

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

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

At September 30, 2006, our rate sensitive balance sheet was shown to be in a negative twelve-month gap position. This would imply that our net interest margin would decrease in the short–term if interest rates rise and would increase in the short-term if interest rates were to fall. However, as noted above, the extent to which our net interest margin will be impacted by changes in prevailing interests rates will depend on a number of factors, including how quickly rate sensitive assets and liabilities react to interest rate changes, the mix of our interest earning assets (loans versus other lower yielding interest earning assets, such as securities) and the mix of our interest bearing deposits (between for example, lower interest core deposits and higher cost time certificates of deposit) and our other interest bearing liabilities.

Financial Condition

Assets

Our total consolidated assets increased by $63 million, or 6%, to $1 billion at September 30, 2006 from $981 million at December 31, 2005, primarily as a result of increases in loan volume. Those increases were funded primarily by increases in deposits and proceeds from the maturity and prepayments of investment securities.

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


	September 30, 2006		December 31, 2005
	Unaudited
Federal funds sold	$	58,800	$	11,400
Interest-bearing deposits with financial institutions		198		441
Federal Reserve Bank and Federal Home Loan Bank Stock, at cost		15,291		13,349
Securities available for sale, at fair value		229,471		265,556
Loans (net of allowances of $5,869 and $5,126, respectively)		705,764		650,027

Loans

The following table sets forth, in thousands of dollars, the composition, by loan category, of our loan portfolio, at September 30, 2006 and December 31, 2005:


	September 30, 2006					December 31, 2005
	Amount			Percent		Amount			Percent
	Unaudited
Commercial loans	$	204,735		28.7	%	$	187,246		28.6	%
Real estate loans		254,582		35.7	%		241,866		36.9	%
Residential mortgage loans		177,225		24.9	%		173,685		26.5	%
Construction loans		70,256		9.9	%		47,056		7.2	%
Consumer loans		5,443		0.8	%		5,523		0.8	%

Gross loans		712,241		100.0	%		655,376		100.0	%

Deferred fee (income) costs, net		(608	)				(223	)
Allowance for loan losses		(5,869	)				(5,126	)

Loans, net	$	705,764				$	650,027

Commercial loans are loans to businesses to finance capital purchases or improvements, or to provide cash flow for operations. Real estate and residential mortgage loans are loans secured by trust deeds on real property, including commercial property and single family and multi-family residences. Construction loans are interim loans to finance specific construction projects. Consumer loans include installment loans to consumers.

The following table sets forth, in thousands of dollars, the maturity distribution of our loan portfolio (excluding consumer and residential mortgage loans) at September 30, 2006:


	September 30, 2006
	One Year or Less		Over One Year Through Five Years		Over Five Years		Total
	Unaudited
Real estate and construction loans⁽¹⁾
Floating rate	$	86,212	$	18,655	$	140,575	$	245,442
Fixed rate		10,620		24,367		44,409		79,396
Commercial loans
Floating rate		132,519		30,235		4,588		167,342
Fixed rate		15,171		18,853		3,369		37,393

Total	$	244,522	$	92,110	$	192,941	$	529,573

⁽¹⁾	Does not include mortgage loans on single and multi-family residences and consumer loans, which totaled $177.2 million and $5.4 million, respectively, at September 30, 2006.

Allowance for Loan Losses and Nonperforming Loans

Allowance for Loan Losses. The allowance for loan losses (the “Allowance”) at September 30, 2006 was $5.9 million, which represented approximately 0.82% of the loans outstanding at September 30, 2006, as compared to $5.1 million, or 0.78%, of the loans outstanding at December 31, 2005.

We carefully monitor changing economic conditions, the loan portfolio by category, the financial condition of borrowers, the history of the loan portfolio, and bank regulatory guidelines in determining the adequacy of the Allowance. We believe that the Allowance at September 30, 2006 was adequate to provide for losses inherent in the loan portfolio. However, as the volume of loans increases, additional provisions for loan losses will be required to maintain the Allowance at adequate levels. Additionally, the Allowance was established on the basis of assumptions and judgments regarding such matters as economic conditions and trends and the condition of borrowers, historical industry loan loss data and regulatory guidelines, and actual loan losses in the future could vary from the losses predicted on the basis of those assumptions, judgments and guidelines. For example, if economic conditions were to deteriorate, or interest rates were to increase significantly, which would have the effect of increasing the risk that borrowers would encounter difficulties meeting their loan payment obligations, it could become necessary to increase the Allowance by means of additional provisions for loan losses. See “—Results of Operations—Provision for Loan Losses” above.

Set forth below is a summary, in thousands of dollars, of the transactions in the allowance for loan losses for the nine months ended September 30, 2006 and the year ended December 31, 2005:


	Nine Months Ended September 30, 2006			Year Ended December 31, 2005
	Unaudited
Balance, beginning of period	$	5,126		$	4,032
Provision for loan losses		830			1,145
Amounts charged off		(87	)		(51	)

Balance, end of period	$	5,869		$	5,126

Non-Performing Loans. We also measure and establish reserves for loan impairments on a loan-by-loan basis using either the present value of expected future cash flows discounted at a loan’s effective interest rate, or the fair value of the collateral if the loan is collateral-dependent. We exclude smaller, homogeneous loans, such as consumer installment loans and lines of credit, from our impairment calculations. Also, loans that experience insignificant payment delays or shortfalls are generally not considered impaired. We cease accruing interest, and therefore classify as nonaccrual, any loan as to which principal or interest has been in default for a period of 90 days or more, or if repayment in full of interest or principal is not expected.

Loans classified as non-performing or impaired totaled $781,000, or 0.11% of total loans outstanding, at September 30, 2006, as compared to $1.4 million, or 0.23% of total loans outstanding, at September 30, 2005. Loans 90 days past due totaled $212,000, or 0.03% of total loans outstanding, at September 30, 2006, as compared to $1.4 million, or 0.23% of total loans outstanding, at September 30, 2005. We had no restructured loans at September 30, 2006 or 2005. At September 30, 2006, the allowance for loan losses totaled $5.9 million, or 0.82%, of core loans outstanding, as compared to $4.7 million and 0.79%, respectively, at September 30, 2005. We increased the dollar amount of the allowance for loan losses by making provisions for loan losses in the quarter and nine months ended September 30, 2006, of $270,000 and $830,000, respectively. At September 30, 2006, our average investment in impaired loans, on a year-to-date basis, was $443,000. The interest that we would have earned in the nine months ended September 30, 2006, had the impaired loans remained current in accordance with their original terms was $21,000.

Deposits

Average Balances of and Average Interest Rates Paid on Deposits. Set forth below, in thousands of dollars, are the average amounts (in thousands of dollars) of, and the average rates paid on, deposits for the nine months ended September 30, 2006:


	Nine Months Ended September 30, 2006
	Unaudited
	Average Balance		Average Rate
Noninterest-bearing demand deposits	$	184,155	—
Interest-bearing checking accounts		25,451	0.66	%
Money market and savings deposits		141,378	2.90	%
Time deposits		274,386	4.48	%

Average total deposits	$	625,370	2.65	%

Deposit Totals. Deposits totaled $704 million at September 30, 2006 as compared to $580 million at December 31, 2005. At September 30, 2006, noninterest-bearing deposits totaled $186 million and represented 26% of total deposits, as compared to $201 million and 35% of total deposits at December 31, 2005. At September 30, 2006, certificates of deposit in denominations of $100,000 or more totaled $203 million and represented 29% of total deposits, as compared to $136 million and 23% of total deposits at December 31, 2005. Set forth below, in thousands of dollars, is a maturity schedule of domestic time certificates of deposit outstanding at September 30, 2006:


	At September 30, 2006
	Certificates of Deposit Under $100,000		Certificates of Deposit of $100,000 or More
	Unaudited
Maturities
Three months or less	$	18,915	$	58,841
Over three and through twelve months		76,084		107,213
Over twelve months		51,110		37,269

Total certificates of deposit	$	146,109	$	203,323

Liquidity

We actively manage our liquidity needs to ensure that sufficient funds are available to meet the ongoing needs of our customers. We project the future sources and uses of funds and maintain sufficient liquid funds for unanticipated events. Our primary sources of cash include payments on loans, and the sale or maturity of investments and growth in deposits. The primary uses of cash include funding new loans and making advances on existing lines of credit, purchasing investments, including securities available for sale, funding deposit withdrawals and paying operating expenses. We maintain funds in overnight federal funds and other short-term investments to provide for short-term liquidity needs. We also have obtained credit lines from the Federal Home Loan Bank and other financial institutions to meet any additional liquidity requirements.

Cash flow Provided by Financing Activities. Cash flow of $56 million was provided by financing activities during the nine months ended September 30, 2006, the source of which consisted primarily of net increases of $124 million in deposits offset by a net decrease of $69 million in net borrowings.

Cash flow From Operating Activities. Cash flow of $6 million was provided by our continuing operations during the nine months ended September 30, 2006.

Cash flow Used in Investing. In the nine months ended September 30, 2006, we used cash flow of $23 million in investing activities, primarily to fund an increase of $57 million in loans, partially offset by $38 million of proceeds from principal payments received on investment securities available for sale.

Cash flow From Discontinued Operations. Our discontinued securities brokerage business provided $98,000 in the nine months ended September 30, 2006.

Our liquid assets, which included cash and due from banks, federal funds sold, interest earning deposits with financial institutions and unpledged securities available for sale (excluding Federal Reserve Bank and Federal Home Loan Bank stock) totaled $161 million or 11% of total assets at September 30, 2006.

The relationship between gross loans and total deposits provides a useful measure of our liquidity. Since repayment of loans tends to be less predictable than the maturity of investments and other liquid resources, the higher the loan-to-deposit ratio the less liquid are our assets. On the other hand, since we realize greater yields and higher interest income on loans than we do on investments, a lower loan-to-deposit ratio can adversely affect interest income and earnings. As a result, our goal is to achieve a loan-to-deposit ratio that appropriately balances the requirements of liquidity and the need to generate a fair return on assets. At September 30, 2006, the ratio of loans-to-deposits was 101%, compared to 112% at December 31, 2005. Even though our loans-to-deposits ratio was 101%, the Company maintained adequate liquidity supported by Federal Home Loan Bank advances and securities sold under repurchase agreements.

Off Balance Sheet Arrangements

Loan Commitments and Standby Letters of Credit. In order to meet the financing needs of our customers in the normal course of business, we make commitments to extend credit and issue standby commercial letters of credit to or for our customers. At September 30, 2006 and December 31, 2005, we were committed to fund certain loans and letters of credit amounting to approximately $219 million and $156 million, respectively.

Commitments to extend credit and standby letters of credit generally have fixed expiration dates or other termination clauses and the customer may be required to pay a fee and meet other conditions in order to draw on those commitments or standby letters of credit. We expect, based on historical experience, that many of the commitments will expire without being drawn upon and, therefore, the total commitment amounts do not necessarily represent future cash requirements.

To varying degrees, commitments to extend credit involve elements of credit and interest rate risk for us that are in excess of the amounts recognized in our balance sheets. Our maximum exposure to credit loss in the event of nonperformance by the customers to whom such commitments are made is equal to the amount of those commitments. As a result, before making such a commitment to a customer, we evaluate the customer’s creditworthiness using the same underwriting standards that we would apply if we were approving loans to the customer. In addition, we often require the customer to secure its payment obligations for amounts drawn on such commitments with collateral such as accounts receivable, inventory, property, plant and equipment, income-producing commercial properties, residential properties and properties under construction. As a consequence, our exposure to credit and interest rate risk on such commitments is not different in character or amount than risks inherent in the outstanding loans in our loan portfolio.

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers.

We believe that our cash and cash equivalent resources, together with available borrowings under our credit facilities, will be sufficient to enable us to meet any increases in demand for loans or in the utilization of outstanding loan commitments or standby letters of credit and any increase in deposit withdrawals that might occur in the foreseeable future.

Contractual Obligations

Borrowings. As of September 30, 2006, we had $90 million of outstanding long-term borrowings and $124 million of outstanding short-term borrowings that we had obtained from the Federal Home Loan Bank. The table below sets forth the amounts (in thousands of dollars) of, the interest rates we pay on, and the maturity dates of these Federal Home Loan Bank borrowings. These borrowings, along with the securities sold under agreements to repurchase, have a weighted-average annualized interest rate of 4.70%.


Principal Amounts	Interest Rate	Maturity Dates	Principal Amounts	Interest Rate	Maturity Dates
(Dollars in thousands)			(Dollars in thousands)
$5,000	2.39%	October 2, 2006	$10,000	5.28%	July 19, 2007
2,000	2.4%	October 2, 2006	3,000	3.14%	September 18, 2007
7,000	4.83%	October 10, 2006	2,000	3.06%	September 24, 2007
5,000	4.96%	October 19, 2006	1,000	2.91%	October 1, 2007
5,000	4.96%	November 9, 2006	7,000	5.6%	October 9, 2007
5,000	5.48%	November 13, 2006	5,000	5.38%	January 22, 2008
10,000	5.04%	November 16, 2006	5,000	5.24%	May 2, 2008
7,000	3.18%	November 22, 2006	10,000	5.29%	May 5, 2008
5,000	2.69%	December 12, 2006	7,000	5.25%	May 19, 2008
10,000	5.03%	December 14, 2006	8,000	5.28%	June 5, 2008
5,000	2.67%	December 18, 2006	8,000	5.55%	July 10, 2008
7,000	5.56%	January 11, 2007	5,000	5.36%	July 25, 2008
10,000	5.03%	January 18, 2007	5,000	5.22%	August 8, 2008
4,000	2.5%	January 22, 2007	10,000	5.22%	October 16, 2008
5,000	2.57%	February 12, 2007	2,000	5.26%	November 5, 2008
5,000	3.87%	May 18, 2007	5,000	3.45%	February 11, 2009
7,000	4.71%	June 20, 2007	12,000	5.25%	May 1, 2009
5,000	5.49%	July 16, 2007

At September 30, 2006, U.S. Agency and Mortgage Backed securities, U.S. Government agency securities and collateralized mortgage obligations with an aggregate fair market value of $187 million and $159 million of residential mortgage and other real estate secured loans were pledged to secure these Federal Home Loan Bank borrowings, repurchase agreements, local agency deposits, and Treasury, Tax and Loan accounts.

The highest amount of borrowings outstanding at any month end during the nine months ended September 30, 2006 consisted of $274 million of borrowings from the Federal Home Loan Bank and $33 million of overnight borrowings in the form of securities sold under repurchase agreements. During 2005, the highest amount of borrowings outstanding at any month end consisted of $249 million of advances from the Federal Home Loan Bank and $40 million of overnight borrowings in the form of securities sold under repurchase agreements.

Junior Subordinated Debentures. Pursuant to rulings of the Federal Reserve Board, bank holding companies have been permitted to issue long term subordinated debt instruments that will, subject to certain conditions, qualify as and, therefore, augment capital for regulatory purposes. Pursuant to those rulings, in 2002, we formed subsidiary grantor trusts to sell and issue to institutional investors a total of $17 million principal amount of floating junior trust preferred securities (“trust preferred securities”). We received the net proceeds from the sale of the trust preferred securities in exchange for our issuance to the grantor trusts, of a total $17 million principal amount of our junior subordinated floating rate debentures (the “Debentures”), the payment terms of which mirror those of the trust preferred securities. The Debentures also were pledged by the grantor trusts as security for their payment obligations under the trust preferred securities.

In October 2004, we established another grantor trust that sold an additional $10 million of trust preferred securities to an institutional investor and, in connection therewith, we sold and issued an additional $10 million principal amount of junior subordinated floating rate debentures in exchange for the proceeds raised from the sale of those trust preferred securities. The payments that we make of interest and principal on the Debentures are used by the grantor trusts to make the payments that come due to the holders of the trust preferred securities pursuant to the terms of those securities.

Set forth below, in thousands of dollars, are the principal amounts of, and certain other information regarding the terms of the Debentures that were outstanding as of September 30, 2006:


Original Issue Dates	Principal Amount		Interest Rates	Maturity Dates
June 2002	$	5,155	LIBOR plus 3.75%⁽¹⁾	June 2032
August 2002		5,155	LIBOR plus 3.625%⁽²⁾	August 2032
September 2002		7,217	LIBOR plus 3.40%⁽¹⁾	September 2032
October 2004		10,310	LIBOR plus 2.00%⁽¹⁾	October 2034

Total	$	27,837

⁽¹⁾	Interest rate resets quarterly.

⁽²⁾	Interest rate resets semi-annually.

These Debentures, which are redeemable at our option, without premium or penalty, beginning five years after their respective original issue dates, require quarterly or semi-annual interest payments. Subject to certain conditions, we have the right, at our discretion, to defer those interest payments for up to five years. However, we have no plans to exercise this deferral right.

Under the Federal Reserve Board rulings, the borrowings evidenced by the Debentures, which are subordinated to all of our other borrowings that are outstanding or which we may obtain in the future, are eligible (subject to certain dollar limitations) to qualify, and at September 30, 2006, a total amount of $27.8 million principal amount of those Debentures qualified, as Tier I capital for regulatory purposes.

Investment Policy and Securities Available for Sale

Our investment policy is designed to provide for our liquidity needs and to generate a favorable return on investments without undue interest rate risk, credit risk or asset concentrations.

Our investment policy:

•

authorizes us to invest in obligations issued or fully guaranteed by the United States Government, certain federal agency obligations, time deposits issued by federally insured depository institutions, municipal securities and in federal funds sold;

•

provides that the weighted average maturities of U.S. Government obligations and federal agency securities cannot exceed 10 years and municipal obligations cannot exceed 25 years;

•

provides that time deposits must be placed with federally insured financial institutions, cannot exceed $100,000 in any one institution and may not have a maturity exceeding 60 months; and

•

prohibits engaging in securities trading activities.

Securities available for sale are those that we intend to hold for an indefinite period of time, but which may be sold in response to changes in liquidity needs, changes in interest rates, changes in prepayment risks or other similar factors. Such securities are recorded at fair value. Any unrealized gains and losses are reported as “Other Comprehensive Income (Loss)” rather than included in or deducted from earnings.

The following is a summary of the major components of securities available for sale and a comparison of the amortized cost, estimated fair values and gross unrealized gains and losses, in thousands of dollars, as of September 30, 2006 and December 31, 2005:


	Amortized Cost		Gross Unrealized Gain		Gross Unrealized Loss		Estimated Fair Value
	Unaudited
September 30, 2006
Securities Available For Sale:
Mortgage-backed securities	$	199,359	$	10	$	5,307	$	194,062
Collateralized mortgage obligations		22,482		—		455		22,027

Total government and agencies securities		221,841		10		5,762		216,089
Municipal securities		11,651		244		—		11,895
Mutual fund		1,487		—		—		1,487

Total Securities Available For Sale	$	234,979	$	254	$	5,762	$	229,471

December 31, 2005
Securities Available For Sale:
U.S. agencies and mortgage-backed securities	$	233,405	$	10		5,621	$	227,794
Collateralized mortgage obligations		25,190		—		583		24,607

Total government and agencies securities		258,595		10		6,204		252,401
Municipal securities		11,651		56		38		11,669
Mutual fund		1,486		—		—		1,486

Total Securities Available For Sale	$	271,732	$	66		6,242	$	265,556

At September 30, 2006, U.S. Agencies and Mortgage Backed securities, U.S. Government Agency securities and collateralized mortgage obligations with an aggregate fair market value of $215 million were pledged to secure Federal Home Loan Bank borrowings, repurchase agreements, local agency deposits and Treasury, Tax and Loan accounts.

The amortized cost and estimated fair value, at September 30, 2006, of securities available for sale are shown, in thousands of dollars in the following table, by contractual maturities and historical prepayments based on the prior nine months of principal payments. Expected maturities will differ from contractual maturities and historical prepayments, particularly with respect to collateralized mortgage obligations, because borrowers may react to interest rate market conditions differently than the historical prepayment rates.


	Maturing in
	One year or less			Over one year through five years			Over five years through ten years			Over ten years			Total
(Dollars in thousands)	Unaudited
Securities available for sale, amortized cost	$	42,115		$	112,751		$	49,887		$	30,226		$	234,979
Securities available for sale, estimated fair value		40,911			109,693			48,875			29,992			229,471
Weighted average yield		4.10	%		4.26	%		4.49	%		4.63	%		4.32	%

The table below shows as of September 30, 2006, the gross unrealized losses and fair values (in thousands of dollars) of our investments, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position.


	Securities With Unrealized Loss as of September 30, 2006
	Less than 12 months					12 months or more					Total
(Dollars In thousands)	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
	Unaudited
US agencies and mortgage backed securities	$	32,084	$	(227	)	$	159,888	$	(5,080	)	$	191,972	$	(5,307	)
Collateralized mortgage obligations		9,705		(98	)		12,322		(357	)		22,027		(455	)
Municipal securities		—		—			—		—			—		—

Total temporarily impaired securities	$	41,789	$	(325	)	$	172,210	$	(5,437	)	$	213,999	$	(5,762	)

We regularly monitor investments for significant declines in fair value. We have determined that the declines in the fair values of these investments below their amortized costs, as set forth in the table above, are temporary based on the following: (i) those declines are due to interest rate changes and not due to a deterioration in the creditworthiness of the issuers of those investment securities, and (ii) we have the ability to hold those securities until there is a recovery in their values.

Capital Resources

Capital Regulatory Requirements Applicable to Banking Institutions. Under federal banking regulations that apply to all United States based bank holding companies and federally insured banks, the Company (on a consolidated basis) and the Bank (on a stand-alone basis) must meet specific capital adequacy requirements that, for the most part, involve quantitative measures that determine the ratios of their capital to their assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. Under those regulations, based primarily on those quantitative measures each bank holding company and each federally insured bank is determined by its primary federal bank regulatory agency to come within one of the following categories.

•

well capitalized

•

adequately capitalized

•

undercapitalized

•

significantly undercapitalized; or

•

critically undercapitalized

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

The following table sets forth the amounts of capital and capital ratios of the Company (on a consolidated basis) and the Bank (on a stand alone basis) at September 30, 2006, as compared to the respective minimum regulatory requirements applicable to them.


					Applicable Federal Regulatory Requirement
	Actual				Capital Adequacy Purposes				To be Categorized Well Capitalized
	Amount		Ratio		Amount		Ratio		Amount		Ratio
	(Dollars in thousands)
Total Capital to Risk Weighted Assets:
Company	$	121,696	15.76	%	$	61,789	At least 8.0	%	$	77,237	At least 10.0	%
Bank		84,730	11.15	%		60,784	At least 8.0	%		75,980	At least 10.0	%
Tier 1 Capital to Risk Weighted Assets:
Company	$	115,827	15.00	%	$	30,895	At least 4.0	%	$	46,342	At least 6.0	%
Bank		78,499	10.33	%		30,392	At least 4.0	%		45,588	At least 6.0	%
Tier 1 Capital to Average Assets:
Company	$	115,827	11.23	%	$	41,253	At least 4.0	%	$	51,566	At least 5.0	%
Bank		78,499	7.66	%		41,002	At least 4.0	%		51,252	At least 5.0	%

As of September 30, 2006, based on applicable capital regulations, the Company (on a consolidated basis) and the Bank (on a stand-alone basis) qualified as well capitalized institutions under the capital adequacy guidelines described above.

Our consolidated total capital and Tier 1 capital of the Company, at September 30, 2006, include an aggregate of $27.8 million of long term indebtedness evidenced by the Junior Subordinated Debentures that we issued in 2002 and 2004 in connection with the sale of trust preferred securities. We contributed $26 million of the net proceeds from the sale of the trust preferred securities to the Bank, thereby, increasing its total capital and Tier 1 capital.

Dividend Policy and Share Repurchase Program. The Board of Directors intends, during the next twelve months, to analyze the Company’s cash flow requirements in order to determine whether to begin to pay dividends.

In July 2005, our Board of Directors concluded that, at prevailing market prices, the Company’s shares represented an attractive investment opportunity and, therefore, that repurchases of Company shares would be a good use of Company funds. As a result, the Board of Directors approved a share repurchase program, which authorizes Company to purchase up to two percent (2%) of the Company’s outstanding common shares, which are approximately 200,000 shares in total. Purchases may be made in the open market or in private transactions, in accordance with applicable Securities and Exchange Commission rules, when opportunities become available to purchase shares at prices believed to be attractive. The Company is under no obligation to repurchase shares under the share repurchase program and the timing, actual number and value of shares that are repurchased by the Company under this program will depend on a number of factors, including the Company’s future financial performance and available cash resources, competing uses for its corporate funds, prevailing market prices of its common stock and the number of shares that become available for sale at prices that the Company believes are attractive, as well as any regulatory requirements applicable to the Company. To date the Company has not purchased any stock under this program.

Risks That Could Affect Our Future Financial Performance

This Report, including the discussion and analysis of our financial condition and results of operations set forth above, contains certain forward-looking statements. Forward-looking statements set forth our estimates of, or our expectations, beliefs or views regarding our future financial performance that are based on current information and that are subject to a number of risks and uncertainties that could cause our actual operating results and financial performance in the future to differ significantly from those expected at the current time. Those risks and uncertainties include, although they are not limited to, the following:

We face intense competition from other banks and financial institutions that could hurt our business

We conduct our business operations in Southern California, where the banking business is highly competitive and is dominated by a relatively small number of large multi-state banks with offices operating over wide geographical areas. We

also compete with other financial service businesses, mutual fund companies, and securities brokerage and investment banking firms that offer competitive banking and financial products and services. Increased competition may prevent us from (i) achieving increases, or could even result in a decrease, in our loan volume or deposit accounts or (ii) increasing interest rates on loans or reducing interest rates we pay to attract or retain deposits, any of which could cause a decline in interest income or an increase in interest expense, that could cause our net interest income and our earnings to decline.

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

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

•

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

•

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

•

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

Additionally, real estate values in California have been increasing rapidly in recent years. In the event that these values are not sustained or other events, such as earthquakes or fires, that may be more prevalent in Southern California than other geographic areas, cause a decline in real estate values, our collateral coverage for our loans will be reduced and we may suffer increased loan losses.

National economic conditions and changes in Federal Reserve Board monetary policies could affect our operating result.

Our ability to achieve and sustain our profitability is substantially dependent on our net interest income. Like most banking organizations and other depository institutions, our interest income is affected by a number of factors outside of our control, including changes in market rates of interest, which in turn are affected by changes in national economic conditions and national monetary policies adopted by the Federal Reserve Board. For example, adverse changes in economic conditions, and increasing rates of interest as a result of the Federal Reserve Board’s monetary policies, could cause prospective borrowers to fail to qualify for our loan products and reduce loan demand, thereby reducing our net interest margins. In addition, such conditions could adversely affect the financial capability of borrowers to meet their loan obligations, which could result in loan losses and require increases in provisions made for possible loan losses.

Rapid growth could strain our resources and lead to operating problems or inefficiencies

We have grown substantially in the past five years by opening new financial centers. We intend to continue to evaluate the opening of new financial centers, primarily in Southern California, either by opening new offices or acquiring one or more community banks. The opening of new offices or the acquisition of another bank will result in increased operating expenses until new banking offices or acquired banking operations attract sufficient business to cover operating expenses, which usually takes at least six to twelve months. There is no assurance, however, as to how long it would take for new financial centers to begin generating positive cash flow and earnings. Also, we cannot assure that we will be able to adequately manage our growth, which will make substantial demands on the time and attention of management and on our capital resources. The failure to prepare appropriately and on a timely basis for growth could cause us to experience inefficiencies or failures in our service delivery systems, regulatory problems, and erosion in customer confidence, unexpected expenses or other problems.

We could incur losses on the loans we make

The failure or inability of borrowers to repay their loans is an inherent risk in the banking business. We take a number of measures designed to reduce this risk, including the maintenance of stringent loan underwriting policies and the establishment of reserves for possible loan losses and the requirement that borrowers provide collateral that we could sell in

the event they fail to pay their loans. However, the ability of borrowers to repay their loans, the adequacy of our reserves and our ability to sell collateral for amounts sufficient to offset loan losses are affected by a number of factors outside of our control, such as changes in economic conditions, increases in market rates of interest and changes in the condition or value of the collateral securing our loans. As a result, we could incur losses on the loans we make that will hurt our operating results and weaken our financial condition.

Government regulations may impair our operations or restrict our growth

We are subject to extensive supervision and regulation by federal and state bank regulatory agencies. The primary objective of these agencies is to protect bank depositors and other customers and not shareholders, whose respective interests will often differ. The regulatory agencies have the legal authority to impose restrictions which they believe are needed to protect depositors and customers of banking institutions, even if such restrictions would adversely affect the ability of the banking institution to expand its business, or result in increases in its costs of doing business or hinder its ability to compete with financial services companies that are not regulated or banks or financial service organizations that are less regulated. Additionally, due to the complex and technical nature of many of the government regulations to which banking organizations are subject, inadvertent violations may occur. In such an event, we would be required to correct or implement measures to prevent a recurrence of such violations. If more serious violations were to occur, the regulatory agencies could limit our activities or growth, fine us or ultimately put us out of business.

The loss of key personnel could hurt our financial performance

Our success depends to a great extent on the continued availability of our existing management, in particular on Raymond E. Dellerba, President and Chief Executive Officer. In addition to their skills and experience as bankers, our executive officers provide us with extensive community ties upon which our competitive strategy is partially based. We do not maintain key-man life insurance on these executives, other than Mr. Dellerba. As a result, the loss of the services of any of these officers could harm our ability to implement our business strategy.

Other Risks

Other risks that could affect our future financial performance are described in Item 1A , entitled “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2005 filed with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended, and readers are urged to review those risks as well.

Due to these and other possible uncertainties and risks, readers are cautioned not to place undue reliance on the forward looking statements, which speak only as of the date of this Report. We also disclaim any obligation to update forward-looking statements contained in this Report or in our Annual Report on Form 10-K.

ITEM 3. MARKET RISK

We are exposed to market risk as a consequence of the normal course of conducting our business activities. The primary market risk to which we are exposed is interest rate risk. Our interest rate risk arises from the instruments, positions and transactions entered into for purposes other than trading. They include loans, securities, deposit liabilities, and short-term borrowings. Interest rate risk occurs when assets and liabilities reprice at different times as market interest rates change. Interest rate risk is managed within an overall asset/liability framework for the Company.

ITEM 4. CONTROLS AND PROCEDURES

Our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) are designed to provide reasonable assurance that information required to be disclosed in our reports filed under that Act (the Exchange Act), such as this Quarterly Report on Form 10-Q, is recorded, processed, summarized and reported within the time periods specified in the rules of the Securities and Exchange Commission. Our disclosure controls and procedures also are designed to provide reasonable assurance that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosures.

Our management, under the supervision and with the participation of our Chief Executive Officer and the Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures in effect as of September 30, 2006. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2006, our disclosure controls and procedures were effective to provide reasonable assurance that material information, relating to the Company and its consolidated subsidiaries, required to be included in our Exchange Act reports, including this Quarterly Report on Form 10-Q, is made known to management, including the Chief Executive Officer and Chief Financial Officer, on a timely basis.

There were no changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2006 that has materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II

ITEM 1A. RISK FACTORS

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

ITEM 6. EXHIBITS

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


Exhibits:
Exhibit 31.1		Certification of Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 31.2		Certification of Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 32.1		Certification of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit 32.2		Certification of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002

SIGNATURES

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


	PACIFIC MERCANTILE BANCORP

Date: November 8, 2006	By:	/s/ NANCY A. GRAY
		Nancy A. Gray, Chief Financial Officer

S-1

EXHIBIT INDEX


Exhibit No.		Description of Exhibit

31.1		Certification of Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Certification of Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Certification of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Certification of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002

E-1

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents