Edgar Filing: PACIFIC MERCANTILE BANCORP

Form 10-Q

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 March 31, 2009

¨	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 has submitted electronically and posted on its corporate website, if any, every interactive data file required to be submitted and posted pursuant to Rule 405 of Regulation S-T (section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨

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

Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨ Smaller reporting company ¨

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

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.

10,434,665 shares of Common Stock as of May 6, 2009

PACIFIC MERCANTILE BANCORP

QUARTERLY REPORT ON FORM 10Q

FOR

THE QUARTER ENDED MARCH 31, 2009

TABLE OF CONTENTS


		Page No.
Part I. Financial Information

Item 1.	Financial Statements	1

	Consolidated Statements of Financial Condition at March 31, 2009 and December 31, 2008	1

	Consolidated Statements of Operations for the Three Months ended March 31, 2009	2

	Consolidated Statement of Comprehensive (Loss) Income for the Three Months ended March 31, 2009	3

	Consolidated Statements of Cash Flows for the Three Months ended March 31, 2009	4

	Notes to Consolidated Financial Statements	5

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15

Item 3.	Market Risk	36

Item 4.	Controls and Procedures	36

Part II. Other Information

Item 1A.	Risk Factors	37

Item 6.	Exhibits	37

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)


	March 31, 2009			December 31, 2008
ASSETS
Cash and due from banks	$	14,012		$	16,426
Interest bearing deposits with financial institutions		153,230			90,707

Cash and cash equivalents		167,242			107,133
Interest-bearing time deposits with financial institutions		38,348			198
Federal Reserve Bank and Federal Home Loan Bank Stock, at cost		13,420			13,420
Securities available for sale, at fair value		117,263			160,945
Loans (net of allowances of $16,263 and $15,453, respectively)		827,709			828,041
Investment in unconsolidated subsidiaries		682			682
Other real estate owned		17,076			14,008
Accrued interest receivable		4,044			3,834
Premises and equipment, net		1,035			1,140
Other assets		19,176			34,658

Total assets	$	1,205,995		$	1,164,059

LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Noninterest-bearing	$	151,911		$	152,462
Interest-bearing		744,681			669,224

Total deposits		896,592			821,686
Borrowings		204,579			233,758
Accrued interest payable		2,166			2,850
Other liabilities		4,015			4,006
Junior subordinated debentures		17,527			17,527

Total liabilities		1,124,879			1,079,827

Commitments and contingencies (Note 2)		—			—
Shareholders’ equity:
Preferred stock, no par value, 2,000,000 shares authorized, none issued		—			—
Common stock, no par value, 20,000,000 shares authorized, 10,434,665 shares issued and outstanding at March 31, 2009 and December 31, 2008		72,697			72,592
Retained earnings		10,697			12,831
Accumulated other comprehensive loss		(2,278	)		(1,191	)

Total shareholders’ equity		81,116			84,232

Total liabilities and shareholders’ equity	$	1,205,995		$	1,164,059

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 OPERATIONS

(Dollars in thousands, except for per share data)

(Unaudited)


	Three Months Ended March 31,
	2009			2008
Interest income:
Loans, including fees	$	11,985		$	12,887
Federal funds sold		—			282
Securities available for sale and stock		1,439			2,733
Interest-bearing deposits with financial institutions		89			2

Total interest income		13,513			15,904
Interest expense:
Deposits		5,908			6,159
Borrowings		2,213			2,860

Total interest expense		8,121			9,019

Net interest income		5,392			6,885
Provision for loan losses		3,450			1,075

Net interest income after provision for loan losses		1,942			5,810

Noninterest income
Service fees on deposits and other banking services		372			212
Net gain on sale of securities available for sale		1,884			1,080
Net loss on sale of other real estate owned		2			—
Other		197			182

Total noninterest income		2,455			1,474

Noninterest expense
Salaries and employee benefits		3,658			3,291
Occupancy		681			683
Equipment and furniture		265			284
Data processing		163			172
Professional fees		526			273
Customer expense		96			114
FDIC expense		324			146
Other real estate owned expense		287			81
Other operating expense		653			652

Total noninterest expense		6,653			5,696

Income (loss) before income taxes		(2,256	)		1,588
Income tax provision (benefit)		(122	)		588

Net income (loss)	$	(2,134	)	$	1,000

Earnings (loss) per share
Basic	$	(0.20	)	$	0.10
Diluted	$	(0.20	)	$	0.09
Dividends paid per share		—		$	0.10
Weighted average number of shares:
Basic		10,434,665			10,491,027
Diluted		10,434,665			10,676,259

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 (LOSS) INCOME

(Dollars in thousands)

(Unaudited)


	Three Months Ended March 31,
	2009			2008
Net (loss) income	$	(2,134	)	$	1,000
Other comprehensive loss, net of tax:
Change in unrealized gain (loss) on securities available for sale, net of tax effect		(1,099	)		(117	)
Change in net unrealized gain (loss) and prior service benefit (cost) on supplemental executive retirement plan, net of tax effect		12			12

Total comprehensive (loss) income	$	(3,221	)	$	895

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)


	Three Months Ended March 31,
	2009			2008
Cash Flows From Operating Activities:
Income (loss) from operations	$	(2,134	)	$	1,000
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		118			168
Provision for loan losses		3,450			1,075
Net amortization of premium on securities		136			87
Net gains on sales of securities available for sale		(1,884	)		(1,080	)
Decrease in current taxes receivable		98			—
Net amortization of deferred fees and unearned income on loans		(8	)		—
Net gain on sales of other real estate owned		(2	)		—
Capitalized costs paid on other real estate owned		(701	)		—
Write down of other real estate owned		180			—
Stock-based compensation expense		105			155
Net (increase) decrease in accrued interest receivable		(212	)		171
Net increase in other assets		(430	)		(988	)
Net increase in deferred taxes		(220	)		—
Net decrease in accrued interest payable		(684	)		(501	)
Net increase in other liabilities		29			730

Net cash (used) provided by operating activities		(2,159	)		817
Cash Flows From Investing Activities:
Net increase in interest-bearing deposits with financial institutions		(38,150	)		—
Maturities of and principal payments received for securities available for sale and other stock		7,583			12,710
Purchase of securities available for sale and other stock		(75,259	)		(73,287	)
Proceeds from sale of securities available for sale and other stock		128,035			67,528
Proceeds from sales of other real estate owned		211			—
Net increase in loans		(5,866	)		(19,639	)
Purchases of premises and equipment		(13	)		(8	)

Net cash provided (used) in investing activities		16,541			(12,696	)
Cash Flows From Financing Activities:
Net increase in deposits		74,906			12,082
Cash dividends paid		—			(1,049	)
Net cash paid for share buyback		—			(44	)
Net (decrease) increase in borrowings		(29,179	)		13,561

Net cash provided by financing activities		45,727			24,550

Net increase in cash and cash equivalents		60,109			12,671
Cash and Cash Equivalents, beginning of period		107,133			53,732

Cash and Cash Equivalents, end of period	$	167,242		$	66,403

Supplementary Cash Flow Information:
Cash paid for interest on deposits and other borrowings	$	8,661		$	9,519

Non-Cash Investing Activities:
Net decrease in net unrealized losses and prior year service cost on supplemental employee retirement plan, net of tax	$	(12	)	$	(12	)

Net increase in net unrealized gains and losses on securities held for sale, net of income tax	$	1,099		$	117

Other real estate owned acquired	$	2,756		$	4,225

Mark to market loss (gain) adjustment of equity securities	$	15		$	(10	)

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 and subject to regulation by the Federal Reserve Bank of San Francisco (“FRB”). In addition, the deposit accounts of the Bank’s customers are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to the maximum amount allowed by law. PMBC and the Bank, together, shall sometimes be referred to in this report as the “Company” or as “we”, “us” or “our”.

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

During 2002, we organized three business trusts, under the names Pacific Mercantile Capital Trust I, PMB Capital Trust I, and PMB Statutory Trust III, respectively, to facilitate our issuance of $5.155 million, $5.155 million and $7.217 million, respectively, principal amount of junior subordinated debentures, all with maturity dates in 2032. In October 2004, we organized PMB Capital Trust III to facilitate our issuance of an additional $10 million principal amount of junior subordinated debentures, with a maturity date in 2034. In accordance with applicable accounting standards, the financial statements of these trusts are not included in the Company’s consolidated financial statements. See Note 2: “Significant Accounting Policies — Principles of Consolidation” below.

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

2. Significant Accounting Policies

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

These unaudited consolidated financial statements have been prepared on a basis consistent with prior periods, and should be read in conjunction with our audited consolidated financial statements as of and for the year ended December 31, 2008, and the notes thereto, included in our Annual Report on Form 10–K for the fiscal year ended December 31, 2008, as filed with the Securities and Exchange Commission under the Securities Exchange Act of 1934.

Our consolidated financial position at March 31, 2009, and the consolidated results of operations for the three month period ended March 31, 2009, are not necessarily indicative of what our financial position will be as of the end of, or of the results of our operations that may be expected for any other interim period during or for, the full year ending December 31, 2009.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

2. Significant Accounting Policies (Cont.-)

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 certain of our assets, liabilities, and contingencies at the date of the financial statements and the reported amounts of our revenues and expenses during the reporting period. For the fiscal periods covered by this Report, those estimates related primarily to our determinations of the allowance for loan losses, the fair value of securities available for sale, and the valuation of deferred tax assets. If circumstances or financial trends on which those estimates were based were to change in the future or there were to occur any currently unanticipated events affecting the amounts of those estimates, our future financial position or results of operation could differ, possibly materially, from those expected at the current time.

Principles of Consolidation

The consolidated financial statements for the three month period ended March 31, 2009 and 2008 include the accounts of PMBC and its wholly owned subsidiary, Pacific Mercantile Bank.

Nonperforming Loans and Other Assets

As of March 31, 2009, the Company had $34.2 million of loans deemed impaired of which $21.9 million was nonaccrual, $12 million of troubled debt restructurings which was comprised of $9 million in nonaccrual loans and $3 million accruing loans performing in accordance to the modified terms, and $9.3 million of other impaired loans less than 90 days delinquent. As of December 31, 2008, the Company had $30.7 million of loans deemed impaired of which $11 million was nonaccrual, $7.5 million of troubled debt restructurings which was comprised of $4.9 million in nonaccrual loans and $2.6 million accruing loans performing in accordance to the modified terms, and $12.3 million of loans less than 90 days delinquent. Other real estate owned (OREO) balance was $17.1 million and $14.0 million, respectively, as of March 31, 2009 and December 31, 2008.

(Loss) Income Per Share

Basic (loss) income is computed by dividing net (loss) income by the weighted average number of common shares outstanding for the period. Diluted (loss) income reflects the potential dilution that would occur if stock options or other contracts to issue common stock were exercised or converted into shares of common stock which would share in our earnings. For the three month periods ended March 31, 2009, stock options to purchase 1,127,744 shares, were not considered in computing diluted (loss) income per common share because they were antidilutive.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

2. Significant Accounting Policies (Cont.-)

The following table shows how we computed basic and diluted (loss) income for the three month period ended March 31, 2009 and 2008.


	For the Three Months Ended March 31,
(In thousands, except earnings per share data)	2009			2008
Net income (loss) available for common shareholders (A)	$	(2,134	)	$	1,000

Weighted average outstanding shares of common stock (B)		10,435			10,491
Dilutive effect of employee stock options and warrants		—			185

Common stock and common stock equivalents (C)		10,435			10,676

Income (loss) per share:
Basic (A/B)	$	(0.20	)	$	0.10
Diluted (A/C)	$	(0.20	)	$	0.09

Comprehensive Income

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

Recent Accounting Pronouncements

In December 2007, the SEC issued Staff Accounting Bulletin No. 110 (“SAB No. 110”), Certain Assumptions Used in Valuation Methods, which extends the use of the “simplified” method, under certain circumstances, in developing an estimate of expected term of “plain vanilla” share options in accordance with SFAS No. 123R. Prior to SAB No. 110, SAB No. 107 stated that the simplified method was only available for grants made up to December 31, 2007. The Company used the simplified method in developing an estimate of expected term of stock options. Beginning January 1, 2008 the Company began to use historical data based on award’s vesting period and the award recipient’s exercise history to estimate the expected life of the share options grants.

In May 2008, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard No. 162, or SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles”. SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles. SFAS No. 162 will become effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles”. The Company does not expect the adoption of this statement to have a material effect on its consolidated financial statements.

In October, 2008, the FASB issued Staff Position 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset is not Active,” (FSP 157-3). FSP 157-3 clarifies the application of SFAS 157, “Fair Value Measurements,” in a market that is not active. This FSP was effective upon issuance, including prior periods for which financial statements have not been issued. The Company uses existing techniques when valuing our level 3 assets, which we feel are appropriate and accurately reflect fair value as of the financial statement date.

In April, 2009, the Financial Accounting Standards Board (“FASB”) issued Financial Staff Position Financial Accounting Standard 157-4 (“FSP FAS 157-4”), Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly, which provides guidelines for making fair value measurements more consistent with the principles presented in FASB Statement No. 157, Fair Value Measurements. FSP FAS 157-4 relates to determining fair values when there is no active market or where the price inputs being used represent distressed sales. It reaffirms what Statement 157 states is the objective of fair value measurement—to reflect how much an asset would be sold for in an orderly transaction (as opposed to a distressed or forced transaction) at the date of the financial statements under current market conditions. Specifically, it reaffirms the need to use judgment to ascertain if a formerly active market has become inactive and in determining fair values when markets have become inactive. This FSP is effective for interim and annual periods ending after June 15, 2009, but entities may early adopt for the interim and annual periods ending after March 15, 2009. The Company has chosen not to early adopt this FSP, and does not feel the required adoption next quarter will have a material effect on our financial statements.

In April, 2009, the FASB issued Financial Staff Position Financial Accounting Standard 107-1 and Accounting Principles Board 28-1 (“FSP FAS 107-1 and APB 28-1”), Interim Disclosures about Fair Value of Financial Instruments, which enhances consistency in financial reporting by increasing the frequency of fair value disclosures. FSP FAS 107-1 and APB 28-1 relate to fair value disclosures for any financial instruments that are not currently reflected on the balance sheet of companies at fair value. Prior to issuing this FSP, fair values for these assets and liabilities were only disclosed once a year. The FSP now requires these disclosures on a quarterly basis, providing qualitative and quantitative information about fair value estimates for all those financial instruments not measured on the balance sheet at fair value. This FSP is effective for interim and annual periods ending after June 15, 2009, but entities may early adopt for the interim and annual periods ending after March 15, 2009. The Company has chosen not to early adopt this FSP, and does not feel the required adoption next quarter will have a material effect on our financial statements.

In April, 2009, the FASB issued Financial Staff Position Financial Accounting Standard 115-2 and Financial Accounting Standard 124-2 (“FSP FAS 115-2 and FAS 124-2”), Recognition and Presentation of Other-Than-Temporary Impairments, which provides additional guidance designed to create greater clarity and consistency in accounting for and presenting impairment losses on securities. FSP FAS 115-2 and FAS 124-2 provide greater clarity to investors about the credit and noncredit components of impaired debt securities that are not expected to be sold. The measure of impairment in comprehensive income remains fair value. The FSP also requires increased and more timely disclosures sought by investors regarding expected cash flows, credit losses, and an aging of securities with unrealized losses. This FSP is effective for interim and annual periods ending after June 15, 2009, but entities may early adopt for the interim and annual periods ending after March 15, 2009. The Company has chosen not to early adopt this FSP, and does not feel the required adoption next quarter will have a material effect on our financial statements.

Commitments and Contingencies

To meet the financing needs of our customers in the normal course of business, we are a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated financial statements. At March 31, 2009, loan commitments and letters of credit totaled $198 million and $16 million, respectively. The contractual amount of a credit-related financial instrument such as a commitment to extend credit, a credit-card arrangement or a letter of credit represents the amounts of potential accounting loss should the commitment be fully drawn upon, the customer default, and the value of any existing collateral securing the customer’s payment obligation become worthless.

As a result, we use the same credit policies in making commitments to extend credit and conditional obligations as we do 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. We evaluate 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 any, 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 March 31, 2009, we were not a party to any pending legal action that is expected to be material to our consolidated financial condition or results of operations.

3. Stock-Based Employee Compensation Plans

Effective March 2, 1999, the Board of Directors adopted, and in January 2000 our shareholders approved, the 1999 Stock Option Plan (the “1999 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 Plan. Options may be granted for terms of up to 10 years, but will terminate sooner upon or shortly after a termination of service occurring prior to the expiration of the term of the option. A total of 1,248,230 shares were authorized for issuance under the 1999 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 generally ranging up to five years, or based on the achievement of specified performance goals, as determined by the Compensation Committee at the time it grants the options or the stock purchase rights. Options may be granted under the 2004 Plan for terms of up to 10 years after the grant date, but will terminate sooner upon or shortly after a termination of service occurring prior to the expiration of the term of the option. The Company will become entitled to repurchase any unvested shares subject to restricted purchase rights in the event of a termination of employment or service of the holder of the stock purchase right or in the event the holder fails to achieve any goals that are required to be met as a condition of vesting. A total of 400,000 shares were authorized for issuance under the 2004 Plan.

Effective April 15, 2008, the Board of Directors adopted the Pacific Mercantile Bancorp 2008 Equity Incentive Plan (the “2008 Plan”), which was approved by the Company’s shareholders in May 2008. That Plan authorizes the granting of stock 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. In addition, the 2008 Plan authorizes the Compensation Committee of the Board to grant stock appreciation rights (“SARs”), which entitle the recipient of such rights to receive a cash payment in an amount equal to the difference between the fair market value of the Company’s shares on the date of vesting or exercise and a “base price” which, in most cases, will be equal to fair market value of the Company’s shares on the date of grant. In lieu of such cash payment, the Company may deliver shares of common stock with a fair market value, on the date of exercise, equal to the amount of such payment. Options, restricted stock purchase rights and SARs ordinarily will vest over various periods generally ranging up to five years, or based on the achievement of specified performance goals, as determined by the Compensation Committee at the time it grants the options, the stock purchase rights or the SARs. However, the Committee has the authority to grant options that are fully vested at the time of grant. Options and SARs may be granted under the 2008 Plan for terms of up to 10 years after the grant date, but will terminate sooner upon or shortly after a termination of service occurring prior to the expiration of the term of the option or SAR. 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 are authorized for issuance under the 2008 Equity Incentive Plan.

In December 2004, FASB issued SFAS No. 123(R), “Share-Based Payment”, which requires companies or other organizations that grant stock options or other equity compensation awards to employees to recognize, in their financial statements, the fair value of those options and shares as compensation cost over their respective service (vesting) periods. In the case of the Company, SFAS No. 123(R) became effective January 1, 2006 and, as of that date, the Company adopted the fair value recognition provisions of SFAS No. 123(R), using the modified-prospective-transition method. Under this transition method, equity compensation expense includes: (a) compensation expense for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on their grant date fair values estimated in accordance with the original provisions of SFAS No. 123, and (b) compensation cost for all share-based payments granted subsequent to December 31, 2005, based on their grant date fair values estimated in accordance with the provisions of SFAS No. 123(R). Since stock-based compensation that is recognized in the statement of income is to be determined based on the equity compensation awards that we expect will ultimately vest, that compensation expense has been reduced for estimated forfeitures of unvested options that typically occur due to terminations of employment of optionees. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods in the event actual forfeitures differ from those estimates. For purposes of determining stock-based compensation expense for the quarter ended March 31, 2009, the Company estimated no forfeitures of options held by the Company’s directors and all other forfeitures to be 7.9% of the unvested options issued.

The fair values of the options that were outstanding under the 1999, 2004 and 2008 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 March 31,
Assumptions with respect to:	2009			2008⁽¹⁾
Expected volatility		29	%		—
Risk-free interest rate		1.65	%		—
Expected dividends		0.26	%		—
Expected term (years)		6.9			—
Weighted average fair value of options granted during period	$	1.52		$	—

⁽¹⁾	The Company did not grant stock options during the first quarter of 2008.

The following tables summarize the share option activity under the Company’s 1999, 2004 and 2008 Plans during the three month period ended March 31, 2009 and 2008, respectively.


	Three Months Ended March 31,
	2009				2008
	Number of Shares Subject to Options		Weighted- Average Exercise Price Per Share		Number of Shares Subject to Options	Weighted- Average Exercise Price Per Share
Outstanding—January 1,	1,137,244		$	9.31	1,133,139	$	9.82
Granted	3,000			4.35	—		—
Exercised	—			—	—		—
Forfeited/Canceled	(12,500	)		11.57	—		—

Outstanding—March 31,	1,127,744			9.27	1,133,139		9.82

Options Exercisable—March 31,	921,130		$	9.54	937,267	$	8.96

There were no options exercised during the three months ended March 31, 2009 and 2008. Total fair values of vested options at March 31, 2009 and 2008, were $145,000 and $202,000, respectively.


	Options Outstanding as of March 31, 2009					Options Exercisable as of March 31, 2009
Range of Exercise Price	Vested	Unvested	Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Life (Years)	Shares	Weighted- Average Exercise Price
$ 3.48 – $5.99	1,046	119,454	$	3.80	9.59	1,046	$	3.48
$ 6.00 – $9.99	509,801	12,500		7.32	1.71	509,801		7.32
$10.00 – $12.99	304,300	7,300		11.23	4.88	304,300		11.23
$13.00 – $17.99	92,183	58,160		15.04	6.66	92,183		15.05
$18.00 – $18.84	13,800	9,200		18.11	6.83	13,800		18.11

	921,130	206,614	$	9.27	4.19	921,130	$	9.54

The aggregate intrinsic values of options that were outstanding and exercisable under the Plans at March 31, 2009, and 2008, were $52 and $1.5 million, respectively. A summary of the status of the unvested options as of December 31, 2008, and changes during the three month period ended March 31, 2009, are set forth in the following table.


	Number of Shares Subject to Options		Weighted- Average Grant Date Fair Value
Unvested at December 31, 2008	233,416		$	3.39
Granted	3,000			1.52
Vested	(17,302	)		5.80
Forfeited/Canceled	(12,500	)		4.10

Unvested at March 31, 2009	206,614		$	3.05

The aggregate amounts charged against income in relation to stock-based compensation awards was $99,000 net of $6,000 in taxes for the three months ended March 31, 2009. The weighted average period over which nonvested awards are expected to be recognized was 1.91 year at March 31, 2009. The before income tax compensation expense at March 31, 2009 related to non-vested stock option were expected to be recognized in the respective amounts set forth in the table below:


	Stock Based Compensation Expense
	(In thousands)
Remainder of 2009	$	223
For the year ended December 31,
2010		173
2011		103
2012		46
2013		24
2014		—

Total	$	569

4. Employee Benefit Plan

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


	Three Months Ended March 31,
	2009		2008
	(In thousands)
Service cost	$	48	$	45
Interest cost		30		26
Expected return on plan assets		—		—
Amortization of prior service cost		4		4
Amortization of net actuarial loss		16		16

Net periodic SERP cost	$	98	$	91

5. Income Taxes

The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109,” (“FIN 48”) on January 1, 2007. We did not have any unrecognized tax benefits at March 31, 2009 and 2008.

We file income tax returns with the U.S. federal government and the state of California. As of March 31 and January 1, 2009, we were subject to examination by the Internal Revenue Service with respect to our U.S. federal tax returns and the Franchise Tax Board for California, for the 2005-2007 tax years. We do not believe there will be any material changes in our unrecognized tax positions over the next 12 months.

Net operating losses (NOL) on U.S. federal income tax returns may be carried back two years and forward twenty years. NOL on California state income tax returns maybe carried forward twenty years. The Company expects to file an amended prior year U.S. federal tax return and recognize the U.S. federal tax net operating loss. The state of California has suspended the net operating loss carryover deduction in 2008 and 2009, but corporations may continue to compute and carryover an NOL during the suspension period. Starting in 2011, taxpayers can carry back losses for two years and carry forward for 20 years which will conform to the U.S. tax laws by 2013. The Company expects to have taxable income in 2011 to offset the NOL for 2008.

Our policy is that we recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. We did not have any accrued interest or penalties associated with any unrecognized tax benefits, and no interest expense was recognized during the three months ended March 31, 2009 and 2008. Our effective tax rate differs from the federal statutory rate primarily due to tax free income on municipal bonds and the non-deductibility of certain expenses recognized for financial reporting purposes and state taxes.

6. Fair Value

We use fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Securities available for sale are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record at fair value other assets on a nonrecurring basis, such as loans held for investment and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Fair Value Hierarchy. Under SFAS No. 157, we group assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:


Level 1		Valuation is based upon quoted prices for identical instruments traded in active markets.

Level 2		Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

Level 3		Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

The following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

Assets

Investment Securities Available for Sale. Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the- counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as level 3 include asset-backed securities in less liquid markets.

Impaired Loans. SFAS No. 157 applies to loans measured for impairment in accordance with SFAS No. 114, “Accounting by Creditors for Impairment of a Loan”, including impaired loans measured at an observable market price (if available), and at the fair value of the loan’s collateral (if the loan is collateral dependent). The fair value of an impaired loan is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance for possible losses represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the impaired loan at nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the impaired loan at nonrecurring Level 3.

Foreclosed Assets. Foreclosed assets are adjusted to the lower of cost or fair value, less estimated costs to sell, at the time the loans are transferred to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value less estimated costs to sell. Fair value is determined on the bases of upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the foreclosed asset at nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the foreclosed asset at nonrecurring Level 3.

The following table shows the recorded amounts of assets measured at fair value on a recurring basis.


	At March 31, 2009 (in thousands)
	Total		Level 1		Level 2		Level 3
Assets at Fair Value:
Investment securities available for sale	$	117,263	$	1,765	$	114,767	$	731

The changes in Level 3 assets measured at fair value on a recurring basis are summarized in the following table:


	Investment Securities Available for Sale (in thousands)
Balance of recurring Level 3 instruments at January 1, 2009	$	1,237
Total gains or losses (realized/unrealized):
Included in earnings-realized		—
Included in earnings-unrealized		—
Included in other comprehensive income		(506	)
Purchases, sales, issuances and settlements, net		—
Transfers in and/or out of Level 3		—

Balance of recurring Level 3 assets at March 31, 2009	$	731

Assets Recorded at Fair Value on a Nonrecurring Basis

The Company may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principles. These include assets that are measured at the lower of cost or market or that were recognized at a fair value below cost at the end of the period. Information regarding assets measured at fair value on a nonrecurring basis is set forth in the table below.


	At March 31, 2009 (in thousands)
	Total		Level 1		Level 2		Level 3
Assets at Fair Value:
Loans	$	34,177	$	—	$	29,938	$	4,239
Other assets⁽¹⁾		17,076		—		17,076		—

Total	$	51,253	$	—	$	47,014	$	4,239

⁽¹⁾	Includes foreclosed assets

7. Loans

The composition of the Company’s loan portfolio as of March 31, 2009 and December 31, 2008 is as follows:


	March 31, 2009					December 31, 2008
	Amount			Percent		Amount			Percent
Commercial loans	$	302,996		35.9	%	$	300,945		35.7	%
Commercial real estate loans - owner occupied		178,734		21.1	%		174,169		20.6	%
Commercial real estate loans - all other		127,229		15.1	%		127,528		15.1	%
Residential mortgage loans - multi-family		101,751		12.1	%		100,971		12.0	%
Residential mortgage loans - single family		65,075		7.7	%		65,127		7.7	%
Construction loans		29,299		3.5	%		32,528		3.9	%
Land development loans		31,577		3.7	%		33,283		3.9	%
Consumer loans		7,702		0.9	%		9,173		1.1	%

Gross loans		844,363		100.0	%		843,724		100.0	%

Deferred fee (income) costs, net		(391	)				(230	)
Allowance for loan losses		(16,263	)				(15,453	)

Loans, net	$	827,709				$	828,041

Changes in the allowance for loan losses for the three months ended March 31, 2009 and 2008 are as follows:


	For three months ended March 31
	2009			2008
Balance, beginning of period	$	15,453		$	6,126
Provision for loan losses		3,450			1,075
Net, amounts charged off		(2,640	)		(540	)

Balance, end of period	$	16,263		$	6,661

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Introduction

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

The following discussion presents information about our consolidated results of operations for the three month period ended March 31, 2009 and 2008 and our consolidated financial condition, liquidity and capital resources at March 31, 2009 and should be read in conjunction with our interim consolidated financial statements and the notes thereto included elsewhere in this Report.

Forward-Looking Information

Statements contained in this Report that are not historical facts or that discuss our expectations, beliefs or views regarding our future operations or future financial performance, or financial or other trends in our business, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include the words “believe,” “expect,” “anticipate,” “intend,” “plan,” “estimate,” “project,” or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could,” or “may.” The information contained in such forward-looking statements is based on current information and assumptions about future events over which we do not have control and our business is subject to a number of risks and uncertainties 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 and uncertainties 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 Part II of this Report and in Item 1A in our Annual Report on Form 10-K for our fiscal year ended December 31, 2008 and readers of this Report are urged to read that summary below and the information contained in Item 1A in Part II of this report and in Item 1A of our 2008 10-K in conjunction with this Report.

Due to those risks and uncertainties, readers are cautioned not to place undue reliance on the forward-looking statements contained in this Report, which speak only as of the date of this Report, or to make predictions about future performance based solely on historical financial performance. We also disclaim any obligation to update forward-looking statements contained in this Report or in our 2008 10-K or any other prior filings with Securities and Exchange Commission.

Overview of Operating Results in the Three Months Ended March 31, 2009

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 (loss) and net income (loss) per share for the three months ended March 31, 2009 and 2008.


	Three Months Ended March 31,
	2009 Amounts			2008 Amounts		Percent Change
Interest income	$	13,513		$	15,904	(15.0	)%
Interest expense		8,121			9,019	(10.0	)%

Net interest income	$	5,392		$	6,885	(21.7	)%
Provision for loan losses	$	3,450		$	1,075	220.9	%

Net interest income after provision for loan losses	$	1,942		$	5,810	(66.6	)%
Noninterest income	$	2,455		$	1,474	66.6	%
Noninterest expense	$	6,653		$	5,696	16.8	%

Income before income tax	$	(2,256	)	$	1,588	(242.1	)%
Income tax (benefit) provision		(122	)		588	(120.7	)%

Net income (loss)	$	(2,134	)	$	1,000	(313.4	)%

Net income (loss) per diluted share	$	(0.20	)	$	0.09	(322.2	)%

Weighted average number of diluted shares		10,434,665			10,676,259	(2.3	)%

As the table above indicates, we incurred a net loss of $2.1 million, or $0.20 per diluted share, in the three months ended March 31, 2009, as compared to net income of $1.0 million, or $0.09 per diluted share, in the same three months of 2008. That net loss was primarily attributable to:

•

A decline in net interest income of $1.5 million, or 21.7%, in the three months ended March 31, 2009, primarily due to a decline in interest income of $2.4 million, or 15.0%, which was only partially offset by a $900,000, or 10%, decline in interest expense during that three month period. The decline in interest income was attributable to:

^¡

reductions in interest rates by the Federal Reserve Board in response to the economic downturn, which has led to decreases in prevailing interest rates that reduced the yields on our loans and other interest-earning assets;

^¡

an increase of $11.2 million, or 104%, in non-performing loans, on which we had to cease accruing interest, during the three months ended March 31, 2009 as compared to non-performing loans at March 31, 2008, which we believe was attributable to the continued deterioration of economic conditions and the on-going credit crisis in the United States that have adversely affected the financial condition of an increasing number of borrowers and prevented them from (i) refinancing their non-performing loans on more affordable terms and (ii) selling the real properties that collateralized and had been expected to provide a source of repayment of their loans.

•

An increase of $2.4 million, or approximately 221%, in the provision we made for possible loan losses in the three months ended March 31, 2009, in order to increase the loan loss reserve to provide for the increases that occurred in nonperforming loans during that period and the risk of further increases in non-performing loans due to worsening economic conditions and the prospect that these conditions will not improve significantly during 2009. This increase in the provision for possible loan losses resulted in an increase in our loan loss reserve to $16.3 million, or approximately 1.93% of loans outstanding, at March 31, 2009 as compared to $15.5 million, or 1.83%, of the loans outstanding at December 31, 2008.

•

An increase of $957,000, or 16.8%, in noninterest expense due primarily to (i) the addition of personnel in our credit administration and mortgage banking departments, (ii) increases in expenses incurred in connection with foreclosures of non-performing loans and the carrying costs of the properties acquired by foreclosure (“Other Real Estate Owned” or “OREO”) and (iii) an increase by the FDIC in insurance premiums imposed on all FDIC-insured banks as a means of funding increases in the FDIC’s insurance fund necessitated by an increase in bank failures attributable to the economic problems and conditions that led to the economic recession and credit crisis.

In light of prevailing economic conditions and the uncertainties regarding the ultimate severity of the economic recession and credit crisis, we believe that our actions in charging off nonperforming loans and increasing the loan loss reserve are prudent in the current weak economy.

The following table indicates the impact that the decreases in our net interest income in and the net loss for the three months ended March 31, 2009 had on our net interest margin and the returns on average assets and average equity during that three month period:


	Three Months Ended March 31,
	2009		2008
Net interest margin ^{(1) (2)}	1.92	%	2.60	%
Return on average assets ⁽¹⁾	(0.74	)%	0.37	%
Return on average shareholders’ equity ⁽¹⁾	(10.43	)%	4.08	%

⁽¹⁾	Annualized.

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

At March 31, 2009, non-performing loans, together with other nonperforming assets consisting of OREO, totaled $39 million, or 3.2% of total assets, as compared to $29.9 million or 2.7% of total assets at December 31, 2008.

However, notwithstanding the net loss incurred in the quarter ended March 31, 2009, the ratio of the Bank’s total capital to risk-weighted assets was 10.9% at March 31, 2009, which exceeded the ratio required, under bank regulatory guidelines, for the Bank to continue to be rated, for capital adequacy purposes, as a well-capitalized banking institution.

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) and general practices in the banking industry. Certain of those accounting policies are considered critical accounting policies, because they require us to make estimates and assumptions regarding circumstances or trends that could affect the value of those assets, such as, for example, assumptions regarding economic conditions or trends that could impact our ability to fully collect our loans or ultimately realize the carrying value of certain of our other assets. Those estimates and assumptions are made based on current information available to us regarding those economic conditions or trends or other circumstances. If changes were to occur in the events, trends or other circumstances on which our estimates or assumptions were based, or other unanticipated events were to happen that might affect our operating results, under GAAP it could become necessary to reduce the carrying values of the affected assets on our balance sheet. In addition, because reductions in the carrying value of assets are sometime effectuated by or require charges to income, such reductions also may have the effect of reducing our income.

Our critical accounting policies relate to the determinations we make with respect to 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 failure of borrowers to repay their loans is an inherent risk of the banking business. Therefore, like virtually all banks and other lending institutions, we follow the practice of maintaining reserves (often referred to as an allowance) against which we charge losses on the loans we make (the “allowance for loan losses”). The accounting policies and practices we follow in determining the sufficiency of that allowance require us to make judgments and assumptions about economic and market conditions and trends that can affect the ability of our borrowers to meet their loan payment obligations to us. Accordingly, we use historical loss factors, adjusted for current economic market conditions and other economic indicators, to estimate the potential losses inherent in our loan portfolio and assess the sufficiency of our allowance for loan losses. If unanticipated changes were to occur in those conditions or trends, actual loan losses could be greater than those predicted by those loss factors and our prior assessments of economic conditions and trends. In such an event, it could be necessary for us to increase the allowance for loan losses by means of a charge to income referred to in our financial statements as the “provision for loan losses.” Such an increase would reduce the carrying value of the loans on our balance sheet, and the additional provision for loan losses taken to increase that allowance would reduce our income in the period when it is determined that an increase in the allowance for loan losses is necessary. See the discussion in the subsections entitled “Results of Operations—Provision for Loan Losses” and “Financial Condition—Allowance for Loan Losses and Nonperforming Loans” below.

Fair Value of Securities Available for Sale. We determine the fair value of our investment 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, and option adjusted spread models, as well as fundamental analysis. These pricing methodologies require us to make various assumptions relating to such matters as the effects of prepayments on future yields on and duration of such securities, monetary policies and demand and supply for the individual securities. Consequently, if changes were to occur in the market or other conditions on which those assumptions were based, it could become necessary for us to reduce the fair values of our securities, which would result in changes to accumulated other comprehensive income (loss) on our balance sheet. If the Company determines that any reductions in the fair values of any securities are other than temporary, it will be necessary for the Company to record an impairment loss in our statement of operations.

Utilization and Valuation of Deferred Income Tax Benefits. We recognize deferred tax assets and liabilities for the future tax consequences resulting from differences between the financial statement carrying amounts of those assets and liabilities and their respective tax bases, and for tax credits. We evaluate our deferred tax assets for recoverability using a consistent approach that takes account of our historical profitability and projections of future taxable income that can affect the recoverability of our deferred tax assets. We are required to establish a valuation allowance for deferred tax assets and record a charge to income or stockholders’ equity if we determine, based on available evidence, at the time the determination is made, that it is more likely than not that some portion or all of the tax benefits comprising the deferred tax assets will not be recovered. In evaluating the need for a valuation allowance, we estimate future taxable income based on management-approved business plans and ongoing tax planning strategies. This process involves significant management judgments that are subject to change from period to period based on changes in tax laws or variances between our projected operating performance, our actual results and other factors. Accordingly, we have included the assessment of a deferred tax asset valuation allowance as a critical accounting policy.

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. As a general rule, all other things being equal, the greater the difference between the amount of our interest income and the amount of our interest expense, the greater will be our income; whereas, a decline in that difference will generally result in a decline in our net income. 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 months ended March 31, 2009 and 2008, respectively:


	Three Months Ended March 31,
	2009 Amount			2008 Amount			Percent Change
Interest income	$	13,513		$	15,904		(15.0	)%
Interest expense		8,121			9,019		(10.0	)%

Net interest income	$	5,392		$	6,885		(21.7	)%

Net interest margin		1.92	%		2.60	%

As the above table indicates, our net interest income decreased by $1.5 million, or 22%, in the first quarter of 2009. The decrease was primarily attributable to a decrease in interest income of $2.4 million, or 15%, in the three month period of 2009, which more than offset a decrease in interest expense of $900,000, or 10% in the three months ended March 31, 2009 over the respective corresponding period of 2008.

The decrease in interest income in the three months ended March 31, 2009, was due primarily to (i) a 200 basis points decline in prevailing market rates of interest, which we believe was primarily the result of reductions, commenced in September 2008, in the federal funds rate implemented by the Federal Reserve Board in response to the economic downturn, and (ii) increases in non-performing loans on which we ceased accruing interest income. The decrease was partially offset by the positive effect on our interest income of an increase of $69 million, or 8.8%, in our average loans outstanding, compared to the three months ended March 31, 2008, which generate higher yields than other earning assets. We used lower-yielding federal funds and proceeds from the sale of securities available for sale to fund those increases in loans.

The decrease in interest expense during the three month period ended March 31, 2009 was primarily attributable to the aforementioned decrease in prevailing market rates of interest, which enabled us to reduce interest rates on interest bearing deposits, partially offset by increases in the volume of interest-bearing deposits and a change in the mix of our deposits to a greater proportion of time deposits which bear higher rates of interest than other types of deposits. The increase in the proportion of time deposits was necessitated by a decrease in the volume of demand, savings and money market deposits, which we believe was due to (i) the worsening of economic conditions in the United States which led consumers to make greater use of their savings to pay on-going expenses, (ii) downsizing by businesses which led to reductions in balances in business transaction accounts and (iii) the loss in confidence by consumers and investors in banks, which led to a shift of funds out of banks to treasury securities.

Due primarily to the decline in net interest income, our net interest margin decreased by 68 basis points to 1.92% in the three months ended March 31, 2009, from 2.60% in the same period of 2008. In the three months ended March 31, 2009, the yield on interest-earning assets declined to 4.80% from 6.02% in the same period of 2008, which more than offset a decline in the average interest rate paid on interest bearing liabilities to 3.68%, from 4.40% in the same three month period of 2008. The decrease in the net interest margin also reflects timing differences in the impact of the decline in market rates of interest on our interest income and interest expense. Those declines resulted in automatic decreases in the interest rates on our adjustable rate loans, whereas the impact of those declines on the interest we paid on deposits has been more gradual primarily as a result of the maturity schedule of our time deposits

Average Balances

Information Regarding Average Assets and Average Liabilities

The following table sets forth information regarding our average balance sheet, yields on interest earning assets, interest expense on interest-bearing liabilities, the interest rate spread and the interest rate margin for the three months ended March 31, 2009 and 2008.


	Three Months Ended March 31,
	2009						2008
	Average Balance		Interest Earned/ Paid		Average Yield/ Rate		Average Balance		Interest Earned/ Paid		Average Yield/ Rate
	(Dollars in thousands)
Interest earning assets:
Short-term investments⁽¹⁾	$	138,607	$	89	0.26	%	$	37,283	$	284	3.06	%
Securities available for sale and stock⁽²⁾		151,135		1,439	3.86	%		242,717		2,733	4.53	%
Loans⁽³⁾		851,596		11,985	5.71	%		783,057		12,887	6.62	%

Total earning assets		1,141,338		13,513	4.80	%		1,063,057		15,904	6.02	%
Noninterest earning assets		38,479						30,415

Total Assets	$	1,179,817					$	1,093,472

Interest-bearing liabilities:
Interest-bearing checking accounts	$	25,237		26	0.42	%	$	19,326		30	0.62	%
Money market and savings accounts		101,351		280	1.12	%		161,225		1,024	2.55	%
Certificates of deposit		524,965		5,603	4.33	%		409,838		5,105	5.01	%
Other borrowings		213,425		2,028	3.85	%		216,336		2,554	4.75	%
Junior subordinated debentures		17,682		184	4.22	%		17,682		306	6.96	%

Total interest-bearing liabilities		882,660		8,121	3.68	%		824,407		9,019	4.40	%

Noninterest-bearing liabilities		213,932						170,869

Total Liabilities		1,096,592						995,276
Shareholders’ equity		83,225						98,196

Total Liabilities and Shareholders’ Equity	$	1,179,817					$	1,093,472

Net interest income			$	5,392					$	6,885

Interest rate spread					1.12	%					1.62	%

Net interest margin					1.92	%					2.60	%

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

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

⁽³⁾	Loans include the average balance of nonaccrual loans. Those nonaccrual loans contributed to the declines, shown in this table, in interest earned and in the interest rate spread and our net interest margin in the three months ended March 31, 2009.

The following table sets forth the changes in interest income, including loan fees, and interest paid in the three months ended March 31, 2009, as compared to the same period in 2008, and the extent to which those changes were attributable to changes in (i) the volumes of or in the rates of interest earned on interest-earning assets and (ii) the volumes of or in the rates of interest paid on our interest-bearing liabilities.


	Three Months Ended March 31, 2009 vs. 2008 Increase (decrease) due to:
	Volume⁽¹⁾			Rate⁽¹⁾			Total
	(Dollars in thousands)
Interest income:
Short-term investments⁽¹⁾	$	240		$	(435	)	$	(195	)
Securities available for sale and stock⁽²⁾		(931	)		(363	)		(1,294	)
Loans		1,017			(1,919	)		(902	)

Total earning assets		326			(2,717	)		(2,391	)
Interest expense:
Interest-bearing checking accounts		8			(12	)		(4	)
Money market and savings accounts		(296	)		(448	)		(744	)
Certificates of deposit		1,264			(766	)		498
Borrowings		(35	)		(491	)		(526	)
Junior subordinated debentures		—			(122	)		(122	)

Total interest-bearing liabilities		941			(1,839	)		(898	)

Net interest income	$	(615	)	$	(878	)	$	(1,493	)

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

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

The above table indicates that the decrease of $1.5 million in our net interest income in the three months ended March 31, 2009, as compared to the like period of 2008, was primarily the result of decreases of $878,000 and $615,000 in rate and volume variances, respectively. The decrease in volume variance in the three months ended March 31, 2009 was primarily the result of changes in the mix of (i) our earning assets from higher yielding loans to lower yielding short-term investments and securities available for sale, and (ii) our deposits to a greater proportion of higher cost certificates of deposit, and a lesser proportion of lower cost transaction savings and money market deposits. The decline in rate variance was a result of a decrease in interest rates on average earning assets of 122 basis points, which was only partially offset by a decrease of 72 basis points in interest rates paid on interest bearing liabilities.

Provision for Loan Losses

The failure of borrowers to repay their loans is an inherent risk of the banking business. Therefore, like virtually all banks and other lending institutions, we follow the practice of maintaining an allowance for possible loan losses that occur from time to time as an incidental part of the banking business. When it is determined that the payment in full of a loan has become unlikely, the carrying value of the loan is reduced to what management believes is its realizable value. This reduction, which is referred to as a loan “charge-off,” or “write-down” is charged against that allowance.

The amount of the allowance for loan losses is increased periodically (i) to replenish the allowance after it has been reduced due to loan charge-offs, (ii) to reflect changes in the volume of outstanding loans, and (iii) to take account of increases in the risk of potential future losses due to a deterioration in the condition of borrowers or in the value of property securing non–performing loans or adverse changes in economic conditions. Increases in the allowance are made through a charge, recorded as an expense in the statement of operations, referred to as the “provision for loan losses.” Recoveries of loans previously charged-off are added back to the allowance and, therefore, have the effect of increasing the allowance and reducing the amount of the provision that might otherwise have had to be made to replenish or increase the allowance. See “—Financial Condition—Allowance for Loan Losses and Nonperforming Loans” below in this Section of this Report.

During the first quarter of 2009, we made a $3.5 million provision for potential loan losses as compared to $1.1 million in the same quarter of 2008. The increase was due to $2.6 million in net loan charge-offs for the quarter ended March 31, 2009, compared to $540,000 of net loan charge-offs in the same quarter of 2008. Nonaccrual loans increased to $21.9 million at March 31, 2009, as compared to $10.7 million at March 31, 2008, as a result of the continuing economic recession and credit crisis.

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

In addition, the Federal Reserve Bank of San Francisco 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 account transactions and gains on sales of assets. The following table identifies the components (in thousands of dollars) of, and sets forth the percentage changes in, noninterest income in the three months ended March 31, 2009, as compared to the same period of 2008.


	Three Months Ended March 31,
	Amount				Percentage Change 2009 vs. 2008
	2009		2008		Percentage Change 2009 vs. 2008
Service fees on deposits	$	372	$	212	75.5	%
Net gains on sales of securities available for sale		1,884		1,080	74.4	%
Net gain (loss) on sale of other real estate owned		2		—	N/M
Other		197		182	8.2	%

Total Noninterest Income	$	2,455	$	1,474	66.6	%

The increase in non-interest income in the three months ended March 31, 2009, as compared to the same period in 2008, was primarily the result of a $160,000 increase in service fees on deposit account transactions primarily as a result of an increase in the volume of deposit transactions and an $804,000 increase in gains on sales of securities available for sale the proceeds from which were used by us to repay borrowings and, to a lesser extent, fund new loans during that three month period.

Noninterest Expense

The following table compares the amounts (in thousands of dollars) of the principal components of noninterest expense in the three months ended March 31, 2009 and 2008.


	Three Months Ended March 31,
	Amount				Percentage Change 2009 vs. 2008
	2009		2008		Percentage Change 2009 vs. 2008
	(Dollars in thousands)
Salaries and employee benefits	$	3,658	$	3,291	11.2	%
Occupancy		681		683	(.3	)%
Equipment and depreciation		265		284	(6.7	)%
Data processing		163		172	(5.2	)%
Professional fees		526		273	92.7	%
Customer expense		96		114	(15.8	)%
FDIC insurance		324		146	121.9	%
Other real estate owned expense		287		81	254.3	%
Other operating expense⁽¹⁾		653		652	0.2	%

Total	$	6,653	$	5,696	16.8	%

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

For the three months ended March 31, 2009, noninterest expense increased by $957,000, or 17%, due to (i) a $367,000 increase in compensation expense, primarily as a result of the addition of asset managers in our credit administration department and loan officers and administrators needed for our recently established mortgage banking department; (ii) a $253,000 increase in professional fees, consisting primarily of legal fees incurred in connection with foreclosures of non-performing loans, (iii) a $206,000 increase in OREO expenses, consisting primarily of costs incurred to maintain and market foreclosed properties, and (iv) a $178,000 increase in FDIC insurance premiums imposed on all FDIC-insured banking institutions to fund increases in the FDIC’s insurance fund, which has declined as a result of an increase in bank failures caused primarily by mortgage lending practices, financial problems and economic conditions that led to the current recession and credit crisis.

In the three months ended March 31, 2009, our efficiency ratio was 85%, as compared to 68% for the same three months of 2008, due to the combined effects of the decline in net interest income and the increase in non-interest expense in that three month period.

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 repricing these assets and liabilities 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, interest rates for different asset and liability products offered by depository institutions respond differently to changes in the interest rate environment. As a result, 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, can cause the interest sensitivities to vary.

The table below sets forth information concerning our rate sensitive assets and liabilities at March 31, 2009. The assets and liabilities are classified by the earlier of maturity or repricing dates in accordance with their contractual terms. As described above, certain shortcomings are inherent in the method of analysis presented in this table.


	Three Months or Less			Over Three Through Twelve Months			Over One Year Through Five Years			Over Five Years			Non- Interest- Bearing			Total
	(Dollars in thousands)
Assets
Interest-bearing deposits in other financial institutions	$	24,000		$	14,348		$	—		$	—		$	—		$	38,348
Investment in unconsolidated trust subsidiaries		—			—			—			682			—			682
Securities available for sale		7,114			81,138			15,699			13,312			—			117,263
Federal Reserve Bank and Federal Home Loan Bank stock		13,420			—			—			—			—			13,420
Interest bearing deposits with financial institutions		153,230			—			—			—			—			153,230
Loans, gross		388,771			78,178			305,522			71,501			—			843,972
Non-interest earning assets, net		—			—			—			—			39,080			39,080

Total assets	$	586,535		$	173,664		$	321,221		$	85,495		$	39,080		$	1,205,995

Liabilities and Shareholders Equity
Noninterest-bearing deposits	$	—		$	—		$	—		$	—		$	151,911		$	151,911
Interest-bearing deposits^{(1) (2)}		87,594			450,185			73,982			—			132,920			744,681
Borrowings		40,579			125,000			39,000			—			—			204,579
Junior subordinated debentures		17,527			—			—			—			—			17,527
Other liabilities		—			—			—			—			6,181			6,181
Shareholders’ equity		—			—			—			—			81,116			81,116

Total liabilities and shareholders equity	$	145,700		$	575,185		$	112,982		$	—		$	372,128		$	1,205,995

Interest rate sensitivity gap	$	440,835		$	(401,521	)	$	208,239		$	85,495		$	(333,048	)	$	—

Cumulative interest rate sensitivity gap	$	440,835		$	39,314		$	247,553		$	333,048		$	—		$	—

Cumulative % of rate sensitive assets in maturity period		49	%		63	%		90	%		97	%		100	%

Rate sensitive assets to rate sensitive liabilities and shareholders’ equity		403	%		30	%		284	%		N/A			11	%

Cumulative ratio		403	%		105	%		130	%		140	%		100	%

⁽¹⁾	Excludes savings accounts that we maintain at the Bank totaling $11.3 million and maturing within three months of March 31, 2009.

⁽²⁾	Excludes a certificate of deposit issued to us by the Bank in the amount of $250,000, which matures within 12 months of March 31, 2009.

At March 31, 2009, our rate sensitive balance sheet was shown to be in a positive twelve-month gap position. This would imply that our net interest margin would increase in the short–term if interest rates were to rise and would decrease 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 or federal funds sold) 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 $42 million to $1.206 billion at March 31, 2009 from $1.164 billion at December 31, 2008, as we used increases in deposits and proceeds from sales of securities available for sale during the three months ended March 31, 2009 to fund increases in interest bearing deposits maintained at other financial institutions and an increase in outstanding loans in the three months ended March 31, 2009.

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


	March 31, 2009		December 31, 2008
Interest-bearing deposits with financial institutions⁽¹⁾	$	153,230		90,707
Interest-bearing time deposits with financial institutions		38,348		198
Federal Reserve Bank and Federal Home Loan Bank Stock, at cost		13,420		13,420
Securities available for sale, at fair value		117,263		160,945
Loans (net of allowances of $16,263 and $15,453, respectively)	$	827,709	$	828,041

⁽¹⁾	Includes interest-earning balances maintained at the Federal Reserve Bank of San Francisco.

Loans

The following table sets forth, in thousands of dollars, the composition, by loan category, of our loan portfolio at March 31, 2009 and December 31, 2008:


	March 31, 2008					December 31, 2008
	Amount			Percent		Amount			Percent
Commercial loans	$	302,996		35.9	%	$	300,945		35.7	%
Commercial real estate loans—owner occupied		178,734		21.1	%		174,169		20.6	%
Commercial real estate loans—all other		127,229		15.1	%		127,528		15.1	%
Residential mortgage loans – multi- family		101,751		12.1	%		100,971		12.0	%
Residential mortgage loans—single-family		65,075		7.7	%		65,127		7.7	%
Construction loans		29,299		3.5	%		32,528		3.9	%
Land development loans		31,577		3.7	%		33,283		3.9	%
Consumer loans		7,702		0.9	%		9,173		1.1	%

Gross loans		844,363		100.0	%		843,724		100.0	%

Deferred fee (income) costs, net		(391	)				(230	)
Allowance for loan losses		(16,263	)				(15,453	)

Loans, net	$	827,709				$	828,041

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

The following table sets forth, in thousands of dollars, the maturity distribution of our loan portfolio (excluding consumer and residential mortgage loans) at March 31, 2009:


	March 31, 2009
	One Year or Less		Over One Year through Five Years		Over Five Years		Total
Real estate and construction loans⁽¹⁾
Floating rate	$	24,821	$	20,880	$	161,371	$	207,072
Fixed rate		41,213		84,607		33,947		159,767
Commercial loans
Floating rate		59,955		22,459		7,848		90,262
Fixed rate		128,206		56,580		27,948		212,734

Total	$	254,195	$	184,526	$	231,114	$	669,835

⁽¹⁾	Does not include mortgage loans on single and multi-family residences and consumer loans, which totaled $166.8 million and $7.7 million, respectively, at March 31, 2009.

Allowance for Loan Losses and Nonperforming Loans

Allowance for Loan Losses. The allowance for loan losses (the “Allowance”) at March 31, 2009 was $16.3 million, which represented approximately 1.93% of the loans outstanding at March 31, 2009, as compared to $15.5 million, or 1.83%, of the loans outstanding at December 31, 2008.

We carefully monitor changing economic conditions, the loan portfolio by category, the financial condition of borrowers, the historical performance of the loan portfolio, and we follow bank regulatory guidelines in determining the adequacy of the Allowance. We believe that the Allowance at March 31, 2009 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, the condition of borrowers, historical industry loan loss data and regulatory guidelines. If there are changes in those conditions or trends, actual loan losses in the future could vary from the losses that were predicted on the basis of those earlier assumptions, judgments and guidelines. For example, if economic conditions were to deteriorate further, 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 three months ended March 31, 2009 and the year ended December 31, 2008:


	Three Months Ended March 31, 2009			Year Ended December 31, 2008
Balance, beginning of period	$	15,453		$	6,126
Provision for loan losses		3,450			21,685
Recoveries on loans previously charged off		18			80
Amounts charged off		(2,658	)		(12,438	)

Balance, end of period	$	16,263		$	15,453

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 generally 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.

The following table sets forth information regarding nonaccrual loans and Other Real Estate Owned, which comprise our nonperforming assets, and the restructured loans, at March 31, 2009 and December 31, 2008:


	At March 31, 2009		At December 31, 2008
Nonaccrual loans:
Commercial loans	$	4,383	$	5,865
Commercial real estate		3,133		0
Residential real estate		2,273		2,478
Construction and land development		12,093		7,555
Consumer loans		24		27

Total nonaccrual loans	$	21,906	$	15,925

Other real estate owned (OREO):
Construction and land development		7,335		5,430
Residential-multi family		2,314		976
Residential-single family		2,233		2,408
Commercial real estate		5,194		5,194

Total other real estate owned		17,076		14,008

Total nonperforming assets	$	38,982	$	29,933

Restructured loans:
Accruing loans		2,957		2,606
Nonaccruing loans		9,026		4,913

Total Restructured Loans	$	11,983	$	7,519

Loan delinquencies 90 days or more totaled $7.6 million at March 31, 2009; whereas, as of March 31, 2008, $11.9 million of loans were delinquent 90 days or more, of which $2.0 million were still accruing interest. Loans less than 90 days delinquent and deemed impaired was $9.3 million and $0, respectively, as of March 31, 2009 and March 31, 2008. At March 31, 2009, the Bank had $34.2 million of loans deemed impaired as compared to $14.0 million at March 31, 2008. The Bank had an average quarterly investment in impaired loans of $32.4 million at March 31, 2009 and $27.1 million at December 31, 2008, respectively. The interest that would have been earned had the impaired loans remained current in accordance with their original terms was $153,000 at March 31, 2009.

Deposits

Average Balances of and Average Interest Rates Paid on Deposits.

Set forth below are the average amounts (in thousands of dollars) of, and the average rates paid on, deposits for the three months ended March 31, 2009:


	Three Months Ended March 31, 2009
	Average Balance		Average Rate
Noninterest-bearing demand deposits	$	158,501	—
Interest-bearing checking accounts		25,237	0.42	%
Money market and savings deposits		101,351	1.12	%
Time deposits		524,965	4.33	%

Average total deposits	$	810,054	2.96	%

Deposit Totals. Deposits totaled $897 million at March 31, 2009 as compared to $822 million at December 31, 2008. At March 31, 2009, noninterest-bearing deposits totaled $152 million and represented 17% of total deposits, as compared to $152 million and 19% of total deposits at December 31, 2008. At March 31, 2009, certificates of deposit in denominations of $100,000 or more totaled $400 million and represented 45% of total deposits, as compared to $326 million and 40% of total deposits at December 31, 2008. Due to the deterioration of the economy and continuing uncertainties as to the ultimate severity and duration of the recession, we decided to increase the Bank’s liquidity by increasing the volume of the time certificates of deposits in the quarter ended March 31, 2009.

Set forth below, in thousands of dollars, is a maturity schedule of domestic time certificates of deposit outstanding at March 31, 2009:


	At March 31, 2009
	Certificates of Deposit Under $100,000		Certificates of Deposit of $100,000 or More
Maturities
Three months or less	$	26,841	$	63,273
Over three and through twelve months		159,475		290,945
Over twelve months		29,016		45,430

Total certificates of deposit	$	215,332	$	399,648

Liquidity

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

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 $190 million, which represented 15.8% of total assets at March 31, 2009.

Cash Flow Used in Operating Activities. We used net cash flow of $2.2 million from operating activities primarily to fund the net loss of $2.1 million in the three months ended March 31, 2009.

Cash Flow Provided by Investing Activities. In the three months ended March 31, 2009, investing activities provided net cash of $16.5 million, primarily as a result sales of securities available for sale that generated proceeds totaling $128.0 million, and the use of cash totaling approximately $119.3 million, to fund $75.3 million of purchases of other securities available for sale, which are pledged to secure (i) Federal Home Loan Bank (FHLB) borrowings, (ii) repurchase agreements, (iii) local agency deposits and (iv) treasury, tax and loan accounts, $38.2 million of increases in interest bearing deposits maintained at other depository institutions, and $5.9 million of additional loans.

Cash Flow Provided by Financing Activities. Cash flow of $46 million was provided by financing activities during the three months ended March 31, 2009, comprised of a net increase of $75 million in deposits and a net decrease of $29 million in borrowings.

Ratio of Loans to Deposits. The relationship between gross loans and total deposits can provide a useful measure of a bank’s liquidity. Since repayment of loans tends to be less predictable than the maturity of investments and other liquid resources, the higher the loan-to-deposit ratio the less liquid are our assets. On the other hand, since we realize greater yields 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 March 31, 2009 and December 31, 2008 the ratios of loans-to-deposits were 92% and 101%, respectively.

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 March 31, 2009 and December 31, 2008, we were committed to fund certain loans, including letters of credit, amounting to approximately $214 million and $218 million, respectively.

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

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

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

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

Contractual Obligations

Borrowings. As a source of additional funds that we have used primarily to fund loans and to purchase other interest earning assets, and to provide us with a supplemental source of liquidity, we have obtained long and short term borrowings from the Federal Home Loan Bank (the “FHLB”). As of March 31, 2009, we had $39 million of outstanding long-term borrowings, with maturities ranging from April 2010 to December 2010, and $154 million of outstanding short-term borrowings, with maturities ranging from May 2009 to March 2010 that we had obtained from the Federal Home Loan Bank. These borrowings, together with securities sold under agreements to repurchase, have a weighted-average annualized interest rate of 3.71%. By comparison, as of December 31, 2008, we had $121 million of outstanding long-term borrowings and $104 million of outstanding short-term borrowings that we had obtained from the Federal Home Loan Bank, which, together with the securities sold under agreements to repurchase, had a weighted-average annualized interest rate of 3.71%.

At March 31, 2009, U.S. agency and mortgage backed securities, U.S. Government agency securities, collateralized mortgage obligations and time deposits with an aggregate fair market value of $129 million and $204 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 that were outstanding at any month-end during the three months ended March 31, 2009 consisted of $208 million of borrowings from the Federal Home Loan Bank and $12 million of overnight borrowings in the form of securities sold under repurchase agreements. During 2008, the highest amount of borrowings outstanding at any month-end consisted of $236 million of advances from the Federal Home Loan Bank and $13 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 are 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 $17.5 million principal amount of floating junior trust preferred securities (“trust preferred securities”). In October 2004 we established another grantor trust that sold an additional $10.3 million of trust preferred securities to an institutional investor. We received the net proceeds from the sales of the trust preferred securities in exchange for our issuances to the grantor trusts, of a total $27.8 million principal amount of 30-year junior subordinated floating rate debentures (the “Debentures”). The payment terms of the Debentures mirror those of the trust preferred securities and 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. The Debentures also were pledged by the grantor trusts as security for their payment obligations under the trust preferred securities.

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

During the third quarter of 2007, using available cash, we exercised our optional redemption rights to redeem, at par, $10.3 million principal amount of the Debentures that we issued in 2002.

Set forth below is certain information regarding the terms of the Debentures that remained outstanding as of December 31, 2008:


Original Issue Dates	Principal Amount		Interest Rates		Maturity Dates
	(In thousands)
September 2002	$	7,217	LIBOR plus 3.40	%	September 2032
October 2004		10,310	LIBOR plus 2.00	%	October 2034

Total	$	17,527

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 March 31, 2009, a total of $17.5 million principal amount of those Debentures qualified, as Tier I capital for regulatory purposes. See discussion below under the subcaption “—Capital Resources-Regulatory Capital Requirements.”

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 the current federally insured amount 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 March 31, 2009 and December 31, 2008:


	Amortized Cost		Gross Unrealized Gain		Gross Unrealized Loss			Estimated Fair Value
March 31, 2009
Securities Available For Sale:
US Treasury securities	$	75,209	$	36	$	—		$	75,245
Mortgage-backed securities issued by US agencies		17,178		7		(180	)		17,005

Total securities issued or guaranteed by US government or by US agencies		92,387		43		(180	)		92,250
Municipal securities		15,708		1		(1,201	)		14,508
Non agency collateralized mortgage obligations		9,725		—		(1,716	)		8,009
Asset-backed securities		1,247		—		(516	)		731
Mutual fund		1,765		—		—			1, 765

Total Securities Available For Sale	$	120,832	$	44	$	(3,613	)	$	117,263

December 31, 2008
Securities Available For Sale:
US agencies and mortgage-backed securities	$	126,065	$	1,538	$	(471	)	$	127,132
Collateralized mortgage obligations		425		4		—			429

Total government and agencies securities		126,490		1,542		(471	)		127,561
Municipal securities		22,895		90		(1,523	)		21,462
Non agency collateralized mortgage obligations		10,278		—		(1,340	)		8,938
Asset backed securities		1,237		—		—			1,237
Mutual fund		1,747		—		—			1,747

Total Securities Available For Sale	$	162,647	$	1,632	$	(3,334	)	$	160,945

At March 31, 2009, U.S. agencies and mortgage backed securities, U.S. Government agency securities, collateralized mortgage obligations and time deposits with an aggregate fair market value of $129 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 March 31, 2009, of securities available for sale are shown, in thousands of dollars, in the following table, by contractual maturities and historical prepayments based on the prior three months of principal payments. Expected maturities will differ from contractual maturities and historical prepayments, particularly with respect to collateralized mortgage obligations, because borrowers may react to interest rate market conditions differently than the historical prepayment rates.


	March 31, 2008 Maturing in
	One year or less				Over one year through five years				Over five years through ten years				Over ten years				Total
	Book Value		Weighted Average Yield		Book Value		Weighted Average Yield		Book Value		Weighted Average Yield		Book Value		Weighted Average Yield		Book Value		Weighted Average Yield
	(Dollars in thousands)
Securities available for sale:
US Treasury securities	$	75,209	0.48	%	$	—	—		$	—	—		$	—	—		$	75,209	0.48	%
US agencies/mortgage-backed securities		3,718	3.71	%		6,426	3.89	%		3,217	4.15	%		3,817	4.44	%		17,178	4.02	%
Non Agency Collateralized mortgage obligations		1,857	4.67	%		2,246	4.47	%		5,622	4.53	%		—	—			9,725	4.54	%
Municipal securities		—	—			—	—			1,349	4.10	%		14,359	4.27	%		15,708	4.26	%
Asset backed securities		—	—			—	—			—	—			1,247	6.23	%		1,247	6.23	%
Mutual funds		—	—			1,765	4.00	%		—	—			—	—			1,765	4.00	%

Total Securities Available for sale	$	80,784	0.73	%	$	10,437	4.03	%	$	10,188	4.35	%	$	19,423	4.43	%	$	120,832	1.91	%

The table below shows as of March 31, 2009, 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 March 31, 2009
	Less than 12 months					12 months or more					Total
(Dollars In thousands)	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
US agencies and mortgage backed securities	$	13,130	$	(176	)	$	363	$	(4	)	$	13,493	$	(180	)
Non Agency Collateralized mortgage obligations		6,953		(1,675	)		1,056		(41	)		8,009		(1,716	)
Asset backed securities		—		—			731		(516	)		731		(516	)
Municipal securities		3,013		(551	)		8,741		(650	)		11,754		(1,201	)

Total temporarily impaired securities	$	23,096	$	(2,402	)	$	10,891	$	(1,211	)	$	33,987	$	(3,613	)

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

Capital Resources

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

The following table sets forth the capital and capital ratios of the Company (on a consolidated basis) and the Bank (on a stand-alone basis) at March 31, 2009, 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	$	109,309	12.1	%	$	72,301	At least 8.0	%		N/A	N/A
Bank		97,442	10.9	%		71,548	At least 8.0	%	$	89,435	At least 10.0	%
Tier 1 Capital to Risk Weighted Assets:
Company	$	97,947	10.8	%	$	36,150	At least 4.0	%		N/A	N/A
Bank		86,197	9.6	%		35,774	At least 4.0	%	$	53,661	At least 6.0	%
Tier 1 Capital to Average Assets:
Company	$	97,947	8.3	%	$	47,199	At least 4.0	%		N/A	N/A
Bank		86,197	7.4	%		46,828	At least 4.0	%	$	58,535	At least 5.0	%

At March 31, 2009 the Bank (on a stand-alone basis) continued to qualify as a well-capitalized institution, and the Company continued to exceed the minimum required capital ratios, under the capital adequacy guidelines described above. During the quarter ended March 31, 2009, the Company made a $8.0 million capital contribution to the Bank to better enable the Bank to absorb any additional loan losses that could occur as a result of economic and financial crisis in the United States and at the same time maintain its capital ratios well above those required to qualify as a well capitalized banking institution for regulatory purposes.

The consolidated total capital and Tier 1 capital of the Company, at March 31, 2009, include an aggregate of $17.5 million principal amount of Junior Subordinated Debentures that we issued in 2002 and 2004 in connection with the sale of trust preferred securities. We contributed $17.5 million of the net proceeds from the sale of the trust preferred securities to the Bank, thereby providing it with additional cash to fund the growth of its banking operations and at the same time, to increase its total capital and Tier 1 capital.

Dividend Policy. It continues to be the policy of the Board to retain earnings to support future growth and, at the present time, there are no plans to declare any cash dividends, at least until economic conditions improve. However, the Board of Directors intends from time to time to consider the advisability of paying cash dividends in the future. Any such decision will be based on a number of factors, including the Company’s future financial performance, its available cash and capital resources and any competing needs for cash that the Company or the Bank may have.

Share Repurchase Programs. In June 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 (the “2005 Share Repurchase Program”), which authorized the Company to purchase up to two percent (2%) of the Company’s outstanding common shares, which approximates 200,000 shares in total.

For the same reasons, in October 2008 the Board of Directors adopted a new share repurchase program which authorizes purchases by the Company of up to $2 million of our common shares, in addition to the shares that may still be purchased under the 2005 Share Repurchase Program.

Pursuant to these two programs, share 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 either of these share repurchase programs and the timing, actual number and value of shares that are repurchased by the Company 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.

These share repurchase programs do not have expiration dates. However, the Company may elect (i) to suspend share repurchases at any time or from time to time, or (ii) to terminate the programs prior to the repurchase of all of the shares authorized for repurchase under these programs. Accordingly, there is no assurance that any additional shares will be repurchased under these programs.

Since share repurchases have the effect of reducing capital, we do not expect to make any significant share repurchases at least until economic and financial conditions improve and we see a reduction in nonperforming assets.

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 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:

The United States is currently experiencing a severe economic recession and unprecedented credit crisis that have adversely affected the banking and financial services industry and have created substantial uncertainties and risks for our business and future financial performance

The United States is experiencing a severe economic recession, which is reported to have begun at the end of 2007 and since the latter half of 2008 has been creating wide ranging consequences and difficulties for the banking and financial services industry, in particular, and the economy in general. The recession began with dramatic declines in the housing market, which resulted in decreasing home prices and increasing loan delinquencies and foreclosures that led to significant write-downs of the assets and an erosion of the capital of a large number of lending and other financial institutions. As a result, several very large and prominent banking and financial organizations, such as Merrill Lynch, Bear Stearns, Wachovia Bank and Washington Mutual had to seek merger partners to survive and others, such as Lehman Bros. and Indy Mac Bank, failed and went out of business, which led to concerns over the stability and viability of the financial markets. In an effort to preserve their capital and avoid increased losses, banks and other lending institutions severely tightened their credit standards and significantly reduced their lending activities, creating a credit crisis that has led to a contraction of the economy, significant increases in unemployment and significant reductions in business and consumer spending.

As a result, like many other banks, we experienced increases in loan delinquencies and nonperforming loans, not only in our real estate, but also in our commercial, loan portfolios that resulted in significant increases in loan losses in 2008 and in the first quarter of 2009. Those loan losses, coupled with the expectation that economic and market conditions will worsen for at least the first six months of 2009 and uncertainties about the ultimate duration and severity of the economic recession, led us (and many other banks) to significantly increase loan loss reserves by charges to income that caused us to incur a net loss of $12.0 million, or $1.14 per diluted share, in 2008 and $2.1 million, or $0.20 per diluted share, in the three months ended March 31, 2009.

As a result of these conditions and the likelihood that economic and market conditions will worsen for at least the first six months of 2009, we face a number of risks that could adversely affect our operating results and financial condition in the future, including the following:

•

If economic and market conditions do not improve during the remainder of 2009, we could incur additional loan losses, and experience an increase in foreclosures of real properties collateralizing loans that we have made that would require us to set aside reserves for possible declines in the value of or the costs of maintaining those properties, which could adversely affect our results of operations and cause us to incur operating losses in 2009.

•

Due to the uncertainties about economic conditions in 2009, there is an increased risk that the judgments that we might make in estimating loan losses that may be inherent in our loan portfolio and in establishing loan loss reserves will prove to be incorrect, requiring us to set aside additional reserves that would adversely affect our future results of operation.

•

Possible further declines in economic activity in the United States, generally, and in our markets, in particular, due to lack of business and consumer spending and increased unemployment could result in reductions in loan demand and a further tightening of credit that would lead to reductions in our interest income, net interest income and margins.

•

Adverse economic conditions, such as a continued tightening of available business and consumer credit and continued high unemployment, could lead customers to withdraw funds from their deposit accounts with us to meet their operating or living expenses, which could reduce our liquidity and, therefore, the funds we would have available for lending, as a result of which our interest income could decline, possibly significantly, and our costs of funds could increase, thereby adversely affecting our operating results and financial condition.

•

In response to the causes of the credit and foreclosure crises and the economic recession, the federal government is likely to increase its regulation of and impose new restrictions on banks and other financial institutions, which would increase our costs of doing business and limit our ability to pursue business and growth opportunities.

•

We, as well as all other federally insured banks, may be required to pay significantly higher FDIC premiums to increase the FDIC’s insurance fund, which is being depleted by bank failures that have increased as a result of the credit crisis and economic recession.

•

There is no assurance that the enactment of recent federal legislation, such as EESA and the ARRA, and the implementation of regulatory programs and initiatives, such as the TARP CPP program, which are designed to address the difficult market and economic conditions that we are experiencing, will prove to be successful in curtailing the recession and providing the stimulus and resources needed to improve the economy. In addition, the impact of this legislation and these regulatory initiatives on the financial markets is uncertain and if they fail to lead to improvements in economic and market conditions, the recession could worsen and, thereby, adversely affect our business, financial condition, results of operations, access to credit or the value of our securities.

•

If we experience increased losses in 2009 due to these economic and market conditions, our regulatory capital and capital ratios could be reduced, requiring us to seek additional capital through sales of equity securities. If economic and market conditions do not improve, there is no assurance that we will succeed in raising additional equity capital, if needed, and any sales of equity securities that we might make could be dilutive of the financial and equity interests of our existing shareholders. If it becomes necessary, but we are unable to raise additional capital, we could be forced to sell some of our assets in order to prevent a decline in our capital ratios. However, there is no assurance that we would succeed in selling assets and we could incur losses on those asset sales.

Without an improvement in economic conditions, our liquidity, results of operations and financial condition could be adversely affected.

Although the Company and the Bank remain well capitalized and have not suffered any significant liquidity issues as a result of the economic recession and instability in the banking and financial markets, the cost and availability of funds may be adversely affected by illiquid credit markets. In addition, the demand for our products and services may decline as our borrowers and customers are more severely impacted by the economic recession. In view of the concentration of our operations and the collateral securing our loan portfolio in Southern California, we may be particularly susceptible to the adverse economic conditions in the state of California, which has been experiencing higher unemployment and higher foreclosure rates and greater budgetary difficulties than other states in the country. In addition, the severity and duration of the economic recession is unknown and may exacerbate our exposure to credit risk and adversely affect the ability of borrowers to perform under the terms of their lending arrangements with us.

We could incur losses on the loans we make

There has been a significant slowdown in the housing market and a significant increase in real estate loan foreclosures in portions of Los Angeles, Orange, Riverside and San Diego counties of California where a majority of our loan customers are based. This slowdown has caused declining home prices and excess inventories of unsold homes and increases in unemployment and a resulting loss of confidence about the future among businesses and consumers that have combined to adversely affect business and consumer spending. These conditions have led to increased loan defaults in 2008 and so far in 2009. A continuing deterioration in the real estate market and a continuation or worsening of the economic recession could result in additional loan charge-offs and increases in the provisions for loan losses in the future, which could cause us to incur additional losses and have a material adverse effect on our operating results, financial condition and capital.

Liquidity risk could impair our ability to fund operations and jeopardize our financial condition

Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a material adverse effect on our liquidity. Our access to funding sources in amounts adequate to finance our lending and other activities could be impaired by factors that affect us specifically or the financial services industry in general, including a decrease in the level of business activity due to the economic downturn or the imposition of regulatory restrictions on our operations. Our ability to acquire deposits or borrow, or raise additional equity capital, could also be impaired by factors that are not specific to us, such as a continued severe disruption of the financial markets or negative views and expectations about the prospects for the financial services industry as a whole, particularly if the recent turmoil faced by banking organizations in the domestic and worldwide credit markets worsens.

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, as well as large in-state, banks with operations and offices covering 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 as well as products and services that we do not offer. The larger banks, and some of those other financial institutions, have greater resources that enable them to conduct extensive advertising campaigns and to shift resources to regions or activities of greater potential profitability. Some of these banks and institutions also have substantially more capital and higher lending limits that enable them to attract larger clients, and offer financial products and services that we are unable to offer, particularly with respect to attracting loans and deposits. Increased competition may prevent us (i) from achieving increases, or could even result in decreases, in our loan volume or deposit balances, or (ii) from increasing interest rates on loans or reducing interest rates we pay to attract or retain deposits, either or both of which could cause a decline in our interest income or an increase in our interest expense, that could lead to reductions in our net interest income and earnings.

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 continued downturn in economic conditions or the occurrence of natural disasters, such as earthquakes or fires, which are more common in Southern California than in other parts of the country, could harm our business by:

•

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

•

adversely affecting the financial capability of borrowers to meet their loan obligations, which could result in increases in loan losses and require us to make additional provisions for possible loan losses, thereby adversely affecting our operating results; and

•

causing 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 sales of such real properties.

Our business is subject to interest rate risk and variations in interest rates may negatively affect our financial performance

A substantial portion of our income is derived from the differential or “spread” between the interest we earn on loans, securities and other interest-earning assets, and interest we pay on deposits, borrowings and other interest-bearing liabilities. Because of the differences in the maturities and repricing characteristics of our interest-earning assets and interest-bearing liabilities, changes in interest rates do not produce equivalent changes in interest income earned on interest-earning assets and interest paid on interest-bearing liabilities. Accordingly, fluctuations in interest rates could adversely affect our interest rate spread and, in turn, our profitability. In addition, loan origination volumes are affected by market interest rates. Rising interest rates, generally, are associated with a lower volume of loan originations while lower interest rates are usually associated with higher loan originations. Conversely, in rising interest rate environments, loan repayment rates may decline and in falling interest rate environments, loan repayment rates may increase. Also, in a rising interest rate environment, we may need to accelerate the pace of rate increases on our deposit accounts as compared to the pace of future increases in short-term market rates. Accordingly, changes in market interest rates could materially and adversely affect our net interest spread, asset quality and loan origination volume.

Government regulations may impair our operations, restrict our growth or increase our operating costs

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 those restrictions would adversely affect the ability of the banking institution to expand its business or pay cash dividends, 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 of those regulations 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 and, in particular, on Raymond E. Dellerba, our 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. As a result, the loss of the services of any of these officers could harm our ability to implement our business strategy or our future operating results.

Expansion of our banking franchise and our new residential mortgage lending business may not be successful and could adversely affect our future operating results

We have grown substantially in the past nine years by (i) opening new financial centers in population centers, and (ii) adding banking professionals at our existing financial centers, with the objective of attracting additional customers including, in particular, small to medium size businesses, that will add to our profitability. We intend to continue that growth strategy.

Additionally, as we have recently reported, during the first quarter of 2009 we commenced a wholesale mortgage lending business, pursuant to which we have begun originating and purchasing FHA approved residential real estate mortgage loans that qualify for resale into the secondary mortgage market. The decision to commence that business is based on our belief that, beginning in 2009, there will be a substantial increase in the demand for conventional residential mortgage loans due to (i) the significant declines that have occurred in housing prices, particularly in Southern California, (ii) the decreases in prevailing interest rates, and (iii) the new federal income tax credit that is now available to first-time home buyers. These conditions, we believe, make home ownership more affordable for consumers with good credit histories who had previously been shut out of the residential real estate market primarily by the high prices of homes and increasing interest rates prior to mid-2008.

However, our growth strategy and the commencement of our new wholesale mortgage lending business pose a number of potentially significant risks that could adversely affect our business and future financial performance. Those risks include, among others: the strain that growth and the commencement of the new wholesale mortgage lending business will put on our cash and management resources; the risk that management’s time and efforts will be diverted from our existing banking business, which could cause its operating results to decline; the risk that expansion of our banking franchise and our new mortgage lending business will not generate revenues in amounts sufficient to enable us to recover the substantial expenditures we will have to make to establish new banking offices and a presence in new markets and to add banking professionals and experienced mortgage loan officers and administrators; the risk that our belief that the demand for residential mortgage loans will grow substantially, which is the primary basis for our decision to commence a wholesale residential mortgage lending business, will prove not to have been correct; and the risk that we will be unable to sell the mortgage loans we originate into the secondary mortgage market for amounts sufficient to cover the costs of that business if, for example, the interest rates prove to be volatile or if there is another credit crisis that adversely affects the flow of funds into the secondary mortgage market. Accordingly, there is no assurance that the implementation of our growth strategy or our entry into the wholesale residential mortgage lending business will not hurt our earnings or cause us to incur losses in the future.

Our computer and network systems may be vulnerable to unforeseen problems and security risks

The computer systems and network infrastructure that we use to provide automated and internet banking services could be vulnerable to unforeseen problems. Our operations are dependent upon our ability to protect our computer equipment against damage from fire, power loss, telecommunications failure, earthquakes and similar catastrophic events and from security breaches. Any of those occurrences could result in damage to or a failure of our computer systems that could cause an interruption in our banking services and, therefore, harm our business, operating results and financial condition. Additionally, interruptions in service and security breaches that could result in the theft of confidential customer information could lead existing customers to terminate their banking relationships with us and could make it more difficult for us to attract new banking customers.

We are exposed to risk of environmental liabilities with respect to properties to which we take title

Due to the current economic recession, the resulting financial difficulties encountered by many borrowers and the declines in the market values and in the demand for real properties, during 2008 and continuing into 2009 we have had to initiate foreclosure proceedings with respect to and take title to an greater number of real properties that had collateralized loans which had become nonperforming. Moreover, if the economic recession worsens, we may have to foreclose and take title to additional real properties during the remainder of 2009. As a result, we could become subject to environmental liabilities and incur costs, which could be substantial, with respect to these properties for property damage, personal injury, investigation and clean-up costs incurred in connection with environmental contamination at such properties. In addition, if we are the owner or former owner of a contaminated site, we may be subject to common law claims by third parties seeking damages and costs resulting from environmental contamination emanating from the site. If we become subject to significant environmental liabilities on costs, our business, financial condition, results of operations and prospects could be adversely affected.

Managing reputational risk is important to attracting and maintaining customers, investors and employees

Threats to our reputation can come from many sources, including adverse sentiment about financial institutions generally, unethical practices, employee misconduct, failure to deliver minimum standards of service or quality, compliance deficiencies, and questionable or fraudulent activities of our customers. We have policies and procedures in place to protect our reputation and promote ethical conduct, but these policies and procedures may not be fully effective. Negative publicity regarding our business, employees, or customers, with or without merit, may result in the loss of customers, investors and employees, costly litigation, a decline in revenues and increased governmental regulation.

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, 2008 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

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including our CEO and CFO, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, our management recognized that any system of controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, as ours are designed to do, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

In connection with the preparation of this Quarterly Report on Form 10-Q, an evaluation was performed under the supervision and with the participation of our management, including our CEO and CFO, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Based on that evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of the end of the period covered by this Quarterly Report on Form 10-Q to ensure that the information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and to ensure that the information required to be disclosed by us in reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our CEO and CFO, as appropriate, to allow timely decisions regarding required disclosures.

There were no changes in our internal control over financial reporting that occurred during the quarter or three months ended March 31, 2009 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 that were disclosed under the caption “Risk Factors” in Item 1A of Part I of our Annual Report on Form 10-K for the fiscal year ended December 31, 2008 (the “2008 10-K”), except as follows:

ITEM 1A — “Risk Factors” in our 2008 10-K contained a risk factor entitled “Expansion of our banking franchise might not achieve expected growth or increases in profitability and may adversely affect our operating results”. As included in Part I of this Quarterly Report on Form 10-Q, in Item 2.— Management’s Discussion & Analysis of Financial Condition and Results of Operations, under the caption “Factors That Can Affect Our Future Financial Performance” that risk factor has been re-titled “Expansion of our banking franchise and our new residential mortgage lending business may not be successful and could adversely affect our future operating results” and includes material changes from the corresponding risk factor in our 2008 10-K.

ITEM 6.

EXHIBITS

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


Exhibit No.		Description of Exhibit

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

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

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

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

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: May 11, 2009	By:	/s/ NANCY A. GRAY
		Nancy A. Gray, Chief Financial Officer

S-1

EXHIBIT INDEX


Exhibit No.		Description of Exhibit

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

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

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

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

E-1