UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20529

FORM 10-K

For the transition period N/A to N/A

Commission file number 000-23925

MID-STATE BANCSHARES
(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code : (805) 473-6829

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock

(no par value)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Role 405 of the Securities Act. Yes o  Nox

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes  o  No x

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 shorter period that the Registrant was required to file such reports) Yes [X] No [  ], and (2) has been subject to such filing requirements for the past 90 days. Yes x  No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is a large accelerated filer, accelerated filer, or a non-accelerated filer (as defined in Exchange Act Rule 12b-2).

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

The aggregate market value of the common stock held by non-affiliates of the registrant as of June 30, 2006 was $619,383,016.

The number of shares of common stock of the registrant outstanding as of March 2, 2007 was 22,251,545.

This annual report on Form 10K is 117 pages long including the signature pages, certifications and consent.

TABLE OF CONTENTS

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PART I

Certain statements contained in this Annual Report on Form 10-K (“Annual Report”), including, without limitation, statements containing the words “estimates”, “believes”, “anticipates”, “intends”, “may”, “expects”, “could” and words of similar import, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities and Exchange Act of 1934. These forward- looking statements relate to, among other things, our current expectations regarding future operating results, net interest margin, strength of the local economy and allowance for credit losses. They involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others, the following: general economic and business conditions in those areas in which the Company operates, competition, natural disasters, growth in loans and deposits, fluctuations in interest rates, changes in business strategy or development plans, changes in governmental regulation, credit quality, economic, political and global changes arising from the war on terrorism and the conflict in Iraq, the occurrence of any event, change or other circumstances that could give rise to the termination of the agreement and plan of merger with Rabobank, the outcome of any legal proceedings that have been or may be instituted against the Company and others related to the agreement and plan of merger and the transactions contemplated thereby, failure to obtain shareholder approval or any other failure to satisfy other conditions required to complete the proposed merger, including required regulatory approvals, the amount of the costs, fees, expenses and charges related to the proposed merger and other factors referenced in this report, including in “Item 1A. Risk Factors.”  We can make no assurances regarding the likelihood of consummation of the merger described in this report. When relying on forward-looking statements to make decisions with respect to our Company, investors and others are cautioned to consider these and other risks and uncertainties. The Company disclaims any obligation to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements contained herein to reflect future events or developments.

This discussion should be read in conjunction with our financial statements, including the notes thereto, appearing elsewhere in this report.

ITEM 1.                BUSINESS

Mid-State Bancshares and Mid-State Bank & Trust

Mid-State Bancshares (the Company) is the parent company to Mid-State Bank & Trust (the Bank), its 100% owned principal subsidiary. The Company is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (BHC Act) and is subject to the supervision and regulation of the Board of Governors of the Federal Reserve System (Federal Reserve Board).

Rabobank Merger

On November 2, 2006, the Company and Rabobank announced that they had entered into an agreement and plan of merger through which Mid-State Bank & Trust will become part of the Rabobank Group. Upon completion, Mid-State Bank & Trust will be merged into Rabobank, N.A., Rabobank’s community banking subsidiary in California.

Under terms of the agreement and plan of merger, Rabobank will acquire all of the shares of Mid-State Bancshares, through a merger with a Rabobank subsidiary, for a purchase price of $37.00 per share in cash, or a total purchase price of approximately $851 million. This represented a 23% premium over the average share price of Mid-State Bancshares common stock in October of 2006. The transaction is expected to close in the second quarter of 2007, subject to approval by Mid-State Bancshares shareholders and the receipt of all required regulatory approvals. It is currently anticipated that the special meeting of shareholders to vote on the acquisition will be held on or about April 25, 2007 and a proxy statement

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containing information about the transaction will be sent out approximately 30 days in advance of such meeting to shareholders of record. If the transaction does not close on or before April 30, 2007, the Company may pay an additional cash dividend, or dividends, to shareholders as more fully described in Part II, Item 5 of this report.

Please see our Report on Form 8-K filed with the Securities and Exchange Commission on November 3, 2006. Attached to that Report is a copy of the definitive agreement for the acquisition to which you are referred and by which this discussion is qualified in its entirety. See the section entitled “Where you can Find Additional Information” at the end of this Item 1 for how to get a copy of that Report. See also, Item 3 of this Report on Form 10-K entitled Legal Proceedings for information regarding a lawsuit filed in connection with the acquisition.

In reviewing this Annual Report on Form 10-K, please understand that the entire discussion of the Company, its business and all related disclosures herein is influenced to some extent by the acquisition by Rabobank which is expected to be consummated in the second quarter of 2007. Thus, the Company has focused its discussion on historical information and has omitted discussion of the future independent operations or prospects of the Company during this year or in the future unless otherwise required under SEC rules.

General

The Company, through the Bank, derives its income primarily from interest received on loans, and to a lesser extent, from interest on investment securities, fees received in connection with loans and other services offered, including loan servicing and deposit services. The Company’s major operating expenses are the interest it pays on deposits and borrowings and general operating expenses. The Company’s operations, like those of other financial institutions operating in California, are significantly influenced by economic conditions in California, including the strength of the real estate market, the fiscal and regulatory policies of the federal government and of the regulatory authorities that govern financial institutions. See, “Supervision and Regulation.”

Mid-State Bank & Trust was incorporated under the laws of the State of California and commenced operations on June 12, 1961 as a California state chartered bank. The Bank’s accounts are insured by the Federal Deposit Insurance Corporation (FDIC), but it is not a member of the Federal Reserve System. At December 31, 2006 the Company had total assets of approximately $2.4 billion, total deposits of $2.0 billion and total shareholders’ equity of $282 million.

The Bank operates 41 full service retail-banking offices along the central coast of California in Santa Barbara, San Luis Obispo and Ventura counties. The Bank’s headquarters is located in Arroyo Grande and it also serves the communities of Paso Robles, Cambria, Templeton,  Atascadero, Cayucos, Morro Bay, Los Osos, San Luis Obispo, Pismo Beach, Grover Beach, Guadalupe, Nipomo, Santa Maria, Orcutt, Lompoc, Vandenberg Village, Buellton, Santa Ynez, Solvang, Goleta, Oxnard, Camarillo, Ojai, Oak View, Ventura, Westlake Village and Santa Barbara. The headquarters’ street address is 1026 Grand Ave., Arroyo Grande, CA 93420. Its mailing address is P.O. Box 6002, Arroyo Grande, CA 93421-6002. The telephone number is: (805) 473-6829. The Bank can also be reached through its internet address at www.midstatebank.com. Investors can obtain copies of this Annual Report on Form 10-K or other filings made by the Company with the Securities and Exchange Commission (SEC) through this website which provides a link to the SEC internet website. See the section entitled “Where you can Find Additional Information” at the end of this Item 1.

The Bank is a full-service community bank offering a broad range of banking products and services, including accepting time and demand deposits, originating loans and leases, providing trust services, and making other investments. The Bank originates several types of loans, including secured and unsecured commercial and consumer loans, residential real estate mortgage loans, and residential construction loans.

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The Bank’s loans are both short-term and intermediate term in length and consist of both fixed and adjustable rate contracts. Special services and requests beyond the lending limits of the Bank are arranged through correspondent banks.

Bank Subsidiaries

The Bank operates two wholly owned subsidiaries—Mid-Coast Land Company and MSB Properties, Inc. Mid-Coast Land Company was founded in 1984 pursuant to section 751.3 of the Financial Code of the State of California. Section 751.3 provided that state-chartered banks were authorized to invest in a corporation that engaged in real estate activities. Under the Federal Deposit Insurance Corporation Improvement Act (FDICIA) which became law in December 1991, the Bank, through Mid-Coast Land Company, was required to divest itself of its real estate development activities. That process was completed in January 2003. The holdings and results of operations of Mid-Coast Land Company are included within the consolidated financial statements of the Company. On a stand-alone basis, Mid-Coast Land Company had after-tax earnings of $195 thousand in 2006, $409 thousand in 2005, and $379 thousand in 2004. For further information concerning Mid-Coast Land Company, see the Subsidiary Activity section of the Management’s Discussion and Analysis section included in Item 7 of this Report.

MSB Properties Inc. was incorporated under the laws of the State of California in May of 1968, allowing for the ownership of property which may be reasonably necessary for the expansion of the Bank’s business, or which is otherwise reasonably related to the conduct of the Bank’s business, pursuant to Section 752 of the Financial Code of the State of California.

The holdings and results of operations of MSB Properties are included within the consolidated financial statements of the Company. On a stand-alone basis, MSB Properties had earnings of $1.1 million, $1.2 million, and $1.2 million in 2006, 2005, and 2004, respectively. For further information concerning MSB Properties, see the Subsidiary Activity portions of the Management’s Discussion and Analysis section included in Item 7. of this Report.

Services

The Bank offers a full range of commercial banking services including checking accounts, NOW accounts, health savings accounts, savings accounts, money market accounts, and various types of time certificates of deposit (including various maturities and individual retirement accounts). The Bank makes a variety of construction and land development loans, real estate related loans, home equity credit lines, installment loans, agricultural and commercial loans, business equipment leases, Small Business Administration (SBA) and other government agency loans. Other services offered by the Bank include, but are not limited to, trust services, safe deposit boxes, travelers cheques, notary public, merchant depository services for VISA and Mastercard, cash management, home banking, telephone voice response system and ATM’s. The Bank’s organization and structure is designed to serve the banking needs of individuals and small to medium sized businesses in Santa Barbara, Ventura and San Luis Obispo counties.

Deposit and Liability Management

Deposits represent the Bank’s primary source of funds. As of December 31, 2006 the Bank had approximately 42,809 non-interest bearing demand deposit accounts representing $523.1 million, or an average of $12,220 per account. The Bank also had approximately 105,026 NOW, Money Market and Savings accounts amounting to $994.6 million, or about $9,470 average per account. There were 17,513 time certificates of deposit outstanding at December 31, 2006, representing $487.1 million with an average deposit balance of approximately $27,811. Of the total time certificates of deposit, $229.4 million represented holders who carried an amount on deposit of $100,000 or more, approximately 47% of the total.

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The Bank is not dependent on a single or a few customers for its deposits. Most deposits are obtained from individuals and small-to-medium sized businesses. This results in the relatively small average balances noted above and allows the Bank to be less subject to the adverse effects of the loss of a large depositor. As of December 31, 2006, no individual, corporate, or public depositor accounted for more than 2% of the Bank’s total deposits.

Liquidity is the Bank’s ability to meet fluctuations in deposit levels and to provide for the credit needs of its customers. The objective in liquidity management is to maintain a balance between the sources and uses of funds. Principal sources of liquidity include interest and principal payments on loans and investments, proceeds from the maturity of investments and growth in deposits. The Bank holds overnight Fed Funds Sold as a cushion for temporary liquidity needs. For 2006, Fed Funds Sold averaged $39.9 million representing 1.7% of average assets. In addition, the Bank maintains Federal Funds lines of credit totaling $70 million with major correspondents, subject to customary terms for such arrangements.

The Bank’s internally calculated liquidity ratio, which measures the percentage of total liabilities (excluding equity) which are used to fund cash, cash equivalents and non-pledged marketable securities, was 24.7%, greater than the Bank’s policy minimum of 15%.

Liquidity demands at the Holding Company have been limited historically to dividend payments it makes to its stockholders, the repurchase of its common stock, and certain payments to vendors. Management does not anticipate any demands requiring additional liquidity in the near term. Currently, the liquidity needs of the Holding Company are funded by dividends it receives from the Bank.

Loans

The Bank’s loan-to-deposit ratio stood at approximately 78.7% at year-end 2006 up from 73.6% at the end of 2005. It is the Bank’s policy to maintain its loan-to-deposit ratio in the 60% to 80% range while maintaining credit quality.

The Bank maintains an allowance for loan losses which is netted against loans on the balance sheet. Additions to the allowance are made by charges to expense. All loans deemed to be uncollectible are charged to the allowance; subsequent recoveries are credited to the allowance. The amount in the loan loss allowance is an estimate of the losses inherent in the loan portfolio as determined by a variety of factors considered by Management. Factors include, but are not limited to, the current economic climate, type and quality of loans in the portfolio, trends in delinquencies, historical loss rates, non-accrual totals, diversification of the portfolio, value of available collateral and the cost of collateral liquidation.

As of December 31, 2006, the Bank’s allowance for loan losses stood at $11.9 million. Additionally, the Bank has an allowance for losses on unfunded commitments totaling $1.8 million. Collectively, these allowances for losses represent 2,605% of non-performing loans (non-accrual loans plus loans 90 days or more past due). Outside factors, not within the Bank’s control, such as adverse changes in the economy, can affect the adequacy of the allowances and there can be no assurance that in any given period, the Bank might not suffer losses which are substantial in relation to the size of the allowances. During 2006, the Bank experienced net charge-offs after recoveries, of $26 thousand.

Underwriting and Credit Administration

The lending activities of Mid-State Bank & Trust are guided by the lending policies approved by the Bank’s Board of Directors. The credit policy is managed through periodic reviews and approved annually by the Board.

Each loan is evaluated using underwriting criteria established in the Bank’s lending policy. Lending authority is granted to officers of the Bank on a limited basis, dependent upon individual knowledge and experience. During 2005, the approval process was revised. Loan requests exceeding individual limits are

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now submitted to the Bank’s Loan Committee, which consists of the chief executive officer, chief credit officer, the presidents of community banking for the bank’s three regions, the credit operations manager, the credit administrators and one non-management director. The Loan Committee meets on a regular basis in order to provide timely responses to the Bank’s clients. Additionally, a Board Loan Committee consisting of the president, chief credit officer and 3 non-management directors meet monthly to review all credits made over certain dollar thresholds and to establish Bank credit policy and monitor adherence to it. The new structure has satisfied Management’s and the Board’s concern for improved efficiency in the approval process.

The Bank’s credit administration function includes an internal review and the regular use of an independent outside loan review firm.

Loan Portfolio

At December 31, 2006 and 2005, the Bank’s gross loan portfolio totaled $1.6 billion and $1.5 billion, respectively. The portfolio was distributed as follows:

The interest rates charged for the loans made by the Bank vary with the degree of risk, size and maturity of the loans. Rates are generally affected by competition, the client’s deposit relationship with the Bank, and the Bank’s cost of funds.

Commercial Loans.   The Bank provides financial services to diverse commercial and professional businesses in the marketplace. Commercial loans consist primarily of short term loans (normally with a maturity of one year or less) for working capital and business expansion. Commercial loans typically include revolving lines of credit, either uncollateralized or collateralized by inventory, loans secured by accounts receivable and equipment loans. Emphasis is placed on the borrower’s earnings history, capitalization, secondary sources of repayment, and in some instances, third-party guarantees or highly liquid collateral (such as time deposits and investment securities). Commercial loan pricing is generally at a rate tied to the prime rate (as quoted in the Wall Street Journal) or the Bank’s reference rates. Certain equipment loans may be made at fixed rates for short to medium terms.

The Bank has developed a streamlined underwriting process for small business loans up to $250,000. This process includes, but is not limited to, automated approval on loans using a business scoring model, combined with requiring only limited financial information for loans over $100,000. This process was implemented in January, 2006.

The Bank participates in Small Business Administration (SBA) loan guarantee programs. The programs used include: 1) SBA Express, which is scored and underwritten using the Bank’s small business loan guidelines and products described above in addition to SBA criteria; 2) the 504 program, which is focused toward longer-term financing of buildings and other long-term assets; and 3) the 7A program,

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which is primarily used for financing of equipment, inventory and working capital needs of eligible businesses, generally over a seven to twenty-five year term. The Bank’s collateral position in the SBA loans is enhanced by the SBA guarantee in the case of SBA Express and 7A loans, and by lower loan-to-value ratios under the 504 program. The Bank is designated as a preferred lender by the SBA, allowing it to process these loans more quickly. Under the SBA’s Preferred Lending Program, the SBA delegates a substantial degree of lending authority to participating lenders, such as the Bank. The Bank also participates in other government sponsored loan programs offered by various government agencies, such as through the California Coastal Rural Development Corporation, Central Coast Development Companies and others.

Agricultural Loans.   The Bank provides production loans to help finance the seasonal needs of farming operations, including crop and livestock financing, inventory purchases, and receivable financing. The Bank has very limited vineyard lending exposure (less than $15 million at December 31, 2006). Equipment loans are also financed on everything from field equipment to office automation systems. Emphasis is placed on the borrower’s earnings history, capitalization, secondary sources of repayment, and in some instances, third-party guarantees or highly liquid collateral (such as time deposits and investment securities). Agricultural loan pricing, like commercial loan pricing, is generally at a rate tied to the prime rate (as quoted in the Wall Street Journal) or the Bank’s reference rates. Certain equipment loans may be made at fixed rates for short to medium terms.

Real Estate Construction and Development Loans.   The Bank’s real estate construction loan activity has focused on providing short-term (maturity of two years or less) loans to individuals and developers with whom the Bank has established relationships, for the construction primarily of single family residences in the Bank’s market area.

Residential real estate construction loans are typically secured by first deeds of trust. The economic viability of the project and the borrower’s credit-worthiness are primary considerations in the loan underwriting decision. The Bank utilizes approved independent local appraisers as well as in-house staff, and loan-to-value ratios that generally do not exceed 80% of the appraised value of the property. The Bank monitors projects during the construction phase through regular construction inspections and a disbursement program tied to the percentage of completion of each project.

The Bank also occasionally makes land loans to individuals and developers who intend to construct a single-family residence(s) on the lot, generally within 24 months. In addition, the Bank makes commercial real estate construction loans for construction of office and warehouse properties, generally to high-net-worth clients with adequate liquidity.  The economic viability of the project and the borrower’s credit-worthiness are primary considerations in the loan underwriting decision. Such loans are typically secured by first deeds of trust.

Commercial Real Estate Term Loans and Loans Secured by Farmland.      The Bank provides medium-term commercial real estate loans secured by commercial or industrial buildings or farmland where the properties are either used by the owner for business purposes (owner-user properties) or have income derived from tenants (investment properties). As a general rule, the Bank’s loan policies require the principal balance of the loan to not exceed 75% of the stabilized appraised value of the underlying real estate collateral. The loans, which are typically secured by first deeds of trust only, generally have terms of no more than ten years and are amortized over 25 to 30 years. Some of these loans have rates tied to Wall Street Journal prime rate that adjust whenever the prime rate changes. The remaining loans adjust every three, five or seven years depending upon the index to which the loan is tied.

Residential Real Estate Loans.   The Bank provides a variety of real estate loans secured by residential real estate. These loans are generally secured by first or second trust deeds on individual residential properties. Most of these loans are sold, servicing retained, in the secondary market. Certain shorter term mortgages, especially jumbo adjustable rate mortgages, may be kept in portfolio and not sold in the

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secondary market depending on the Bank’s desire to retain these earning assets. These consist of adjustable rate loans with a short fixed rate period of 3, 5 or 7 years, then adjusted annually using an index of the 1 year treasury constant maturity or 1 year LIBOR. These loans are originated using FNMA/FHMLC underwriting guidelines. Although the loans are held for investment, they are eligible for sale in the secondary market.

Home Equity Credit Lines.   The Bank provides lines of credit secured by a first or second deed of trust on the borrower’s residential real property. The loans have a 15 year draw period followed by a 15 year amortization of the outstanding principal balance. The loans have an interest rate that adjusts monthly with the Wall Street Journal published prime rate. The total combined percentage of Home Equity Credit Line and first mortgage is dependent on several factors such as credit score, income ratios, stability of employment etc, and can go as high as 100%.

Consumer and Other Loans.   The Bank’s consumer and other loan portfolio is divided between installment loans secured by automobiles, other consumer purposes and revolving, unsecured consumer debt such as reserve lines of credit. Installment loans tend to be fixed rate and longer-term (one-to-five-year maturity). The Bank’s portfolio of revolving credit plans, issued as an additional service to its clients, is minimal at just 0.2% of total loans.

The Bank does not participate in “sub-prime” lending, whereby loans are made to borrowers who do not qualify for conventional loan programs. These loans typically have much lower credit requirements, allowing higher loan to value and debt to income ratios, require reduced documentation, accept property types/condition as collateral that would not otherwise qualify, and carry higher interest rates.

Investment Securities

The Bank maintains a portfolio of investment securities to provide income and to serve as a secondary source of liquidity for its operations in conjunction with Federal Funds Sold (see Deposit and Liability Management above). The Bank’s investment policy provides for the purchase of United States Treasury Securities, United States Government Agency Securities, Mortgage Backed Securities, Obligations of State and Political Subdivisions, and Other Securities as permitted by Federal and State regulation. As of December 31, 2006, the aggregate carrying value of the Investment Portfolio was $487.7 million. Of this total, $15.6 million was invested in U.S. Treasury Securities, $129.8 million in U.S. Government Agencies, $6.6 million in Mortgage Backed Securities, $320.7 million in Obligations of State and Political Subdivisions and $14.9 million in Other Securities. The types of securities held are influenced by several factors, which include: rate of return, maturity, and risk. Generally, the Bank endeavors to stagger the maturities of its securities so that it has regular maturities for liquidity purposes. The Bank does not participate in any swap or hedge activity on the investment portfolio (or any other part of the balance sheet) and has no plans to begin such activity.

Acceptable securities may be pledged to secure public deposits from State and Public Agencies. As of December 31, 2006, the Bank had public funds totaling approximately $51.5 million. The Bank has made available $111.9 million of securities to securitize these funds. Excess collateral can be released as needed.

Senior Housing Crime Prevention Foundation Investment

The Bank owns a $30 million holding of the Preferred Stock of Senior Housing Crime Prevention Foundation Investment Corporation (SHCPF-I) which is carried under a separate caption on the Consolidated Statement of Financial Position. That investment is secured by a federal agency security issued by FNMA. The Bank has the right after five years on April 29, 2010 to require SHCPF to redeem all or a part of the shares of the Preferred Stock. Dividends are paid to the Bank on the Preferred Stock at a rate which is 1.875% below the interest earned on the underlying FNMA agency security. This 1.875% differential is used by SHCPF to fund the various programs of the Senior Housing Crime Prevention

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Foundation at 53 nursing home facilities in the Bank’s tri-county service area. These include, among other things, the senior crime stoppers program which is reducing crimes against the elderly living in those facilities. The benefits to the Bank of this program include full Community Reinvestment Act (CRA) credit for our $30 million investment, positive public relations, and significant marketing opportunities with the operators of the facilities, their owners, Board of Directors, employees, family members and residents.

Economic Climate

The economy in the Bank’s trade area is based upon agriculture, oil, tourism, light industry, government services, aerospace industries and retail trade. Services supporting those involved in these industries have also developed in the areas of medical, financial and educational services. Population in the Tri-county area, according to the California Department of Finance, is estimated at July 2006 to be 1,507,178. Ventura County represents about 54.5% of this total with Santa Barbara and San Luis Obispo Counties accounting for 28.0% and 17.5%, respectively. Certain economic activities are unique to the area such as the space launching facilities at Vandenberg Air Force Base and the production of seeds for various flowers grown worldwide. While major oil companies have elected to do business elsewhere (due to very stringent county business regulations), smaller production companies have moved in to continue the oil industry in the area. The moderate climate allows a year round growing season for numerous vegetables and fruits. Vineyards and cattle ranches make large contributions to the local economy. There are large numbers of retail businesses and light manufacturers with only limited numbers of high tech firms throughout the service area. Access to numerous recreational activities, including both mountains and beaches, provide a fairly stable tourist industry from larger metropolitan areas such as the Los Angeles/Orange County basin and the San Francisco Bay area. Real estate values throughout the Tri-counties have steadily increased in recent years. Management does foresee the risk of a slowdown in real estate in 2007, which could potentially create some modest downward pressure on prices as a correction to the dramatic increases seen over the past several years. With the diversity of the various types of industries in the Bank’s service area, the Central Coast, while not immune from economic fluctuations, has historically tended to enjoy a more stable level of economic activity than many other parts of California.

Competition

The banking business in California generally, and in the Bank’s primary service areas specifically, is highly competitive with respect to both loans and deposits and is dominated by a relatively small number of major banks with many offices and operations over a wide geographic area. Among the advantages such major banks have over the Bank are their ability to finance wide-ranging advertising campaigns and to allocate their investment assets to regions of higher yield and demand. Such banks offer certain services such as international banking which is not offered directly by the Bank, but which can be offered indirectly by the Bank through correspondent institutions. In addition, by virtue of their greater total capitalization, such banks have substantially higher lending limits than the Bank. (Legal lending limits to an individual customer are based upon a percentage of a bank’s total capital accounts.)  The Bank’s secured and unsecured lending limits at December 31, 2006, were approximately $57.9 million and $34.7 million, respectively. These levels compare to $56.1 million and $33.7 million, respectively, at December 31, 2005 (see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—External Factors Impacting the Bank - Competitive Factors”).

Other entities, both governmental and private industry, seeking to raise capital through the issuance and sale of debt or equity securities, also provide competition for the Bank in the acquisition of deposits. Banks also compete with money market funds and other providers of money market instruments.

Commercial banks compete with savings and loan associations, credit unions, other financial institutions, securities brokerage firms and other entities for funds. For instance, yields on corporate and

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government debt securities and other commercial paper affect the ability of commercial banks to attract and hold deposits. Commercial banks also compete for loans with savings and loan associations, credit unions, consumer finance companies, mortgage companies, insurance companies and other lending institutions.

The financial services industry is undergoing rapid technological changes involving frequent introductions of new technology-driven products and services that have further increased competition. There can also be no assurance that these technological improvements, if made, will increase the Bank’s operational efficiency or that the Bank will be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers.

The trend toward consolidation of banking assets exhibited over the past few years in California continued in 2006 but other new institutions are coming on line to replace them. Statewide in 2006, there were 12 banks which announced merger into another institution including the pending merger between the Company and Rabobank, discussed earlier. According to the California State Department of Financial Institutions 13 applications for new banks were approved in 2006 in California and an additional one was approved in San Luis Obispo County in early 2007.

Employees

At December 31, 2006, the Bank had a total of 886 employees, a number of which are part-time. On a full-time equivalent basis, employees represent 834 positions. The Bank believes that its employee relations are positive.

Effect of Governmental Policies and Legislation

Banking is a business that is largely dependent on rate differentials. In general, the difference between the interest rate paid by the Bank on its deposits and its other borrowings and the interest rate received by the Bank on loans extended to its customers and securities held in the Bank’s portfolio comprise the major portion of the Bank’s earnings. These rates are highly sensitive to many factors that are beyond the control of the Bank. Accordingly, the earnings and growth of the Bank are subject to the influence of local, domestic and foreign economic conditions, including recession, unemployment and inflation.

The commercial banking business is not only affected by general economic conditions but is also influenced by the monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Federal Reserve Board. The Federal Reserve Board implements national monetary policies (with objectives such as curbing inflation and combating recession) by its open-market operations in United States Government securities which effect short term rates such as the Fed Funds rate, by adjusting the required level of reserves for financial institutions subject to its reserve requirements and by varying the discount rates applicable to borrowings by depository institutions. The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and impact on the Bank of any future changes in monetary policies cannot be predicted.

From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial intermediaries. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial intermediaries are frequently made in Congress, the California legislature and before various bank regulatory and other professional agencies.

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Supervision and Regulation

The Bank is extensively regulated under both federal and state law. Set forth below, is a summary description of certain laws which relate to the regulation of the Company and the Bank. The description does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations.

Mid-State Bancshares

The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the “Bank Holding Company Act”), and is registered as such with, and subject to the supervision of, the Federal Reserve Board. It  is required to file with the Federal Reserve Board quarterly and annual reports and such additional information as the Federal Reserve Board may require pursuant to the Bank Holding Company Act. The Federal Reserve Board may conduct examinations of bank holding companies and their subsidiaries.

The Company is required to obtain the approval of the Federal Reserve Board before it may acquire all or substantially all of the assets of any bank, or ownership or control of the voting shares of any bank if, after giving effect to such acquisition of shares, the Company would own or control more than 5% of any class of the outstanding voting shares of such bank. Prior approval of the Federal Reserve Board is also required for the merger or consolidation of the Company and another bank holding company.

The Company is prohibited by the Bank Holding Company Act, except in certain statutorily prescribed instances, from acquiring direct or indirect ownership or control of more than 5% of the outstanding voting shares of any company that is not a bank or bank holding company and from engaging, directly or indirectly, in activities other than those of banking, managing or controlling banks or furnishing services to its subsidiaries. However, the Company may, subject to the prior approval of the Federal Reserve Board, engage in any, or acquire shares of companies engaged in, activities that are deemed by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.

The Federal Reserve Board may require that the Company terminate an activity or terminate control of or liquidate or divest subsidiaries or affiliates when the Federal Reserve Board determines that the activity or the control or the subsidiary or affiliates constitutes a significant risk to the financial safety, soundness or stability of any of its banking subsidiaries. The Federal Reserve Board also has the authority to regulate provisions of certain bank holding company debt, including authority to impose interest ceilings and reserve requirements on such debt. Under certain circumstances, the Company must file written notice and obtain approval from the Federal Reserve Board prior to purchasing or redeeming its equity securities.

Under the Federal Reserve Board’s regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe and unsound manner. In addition, it is the Federal Reserve Board’s policy that in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company’s failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve Board to be an unsafe and unsound banking practice or a violation of the Federal Reserve Board’s regulations or both.

The Company and the Bank are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services. For example,

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with certain exceptions, neither the Company nor the Bank may condition an extension of credit to a customer on either (1) a requirement that the customer obtain additional services provided by the Company and the Bank or (2) an agreement by the customer to refrain from obtaining other services from a competitor.

The Company’s common stock is registered with the Securities and Exchange Commission (the “SEC”) under the Securities Exchange Act of 1934, as amended. As such, we are subject to the information, proxy solicitation, insider trading, corporate governance, and other requirements and restrictions of that Act.

The Bank

The Bank is chartered under the laws of the State of California and its deposits are insured by the FDIC to the extent provided by law. The Bank is subject to the supervision of, and is regularly examined by, the California Department of Financial Institutions (DFI) and the FDIC. Such supervision and regulation include comprehensive reviews of all major aspects of the Bank’s business and condition.

Various requirements and restrictions under the laws of the United States and the State of California affect the operations of the Bank. Federal and California statutes relate to many aspects of the Bank’s operations, including reserves against deposits, interest rates payable on deposits, loans, investments, mergers and acquisitions, borrowings, dividends and locations of branch offices. Further, the Bank is required to maintain certain levels of capital.

If, as a result of an examination of a bank, the FDIC or the DFI should determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, or other aspects of the Bank’s operations are unsatisfactory or that the Bank or its management is violating or has violated any law or regulation, various remedies are available to these regulatory agencies. Such remedies include the power to enjoin “unsafe or unsound” practices, to require affirmative action to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in capital, to restrict the growth of the Bank, to assess civil monetary penalties, to remove officers and directors, and ultimately to terminate the Bank’s deposit insurance, which for a California chartered bank would result in a revocation of the bank’s charter.

Capital Standards

The Federal Reserve Board and the FDIC have adopted risk-based minimum capital guidelines intended to provide a measure of capital that reflects the degree of risk associated with a banking organization’s operations for both transactions reported on the balance sheet as assets and transactions, such as letters of credit and recourse arrangements, which are recorded as off balance sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U.S. Treasury securities, to 100% for assets with relatively high credit risk, such as certain business loans.

A banking organization’s risk-based capital ratios are obtained by dividing its qualifying capital by its total risk ­adjusted assets. The regulators measure risk-adjusted assets, which includes off balance sheet items, against both total qualifying capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and Tier 1 capital. Tier 1 capital consists primarily of common stock, retained earnings, non-cumulative perpetual preferred stock (cumulative perpetual preferred stock for bank holding companies) and minority interests in certain subsidiaries, less most intangible assets. Tier 2 capital may consist of a limited amount of the allowance for loan and lease losses, cumulative preferred stock,  long term preferred stock, eligible term subordinated debt and certain other instruments with some characteristics of equity. The inclusion of elements of Tier 2 capital is subject to certain other requirements and limitations of the federal banking

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agencies. The federal banking agencies require a minimum ratio of qualifying total capital to risk-adjusted assets of 8% and a minimum ratio of Tier 1 capital to risk-adjusted assets of 4%. Mid-State Bank & Trust’s ratios are 12.2% and 11.5%, respectively, as of December 31, 2006. On a consolidated basis, Mid-State Bancshares’ ratios are 12.8% and 12.1%, respectively, at the same date.

In addition to the risk-based guidelines, federal banking regulators require banking organizations to maintain a minimum amount of Tier 1 capital to total assets, referred to as the leverage ratio. For a banking organization rated in the highest of the five categories used by regulators to rate banking organizations, the minimum leverage ratio of Tier 1 capital to total assets is 3%.  For all banking organizations not rated in the highest category, the minimum leverage ratio must be at least 100 to 200 basis points above the 3% minimum, or 4% to 5%. Mid-State Bank & Trust’s ratio is 9.4% as of December 31, 2006. On a consolidated basis, Mid-State Bancshares’ ratio is 9.9% at the same date. In addition to these uniform risk-based capital guidelines and leverage ratios that apply across the industry, the regulators have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios.

Future changes in regulations or practices could further reduce the amount of capital recognized for purposes of capital adequacy. Such a change could affect the ability of the Bank to grow and could restrict the amount of profits, if any, available for the payment of dividends to the Company.

On January 1, 1998 legislation became effective which, among other things, gave the DFI power to take possession of the business and properties of a bank in the event that the tangible shareholders’ equity of the bank is less than the greater of (i) 3% of the bank’s total assets or (ii) $1.0 million.

For additional information concerning the capital ratios of the Company and the Bank, see, “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Under applicable regulatory guidelines, the Bank was considered “Well Capitalized” as of December 31, 2006.

Prompt Corrective Action and Other Enforcement Mechanisms

Federal banking agencies possess broad powers to take corrective and other supervisory action to resolve the problems of insured depository institutions, including but not limited to those institutions that fall below one or more prescribed minimum capital ratios described above. An institution that, based upon its capital levels, is classified as well capitalized, adequately capitalized, or undercapitalized may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, determines that an unsafe or unsound condition or an unsafe or unsound practice warrants such treatment. At each successive lower capital category, an insured depository institution is subject to more restrictions. The federal banking agencies, however, may not treat a significantly undercapitalized institution as critically undercapitalized unless its capital ratio actually warrants such treatment.

In addition to measures taken under the prompt corrective action provisions, commercial banking organizations may be subject to potential enforcement actions by the federal regulators for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation, or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include:

·       the imposition of a conservator or the issuance of a cease-and-desist order that can be judicially enforced;

·       the termination of insurance of deposits (in the case of a depository institution);

·       the imposition of civil money penalties;

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·       the issuance of directives to increase capital;

·       the issuance of formal and informal agreements;

·       the issuance of removal and prohibition orders against institution-affiliated parties; and

·       the enforcement of such actions through injunctions or restraining orders based upon a judicial determination that the agency would be harmed if such equitable relief was not granted.

Additionally, a holding company’s inability to serve as a source of strength to its subsidiary banking organizations could serve as an additional basis for a regulatory action against the holding company.

Banks are also subject to certain Federal Reserve Board restrictions on extensions of credit to executive officers, directors, principal shareholders or any related interests of such persons (i.e., insiders). Extensions of credit (1) must be made on substantially the same terms and pursuant to the same credit underwriting procedures as those for comparable transactions with persons who are neither insiders nor employees, and (2) must not involve more than the normal risk of repayment or present other unfavorable features. Banks are also subject to certain lending limits and restrictions on overdrafts to insiders. A violation of these restrictions may result in regulatory sanctions on the bank or its insiders.

Premiums for Deposit Insurance

The Bank’s deposits are currently insured to a maximum of $100,000 per depositor through the Deposit Insurance Fund (“DIF”) administered by the FDIC. The Bank is required to pay deposit insurance premiums, which are assessed semiannually and paid quarterly. In November, 2006 the FDIC adopted a new risk-based insurance assessment system effective January 1, 2007 designed to tie what banks pay for deposit insurance more closely to the risks they pose. The FDIC also adopted a new base schedule of rates that the FDIC can adjust up or down, depending on the needs of the DIF, and set initial premiums for 2007 that range from 5 cents per $100 of domestic deposits in the lowest risk category to 43 cents per $100 of domestic deposits for banks in the highest risk category. The new assessment system is expected to result in increased annual assessments on the deposits of our Bank of 5 to 7 cents per $100 of domestic deposits. An FDIC credit available of $1.8 million for prior contributions is expected to offset the assessments for 2007. Significant increases in the insurance assessments of our Bank will increase our costs once the credit is fully utilized.

The FDIC is also empowered to make special assessments on insured depository institutions in amounts determined by the FDIC to be necessary to give it adequate assessment income to repay amounts borrowed from the U.S. Treasury and other sources or for any other purpose the FDIC deems necessary.

The FDIC is authorized to terminate a depository institution’s deposit insurance upon a finding by the FDIC that the institution’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the institution’s regulatory agency.

Sarbanes-Oxley Act of 2002

On July 30, 2002, the Sarbanes-Oxley Act of 2002 (“SOX”), was signed into law to address corporate and accounting fraud. SOX establishes a new accounting oversight board that will enforce auditing standards and restricts the scope of services that accounting firms may provide to their public company audit clients. Among other things, SOX also (i) requires chief executive officers and chief financial officers to certify to the accuracy of periodic reports filed with the SEC; (ii) imposes new disclosure requirements regarding internal controls, off-balance-sheet transactions, and pro forma (non-GAAP) disclosures; (iii) accelerates the time frame for reporting of insider transactions and periodic disclosures by public companies; and (iv) requires companies to disclose whether or not they have adopted a code of ethics for

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senior financial officers and whether the audit committee includes at least one “audit committee financial expert.”

Under SOX, the SEC is required to regularly and systematically review corporate filings, based on certain enumerated factors. To deter wrongdoing, SOX: (i) subjects bonuses issued to top executives to disgorgement if a restatement of a company’s financial statements was due to corporate misconduct; (ii) prohibits an officer or director from misleading or coercing an auditor; (iii) prohibits insider trades during pension fund “blackout periods”; (iv) imposes new criminal penalties for fraud and other wrongful acts; and (v) extends the period during which certain securities fraud lawsuits can be brought against a company or its officers.

As a public reporting company, the Company is subject to the requirements of SOX and related rules and regulations issued by the SEC and NASDAQ. The Company has incurred additional expense as a result of the requirements of the Act, but does not expect that such compliance will have a material impact on its business overall.

Financial Services Modernization Legislation

On November 12, 1999, the Gramm-Leach-Bliley Act of 1999 (the “Financial Services Modernization Act”) was signed into law. The Financial Services Modernization Act is intended to modernize the banking industry by removing barriers to affiliation among banks, insurance companies, the securities industry and other financial service providers. It provides financial organizations with the flexibility of structuring such affiliations through a holding company structure or through a financial subsidiary of a bank, subject to certain limitations. The Financial Services Modernization Act establishes a new type of bank holding company, known as a financial holding company, which may engage in an expanded list of activities that are “financial in nature,” which include securities and insurance brokerage, securities underwriting, insurance underwriting and merchant banking. The Company has not chosen to seek “financial holding company” status.

The Financial Services Modernization Act also sets forth a system of functional regulation that makes the Federal Reserve Board the “umbrella supervisor” for holding companies, while providing for the supervision of the holding company’s subsidiaries by other federal and state agencies. In addition, the Bank is subject to other provisions of the Financial Services Modernization Act, including those relating to CRA, privacy and safe-guarding confidential customer information, regardless of whether the Company elects to become a financial holding company or to conduct activities through a financial subsidiary of the Bank. The Company does not, however, currently intend to file notice with the Federal Reserve Board to become a financial holding company or to engage in expanded financial activities through a financial subsidiary of the Bank.

The Company and the Bank do not believe that the Financial Services Modernization Act will have a material adverse effect on their operations in the near-term. However, to the extent that it permits banks, securities firms, and insurance companies to affiliate, the financial services industry may experience further consolidation. The Financial Services Modernization Act is intended to grant to community banks certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis. Nevertheless, this act may have the result of increasing the amount of competition that the Company and the Bank face from larger institutions and other types of companies offering financial products, many of which may have substantially more financial resources than the Company and the Bank.

USA Patriot Act of 2001

On October 26, 2001, President Bush signed the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism, or the Patriot Act, of 2001. Among other things, the Patriot Act (i) prohibits banks from providing correspondent accounts directly to foreign

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shell banks; (ii) imposes due diligence requirements on banks opening or holding accounts for foreign financial institutions or wealthy foreign individuals; (iii) requires financial institutions to establish an anti-money-laundering compliance program; and (iv) eliminates civil liability for persons who file suspicious activity reports. The Patriot Act also increases governmental powers to investigate terrorism, including expanded government access to account records. The Department of the Treasury is empowered to administer and make rules to implement the Patriot Act. On March 9, 2006, the President signed the USA Patriot Improvement and Reauthorization Act, which extended and modified the original Act. While the Company and the Bank believes the Patriot Act, as amended and reauthorized, affects their recordkeeping and reporting expenses, they do not believe that it has a material adverse effect on their business and operations.

Bank Secrecy Act

In 1970, Congress passed the Currency and Foreign Transactions Reporting Act, otherwise known as the Bank Secrecy Act (the “BSA”), which established requirements for recordkeeping and reporting by banks and other financial institutions. The BSA was designed to help identify the source, volume and movement of currency and other monetary instruments into and out of the United States in order to help detect and prevent money laundering connected with drug trafficking, terrorism and other criminal activities. The primary tool used to implement BSA requirements is the filing of Suspicious Activity Reports. Today, the BSA requires that all banking institutions develop and provide for the continued administration of a program reasonably designed to assure and monitor compliance with certain recordkeeping and reporting requirements regarding both domestic and international currency transactions. These programs must, at a minimum, provide for a system of internal controls to assure ongoing compliance, provide for independent testing of such systems and compliance, designate individuals responsible for such compliance and provide appropriate personnel training.

Commercial Real Estate Lending

Federal banking regulators recently issued final guidance regarding commercial real estate lending to address a concern that rising commercial real estate lending concentrations may expose institutions to unanticipated earnings and capital volatility in the event of adverse changes in the general commercial real estate market. This guidance suggests that institutions that are potentially exposed to significant commercial real estate concentration risk will be subject to increased regulatory scrutiny. Institutions that have experienced rapid growth in commercial real estate lending, have notable exposure to specific types of commercial real estate lending, or are approaching or exceed certain supervisory criteria that measure an institution’s commercial real estate portfolio against its capital levels, may be subject to such increased regulatory scrutiny. Our commercial real estate portfolio may be viewed as falling within one or more of the foregoing categories, and accordingly we may become subject to increased regulatory scrutiny because of our commercial real estate portfolio. If it is determined by our regulator that we have an undue concentration in commercial real estate lending, we may be required to maintain increased levels of capital and/or be required to reduce our concentration in commercial real estate loans.

Transactions between Affiliates

Transactions between a bank and its “affiliates” are quantitatively and qualitatively restricted under the Federal Reserve Act. The Federal Reserve Board issued Regulation W on October 31, 2002, which comprehensively implements Sections 23A and 23B of the Federal Reserve Act. Sections 23A and 23B and Regulation W restrict loans by a depository institution to its affiliates, asset purchases by a depository institution from its affiliates, and other transactions between a depository institution and its affiliates. Regulation W unifies in one public document the Federal Reserve Board’s interpretations of Section 23A and 23B. Regulation W had an effective date of April 1, 2003.

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Community Reinvestment Act

The Bank is subject to certain fair lending requirements and reporting obligations involving home mortgage lending operations and CRA activities. The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of their local communities, including low and moderate income neighborhoods. In addition to substantial penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and CRA into account when regulating and supervising other activities.

When a bank holding company applies for approval to acquire a bank or other bank holding company, the Federal Reserve will review the assessment of each subsidiary bank of the applicant bank holding company, and such records may be the basis for denying the application. A bank’s compliance with its CRA obligations is based on a performance-based evaluation system which bases CRA ratings on an institution’s lending service and investment performance, resulting in a rating by the appropriate bank regulatory agency of “outstanding”, “satisfactory”, “needs to improve” or “substantial noncompliance.” At its last examination by the FDIC, the Bank received a CRA rating of “Satisfactory.”

Safety and Soundness Standards

The Federal Deposit Insurance Corporation Improvement Act (“FDICIA”) imposes certain specific restrictions on transactions and requires federal banking regulators to adopt overall safety and soundness standards for depository institutions related to internal control, loan underwriting and documentation and asset growth. Among other things, FDICIA limits the interest rates paid on deposits by undercapitalized institutions, restricts the use of brokered deposits, limits the aggregate extensions of credit by a depository institution to an executive officer, director, principal shareholder or related interest, and reduces deposit insurance coverage for deposits offered by undercapitalized institutions for deposits by certain employee benefits accounts. The federal banking agencies may require an institution to submit to an acceptable compliance plan as well as have the flexibility to pursue other more appropriate or effective courses of action given the specific circumstances and severity of an institution’s noncompliance with one or more standards.

Privacy

Federal banking rules limit the ability of banks and other financial institutions to disclose non-public information about consumers to non-affiliated third parties. Pursuant to these rules, financial institutions must provide:

·       initial notices to customers about their privacy policies, describing the conditions under which they may disclose non-public information to non-affiliated third parties and affiliates;

·       annual notices of their privacy policies to current customers; and

·       a reasonable method for customers to “opt out” of disclosures to non-affiliated third parties.

These privacy provisions affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors. We have implemented our privacy policies in accordance with the law.

In recent years, a number of states have implemented their own versions of privacy laws. For example, in 2003, California adopted standards that are more restrictive than federal law, allowing bank customers the opportunity to bar financial companies from sharing information with their affiliates.

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Federal Home Loan Bank System

The Bank is a member of the Federal Home Loan Bank (“FHLB”) of San Francisco. Among other benefits, each FHLB serves as a reserve or central bank for its members within its assigned region. Each FHLB is financed primarily from the sale of consolidated obligations of the FHLB system. Each FHLB makes available loans or advances to its members in compliance with the policies and procedures established by the Board of Directors of the individual FHLB.

A new capital plan of the FHLB of San Francisco was approved by the Federal Housing Finance Board and was implemented on April 1, 2004. The new capital plan incorporates a single class of stock with a par value of $100 per share, and may be issued, exchanged, redeemed, and repurchased only at par value. Each member must own stock in an amount equal to the greater of:

·       a membership stock requirement with an initial cap of $25 million (1.00% of “membership asset value” as defined), or

·       an activity based stock requirement (based on percentage of outstanding advances).

The new capital stock is redeemable with five years’ written notice, subject to certain conditions. Total holdings of  FHLB stock by the Company amounted to $8.6 million at December 31, 2006.

Predatory Lending

The term “predatory lending,” much like the terms “safety and soundness” and “unfair and deceptive practices,” is far-reaching and covers a potentially broad range of behavior. As such, it does not lend itself to a concise or a comprehensive definition. But typically predatory lending involves at least one, and perhaps all three, of the following elements:

·       making unaffordable loans based on the assets of the borrower rather than on the borrower’s ability to repay an obligation, or asset-based lending;

·       inducing a borrower to refinance a loan repeatedly in order to charge high points and fees each time the loan is refinanced, or loan flipping; and

·       engaging in fraud or deception to conceal the true nature of the loan obligation from an unsuspecting or unsophisticated borrower.

Federal Reserve Board regulations aimed at curbing such lending significantly widened the pool of high-cost home-secured loans covered by the Home Ownership and Equity Protection Act of 1994, a federal law that requires extra disclosures and consumer protections to borrowers. The following scenarios trigger coverage under the Home Ownership and Equity Protection Act of 1994:

·       interest rates for first lien mortgage loans in excess of 8 percentage points above comparable Treasury securities,

·       subordinate-lien loans of 10 percentage points above Treasury securities, and

·       fees such as optional insurance and similar debt protection costs paid in connection with the credit transaction, when combined with points and fees if deemed excessive.

In addition, the regulation bars loan flipping by the same lender or loan servicer within a year. Lenders also will be presumed to have violated the law—which says loans shouldn’t be made to people unable to repay them—unless they document that the borrower has the ability to repay. Lenders that violate the rules face cancellation of loans and penalties equal to the finance charges paid. The Company does not expect these rules and potential state action in this area to have a material impact on our financial condition or results of operation.

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Accounting Changes

From time to time the Financial Accounting Standards Board (“FASB”) issues pronouncements which govern the accounting treatment for the Company’s financial statements. For a description of the recent pronouncements applicable to the Company see the Notes to the Financial Statements included in Item 8 of this Report.

Off Balance Sheet and Other Related Party Transactions

As noted in Footnote 12 to the financial statements, the Company is contingently liable for letter of credit accommodations made to its customers in the ordinary course of business totaling $39.8 million at December 31, 2006 compared to $40.9 million one year earlier. Additionally, the Company has undisbursed loan commitments, also made in the ordinary course of business, totaling $658.0 million, which compares to $657.7 million outstanding one year earlier.

There are no Special Purpose Entity (“SPE”) trusts, corporations, or other legal entities established by the Company which reside off-balance sheet. There are no other off-balance sheet items other than the aforementioned items related to letter of credit accommodations and undisbursed loan commitments.

As noted in Footnote 5 to the financial statements, the Company does make loans to related parties (directors and officers) in the ordinary course of business at prevailing rates and terms. These loans totaled $20.8 million at the end of 2006, compared to the $14.1 million outstanding one year earlier. While loans to insiders and related parties are generally prohibited under SOX, as a bank, the Bank is exempt from this rule.

Where You Can Find More Information.

Under the Securities Exchange Act of 1934 Sections 13 and 15(d), periodic and current reports must be filed with the SEC. The Company electronically files the following reports with the SEC: Form 10-K (Annual Report), Form 10-Q (Quarterly Report), Form 11-K (Annual Report for Employees’ Stock Purchase and Savings Plans), Form 8-K (Current Report), Forms 3, 4, and 5 (Changes in Beneficial Ownership) and Form DEF 14A (Proxy Statement). The Company may file additional forms. The SEC maintains an Internet site, www.sec.gov, in which all forms filed electronically may be accessed. Additionally, all forms filed with the SEC and additional shareholder information, such as certain corporate governance documents including the Company’s and Bank’s audit committee charter, compensation committee charter, nominating/corporate governance committee charter, corporate governance guidelines, and corporate code of conduct (which includes the code of ethics required by the SEC and applicable to senior executive officers of the Company and Bank), are available free of charge on the Company’s website: www.midstatebank.com. The Company posts these reports to its website as soon as reasonably practicable after filing them with the SEC. None of the information on or hyperlinked from the Company’s website is incorporated into this Annual Report on Form 10-K.

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ITEM 1.A.   RISK FACTORS

An investment in our common stock is subject to risks inherent to our business. The material risks and uncertainties that management believes may affect our business are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing our business. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair our business operations. This report is qualified in its entirety by these risk factors.

If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of our common stock could decline significantly, and you could lose all or part of your investment.

This item 1A has been updated from prior years’ filings to reflect the fact that the Company has entered into an agreement and plan of merger with Rabobank with the acquisition expected to be consummated in the second quarter of 2007.

Risks Associated with our Business.

We are highly dependent on real estate and a downturn in the real estate market could hurt our business.

A significant portion of our loan portfolio is dependent on real estate. At December 31, 2006, real estate served as the principal source of collateral with respect to approximately 83% of our loan portfolio. A decline in current economic conditions or rising interest rates could have an adverse effect on the demand for new loans, the ability of borrowers to repay outstanding loans, the value of real estate and other collateral securing loans and the value of real estate owned by us, as well as our financial condition and results of operations in general and the market value of our common stock. As more fully discussed in Item 7 of this Report under “External Factors Impacting the Bank, Economic Conditions,” real estate prices have continued to rise in the Bank’s service area but increases in sales activity have slowed in 2006 compared to 2005. Slower sales and higher inventories of homes for sale could, potentially cause some downward pressure on prices as well as impact real estate developers ability to repay their development loans according to their original terms

Acts of nature, including earthquakes, floods and fires, which may cause uninsured damage and other loss of value to real estate that secures these loans, may also negatively impact our financial condition.

We also have a concentration in commercial real estate loans.

We also have a high concentration in commercial real estate or CRE loans. CRE loans generally involve a higher degree of credit risk than residential mortgage lending due, among other things, to the large amounts loaned to individual borrowers. Losses incurred on loans to a small number of borrowers could have a material adverse impact on our income and financial condition. Unlike residential mortgage loans, commercial real estate loans generally depend on the cash flow from the property to service the debt. Cash flow may be significantly affected by general economic conditions.

In addition, federal banking regulators recently issued final guidance regarding commercial real estate lending. This guidance suggests that institutions that are potentially exposed to significant commercial real estate concentration risk will be subject to increased regulatory scrutiny. Institutions that have experienced rapid growth in commercial real estate lending, have notable exposure to specific types of commercial real estate lending, or are approaching or exceed certain supervisory criteria that measure an institution’s commercial real estate portfolio against its capital levels, may be subject to such increased regulatory scrutiny. Our commercial real estate portfolio may be viewed as falling within one or more of the foregoing categories, and accordingly we may become subject to increased regulatory scrutiny because of our commercial real estate portfolio. If it is determined by our regulator that we have an undue concentration

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in commercial real estate lending, we may be required to maintain increased levels of capital and/or be required to reduce our concentration in commercial real estate loans.

Our real estate lending also exposes us to the risk of environmental liabilities.

In the course of our business, we may foreclose and take title to real estate, and could be subject to environmental liabilities with respect to these properties. We may be held liable to a governmental entity or to third persons for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, as the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. If we ever become subject to significant environmental liabilities, our business, financial condition, liquidity and results of operations could be materially and adversely affected.

Insufficient loan demand could have an adverse impact on our business.

We are significantly affected by the level of loan demand available in our markets. Strong local pressure from competitors to make loans to existing and potential customers also affects our ability to make sufficient loans. The inability to make sufficient loans directly affects the interest income we earn. Lower loan demand will generally result in lower interest income since funds will be placed in lower yielding investments.

Our business is subject to interest rate risk and changes in interest rates may adversely affect our performance and financial condition.

Our earnings are impacted by changing interest rates. Changes in interest rates impact the demand for new loans, the credit profile of our borrowers, the rates received on loans and securities and rates paid on deposits and borrowings. The difference between the rates received on loans and securities and the rates paid on deposits and borrowings is known as interest rate spread. Increasing levels of competition in the banking and financial services business, which we are currently experiencing in our market, may decrease our net interest spread by forcing us to offer lower lending interest rates and pay higher deposit interest rates.

A sustained decrease in market interest rates could adversely affect our earnings. When interest rates decline, borrowers tend to refinance higher-rate, fixed-rate loans at lower rates, prepaying their existing loans. Under those circumstances, we would not be able to reinvest those prepayments in assets earning interest rates as high as the rates on the prepaid loans. In addition, our commercial real estate and commercial loans, which carry interest rates that, in general, adjust in accordance with changes in the prime rate, will adjust to lower rates. We are also significantly affected by the level of loan demand available in our market. Given our current volume and mix of interest-bearing liabilities and interest-earning assets, our interest rate spread can be expected to increase when market interest rates are rising, and to decline when market interest rates are declining. The Federal Reserve Board’s decrease in rates during 2001, 2002 and 2003 substantially impacted our interest rate spread, as the spread for 2004 declined to 5.38% (taxable equivalent) from 5.54% (taxable equivalent) in 2003 and from 5.74% (taxable equivalent) in 2002. Increases in short term rates by the Federal Reserve Board in the latter half of 2004 through 2006 are having the effect of beginning to reverse this trend with our interest spread rising to 6.00% (taxable equivalent) in 2006. Although we believe our current level of interest rate sensitivity is reasonable, significant fluctuations in interest rates may have an adverse impact on our business, financial condition and results of operations.

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Economic conditions on the California Central Coast could adversely affect our operations and/or cause us to sustain losses.

Our retail and commercial banking operations are concentrated primarily in San Luis Obispo, Ventura and Santa Barbara Counties. As a result of this geographic concentration, our results of operations depend largely upon economic conditions in this area. A significant source of risk arises from the possibility that losses will be sustained if a significant number of our borrowers, guarantors and related parties fail to perform in accordance with the terms of their loans. This risk increases when the economy is weak. We have adopted underwriting and credit monitoring procedures and credit policies, including the establishment and review of the allowance for credit losses, that management believes are appropriate to minimize this risk by assessing the likelihood of nonperformance, tracking loan performance and diversifying our credit portfolio. These policies and procedures, however, may not prevent unexpected losses that could materially adversely affect our results of operations in general and the market value of our stock.

We face strong competition from financial service companies and other companies that offer banking services that could hurt our business.

The financial services business in our market areas is highly competitive. It is becoming increasingly competitive due to changes in regulation, technological advances, and the accelerating pace of consolidation among financial services providers. We face competition both in attracting quality assets and deposits and in making loans. We compete for loans principally through the interest rates and loan fees we charge and the efficiency and quality of services we provide. Increasing levels of competition in the banking and financial services business may reduce our market share, decrease loan demand, cause the prices we charge for our services to fall, or decrease our net interest margin by forcing us to offer lower lending interest rates and pay higher deposit interest rates. Therefore, our results may differ in future periods depending upon the nature or level of competition.

Technology and other changes are allowing parties to complete financial transactions that historically have involved banks through alternative methods. For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts or mutual funds. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.

We may not be able to attract and retain skilled people.

Our success depends, in large part, on our ability to attract and retain key people. Competition for the best people in most of our activities can be intense and we may not be able to hire people or to retain them. The unexpected loss of services of one or more of our key personnel could have a material adverse impact on our business because of their skills, knowledge of our market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.

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Our internal operations are subject to a number of risks.

We are subject to certain operations risks, including, but not limited to, data processing system failures and errors, customer or employee fraud and catastrophic failures resulting from terrorist acts or natural disasters. We maintain a system of internal controls to mitigate against such occurrences and maintain insurance coverage for such risks that are insurable, but should such an event occur that is not prevented or detected by our internal controls, uninsured or in excess of applicable insurance limits, it could have a significant adverse impact on our business, financial condition or results of operations.

Information Systems.   We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.

Technological Advances.   The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on our business and, in turn, our financial condition and results of operations.

Severe Weather, Natural Disasters, Acts Of War Or Terrorism and Other External Events.   Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on our ability to conduct business. Such events could affect the stability of our deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause us to incur additional expenses. For example, the Central Coast of California is subject to earthquakes and fires. Operations in our market could be disrupted by both the evacuation of large portions of the population as well as damage and or lack of access to our banking and operation facilities. While we have not experienced such an occurrence to date, other severe weather or natural disasters, acts of war or terrorism or other adverse external events may occur in the future. Although management has established disaster recovery policies and procedures, the occurrence of any such event could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.

We depend on cash dividends from our subsidiary bank to meet our cash obligations.

As a holding company, dividends from our subsidiary bank provide a substantial portion of our cash flow used to service our obligations, including cash dividends. See “Item 5—Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.” Various statutory provisions restrict the amount of dividends our subsidiary bank can pay to us without regulatory approval.

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Risks Associated with our Industry.

We are subject to government regulation that could limit or restrict our activities, which in turn could adversely impact our operations.

The financial services industry is regulated extensively. Federal and State regulation is designed primarily to protect the deposit insurance funds and consumers, and not to benefit our shareholders. These regulations can sometimes impose significant limitations on our operations.

New laws and regulations or changes in existing laws and regulations or repeal of existing laws and regulations may adversely impact our business. We have to comply with all governmental regulations such as the Sarbanes Oxley Act of 2002, the Bank Secrecy Act, the Patriot Act, the Community Reinvestment Act, and many others. The cumulative cost of compliance with these regulations could be significant and affect the ability of the Company to earn an adequate return for its shareholders. For example, operating expenses were impacted by the significant cost of compliance with the new Sarbanes-Oxley Section 404 provisions in the years ended December 31, 2006 and 2005.

Further, federal monetary policy, particularly as implemented through the Federal Reserve System, significantly affects economic conditions for us.

New legislative and regulatory proposals may affect our operations and growth.

Proposals to change the laws and regulations governing the operations and taxation of, and federal insurance premiums paid by, banks and other financial institutions and companies that control such institutions are frequently raised in the U.S. Congress, state legislatures and before bank regulatory authorities. The likelihood of any major changes in the future and the impact such changes might have on us or our subsidiaries are impossible to determine. Similarly, proposals to change the accounting treatment applicable to banks and other depository institutions are frequently raised by the SEC, the federal banking agencies, the IRS and other appropriate authorities. The likelihood and impact of any additional future changes in law or regulation and the impact such changes might have on us or our subsidiaries are impossible to determine at this time.

Risks Associated with our Stock.

Our current Common Stock value is heavily influenced by the acquisition price to be paid by Rabobank. If the acquisition is not consummated, the price of the Company’s Common Stock is likely to fall.

The price of our Common Stock rose immediately following the public announcement of the signing of the agreement and plan of merger with Rabobank and has risen slightly since then to nearly the acquisition price of $37.00 per share. The acquisition is subject to several conditions, including but not limited to, shareholder and regulatory approvals, which have not yet been obtained and we cannot provide any assurance as to when, or if, they will be obtained. The shareholders will be asked to approve the acquisition at a special meeting anticipated to be held on or about April 25, 2007. The required regulatory approvals have not yet been received. See the agreement and plan of merger attached to Form 8-K filed with the Securities and Exchange Commission on November 3, 2006 for additional conditions to the consummation of the acquisition. See also Item 3, Legal Proceedings of this Annual Report on Form 10-K for further information regarding a lawsuit which has been filed in connection with the acquisition.

Our Common Stock.

Our common stock is not a bank deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company. As a result, if you acquire our common stock, you may lose some or all of your investment.

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Risks Relating to the Proposed Merger

Consummation of the proposed merger is subject to the satisfaction of various closing conditions, including approval of the merger by a vote of a majority of the outstanding shares of our common stock, approval of certain regulatory authorities and other customary closing conditions described in the agreement and plan of merger. We expect the merger to be closed during the second quarter. However, we cannot guarantee that these closing conditions will be satisfied or that the proposed merger will be successfully completed. In the event that the proposed merger is not completed:

·       management’s and employees’ attention from the Company’s day-to-day business may be diverted;

·       the Company may lose key employees;

·       the Company’s relationships with customers may be disrupted as a result of uncertainties with regard to its business and prospects;

·       certain costs related to the proposed merger, including the fees and/or expenses of our legal, accounting and financial advisors, would have to be paid even if the proposed merger is not completed;

·       under circumstances defined in the agreement and plan of merger, the Company may be required to pay a termination (break-up) fee up to $27.5 million and expenses incurred by the acquirer, up to a maximum of $2 million if the Company were to accept a competing offer;

·       additional shareholder lawsuits may be filed against us in connection with the agreement and plan of merger;

·       the market price of shares of the Company’s common stock should be expected to decline since the current market price of those shares reflects a market assumption that the proposed merger will be completed; and

·       a failed merger may result in negative publicity and/or a negative impression of us in the investment community.

Any such events would likely have a material negative impact on the Company’s results of operations and financial condition and could further adversely affect the Company’s stock price.

The announcement of the proposed merger may have had a negative impact on the Company’s ability to attract and retain key management and maintain and attract new third-party relationships. Any such events could have a material negative impact on the Company’s results of operations and financial condition.

ITEM 1B.     UNRESOLVED STAFF COMMENTS.

The Company does not have any unresolved staff comments received from the staff of the Securities and Exchange Commission (SEC).

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ITEM 2.                PROPERTIES

The Company’s principal office is located at 1026 Grand Avenue, Arroyo Grande, California. As of December 31, 2006, the Bank owned 25 of its branch offices, 4 non-banking support offices and leased 18 other Bank locations (covered by 20 leases). The Company believes its present facilities are in good condition and are adequate for its present needs. The Company does not anticipate difficulty in renewing existing leases as they expire or in finding alternative facilities. See Note 6 to the Consolidated Financial Statements for a further description of the Company’s lease obligations.

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Former Bank Offices Leased by Bank—Which Are Sub-Leased

*                    The Bank’s rental expense for 2006 was $2.5 million. See Note 6 of the Company’s financial statements included in Item 8 of this Report for certain additional information concerning the amount of the Bank’s lease commitment. All offices listed are full service branch offices, except those with asterisks noted above. Asterisks represent non-banking support offices (e.g., Administration, Data Processing, Supplies Warehouse, Credit Services, et. al.)

**             Ground lease on property adjacent to a fully owned facility.

ITEM 3.                LEGAL PROCEEDINGS

The Company is, from time to time, subject to various pending and threatened legal actions which arise out of the normal course of its business. The Company is not a party to any pending legal or administrative proceedings as of December 31, 2006 (other than ordinary routine litigation incidental to the Company’s business) and no such proceedings are known to be contemplated. The Company does not expect the resolution of these items to have a material impact on its financial condition or operating results.

On November 15, 2006, David Fuerstenberg, a purported shareholder of Mid-State, filed a complaint seeking class action status in the Superior Court of the State of California, County of San Luis Obispo against Mid-State and each of its directors entitled Fuerstenberg v Mid-State Bancshares et al (Case No. CV060976). The complaint contains a single cause of action for breach of fiduciary duty alleging that the Mid-State directors breached their fiduciary duties with regard to the proposed merger. The alleged breaches of fiduciary duty are non-specific. Among other things, the complaint seeks class action status, a court order enjoining Mid-State and its directors from proceeding with or consummating the merger and the payment of attorneys’ and experts fees. The Company intends to defend this lawsuit vigorously.

There are no material proceedings adverse to the Company to which any director, officer, affiliate of the Company, 5% shareholder of the Company, or any associate of any such director, officer, affiliate or 5% shareholder of the Company is a party, and none of the above persons has a material interest adverse to the Company.

ITEM 4.                SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the fourth quarter of 2006.

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PART II

ITEM 5.                MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information

The Company’s Common Stock trades on the NASDAQ National Market under the symbol “MDST.” The following table summarizes those trades of the Company’s Common Stock on NASDAQ, setting forth the approximate high and low closing sales prices for each quarterly period ended since January 1, 2005. The closing sales price on December 31, 2006 was $36.39 (reflective of the purchase price per share to be paid in the pending Rabobank transaction) compared to the close one year earlier of $26.75.

There are approximately 5,000 holders of Mid-State Bancshares common stock as of December 31, 2006.

Dividends

The following table sets forth the per share amount and month of payment for all cash dividends paid since January 1, 2005 by the Company to its shareholders.

The Company is a legal entity separate and distinct from the Bank. The Company’s shareholders are entitled to receive dividends when declared by its Board of Directors, out of funds legally available therefore, subject to the restrictions set forth in the California General Corporation Law (the Corporation Law). The Corporation Law provides that a corporation may make a distribution to its shareholders if the corporation’s retained earnings equal at least the amount of the proposed distribution. The Corporation Law also provides that, in the event that sufficient retained earnings are not available for the proposed

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distribution, a corporation may, nevertheless, make a distribution to its shareholders if it meets two conditions, which generally stated are as follows: (i) the corporation’s assets equal at least 1-1/4 times its liabilities, and (ii) the corporation’s current assets equal at least its current liabilities or, if the average of the corporation’s earnings before taxes on income and before interest expenses for the two preceding fiscal years was less than the average of the corporation’s interest expenses for such fiscal years, then the corporation’s current assets must equal at least 1-1/4 times its current liabilities.

The ability of the Company to pay a cash dividend depends largely on the Bank’s ability to pay a cash dividend to the Company. The payment of cash dividends by the Bank is subject to restrictions set forth in the California Financial Code (the Financial Code). The Financial Code provides that a bank may not make a cash distribution to its shareholders in excess of the lesser of (a) the bank’s retained earnings; or (b) the bank’s net income for its last three fiscal years, less the amount of any distributions made by the bank or by any majority-owned subsidiary of the bank to the shareholders of the bank during such period. However, a bank may, with the approval of the DFI, make a distribution to its shareholders in an amount not exceeding the greater of (x) its retained earnings; (y) its net income for its last fiscal year; or (z) its net income for its current fiscal year. In the event that the DFI determines that the shareholders’ equity of a bank is inadequate or that the making of a distribution by the bank would be unsafe or unsound, the DFI may order the bank to refrain from making a proposed distribution. The FDIC may also restrict the payment of dividends if such payment would be deemed unsafe or unsound or if after the payment of such dividends, the Bank would be included in one of the “undercapitalized” categories for capital adequacy purposes pursuant to federal law. (See, “Item 1—Prompt Corrective Action and Other Enforcement Mechanisms.”) Additionally, while the Federal Reserve Board has no general restriction with respect to the payment of cash dividends by an adequately capitalized bank to its parent holding company, the Federal Reserve Board might, under certain circumstances, place restrictions on the ability of a particular bank to pay dividends based upon peer group averages and the performance and maturity of the particular bank, or object to management fees to be paid by a subsidiary bank to its holding company on the basis that such fees cannot be supported by the value of the services rendered or are not the result of an arm’s length transaction.

Whether or not dividends will be paid in the future will be determined by the Board of Directors after consideration of various factors. The Company’s profitability and regulatory capital ratios in addition to other financial conditions will be key factors considered by the Board of Directors in making such determinations regarding the payment of dividends by the Company.

The agreement and plan of merger with Rabobank provides that the Company may pay regular quarterly dividends in accordance with its prior practices up to the close of the transaction, not to exceed $.18 per share per quarter. Again, any decision to do so will be made by the Board of Directors as described above. In addition to any regular quarterly dividend paid for the first quarter, the Company may pay a special cash dividend of an additional $.18 per share if the transaction has not been consummated on or before April 30, 2007. Similarly, if the transaction has not been consummated on or before July 31, 2007, the Company may pay a special cash dividend of an additional $.18 per share over any regularly declared dividend for the second quarter.

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Transfer Agent

Mellon Investor Services, LLC serves as the Company’s transfer agent. Shareholder inquiries regarding holdings of Mid-State Bancshares Common Stock can be directed to:

Mellon Investor Services, LLC
P. O. Box 3315
South Hackensack, NJ 07606

Or

Mellon Investor Services, LLC
480 Washington Boulevard
Jersey City, NJ 07310-1900

By Phone:
1-(888)-540-9878 (U.S. & Canada)
1-(201)-329-8660 (Outside U.S.)

TDD for Hearing Impaired:             (800) 231-5469
Foreign Shareowners:                        (201) 680-6578
TDD Foreign Shareowners:             (201) 680-6610

Web Site Address:              www.melloninvestor.com/isd

Mellon Investor Services maintains the records for registered Mid-State Bancshares shareholders and can help with such services as change of name or address, consolidation of accounts, duplicate mailings, dividend reinvestment enrollment, lost stock certificates, transfer of stock to another person, and additional administrative services. For more information, they can be contacted via the Internet at www.melloninvestor.com.

Stock Repurchase Program

The Board of Directors at its regular meeting of June 15, 2005, authorized the purchase of up to 1,141,373 additional shares since its prior authorizations in May 2002 and January 2004 had expired. The June 2005 authorization does not have an expiration date. The repurchase program seeks to reduce the number of outstanding shares resulting in an improvement to the Company’s earnings per share and to its return on equity. All of these shares were purchased at current market prices on the date of transaction in compliance with the SEC rules. The total number of shares repurchased was 608,876, 845,055, and 658,867 in 2006, 2005 and 2004, respectively. The average price paid per share in 2006, 2005, and 2004 was $27.79, $27.29, and $25.26, respectively. As of December 31, 2006, the Company could repurchase up to an additional 207,799 shares under the June 2005 authorization. There was no repurchase activity in the fourth quarter of 2006 and no further repurchase activity is anticipated prior to the consummation of the pending merger with Rabobank.

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ITEM 6.                SELECTED FINANCIAL DATA

Selected Consolidated Financial Data—Mid-State Bancshares

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Selected Consolidated Financial Data—Mid-State Bancshares (Continued)

(1)          Includes allowance for loan losses and allowance for losses-unfunded commitments.

(2)          Taxable equivalent converts tax exempt income as if it were taxable.

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ITEM 7.                MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Introduction and Business of the Company

The following discussion and analysis will provide insight and supplementary information into the accompanying consolidated financial statements of the Company. It also provides Management’s assessment of the operating trends over the past few years. Unless otherwise noted below, the discussion and analysis section deals almost exclusively with the Community Banking segment of the Company. The other two segments, Mid-Coast Land Company and Trust Services, contribute a small percentage (less than 4%) to the overall earnings of the Company.

2006 RESULTS AND ACCOMPLISHMENTS

Financial Summary

The Company, on a consolidated basis, reported net income of $35.3 million in 2006, $37.5 million in 2005 and $35.1 million in 2004. The diluted Earnings Per Share (EPS) was $1.55 for 2006 compared to $1.61 in 2005 and $1.47 in 2004. Consolidated total assets at December 31, 2006 were $2.355 billion compared to $2.391 billion at December 31, 2005, down 1.5%. Total deposits also decreased from $2.070 billion as of December 31, 2005 to $2.005 billion as of December 31, 2006. Shareholders’ common equity stood at $282.4 million at year end up from its $272.6 million level one year earlier. There were a number of factors working to both increase and decrease this account which showed a net increase. The primary factors working to increase shareholders’ common equity included: 1) $35.3 million of net income generated for the year; and 2) $4.4 million received for the exercise of stock options. These were offset by: 1) $16.0 million in dividends paid out during 2006; and 2) $16.9 million paid for the repurchase of common stock outstanding.

The table below illustrates net income by subsidiary unit.

Executive Summary

Management considers the following to be the most significant items affecting net income during 2006 compared to 2005.

·       During 2006, the Federal Reserve continued making a number of increases in short term interest rates, the Prime Rate (to which many of the Company’s loans are tied) increased 4 times over the course of the year from 7.25% at the start of the year to 8.25% by the end of the year. Because of its general asset sensitivity, the Company saw an improvement in its net interest margin (from 5.76% in 2005 to 6.00% in 2006, taxable equivalent). This allowed the Company to show a $5.6 million increase in net interest income.

·       The Company realized non-recurring, pre-tax gains in 2006 of $581 thousand related to the sale of its share of the Western States Bancard Association (WSBA) merchant processing activity to a third party. The Company was a founding member of the WSBA.

·       The net increase in total non-interest expense amounted to $8.1 million in 2006 compared to 2005. Factors contributing to this increase included: 1) the adoption of SFAS 123(R), “Share-Based

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Payments”, which accounted for approximately $1.9 million in additional salary expense; 2) other salary and benefit increases of approximately $2.2 million related to additional staffing for the new Westlake Village branch, regulatory compliance, particularly the Bank Secrecy Act and U.S.A. Patriot Act, and for regular salary increases across the Company; 3) increases in professional services of approximately $1.4 million for consulting, outsourcing and accounting services; and 4) charges incurred in connection with the pending merger with Rabobank, of approximately $0.5 million, primarily made up of attorneys’ and accountants’ fees.

Management considers the following to be the most significant items affecting net income during 2005 compared to 2004.

·       During 2005, with the Federal Reserve orchestrating a number of increases in short term interest rates, the Prime Rate (to which many of the Company’s loans are tied) increased 8 times over the course of the year from 5.25% at the start of the year to 7.25% by the end of the year. Because of its general asset sensitivity, the Company saw an improvement in its net interest margin (from 5.36% in 2004 to 5.74% in 2005, taxable equivalent). Coupled with a $69.9 million increase in earning assets, this allowed the Company to show an $11.3 million increase in net interest income.

·       The Company took a benefit to provision for loan losses of $2.7 million in 2004 compared to no provision during 2005. The benefit taken to the provision for loan losses in 2004 reflected strong credit quality standards, consistent performance of the loan portfolio in recent years, improving trends in classified loans, improving trends in delinquencies and charge-offs, an improved outlook for the collection of the Company’s non-accrual loans, and an improved outlook for economic activity in general. The Company did not need to take any benefit to the provision for loan losses in 2005. Because of the continued quality of the portfolio, it also did not have to take a charge to the provision for loan losses in 2005.

·       The Company realized non-recurring gains in 2004 of $1.1 million on the sale of OREO and $475 thousand in securities gains. The Company had only minor securities gains of $88 thousand in 2005 and no OREO gains.

·       The net decrease in total non-interest expense amounted to $1.6 million in 2005 compared to 2004. Factors contributing to this decrease included 1) decreases in merchant credit card processing fees of $4.3 million on 2005 compared to 2004; 2) increases in salaries and employee benefits of $2.8 million related primarily to the Company’s incentive bonus program and 3) all other operating expenses increasing by $180 thousand from one year to another. The decrease in merchant credit card processing charges was a result of outsourcing this function to a third party. There was a similar drop in non-interest income.

EXTERNAL FACTORS IMPACTING THE BANK

Economic Conditions

The Board of Governors of the Federal Reserve System continued raising short term interest rates and the target Fed Funds rate reached 5.25% by mid-year 2006. The national unemployment rate dropped from 4.9% at the start of 2006 to 4.5% by the end of the year. Locally, unemployment rates continue to be at low levels in San Luis Obispo County at 3.6% at the end of 2006 and in Santa Barbara County at 4.1%. The yield curve inverted with the spread between the three month and ten year Treasury declining from a positive 31 basis points at the start of 2006 to negative 31 basis points at the end of the year. The ten year Treasury is actually little changed from its 4.39% level at the start of the year having closed at 4.71% at the end of 2006. Management is of the opinion that the flattening of the yield curve portrays a general belief that future inflation will be in-line with recent historical experience (e.g.—the Consumer Price Index was up 2.5% and 3.4% in 2006 and 2005, respectively) and we have no reason to change that expectation. Notwithstanding spikes in energy prices, inflation does appear to be in check.

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The most comprehensive review of local economic conditions in our market known to Management comes from the University of California at Santa Barbara (UCSB) Economic Forecast Project. According to UCSB, Gross County Product in the tri-county area was estimated at $87.3 billion in 2006, up 6.1% from the $82.3 level in the prior year. Adjusted for real dollars, it was up 3.3% following a 3.8% growth rate in 2005 and 3.5% in 2004. These rates of growth were down from the double digit increases witnessed in the late 1990’s. For California as a whole, real Gross State Product was up 4.0% in 2006, up 4.4% in 2005 and up 5.1% in 2004, slightly ahead of the Tri County experience. Expectations by UCSB for 2007 are for further improvements with the real State Product growing 3.5% and the real Tri County Gross Product growing somewhat slower at a 3.1% pace.

Median home prices continue near historical highs throughout the Bank’s service area. The median price of a home in 2006 is estimated to have reached $604 thousand in San Luis Obispo County, up 12% from a year earlier. Sales volume was up 4% over that period, which is a much slower increase than the 13% in 2005. Sales volume was off in Santa Barbara County having fallen by an estimated 10% and was up by only 2% in Ventura County. Median home prices continue to be quite high in these counties, as well, ending at an estimated $768 thousand in Santa Barbara County and $750 thousand in Ventura County. Management believes that the slower sales and higher inventories of homes for sale could potentially put downward pressure on prices throughout the Tri-County area.

With positive indicators continuing in the national economic statistics and a solid economic base locally, Management is encouraged that 2007 should again be a positive year overall for the economy in the Company’s trade area, in spite of a generally softer real estate market. As mentioned last year, this optimism must be tempered by the potential for disruption resulting from geopolitical issues surrounding homeland security and terrorism. The effects of episodes such as the 9/11 terrorist attacks, the wars in Afghanistan and Iraq, and the international tensions surrounding these events, can have a significant impact on economic activity. In spite of this caveat, our local trade area again appears to be in a solid position at the start of 2007 to continue solid economic growth and maintain low unemployment rates. The Board of Governors of the Federal Reserve System are widely believed to be reaching the end of their drive to raise short term interest rates and Management does not expect additional increases in the target Fed Funds rate. Management expects that longer term rates will remain stable, with a continued flat yield curve in place throughout 2007.

Competitive Factors

Competitive pressures from other financial institutions continue to be intense both in the Company’s trade area and throughout the nation. Many banks are suffering from insufficient loan volumes and have become very aggressive on the pricing of those good credits available. In the Company’s tri-counties service area, 45 financial institutions (banks and savings institutions) operate 343 offices serving $25.5 billion in deposits based on data as of June 30, 2006. These figures are up from 43 institutions operating 336 offices with $24.6 billion in deposits one year earlier. Additionally, while Management does not have specific metrics on competition from broker dealers, there is significant competition from brokerage houses providing competing deposit and investment products. Also, “conduit financing” from Wall Street is competing with the Bank for larger loan transactions.

It should be noted that the trend toward consolidation of banking assets exhibited over the past few years in California continued in 2006. Statewide, in 2006, there were 12 banks which announced merger into another institution including the pending merger between the Company and Rabobank. According to the California State Department of Financial Institutions 13 applications for new banks were approved in 2006 in California. In addition, an application for a new bank in San Luis Obispo County was filed in early 2007.

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ANALYSIS OF STATEMENT OF FINANCIAL POSITION

Loans

The Bank experienced an increase in net loans from $1,507.1 million at the end of 2005, to $1,562.8 million at the end of 2006. This represents an increase in the loan portfolio of $55.7 million, or 3.7%, following the $99.0 million, or 7.0% increase in 2005. The loan portfolio represents approximately 66% of the Bank’s assets. Additionally, loans held for sale (which are single family residential mortgages pending sale) total $12.8 million at the end of 2006, up from $10.2 million one year earlier.

The graph above displays the trend over the five year period ended December 31, 2006 in the various components of the loan portfolio, net of deferred loan fees. Construction loans have risen from their level four years earlier—$213.4 million at December 31, 2002 compared to $290.1 million at year-end 2006. Real Estate loans generally trended up from $525.2 million at the end of 2002 to $848.4 million at the end of 2006. The larger growth in real estate loans, especially in recent years, reflects an expanded use of jumbo adjustable rate mortgage loans in the portfolio ($131.9 million at the end of 2006) along with the purchase of certain of these same type of loan assets in the secondary market ($22.1 million at the end of 2006).

Home Equity Credit Lines, although declining in 2006 compared to 2005, have generally increased from $74.3 million at the end of 2002 compared to $152.1 million at the end of 2006. Consumer loans (installment and credit reserve) have decreased from $30.9 million at December 31, 2002 to $21.6 million at year-end 2006. Commercial and other loans have rebounded to $222.5 million at December 31, 2006, just slightly ahead of 2002 levels. Agricultural production loans have remained relatively flat, ending at $39.9 million in 2006. The Bank expects to continue to emphasize all types of lending activity in order to diversify the risk in its portfolio. Economic activity in the Central Coast will determine the types of credit the Bank will be able to extend and hence its ability to achieve this objective. For a discussion of the Company’s concentrations in total real estate loans and in commercial real estate loans, see “Item 1A. Risk Factors.”

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The Bank’s allowances for loan and lease losses collectively stand at $13.7 million, or 0.9% of gross loans, and represents losses not yet realized, but inherent in the loan portfolio and on unfunded commitments. The allowance for losses was $13.7 million at December 31, 2005. The year-end 2006 balance now represents 2,605% of non-performing loans which is up from the 554% level at the end of 2005 owing to a drop in non performing loans.

A five-year review of activity in the allowance for losses and an allocation by loan type of the allowance is shown in the tables below.