Edgar Filing: PACIFIC MERCANTILE BANCORP

PACIFIC MERCANTILE BANCORP

Date: November 9, 2012

/S/ NANCY A. GRAY

Nancy A. Gray, Chief Financial Officer

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2012

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

For the transition period from to

Commission file number 0-30777

PACIFIC MERCANTILE BANCORP

(Exact name of Registrant as specified in its charter)


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

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

(714) 438-2500

(Registrant’s telephone number, including area code)

Not Applicable

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

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

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

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


Large accelerated filer	¨	Accelerated filer	¨

Non-accelerated filer	¨	Smaller reporting company	x

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

APPLICABLE ONLY TO CORPORATE ISSUERS:

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

16,670,703 shares of Common Stock as of November 2, 2012

QUARTERLY REPORT ON FORM 10Q

FOR

THE QUARTER ENDED SEPTEMBER 30, 2012

TABLE OF CONTENTS


		Page
Part I. Financial Information

Item 1.	Financial Statements (unaudited)

	Consolidated Statements of Financial Condition at September 30, 2012 and December 31, 2011		1

	Consolidated Statements of Income for the Three and Nine Months ended September 30, 2012 and 2011		2

	Consolidated Statements of Comprehensive Income for the Three and Nine Months ended September 30, 2012 and 2011		3

	Consolidated Statements of Cash Flows for the Nine Months ended September 30, 2012 and 2011		4

	Consolidated Statement of Shareholders’ Equity for the Nine Months ended September 30, 2012		5

	Notes to Consolidated Financial Statements		6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		32

Item 4T.	Controls and Procedures		60

Part II. Other Information

Item 1A.	Risk Factors		61

Item 6.	Exhibits		61

Signatures			S-1

Exhibit Index			E-1

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

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

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

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

Exhibit 101.INS XBRL Instance Document

Exhibit 101.SCH XBRL Taxonomy Extension Schema Document

Exhibit 101.CAL XBRL Taxonomy Extension Calculation Linkbase Document

Exhibit 101.DEF XBRL Taxonomy Extension Definition Linkbase Document

Exhibit 101.LAB XBRL Taxonomy Extension Labels Linkbase Document

Exhibit 101.PRE XBRL Taxonomy Extension Presentation Linkbase Document

(i)

PART I.—FINANCIAL INFORMATION

ITEM 1.

FINANCIAL STATEMENTS

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands, except per share data)

(Unaudited)


	September 30, 2012			December 31, 2011
ASSETS
Cash and due from banks	$	11,727		$	10,290
Interest bearing deposits with financial institutions		126,009			86,177

Cash and cash equivalents		137,736			96,467
Interest-bearing time deposits with financial institutions		1,553			1,423
Federal Reserve Bank and Federal Home Loan Bank Stock, at cost		10,324			11,154
Securities available for sale, at fair value		52,534			147,909
Loans held for sale (loans held for sale at fair value: $151,919 and $41,990, respectively)		151,919			66,230
Loans (net of allowances of $12,659 and $15,627, respectively)		680,151			641,962
Investment in unconsolidated subsidiaries		682			682
Other real estate owned		30,177			37,421
Accrued interest receivable		2,387			2,505
Premises and equipment, net		1,396			977
Other assets		29,011			17,822

Total assets	$	1,097,870		$	1,024,552

LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Noninterest-bearing	$	187,570		$	164,382
Interest-bearing		692,624			697,665

Total deposits		880,194			862,047
Borrowings		60,000			49,000
Accrued interest payable		1,762			1,444
Other liabilities		14,974			7,909
Junior subordinated debentures		17,527			17,527

Total liabilities		974,457			937,927

Commitments and contingencies (Note 2)
Shareholders’ equity:
Preferred stock, no par value, 2,000,000 shares authorized:
Series A Convertible 10% Cumulative Preferred Stock, 155,000 shares authorized, none issued or outstanding at September 30, 2012; 11,000 shares issued and outstanding at December 31, 2011; liquidation preference $100 per share plus accumulated and undeclared dividends at December 31, 2011		—			1,100
Series B Convertible 8.4% Noncumulative Preferred Stock, 300,000 shares authorized, 112,000 issued and outstanding at September 30, 2012 and December 31, 2011; liquidation preference $100 per share plus accumulated dividends and undeclared dividends at September 30, 2012 and December 31, 2011		8,747			8,747
Series C 8.4% Noncumulative Preferred Stock, 300,000 shares authorized, 8,100 issued and outstanding at September 30, 2012 and none issued or outstanding at December 31, 2011; liquidation preference $100 per share plus accumulated dividends and undeclared dividends at September 30, 2012 and December 31, 2011		—			—
Common stock, no par value, 85,000,000 shares authorized, 16,670,703 and 12,273,003 shares issued and outstanding at September 30, 2012 and December 31, 2011, respectively		110,808			84,742
Retained earnings (accumulated deficit)		4,616			(5,921	)
Accumulated other comprehensive loss		(758	)		(2,043	)

Total shareholders’ equity		123,413			86,625

Total liabilities and shareholders’ equity	$	1,097,870		$	1,024,552

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

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in thousands, except for shares and per share data)

(Unaudited)


	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Interest income
Loans, including fees	$	10,769		$	10,005		$	30,034		$	30,458
Securities available for sale and stock		402			879			1,671			3,277
Interest-bearing deposits with financial institutions		203			59			332			126

Total interest income		11,374			10,943			32,037			33,861
Interest expense
Deposits		1,829			2,465			5,778			7,469
Borrowings		286			298			841			1,014

Total interest expense		2,115			2,763			6,619			8,483

Net interest income		9,259			8,180			25,418			25,378
Provision for loan losses		500			—			1,950			—

Net interest income after provision for loan losses		8,759			8,180			23,468			25,378
Noninterest income
Total other-than-temporary impairment of securities		—			(131	)		(25	)		(36	)
Less: Portion of other-than-temporary impairment losses recognized in other comprehensive loss		—			(77	)		52			133

Net impairment loss recognized in earnings		—			(54	)		(77	)		(169	)
Service fees on deposits and other banking services		209			239			687			763
Mortgage banking (including net gains on sales of loans held for sale)		9,168			1,425			22,149			3,592
Net gains on sale of securities available for sale		937			365			2,123			405
Net (loss) gain on sale of other real estate owned		(560	)		—			(449	)		206
Other		197			248			672			642

Total noninterest income		9,951			2,223			25,105			5,439
Noninterest expense
Salaries and employee benefits		7,349			4,273			19,497			12,258
Occupancy		684			594			2,005			1,861
Equipment and depreciation		460			378			1,378			1,093
Data processing		187			154			562			485
FDIC expense		592			539			1,751			1,721
Other real estate owned expense		1,068			716			4,769			1,912
Professional fees		1,030			1,156			3,659			3,198
Mortgage related loan expense		733			157			2,011			439
Provision for contingencies		80			900			419			900
Other operating expense		1,224			909			3,275			2,773

Total noninterest expense		13,407			9,776			39,326			26,640

Income before income taxes		5,303			627			9,247			4,177
Income tax (benefit) provision		1,944			(225	)		(1,290	)		405

Net income		3,359			852			10,537			3,772
Accumulated undeclared dividends on preferred stock		(241	)		(121	)		(241	)		(176	)

Net income allocable to common shareholders	$	3,118		$	731		$	10,296		$	3,596

Income per common share
Basic	$	0.19		$	0.06		$	0.69		$	0.33
Diluted	$	0.18		$	0.06		$	0.61		$	0.33
Weighted average number of common shares outstanding
Basic		16,669,350			12,273,003			14,954,413			11,054,178
Diluted		19,170,781			12,315,065			17,374,156			11,072,523

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

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME

(Dollars in thousands)

(Unaudited)


	Three Months Ended September 30,					Nine Months Ended September 30,
	2012			2011		2012			2011
Net income	$	3,359		$	852	$	10,537		$	3,772
Other comprehensive loss, net of tax:
Change in unrealized loss on securities available for sale		274			398		1,313			1,994
Change in net unrealized gain (loss) and prior service benefit on supplemental executive retirement plan		(46	)		5		(28	)		(31	)

Total comprehensive income	$	3,587		$	1,255	$	11,822		$	5,735

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

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)


	Nine Months Ended September 30,
	2012			2011
Cash Flows From Operating Activities:
Net income	$	10,537		$	3,772
Adjustments to reconcile net income to net cash used in operating activities:
Depreciation and amortization		384			370
Provision for loan losses		1,950			—
Net amortization of premium on securities		262			468
Net gains on sales of securities available for sale		(2,123	)		(405	)
Net gains on sales of loans held for sale		(31,002	)		(2,648	)
Net mark to market on mortgage loans held for sale		(8,616	)		—
Proceeds from sales and principal reductions of mortgage loans held for sale		694,664			195,959
Originations and purchases of mortgage loans held for sale		(743,968	)		(217,504	)
Repurchases of mortgage loans held for sale		(1,086	)		—
Other than temporary impairment on securities available for sale		77			169
Net amortization of deferred fees and unearned income on loans		(430	)		(349	)
Net (gain) loss on sales of other real estate owned		449			(187	)
Net gain on sale of fixed assets		(25	)		(18	)
Write down of other real estate owned		876			470
Stock-based compensation expense		330			206
Net mark to market loss on derivatives		703			—
Net mark to market gain on mortgage servicing rights		(1,000	)
Changes in operating assets and liabilities:
Net decrease in accrued interest receivable		118			576
Net (increase) decrease in other assets		(3,500	)		656
Net increase in deferred taxes		(5,048	)		(880	)
Net (increase) decrease in income taxes receivable		(418	)		6,205
Net increase accrued interest payable		318			301
Net increase in other liabilities		7,037			1,078

Net cash used in operating activities		(79,511	)		(11,761	)
Cash Flows From Investing Activities:
Net (increase) decrease in interest-bearing time deposits with financial institutions		(130	)		610
Maturities of and principal payments received for securities available for sale and other stock		29,100			9,951
Purchase of securities available for sale and other stock		(117,717	)		—
Proceeds from sale of securities available for sale and other stock		185,696			95,609
Proceeds from sale of other real estate owned		8,415			9,717
Capitalized cost of other real estate owned		(337	)		(155	)
Net (increase) decrease in loans		(37,252	)		47,387
Purchases of premises and equipment		(814	)		(348	)
Proceeds from sales of loans		—			1,531
Proceeds from sale of premises and equipment		36			18

Net cash provided by investing activities		66,997			164,320
Cash Flows From Financing Activities:
Proceeds from sale of common stock		24,591			—
Proceeds from sale of Series B preferred stock		—			8,862
Net increase in deposits		18,147			29,352
Net increase (decrease) in borrowings		11,000			(54,000	)
Proceeds from exercise of stock options		1			—
Proceeds from sale of stock purchase warrants		44			—

Net cash provided by (used in) financing activities		53,783			(15,786	)
Net increase in cash and cash equivalents		41,269			136,773
Cash and Cash Equivalents, beginning of period		96,467			32,678

Cash and Cash Equivalents, end of period	$	137,736		$	169,451

Supplementary Cash Flow Information:
Cash paid for interest on deposits and other borrowings	$	6,301		$	8,182

Cash paid for income taxes		1,033			978

Non-Cash Investing Activities:
Transfer of loans into other real estate owned	$	—		$	416

Transfer of loans held for sale to loans held for investment	$	10,004		$	1,586

Transfer of loans held for investment to loans held for sale	$	5,388		$	—

Net increase in net unrealized losses and prior year service cost on supplemental employee retirement plan, net of tax	$	(28	)	$	(31	)

Net change in net unrealized gains and losses on securities held for sale, net of income tax	$	1,313		$	1,994

Non-Cash Financing Activities:
Conversion of Series A cumulative preferred Stock to Common Stock	$	1,100		$	—

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

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(Shares and dollars in thousands)

(Unaudited)

For The Nine Months Ended September 30, 2012


	Series A, B, and C Preferred Stock						Common Stock				Retained Earnings Accumulated (Deficit)			Accumulated Other Comprehensive (Loss)			Total
	Number of Shares			Amount			Number of Shares		Amount		Retained Earnings Accumulated (Deficit)			Accumulated Other Comprehensive (Loss)			Total
Balance at January 1, 2012		123		$	9,847			12,273	$	84,742	$	(5,921	)	$	(2,043	)	$	86,625
Sale of Common Stock								4,201		24,591								24,591
Conversion of Series A cumulative preferred stock common stock		(11	)		(1,100	)		144		1,100		—			—			—
Series A cumulative preferred stock dividend		—			—			37		—		—			—			—
Series C noncumulative preferred stock issued as a stock dividend on Series B noncumulative preferred stock		8			—			—		—		—			—			—
Common stock based compensation expense		—			—			—		330		—			—			330
Stock options exercised		—			—			16		1		—			—			1
Common stock warrants issued		—			—			—		44		—			—			44
Net income		—			—			—		—		10,537			—			10,537
Change in unrealized gain on securities held for sale		—			—			—		—		—			1,313			1,313
Change in unrealized loss on supplemental executive retirement plan		—			—			—		—		—			(28	)		(28	)

Balance at September 30, 2012		120		$	8,747			16,671	$	110,808	$	4,616		$	(758	)	$	123,413

The accompanying notes are an integral part of this consolidated financial statement.

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements

(Unaudited)

1.	Nature of Business

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

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

During 2002, we organized three business trusts, under the names Pacific Mercantile Capital Trust I, PMB Capital Trust I, and PMB Statutory Trust III, respectively, to facilitate our issuance of $5.155 million, $5.155 million and $7.217 million, respectively, principal amount of junior subordinated debentures, all with maturity dates in 2032. In October 2004, we organized PMB Capital Trust III to facilitate our issuance of an additional $10.310 million principal amount of junior subordinated debentures, with a maturity date in 2034. In accordance with applicable accounting standards, the financial statements of these trusts are not included in the Company’s consolidated financial statements. See Note 2: “Significant Accounting Policies—Principles of Consolidation” in the Notes to Consolidated Financial Statements included in the Company’s Form 10-K for the year ended December 31, 2011.

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

2.	Significant Accounting Policies, Recent Accounting Pronouncements, Commitments and Contingencies

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

These unaudited consolidated financial statements have been prepared on a basis consistent with prior periods, and should be read in conjunction with our audited consolidated financial statements as of and for the year ended December 31, 2011, and the notes thereto, included in our Annual Report on Form 10-K for the year ended December 31, 2011 (our “2011 10-K”), as filed with the Securities and Exchange Commission (“SEC”) under the Securities Exchange Act of 1934. The Company evaluates subsequent events through the date of the filing with the SEC.

Our consolidated financial position at September 30, 2012, and the consolidated results of operations for the three and nine month periods ended September 30, 2012, are not necessarily indicative of what our financial position will be at of December 31, 2012, or of the results of our operations that may be expected for any other interim period or for the full year ending December 31, 2012.

2.	Significant Accounting Policies, Recent Accounting Pronouncements, Commitments and Contingencies (Cont,-)

Use of Estimates

The preparation of financial statements in conformity with GAAP requires us to make certain estimates and assumptions that could affect the reported amounts of certain of our assets, liabilities and contingencies at the date of the financial statements and the reported amounts of our revenues and expenses during the reporting periods. For the fiscal periods covered by this Report, those estimates related primarily to our determinations of (i) allowance for loan losses, (ii) the respective fair values of securities available for sale and mortgage loans held for sale, and (iii) whether and the extent to which it is necessary to establish a valuation allowance against our deferred tax asset. If circumstances or financial trends on which those estimates were based were to change in the future or there were to occur any currently unanticipated events affecting the amounts of those estimates, our future financial position or results of operations could differ, possibly materially, from those expected at the current time.

Recent Accounting Pronouncements

In May 2011, the FASB issued ASU 2011-04—Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements (“ASU 2011-04”), clarifying how to measure and disclose fair value. This guidance amends the application of the “highest and best use” concept to be used only in the measurement of fair value of nonfinancial assets, clarifies that the measurement of the fair value of equity-classified financial instruments should be performed from the perspective of a market participant who holds the instrument as an asset, clarifies that an entity that manages a group of financial assets and liabilities on the basis of its net risk exposure can measure those financial instruments on the basis of its net exposure to those risks, and clarifies when premiums and discounts should be taken into account when measuring fair value. The fair value disclosure requirements also were amended. For public entities, the amendments in ASU 2011-04 are effective prospectively for interim and annual periods beginning after December 15, 2011. The adoption of the amended guidance did not have a significant impact on the Company’s results of operations, financial position, or disclosures.

Commitments and Contingencies

Commitments

To meet the financing needs of our customers in the normal course of business, we are a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated financial statements. At September 30, 2012, loan commitments and letters of credit totaled $117 million and $805,000, respectively. The contractual amount of a credit-related financial instrument such as a commitment to extend credit, a credit-card arrangement or a letter of credit represents the amounts of potential accounting loss should the commitment be fully drawn upon, the customer were to default, and the value of any existing collateral securing the customer’s payment obligation becomes worthless.

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

2.	Significant Accounting Policies, Recent Accounting Pronouncements, Commitments and Contingencies (Cont,-)

During the first quarter of 2012, we began selling a portion of our mortgage loan production directly to secondary market investors on a “mandatory commitment” basis, agreeing to sell a specified dollar amount of mortgage loans at an agreed-upon price within a specified timeframe in order to avail ourselves of more favorable pricing on loan sales to investors. In order to mitigate interest rate risk on loans subject to such mandatory commitments, when we lock the interest rate for the borrowers on those loans prior to funding, we lock the price to sell the loans to investors in a mandatory commitment and enter into a mortgage backed to-be-announced (“TBA”) security. The mandatory commitment and the TBA security act as a hedge against market interest rate movements between the time the interest rate is locked and the loan is funded and sold in the secondary market. TBA securities are deemed to be derivatives and involve off-balance sheet financial risk. The contractual or notional amounts of the TBA securities are tied to the Bank’s loan origination volume and we bear a financial risk from such securities. The unrealized fair value gains from the interest rate contracts and TBA security hedges were $941,000 as of September 30, 2012. These gains or losses depend upon the value of the underlying financial instruments and are affected by market changes in interest rates.

TBA securities pose credit risk for us if and to the extent that the institutional counterparties are unable to meet the terms of the agreements. We control counterparty credit risk by using multiple counterparties and limiting them to major financial institutions with investment grade credit ratings. In addition, we regularly monitor the potential risk of loss with any one party resulting from this type of credit risk.

Legal Proceedings

Mark Zigner vs. Pacific Mercantile Bank, et al., filed in January, 2010, in the California Superior Court for the County of Orange (Case No.0337433). This lawsuit was filed by plaintiff asserting that the Bank had wrongfully exercised certain remedies in its efforts to recover borrowings owed by plaintiff to the Bank. In his lawsuit, the plaintiff claimed that the set off by the Bank against plaintiff’s deposit accounts was wrongful. The Plaintiff also asserted certain related claims, including an alleged breach by the Bank of the covenant of good faith and fair dealing.

The case was tried before a jury in August, 2011. However (i) before the case went to the jury for a decision, the trial judge ruled that the Bank had wrongfully exercised its set off rights and based on that finding, the jury awarded plaintiff $100,000 of compensatory damages, and (ii) the jury later found that the Bank’s exercise of its set off rights also constituted a wrongful conversion of plaintiff’s funds and awarded the plaintiff $150,000 in compensatory damages and $950,000 in punitive damages against the Bank. In addition, the trial court entered an award to plaintiff of his attorney’s fees and costs, in the amount of $762,000.

Following the entry of the final judgment by the trial court in February 2012, the Bank filed an appeal of the trial court’s rulings and the jury verdict, asserting that those rulings and the jury’s verdict were erroneous and that plaintiff is not entitled, as a matter of law, to an award of either compensatory or punitive damages. Because the appeals process has just begun, it is not possible at this time to predict, with any certainty, how the appellate courts will ultimately rule on our appeal. However, we believe that the judgment entered by the court against the Bank should be overturned on appeal.

Other Claims. We also are subject to legal actions that arise from time to time in the ordinary course of our business. Currently there are no such pending legal proceedings that we believe will become material to our financial condition or results of operations.

Regulatory Matters

On August 31, 2010, the Company and the Bank entered into a Written Agreement (the “FRB Agreement”) with FRB. On the same date, the Bank consented to the issuance of a regulatory order by the California Department of Financial Institutions (the “DFI Order”). The principal purposes of the FRB Written Agreement and DFI Order, which constitute formal supervisory actions by the FRB and the DFI, were to require us to adopt and implement formal plans and take certain actions, as well as to continue to implement other measures that we previously adopted, to address the adverse consequences that the economic recession has had on the performance of our loan portfolio and our operating results, to improve our operating results, and to increase our capital to strengthen our ability to weather any further adverse economic conditions that might arise in the future.

2.	Significant Accounting Policies, Recent Accounting Pronouncements, Commitments and Contingencies (Cont,-)

The FRB Agreement and DFI Order contain substantially similar provisions. They required the Boards of Directors of the Company and the Bank to prepare and submit written plans to the FRB and the DFI to address the following matters: (i) strengthening board oversight of the management operations of the Bank; (ii) strengthening credit risk management practices; (iii) improving credit administration policies and procedures; (iv) improving the Bank’s position with respect to problem assets; (v) maintaining adequate reserves for loan losses in accordance with applicable supervisory guidelines; (vi) improving the capital position of the Bank and, in the case of the FRB Agreement, the capital position of the Company; (vii) improving the Bank’s earnings through the formulation, adoption and implementation of a new strategic plan, and (viii) submitting a satisfactory funding contingency plan for the Bank that would identify available sources of liquidity and a plan for dealing with possible future adverse economic and market conditions. The Bank is also prohibited from paying dividends to the Company without the prior approval of the DFI, and the Company may not declare or pay cash dividends, repurchase any of its shares, make payments on its trust preferred securities or incur or guarantee any debt, without the prior approval of the FRB.

The Company and the Bank already have made substantial progress with respect to several of these requirements and both the Board and management are committed to achieving all of the requirements on a timely basis. However, a failure by the Company or the Bank to meet any of the requirements of the FRB Agreement or a failure by the Bank to meet any of the requirements of the DFI Order could be deemed, by the FRB or the DFI, to be conducting business in an unsafe manner which could subject the Company or the Bank to further regulatory enforcement action.

Under the DFI Order, the Bank was required to achieve a ratio of adjusted tangible shareholders’ equity to its tangible assets to 9.0% by January 31, 2011, by raising additional capital, generating earnings or reducing the Bank’s tangible assets (subject to a 15% limitation on such a reduction) or a combination thereof and, upon achieving that ratio, to thereafter maintain that ratio during the term of the Order.

In August 2011, we completed the sale of $11.2 million of Series B Convertible 8.4% Series B Preferred Stock (the “Series B Preferred Stock”) and contributed the net proceeds from that sale to the Bank, thereby increasing its ratio of adjusted tangible shareholders’ equity to its tangible assets to 9.0%, as required by the DFI Order. At September 30, 2012, that ratio had increased to 11.88%.

3.	Earnings Per Share (“EPS”)

Basic EPS is computed by dividing net income or loss available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS gives effect to the potential dilution that could occur if stock options, convertible preferred stock or other contracts to issue common stock were either exercised or converted into common stock that would then share in our earnings. For the three and nine months ended September 30, 2012, 883,543 and 909,843 shares, respectively, of our common stock subject to stock options were excluded from the computations of diluted earnings per common share, because they were anti-dilutive. This compares to 783,119 and 960,119 shares, respectively, that were excluded from the computations of diluted earnings per common share for the three and nine months ended September 30, 2011. Also, 352,444 shares of common stock subject to stock purchase warrants were excluded from the computation of diluted earnings per common share for the three and nine months ended September 30, 2012 and 2011 because their exercisability is conditioned on future events.

The following table shows how we computed basic and diluted EPS for the nine month periods ended September 30, 2012 and 2011.


	Three Months Ended September 30,						Nine Months Ended September 30,
(In thousands, except earnings per share data)	2012			2011			2012			2011
Net income (loss)	$	3,359		$	852		$	10,537		$	3,772
Accumulated undeclared dividends on preferred stock		(241	)		(121	)		(241	)		(176	)

Net income allocable to common shareholders^(A)	$	3,118		$	731		$	10,296		$	3,596

Weighted average outstanding shares of common stock^(B)		16,669			12,273			14,954			11,054
Dilutive effect of convertible preferred stock, employee stock options and warrants		2,502			42			2,420			19

Common stock and common stock equivalents^(C)		19,171			12,315			17,374			11,073

Income (Loss) per common share:
Basic (A/B)	$	0.19		$	0.06		$	0.69		$	0.33
Diluted (A/C)	$	0.18		$	0.06		$	0.61		$	0.33

4.	Stock-Based Employee Compensation Plans

Our shareholder-approved 2010 Equity Incentive Plan (the “2010 Plan”) provides for the grant of equity incentives, consisting of options, restricted shares and stock appreciation rights (“SARs”) to officers, other key employees and directors of the Company and the Bank. The 2010 Plan set aside, for the grant or awarding of such equity incentives, 400,000 shares of our common stock, plus an additional 158,211 shares of common stock which was equal to the total number of shares that were then available for the grant of equity incentives under our shareholder-approved 2008 and 2004 Plans (the “Previously Approved Plans”). At the same time, those 158,211 shares ceased to be issuable under the Previously Approved Plans. As a result, upon approval of the 2010 Plan by our shareholders, a total of 558,211 shares were available for the grant or awarding of equity incentives under the that plan.

Options to purchase a total of 1,536,465 shares of our common stock granted under the Previously Approved Plans were outstanding at September 30, 2012. The 2010 Plan provides that if any of those outstanding options expire or are terminated for any reason, then, the number of shares that would become available for grants or awards of equity incentives under the 2010 Plan would be increased by an equivalent number of shares, instead of becoming available for new equity incentive grants under the Previously Approved Plans. Assuming that all of the options that were outstanding under the Previously Approved Plans on the date the 2010 Plan was adopted were to expire or be cancelled, then the maximum number of shares that could be issued pursuant to equity incentives under the 2010 Plan would be 1,689,175 shares.

Stock options entitle the recipients to purchase common stock at a price per share that may not be less than 100% of the fair market value of the Company’s shares on the respective grant dates of the stock options. Restricted shares may be granted at such purchase prices or outright and on such other terms, including restrictions and Company repurchase rights, as are fixed by the Compensation Committee of the Company’s Board of Directors at the time awards of restricted shares are granted. SARs entitle the recipient to receive a cash payment in an amount equal to the difference between the fair market value of the Company’s shares on the date of vesting and a “base price” (which, in most cases, will be equal to fair market value of the Company’s shares on the date of grant), subject to the right of the Company to make such payment in shares of its common stock at their then fair market value. Options, restricted shares and SARs may vest immediately or in installments over various periods generally ranging up to five years, subject to the recipient’s continued employment or service with the Company or the achievement of specified performance goals, as determined by the Compensation Committee at the time it grants or awards such equity incentives. Stock options and SARs may be granted for terms of up to 10 years after the date of grant, but will terminate sooner upon or shortly after a termination of service occurring prior to the expiration of the term of the option or SAR. The Company will become entitled to repurchase some or all of the unvested restricted shares, at the same price that was paid for the shares by the recipient, if any, in the event of a termination of employment or service of the holder of such shares or if any performance goals specified in the award are not satisfied prior to the vesting of those shares. To date, the Company has not granted any restricted shares or any SARs.

Under ASC 718-10, we recognize in our statements of operations the fair values of the options or any restricted shares that we grant as compensation cost over their respective service periods.

The fair values of the options that were outstanding at September 30, 2012 under the 2010 Plan or the Previously Approved Plans (collectively referred to as the “Plans”) were estimated as of their respective dates of grant using the Black-Scholes option-pricing model. For additional information regarding the Company’s stock based compensation plans, see Note 12—“Stock-Based Employee Compensation Plans” in the Notes to Consolidated Financial Statement included in the Company’s 2011 10-K. The table below summarizes the weighted average assumptions used to determine the fair values of the options granted during the following periods:


	Three Months Ended September 30,						Nine Months Ended September 30,
Assumptions with respect to:	2012			2011			2012			2011
Expected volatility		43	%		41	%		48	%		41	%
Risk-free interest rate		1.09	%		2.55	%		0.87	%		2.55	%
Expected dividends		0.57	%		0.26	%		0.57	%		0.26	%
Expected term (years)		6.93			6.6-8.2			4.2-7.6			6.6-8.2
Weighted average fair value of options granted during period	$	2.88		$	1.93		$	2.44		$	1.98

4.	Stock-Based Employee Compensation Plans (Cont,-)

The following tables summarize the stock option activity under the Plans during the nine months ended September 30, 2012 and 2011, respectively.


	Number of Shares			Weighted- Average Exercise Price Per Share		Number of Shares			Weighted- Average Exercise Price Per Share
	2012					2011
Outstanding – January 1,		1,153,741		$	7.35		1,177,642		$	7.57
Granted		524,500			5.26		64,000			4.35
Exercised		(15,380	)		3.53		—			—
Forfeited/Canceled		(126,396	)		6.01		(87,401	)		7.53

Outstanding – September 30,		1,536,465			6.81		1,154,241			7.39

Options Exercisable – September 30,		861,069		$	8.41		742,992		$	9.43

Options to purchase 12,407 and 15,380 share of common stock were exercised during the three and nine months ended September 30, 2012, respectively. There were no options exercised to purchase shares of common stock in the three and nine months ended September 2011. The fair values of options vested during the nine months ended September 30, 2012 and 2011 were $291,274 and $179,700, respectively.

The following table provides additional information regarding the vested and unvested options that were outstanding at September 30, 2012.


	Options Outstanding as of September 30, 2012								Options Exercisable as of September 30, 2012⁽¹⁾
	Vested		Unvested		Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (Years)		Shares		Weighted Average Exercise Price
$ 2.97 – $5.99		384,926		569,996	$	4.08		8.42		384,926	$	3.60
$ 6.00 – $9.99		25,200		105,400		6.93		8.45		25,200		7.40
$10.00 – $12.99		310,100		—		11.23		1.38		310,100		11.23
$13.00 – $17.99		121,343		—		15.09		2.89		121,343		15.09
$18.00 – $18.84		19,500		—		18.05		3.34		19,500		18.06

		861,069		675,396	$	6.81		6.50		861,069	$	8.41

(1)	The weighted average remaining contractual life of the options that were exercisable as of September 30, 2012 was 4.53 years.

The aggregate intrinsic values of options that were outstanding and exercisable under the Plans at September 30, 2012 and 2011 were $1.1 million and $29,200, respectively.

A summary of the status of the unvested options as of December 31, 2011, and changes in the number of shares subject to and in the weighted average grant date fair values of the unvested options during the nine months ended September 30, 2012, are set forth in the following table.


	Number of Shares Subject to Options			Weighted Average Grant Date Fair Value
Unvested at December 31, 2011		352,049		$	1.39
Granted		524,500			2.44
Vested		(167,770	)		1.74
Forfeited/Cancelled		(33,383	)		1.34

Unvested at September 30, 2012		675,396		$	2.13

4.	Stock-Based Employee Compensation Plans (Cont,-)

The aggregate amounts of stock based compensation expense recognized in our consolidated statements of operations for the nine months ended September 30, 2012 and 2011, were $216,000 and $170,000, respectively, in each case net of taxes. At September 30, 2012, the weighted average period over which nonvested awards were expected to be recognized was 1.32 years.

The following table sets forth the compensation expense which was expected to be recognized during the periods presented below in respect of non-vested stock options outstanding at September 30, 2012:


	Estimated Stock Based Compensation Expense
(Dollars in thousands)
For the years ending December 31,
Remainder of 2012	$	153
2013		545
2014		426
2015		174
2016		27

	$	1,325

5.	Employee Benefit Plan

The Company has established a Supplemental Retirement Plan (“SERP”) for its Chief Executive Officer. The components of net periodic benefit cost for the SERP are set forth in the table below:


	Three Months Ended September 30,					Nine Months Ended September 30,
	2012			2011		2012			2011
	(In thousands)
Service cost	$	52		$	51	$	154		$	150
Interest cost		42			38		123			109
Expected return on plan assets		—			—		—			—
Amortization of prior service cost		4			4		11			12
Amortization of net actuarial loss		(12	)		1		(35	)		4

Net periodic SERP cost	$	86		$	94	$	253		$	275

6.	Income Taxes

We record as a “deferred tax asset” on our balance sheet an amount equal to the tax credit and tax loss carryforwards and tax deductions (“tax benefits”) that we believe will be available to us to offset or reduce the amounts of our income taxes in future periods. Under applicable federal and state income tax laws and regulations, such tax benefits will expire if not used within specified periods of time. Accordingly, the ability to fully use our deferred tax asset depends on the amount of taxable income that we generate during those time periods. At least once each year, or more frequently, if warranted, we make estimates of future taxable income that we believe we are likely to generate during those future periods. If we conclude, on the basis of those estimates and the amount of the tax benefits available to us, that it is more likely than not that we will be able to fully utilize those tax benefits prior to their expiration, we recognize the deferred tax asset in full on our balance sheet. On the other hand, if we conclude on the basis of those estimates and the amount of the tax benefits available to us that it has become more likely than not that we will be unable to utilize those tax benefits in full prior to their expiration, then, we would establish (or increase any existing) valuation allowance to reduce the deferred tax asset on our balance sheet to the amount which we believe we are more likely than not to be able to utilize. Such a reduction is implemented by recognizing a non-cash charge that would have the effect of increasing the provision, or reducing any credit, for income taxes that we would otherwise have recorded in our statements of operations. The determination of whether and the extent to which we will be able to utilize our deferred tax asset involves significant management judgments and assumptions that are subject to period to period changes as a result of changes in tax laws, or changes in market or economic conditions that could affect our operating results or result in variances between our actual operating results and our projected operating results, as well as other factors.

6.	Income Taxes (Cont,-)

During the fourth quarter of 2008, we concluded that it had become more likely than not that our taxable income in the foreseeable future would not be sufficient to enable us to realize our deferred tax asset in its entirety. That conclusion was based on our consideration of the relative weight of the available evidence, including the rapid deterioration in market and economic conditions, and the uncertainties regarding the duration of, and how our future operating results would be affected by, those conditions. As a result, we recorded a $3.0 million valuation allowance against our deferred tax asset for the portion of the tax benefits which, based on our assessment, we were more likely than not to be unable to use prior to their expiration. At September 30, 2010, based on continued weakness in the economy and financial markets, we concluded that it had become more likely than not that we would be unable to utilize our remaining tax benefits comprising our deferred tax asset prior to their expiration. Therefore, we increased the valuation allowance against our net deferred tax asset by $10.7 million by means of a non-cash charge to income tax expense in the quarter ended September 30, 2010.

As the result of a strengthening of economic conditions, an improvement in the quality of our loan portfolio, as reflected in declines in loan losses and loan delinquencies, and the earnings we were generating from operations, we determined that it had become more likely than not that we would be able to use approximately $7.0 million of the income tax benefits comprising our deferred tax asset to offset or reduce taxes in future years. As a result we reduced, by a corresponding amount, the valuation allowance that we had previously established against our deferred tax asset, which resulted in the recognition of a non-cash income tax benefit for 2011 in the amount of $6.4 million.

At June 30, 2012 we conducted another assessment of the realizability of our deferred tax asset and due to a continued strengthening of economic conditions and the earnings we were generating from operations, we determined that it had become more likely than not that we would be able to use approximately $13.8 million of the income tax benefits comprising our deferred tax asset to offset or reduce taxes in future years. As a result we reduced the valuation allowance that we had previously established against our deferred tax asset, which resulted in the recognition of a non-cash income tax benefit for the second quarter of 2012 in the amount of $5.0 million.

We file income tax returns with the U.S. federal government and the state of California. As of September 30, 2012, we were subject to examination by the Internal Revenue Service with respect to our U.S. federal and Franchise Tax Board for California state income tax returns for the 2008 to 2011 tax years. Our policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of tax expense. We did not have any accrued interest or penalties associated with any unrecognized tax benefits, and no interest expense was recognized during the years ended 2011 and 2010. Our effective tax rate differs from the federal statutory rate primarily due to tax free income on municipal bonds and certain non-deductible expenses recognized for financial reporting purposes and state taxes. We do not believe there will be any material adverse changes in our unrecognized tax benefits over the next 12 months.

Net operating losses (“NOLs”) on our U.S. federal and California state income tax returns for tax year 2010 may be carried forward 20 years. Beginning in 2012, California taxpayers may carryback losses for two years and carry them forward for 20 years, which will conform to the U.S. tax laws by 2013. We expect (although no assurance can be given) that we will generate taxable income in future years in amounts that will enable us to use the California NOL generated in prior years to reduce California taxes.

7.	Fair Value Measurements

Fair Value Hierarchy. Under ASC 820-10, we group assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:


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

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

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

7.	Fair Value Measurements (Cont,-)

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

Assets Measured at Fair Value on a Recurring Basis

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

Loans Held for Sale (LHFS). Effective December 1, 2011, the Company elected to measure new all newly originated mortgage loans held for sale LHFS at fair value. The remaining LHFS are carried at the lower of cost or market. Fair value is based on quoted market prices. We classify those loans subjected to recurring fair value adjustments as Level 2.

Mortgage Servicing Rights. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques that would incorporate assumptions that market participants would use in estimating the fair value of servicing. These assumptions might include estimates of prepayment speeds, discount rate, costs to service, escrow account earnings, contractual servicing fee income, prepayment and late fees, among other considerations. Mortgage servicing rights are considered a Level 3 measurement at September 30, 2012 and are included in other assets in the accompanying consolidated balance sheets.

Derivative assets and liabilities. The Company’s derivative assets and liabilities are carried at fair value as required by GAAP and are accounted for as free standing derivatives. The derivative assets are interest rate lock commitments (“IRLCs”) with prospective residential mortgage borrowers whereby the interest rate on the loan is determined prior to funding and the borrowers have locked in that interest rate. These commitments are determined to be derivative instruments in accordance with GAAP. The derivative liabilities are hedging instruments (typically TBA securities) used to hedge the risk of fair value changes associated with changes in interest rates relating to its mortgage loan origination operations. The Company hedges the period from the interest rate lock (assuming a fall-out factor) to the date of the loan sale. The estimated fair value is based on current market prices for similar instruments. Given the meaningful level of secondary market activity for derivative contracts, active pricing is available for similar assets and accordingly, the Company classifies its derivative assets and liabilities as a Level 2 measurement at September 30, 2012 and are included in other assets in the accompanying consolidated balance sheets.

The following tables shows the recorded amounts of assets measured at fair value on a recurring basis for the following periods:


	At September 30, 2012
	Total			Level 1		Level 2			Level 3
(Dollars in thousands)
Investment securities available for sale:
Mortgage backed securities issued by U.S. agencies	$	45,073			—	$	45,073			—
Collateralized mortgage obligations issued by non-agency		2,754			—		2,754			—
Asset backed securities		248			—		—			248
Mutual funds		4,459			4,459		—			—

Total securities available for sale at fair value		52,534			4,459		47,827			248
Loans held for sale		151,919			—		151,919			—
Mortgage servicing rights		1,365			—		—			1,365
Derivative assets – IRLC’s		3,686					3,686

Total assets measured at fair value on a recurring basis	$	209,504		$	4,459	$	203,432		$	1,613

Derivative liabilities – TBA securities	$	(2,745	)	$		$	(2,745	)	$

Total liabilities measured at fair value on a recurring basis	$	(2,745	)	$		$	(2,745	)	$


	At December 31, 2011
(Dollars in thousands)	Total		Level 1		Level 2		Level 3
Investment securities available for sale
Mortgage backed securities issued by U.S. agencies	$	134,126	$	—	$	134,126	$	—
Municipal securities		6,443		—		6,443		—
Collateralized mortgage obligations issued by non agency		2,585		—		1,930		655
Asset back securities		380		—		—		380
Mutual funds		4,375		4,375		—		—

Total securities available for sale at fair value		147,909		4,375		142,499		1,035
Loans held for sale		41,990		—		41,990		—
Derivative assets – IRLC’s		1,326				1,326

Total assets measured at fair value on recurring basis	$	191,225	$	4,375	$	185,815	$	1,035

The valuation technique used for Level 3 investment securities is a discounted cash flow. Inputs considered in determining Level 3 pricing include, the securities anticipated prepayment rates, default rates, and the loss severity given a future default. Significant increases or decreases in any of those inputs in isolation would result in a significantly lower or higher fair value measurement. In general, a change in the assumption regarding the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity in an event of default. These probabilities are then combined with correlation assumptions using a Monte Carlo simulation. The results from each simulation path are averaged to obtain a final fundamental value and loss estimate. Recovery rates and prepayment rates are assumed to be 0%. Prepayment rates are subject to change based on market conditions. There is a 50% asset correlation for issuers in the same industry and a 30% correlation for issuers in different industries.

The valuation technique used for Level 3 mortgage servicing rights is based upon market prices for similar instruments and an internal discounted cash flow model. The valuation model incorporates assumptions that market participants would use in estimating the fair value of servicing, the most significant of which include estimates of prepayment speeds of between 10% and 15%, and a discount rate of 12%. For mortgage servicing rights, a significant increase in discount rates would result in a significantly lower estimated fair value. The impact of changes in prepayment speeds would have differing impacts depending on the seniority or other characteristics of the instrument.

7.	Fair Value Measurements (Cont,-)

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


	Investment Securities Available for Sale
(Dollars in thousands)
Balance of recurring Level 3 instruments at January 1, 2012	$	1,035
Total gains or losses (realized/unrealized):
Included in earnings-realized		—
Included in earnings-unrealized⁽¹⁾		(77	)
Included in other comprehensive income		1,999
Purchases		—
Sales		—
Issuances		1,365
Settlements		—
Transfers in and/or out of Level 3		(2,709	)

Balance of Level 3 assets at September 30, 2012	$	1,615

(1)	Amount reported as other than temporary impairment loss in the noninterest income portion of the accompanying consolidated statement of operations.

Assets Recorded at Fair Value on a Nonrecurring Basis

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

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

Impaired Loans. ASC 820-10 applies to loans measured for impairment in accordance with ASC 310-10, Accounting by Creditors for Impairment of a Loan, including impaired loans measured at an observable market price (if available), and at the fair value of the loan’s collateral (if the loan is collateral dependent). The fair value of an impaired loan is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance for possible losses represent loans for which the fair value of the expected repayments or collateral exceeds the recorded investments in such loans. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the impaired loan at Level 2. When an appraised value is not available or we determine that the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the impaired loan at Level 3.

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

Loans Held for Sale. Mortgage loans held for sale and funded prior to December 1, 2011 are carried at the lower of cost or market value. The fair value of these loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics. As such, the Company classifies loans subjected to nonrecurring fair value adjustments as Level 2.

7.	Fair Value Measurements (Cont,-)

Information regarding assets measured at fair value on a nonrecurring basis is set forth in the table below.


	At September 30, 2012
	Total		Level 1		Level 2		Level 3
(Dollars in thousands)
Impaired loans	$	39,652	$	—	$	7,906	$	31,746
Loans held for sale not held at fair value		982		—		982		—
Other assets⁽¹⁾		30,177		—		30,177		—

Total	$	70,811	$	—	$	39,065	$	31,746

(1)	Includes foreclosed assets.

Fair value estimates are made at a discrete point in time based on relevant market information and other information about the financial instruments. Because no active market exists for a significant portion of our financial instruments, fair value estimates are based in large part on judgments we make primarily regarding current economic conditions, risk characteristics of various financial instruments, prepayment rates, and future expected loss experience. These estimates are subjective in nature and invariably involve some inherent uncertainties. Additionally unexpected changes in events or circumstances can occur that could require us to make changes to our assumptions and which, in turn, could significantly affect and require us to make changes to our previous estimates of fair value.

In addition, the fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of existing and anticipated future customer relationships and the value of assets and liabilities that are not considered financial instruments, such as premises and equipment and other real estate owned.

The following methods and assumptions were used to estimate the fair value of financial instruments.

Cash and Cash Equivalents. The fair value of cash and cash equivalents approximates its carrying value.

Interest-Bearing Deposits with Financial Institutions. The fair values of interest-bearing deposits maturing within ninety days approximate their carrying values.

Investment Securities Available for Sale. Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions.

Federal Home Loan Bank and Federal Reserve Bank Stock. The Bank is a member of the Federal Home Loan Bank (the “FHLB”) and the Federal Reserve Bank of San Francisco (the “FRB”). As members, we are required to own stock of the FHLB and the FRB, the amount of which is based primarily on the level of our borrowings from those institutions. We also have the right to acquire additional shares of stock in either or both of the FHLB and the FRB; however, to date, we have not done so. The fair values of that stock are equal to their respective carrying amounts, are classified as restricted securities and are periodically evaluated for impairment based on our assessment of the ultimate recoverability of our investments in that stock. Any cash or stock dividends paid to us on such stock are reported as income.

Loans Held for Sale (LHFS). Effective December 1, 2011, in connection with the adoption of ASU 825, The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115 (ASU 825), the Company elected to measure, at fair value, LHFS originated or acquired on or after December 1, 2011. The remaining LHFS are carried at the lower of cost or market value. Fair value is based on quoted market prices.

Loans. The fair value for loans with variable interest rates less a credit discount is the carrying amount. The fair value of fixed rate loans is derived by calculating the discounted value of future cash flows expected to be received by the various homogeneous categories of loans. All loans have been adjusted to reflect changes in credit risk. Changes are not recorded directly as an adjustment to current earnings or comprehensive income, but rather as an adjustment component in determining the overall adequacy of the loan loss reserve.

7.	Fair Value Measurements (Cont,-)

Impaired Loans. ASC 820-10 applies to loans measured for impairment in accordance with ASC 310-10, Accounting by Creditors for Impairment of a Loan, including impaired loans measured at an observable market price (if available), and at the fair value of the loan’s collateral (if the loan is collateral dependent) less selling cost. The fair value of an impaired loan is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance for possible losses represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the impaired loan at nonrecurring Level 2.

Foreclosed Assets. Foreclosed assets are adjusted to the lower of cost or fair value, less estimated costs to sell, at the time the loans are transferred to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value, less estimated costs to sell. Fair value is determined on the basis of independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral.

Derivative assets and liabilities (IRLC’s and TBA Securities). IRLC’s are interest rate lock commitments with prospective residential mortgage borrowers whereby the interest rate on the loan is determined prior to funding and the borrowers have locked in that interest rate. TBA’s are used to economically hedge the risk of fair value changes associated with changes in interest rates relating to its mortgage loan origination operations. The Company hedges the period from the interest rate lock (assuming a fall-out factor) to the date of the loan sale. The estimated fair value is based on current market prices for similar instruments.

Deposits. The fair value of demand deposits, savings deposits, and money market deposits is defined as the amounts payable on demand at quarter-end. The fair value of fixed maturity certificates of deposit is estimated based on the discounted value of the future cash flows expected to be paid on the deposits.

Borrowings. The fair value of borrowings is the carrying amount for those borrowings that mature on a daily basis. The fair value of term borrowings is derived by calculating the discounted value of future cash flows expected to be paid out by the Company.

Junior Subordinated Debentures. The fair value of the junior subordinated debentures is based on quoted market prices of the underlying securities. These securities are variable rate in nature and reprice quarterly.

Commitments to Extend Credit and Standby Letters of Credit. The fair value of commitments to extend credit and standby letters of credit, are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. These fees were not material in amount either at September 30, 2012, or December 31, 2011.

The estimated fair values and related carrying amounts of the Company’s financial instruments are as follows:


	September 30, 2012				December 31, 2011
(Dollars in thousands)	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
Financial Assets:
Cash and cash equivalents	$	137,736	$	137,736	$	96,467	$	96,467
Interest-bearing deposits with financial institutions		1,553		1,553		1,423		1,423
Federal Reserve Bank and Federal Home Loan Bank stock		10,324		10,324		11,154		11,154
Securities available for sale		52,534		52,534		147,909		147,909
Mortgage loans held for sale		151,919		151,919		66,230		66,230
Loans, net		680,151		676,080		641,962		626,227
IRLC’s		3,686		3,686		1,326		1,326
Financial Liabilities:
Noninterest bearing deposits		187,570		187,570		164,382		164,382
Interest-bearing deposits		692,624		693,696		697,665		698,797
Borrowings		60,000		60,217		49,000		58,409
Junior subordinated debentures		17,527		17,527		17,527		17,527
TBA securities		2,745		2,745		—		—

7.	Fair Value Measurements (Cont,-)

Fair Value Option. The following table reflects the differences between the fair value carrying amount of LHFS measured at fair value under ASU 825 and the aggregate unpaid principal amount we are contractually entitled to receive at maturity.


	September 30, 2012
(Dollars in thousands)	Fair Value Carrying Amount		Aggregate Unpaid Principal		Fair Value Carrying Amount Less Aggregate Unpaid Principal
Loans held for sale reported at fair value:
Total loans	$	150,937	$	142,695	$	8,242
Nonaccrual loans		—		—		—
Loans 90 days or more past due and still accruing		—		—		—

The assets accounted for under the fair value option are initially measured at fair value. Gains and losses from initial measurement and subsequent changes in fair value are recognized in earnings. The changes in fair value related to initial measurement and subsequent changes in fair value included in earnings for these assets measured at fair value are shown, by income statement line item, below.

Loans Held for Sale at Fair Value

Three Months Ended
September 30,

Nine Months Ended
September 30,

(Dollars in thousands)

2012

2011

2012

2011

Changes in fair value included in net income:

Mortgage banking noninterest income

2,264

—

8,616

—

The following table includes information for the derivative assets and liabilities for the periods presented:


			Total Gains (Losses)
	Notional Balance		For the Three Months Ended			For the Nine Months Ended
	September 30, 2012		September 30, 2012⁽¹⁾			September 30, 2012⁽¹⁾
Derivative assets - IRLC’s	$	94,866	$	1,086		$	3,650
Derivative liabilities - TBAs		146,015		(3,200	)		(4,542	)

(1)	Amounts included in noninterest income – mortgage banking, within the accompanying consolidated statements of income.

8.	Investment Securities Available For Sale

The following table sets forth the major components of securities available for sale and compares the amortized costs and estimated fair market values of, and the gross unrealized gains and losses on, these securities at September 30, 2012 and December 31, 2011:


(Dollars in thousands)	Amortized Cost		Gross Unrealized Gain		Gross Unrealized Loss			Estimated Fair Value
Securities available for sale at September 30, 2012:
Mortgage backed securities issued by U.S. agencies⁽¹⁾	$	44,289	$	785	$	(1	)	$	45,073
Municipal securities		—		—		—			—
Collateralized non-agency mortgage obligations⁽¹⁾		2,708		76		(30	)		2,754
Asset backed securities⁽²⁾		2,247		—		(1,999	)		248
Mutual funds⁽³⁾		4,459		—		—			4,459

Total securities available for sale	$	53,703	$	861	$	(2,030	)	$	52,534

Securities available for sale at December 31, 2011:
Mortgage-backed securities issued by U.S. agencies⁽¹⁾	$	133,859	$	630	$	(363	)	$	134,126
Municipal securities		6,389		96		(42	)		6,443
Collateralized non-agency mortgage obligations⁽¹⁾		3,040		—		(455	)		2,585
Asset backed securities⁽²⁾		2,324		—		(1,944	)		380
Mutual funds⁽³⁾		4,375		—		—			4,375

Total securities available for sale	$	149,987	$	726	$	(2,804	)	$	147,909

(1)	Secured by closed-end first lien 1-4 family residential mortgages.

(2)	Comprised of a security that represents an interest in a pool of trust preferred securities issued by U.S.-based banks and insurance companies

(3)	Consists primarily of mutual fund investments in closed-end first lien 1-4 family residential mortgages.

8.	Investment Securities Available For Sale (Cont,-)

At September 30, 2012 and December 31, 2011, U.S. agencies/mortgage backed securities and collateralized mortgage obligations with an aggregate fair market value of $9 million and $12 million, respectively, were pledged to secure Federal Home Loan Bank borrowings, repurchase agreements, local agency deposits and Treasury, tax and loan accounts.

The amortized cost and estimated fair values of securities available for sale at September 30, 2012 and December 31, 2011, are shown in the table below by contractual maturities and historical prepayments based on the prior twelve months of principal payments. Expected maturities will differ from contractual maturities and historical prepayments, particularly with respect to collateralized mortgage obligations, primarily because prepayment rates are affected by changes in conditions in the interest rate market and, therefore, future prepayment rates may differ from historical prepayment rates.


	At September 30, 2012 Maturing in
(Dollars in thousands)	One year or less			Over one year through five years			Over five years through ten years			Over ten Years			Total
Securities available for sale, amortized cost	$	5,091		$	19,586		$	16,253		$	12,773		$	53,703
Securities available for sale, estimated fair value		5,148			19,885			16,556			10,945			52,534
Weighted average yield		1.85	%		1.91	%		1.84	%		1.87	%		1.87	%

	At December 31, 2011 Maturing in
(Dollars in thousands)	One year or less			Over one year through five years			Over five years through ten years			Over ten Years			Total
Securities available for sale, amortized cost	$	13,443		$	44,574		$	38,950		$	53,020		$	149,987
Securities available for sale, estimated fair value		13,388			44,353			39,087			51,081			147,909
Weighted average yield		2.15	%		2.32	%		2.43	%		2.48	%		2.39	%

The Company recognized net gains on sales of securities available for sale of $1.4 million, net of $730,000 of taxes, on sale proceeds of $186 million during the nine months ended September 30, 2012 and $336,000, net of $69,000 of taxes, on sale proceeds of $96 million during the nine months ended September 30, 2011.

The table below indicates, as of September 30, 2012, the gross unrealized losses and fair values of our investments, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position.


	Securities with Unrealized Loss at September 30, 2012
	Less than 12 months				12 months or more					Total
Dollars in thousands	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
Mortgage backed securities issued by U.S. agencies		—		—		39		(1	)		39		(1	)
Municipal securities		—		—		—		—			—		—
Collateralized non-agency mortgage obligations		—		—		1,251		(30	)		1,251		(30	)
Asset backed securities		—		—		248		(1,999	)		248		(1,999	)

Total temporarily impaired securities	$	—	$	—	$	1,538	$	(2,030	)	$	1,538	$	(2,030	)

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

8.	Investment Securities Available For Sale (Cont,-)

We recognize other-than-temporary impairments (“OTTI”) for our available-for-sale debt securities in accordance with ASC 320-10. When there are credit losses associated with an impaired debt security, but we have no intention to sell, and it is more likely than not that we will not have to sell the security before recovery of its cost basis, we will separate the amount of impairment, or OTTI, between the amount that is credit related and the amount that is related to non-credit factors. Credit-related impairments are recognized in our consolidated statements of operations. Any non-credit-related impairments are recognized and reflected in other comprehensive income (loss).

Through the impairment assessment process, we determined that the available-for-sale securities discussed below were other-than-temporarily impaired at September 30, 2012. We recorded no impairments of credit losses on available-for-sale securities in our consolidated statement of income in the three month period ended September 30, 2012. The OTTI related to factors other than credit losses, in the aggregate amount of $1.9 million, was recognized as other comprehensive loss in our balance sheet at September 30, 2012.

The table below presents a roll-forward of OTTI where a portion attributable to non-credit related factors was recognized in other comprehensive loss for the nine months ended September 30, 2012:


(Dollars in thousands)	Gross Other- Than- Temporary Impairments			Other-Than- Temporary Impairments Included in Other Comprehensive Loss			Net Other-Than Temporary Impairments Included in Retained Earnings
Balance – June 30, 2012	$	(2,752	)	$	(2,021	)	$	(731	)
Additions for credit losses on securities for which an OTTI was not previously recognized		93			93			—

Balance – September 30, 2012	$	(2,659	)	$	(1,928	)	$	(731	)

In determining the component of OTTI related to credit losses, we compare the amortized cost basis of each OTTI security to the present value of its expected cash flows, discounted using the effective interest rate implicit in the security at the date of acquisition.

As a part of our OTTI assessment process with respect to securities held for sale with unrealized losses, we consider available information about (i) the performance of the collateral underlying each such security, including credit enhancements, (ii) historical prepayment speeds, (iii) delinquency and default rates, (iv) loss severities, (v) the age or “vintage” of the security, and (vi) rating agency reports on the security. Significant judgments are required with respect to these and other factors when making a determination of the future cash flows that can be expected to be generated by the security.

Based on our OTTI assessment process, we determined that there was one investment security, an asset backed security, in our portfolio of securities held for sale that had become or was impaired as of September 30, 2012.

Asset-Backed Security. At September 30, 2012, we had one impaired asset backed security in our portfolio of available for sale investment securities. We purchased $3.0 million face value of this security in November 2007 at a price of 95.21% for a total purchase price of $2,856,420. This security is a multi-class, cash flow collateralized bond obligation backed by a pool of trust preferred securities issued by a diversified pool of 56 issuers which consisted of 45 U.S. depository institutions and 11 insurance companies at the time of the security’s issuance in November 2007. This security was part of a $363 million issuance. The security that we own (CUSIP 74042CAE8) in the mezzanine class B piece security had a variable interest rate of 3 month LIBOR +60 basis points and a rating of Aa2/AA by Moody’s and Fitch at the time of issuance.

8.	Investment Securities Available For Sale (Cont,-)

As of September 30, 2012 the amortized cost of this security was $2.2 million with a fair value of $248,000 for an approximate unrealized loss of $2.0 million. Currently, the security has a Ca rating from Moody’s and CC rating from Fitch and has experienced $47.5 million in defaults (13.2% of total current collateral) and $43.5 million in payment deferrals (12.1% of total current collateral) from issuance to September 30, 2012. Since September 30, 2010, the security has not paid its scheduled quarterly interest payment, and the Company has not accrued interest on this security. The Company estimates that the security could experience another $74 million in defaults before we would not receive all of its contractual cash flows. This analysis is based on the following assumptions: future default rates of 2.3%, prepayment rates of 1% until maturity, and 15% recovery of future defaults. We have recognized no impairment losses in earnings with respect to this security for the three months ended September 30, 2012 and $77,000 for the nine months ended September 30, 2011.

We have made a determination that the remainder of our securities with respect to which there were unrealized losses as of September 30, 2012 are not other-than-temporarily impaired, because we have concluded that we have the ability to continue to hold those securities until their respective fair market values increase above their respective amortized costs or, if necessary, until their respective maturities. In reaching that conclusion we considered a number of factors and other information, which included: (i) the significance of each such security, (ii) the amount of the unrealized losses attributable to each such security, (iii) our liquidity position, (iv) the impact that retention of those securities could have on our capital position and (v) our evaluation of the expected future performance of these securities (based on the criteria discussed above).

Impairment Losses on OTTI Securities


	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
	(Dollars in thousands)
Asset Backed Security	$	—	$	54	$	77	$	169

Total impairment loss recognized in earnings	$	—	$	54	$	77	$	169

9.	Loans and Allowance for Loan Losses

The composition of the Company’s loan portfolio as of September 30, 2012 and December 31, 2011 was as follows:


	September 30, 2012						December 31, 2011
(Dollars in thousands)	Amount			Percent			Amount			Percent
Commercial loans	$	170,894			24.6	%	$	179,305			27.2	%
Commercial real estate loans – owner occupied		150,968			21.8	%		170,960			26.0	%
Commercial real estate loans – all other		157,384			22.7	%		121,813			18.5	%
Residential mortgage loans – multi-family		68,753			9.9	%		65,545			10.0	%
Residential mortgage loans – single family		90,400			13.0	%		68,613			10.4	%
Construction loans		—			—	%		2,047			0.3	%
Land development loans		26,727			3.9	%		25,638			3.9	%
Consumer loans		28,262			4.1	%		24,358			3.7	%

Gross loans		693,388			100.0	%		658,279			100.0	%

Deferred fee (income) costs, net		(578	)					(690	)
Allowance for loan losses		(12,659	)					(15,627	)

Loans, net	$	680,151					$	641,962

At September 30, 2012 and December 31, 2011, real estate loans of approximately $164 million and $161 million, respectively, were pledged to secure borrowings obtained from the Federal Home Loan Bank.

Allowance for Loan Losses

The allowance for loan losses (“ALL”) represents our estimate of credit losses inherent in the loan portfolio at the balance sheet date. We employ economic models that are based on bank regulatory guidelines, industry standards and our own historical loan loss experience, as well as a number of more subjective qualitative factors, to determine both the sufficiency of the ALL and the amount of the provisions that are required to be made for potential loan losses.

The ALL is first determined by analyzing all classified loans (graded as “Substandard” or “Doubtful” under our internal credit quality grading parameters—see below) on non-accrual status for loss exposure and establishing specific reserves as needed. ASC 310-10 defines loan impairment as the existence of uncertainty concerning collection of all principal and interest in accordance with the contractual terms of a loan. For collateral dependent loans, impairment is typically measured by comparing the loan amount to the fair value of collateral, less closing costs to sell, with a specific reserve established for the “shortfall” amount. Other methods can be used in estimating impairment, including market price and the present value of expected future cash flows discounted at the loan’s original interest rate.

On a quarterly basis, we utilize a classification migration model and individual loan review analytical tools as starting points for determining the adequacy of the ALL for homogenous pools of loans that are not subject to specific reserve allocations. Our loss migration analysis tracks a certain number of quarters of loan loss history and industry loss factors to determine historical losses by classification category for each loan type, except certain consumer loans. We then apply these calculated loss factors, together with a qualitative factor based on external economic factors and internal assessments, to the outstanding loan balances in each homogenous group of loans, and then, using our internal credit quality grading parameters, we grade the loans as “Pass,” “Special Mention,” “Substandard” or “Doubtful”. We also conduct individual loan review analysis, as part of the allowance for loan losses allocation process, applying specific monitoring policies and procedures in analyzing the existing loan portfolios. Set forth below is a summary of the activity in the ALL during the following periods:


	Three Months Ended September 30, 2012			Nine Months Ended September 30, 2012			Year Ended December 31, 2011
	(Dollars in thousands)
Balance, beginning of period	$	14,648		$	15,627		$	18,101
Charged off loans		(4,003	)		(6,664	)		(2,736	)
Recoveries on loans previously charged off		1,514			1,746			1,095
Provision for loan losses		500			1,950			(833	)

Balance, end of period	$	12,659		$	12,659		$	15,627

9.	Loans and Allowance for Loan Losses (Cont,-)

Set forth below is information regarding loan balances and the related allowance for loan losses, by portfolio type, for the nine months ended September 30, 2012 and the year ended December 31, 2011.


(Dollars in thousands)	Commercial			Real Estate			Construction and Land Development			Consumer and Single Family Mortgages			Total
Nine Months Ended September 30, 2012
Allowance for loan losses:
Balance at beginning of period	$	8,908		$	5,777		$	316		$	626		$	15,627
Charge offs		(5,052	)		(1,126	)		(158	)		(328	)		(6,664	)
Recoveries		1,533			196			0			17			1,746
Provision		333			678			594			345			1,950

Balance at end of period	$	5,722		$	5,525		$	752		$	660		$	12,659

Three Months Ended September 30, 2012
Allowance for loan losses:
Balance at beginning of period	$	8,408		$	4,904		$	726		$	610		$	14,648
Charge offs		(2,597	)		(1,126	)		(78	)		(202	)		(4,003	)
Recoveries		1,312			194			—			8			1,514
Provision		(1,401	)		1,553			104			244			500

Balance at end of period	$	5,722		$	5,525		$	752		$	660		$	12,659

Allowance balance at September 30, 2012 related to:
Loans individually evaluated for impairment	$	3,057		$	—		$	—		$	—		$	3,057

Loans collectively evaluated for impairment	$	2,665		$	5,525		$	752		$	660		$	9,602

Loans balance at September 30, 2012:
Loans individually evaluated for impairment	$	11,569		$	25,825		$	314		$	729		$	38,437
Loans collectively evaluated for impairment		159,325			351,280			26,413			117,933			654,951

Ending Balance	$	170,894		$	377,105		$	26,727		$	118,662		$	693,388

December 31, 2011
Allowance for loan losses:
Balance at beginning of year	$	10,017		$	6,351		$	830		$	903		$	18,101
Charge offs		(1,218	)		(1,315	)		(138	)		(65	)		(2,736	)
Recoveries		1,067			3			—			25			1,095
Provision		(958	)		738			(376	)		(237	)		(833	)

Balance at end of year	$	8,908		$	5,777		$	316		$	626		$	15,627

Allowance balance at end of year related to:
Loans individually evaluated for impairment	$	1,648		$	1,135		$	—		$	—		$	2,783

Loans collectively evaluated for impairment	$	7,260		$	4,642		$	316		$	626		$	12,844

Loans balance at end of year:
Loans individually evaluated for impairment	$	5,140		$	10,088		$	2,597		$	570		$	18,395
Loans collectively evaluated for impairment		174,165			348,230			25,088			92,401			639,884

Ending Balance	$	179,305		$	358,318		$	27,685		$	92,971		$	658,279

9.	Loans and Allowance for Loan Losses (Cont,-)

Credit Quality

The quality of the loans in the Company’s loan portfolio is assessed as a function of net credit losses and the amounts of the nonperforming assets and delinquencies that occur within our loan portfolio. These factors are an important part of our overall credit risk management process and our evaluation of the adequacy of the ALL.

The following table provides a summary of the delinquency status of loans by portfolio type:


(Dollars in thousands)	30-59 Days Past Due		60-89 Days Past Due		90 Days and Greater		Total Past Due		Current		Total Loans Outstanding		Loans >90 Days and Accruing
September 30, 2012
Commercial loans	$	92	$	517	$	4,727	$	5,336	$	165,558	$	170,894	$	—
Commercial real estate loans – owner-occupied		—		—		3,863		3,863		147,105		150,968		—
Commercial real estate loans – all other		—		428		—		428		156,956		157,384		—
Residential mortgage loans – multi-family		—		—		—		—		68,753		68,753		—
Residential mortgage loans – single family		—		1,237		348		1,585		88,815		90,400		—
Construction loans		—		—		—				—		—		—
Land development loans		350		314		—		664		26,063		26,727		—
Consumer loans		5		—		—		5		28,257		28,262		—

Total	$	447	$	2,496	$	8,938		11,881	$	681,507	$	693,388	$	—

December 31, 2011
Commercial loans	$	1,877	$	159	$	2,021	$	4,057	$	175,248	$	179,305	$	—
Commercial real estate loans – owner occupied		—		2,016		—		2,016		168,944		170,960		—
Commercial real estate loans – all other		—		—		—		—		121,813		121,813		—
Residential mortgage loans – multi-family		—		859		—		859		64,686		65,545		—
Residential mortgage loans – single family		80		1,050		492		1,622		66,991		68,613		—
Construction loans		—		—		2,047		2,047		—		2,047		—
Land development loans		—		—		550		550		25,088		25,638		—
Consumer loans		—		—		—		—		24,358		24,358		—

Total	$	1,957	$	4,084	$	5,110	$	11,151	$	647,128	$	658,279	$	—

As the above table indicates, total past due loans increased by $730,000, to $11.9 million at September 30, 2012, from $11.2 million at December 31, 2011. Loans past due 90 days or more increased by $3.8 million, to $8.9 million at September 30, 2012, from $5.1 million at December 31, 2011 primarily due to (i) a $2.7 million increase in past due commercial loans as a result of a bankruptcy filing by the borrower, and (ii) a $3.9 million increase in past due owner-occupied commercial real estate loans to three borrowers, partially offset by the foreclosure of the property securing a $2.0 million construction loan, which resulted in the transfer of that loan to other real estate owned. These loans are in various stages of collection and the adequacy of the collateral securing the repayment of and the prospects for recoveries on these loans are reflected in the allowance for loan losses at September 30, 2012.

Between December 31, 2011 and September 30, 2012, loans 30-89 days past due decreased by $3.1 million, primarily as a result of the payoff of a $1.4 million commercial loan by a borrower who also brought all payments current on $2.4 million of additional commercial loans.

9.	Loans and Allowance for Loan Losses (Cont,-)

Generally, the accrual of interest on a loan is discontinued when principal or interest payments become more than 90 days past due, unless management believes the loan is adequately collateralized and it is in the process of collection. There were no loans 90 days or more past due and still accruing interest at September 30, 2012 or December 31, 2011. In certain instances, when a loan is placed on non-accrual status, previously accrued but unpaid interest is reversed against current income. Subsequent collections of cash are applied as principal reductions when received, except when the ultimate collectability of principal is probable, in which case payments are applied to accrued and unpaid interest, which is credited to income. Non-accrual loans may be restored to accrual status when principal and interest become current and full repayment is expected.

The following table provides information, as of September 30, 2012 and December 31, 2011, with respect to loans on nonaccrual status, by portfolio type:


	September 30, 2012		December 31, 2011
	(Dollars in thousands)
Nonaccrual loans:
Commercial loans	$	7,240	$	4,702
Commercial real estate loans – owner occupied		3,863		2,016
Commercial real estate loans – all other		4,290		4,214
Residential mortgage loans – single family		791		570
Construction loans		—		2,047
Land development loans		314		550
Consumer loans		—		—

Total	$	16,498	$	14,099

As the above table indicates, at September 30, 2012, nonaccrual loans increased by $2.4 million to $16.5 million from $14.1 million at December 31, 2011 primarily due to the bankruptcy filing by a borrower with a $2.7 million loan commercial loan relationship and a commercial real estate property of $1.9 million in the third quarter of 2012, substantially offset by the foreclosure and transfer of a $2.0 million construction loan to other real estate owned in the first quarter of 2012.

9.	Loans and Allowance for Loan Losses (Cont,-)

The Company classifies its loan portfolio using internal credit quality ratings. The following table provides a summary of loans by portfolio type and the Company’s internal credit quality ratings as of September 30, 2012 and December 31, 2011, respectively.


(Dollars in thousands)	September 30, 2012		December 31, 2011		Increase (Decrease)
Pass:
Commercial loans	$	145,758	$	149,522		(3,764	)
Commercial real estate loans – owner occupied		137,459		148,380		(10,921	)
Commercial real estate loans – all other		132,163		109,482		22,681
Residential mortgage loans – multi family		68,372		61,190		7,182
Residential mortgage loans – single family		87,541		66,631		20,910
Construction loans		—		—		—
Land development loans		11,953		16,758		(4,805	)
Consumer loans		28,262		24,358		3,904

Total pass loans	$	611,508	$	576,321	$	35,187

Special Mention:
Commercial loans	$	8,014	$	4,570	$	3,444
Commercial real estate loans – owner occupied		—		6,826		(6,826	)
Commercial real estate loans – all other		6,059		2,553		3,506
Residential mortgage loans – multi family		381		3,316		(2,935	)
Residential mortgage loans – single family		—		1,014		(1,014	)
Construction loans		—		—		—
Land development loans		8,215		8,330		(115	)
Consumer loans		—		—		—

Total special mention loans	$	22,669	$	26,609	$	(3,940	)

Substandard:
Commercial loans	$	16,898	$	24,551	$	(7,653	)
Commercial real estate loans – owner occupied		13,509		15,754		(2,245	)
Commercial real estate loans – all other		19,162		9,778		9,384
Residential mortgage loans – multi family		—		1,039		(1,039	)
Residential mortgage loans – single family		2,859		968		1,891
Construction loans		—		2,047		(2,047	)
Land development loans		6,559		550		6,009
Consumer loans		—		—		—

Total substandard loans	$	58,987	$	54,687	$	4,300

Doubtful:
Commercial loans	$	224	$	662	$	(438	)
Commercial real estate loans – owner occupied		—		—		—
Commercial real estate loans – all other		—		—		—
Residential mortgage loans – multi family		—		—		—
Residential mortgage loans – single family		—		—		—
Construction loans		—		—		—
Land development loans		—		—		—
Consumer loans		—		—		—

Total doubtful loans	$	224	$	662	$	(438	)

Total Outstanding Loans, gross:	$	693,388	$	658,279	$	35,109

9.	Loans and Allowance for Loan Losses (Cont,-)

As the above table indicates, the Company’s total loans approximated $693 million at September 30, 2012, an increase of $35 million from $658 million at December 31, 2011. The disaggregation of the portfolio by risk rating in the table above reflects the following changes between December 31, 2011 and September 30, 2012:

•

Loans rated “pass” increased $35 million to $611 million at September 30, 2012 from $576 million at December 31, 2011, due primarily to the $35 million increase in total loans outstanding.

•

The loans rated “special mention” decreased $3.9 million to $22.7 million at September 30, 2012 from $26.6 million at year end 2011. The decrease was primarily the result of downgrades to “substandard”.

•

Loans classified “substandard” increased $4.3 million to $59.0 million at September 30, 2012, from $54.7 million at December 31, 2011, due primarily to net transfers from “special mention”.

•

A $224,000 commercial loan is classified as “doubtful” at September 30, 2012. The doubtful category declined $438,000 from the end of the year 2011.

The ALL at September 30, 2012, totaled approximately $12.7 million, or 1.83% of the loans then outstanding. The loan portfolio stood at $693 million, a decrease of $15 million from $708 million at June 30, 2012. This decrease was attributable to principal pay downs of $10 million in loans classified substandard or doubtful and $7 million of loans (gross before $1.7 million write down) transferred to held for sale. The decrease in loans classified substandard or doubtful is attributable to negotiated settlements with problem borrowers to pay off or reduce loan balances and/or provide additional collateral to adequately collateralize outstanding position(s). At September 30, 2012, the ALL was $1.9 million and $2.9 million lower than the ALL at June 30, 2012 and December 31, 2011, respectively.

Impaired Loans

A loan is generally classified as impaired and placed on nonaccrual status when, in management’s judgment, the principal or interest will not be collectible in accordance with the contractual terms of the loan agreement. The Company measures and reserves for impairment on a loan-by-loan basis, using either the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if the loan is collateral dependent.

The following table sets forth information regarding nonaccrual loans and restructured loans, at September 30, 2012 and December 31, 2011:


(Dollars in thousands)	September 30, 2012		December 31, 2011
Impaired loans:
Nonaccruing loans	$	10,786	$	9,885
Nonaccruing restructured loans		5,712		4,214
Accruing restructured loans		22,531		—
Accruing impaired loans		357		4,296

Total impaired loans	$	39,386	$	18,395

Impaired loans less than 90 days delinquent and included in total impaired loans	$	30,008	$	13,285

The increase of $21.0 million in impaired loans to $39.4 million at September 30, 2012, from $18.4 million at December 31, 2011, was primarily attributable to $22.5 million in accruing restructured loans, made during the nine months ended September 30, 2012 to a number of large relationships performing at modified terms, which included lower interest rates, deferred payments, or modified payment terms.

9.	Loans and Allowance for Loan Losses (Cont,-)

Based on an SFAS 114 analysis, using the current fair value of the collateral or the discounted present value of the future cash flows of the accruing restructured loans, we concluded that those loans were well secured and adequately collateralized as of September 30, 2012.

The tables that follow contain additional information with respect to impaired loans, by portfolio type, at September 30, 2012 and December 31, 2011:


	Recorded Investment		Unpaid Principal Balance		Related Allowance⁽¹⁾		Average Recorded Investment		Interest Income Recognized
(Dollars in thousands)
September 30, 2012
With no related allowance recorded:
Commercial loans	$	5,508	$	7,657	$	—	$	5,196	$	70
Commercial real estate loans – owner occupied		5,283		5,549		—		5,319		104
Commercial real estate loans – all other		20,099		20,103		—		6,598		632
Residential mortgage loans – multi-family		—		—		—		45		—
Residential mortgage loans – single family		791		905		—		983		12
Construction loans		—		—		—		512		—
Land development loans		314		318		—		483		13
Consumer loans		—		—		—		—		—
With an allowance recorded:
Commercial loans	$	7,391	$	7,459	$	3,057	$	6,752	$	200
Commercial real estate loans – owner occupied		—		—		—		504		—
Commercial real estate loans – all other		—		—		—		3,107		—
Residential mortgage loans – multi-family		—		—		—		45		—
Residential mortgage loans – single family		—		—		—		—		—
Construction loans		—		—		—		—		—
Land development loans		—		—		—		—		—
Consumer loans		—		—		—		—		—
Total:
Commercial loans	$	12,899	$	15,116	$	3,057	$	11,948	$	270
Commercial real estate loans – owner occupied		5,283		5,549		—		5,823		104
Commercial real estate loans – all other		20,099		20,103		—		9,705		632
Residential mortgage loans – multi-family		—		—		—		90		—
Residential mortgage loans – single family		791		905		—		983		12
Construction loans		—		—		—		512		—
Land development loans		314		318		—		483		13
Consumer loans		—		—		—		—		—

9.	Loans and Allowance for Loan Losses (Cont,-)


	Recorded Investment		Unpaid Principal Balance		Related Allowance⁽¹⁾		Average Recorded Investment		Interest Income Recognized
(Dollars in thousands)
December 31, 2011
With no related allowance recorded:
Commercial loans	$	1,636	$	2,361	$	—	$	1,395	$	38
Commercial real estate loans – owner occupied		3,583		3,583		—		4,621		340
Commercial real estate loans – all other		96		96		—		3,420		3
Residential mortgage loans – multi-family		—		—		—		—		—
Residential mortgage loans – single family		570		581		—		790		15
Construction loans		2,047		2,215		—		621		—
Land development loans		550		554		—		632		11
Consumer loans		—		—		—		32		—
With an allowance recorded:
Commercial loans	$	3,503	$	3,527	$	1,648	$	1,722	$	203
Commercial real estate loans – owner occupied		2,016		2,016		659		3,015		48
Commercial real estate loans – all other		4,214		4,818		347		9,281		—
Residential mortgage loans – multi-family		180		180		129		45		14
Residential mortgage loans – single family		—		—		—		273		—
Construction loans		—		—		—		1,604		—
Land development loans		—		—		—		—		—
Consumer loans		—		—		—		—		—
2011 Total:
Commercial loans	$	5,139	$	5,888	$	1,648	$	3,117	$	241
Commercial real estate loans – owner occupied		5,599		5,599		659		7,636		388
Commercial real estate loans – all other		4,310		4,914		347		12,701		3
Residential mortgage loans – multi-family		180		180		129		45		14
Residential mortgage loans – single family		570		581		—		1,063		15
Construction loans		2,047		2,215		—		2,225		—
Land development loans		550		554		—		632		11
Consumer loans		—		—		—		32		—

(1)

If the discounted cash flows expected to be generated by a loan, or the collateral value or market price of collateral securing the loan equals or exceeds the recorded investment in the loan, then there is no further need to maintain reserves for the loan. This typically occurs when an impaired loan has been partially charged-off and/or payments are received and applied to the loan balance.

The allowance for loan losses at September 30, 2012 included $3.1 million of reserves for $39 million of impaired loans, as compared to $2.8 million of reserves for $18.4 million of impaired loans at December 31, 2011. At September 30, 2012 and December 31, 2011 there were impaired loans of $32 million and $8.5 million, respectively, to which no specific reserves had been allocated because these loans, in our judgment, were sufficiently collateralized. Of the impaired loans at September 30, 2012 for which no specific reserves were allocated, $25 million had been deemed impaired in prior quarters and the deficiency was charged off during the quarter the loans were deemed impaired.

We had average investments in impaired loans of $29.5 million and $27.5 million for the three and nine month periods ended September 30, 2012 and December 31, 2011, respectively. The interest that would have been earned, during the three and nine months ended September 30, 2012 had the impaired loans remained current in accordance with their original terms was $253,000 and $441,000, respectively.

9.	Loans and Allowance for Loan Losses (Cont,-)

Troubled Debt Restructurings

Pursuant to FASB’s Accounting Standard Update No. 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring (“ASU No. 2011-02”), the Bank’s troubled debt restructured loans (“TDRs”) totaled $28.2 million as of September 30, 2012, as compared to $4.2 million as of December 31, 2011. The restructured loans represent modifications for the purpose of alleviating temporary impairments to the borrowers’ financial condition. The modifications that we have extended to borrowers have come in the forms of changes in amortization terms, reductions in interest rates, interest only payments and, in limited cases, concessions to outstanding loan balances. The workout plans we enter into with the borrowers are designed to provide a bridge for cash flow shortfalls in the near term. If a borrower works through the near term issues, then in most cases, the original contractual terms of the borrower’s loan will be reinstated.

As of September 30, 2012, troubled debt restructurings (“TDR’s”) totaled $28.2 million, of which $22.5 were performing in accordance with their terms and accruing interest, and $5.7 million were not performing in accordance with their terms. The performing TDR’s increased by $6.3 million to $22.5 million at September 30, 2012 compared to $16.2 million at June 30, 2012, primarily due to interest rate modifications made with respect to two investment related commercial real estate secured loans. We carried $2.6 million of specific reserves pertaining to the performing TDR’s as of September 30, 2012. There were no performing TDR’s at December 31, 2011. Nonperforming TDR’s decreased approximately $500,000 to $5.7 million at September 30, 2012 from $6.2 million at June 30, 2012. The nonperforming TDR’s have increased by $1.5 million from December 31, 2011. As of September 30, 2012, we carried $500,000 of specific reserves pertaining to nonperforming TDR’s. The modified loans are all classified as “substandard” as of September 30, 2012.


	September 30, 2012
(Dollars in thousands)	Number of Loans		Pre- Modification Outstanding Recorded Investment		Post Modification Outstanding Recorded Investment		End of Period Balance
Performing
Commercial loans		4	$	5,318	$	5,318	$	5,302
Commercial real estate – all other		5		15,833		15,833		15,809
Land development loans		1		1,429		1,429		1,420

		10		22,580		22,580		22,531
Nonperforming
Commercial loans		3		1,943		1,855		1,788
Commercial real estate – all other		2		6,814		6,685		3,862
Residential mortgage loans – single family		1		171		64		62

		6		8,928		8,604		5,712

Total Troubled Debt Restructurings		16	$	31,508	$	31,184	$	28,243


	December 31, 2011
	Number of loans		Pre- Modification Outstanding Recorded Investment		Post Modification Outstanding Recorded Investment		End of Period Balance
Nonperforming
Commercial real estate-all other		1		4,942		4,818		4,214

Total troubled debt restructurings		1	$	4,942	$	4,818	$	4,214

10.

Shareholder’s Equity

We sold a total of 126,500 shares of a new issue of Series A Convertible Preferred Shares (the “Series A Shares”), at a price of $100 per share in cash, to a limited number of accredited investors in a private placement that commenced in November 2009 and was completed in August 2010. The gross proceeds from that private placement totaled $12,655,000. The holders of 115,500 of those Series A Shares converted those shares, at $7.65 per common share, into a total of 1,510,238 shares of our common stock in the third quarter of 2011. At the same time we issued to those Series A holders a total of 328,100 additional shares of common stock in lieu of the payment of undeclared dividends that had accumulated on those Shares.

In January 2012, the remaining 11,000 outstanding shares of Series A Shares were converted, at a conversion price of $7.65, into a total of 143,790 shares of our common stock. At the same time we issued to the holders of those Series A Shares a total of 37,272 additional shares of common stock in lieu of undeclared dividends that had accumulated on their Series A Shares.

On August 26, 2011, we sold to three institutional investors a total of 112,000 shares of a newly created Series B Convertible 8.4% Noncumulative Preferred Stock (the “Series B Shares”), at a price of $100.00 per share in cash, generating aggregate gross proceeds for us of $11.2 million.

On April 20, 2012 we sold to two institutional investors a total of 4,201,278 shares of our common stock at $6.26 per share in cash, generating aggregate gross proceeds for us of $26.3 million.

The dividend provisions of the Series B Shares provide that if we are not permitted, under applicable law or due to regulatory restrictions, to pay cash dividends on the Series B Shares for two semi-annual dividend periods, then we will issue shares of our Series C 8.4% non-convertible Preferred Stock (the “Series C Shares”) in lieu of such cash dividends. For this purpose the issue price of each such Series C Share is $100. During the third quarter of 2012, we issued 8,100 Series C Shares in lieu of undeclared dividends accumulated on the Series B Shares to June 30, 2012.

11.

Business Segment Information

We have two reportable business segments, commercial banking and mortgage banking, the latter of which began operations in the second quarter of 2009. Our commercial banking segment provides small and medium-size businesses, professional firms and individuals with a diversified range of products and services, such as various types of deposit accounts, various types of commercial and consumer loans, cash management services, and online banking services. Our mortgage banking segment originates mortgage loans that, for the most part, are resold within 30 days to long-term investors in the secondary residential mortgage market.

Since these operating segments derive all of their revenues from interest and noninterest income and interest expense constitutes their most significant expense, these two segments are reported below using net interest income (interest income less interest expense) and noninterest income (primarily net gains on sales of loans held for sale and fee income). We do not allocate general and administrative expenses or income taxes to our operating segments.

The following table sets forth information regarding the interest income and noninterest income of our commercial banking and mortgage banking segments, respectively, for the three and nine months ended September, 2012 and 2011.


(Dollars in thousands)	Commercial		Mortgage		Other			Total
Net interest income for the three months ended September 30:
2012	$	8,054	$	1,308	$	(103	)	$	9,259
2011	$	7,918	$	379	$	(117	)	$	8,180
Net interest income for the nine months ended September 30:
2012	$	22,754	$	2,997	$	(333	)	$	25,418
2011	$	24,761	$	955	$	(338	)	$	25,378
Noninterest income for the three months ended September 30:
2012	$	784	$	9,167	$	—		$	9,951
2011	$	1,678	$	545	$	—		$	2,223
Noninterest income for the nine months ended September 30
2012	$	2,957	$	22,148	$	—		$	25,105
2011	$	4,498	$	941	$	—		$	5,439
Segment Assets at:
September 30, 2012	$	888,432	$	195,375	$	14,063		$	1,097,870
December 31, 2011	$	934,568	$	85,483	$	4,501		$	1,024,552

ITEM 2.

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

Introduction

Pacific Mercantile Bancorp is a bank holding company (the “Company”) which owns all of the stock of Pacific Mercantile Bank (the “Bank”), which is a commercial bank that provides a full range of banking services to small and medium-size businesses and to professionals and the general public in Orange, Los Angeles, San Bernardino and San Diego counties, in Southern California. The Bank also operates a mortgage banking business, originating and funding residential mortgage loans and selling those loans, generally within the succeeding 30 days, into the secondary mortgage market. Substantially all of our operations are conducted and substantially all of our assets are owned by the Bank, which accounts for substantially all of our consolidated revenues, expenses and operating income. For ease of reference we will sometimes refer to the Company and the Bank, together as “we”, “us” or “our”.

The following discussion presents information about (i) our consolidated results of operations for the three and nine months ended September 30, 2012 and comparisons of those results with the results of operations for the corresponding three and nine month periods of 2011, and (ii) our consolidated financial condition, liquidity and capital resources at September 30, 2012. The information in the following discussion should be read in conjunction with our interim consolidated financial statements and the notes thereto included elsewhere in this Report.

Forward-Looking Information

Statements contained in this Report that are not historical facts or that discuss our expectations, beliefs or views regarding our future operations or future financial performance, or financial or other trends in our business or in the markets in which we operate, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “estimate,” “project,” “forecast” or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could,” or “may.” The information contained in such forward-looking statements is based on current information and on assumptions that we make about future events over which we do not have control. In addition, our business and the markets in which we operate are subject to a number of risks and uncertainties. Such risks and uncertainties, and the occurrence of events in the future or changes in circumstances that had not been anticipated, could cause our financial condition or actual operating results in the future to differ significantly from our expected financial condition or operating results that are set forth in the forward-looking statements contained in this Report and could, therefore, also affect the price performance of our shares.

Many of those risks and uncertainties are discussed in Item 1A Part I, entitled “Risk Factors,” in our Annual Report on Form 10-K for the year ended December 31, 2011 (the “2011 10-K”) that we filed with the SEC on February 27, 2012. Additional risk factors are discussed in Item 1A of Part II in our Quarterly Reports on Form 10-Q for the quarters ended March 31, 2012 and June 30, 2012, which we filed with the SEC on May 7, 2012 and August 14, 2012, respectively. We urge you to read those risk factors in conjunction with your review of the following discussion and analysis of our results of operations for the three and nine months ended, and our financial condition at, September 30, 2012.

Due to the risks and uncertainties we face, readers are cautioned not to place undue reliance on the forward-looking statements contained in this Report, which speak only as of the date of this Report, or to make predictions about future performance based solely on historical financial performance. We also disclaim any obligation to update forward-looking statements contained in this Report, except as may otherwise be required by law or NASDAQ rules.

Overview of Operating Results in the Three and Nine Months Ended September 30, 2012

The following table provides comparative information with respect to our results of operations for the three and nine month periods ended September 30, 2012 and 2011, respectively.


	Three Months Ended September 30,									Nine Months Ended September 30,
	2012			2011			2012 vs. 2011			2012			2011			2012 vs. 2011
	Amount			Amount			% Change			Amount			Amount			% Change
	(Dollars in thousands, except per share data)
Interest income	$	11,374		$	10,943			3.9	%	$	32,037		$	33,861			(5.4	)%
Interest expense		2,115			2,763			(23.5	)%		6,619			8,483			(22.0	)%

Net interest income		9,259			8,180			13.2	%		25,418			25,378			0.2	%
Provision for loan losses		500			—			N/M			1,950			—			N/M

Net interest income after provision for loan losses		8,759			8,180			7.1	%		23,468			25,378			(7.5	)%
Noninterest income		9,951			2,223			347.6	%		25,105			5,439			361.6	%
Noninterest expense		13,407			9,776			37.1	%		39,326			26,640			47.6	%

Income before income taxes		5,303			627			745.8	%		9,247			4,177			121.4	%
Income tax expense		1,944			(225	)		N/M			(1,290	)		405			(418.5	)%

Net income		3,359			852			294.2	%		10,537			3,772			179.3	%
Accumulated undeclared dividends on preferred stock		(241	)		(121	)		99.2	%		(241	)		(176	)		36.9	%

Net income allocable to common shareholders	$	3,118		$	731			326.5	%	$	10,296		$	3,596			186.3	%

Net income per common share
Basic	$	0.19		$	0.06			216.4	%	$	0.69		$	0.33			109.1	%
Diluted	$	0.18		$	0.06			200.0	%	$	0.61		$	0.33			84.9	%
Weighted average number of shares outstanding
Basic		16,669,350			12,273,003			35.8	%		14,954,413			11,054,178			35.3	%
Diluted		19,170,781			12,315,065			55.7	%		17,374,156			11,072,523			56.9	%

Results of Operations in the Three Months Ended September 30, 2012.

As the above table indicates, net income in this year’s third quarter increased by $2.5 million, or 294%, to $3.4 million, from $852,000 in the same three months of 2011, notwithstanding a $2.2 million increase in income taxes in this year third quarter. At the same time, income per diluted share of common stock increased by 200% to $0.18 for the three months ended September 30, 2012, from $0.06 per diluted share of common stock for the same three months of 2011, notwithstanding a 56% increase in the weighted average number of diluted shares of common stock outstanding in this year’s third quarter over the same quarter of 2011. These increases were primarily attributable to an increase in net interest income of $1.1 million, or 13.2%, to $9.3 million, and an increase in mortgage banking revenues of $7.8 million, or 543%, to $9.2 million, in each case as compared to the same three months of 2011. These increases in net interest income and mortgage banking revenues more than offset a $3.6 million, or 37%, increase in noninterest expense, to $13.4 million in the three months ended September 30, 2012 from $9.8 million in the same three months of 2011.

Results of Operation for the Nine Months Ended September 30, 2012. Net income for the nine months ended September 30, 2012 increased by $6.7 million, or 179%, to $10.5 million, from $3.8 million in the same nine months of 2011. Income per diluted share for the nine months ended September 30, 2012 increased by 85% to $0.61, from $0.33 for the same nine months of 2011, notwithstanding a 57% increase in the weighted average number of diluted shares of common stock outstanding during the first nine months of 2012 over the same nine months of 2011. Those increases were primarily attributable to an increase of $18.6 million, or 517%, in mortgage banking revenues to $22.1 million, and an increase of $1.7 million, or 424%, in net gains on sales of securities, to $2.1 million, in the nine months ended September 30, 2012, in each case as compared to the same nine months of 2011. Those increases more than offset a nearly $2.0 million increase in the provision made for loan losses, and an increase of $12.7 million, or 47.6%, in non-interest expense, in each case as compared to the same nine months of 2011.

Information regarding the changes in our net interest income, the provisions made for loan losses, our mortgage banking revenues and our non-interest expense in the three and nine months ended September 30, 2012, as compared to the same respective periods of 2011, is set forth under the caption “—Results of Operations” below.

Outlook for the Fourth Quarter of 2012. As is discussed above, the increases in our net income in both the third quarter and nine months ended September 30, 2012 were largely attributable to increases in our mortgage banking revenues. Those increases were attributable primarily to substantial increases, in each of those periods, in the volume of mortgage loans that we originated directly from consumers (our “retail mortgage business”) and in the volume of mortgage loans originated for us by independent mortgage brokers (our “wholesale mortgage business”), in each case as compared to the quarter and nine months ended September 30, 2011. As previously reported, we made a decision to exit the wholesale mortgage business effective August 31, 2012. As we disclosed, that decision was made in order (i) to redeploy capital resources committed to our wholesale mortgage lending business to our core commercial lending business, (ii) to reduce our staffing and other operating costs and, thereby, improve the efficiency and profitability of our mortgage banking operations and (iii) to manage and limit the interest rate risk and some of the other risks that are inherent in wholesale mortgage businesses.

Although we ceased accepting mortgage loan applications from outside mortgage brokers submitted to us after August 31, 2012, we continued to fund mortgage loans in process or originated on or before that date and, as a result, that cessation of wholesale mortgage loan originations did not materially affect the volume of mortgage loans that we funded or sold into the secondary mortgage market during the third quarter of 2012. However, we anticipate that, as a result of our exist from the wholesale mortgage business, commencing with the fourth quarter of 2012 there will be a significant decline in mortgage loan originations and mortgage banking revenues as compared to the first three quarters of 2012. It is too early to predict the extent of that decline or its effect on our results of operations in this year’s fourth quarter.

Financial Ratios. The following table indicates the positive impact that the increase in net interest income in this year’s third quarter had on our net interest margin, and the positive effects that the increases in net income in both the three months and nine months ended September 30, 2012 had on the returns we generated on average assets and equity during those periods:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Net interest margin⁽¹⁾⁽²⁾		3.56	%		3.37	%		3.38	%		3.49	%
Return on average assets⁽¹⁾		1.22	%		0.32	%		1.32	%		0.49	%
Return on average shareholders’ equity⁽¹⁾		10.90	%		4.61	%		14.51	%		7.46	%

(1)	Annualized.

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

Critical Accounting Policies

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

Our critical accounting policies consist of the accounting policies and practices we follow in determining (i) the sufficiency of the allowance we establish for loan losses; (ii) the fair values of our investment securities that we hold for sale, and (iii) the amount of our deferred tax asset, consisting primarily of tax loss carryforwards and tax credits that we believe will be able to use to offset income taxes in future periods. There were no significant changes in the Company’s critical accounting policies or their application during the nine months ended September 30, 2012, as compared to our critical accounting policies in effect as of December 31, 2011. Information regarding our critical accounting policies in effect as of December 31, 2011 is contained in the sections captioned “Critical Accounting Policies” and “Allowance for Loan Losses” in Item 7, entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained in our 2011 10-K which we filed with the SEC on February 27, 2012 and readers of this report are urged to read those sections of that 10-K.

Results of Operations

Net Interest Income

One of the principal determinants of a bank’s income is its net interest income, which is the difference between (i) the interest that a bank earns on loans, investment securities and other interest-earning assets, on the one hand, and (ii) its interest expense, which consists primarily of the interest it must pay to attract and retain deposits and the interest that it pays on borrowings and other interest-bearing liabilities, on the other hand. As a general rule, all other things being equal, the greater the difference or “spread” between the amount of our interest income and the amount of our interest expense, the greater will be our net income; whereas, a decline in that difference or “spread” will generally result in a decline in our net income.

A bank’s interest income and interest expense are, in turn, affected by a number of factors, some of which are outside of its control, including national and local economic conditions and the monetary policies of the Federal Reserve Board which affect interest rates, competition in the market place for loans and deposits, and the demand for loans and the ability of borrowers to meet their loan payment obligations. Net interest income, when expressed as a percentage of total average interest earning assets, is a banking organization’s “net interest margin.”

The following table sets forth our interest income, interest expense and net interest income (in thousands of dollars) and our net interest margin for the three and nine months ended September 30, 2012 and 2011, respectively:


	Three Months Ended September 30,									Nine Months Ended September 30,
	Amount			Amount			Amount			Amount			Amount			Percentage Change
	2012			2011			2012 vs. 2011			2012			2011			2012 vs. 2011
Interest income	$	11,374		$	10,943			3.9	%	$	32,037		$	33,861			(5.4	)%
Interest expense		2,115			2,763			(23.5	)%		6,619			8,483			(22.0	)%

Net interest income	$	9,259		$	8,180			13.2	%	$	25,418		$	25,378			0.2	%

Net interest margin		3.56	%		3.37	%					3.38	%		3.49	%

In the three months ended September 30, 2012, net interest income increased by $1.1 million, or 13.2%, due to a $430,000, or 3.9%, increase in interest income and a $648,000, or 23.5%, decrease in interest expense, in each case as compared to the same three months of 2011. The increase in interest income was primarily attributable to a nearly $1.6 million increase in the volume of loans outstanding (exclusive of loans held for sale), which more than offset declines in the volume of other interest earning assets and in the yields on interest earning assets, including loans, as a result of further declines in market rates of interest. The decrease in interest expense was primarily attributable to reductions in the rates of interest we were paying on time certificates of deposit, which also resulted, in declines in the volume of those deposits in the three months ended September 30, 2012 as compared to the same three months of 2011.

In the nine months ended September 30, 2012 our net interest income was essentially unchanged from our net interest income in the same nine months of 2011, as a $1.8 million decrease in interest income was offset by a nearly $1.9 million reduction in interest expense that was primarily due to reductions in the rates of interest we paid on, and a resulting decline in the volume of, time certificates of deposit.

As a result of the increase in net interest income in the three months ended September 30, 2012, our net interest margin increased by 19 basis points to 3.56% from 3.37% in the three ended September 30, 2011. In the nine months ended September 30, 2012 our net interest margin declined by 11 basis points, to 3.38% from 3.49% in the same nine months of 2011, due primarily to an increase in average earning assets.

Average Balances

Information Regarding Average Assets and Average Liabilities

The following table sets forth information regarding our average balance sheet, yields on interest earning assets, interest expense on interest-bearing liabilities, the interest rate spread and the interest rate margin for the three months ended September 30, 2012 and 2011.


	Three Months Ended September 30,
	2012							2011
(Dollars in thousands)	Average Balance		Interest Earned/ Paid		Average Yield/ Rate			Average Balance		Interest Earned/ Paid		Average Yield/ Rate
Interest earning assets:
Short-term investments⁽¹⁾	$	81,277	$	52		0.25	%	$	92,511	$	59		0.25	%
Securities available for sale and stock⁽²⁾		107,315		553		2.05	%		142,253		879		2.45	%
Loans⁽³⁾		844,248		10,769		5.07	%		727,355		10,005		5.46	%

Total earning assets		1,032,840		11,374		4.37	%		962,119		10,943		4.51	%
Noninterest earning assets		63,147							94,194

Total Assets	$	1,095,987						$	1,056,313

Interest-bearing liabilities:
Interest-bearing checking accounts	$	26,435		21		0.32	%	$	25,755		22		0.34	%
Money market and savings accounts		174,255		344		0.79	%		147,334		361		0.97	%
Certificates of deposit		492,622		1,464		1.18	%		520,749		2,082		1.59	%
Other borrowings		65,391		140		0.85	%		54,304		168		1.23	%
Junior subordinated debentures		17,682		146		3.28	%		17,682		130		2.92	%

Total interest-bearing liabilities		776,385		2,115		1.08	%		765,824		2,763		1.43	%

Noninterest-bearing liabilities		197,025							217,237

Total Liabilities		973,410							983,061
Shareholders’ equity		122,577							73.252

Total Liabilities and Shareholders’ Equity	$	1,095,987						$	1,056,313

Net interest income			$	9,259						$	8,180

Interest rate spread						3.29	%						3.08	%

Net interest margin						3.56	%						3.37	%

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

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

(3)	Loans include the average balance of nonaccrual loans.


	Nine Months Ended September 30,
	2012							2011
(Dollars in thousands)	Average Balance		Interest Earned/ Paid		Average Yield/ Rate			Average Balance		Interest Earned/ Paid		Average Yield/ Rate
Interest earning assets:
Short-term investments⁽¹⁾	$	95,308	$	181		0.25	%	$	67,080	$	126		0.25	%
Securities available for sale and stock⁽²⁾		113,834		1,822		2.14	%		166,817		3,277		2.63	%
Loans⁽³⁾		792,460		30,034		5.06	%		736,975		30,458		5.53	%

Total earning assets		1,001,602		32,037		4.27	%		970,872		33,861		4.66	%
Noninterest earning assets		61,150							58,897

Total Assets	$	1,062,752						$	1,029,769

Interest-bearing liabilities:
Interest-bearing checking accounts	$	27,528		62		0.30	%	$	26,133		67		0.34	%
Money market and savings accounts		177,555		1,096		0.82	%		142,983		1,010		0.94	%
Certificates of deposit		492,622		4,620		1.25	%		512,868		6,392		1.67	%
Other borrowings		65,391		404		0.83	%		82,440		618		1.00	%
Junior subordinated debentures		17,682		437		3.30	%		17,682		396		2.99	%

Total interest-bearing liabilities		780,778		6,619		1.13	%		782,106		8,483		1.45	%

Noninterest-bearing liabilities		185,000							180,077

Total Liabilities		965,778							962,183
Shareholders’ equity		96,974							67,586

Total Liabilities and Shareholders’ Equity	$	1,062,752						$	1,029,769

Net interest income			$	25,418						$	25,378

Interest rate spread						3.14	%						3.21	%

Net interest margin						3.38	%						3.49	%

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

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

(3)	Loans include the average balance of nonaccrual loans.

The following table sets forth, in thousands of dollars, the changes in our interest income, including loan fees, and interest expense in the three and nine months ended September 30, 2012, as compared to the same respective periods of 2011, and the extent to which those changes were attributable to changes in (i) the volume of, or in the rates of interest earned on interest-earning assets and (ii) the volume of, or the rates of interest paid on our interest-bearing liabilities.


	Three Months Ended September 30, 2012 vs. 2011									Nine Months Ended September 30, 2012 vs. 2011
	Increase (Decrease) due to:						Total			Increase (Decrease) due to:						Total
	Volume			Rate			Total			Volume			Rate			Total
Interest income:
Short term investments⁽¹⁾	$	(7	)		—		$	(7	)	$	54		$	1		$	55
Securities available for sale and stock⁽²⁾		(195	)		(131	)		(326	)		(917	)		(538	)		(1,455	)
Loans		1,527			(763	)		764			2,217			(2,641	)		(424	)

Total earning assets		1,325			(894	)		431			1,354			(3,178	)		(1,824	)
Interest expense
Interest bearing checking accounts		1			(2	)		(1	)		3			(8	)		(5	)
Money market and savings accounts		60			(77	)		(17	)		225			(139	)		86
Certificates of deposit		(107	)		(511	)		(618	)		(243	)		(1,529	)		(1,772	)
Borrowings		30			(58	)		(28	)		(115	)		(99	)		(214	)
Junior subordinated debentures		—			16			16			—			41			41

Total interest bearing liabilities		(16	)		(632	)		(648	)		(130	)		(1,734	)		(1,864	)

Net interest income	$	1,341		$	(262	)	$	1,079		$	1,484		$	(1,444	)	$	40

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

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

Provision for Loan Losses

Like virtually all banks and other financial institutions, we follow the practice of maintaining reserves to provide for possible loan losses that occur in banking. When it is determined that the payment in full of a loan has become unlikely, the carrying value of the loan is reduced (“written down”) to what management believes is its realizable value or, if it is determined that a loan no longer has any realizable value, the carrying value of the loan is written off in its entirety (a loan “charge-off”). Loan charge-offs and write-downs are charged against an allowance for loan losses (the “Allowance for Loan Losses” or the “ALL”) which, at September 30, 2012, totaled $14.6 million. The amount of the ALL is increased periodically to replenish the ALL after it has been reduced due to loan write-downs or charge-offs. The ALL also is increased or decreased periodically to reflect increases or decreases in the volume of outstanding loans, and to take account of changes in the risk of potential loan losses due to a deterioration or improvement in the condition of borrowers or in the value of properties securing non–performing loans or adverse changes or improvements in economic conditions. Increases in the ALL are made through a charge, recorded as an expense in the statement of income, referred to as the “provision for loan losses.” Recoveries of loans previously charged-off are added back to and, therefore, to that extent increase the ALL and reduce the amount of the provision for loan losses that might otherwise have had to be made to replenish or increase the ALL. See “—Financial Condition—Nonperforming Loans and the Allowance for Loan Losses” below in this Item 2 for additional information regarding the ALL.

We employ economic models that are based on bank regulatory guidelines, industry standards and our own historical loan loss experience, as well as a number of more subjective qualitative factors, to determine both the sufficiency of the ALL and the amount of the provisions that need to be made for potential loan losses. However, those determinations involve judgments and assumptions about trends in current economic conditions and other events that can affect the ability of borrowers to meet their loan obligations to us and a weighting among the quantitative and qualitative factors we consider in determining the amount of the ALL. Moreover, the duration and anticipated effects of prevailing economic conditions or trends can be uncertain and can be affected by number of risks and circumstances that are outside of our ability to control. See the discussion below in this Item 2 under the caption “Financial Condition—Nonperforming Loans and the Allowance for Loan Losses”. If changes in economic or market conditions or unexpected subsequent events or changes in circumstances were to occur, or if changes were made to bank regulatory guidelines or industry standards that are used to assess the sufficiency of the ALL, it could become necessary for us to record additional, and possibly significant, charges to increase the allowance for loan losses, which would have the effect of reducing our income or causing us to incur losses.

In addition, the FRB and the DFI, as an integral part of their examination processes, periodically review the adequacy of our ALL. These agencies may require us to make additional provisions for possible loan losses, over and above the provisions that we have already made, the effect of which would be to reduce our income or increase any losses we might incur.

At September 30, 2012, the ALL totaled $12.7 million, which was $2.9 million, or 19.0%, lower than at December 31, 2011. This decrease was principally due to net charge-offs of $2.5 million, partially offset by a $2.0 million provision that we made for loan losses in the nine months ended September 30, 2012. The ratio of the ALL to total loans outstanding as of September 30, 2012 was 1.83% compared to 2.37% as of December 31, 2011. Notwithstanding the decrease in the Allowance at September 30, 2012, based on the methodologies we use to assess asset quality, bank regulatory guidelines and our historical loan loss history, we determined that that the Allowance was adequate at September 30, 2012 to cover inherent losses in the loan portfolio.

Noninterest Income

The following table identifies the components of and the percentage changes in noninterest income in the three and nine months ended September 30, 2012, as compared to the same respective periods of 2011:


	Three Months Ended September 30,									Nine Months Ended September 30,
	Amounts						Percent Change			Amounts						Percent Change
(Dollars in thousands)	2012			2011			2012 vs. 2011			2012			2011			2012 vs. 2011
Total other-than-temporary impairment of securities	$	—		$	(131	)		N/M		$	(25	)	$	(36	)		30.6	%
Portion of other-than-temporary impairment losses recognized in other comprehensive loss		—			(77	)		N/M			52			133			(60.9	)%

Net impairment loss recognized in earnings		—			(54	)		N/M			(77	)		(169	)		(54.4	)%
Service fees on deposits and other banking services		209			239			(12.6	)%		687			763			(10.0	)%
Mortgage banking (including net gains on sales of loans held for sale)		9,168			1,425			543.4	%		22,149			3,592			516.6	%
Net gains on sale of securities available for sale		937			365			156.7			2,123			405			424.2	%
Net gain on sale of other real estate owned		(560	)		—			N/M			(449	)		206			(318.0	)
Other		197			248			(20.6	)%		672			642			4.7	%

Total noninterest income	$	9,951		$	2,223			347.6	%	$	25,105		$	5,439			361.6	%

As the table above indicates, the increase in noninterest income in the three months ended September 30, 2012, as compared to the same period in 2011, was primarily attributable to a $7.7 million, or 543%, increase in mortgage banking revenue. The increase in noninterest income in the nine months ended September 30, 2012, as compared to the same nine months in 2011, was primarily attributable to (i) a $18.5 million, or 517%, increase in mortgage banking revenue and (ii) a $2.1 million, or 424%, increase in net gains on sales of securities available for sale.

The increases in mortgage banking revenue in the three and nine months ended September 30, 2012 were primarily attributable to increases of approximately 257% and 218%, respectively, in the dollar volume of mortgage loan originations, as compared to same three and nine month periods of 2011. Those increases in mortgage loan originations were attributable primarily to the growth of our mortgage banking business, which resulted in the addition of mortgage loan personnel, an expansion of our network of outside mortgage brokers and the implementation of marketing and business development programs by the mortgage banking division.

As discussed above in the subsection of this Item 2, entitled “Overview of Operating Results in the Three and Nine Months Ended September 30, 2012—Outlook for the Fourth Quarter of 2012”, we decided to exit our wholesale mortgage loan business and ceased accepting new wholesale originated mortgage loan applications effective on August 31, 2012. Due to the volume of mortgage loan applications (both retail and wholesale) received or in process as of August 31, 2012, we do not believe that the exit from our wholesale mortgage business materially affected our mortgage banking revenues in this year’s third quarter. However, due to our exit from the wholesale mortgage business, we expect that there will be a significant decline in mortgage loan originations and mortgage banking revenues in this year’s fourth quarter as compared to the first three quarters of 2012.

Noninterest Expense

The following table compares the amounts of the principal components of noninterest expense in the three and nine months ended September 30, 2012 and 2011.


	Three Months Ended September 30,							Nine Months Ended September 30,
	Amounts				Percentage Change			Amounts				Percentage Change
(Dollars in thousands)	2012		2011		2012 vs. 2011			2012		2011		2012 vs. 2011
Salaries and employee benefits	$	7,349	$	4,273		72.0	%	$	19,497	$	12,258		59.1	%
Occupancy		684		594		15.2	%		2,005		1,861		7.7	%
Equipment and depreciation		460		378		21.7	%		1,378		1,093		26.1	%
Data processing		187		154		21.4	%		562		485		15.9	%
FDIC expense		592		539		9.8	%		1,751		1,721		1.7	%
Other real estate owned expense		1,068		716		49.2	%		4,769		1,912		149.4	%
Professional fees		1,030		1,156		(10.9	)%		3,659		3,198		14.4	%
Mortgage related loan expense		733		157		366.9	%		2,011		439		358.1	%
Provision for contingencies		80		900		(91.1	)%		419		900		(53.4	)%
Other operating expense⁽¹⁾		1,224		909		34.7	%		3,275		2,773		18.1	%

Total noninterest expense	$	13,407	$	9,776		37.1	%	$	39,326	$	26,640		47.6	%

(1)	Mortgage related loan expense consist primarily of repurchase provision expense, appraisal, underwriting and document expense.

(2)	Other operating expenses consist of telephone, advertising, and investor relations, charges for promotional, business development, and regulatory expenses, insurance premiums and correspondent bank fees.

The increases in noninterest expense in the three and nine months ended September 30, 2012 were due primarily to (i) the growth of our mortgage banking business, as we added mortgage personnel, and related support staff, and incurred higher marketing, business development and other costs to increase the volume of mortgage loan originations and (ii) $933,000 and $3.8 million of write downs in the carrying values of other real estate owned (“OREO”) to their respective fair values for the three and nine months ended September 30, 2012, respectively. Due primarily to our exit from the wholesale mortgage loan business at the end of August 2012, we expect mortgage banking related noninterest expense to decline in the fourth quarter of 2012.

A measure of our ability to control noninterest expense is our efficiency ratio, which is the ratio of noninterest expense to net revenue (net interest income plus noninterest income). As a general rule, a lower efficiency ratio indicates an ability to generate increased revenue without a commensurate increase in the staffing and equipment and third party services and, therefore, would be indicative of greater operational efficiencies. Due to the increase in noninterest income, largely attributable to the growth of our mortgage banking division, our efficiency ratio improved to 69.8% in the three months ended September 30, 2012 from 94.0% in the corresponding three month period of 2011, and to 77.8% in the nine months ended September 30, 2012 from 86.4% in the same nine months of 2011.

Provision for (Benefit from) Income Tax

For the three months ended September 30, 2012, we recorded a tax provision of $1.9 million as compared to a tax benefit of $225,000 for the same period in 2012.

For the nine months ended September 30, 2012 we recorded a tax benefit of $1.3 million as compared to a tax provision of $405,000 for the same period in 2011. During the nine months ended September 30, 2012 we released the remaining valuation allowance, in the amount of $5.0 million, which had been established against our deferred tax asset by means of charges to the provision for income taxes in prior years. The release of the valuation allowance was based on an assessment we made in the second quarter of 2012 that, due primarily to the taxable earnings we have been generating from operations since the quarter ended December 31 2010, it had become more likely than not that we would be able to use the income tax benefits comprising our deferred tax asset, in their entirety, to offset or reduce taxes in future periods.

Asset/Liability Management

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

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

The table below sets forth information concerning our rate sensitive assets and liabilities at September 30, 2012. The assets and liabilities are classified by the earlier of maturity or repricing dates in accordance with their contractual terms. As described above, certain shortcomings are inherent in the method of analysis presented in this table.


(Dollars in thousands)	Three Months or Less			Over Three Through Twelve Months			Over One Year Through Five Years			Over Five Years			Non- Interest- Bearing			Total
Assets
Interest-bearing time deposits in other financial institutions	$	1,304		$	—		$	249		$	—		$	—		$	1,553
Investment in unconsolidated trust subsidiaries		—			—			—			682			—			682
Securities available for sale		9,188			6,955			23,342			13,049			—			52,534
Federal Reserve Bank and Federal Home Loan Bank stock		10,324			—			—			—			—			10,324
Interest bearing deposits with financial institutions		126,009			—			—			—			—			126,009
Loans held for sale, at fair value		151,919			—			—			—			—			151,919
Loans, gross		273,401			88,878			246,699			83,832			—			692,810
Noninterest earning assets, net		—			—			—			—			62,039			62,039

Total assets	$	572,145		$	95,833		$	270,290		$	97,563		$	62,039		$	1,097,870

Liabilities and Shareholders’ Equity
Noninterest-bearing deposits	$	—		$	—		$	—		$	—		$	187,570		$	187,570
Interest-bearing deposits⁽¹⁾⁽²⁾		308,343			283,074			101,207			—			—			692,624
Borrowings		5,000			15,000			40,000			—			—			60,000
Junior subordinated debentures		17,527			—			—			—			—			17,527
Other liabilities		—			—			—			—			16,736			16,736
Shareholders’ equity		—			—			—			—			123,413			123,413

Total liabilities and shareholders’ equity	$	330,870		$	298,074		$	141,207		$	—		$	327,719		$	1,097,870

Interest rate sensitivity gap	$	241,275		$	(202,241	)	$	129,083		$	97,563		$	(265,680	)

Cumulative interest rate sensitivity gap	$	241,275		$	39,034		$	168,117		$	265,680		$	—

Cumulative % of rate sensitive assets in maturity period		52	%		61	%		85	%		94	%		100	%

Rate sensitive assets to rate sensitive liabilities and shareholders’ equity		173	%		32	%		191	%		—			19	%

Cumulative ratio		173	%		106	%		122	%		134	%		100	%

(1)	Excludes savings accounts that we maintain at the Bank totaling $12.5 million.

(2)	Excludes a $250,000 certificate of deposit issued to us by the Bank, which matures January 2013.

At September 30, 2012, our rate sensitive balance sheet was shown to be in a positive twelve-month gap position. This would imply that our net interest margin would increase in the short-term if interest rates were to rise and would decrease in the short-term if interest rates were to fall. However, as noted above, the extent to which our net interest margin will be impacted by changes in prevailing interest rates will depend on a number of factors, including how quickly rate sensitive assets and liabilities react to interest rate changes, the mix of our interest earning assets (loans versus other lower yielding interest earning assets, such as securities or federal funds sold) and the mix of our interest bearing deposits (between, for example, lower interest core deposits and higher cost time certificates of deposit) and our other interest-bearing liabilities.

Financial Condition

Assets

Our consolidated assets totaled $1.098 billion at September 30, 2012, which represents a $73 million, or 7.1%, increase from our total consolidated assets of $1.025 billion at December 31, 2011. The increase in assets is primarily due to an $86 million increase in loans available for sale, to $152 million, at September 30, 2012.

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


	September 30, 2012		December 31, 2011
Interest-bearing deposits with financial institutions⁽¹⁾	$	126,009	$	86,177
Interest-bearing time deposits with financial institutions		1,553		1,423
Federal Reserve Bank and Federal Home Loan Bank Stock, at cost		10,324		11,154
Securities available for sale, at fair value		52,534		147,909
Loans held for sale, at lower of cost or market		151,919		66,230
Loans (net of allowances of $12,659 and $15,627, respectively)		680,151		641,962

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

Loans Held for Sale

We commenced a new mortgage banking business during the second quarter of 2009 to originate, primarily in Southern California, residential real estate mortgage loans that qualify for resale into the secondary mortgage markets. Our mortgage originations have been primarily for the financing of purchases of residential property and, to a lesser extent, refinancing of existing residential mortgage loans. In addition to conventional mortgage loans, we offer loan programs for low to moderate income families that qualify for mortgage assistance, such as the FHLB’s Wish Program, Homepath-financing on FNMA repossessed homes, and Southern California Home Financing Authority and various mortgage assistance programs in counties and cities within our branch network. As a general rule, most of the residential mortgage loans that we originate are sold in the secondary mortgage market within a period of 10 to 21 days following their origination. Mortgage loans held for sale totaled $152 million, an increase of $86 million at September 30, 2012 as compared to $66 million at December 30, 2011. The following table reflects the activity, in thousands of dollars, of our mortgage loan operations.


	September 30, 2012		December 31, 2011
Commercial loans	$	149	$	—
Commercial real estate loans		5,239		—
Single family mortgage loans		146,531		66,230

Loans held for sale, at lower of cost or market	$	151,919	$	66,230


	Three Months Ended				Nine Months Ended
	September 30, 2012		September 30, 2011		September 30, 2012		September 30, 2011
Wholesale	$	221,808	$	26,088	$	493,460	$	49,112
Retail		97,660		62,617		250,508		178,138

Total single family mortgage loans funded	$	319,468	$	88,705	$	743,968	$	227,250


Single family mortgage loan sales	$	314,263	$	71,145	$	662,863	$	192,906

As discussed above, the Company ceased taking mortgage submissions from mortgage brokers after August 31, 2012, which we expect will result in significant reductions in our mortgage loan originations, commencing in the fourth quarter of 2012.

Loans held for sale (“LHFS”) that were originated prior to December 1, 2011 are carried at the lower of aggregate cost or market. Effective December 1, 2011, in connection with the adoption of ASU 825, The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115 (ASU 825), the Company elected to measure, at fair value, LHFS originated on or after December 1, 2011. Fair values of LHFS are based on quoted market prices. Gains and losses on LHFS at fair value are, respectively, added to or charged against noninterest income from mortgage banking. Loan origination costs related to LHFS for which we elect the fair value option are recognized in noninterest expense when incurred.

Net unrealized losses, if any, on LHFS carried at the lower of aggregate cost or market, would be recognized through a valuation allowance established by a charge to income. Loan origination costs for LHFS carried at the lower of cost or market are capitalized as part of the carrying amount of the loans and recognized as a reduction of mortgage banking income upon the sale of such loans.

As of September 30, 2012, LHFS included $112.6 million of loans with interest rate lock commitments providing a hedge to interest rates and $43.4 million of loans with expired rate locks. The rate locks are obtained for specific time frames and, on their expiration are generally renewed with investors for an incremental charge.

TBA securities are deemed to be derivatives and involve off-balance sheet financial risk. The contractual or notional amounts of the TBA securities are tied to our loan origination volume. We bear a financial risk from such securities for the unrealized fair valuation gains or losses on such securities which are recorded in the consolidated balance sheets. These gains or losses depend upon the value of the underlying financial instruments and are affected by market changes in interest rates.

TBA securities possess credit risks for us to the extent that the institutional counterparties may be unable to meet the terms of the agreements. We seek to control counterparty credit risk by using multiple counterparties and limiting them to major financial institutions with investment grade credit ratings. In addition, we regularly monitor the potential risk of loss with any one party. We also work with an experienced third-party firm which assists us in placing TBA transactions, documenting such transactions, and providing information for bookkeeping and accounting purposes.

We recorded a fair value loss of $2.7 million on a notional $146 million in TBA securities for the three and nine months ended September 30, 2012. That loss was applied as an offset against mortgage banking revenues in determining mortgage banking income for the three and nine months ended September 30, 2012. All of our TBA securities outstanding at September 30, 2012 were short-term in nature with maturities of three months or less. We did not have TBA securities outstanding at September 30, 2011.

During the second quarter of 2012, we began selling a portion of our mortgage loan production directly to the Federal Home Loan Mortgage Corporation (“Freddie Mac”) on a “mandatory commitment” basis in order to avail ourselves of more favorable pricing on loan sales to Freddie Mac. We also began issuing Government National Mortgage Association (“Ginnie Mae”) securities, and we were approved to sell loans directly to the Federal National Mortgage Association (“Fannie Mae”), both of which will result in an increase in our use of mandatory commitments and TBA securities in the coming quarters. The majority of our mortgage loan originations are eligible for sale to Fannie Mae or Freddie Mac or for Ginnie Mae securities issuances. We believe that having the ability to sell loans directly to these agencies and issue Ginnie Mae securities gives us an advantage in the overall mortgage origination market with regard to products and pricing.

During the third quarter, we recorded in Other Assets, $1.4 million of fair value related to mortgage servicing rights retained from the issuance of $250 million in Ginnie Mae securities. The fair value was based upon quoted market prices.

Loans

The following table sets forth the composition, by loan category, of our loan portfolio at September 30, 2012 and December 31, 2011, respectively:


	September 30, 2012						December 31, 2011
(Dollars in thousands)	Amount			Percent			Amount			Percent
Commercial loans	$	170,894			24.6	%	$	179,305			27.2	%
Commercial real estate loans – owner occupied		150,968			21.8	%		170,960			26.0	%
Commercial real estate loans – all other		157,384			22.7	%		121,813			18.5	%
Residential mortgage loans – multi-family		68,753			9.9	%		65,545			10.0	%
Residential mortgage loans – single-family		90,400			13.0	%		68,613			10.4	%
Construction loans		—			—	%		2,047			0.3	%
Land development loans		26,727			3.9	%		25,638			3.9	%
Consumer loans		28,262			4.1	%		24,358			3.7	%

Gross loans		693,388			100.0	%		658,279			100.0	%

Deferred fee (income) costs, net		(578	)					(690	)
Allowance for loan losses		(12,659	)					(15,627	)

Loans, net		680,151					$	641,962

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

The following table sets forth the maturity distribution of our loan portfolio (excluding consumer and residential mortgage loans) at September 30, 2012:


	September 30, 2012
(Dollars in thousands)	One Year or Less		Over One Year through Five Years		Over Five Years		Total
Real estate and construction loans⁽¹⁾
Floating rate	$	64,318	$	61,848	$	678	$	126,844
Fixed rate		41,407		79,651		87,177		208,235
Commercial loans
Floating rate		56,601		2,130		568		59,299
Fixed rate		79,368		23,372		8,855		111,595

Total	$	241,694	$	167,001	$	97,278	$	505,973

(1)	Does not include mortgage loans on single and multi-family residences and consumer loans, which totaled $159.2 million and $28.3 million, respectively, at September 30, 2012.

Nonperforming Loans and Allowance for Loan Losses

Nonperforming Loans. Non-performing loans consist of (i) loans on non-accrual status which are loans on which the accrual of interest has been discontinued and include restructured loans when there has not been a history of past performance on debt service in accordance with the contractual terms of the restructured loans, and (ii) loans 90 days or more past due and still accruing interest. Non-performing assets are comprised of non-performing loans and other real estate owned, or OREO, which consists of real properties which have been acquired by or in lieu of foreclosure and which we intend to offer for sale.

Loans are placed on non-accrual status when, in our opinion, the full or timely collection of principal or interest is in doubt. Generally, the accrual of interest is discontinued when principal or interest payments become more than 90 days past due, unless we believe the loan is adequately collateralized and the loan is in the process of collection. However, in certain instances, we may place a particular loan on non-accrual status earlier, depending upon the individual circumstances involved in that loan’s delinquency. When a loan is placed on non-accrual status, previously accrued but unpaid

interest is reversed against current income. Subsequent collections of unpaid amounts on such a loan are applied to reduce principal when received, except when the ultimate collectability of principal is probable, in which case such payments are applied to interest and are credited to income. Non-accrual loans may be restored to accrual status if and when principal and interest become current and full repayment is expected. Interest income is recognized on the accrual basis for impaired loans not meeting the criteria for non-accrual treatment.

The following table sets forth information regarding our nonperforming assets, as well as restructured loans, at September 30, 2012 and December 31, 2011:


(Dollars in thousands)	At September 30, 2012		At December 31, 2011
Nonaccrual loans:
Commercial loans	$	7,240	$	4,702
Commercial real estate		8,153		6,230
Residential real estate		791		570
Construction and land development		314		2,597
Consumer loans		—		—
Loans held for sale		588		—

Total nonaccrual loans	$	17,086	$	14,099

Loans past due 90 days and still accruing:
Total loans past due 90 days and still accruing	$	—	$	—

Other real estate owned (OREO):
Commercial real estate	$	23,764	$	27,103
Residential real estate		—		616
Construction and land development		6,413		9,702

Total other real estate owned	$	30,177	$	37,421

Other nonperforming assets:
Asset backed security		248		380

Total other nonperforming assets	$	248	$	380

Total nonperforming assets including loans held for sale	$	47,511	$	51,900
Total nonperforming assets excluding loans held for sale	$	46,923	$	51,900

Restructured loans:
Accruing loans	$	22,531	$	—
Nonaccruing loans (included in nonaccrual loans above)		5,712		4,214

Total restructured loans	$	28,243	$	4,214

As the above table indicates, during the nine months ended September 30, 2012, non-performing loans increased by approximately $3 million, or 21.2%, including a $588,000 increase in loans held for sale, and a $2.4 million increase in non-performing loans (exclusive of loans held sale). The increase in nonaccrual loans was primarily due to a bankruptcy filing, in this year’s third quarter, by a borrower with outstanding borrowings from us totaling $2.7 million and a commercial real estate property of $1.9 million, partially offset by the transfer, in the first quarter of 2012, of a $2.0 million construction loan into other real estate owned as a result of our foreclosure of the underlying property. On the other hand, nonperforming assets, inclusive of loans held for sale, declined by $4.4 million to $47.5 million at September 30, 2012, from $51.9 million at December 31, 2011, due primarily to the sale of $7.2 million of OREO properties during the nine months ended September 30, 2012.

We have allocated specific reserves within the ALL to provide for losses we may incur on the loans that were classified as nonaccrual loans, and we have established specific reserves on the real properties classified as OREO.

Information Regarding Impaired Loans. At September 30, 2012 and December 31, 2011, loans deemed impaired totaled $39.4 million and $18.4 million, respectively. At September 30, 2012 we had an average investment in impaired loans of $29.5 million as compared to an average investment in impaired loans of $27.5 million at December 31, 2011. The interest that would have been earned during the three and nine months ended September 30, 2012 had the nonaccruing impaired loans remained current in accordance with their original terms was $253,000, and $441,000, respectively.

The following table sets forth the amount of impaired loans to which a portion of the ALL has been specifically allocated, and the aggregate amount so allocated, in accordance with ASC 310-10, and the amount of that allowance and the amount of impaired loans for which no such allocations were made, at September 30, 2012 and December 31, 2011, respectively:


	September 30, 2012							December 31, 2011
Impaired Loans	Loans		Reserves for Loan Losses		% of Reserves to Loans			Loans		Reserves for Loan Losses		% of Reserves to Loans
(Dollars in thousands)
Impaired loans with specific reserves	$	7,391	$	3,057		41.4	%	$	9,913	$	2,783		28.1	%
Impaired loans without specific reserves		31,995		—		—			8,482		—		—

Total impaired loans	$	39,386	$	3,057		7.8	%	$	18,395	$	2,783		15.1	%

Allowance for Loan Losses. The ALL was $12.7 million, and 1.83% of loans outstanding, at September 30, 2012, as compared to $15.6 million, and 2.37% of loans outstanding, at December 31, 2011.

The adequacy of the ALL is determined through periodic evaluations of the loan portfolio and other factors that can reasonably be expected to affect the ability of borrowers to meet their loan obligations. Those factors are inherently subjective as the process for determining the adequacy of the ALL involves some significant estimates and assumptions about such matters as (i) the amounts and timing of expected future cash flows of borrowers, (ii) the fair value of the collateral securing non-performing loans, (iii) estimates of losses that the we may incur on non-performing loans, which are determined on the basis of historical loss experience, industry loss factors and bank regulatory guidelines, and (iv) various qualitative factors. Those factors are subject to changes in economic and other conditions and changes in regulatory guidelines or circumstances over which we have no control. As a result, the amount of the ALL may prove to be insufficient to cover all of the loan losses we might incur in the future and, therefore, it may become necessary for us to increase the ALL from time to time to maintain its adequacy.

The amount of the ALL is first determined by assigning reserve ratios to non-accrual loans and other loans classified as “special mention,” “substandard” or “doubtful” (“classified loans” or “classification categories”). These ratios are determined based on prior loss history and industry guidelines and loss factors, by type of loan, adjusted for current economic factors, with greater reserve ratios or percentages applied to loans deemed to be a higher risk.

On a quarterly basis, we utilize a classification migration model and individual loan review analysis tools as starting points for determining the adequacy of the ALL. Our loss migration analysis tracks a certain number of quarters of loan loss history and industry loss factors to determine historical losses by classification category for each loan type, except certain loans (automobile, mortgage and credit cards), which are analyzed as homogeneous loan pools. These calculated loss factors are then applied to outstanding loan balances. We also conduct individual loan review analysis, as part of the ALL allocation process, applying specific monitoring policies and procedures in analyzing the existing loan portfolios.

In determining whether and the extent to which we will make adjustments to our loan loss migration model for purposes of determining the ALL, we also consider a number of qualitative factors that can affect the performance and the collectability of the loans in our loan portfolio. Such qualitative factors include:

•

The effects of changes that we may make in our loan policies or underwriting standards on the quality of the loans and the risks in our loan portfolios;

•

Trends and changes in local, regional and national economic conditions, as well as changes in industry specific conditions, and any other reasonably foreseeable events that could affect the performance or the collectability of the loans in our loan portfolios;

•

Material changes that may occur in the mix or in the volume of the loans in our loan portfolios that could alter, whether positively or negatively, the risk profile of those portfolios;

•

Changes in management or loan personnel or other circumstances that could, either positively or negatively, impact the application of our loan underwriting standards, the monitoring of nonperforming loans or our loan collection efforts;

•

Changes in the concentration of risk in the loan portfolio; and

•

External factors that, in addition to economic conditions, can affect the ability of borrowers to meet their loan obligations, such as fires, earthquakes and terrorist attacks.

Determining the effects that these qualitative factors may have on the performance of our loan portfolios requires numerous judgments, assumptions and estimates about conditions, trends and events which may subsequently prove to have been incorrect due to circumstances outside of our control. Moreover, the effects of qualitative factors such as these on the performance of our loan portfolios are often difficult to quantify. As a result, we may sustain loan losses in any particular period that are sizable in relation to the ALL or that may even exceed the ALL.

In response to the economic recession and continued weakness in the economy, which has resulted in increased and relatively persistent high rates of unemployment, and the credit crisis that has led to a severe tightening in the availability of credit, preventing borrowers from refinancing their loans, we have (i) implemented more stringent loan underwriting standards, (ii) strengthened loan underwriting and approval processes and (iii) added personnel with experience in addressing problem assets.

The following table compares the total amount of loans outstanding, and the allowance for loan losses, by loan category, in each case, in thousands of dollars, and certain related ratios, as of September 30, 2012 and December 31, 2011.


							Increase (Decrease)
	September 30, 2012			December 31, 2011			September 30, 2012 to December 31, 2011
(Dollars in thousands)
Commercial loans	$	170,894		$	179,305		$	(8,411	)
Loans impaired⁽¹⁾		12,899			5,140			7,759
Loans 90 days past due		4,727			2,021			2,706
Loans 30 days past due		609			2,036			(1,427	)
Allowance for loan losses
General component	$	2,665		$	7,260		$	(4,595	)
Specific component⁽¹⁾		3,057			1,648			1,409

Total allowance	$	5,722		$	8,908		$	(3,186	)
Ratio of allowance to loan category		3.35	%		4.97	%		(1.62	)%
Real estate loans:	$	377,105		$	358,318		$	18,787
Loans impaired⁽¹⁾		25,382			10,088			15,294
Loans 90 days past due		3,863			—			3,863
Loans 30 days past due		428			2,875			(2,447	)
Allowance for loan losses
General component	$	5,525		$	4,642		$	883
Specific component⁽¹⁾		—			1,135			(1,135	)

Total allowance	$	5,525		$	5,777		$	(252	)
Ratio of allowance to loan category		1.47	%		1.61	%		(0.14	)%
Construction loans and land development	$	26,727		$	27,685		$	(958	)
Loans impaired⁽¹⁾		314			2,597			(2,283	)
Loans 90 days past due		—			2,597			(2,597	)
Loans 30 days past due		664			—			664
Allowance for loan losses
General component	$	752		$	316		$	436
Specific component⁽¹⁾		—			—			—

Total allowance	$	752		$	316		$	436
Ratio of allowance to loan category		2.81	%		1.14	%		1.67	%
Consumer loans and single family mortgages	$	118,662		$	92,971		$	25,691
Loans impaired⁽¹⁾		791			570			221
Loans 90 days past due		348			492			(144	)
Loans 30 days past due		1,242			1,130			112
Allowance for loan losses
General component	$	660		$	626		$	34
Specific component⁽¹⁾		—			—			—

Total allowance	$	660		$	626		$	34
Ratio of allowance to loan category		0.56	%		0.67	%		(0.11	)%
Total loans outstanding	$	693,388		$	658,279		$	35,109
Loans impaired⁽¹⁾		39,386			18,395			20,991
Loans 90 days past due		8,938			5,110			3,828
Loans 30 days past due		2,943			6,041			(3,098	)
Allowance for loan losses
General component	$	9,602		$	12,844		$	(3,242	)
Specific component⁽¹⁾		3,057			2,783			274

Total allowance	$	12,659		$	15,627		$	(2,968	)
Ratio of allowance to total loans outstanding		1.83	%		2.37	%		(0.54	)%

(1)	Amounts in impaired loans and in specific components include nonperforming delinquent loans.

We classify our loan portfolios using internal credit quality ratings. The following table provides a summary of loans by portfolio type and the Company’s internal credit quality ratings as of September 30, 2012 and December 31, 2011.


(Dollars in thousands)	September 30, 2012		December 31, 2011		Increase (Decrease)
Pass:
Commercial loans	$	145,758	$	149,522		(3,764	)
Commercial real estate loans – owner occupied		137,459		148,380		(10,921	)
Commercial real estate loans – all other		132,163		109,482		22,681
Residential mortgage loans – multi family		68,372		61,190		7,182
Residential mortgage loans – single family		87,541		66,631		20,910
Construction loans		—		—		—
Land development loans		11,953		16,758		(4,805	)
Consumer loans		28,262		24,358		3,904

Total pass loans	$	611,508	$	576,321	$	35,187

Special Mention:
Commercial loans	$	8,014	$	4,570	$	3,444
Commercial real estate loans – owner occupied		—		6,826		(6,826	)
Commercial real estate loans – all other		6,059		2,553		3,506
Residential mortgage loans – multi family		381		3,316		(2,935	)
Residential mortgage loans – single family		—		1,014		(1,014	)
Construction loans		—		—		—
Land development loans		8,215		8,330		(115	)
Consumer loans		—		—		—

Total special mention loans	$	22,669	$	26,609	$	(3,940	)

Substandard:
Commercial loans	$	16,898	$	24,551	$	(7,653	)
Commercial real estate loans – owner occupied		13,509		15,754		(2,245	)
Commercial real estate loans – all other		19,162		9,778		9,384
Residential mortgage loans – multi family		—		1,039		(1,039	)
Residential mortgage loans – single family		2,859		968		1,891
Construction loans		—		2,047		(2,047	)
Land development loans		6,559		550		6,009
Consumer loans		—		—		—

Total substandard loans	$	58,987	$	54,687	$	4,300

Doubtful:
Commercial loans	$	224	$	662	$	(438	)
Commercial real estate loans – owner occupied		—		—		—
Commercial real estate loans – all other		—		—		—
Residential mortgage loans – multi family		—		—		—
Residential mortgage loans – single family		—		—		—
Construction loans		—		—		—
Land development loans		—		—		—
Consumer loans		—		—		—

Total doubtful loans	$	224	$	662	$	(438	)

Total Outstanding Loans, gross:	$	693,388	$	658,279	$	35,109

As the above table indicates, the Company’s total loans were $693 million at September 30, 2012, an increase of $35 million from $658 million at December 31, 2011. The disaggregation of the portfolio by risk rating in the table above reflects the following changes between at September 30, 2012 from December 31 2011:

•

Loans rated “pass” increased by $35 million to $611 million at September 30, 2012 from $576 million at December 31,2011, due primary to the $35 million increase in total loans outstanding.

•

Loans rated “special mention” decreased by $3.9 million to $22.7 million at September 30, 2012 from $26.6 million at December 31, 2011, due to downgrades to substandard loans.

•

Loans classified “substandard” increased by $4.3 million to $59.0 million at September 30, 2012, from $54.7 million at December 31, 2011, due primarily to net transfers from “special mention” loans.

•

The doubtful category declined by $438,000 to $224,000 at September 30, 2012 from $662,000 at December 31, 2011.

The Company uses a rolling eight quarter loss migration analysis in order to determine loss factors to apply to each of the classification categories. As a result, for purposes of determining applicable loss factors at September 30, 2012, our migration analysis covered the period from September 30, 2010 to September 30, 2012. That migration analysis resulted in a modest reduction in the loss factors in the quantitative component of our September 30, 2012 ALL analysis, which we believe is consistent with and reasonably reflects current economic conditions and the risks that were inherent in our loan portfolio at September 30, 2012.

The table below sets forth loan delinquencies, by quarter, from September 30, 2012 to September 30, 2011.


	2012						2011
	At September 30		At June 30		At March 31		At December 31		At September 30
(Dollars in thousands)
Loans Delinquent:
90 days or more:
Commercial loans	$	4,727	$	4,775	$	3,231	$	2,021	$	977
Commercial real estate		3,863		5,491		2,253		—		18,470
Residential mortgages		348		—		1,677		492		1,112
Construction and land development loans		—		528		539		2,597		3,036
Consumer loans		—		—		—		—		—

		8,938		10,794		7,700		5,110		23,595

30-89 days:
Commercial loans		609		12,239		4,961		2,036		2,750
Commercial real estate		428		—		3,334		2,875		3,455
Residential mortgages		1,237		347		758		1,130		347
Construction and land development loans		664		320		—		—		—
Consumer loans		5		2		—		—		—

		2,943		12,908		9,053		6,041		6,552

Total Past Due⁽¹⁾ :		11,881		23,702		16,753		11,151	$	30,147

(1)	Past due balances include nonaccrual loans.

As the above table indicates, total past due loans increased by $730,000, to $11.9 million at September 30, 2012, from $11.2 million at December 31, 2011. Loans past due 90 days or more increased by $3.8 million, to $8.9 million at September 30, 2012, from $5.1 million at December 31, 2011 primarily due to (i) a $2.7 million increase in past due commercial loans as a result of a bankruptcy filing by a borrower, and (ii) a $3.9 million increase in past due owner-occupied commercial real estate loans partially offset by the foreclosure and resulting transfer of a $2.0 million construction loan into other real estate owned. These loans are in various stages of collection and the adequacy of the collateral securing the repayment of and the prospects for recoveries on these loans are reflected in the allowance for loan losses at September 30, 2012.

Loans 30-89 days past due decreased by $3.1 million to $2.9 million at September 30, 2012 from $6.0 million at December 31, 2011, primarily as a result of an $3.8 million commercial loan relationship comprised of several loans, of which one loan in the amount of $1.4 million was paid off and the other loans were brought current by the borrower and are no longer past due.

Set forth below is a summary of the transactions in the ALL in the three months ended September 30, 2012 and the year ended December 31, 2011:


	Three Months Ended September 30, 2012			Nine Months Ended September 30, 2012			Year Ended December 31, 2011
	(Dollars in thousands)
Balance, beginning of period	$	14,648		$	15,627		$	18,101
Charged off loans		(4,003	)		(6,664	)		(2,736	)
Recoveries on loans previously charged off		1,514			1,746			1,095
Provision for loan losses		500			1,950			(833	)

Balance, end of period	$	12,659		$	12,659		$	15,627

As the above table indicates, at September 30, 2012 the ALL totaled $12.7 million, which was $2.9 million, or 18.6%, lower than at December 31, 2011. That decrease was due to $4.0 million in loan charge-offs, partially offset by $1.5 million in recoveries of loans charged off in 2010 and a $500,000 provision made for loan losses in the three months ended September 30, 2012. The loan charge-offs were comprised of $1.7 million in write-down of loans transferred to held for sale and $2.3 million in charge-offs of loans held for investment. As a result of the decrease in the ALL and an increase in loans outstanding at September 30, 2012, as compared to December 31, 2011, the ratio of the ALL to total loans outstanding as of September 30, 2012 was 1.83%, compared to 2.37% as of December 31, 2011. Notwithstanding the decrease in the ALL at September 30, 2012, based on the methodologies we use to assess asset quality, bank regulatory guidelines and our historical loan loss history, we believe that the ALL was adequate to cover potential losses in the loan portfolio at September 30, 2012.

Deposits

Average Balances of and Average Interest Rates Paid on Deposits

Set forth below are the average amounts (in thousands of dollars) of, and the average rates paid on, deposits in the three months ended September 30, 2012:


	Three Months Ended September 30, 2012
	Average Balance		Average Rate
Noninterest-bearing demand deposits	$	169,220		—
Interest-bearing checking accounts		27,528		0.30	%
Money market and savings deposits		177,555		0.82	%
Time deposits		493,901		1.25	%

Average total deposits	$	868,204		0.89	%

Deposit Totals. Deposits totaled $880 million at September 30, 2012 as compared to $862 million at December 31, 2011 and $846 million at September 30, 2011. The following table compares the mix of our deposits, as between lower cost core deposits and higher cost time deposits, at September 30, 2012, December 31, 2011 and September 30, 2011, respectively:


	At September 30, 2012					At December 31, 2011					At September 30, 2011
	Amounts		Percent of Total Deposits			Amounts		Percent of Total Deposits			Amounts		Percent of Total Deposits
(Dollars in thousands)
Core deposits
Noninterest bearing demand deposits	$	187,570		21.3	%	$	164,382		19.1	%	$	152,376		18.0	%
Savings and other interest-bearing transaction deposits		198,566		22.6	%		187,977		21.8	%		173,774		20.6	%
Time deposits		494,058		56.1	%		509,688		59.1	%		519,428		61.4	%

Total deposits	$	880,194		100.0	%	$	862,047		100.0	%	$	845,578		100.0	%

As indicated in the above table, savings and other interest-bearing deposits increased slightly to 22.6% of total deposits at September 30, 2012, from 21.8% of total deposits at December 31, 2011. However, the mix of deposits changed to a lower proportion of time deposits, which bear higher rates of interest than our core deposits, as time deposits decreased to 56.1% of total deposits at September 30, 2012 from 61.4% of total deposits at September 30, 2011. That change in the mix of deposits contributed to the reduction in interest expense in this year’s third quarter, as compared to the same quarter of 2011. See “—Results of Operations—Net Interest Income” above in this Section of this Report.

Set forth below, in thousands of dollars, is a maturity schedule of domestic time certificates of deposit outstanding at September 30, 2012:


	At September 30, 2012
	Certificates of Deposit under $100,000		Certificates of Deposit of $100,000 or More
Maturities
Three months or less	$	13,888	$	87,803
Over three and through nine months		24,314		123,608
Over nine and through twelve months		23,993		117,067
Over twelve months		15,035		88,350

Total certificates of deposit	$	77,230	$	416,828

Liquidity

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

Our liquid assets, which included cash and due from banks, federal funds sold, interest earning deposits with financial institutions and unpledged securities available for sale (excluding Federal Reserve Bank and Federal Home Loan Bank stock) totaled $169 million, which represented 15% of total assets, at September 30, 2012.

Cash Flow Used in Operating Activities. In the nine months ended September 30, 2012, we used net cash of $80 million in operating activities, of which $50 million represented the amount by which mortgage loan originations of $744 million exceeded the $694 million in the proceeds we generated from sales of mortgages loans available for sale. This compares to approximately $12 million of net cash used in operating activities in the nine months ended September 30, 2011, during which originations of mortgage loans exceeded the proceeds we generated from sales of mortgages loans available for sale by approximately $22 million.

Cash Flow Provided by Investing Activities. In the nine months ended September 30, 2012, investing activities provided net cash of $67 million, comprised primarily of (i) $186 million from sales of securities available for sale, partially offset by $118 million in purchases of securities available for sale, (ii) $29 million representing payments on the maturities of and partial payments received on securities available for sale, and (iii) $8.4 million of proceeds from sales of other real estate owned, partially offset by the use of $37 million to fund an increase in loans. By comparison, in the nine months ended September 30, 2011, investing activities provided net cash of $164 million, comprised primarily of $96 million of proceeds from sales of securities available for sale, a $47 million decrease in loans, $10 million from maturities of and partial principal payments on securities available for sale, and $9.7 million of proceeds from sales of other real estate owned.

Cash Flow Used in Financing Activities. In the nine months ended September 30, 2012, financing activities provided net cash of $54 million, comprised primarily of $25 million of proceeds from our sale of shares of common stock to two institutional investors in this year’s second quarter, a net increase of $18 million in deposits and an $11 million increase in borrowings. By comparison, in the nine months ended September 30, 2011 we used net cash of $16 million in financing activities, comprised of $54 million used to reduce outstanding borrowings, partially offset by a $29 million increase in deposits and nearly $9 million of net proceeds from the sale of shares of our Series B Convertible 8.4% Noncumulative Preferred Stock (the “Series B Shares”) to three institutional investors in August 2011.

Ratio of Loans to Deposits. The relationship between gross loans and total deposits can provide a useful measure of a bank’s liquidity. Since repayments of loans tend to be less predictable than the maturity of investments and other liquid resources, the higher the loan-to-deposit ratio the less liquid are our assets. On the other hand, since we realize greater yields on loans than we do on investments, a lower loan-to-deposit ratio can adversely affect interest income and earnings. As a result, our goal is to achieve a loan-to-deposit ratio that appropriately balances the requirements of liquidity and the need to generate a fair return on our assets. At September 30, 2012 and December 31, 2011, the loan-to-deposit ratios were 79% and 76%, respectively.

Off Balance Sheet Arrangements

Loan Commitments and Standby Letters of Credit. In order to meet the financing needs of our customers, in the normal course of business we make commitments to extend credit and issue standby commercial letters of credit to or for our customers. At September 30, 2012 and December 31, 2011, we were committed to fund certain loans, including letters of credit, amounting to approximately $118 million and $121 million, respectively.

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

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

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

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

Contractual Obligations

Borrowings. As a source of additional funds that we have used primarily to fund loans and to purchase other interest earning assets, and to provide us with a supplemental source of liquidity, we have obtained short and long term borrowings from the Federal Home Loan Bank (the “FHLB”). As of September 30, 2012, our outstanding FHLB borrowings totaled $60 million, comprised of (i) $20 million of short-term borrowings, with maturities ranging from August 2012 to February 2013, and (ii) $40 million of long-term borrowings, with maturities ranging from August 2013 to March 2015. These borrowings have a weighted-average annualized interest rate of 0.89%. By comparison, as of December 31, 2011, our outstanding FHLB borrowings totaled $49 million, comprised of (i) $34 million of short-term borrowings and (ii) $15 million of long-term borrowings which had a weighted-average annualized interest rate of 1.19%.

The highest amount of FHLB borrowings that were outstanding at any month-end during the nine months ended September 30, 2012 was $69 million. During 2011, the highest amount of borrowings outstanding at any month-end was $114 million from FHLB.

At September 30, 2012, U.S. agency and mortgage backed securities, U.S. Government agency securities and collateralized mortgage obligations with an aggregate fair market value of $8.5 million and $173 million of residential mortgage and other real estate secured loans were pledged to secure these FHLB borrowings, repurchase agreements, and local agency deposits.

Junior Subordinated Debentures. Pursuant to rulings of the Federal Reserve Board, bank holding companies were permitted to issue long term subordinated debt instruments that, subject to certain conditions, would qualify as and, therefore, augment capital for regulatory purposes. At September 30, 2012, we had outstanding approximately $17.5 million principal amount of 30-year junior subordinated floating rate debentures (the “Debentures”), of which $16.8 million qualified as Tier 1 capital for regulatory purposes as of September 30, 2012. See discussion below under the subcaption “—Capital Resources-Regulatory Capital Requirements.”

Set forth below is certain information regarding the Debentures:

(Dollars in thousands)

Principal Amount

Interest Rate

Maturity Dates⁽¹⁾

September 2002

7,217

Libor plus 3.40

September 2032

October 2004

10,310

Libor plus 2.00

October 2034

Total

17,527

(1)	Subject to the receipt of prior regulatory approval, we may redeem the Debentures, in whole or in part, without premium or penalty, at any time prior to maturity.

Interest on the Debentures is payable quarterly. However, subject to certain conditions, we are entitled by the express terms of the Debentures to defer those interest payments for up to 20 quarters.

As previously reported, since July 2009 we have been required to obtain the prior approval of the Federal Reserve Bank of San Francisco (the “FRBSF”) to make interest payments on the Debentures. Since September 2010, we have been unable to obtain FRBSF approvals needed to permit us to make interest payments on the Debentures. As a result, as of September 30, 2012, we had deferred 10 quarterly interest payments, totaling $737,000, on the $7.2 million of Debentures due in September, 2032, and 11 quarterly interest payments, totaling $691,000, on the $10.3 million of Debentures due in October, 2034. We cannot predict when the FRBSF will approve our resumption of such interest payments and until such approval can be obtained it will be necessary for us to continue deferring interest payments on the Debentures. Since we have the right, under the terms of the Debentures, to defer interest payments for up to twenty (20) quarters, the deferrals of interest payments to date have not, and any deferral of future interest payments through January, 2015, will not constitute a default under or with respect to the Debentures. However, if we are not able to obtain regulatory approval to pay all of the deferred interest payments by January, 2015, we would then be in default under the Debentures. For additional information regarding the restrictions on the payment by us of interest on the Debentures, as well as other regulatory restrictions that apply to us and the Bank under a regulatory agreement entered into with the FRBSF and a regulatory order issued by the California Department of Financial Institutions, see “Capital Resources-Capital and Other Requirements under FRB Agreement and DFI Order” below in this section of this report and “Supervision and Regulation-Regulatory Action by the FRB and DFI” in Item 1 and “RISK FACTORS” in Item 1A in Part I of our 2011 10-K.

Investment Policy and Securities Available for Sale

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

Our investment policy:

•

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

•

provides that the aggregate weighted average life of U.S. Government obligations and federal agency securities exclusive of variable rate securities cannot, without approval by the Board of Directors, exceed 10 years and municipal obligations cannot exceed 25 years;

•

provides that time deposits must be placed with federally insured financial institutions, cannot exceed the current federally insured amount in any one institution and may not have a maturity exceeding 60 months, unless that time deposit is matched to a liability instrument issued by the Bank; and

•

prohibits engaging in securities trading activities.

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

The following is a summary of the major components of securities available for sale and a comparison of the amortized cost, estimated fair values and gross unrealized gains and losses, in each case, in thousands of dollars, as of September 30, 2012 and December 31, 2011:


(Dollars in thousands)	Amortized Cost		Gross Unrealized Gain		Gross Unrealized Loss			Estimated Fair Value
Securities available for sale at September 30, 2012:
Mortgage backed securities issued by U.S. Agencies⁽¹⁾	$	44,289	$	785	$	(1	)	$	45,073
Municipal securities		—		—		—			—
Collateralized non-agency mortgage obligations⁽¹⁾		2,708		76		(30	)		2,754
Asset backed securities⁽²⁾		2,247		—		(1,999	)		248
Mutual funds⁽³⁾		4,459		—		—			4,459

Total securities available for sale	$	53,703	$	861	$	(2,030	)	$	52,534

Securities available for sale at December 31, 2011:
Mortgage-backed securities issued by U.S. agencies⁽¹⁾	$	133,859	$	630	$	(363	)	$	134,126
Municipal securities		6,389		96		(42	)		6,443
Collateralized non-agency mortgage obligations⁽¹⁾		3,040		—		(455	)		2,585
Asset backed securities⁽²⁾		2,324		—		(1,944	)		380
Mutual funds⁽³⁾		4,375		—		—			4,375

Total securities available for sale	$	149,987	$	726	$	(2,804	)	$	147,909

(1)	Secured by closed-end first lien 1-4 family residential mortgages.

(2)	Comprised of a security that represents an interest in a pool of trust preferred securities issued by U.S.-based banks and insurance companies

(3)	Consists primarily of mutual fund investments in closed-end first lien 1-4 family residential mortgages.

At September 30, 2012, U.S. agencies and mortgage backed securities, U.S. government agency securities, collateralized mortgage obligations and time deposits with an aggregate fair market value of $9 million were pledged to secure FHLB borrowings, repurchase agreements, local agency deposits, to secure lines of credit at our correspondent banks and treasury, and tax and loan accounts.

The amortized costs, at September 30, 2012, of securities available for sale are shown in the following table, by contractual maturities and historical prepayments based on the prior three months of principal payments. Expected maturities will differ from contractual maturities and historical prepayments, particularly with respect to collateralized mortgage obligations, because borrowers may react to interest rate market conditions differently than the historical prepayment rates.


	September 30, 2012 Maturing in
	One year or less					Over one year through five years					Over five years through ten years					Over ten years					Total
(Dollars in thousands)	Book Value		Weighted Average Yield			Book Value		Weighted Average Yield			Book Value		Weighted Average Yield			Book Value		Weighted Average Yield			Book Value		Weighted Average Yield
Securities available for sale:
Mortgage-backed securities issued by U.S. Agencies	$	4,283		1.73	%	$	15,127		1.83	%	$	16,253		1.84	%	$	8,626		1.97	%	$	44,289		1.85	%
Collateralized non-agency mortgage obligations		808		2.49	%		—		—			—		—			1,900		3.61	%		2,708		3.28	%
Municipal securities		—		—			—		—			—		—			—		—			—		—
Asset backed securities		—		—			—		—			—		—			2,247		—			2,247		—
Mutual funds		—		—			4,459		2.19	%		—		—			—		—			4,459		2.19	%

Total securities available for sale	$	5,091		1.85	%	$	19,586		1.91	%	$	16,253		1.84	%	$	12,773		1.87	%	$	53,703		1.87	%

The table below shows, as of September 30, 2012, the gross unrealized losses and fair values of our investments, aggregated by investment category, and the length of time that the individual securities have been in a continuous unrealized loss position.


	Securities with Unrealized Loss at September 30, 2012
	Less than 12 months				12 months or more					Total
Dollars in thousands	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
Mortgage backed securities issued by U.S. agencies		—		—		39		(1	)		39		(1	)
Municipal securities		—		—		—		—			—		—
Collateralized non-agency mortgage obligations		—		—		1,251		(30	)		1,251		(30	)
Asset backed securities		—		—		248		(1,999	)		248		(1,999	)

Total temporarily impaired securities	$	—	$	—	$	1,538	$	(2,030	)	$	1,538	$	(2,030	)

Impairment exists when the fair value of the security has declined below its cost. We perform quarterly assessments of the securities that have an unrealized loss to determine whether the decline in fair value of those securities below their cost is other-than-temporary.

We adopted ASC 321-10 effective April 1, 2009 and, accordingly, we recognize other-than-temporary impairments (“OTTI”) to our available-for-sale debt securities. In accordance with ASC 321-10, when there are credit losses associated with an impaired debt security and (i) we do not have the intent to sell the security and (ii) it is more likely than not that we will not have to sell the security before recovery of its cost basis, then, we will separate the amount of an impairment that is credit-related from the amount thereof related to non-credit factors. The credit-related impairment is recognized in our consolidated statements of income. The non-credit-related impairment is recognized and reflected in Other Comprehensive Income.

Capital Resources

Capital Regulatory Requirements Applicable to Banking Institutions.

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

•

well capitalized;

•

adequately capitalized;

•

undercapitalized;

•

significantly undercapitalized; or

•

critically undercapitalized.

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

The following table sets forth the capital and capital ratios of the Company (on a consolidated basis) and the Bank (on a stand-alone basis) at September 30, 2012, as compared to the respective regulatory requirements applicable to them.


	Actual					Applicable Federal Regulatory Requirement
	Actual					To be Categorized as Adequately Capitalized					To be Categorized as Well Capitalized
	Amount		Ratio			Amount		Ratio			Amount		Ratio
(Dollars in thousands)
Total Capital to Risk
Weighted Assets:
Company	$	144,678		16.9	%	$	68,656		At least 8	%		N/A		N/A
Bank		135,605		15.8	%		68,599		At least 8	%		85,749		At least 10	%
Tier 1 Capital to Risk
Weighted Assets:
Company	$	133,925		15.6	%	$	34,328		At least 4	%		N/A		N/A
Bank		124,860		14.6	%		34,300		At least 4	%	$	51,949		At least 6	%
Tier 1 Capital to
Average Assets:
Company	$	133,925		12.3	%	$	43,556		At least 4	%		N/A		N/A
Bank		124,860		11.5	%		43,505		At least 4	%	$	54,381		At least 5	%

At September 30, 2012, the Bank (on a stand-alone basis) continued to qualify as a well-capitalized institution, and the Company continued to exceed the minimum required capital ratios, under the capital adequacy guidelines described above.

The Company’s consolidated total capital and Tier 1 capital, at September 30, 2012, includes an aggregate of $16.8 million principal amount of the $17.5 million of Junior Subordinated Debentures that we issued in 2002 and 2004. We contributed that amount to the Bank over the three year period ended December 31, 2009, thereby providing it with additional cash to fund the growth of its banking operations and, at the same time, to increase its total capital and Tier 1 capital.

Capital and Other Requirements under FRB Agreement and DFI Order.

On August 31, 2010, the Company and the Bank entered into a regulatory agreement with the FRBSF (the “FRB Agreement”) and the Bank consented to the issuance, by California Department of Financial Institutions (the “DFI”), of a regulatory order (the “DFI Order”).

The principal purposes of the FRB Agreement and the DFI Order, which constitute formal supervisory actions by the FRB and the DFI, were to require the Company and the Bank to adopt and implement formal plans and take certain actions, as well as to continue implementing measures that we previously adopted, to address the adverse consequences that the economic recession and weakened state of the economy have had on the performance of our loan portfolio and our operating results and to increase our capital to strengthen our ability to weather any further adverse economic conditions that might arise in the future.

The FRB Agreement and DFI Order contain substantially similar provisions. They required the Boards of Directors of the Company and the Bank to prepare and submit written plans to the FRBSF and the DFI that address a number of matters, including improving the Bank’s position with respect to problem assets, maintaining adequate reserves for loan and lease losses in accordance with applicable supervisory guidelines, and improving the capital position of the Bank and, in the case of the FRB Agreement, the capital position of the Company. The Bank is also prohibited from paying dividends to the Company without the prior approval of the DFI, and the Company may not declare or pay cash dividends, repurchase any of its shares, make interest or principal payments on its Junior Subordinated Debentures or incur or guarantee any debt without the prior approval of FRBSF.

The DFI Order also states that if we were to violate or fail to comply with the Order the Bank could be deemed to be conducting business in an unsafe manner which could subject the Bank to further regulatory enforcement action.

The FRB Agreement also required us to submit a capital plan to the FRBSF that would meet with its approval and then to implement that plan. Under the DFI Order, the Bank was required to achieve a ratio of adjusted tangible shareholders’ equity to its tangible assets of 9% by January 31, 2011, by raising additional capital, generating earnings or reducing the Bank’s tangible assets (subject to a 15% limitation on such a reduction) or a combination thereof and, upon achieving that ratio, to maintain at least a 9% ratio during the remaining term of the Order.

The Company and the Bank have made substantial progress with respect to the requirements of the FRB Agreement and the DFI Order and both the Board and management are committed to achieving all of those requirements.

Among other things, on August 26, 2011, we sold to three institutional investors (the “Investors”) a total of 112,000 shares of a newly created Series B Convertible 8.4% Noncumulative Preferred Stock (the “Series B Shares”), at a price of $100.00 per share in cash, generating aggregate gross proceeds to the Company of $11.2 million. The Investors were SBAV LP, an affiliate of the Clinton Group, which purchased 75,000 Series B Shares, and Carpenter Community BancFund LP and Carpenter Community BancFund-A LP (collectively, the “Carpenter Funds”) which, together, purchased a total of 37,000 Series B Shares. We contributed the net proceeds from the sale of those Series B Shares to the Bank, which enabled it to increase the ratio of its adjusted tangible shareholders’ equity to its tangible assets above 9% and thereby meet the capital requirements under the DFI Order.

As we reported in our Current Report on Form 8-K dated April 23, 2012, on April 20, 2012 we sold to the Carpenter Funds a total of 4,201,278 shares of our common stock at a price of $6.26 per share in cash, generating aggregate gross proceeds to the Company of $26.3 million, which has further increased the amount of our Tier 1 capital. We then used $15.0 million of those proceeds to make a capital contribution to the Bank. As a result of that capital contribution and the income generated by the Bank during the nine months ended September 30, 2012, the ratio of the Bank’s adjusted tangible shareholders’ equity to its tangible assets had increased to 11.9% at September 30, 2012.

Additional information regarding the FRB Agreement and the DFI Order is set forth in our 2011 10-K in the subsection of Item 1 thereof entitled “Supervision and Regulation - Regulatory Action by the FRB and DFI” and in Item 1A thereof entitled “RISK FACTORS”.

Dividend Policy and Share Repurchase Programs. It is, and since the beginning of 2009 it has been, the policy of the Boards of Directors of the Company and the Bank to preserve cash to enhance their capital positions and the Bank’s liquidity. Moreover, since mid-2009, bank regulatory restrictions, including those under the FRB Agreement and DFI Order, have precluded the Company and the Bank from paying cash dividends and we have been precluded from repurchasing our shares without the prior approval of the FRBSF. Accordingly, we do not expect to pay dividends or make share repurchases at least for the foreseeable future.

ITEM 4T.

CONTROLS AND PROCEDURES

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

As required by Rules 13a-15 and 15d-15 under the Exchange Act, in connection with the filing of this Quarterly Report on Form 10-Q, an evaluation was performed under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2012. Based on that evaluation, our CEO and CFO have concluded that, as of September 30, 2012, the Company’s disclosure controls and procedures were effective to provide reasonable assurance that information required to disclose in our reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules of the Securities and Exchange Commission and that such information is accumulated and communicated to management, including our Chief Executive and Chief Financial Officers, to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting during the three months ended September 30, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II

ITEM 1A.

RISK FACTORS

There have been no material changes in our assessment of our risk factors from those set forth in our 2011 10-K and in our Quarterly Reports on Form 10-Q for the quarters ended March 31, 2012 and June 30, 2012.

ITEM 6.

EXHIBITS

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


Exhibit No.		Description of Exhibit

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

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

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

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

Exhibit 101.INS		XBRL Instance Document

Exhibit 101.SCH		XBRL Taxonomy Extension Schema Document

Exhibit 101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document

Exhibit 101.DEF		XBRL Taxonomy Extension Definition Linkbase Document

Exhibit 101.LAB		XBRL Taxonomy Extension Labels Linkbase Document

Exhibit 101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document

SIGNATURES

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

S-1

EXHIBIT INDEX


Exhibit No.		Description of Exhibit

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

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

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

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

Exhibit 101.INS		XBRL Instance Document

Exhibit 101.SCH		XBRL Taxonomy Extension Schema Document

Exhibit 101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document

Exhibit 101.DEF		XBRL Taxonomy Extension Definition Linkbase Document

Exhibit 101.LAB		XBRL Taxonomy Extension Labels Linkbase Document

Exhibit 101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document

E-1