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, 2010

OR

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

For the transition period from                  to                 

Commission file number 0-30777

PACIFIC MERCANTILE BANCORP

(Exact name of Registrant as specified in its charter)

California	33-0898238
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification Number)
949 South Coast Drive, Suite 300, Costa Mesa, California	92626
(Address of principal executive offices)	(Zip Code)

(714) 438-2500

(Registrant’s telephone number, including area code)

Not Applicable

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

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

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

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

Large accelerated filer	¨	Accelerated filer	¨
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.

10,434,665 shares of Common Stock as of November 9, 2010

QUARTERLY REPORT ON FORM 10Q

FOR

THE QUARTER ENDED SEPTEMBER 30, 2010

TABLE OF CONTENTS

		Page
Part I. Financial Information
Item 1.	Financial Statements (unaudited)
	Consolidated Statements of Financial Condition at September 30, 2010 and December 31, 2009		1
	Consolidated Statements of Operations for the Three and Nine Months ended September 30, 2010 and 2009		2
	Consolidated Statements of Comprehensive Income (Loss) for the Three and Nine Months ended September 30, 2010 and 2009		3
	Consolidated Statements of Cash Flows for the Nine Months ended September 30, 2010 and 2009		4
	Consolidated Statement of Shareholders’ Equity for the Nine Months ended September 30, 2010		6
	Notes to Consolidated Financial Statements		7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		25
Item 3.	Market Risk		51
Item 4T.	Controls and Procedures		52
Part II. Other Information
Item 1.	Legal Proceedings		53
Item 1A.	Risk Factors		53
Item 6.	Exhibits		55
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

i

PART I. — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands)

(Unaudited)

	September 30, 2010			December 31, 2009
ASSETS
Cash and due from banks	$	11,106		$	13,866
Interest bearing deposits with financial institutions		194,738			127,785
Cash and cash equivalents		205,844			141,651
Interest-bearing time deposits with financial institutions		9,043			9,800
Federal Reserve Bank and Federal Home Loan Bank Stock, at cost		13,459			14,091
Securities available for sale, at fair value		113,367			170,214
Loans held for sale, at lower of cost or market		19,151			7,572
Loans (net of allowances of $23,301 and $20,345, respectively)		738,750			813,194
Investment in unconsolidated subsidiaries		682			682
Other real estate owned		21,459			10,712
Accrued interest receivable		3,140			3,730
Premises and equipment, net		1,034			1,329
Other assets		21,748			27,661
Total assets	$	1,147,677		$	1,200,636
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Noninterest-bearing	$	186,550		$	183,789
Interest-bearing		768,108			776,649
Total deposits		954,658			960,438
Borrowings		101,027			141,003
Accrued interest payable		1,133			1,901
Other liabilities		5,085			5,295
Junior subordinated debentures		17,527			17,527
Total liabilities		1,079,430			1,126,164
Commitments and contingencies (Note 2)		—			—
Shareholders’ equity:
Preferred stock, no par value, 2,000,000 shares authorized, 126,550 and 80,050 shares issued and outstanding at September 30, 2010 and December 31, 2009, respectively; liquidation preference $100 per share plus accumulated dividends at September 30, 2010 and December 31, 2009		12,655			8,050
Common stock, no par value, 20,000,000 shares authorized, 10,434,665 shares issued and outstanding at September 30, 2010 and December 31, 2009		73,006			72,891
Accumulated deficit		(15,581	)		(3,599	)
Accumulated other comprehensive loss		(1,833	)		(2,870	)
Total shareholders’ equity		68,247			74,472
Total liabilities and shareholders’ equity	$	1,147,677		$	1,200,636

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

1

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except for per share data)

(Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2009			2010			2009
Interest Income
Loans, including fees	$	11,368		$	11,936		$	35,058		$	35,529
Securities available for sale and stock		790			814			3,448			2,912
Interest bearing deposits with financial institutions		147			129			389			373
Total interest income		12,305			12,879			38,895			38,814
Interest expense
Deposits		3,822			5,701			12,229			17,699
Borrowings		564			1,794			2,082			5,922
Total interest expense		4,386			7,495			14,311			23,621
Net interest income		7,919			5,384			24,584			15,193
Provision for loan losses		1,688			3,790			7,488			13,833
Net interest income after provision for loan losses		6,231			1,594			17,096			1,360
Non-interest income
Total other than temporary impairment of securities		(139	)		(787	)		(2,051	)		(787	)
Portion of losses recognized in other comprehensive loss		(87	)		704			(1,765	)		704
Net impairment loss recognized in earnings		(52	)		(83	)		(286	)		(83	)
Service fees on deposits and other banking services		278			352			930			1,101
Mortgage banking (including net gains on sales of loans held for sale)		1,113			540			2,743			607
Gain on sale of securities available for sale		780			446			1,417			2,334
Net gain (loss) on sale of other real estate owned		(5	)		(147	)		(64	)		(145	)
Other		178			367			602			776
Total non-interest income		2,292			1,475			5,342			4,590
Non-interest expense
Salaries & employee benefits		3,703			4,194			11,747			11,580
Occupancy		673			682			2,020			2,038
Equipment and furniture		295			313			952			868
Data processing		156			276			514			662
Professional Fees		1,227			1,338			3,207			2,740
Customer expense		52			92			232			281
FDIC expense		1,256			683			2,522			1,933
Other real estate owned expense		439			1,170			1,330			1,689
Other operating expense		847			764			2,837			2,252
Total non-interest expense		8,648			9,512			25,361			24,043
Loss before income taxes		(125	)		(6,443	)		(2,923	)		(18,093	)
Income tax provision (benefit)		—			(2,577	)		9,059			(7,546	)
Net loss	$	(125	)	$	(3,866	)	$	(11,982	)	$	(10,547	)
Cumulative undeclared dividends on preferred stock	$	(327	)	$	—		$	(756	)	$	—
Net loss allocable to common stockholders	$	(452	)	$	(3,866	)	$	(12,738	)	$	(10,547	)
Net loss per common share
Basic	$	(0.04	)	$	(0.37	)	$	(1.22	)	$	(1.01	)
Diluted	$	(0.04	)	$	(0.37	)	$	(1.22	)	$	(1.01	)
Weighted average number of shares outstanding
Basic		10,434,665			10,434,665			10,434,665			10,434,665
Diluted		10,434,665			10,434,665			10,434,665			10,434,665

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

2

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (LOSS)

(In thousands)

(Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2009			2010			2009
Net loss	$	(125	)	$	(3,866	)	$	(11,982	)	$	(10,547	)
Other comprehensive loss, net of tax:
Change in unrealized gain (loss) on securities available for sale, 2009 net of tax effect		88			140			1,057			(506	)
Change in net unrealized gain (loss) and prior service benefit on supplemental executive retirement plan, 2009 net of tax effect		10			7			(20	)		115
Total comprehensive loss	$	(27	)	$	(3,719	)	$	(10,945	)	$	(10,938	)

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

3

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Nine Months  Ended September 30,
	2010			2009
Cash Flows From Operating Activities:
Net loss	$	(11,982	)	$	(10,547	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		383			359
Provision for loan losses		7,488			13,833
Net amortization of premium on securities		456			1,104
Net gains on sales of securities available for sale		(1,417	)		(2,334	)
Net gains on sales of mortgage loans held for sale		(2,344	)		(311	)
Proceeds from sales of mortgage loans held for sale		144,276			28,874
Originations and purchases of mortgage loans held for sale		(154,183	)		(39,058	)
Market to market adjustment of loans held for sale		(55	)		(166	)
Decrease (increase) in current taxes receivable		980			(2,662	)
Net amortization of deferred fees and unearned income on loans		(413	)		(141	)
Net loss on sales of other real estate owned		64			145
Write down of other real estate owned		367			1,309
Capitalized costs of other real estate owned		(1,661	)		—
Stock-based compensation expense		115			252
Other than temporary impairment of securities		286			83
Changes in operating assets and liabilities:
Net (increase) decrease in accrued interest receivable		590			(216	)
Net increase in other assets		(7,159	)		(1,460	)
Net (increase) decrease in deferred taxes		10,086			(6,129	)
Net decrease in accrued interest payable		(768	)		(1,221	)
Net increase (decrease) in other liabilities		(182	)		1,650
Net cash used in operating activities		(15,073	)		(16,636	)
Cash Flows From Investing Activities:
Net increase (decrease) in interest-bearing deposits with financial institutions		757			(16,602	)
Maturities of and principal payments received for securities available for sale and other stock		29,103			12,037
Purchase of securities available for sale and other stock		(195,400	)		(136,596	)
Proceeds from sale of securities available for sale and other stock		227,466			187,681
Proceeds from sales of other real estate owned		4,857			3,160
Net (increase) decrease in loans		68,096			(2,676	)
Net increase in other real estate owned		(14,374	)		—
Purchases of premises and equipment		(88	)		(549	)
Net cash provided by investing activities		120,417			46,455
Cash Flows From Financing Activities:
Net (decrease) increase in deposits		(5,780	)		35,852
Proceeds from issuances of preferred stock		4,605			—
Net decrease in borrowings		(39,976	)		(81,758	)
Net cash used in financing activities		(41,151	)		(45,906	)
Net increase (decrease) in cash and cash equivalents		64,193			(16,087	)
Cash and Cash Equivalents, beginning of period		141,651			107,133
Cash and Cash Equivalents, end of period	$	205,844		$	91,046

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

4

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Nine Month Ended September 30,
	2010			2009
Supplementary Cash Flow Information:
Cash paid for interest on deposits and other borrowings	$	15,079		$	24,698
Cash paid for income taxes	$	—		$	—
Non-Cash Investing Activities:
Net decrease (increase) in net unrealized losses and prior year service cost on supplemental employee retirement plan, net of taxes in 2009	$	(20	)	$	115
Net decrease (increase) in net unrealized losses on securities held for sale, 2009 net of tax	$	1,057		$	(506	)
Transfer into other real estate owned	$	18,382		$	2,756
Transfer of loans held for sale to loans held for investment	$	2,176		$	—
Mark to market (gain) loss adjustment of equity securities	$	(86	)	$	42

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

5

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, 2010

	Preferred Stock				Common Stock							Accumulated Other
	Number of Shares		Amount		Number of Shares		Amount		Accumulated Deficit			Comprehensive Income (Loss)			Total
Balance at December 31, 2009		81	$	8,050		10,435	$	72,891	$	(3,599	)	$	(2,870	)	$	74,472
Issuances of cumulative preferred stock		46		4,605		—		—		—			—			4,605
Stock based compensation expense		—		—		—		115		—			—			115
Comprehensive income:
Net loss		—		—		—		—		(11,982	)		—			(11,982	)
Change in unrealized gain on securities held for sale, net of taxes		—		—		—		—		—			1,057			1,057
Change in unrealized loss on supplemental executive retirement plan		—		—		—		—		—			(20	)		(20	)
Balance at September 30, 2010		127	$	12,655		10,435	$	73,006	$	(15,581	)	$	(1,833	)	$	68,247

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

6

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

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

During 2002, we organized three business trusts, under the names Pacific Mercantile Capital Trust I, PMB Capital Trust I, and PMB Statutory Trust III, respectively, to facilitate our issuance of $5.155 million, $5.155 million and $7.217 million, respectively, principal amount of junior subordinated debentures, all with maturity dates in 2032. In October 2004, we organized PMB Capital Trust III to facilitate our issuance of an additional $10 million principal amount of junior subordinated debentures, with a maturity date in 2034. The financial statements of these trusts are not included in the Company’s consolidated financial statements. 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 financial position, results of operations, changes in cash flows and comprehensive income (loss) in accordance with generally accepted accounting principles in the United States (“GAAP”). However, these interim financial statements reflect all adjustments (consisting of normal recurring adjustments and accruals) which, in the opinion of our management, are necessary for a fair presentation of our financial position and our results of operations for the interim periods presented.

These unaudited consolidated financial statements have been prepared on a basis consistent with prior periods, and should be read in conjunction with our audited consolidated financial statements as of and for the year ended December 31, 2009, and the notes thereto, included in our Annual Report on Form 10-K for the year ended December 31, 2009, as filed with the Securities and Exchange Commission (“SEC”) under the Securities Exchange Act of 1934.

Our consolidated financial position at September 30, 2010, and the consolidated results of operations for the three and nine month periods ended September 30, 2010, are not necessarily indicative of what our financial position will be as of December 31, 2010, or of the results of our operations that may be expected for the full year ending December 31, 2010.

7

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements (Cont-)

(Unaudited)

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

Use of Estimates

The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make certain estimates and assumptions that 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 the allowance for loan losses, the fair value of securities available for sale, loans held for sale and the valuation of our deferred tax assets. If circumstances or financial trends on which those estimates were based were to change in the future or there were to occur any currently unanticipated events affecting the amounts of those estimates, our future financial position or results of operations could differ, possibly materially, from those expected at the current time.

Recent Accounting Pronouncements

In September 2009, the Financial Accounting Standards Board (“FASB”) issued an update to Accounting Standard Codification 105-10, “Generally Accepted Accounting Principles”. This standard establishes the FASB Accounting Standard Codification (“Codification” or “ASC”) as the source of authoritative U.S. Generally Accepted Accounting Principles (“GAAP”) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of authoritative GAAP for SEC companies. The Codification supersedes all then-existing non-SEC accounting and reporting standards. This Statement is effective for financial statements issued for interim and annual periods ending after September 15, 2009. FASB Statement No. 162, The Hierarchy of Generally Accepted Accounting Principles, which became effective on November 13, 2008, identified the sources of accounting principles and the framework for selecting the principles used in preparing the financial statements in conformity with GAAP. Statement 162 arranged these sources of GAAP in a hierarchy for users to apply accordingly. The Codification, and all of its content, will carry the same level of authority, effectively superseding Statement 162. In other words, the GAAP hierarchy is modified to include only two levels of GAAP: authoritative and non-authoritative. As a result, this Statement replaces Statement 162 to indicate this change to the GAAP hierarchy.

In January 2010, the FASB issued Accounting Standards Update 2010-06 (“ASU 2010-06”), an update of ASC 820-10, Fair Value Measurements and Disclosures, which now requires new disclosures that expand on activity included in the three fair value levels, as defined in ASC 820-10. ASU 2010-06 also provides amendments to ASC 820-10 in that a reporting entity should provide fair value measurement disclosures for each class of assets and liabilities, and provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. Those disclosures are required for fair value measurements that fall in either Level 2 or Level 3. New disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for certain Level 3 roll forward disclosures, which are effective for fiscal years beginning after December 15, 2010. We adopted the former disclosures and clarifications (those effective after December 15, 2009) as of January 1, 2010, and they did not have a material effect on our financial statements.

In February 2010, the FASB issued Accounting Standards Update No. 2010-09, Subsequent Events (Topic 855), Amendments to Certain Recognition and Disclosure Requirements (“Topic 855”), which states an entity that is an SEC filer is not required to disclose the date through which subsequent events have been evaluated. This change alleviates potential conflicts between Subtopic 855-10 and SEC requirements.

8

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements (Cont-)

(Unaudited)

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

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, 2010, loan commitments and letters of credit totaled $163 million and $11 million, respectively. The contractual amount of a credit-related financial instrument such as a commitment to extend credit, a credit-card arrangement or a letter of credit represents the amounts of potential accounting loss should the commitment be fully drawn upon, the customer were to default, and the value of any existing collateral securing the customer’s payment obligation become worthless.

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

Legal Proceedings

James Laliberte, et al. vs. Pacific Mercantile Bank, filed in May 2003 in the California Superior Court for the County of Orange (Case No. 030007092). Information regarding this law suit is contained under the caption “—Commitments and Contingencies—Legal Proceeding” in, and is incorporated herein by reference to, Note 17 of Item 8 of Part II of our Annual Report on Form 10-K for the fiscal year ended December 31, 2009 (the “2009 10-K”) filed with the SEC on April 1, 2010.

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.

Current Regulatory Matters

On August 31, 2010, the members of the respective Boards of Directors of Pacific Mercantile Bancorp (the “Company”) and its the wholly-owned banking subsidiary, Pacific Mercantile Bank (the “Bank”), entered into a Written Agreement (the “Agreement”) with the Federal Reserve Bank of San Francisco (the “FRB”). On the same date, the Bank consented to the issuance of a Final Order (the “Order”) by the California Department of Financial Institutions (the “DFI”). The principal purposes of the Agreement and Order, which constitute formal supervisory actions by the FRB and the DFI, are 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 conditions that might arise if the hoped-for improvement in the economy does not materialize.

The Agreement and Order contain substantially similar provisions. They require the Boards of Directors of the Company and the Bank to prepare and submit written plans to the FRB and the DFI that 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 and lease 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 strategic plan and a budget for fiscal 2011; and (viii) submitting a satisfactory funding contingency plan for the Bank that identifies available sources of liquidity and includes a plan for dealing with 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.

Under the Agreement, the Company also must submit a capital plan to the FRB that will meet with its approval and then implement that plan. Under the Order, the Bank is 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.

The Company and the Bank already have made progress with respect to several of these requirements, and is exploring alternatives for raising additional capital by January 31, 2011, and both the Board of Directors and management are committed to achieving all of the requirements on a timely basis.

3. Income (Loss) Per Share

Basic income (loss) per share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted income (loss) per share reflects the potential dilution that would occur if stock options or other contracts to issue common stock were exercised or converted into shares of common stock which would share in our earnings. For the three and nine month periods ended September 30, 2010, (i) stock options to purchase 1,002,842 shares of our common stock and (ii) 1,425,283 shares of our common stock issuable on conversion of our Series A Preferred Stock, were not considered in computing diluted income (loss) per common share because they were antidilutive. For the three and nine month periods ended September 30, 2009 stock options to purchase 1,151,744 shares were not considered in computing diluted earnings per common shares because they were antidilutive.

9

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements (Cont-)

(Unaudited)

3. Income (Loss) Per Share (Cont-)

The following table illustrates our computation of basic and diluted loss for the three and nine month periods ended September 30, 2010 and 2009.

	Three Months Ended September 30,						Nine Months Ended September 30,
(In thousands, except earnings per share data)	2010			2009			2010			2009
Net loss allocable to common shareholders (A)	$	(452	)	$	(3,866	)	$	(12,738	)	$	(10,547	)
Weighted average outstanding shares of common stock (B)		10,435			10,435			10,435			10,435
Dilutive effect of employee stock options and preferred stock		—			—			—			—
Common stock and common stock equivalents (C)		10,435			10,435			10,435			10,435
Loss per share:
Basic (A/B)	$	(0.04	)	$	(0.37	)	$	(1.22	)	$	(1.01	)
Diluted (A/C)	$	(0.04	)	$	(0.37	)	$	(1.22	)	$	(1.01	)

4. Stock-Based Employee Compensation Plans

At the Company’s 2010 Annual Meeting, held on May 25, 2010, our shareholders approved a 2010 Equity Incentive Plan (the “2010 Plan”), which 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 share of our common stock, plus an additional 158,211 shares of common stock which was equal to the total of the shares that were then available for the grant of new 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 2010 Plan.

Options to purchase a total of 1,143,844 shares of our common stock granted under the Previously Approved Plans were outstanding on the date the 2010 Plan was adopted. Those Plans had provided that, if any of the outstanding options were to expire or otherwise terminate, rather than being exercised, the shares that had been subject to those options would become available for the grant of new options under those Plans. However, the 2010 Plan provides that if any of the outstanding options granted under the Previously Approved Plans 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 1,704,555 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 and on such other terms, including restrictions and Company repurchase rights, as are fixed by the Compensation Committee at the time rights to purchase such 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 or the achievement of specified performance goals, as determined by the Compensation Committee at the time it grants or awards the options, the restricted shares or the SARs. 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 any unvested restricted shares, at the same price that was paid for the shares by the recipient, 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. To date, the Company has not granted any restricted shares or any SARs.

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PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements (Cont-)

(Unaudited)

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

Under ASC 718-10, we (and other public companies in the United States) are required to recognize, in our financial statements, the fair value 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, 2010 under the 2010 Plan or the Previously Approved Plans were estimated as of their respective dates of grant using the Black-Scholes option-pricing model. 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,
	2010			2009			2010			2009
Assumptions with respect to:
Expected volatility		34	%		34	%		34	%		34	%
Risk-free interest rate		2.36	%		2.41	%		3.09	%		2.41	%
Expected dividends		0.26	%		0.26	%		0.26	%		0.26	%
Expected term (years)		6.9			6.9			6.9			6.9
Weighted average fair value of options granted during period	$	1.36		$	1.41		$	1.20		$	1.39

(1) There were no options granted during the three months ended September 30, 2010.

The following tables summarize the stock option activity under the Company’s 1999, 2004, 2008 and 2010 Plans during the nine month periods ended September 30, 2010 and 2009, respectively.

	Nine Months Ended September 30,
	2010					2009
	Number of Shares Subject to Options			Weighted- Average Exercise Price Per Share		Number of Shares Subject to Options			Weighted- Average Exercise Price Per Share
Outstanding – January 1,		1,162,744		$	8.93		1,137,244		$	9.31
Granted		170,122			2.97		58,500			3.58
Exercised		—			—		—			—
Forfeited/Canceled		(351,724	)		7.48		(40,500	)		10.70
Outstanding – September 30,		981,142			8.42		1,155,244			8.97
Options Exercisable – September 30,		681,081		$	10.32		930,936		$	9.58

There were no options exercised during the nine months ended September 30, 2010 or the nine months ended September 30, 2009. The fair values of vested options at September 30, 2010 and 2009 were $164,378 and $272,645, respectively.

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PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements (Cont-)

(Unaudited)

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

The following table provides additional information regarding the vested and unvested options that were outstanding at September 30, 2010.

	Options Outstanding as of September 30, 2010								Options Exercisable as of September 30, 2010(1)
	Vested		Unvested		Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (Years)		Shares		Weighted Average Exercise Price
$ 2.97 – $5.99		63,121		277,001	$	3.34		8.88		63,121	$	3.37
$ 6.00 – $9.99		180,877		7,200		7.60		1.38		180,877		7.63
$10.00 – $12.99		311,100		—		11.23		3.38		311,100		11.23
$13.00 – $17.99		110,383		11,960		15.11		4.90		110,383		15.05
$18.00 – $18.84		15,600		3,900		18.06		5.34		15,600		18.06
		681,081		300,061		8.42		5.13		681,081		10.32

(1) The weighted average remaining contractual life of the options that were exercisable as of September 30, 2010 was 3.55 years

The aggregate intrinsic values of options that were outstanding and exercisable under the Plans at September 30, 2010, and 2009, were $1,400 and zero, respectively.

A summary of the status of the unvested options as of December 31, 2009, 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 month period ended September 30, 2010, are set forth in the following table.

	Number of Shares Subject to Options			Weighted Average Grant Date Fair Value
Unvested at December 31, 2009		207,032		$	2.36
Granted		170,122			1.20
Vested		(60,793	)		2.70
Forfeited/Cancelled		(16,300	)		3.64
Unvested at September 30, 2010		300,061		$	1.57

The aggregate amounts of stock based compensation expense recognized in our Consolidated Statements of Operations for the nine month periods ended September 30, 2010 and 2009 were $115,000 and $148,000, net of $104,000 in taxes, respectively. At September 30, 2010, the weighted average period over which nonvested awards were expected to be recognized was 1.44 years.

12

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements (Cont-)

(Unaudited)

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

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, 2010:

	Estimated Stock Based Compensation Expense
	(In thousands)
Remainder of 2010	$	47
For the years ending December 31,
2011		155
2012		118
2013		49
2014		5
2015		1
	$	375

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,
	2010		2009		2010		2009
	(In thousands)				(In thousands)
Service cost	$	48	$	47	$	144	$	140
Interest cost		35		30		101		91
Expected return on plan assets		—		—		—		—
Amortization of prior service cost		4		3		11		11
Amortization of net actuarial loss		6		7		17		30
Net periodic SERP cost	$	93	$	87	$	273	$	272

13

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements (Cont-)

(Unaudited)

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, changes in market or economic conditions that could affect our operating results or variances between our actual operating results and our projected operating results, as wells as other factors.

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 June 30, 2010 we conducted an assessment of the realizability of our remaining deferred tax asset. Based on that assessment and due, in part, to 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 recorded an additional valuation allowance against our net deferred tax asset in the amount of $10.7 million by means of a non-cash charge to income tax expense in the quarter ended June 30, 2010. That second quarter 2010 non-cash charge accounted for $9.0 million of the provision for income taxes recorded in our consolidated statement of operations for the nine months ended September 30, 2010.

If, in the future, market and economic conditions and our financial performance were to improve and, as a result, it were to become more likely than not that we will be able to utilize a portion of the tax benefits with respect to which we had established that valuation allowance, then we would be able to reverse that portion of the valuation allowance, which would then become available to reduce income tax expense that we would otherwise have to record in future periods.

The Company files income tax returns with the U.S. federal government and the state of California. As of September 30, and January 1, 2010, we were subject to examination by the Internal Revenue Service with respect to our U.S. federal tax returns and the Franchise Tax Board for California, for the 2005 to 2008 tax years. We do not believe there will be any material adverse changes in our unrecognized tax benefits over the next 12 months.

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 nine months ended September 30, 2010 and 2009. 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.

14

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements (Cont-)

(Unaudited)

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.

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.

15

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements (Cont-)

(Unaudited)

7. Fair Value Measurements (Cont-)

The following table shows the recorded amounts of assets (in thousands of dollars) measured at fair value on a recurring basis.

	At September 30, 2010 (in thousands)
	Total		Level 1		Level 2		Level 3
Assets at Fair Value:
Investment securities available for sale
Mortgage backed securities issued by U.S. agencies	$	99,268	$	—	$	99,268	$	—
Municipal securities		6,482		—		6,482		—
Collateralized mortgage obligations issued by non agency		3,496		—		2,587		909
Asset backed securities		785		—		—		785
Mutual funds		3,336		3,336		—		—
Total assets at fair value on a recurring basis	$	113,367	$	3,336	$	108,337	$	1,694

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

	Investment Securities Available for Sale
	(In thousands)
Balance of recurring Level 3 instruments at January 1, 2010	$	4,103
Total gains or losses (realized/unrealized)
Included in earnings realized		—
Included in earnings unrealized(1)		(286	)
Included in other comprehensive income		1,765
Purchases		—
Sales		—
Issuances		—
Settlements		—
Transfers in/or out of Level 3		(3,888	)
Balance of Level 3 assets at September 30, 2010	$	1,694

(1) Amount reported as an other-than-temporary impairment loss in the consolidated statements 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.

Loans Held for Sale. Mortgage loans held for sale are reported at fair value if, on an aggregate basis, the fair value of the loans is less than cost. In determining whether the fair value of loans held for sale is less than cost when quoted market prices are not available, the Company may consider outstanding investor commitments, discounted cash flow analysis with market assumptions or the fair value of the collateral if the loan is collateral dependent. Such loans are classified within either level 2 or level 3 of the fair value hierarchy. Where assumptions are made using significant unobservable inputs, such loans held for sale are classified as level 3.

16

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements (Cont-)

(Unaudited)

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). 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 Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the impaired loan at 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 management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the foreclosed asset at Level 3.

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

	At September 30, 2010 (in thousands)
	Total		Level 1		Level 2		Level 3
Assets at Fair Value:
Impaired loans	$	44,895	$	—	$	30,807	$	14,088
Loans held for sale		19,151		—		—		19,151
Foreclosed assets		21,459		—		21,459		—
Total	$	85,505	$	—	$	52,266	$	33,239

There were no significant transfers in or out of level 3 measurements for nonrecurring items during the nine months ended September 30, 2010.

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

Fair value 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.

17

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements (Cont-)

(Unaudited)

7. Fair Value Measurements (Cont-)

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. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as level 3 include asset-backed securities in less liquid markets.

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. Loans held for sale are carried at the lower of cost or market value. The fair value of 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 3. There were no fair value adjustments related to the loans held for sale at September 30, 2010.

Loans. The fair value for loans with variable interest rates 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.

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. When an appraised value is not available, or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price or a discounted cash flow has been used to determine the fair value, we record the impaired loan at nonrecurring Level 3.

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

18

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements (Cont-)

(Unaudited)

7. Fair Value Measurements (Cont-)

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 determined based on an analysis prepared by management, which considers the company’s own credit risk. 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, 2010 or December 31, 2009.

The following table sets forth the estimated fair values and related carrying amounts of our financial instruments as September 30, 2010 and December 31, 2009, respectively.

	September 30, 2010				December 31, 2009
	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
	(Dollars in thousands)
Financial Assets:
Cash and cash equivalents	$	205,844	$	205,844	$	141,651	$	141,651
Interest-bearing deposits with financial institutions		9,043		9,043		9,800		9,800
Federal Reserve Bank and Federal Home Loan Bank stock		13,459		13,459		14,091		14,091
Securities available for sale		113,367		113,367		170,214		170,214
Loans held for sale		19,151		19,151		7,572		7,572
Loans, net		738,750		732,335		813,194		807,707
Financial Liabilities:
Noninterest bearing deposits		186,550		186,550		183,789		183,789
Interest-bearing deposits		768,108		772,022		776,649		779,924
Borrowings		101,027		101,229		141,003		141,443
Junior subordinated debentures		17,527		17,527		17,527		17,527

19

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements (Cont-)

(Unaudited)

8. Investment Securities Available For Sale

The following table summarizes the major components of securities available for sale and compares the amortized cost, estimated fair market values of, and gross unrealized gains and losses on, such securities at September 30, 2010 and December 31, 2009:

	September 30, 2010									December 31, 2009
	Amortized		Gross Unrealized					Fair		Amortized		Gross Unrealized					Fair
	Cost		Gain		Loss			Value		Cost		Gain		Loss			Value
	(Dollars in thousands)
Securities Available for Sale
U.S. Treasury Securities	$	5,020	$	29	$	—		$	5,049	$	18,040	$	11	$	—		$	18,051
Mortgage backed securities issued by U.S. Agencies(1)		94,210		173		(164	)		94,219		134,331		89		(1,651	)		132,769
Total government and agencies securities		99,230		202		(164	)		99,268		152,371		100		(1,651	)		150,820
Municipal securities		6,389		103		(10	)		6,482		10,545		13		(431	)		10,127
Collateralized mortgage obligations issued by non agency(1)		3,665		29		(198	)		3,496		7,094		10		(1,069	)		6,035
Asset backed securities(2)		2,493		—		(1,708	)		785		2,704		—		(1,732	)		972
Mutual funds(3)		3,336		—		—			3,336		2,260		—		—			2,260
Total securities available for sale	$	115,113	$	334	$	(2,080	)	$	113,367	$	174,974	$	123	$	(4,883	)	$	170,214

(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.

The amortized cost and estimated fair values of securities available for sale at September 30, 2010 and December 31, 2009, 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, 2010 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	$	9,492		$	20,481		$	18,605		$	66,535		$	115,113
Securities available for sale, estimated fair value		9,534			20,539			18,485			64,809			113,367
Weighted average yield		2.90	%		2.28	%		3.05	%		2.94	%		2.84	%
	At December 31, 2009 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	$	29,819		$	40,075		$	36,000		$	69,080		$	174,974
Securities available for sale, estimated fair value		29,497			38,696			35,505			66,516			170,214
Weighted average yield		1.63	%		3.58	%		3.58	%		3.49	%		3.21	%

The Company recognized net gains on sales of securities available for sale of $1.4 million on sale proceeds of $228 million during the nine months ended September 30, 2010 and $1.4 million, net of $980,000 of taxes on sale proceeds of $188 million, during the nine months ended September 30, 2009.

20

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements (Cont-)

(Unaudited)

8. Investment Securities Available For Sale (Cont-)

The table below shows, as of September 30, 2010, the gross unrealized losses and fair values of our investments, in thousands of dollars, 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, 2010
	Less than 12 months					12 months or more					Total
	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
US agencies and mortgage backed securities	$	37,509	$	(160	)	$	484	$	(4	)	$	37,993	$	(164	)
Municipal securities		—		—			460		(10	)		460		(10	)
Non-agency collateralized mortgage obligations		—		—			2,444		(198	)		2,444		(198	)
Asset backed securities		—		—			785		(1,708	)		785		(1,708	)
Total temporarily impaired securities	$	37,509	$	(160	)	$	4,173	$	(1,920	)	$	41,682	$	(2,080	)

Impairment exists when the fair value of the security is less than its cost. The company performs a quarterly assessment of its securities that have an unrealized loss to determine whether the decline in fair value of these securities below their cost is other-than-temporary.

Effective April 1, 2009 we adopted ASC 321-10 and, as a result, we recognize other-than-temporary impairments (“OTTI”) for our available-for-sale debt securities in accordance with ASC 321-10. Therefore, 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 into the amount that is credit related and the amount that is related to non-credit factors. The credit-related impairment is recognized in net gain on the sale of securities in our consolidated statements of operations. Any non-credit-related impairment is recognized and reflected in other comprehensive income (loss).

Through the impairment assessment process, we determined that the investments discussed below were other-than-temporarily impaired at September 30, 2010. We recorded in our consolidated statements of operations for the three and nine months ended September 30, 2010 impairment credit losses on available for sale securities of $52,000 and $286,000, respectively.

21

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements (Cont-)

(Unaudited)

8. Investment Securities Available For Sale (Cont-)

Certain OTTI amounts were related to credit losses and recognized in our consolidated statement of operations, with the remainder recognized as part of other comprehensive loss. The table below presents information regarding other-than-temporary impairments (in thousands of dollars) for the three months ended September 30, 2010:

	Gross Other than Temporary Impairments			Temporary Impairments Included in Other Comprehensive Loss			Net Other- Than Temporary Impairments Included in Earnings
Balance at July 1, 2010	$	(1,912	)	$	(1,678	)	$	(234	)
Additions for credit and non credit losses on securities for which an OTTI was not previously recognized		(139	)		(87	)		(52	)
Balance at September 30, 2010	$	(2,051	)	$	(1,765	)	$	(286	)

Non-Agency CMO

We have identified one non-agency collateralized mortgage obligation security (CUSIP 94982HAK3) that required an assessment for OTTI at September 30, 2010. This CMO is a “Super Senior Support” bond, which was originated in 2005 and issued by Wells Fargo & Company, was rated AAA by Standard & Poor’s and Aa1 by Moody’s, and had a credit support of 2.5% of the total balance at issuance. As of September 30, 2010, the security was rated BBB and Caa3 by Standard and Poor’s and Moody’s, respectively, has an approximate amortized cost of $967,000 and an approximate fair value of $909,000, for a loss of $57,000. The principal collateral for this security is a pool of one-to-four family, fully amortizing residential first mortgage loans that have a fixed payment for approximately five years, after which they bear interest at variable rates with annual resets. Credit support at September 30, 2010 was approximately 5.5% and delinquencies 60 days and over totaled approximately 5.6%. Factors considered in the impairment include the rating change of the security, the current level of subordination from other CMO classes, anticipated prepayment rates, cumulative default rates and the loss severity given a default. For the three months ended September 30, 2010, there was no impairment for this security, We recognized $87,000 impairment loss with respect to this CMO, constituting a credit loss, in earnings for the nine months ended September 30, 2010. This non credit portion of OTTI is attributed to external market conditions, primarily the lack of liquidity in these securities and risks of potential additional declines in the housing market.

Asset Backed Securities

The Company has one asset backed security in its investment securities available for sale portfolio. The 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 consisting of 45 U.S. depository institutions and eleven insurance companies at the time of issuance in November 2007. The total size of this security at issuance was $363 million. The security that the Company owns (CUSIP 74042CAE8) is the mezzanine class B piece that floats with 3 month libor +60 basis points and had a rating of Aa2/AA by Moody’s and Fitch at the time of issuance. The Company purchased $3.0 million face value at a price of 95.21 for $2,856,420 in November 2007.

As of September 30, 2010 the book value of this security was $2.5 million with a fair value of $785,000 for an approximate unrealized loss of $1.7 million. Currently, the security has a Ca1 rating from Moody’s and CC rating from Fitch and has experienced $42.5 million in defaults (12% of total current collateral) and $39 million in payment deferrals (11% of total current collateral) from issuance to September 30, 2010. The security did not pay its scheduled third quarter interest payment. The Company is not currently accruing interest on this security. The Company estimates that the security could experience another $70 million in defaults before it would not receive all of its contractual cash flows.

22

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements (Cont-)

(Unaudited)

8. Investment Securities Available For Sale (Cont-)

This analysis is based on the following assumptions: future default rates of 2.2%, prepayment rates of 1% until maturity, and 15% recovery of future defaults. We recognized $52,000 impairment loss with respect to this security, constituting a credit loss, in earnings, for the three months ended September 30, 2010. The remaining loss of $1.7 million in this security was recognized through other comprehensive loss.

Impairment Losses on OTTI Securities

	Three Months Ended September 30,				Nine Months Ended September 30,
	2010		2009		2010		2009
	(In thousands)				(In thousands)
Asset Backed Security	$	52	$	—	$	199	$	—
Non Agency CMO		—		83		87		83
Total impairment loss recognized in earnings	$	52	$	83	$	286	$	83

As a part of our OTTI assessment, we consider information available about the performance of the underlying collateral, including credit enhancements, default rates, loss severities, delinquency rates, vintage, as well as rating agency reports and historical prepayment speeds. As a result, significant judgments are required in connection with our analysis to determine the expected cash flows for impaired securities. In determining the component of the OTTI related to credit losses, we compare the amortized cost basis of each other-than-temporarily impaired security to the present value of its expected cash flows, discounted using its effective interest rate implicit in the security at the date of acquisition.

Our assessment of our ability to continue to hold impaired investment securities, along with the evaluation of their future performance, as indicated by the criteria discussed above, provided the basis for our conclusion that, at September 30, 2010, the remainder of our impaired securities were not other-than-temporarily impaired. In assessing whether it is more likely than not that the Company will be required to sell any impaired security before its anticipated recovery, which may be at its maturity, we consider the amount of impairment, as well as the significance of each investment to our liquidity position and its impact on our capital position. As a result of our analyses, we determined that, at September 30, 2010, the unrealized losses on our securities portfolio on which impairments have not been recognized are temporary.

23

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements (Cont-)

(Unaudited)

9. Loans

The composition of the Company’s loan portfolio as of September 30, 2010 and December 31, 2009 was as follows:

	September 30, 2010						December 31, 2009
	Amount			Percent			Amount			Percent
	(In thousands)						(In thousands)
Commercial loans	$	224,421			29.4	%	$	290,406			34.8	%
Commercial real estate loans – owner occupied		175,712			23.0	%		179,682			21.5	%
Commercial real estate loans – all other		140,400			18.4	%		135,152			16.2	%
Residential mortgage loans – multi-family		90,658			11.9	%		101,961			12.2	%
Residential mortgage loans – single family		74,290			9.7	%		67,023			8.0	%
Construction loans		5,024			0.7	%		20,443			2.6	%
Land development loans		34,049			4.5	%		30,042			3.6	%
Consumer loans		18,147			2.4	%		9,370			1.1	%
Gross loans		762,701			100.0	%		834,079			100.0	%
Deferred fee (income) costs, net		(650	)					(540	)
Allowance for loan losses		(23,301	)					(20,345	)
Loans, net	$	738,750					$	813,194

Changes in the allowance for loan losses (in thousands of dollars) for the nine months ended September 30, 2010 and the year ended December 31, 2009 are as follows:

	Nine Months Ended September 30, 2010			Year Ended December 31, 2009
Balance, beginning of period	$	20,345		$	15,453
Provision for loan losses		7,488			23,673
Recoveries on loans previously charged off		2,086			357
Net, amounts charged off		(6,618	)		(19,138	)
Balance, end of period	$	23,301		$	20,345

The following table sets forth information regarding nonaccrual loans and restructured loans at September 30, 2010:

	September 30, 2010		December 31, 2009
Impaired loans:
Nonaccruing loans	$	28,262	$	28,092
Nonaccruing restructured loans		15,433		21,357
Accruing restructured loans		1,200		1,243
Accruing loans 90 days or more delinquent		—		6,697
Total impaired loans	$	44,895	$	57,389
Impaired loans less than 90 days delinquent and included in total impaired loans	$	19,098	$	27,408

Our allowance for loan losses included $9.7 million of reserves for $44.9 million of impaired loans at September 30, 2010 and $4.8 million of reserves for $57.4 million of impaired loans at December 31, 2009. The impaired loan balances for which no reserves had been allocated totaled $19.6 million and $29.2 million at September 30, 2010 and December 30, 2009, respectively, based on our conclusion that those loans were sufficiently collateralized to offset any charge-offs or write-downs of those loans.

24

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

Introduction

Pacific Mercantile Bancorp is a bank holding company that owns all of the stock of Pacific Mercantile Bank (the “Bank”), which is a commercial bank that provides a full range of banking services to small and medium-size businesses and to professionals and the general public in Orange, Los Angeles, San Bernardino and San Diego counties, in Southern California. Substantially all of our operations are conducted and substantially all of our assets are owned by the Bank, which accounts for substantially all of our consolidated revenues, expenses and operating income. For ease of reference we will sometimes refer to Pacific Mercantile Bancorp as the “Company” or “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, 2010 and comparisons of those results with the results of operations for the corresponding three and nine month periods of 2009, and (ii) our consolidated financial condition, liquidity and capital resources at September 30, 2010. 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, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include 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. Unexpected future events and such risks and uncertainties 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. Certain of those risks and uncertainties are discussed below in this Item 2 of this Report, in Item 1A, entitled “Risk Factors” contained in our Annual Report on Form 10-K for our fiscal year ended December 31, 2009 (our “2009 10-K”), and in Item 1A, entitled “Risk Factors” in Part II of this Report below. Therefore, you are urged to read not only the information contained in this section of this Report, but also the risk factors that are discussed in our 2009 10-K and in this report in conjunction with your review of the following discussion regarding our results of operations for the three and nine months ended, and our financial condition at, September 30, 2010.

Due to those risks and uncertainties, readers are cautioned not to place undue reliance on the forward-looking statements contained in this Report, which speak only as of the date of this Report, or to make predictions about future performance based solely on historical financial performance. We also disclaim any obligation to update forward-looking statements contained in this Report or in our 2009 10-K, except as may otherwise be required by law or Nasdaq rules.

25

Overview of Operating Results in the Three and Nine Months Ended September 30, 2010

The following table sets forth information regarding the interest income that we generated, the interest expense that we incurred, our net interest income, noninterest income, noninterest expense, and our net income (loss) and net income (loss) per share for the three and nine months ended September 30, 2010 and 2009, respectively.

	Three Months Ended September 30									Nine Months Ended September 30
	Amount			Amount			Percent Change			Amount			Amount			Percent Change
	2010			2009			2010 vs. 2009			2010			2009			2010 vs. 2009
Interest income	$	12,305		$	12,879			(4.5	)%	$	38,895		$	38,814			0.2	%
Interest expense		4,386			7,495			(41.5	)%		14,311			23,621			(39.4	)%
Net interest income		7,919			5,384			47.1	%		24,584			15,193			61.8	%
Provision for loan losses		1,688			3,790			(55.5	)%		7,488			13,833			(45.9	)%
Net interest income after provision for loan losses		6,231			1,594			290.9	%		17,096			1,360			N/M
Noninterest income		2,292			1,475			55.4	%		5,342			4,590			16.4	%
Noninterest expense		8,648			9,512			(9.1	)%		25,361			24,043			5.5	%
Loss before income tax		(125	)		(6,443	)		98.1	%		(2,923	)		(18,093	)		83.8	%
Income tax (benefit) provision		—			(2,577	)		N/A			9,059			(7,546	)		220.1	%
Net loss	$	(125	)	$	(3,866	)		96.8	%	$	(11,982	)	$	(10,547	)		(13.6	)%
Cumulative undeclared dividends on preferred stock		(327	)		—			N/A			(756	)		—			N/M
Net loss allocable to common stockholders		(452	)		(3,866	)		88.3	%		(12,738	)		(10,547	)		(20.8	)%
Net loss per diluted share	$	(0.04	)	$	(0.37	)		89.2	%	$	(1.22	)	$	(1.01	)		(20.8	)%
Weighted average number of diluted shares		10,434,665			10,434,665			—			10,434,665			10,434,665			—

As the above table indicates, during the three months ended September 30, 2010:

• Net interest income increased by $2.5 million, or 47%, to $7.9 million from $5.4 million in the three months ended September 30, 2009.

• We were able to reduce the provision we made for loan losses by $2.1 million, or 56%, to $1.7 million from nearly $3.8 million for the same three months of 2009, due primarily to a decline in net loan charge-offs.

• Accordingly, our net interest income, after the provision for loan losses, increased by $4.6 million, or 291%, to $6.2 million from $1.6 million in the same three months of 2009.

• Our non-interest income increased by $817,000, or 55%, to $2.3 million from $1.5 million in the three months ended September 30, 2009, due primarily to an increase in our mortgage banking revenues and, to a lesser extent, an increase in gains on sales of securities.

• We reduced our non-interest expense by $864,000, or 9.1%, to $8.6 million from $9.5 million in the same three months of 2009, due primarily to decreases in compensation expense and in other real estate owned (“OREO”) expense, which more than offset a $573,000 increase in FDIC deposit insurance premiums.

• Our efficiency ratio improved to 84.7%, from 139% in the same three months of 2009, due to the combination of the increases in our revenues and the reduction in our non-interest expense.

• Due to the above described improvements, we reduced our net loss by $3.8 million, or 97%, to $125,000, or $0.04 per diluted common share, from $3.9 million, or $0.37 per diluted common share, in the same three months of 2009.

• Additionally, Pacific Mercantile Bank, our wholly owned banking subsidiary, generated a net profit of $123,000 in the third quarter ended September 30, 2010, as the net loss for the quarter was attributable to the operations of the Company on a stand-alone basis.

26

Similarly, our operating results for the nine months ended September 30, 2010 showed improvement, due primarily to (i) a $9.4 million, or 62%, increase in net interest income, (ii) a $6.3 million, or 46%, reduction in the provision we made for loan losses, and (iii) a $752,000, or 16%, increase in non-interest income. Those improvements more than offset a $1.3 million, or 5.5%, increase in non-interest expense that was primarily attributable to an increase in FDIC deposit insurance premiums and an increase in professional fees incurred primarily in connection with the collection and foreclosures of non-performing loans. As a result, we were able to reduce our pre-tax loss by $15.2 million, or 84%, to $2.9 million in the nine months ended September 30, 2010 as compared to a pre-tax loss of $18.1 million in the same nine months of 2009.

However, notwithstanding that reduction in our pre-tax loss in the nine months ended September 30, 2010, the provision for income taxes for that nine month period was $9.1 million, of which $9.0 million was attributable to the establishment of a non-cash valuation allowance against our deferred tax asset in the quarter ended June 30, 2010. See “Critical Accounting Policies” and “Results of Operations—Income Tax Provision (Benefit)” below in this Section of this Report. By contrast, we recorded an income tax benefit of $7.5 million for the nine months ended September 30, 2009. As a result, we recorded a net loss of nearly $12.0 million, or approximately $1.22 per diluted common share, for the nine months ended September 30, 2010, as compared to a net loss of $10.5 million, or $1.01 per diluted common share, for the same nine months of 2009. Since that valuation allowance was created by means of a non-cash charge, it did not affect the Company’s cash or liquidity in any way.

Due to accumulated but unpaid dividends on our Series A Convertible 10% Cumulative Preferred Stock (the “Series A Preferred Shares”) of $327,000 and $756,000, respectively, for the three and nine months ended September 30, 2010, the net losses allocable to common shareholders were $452,000, or $0.04 per diluted common share, in the three months ended September 30, 2010 and $12.7 million, or $1.22 per diluted common share, in the nine months ended September 30, 2010.

The following table indicates the improvements in our net interest margin, return on average assets and return on average equity that were attributable to the increases in our net interest income and the improvement in our operating results in the three and nine months ended September 30, 2010:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2009			2010			2009
Net interest margin(1)(2)		2.78	%		1.88	%		2.87	%		1.76	%
Return on average assets(1)		(0.04	)%		(1.30	)%		(1.36	)%		(1.18	)%
Return on average shareholders’ equity(1)		(0.72	)%		(19.86	)%		(31.17	)%		(16.67	)%

(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 accounting practices in the banking industry in the United States. 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 value of those assets, such as, for example, assumptions regarding economic conditions or trends that could impact our ability to fully collect our loans or ultimately realize the carrying value of certain of our other assets, such as securities available for sale and our deferred tax assets. Those assumptions and judgments are made based on current information available to us regarding those economic conditions or trends or other circumstances impacting our financial results. 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 or causing us to incur losses.

27

Deferred Tax Asset. Under our accounting policies, 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 (collectively, “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 that it has become more likely than not that we will be unable to fully utilize those tax benefits 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 to offset future taxes. 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 which we would otherwise have recorded in our statement 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, changes in market or economic conditions that could affect our operating results or variances between our actual operating results and our projected operating results, as wells as other factors.

Due primarily to the continued sluggishness of the economy and market and economic conditions which indicated that the hoped-for economic recovery would be weaker than previously anticipated, and the adverse effects such conditions were likely to have on our future operating results, we conducted an assessment of the realizability of our deferred tax asset at June 30, 2010. Based on that assessment, we concluded that it had become more likely than not that we would be unable to utilize the remaining tax benefits comprising our deferred tax asset prior to their expiration and, therefore, we increased our existing valuation allowance against our deferred tax asset by means of a non-cash charge to income tax expense of $9.0 million in the quarter ended June 30, 2010. As a result, the provision for income taxes for the nine months ended September 30, 2010 was $9.1 million, of which $9.0 million was attributable to the non-cash change we recorded in the quarter ended June 30, 2010. By comparison, we recorded an income tax benefit of $7.5 million for the nine months ended September 30, 2009. See note 6 to our unaudited interim consolidated financial statements included elsewhere in this Report and “Results of Operations – Income Tax Provision (Benefit)” below.

Other Critical Accounting Policies. Our other critical accounting policies, which require us to make assumptions and estimates regarding circumstances or trends that could affect the value of our assets, relate to the determination of the allowance we establish for loan losses and the determination of the fair values of the investment securities that are available for sale. Additional information regarding those critical accounting policies is contained in Item 6, entitled MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — “Critical Accounting Policies” and “Allowance for Loan Losses” and in Note 2—“Significant Accounting Policies” in the Notes to our Consolidated Financial Statements contained in Item 8, of our Annual Report on Form 10-K for the year ended December 31, 2009 and readers of this Report are urged to read those sections of that Annual Report.

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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, 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, 2010 and 2009, respectively:

	Three Months Ended September 30,									Nine Months Ended September 30,
	Amount			Amount			Percentage Change			Amount			Amount			Percentage Change
	2010			2009			2010 vs. 2009			2010			2009			2010 vs. 2009
Interest income	$	12,305		$	12,879			4.5	%	$	38,895		$	38,814			0.2	%
Interest expense		4,386			7,495			(41.5	)%		14,311			23,621			(39.4	)%
Net interest income	$	7,919		$	5,384			47.1	%	$	24,584		$	15,193			61.8	%
Net interest margin		2.78	%		1.88	%					2.87	%		1.76	%

As the above table indicates, our net interest income increased by $2.5 million, or 47.1%, in the third quarter of 2010, and by $9.4 million, or 61.8%, in the nine months ended September 30, 2010, due primarily to decreases in interest expense of $3.1 million, or 41.5%, and $9.3 million, or 39.4%, respectively, in the three and nine months period ended September 30, 2010. The declines in interest expense were primarily attributable to decreases in market rates of interest, which enabled us to reduce the interest we paid on time deposits and resulted in a lowering of the rates at which we pay interest on our borrowings. Also contributing to the decrease in interest expense was a change in the mix of deposits to a higher proportion of lower-cost core deposits and a lower proportion of higher-cost time deposits.

Due primarily to the increase in net interest income, our net interest margin increased by 90 basis points to 2.78%, and 111 basis points to 2.87%, respectively, in the three and nine months ended September 30, 2010, from 1.88% and 1.76%, respectively, in the same three and nine month periods of 2009. In the three and nine months ended September 30, 2010, the average interest rate paid on interest bearing liabilities decreased to 1.90% and 1.53%, respectively, from 3.24% and 3.35% in the same respective periods of 2009.

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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, 2010 and 2009.

	Three Months Ended September 30,
	2010							2009
	Average Balance		Interest Earned/ Paid		Average Yield/ Rate			Average Balance		Interest Earned/ Paid		Average Yield/ Rate
	(Dollars in thousands)
Interest earning assets:
Short-term investments(1)	$	228,795	$	147		0.25	%	$	148,568	$	129		0.34	%
Securities available for sale and stock(2)		118,272		790		2.65	%		147,764		814		2.19	%
Loans		784,149		11,368		5.75	%		842,031		11,936		5.62	%
Total earning assets		1,131,216		12,305		4.32	%		1,138,363		12,879		4.49	%
Noninterest earning assets		34,616							48,957
Total Assets	$	1,165,832						$	1,187,320
Interest-bearing liabilities:
Interest-bearing checking accounts	$	34,556		47		0.54	%	$	26,952		58		0.85	%
Money market and savings accounts		139,675		351		1.00	%		113,350		348		1.22	%
Certificates of deposit		623,525		3,420		2.18	%		604,184		5,295		3.48	%
Other borrowings		106,799		428		1.59	%		163,164		1,648		4.01	%
Junior subordinated debentures		17,682		140		3.14	%		17,682		146		3.28	%
Total interest-bearing liabilities		922,237		4,386		1.89	%		925,332		7,495		3.24	%
Noninterest-bearing liabilities		175,232							184,753
Total Liabilities		1,097,469							1,110,085
Shareholders’ equity		68,363							77,233
Total Liabilities and Shareholders’ Equity	$	1,165,832						$	1,187,320
Net interest income			$	7,919						$	5,384
Interest rate spread						2.43	%						1.25	%
Net interest margin						2.78	%						1.88	%

(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.

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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 nine months ended September 30, 2010 and 2009.

	Nine Months Ended September 30,
	2010							2009
	Average Balance		Interest Earned/ Paid		Average Yield/ Rate			Average Balance		Interest Earned/ Paid		Average Yield/ Rate
	(Dollars in thousands)
Interest earning assets:
Short-term investments(1)	$	184,310	$	389		0.28	%	$	163,971	$	373		0.30	%
Securities available for sale and stock (2)		150,896		3,448		3.06	%		147,791		2,912		2.63	%
Loans		810,136		35,058		5.79	%		845,363		35,529		5.62	%
Total earning assets		1,145,342		38,895		4.54	%		1,157,125		38,814		4.48	%
Noninterest earning assets		37,501							38,594
Total Assets	$	1,182,843						$	1,195,719
Interest-bearing liabilities:
Interest-bearing checking accounts	$	40,770		210		0.69	%	$	26,036		118		0.61	%
Money market and savings accounts		132,150		1,159		1.17	%		105,473		934		1.18	%
Certificates of deposit		634,733		10,860		2.29	%		604,152		16,647		3.68	%
Other borrowings		110,273		1,695		2.06	%		187,296		5,425		3.87	%
Junior subordinated debentures		17,682		387		2.93	%		17,682		497		3.75	%
Total interest-bearing liabilities		935,608		14,311		2.05	%		940,639		23,621		3.35	%
Noninterest-bearing liabilities		173,390							170,509
Total Liabilities		1,108,998							1,111,148
Shareholders’ equity		73,845							84,571
Total Liabilities and Shareholders’ Equity	$	1,182,843						$	1,195,719
Net interest income			$	24,584						$	15,193
Interest rate spread						2.49	%						1.13	%
Net interest margin						2.87	%						1.76	%

(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.

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The following table sets forth, in thousands of dollars, the changes in interest income, including loan fees, and interest paid in the three and nine months ended September 30, 2010, as compared to the same respective periods of 2009, and the extent to which those changes were attributable to changes in (i) the volumes of or in the rates of interest earned on interest-earning assets and (ii) the volumes of or the rates of interest paid on our interest-bearing liabilities.

	Three Months Ended September 30, 2010 vs. 2009									Nine Months Ended September 30, 2010 vs. 2009
	Increase (Decrease) due to:									Increase (Decrease) due to:
	Volume			Rate			Total			Volume			Rate			Total
Interest income:
Short term investments(1)	$	57		$	(39	)	$	18		$	44		$	(28	)	$	16
Securities available for sale and stock(2)		(179	)		155			(24	)		61			475			536
Loans		(835	)		267			(568	)		(1,506	)		1,035			(471	)
Total earning assets		(957	)		383			(574	)		(1,401	)		1,482			81
Interest expense
Interest bearing checking accounts		14			(25	)		(11	)		74			18			92
Money market and savings accounts		73			(70	)		3			234			(9	)		225
Certificates of deposit		164			(2,035	)		(1,871	)		805			(6,592	)		(5,787	)
Borrowings		(444	)		(780	)		(1,224	)		(1,742	)		(1,988	)		(3,730	)
Junior subordinated debentures		—			(6	)		(6	)		—			(110	)		(110	)
Total interest bearing liabilities		(193	)		(2,916	)		(3,109	)		(629	)		(8,681	)		(9,310	)
Net interest income	$	(764	)	$	3,299		$	2,535		$	(772	)	$	10,163		$	9,391

(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.

The above table indicates that the increases in our net interest income of $2.5 million and $9.4 million in the three and nine months ended September 30, 2010, respectively, were primarily attributable to increases in rate variances of $3.3 million and $10.2 million in the three and nine months ended September 30, 2010, respectively. Those increases in rate variance were primarily the result of (i) decreases in interest rates paid on interest bearing liabilities of 135 basis points and 86 basis points, respectively, and (ii) increases of 13 and 17 basis points, respectively, in the average yield on our loan portfolio in the three and nine months ended September 30, 2010, in each case as compared to the same respective periods of 2009.

Provision for Loan Losses

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

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

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 allowance for loan losses and the amount of the provisions that we need to make for potential loan losses. However, those determinations involve judgments about trends in current economic conditions and other events

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or circumstances 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 allowance. 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 Section under the caption “—Financial Condition—Nonperforming Loans, Other Nonperforming Assets and the Allowance for Loan Losses”. If changes in economic or market conditions or unexpected subsequent events were to occur, or if changes were made to bank regulatory guidelines or industry standards that are used to assess the sufficiency of the allowance for loan losses, it could become necessary for us to incur 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 Federal Reserve Bank of San Francisco (the “FRB” or “Reserve Bank”) and the California Department of Financial Institutions (the “DFI”), as an integral part of their examination processes, periodically review the adequacy of our allowance for loan losses. These agencies may require us to make additional provisions 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.

During the three and nine months ended September 30, 2010, we made provisions for loan losses of $1.7 million and $7.5 million, respectively, as compared to $3.8 million and $13.8 million in the respective corresponding periods of 2009. The decreases in the provisions for loan losses in the three and nine months ended September 30, 2010, as compared to the same respective periods of 2009, were the result of reductions in net loan charge offs, during the third quarter and first nine months of this year, as compared to the same respective periods of last year.

Notwithstanding the reduction in the provision made for loan losses in the nine months ended at September 30, 2010 the allowance for loan losses totaled $23.3 million, or 3.06% of the loans then outstanding, as compared to $20.3 million, or 2.44% of loans outstanding, at December 31, 2009 and $20.5 million, or 2.46%, of the loans outstanding at September 30, 2009. That increase in the allowance was primarily attributable to (i) the additions made to the allowance for loan losses in the nine months ended September 30, 2010, (ii) a reduction in loan charge-offs in the nine months ended September 30, 2010, as compared to the nine months ended 2009, and (iii) a reduction in total amount of loans outstanding at September 30, 2010 as compared to the total loans outstanding at December 31, 2009 and September 30, 2009, respectively.

Noninterest Income

The following table identifies the amounts (in thousands of dollars) of, and sets forth the percentage changes in, the components of noninterest income in the three and nine months ended September 30, 2010, as compared to the same period of 2009.

	Three Months Ended September 30									Nine Months Ended September 30
	Amounts						Percent Change			Amounts						Percent Change
	2010			2009			2010 vs. 2009			2010			2009			2010 vs. 2009
Service fees on deposits and other banking services	$	278		$	352			(21.0	)%	$	930		$	1,101			(15.5	)%
Mortgage banking (including net gains on sales of loans held for sale)		1,113			540			106.1	%		2,743			607			N/M
Net gains on sales of securities available for sale		780			446			74.9	%		1,417			2,334			(39.3	)%
Net loss on sale of other real estate owned		(5	)		(147	)		(96.6	)%		(64	)		(145	)		(55.9	)%
Net impairment loss recognized in earnings from securities		(52	)		(83	)		(37.3	)%		(286	)		(83	)		N/M
Other		178			367			(51.5	)%		602			776			(22.4	)%
Total noninterest income	$	2,292		$	1,475			55.4	%	$	5,342		$	4,590			16.4	%

As the table above indicates, the increase in noninterest income in the three months ended September 30, 2010, as compared to the same period in 2009, was primarily attributable to (i) a $573,000 or 106.1% increase in income generated by our mortgage banking division, which commenced its operations during the second quarter 2009, and (ii) a $334,000, or 74.9% increase in net gains on sales of securities.

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The increase in noninterest income in the nine months ended September 30, 2010, as compared to the same period in 2009, was primarily the result of a $2.1 million increase in income generated by our mortgage banking division, partially offset by a $917,000, or 39.3%, decrease in net gains on sales of securities.

Noninterest Expense

The following table compares the amounts (in thousands of dollars) of the principal components of noninterest expense in the three and nine months ended September 30, 2010 and 2009.

	Three Months Ended September 30,							Nine Months Ended September 30,
	Amount		Amount		Percent Change			Amount		Amount		Percent Change
	2010		2009		2010 vs. 2009			2010		2009		2010 vs. 2009
Salaries and employee benefits	$	3,703	$	4,194		(11.7	)%	$	11,747	$	11,580		1.4	%
Occupancy expense		673		682		(1.3	)%		2,020		2,038		(0.9	)%
Equipment and depreciation		295		313		(5.8	)%		952		868		9.7	%
Data processing		156		276		(43.5	)%		514		662		(22.4	)%
Professional fees		1,227		1,338		(8.3	)%		3,207		2,740		17.0	%
Customer expense		52		92		(43.5	)%		232		281		(17.4	)%
FDIC insurance		1,256		683		83.9	%		2,522		1,933		30.5	%
Other real estate owned		439		1,170		(62.5	)%		1,330		1,689		(21.3	)%
Other operating expenses(1)		847		764		10.9	%		2,837		2,252		26.0	%
Total	$	8,648	$	9,512		(9.1	)%	$	25,361	$	24,043		5.5	%

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

In the three months ended September 30, 2010, noninterest expense decreased by $864,000, or 9.1%, compared to the same three months of 2009. That decrease was primarily attributable to (i) a $731,000, or 62.5%, decrease in other real estate owned expenses, and (ii) a $491,000, or 11.7%, decrease in salaries and employee benefits, partially offset by a $573,000, or 83.9%, increase in FDIC insurance premiums.

In the nine months ended September 30, 2010, noninterest expense increased by $1.3 million, or 5.5%, as compared to the same nine months of 2009, primarily as a result of (i) an increase in FDIC insurance expense of $589,000, or 30.5%, and (ii) an increase of $467,000, or 17.0%, in professional fees incurred in connection with the collection and foreclosures of non-performing loans, partially offset by a $359,000, or 21.3%, decrease in other real estate owned expenses.

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. For the three and nine months ended September 30, 2010, our efficiency ratios improved to 85% in both those periods, from 139% and 122%, respectively, in the corresponding three and nine month periods of 2009, due primarily to the increases in our net interest income of $2.5 million and $9.4 million in the three and nine months ended September 30, 2010, respectively.

Expense Reduction Initiatives. In February 2010, we initiated a number of cost-cutting measures that are designed to improve the efficiency of our operations and reduce our noninterest expense by at least 8%. Those measures included a work force reduction, a freeze on salaries, elimination of a management bonus program for 2010, and suspension of Company 401-K plan matching contributions. However, there is no assurance that we will achieve our expense reduction objective in fiscal 2010, because the amount of our noninterest expense can be affected by events or conditions that are outside of our control, such as the costs of managing non-performing loans and foreclosing and reselling other real estate owned and the amount of the FDIC insurance premiums that we are required to pay.

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Income Tax Provision (Benefit)

We recorded provisions for income tax expense of $0 and $9.1 million, respectively, in the three and nine months ended September 30, 2010, as compared to income tax benefits of $1.2 million and $6.2 million, respectively, in the three and nine months ended September 30, 2009. Those swings in the provision (benefit) for income taxes were primarily attributable to our recognition of a $9.0 million non-cash charge recorded in the quarter ended June 30, 2010 to increase the valuation allowance established for the deferred tax asset on our balance sheet as a result of a determination that it had become more likely, than not, that we would be unable to utilize that deferred tax asset to offset income tax expense in future periods. See Note 6 to our unaudited interim consolidated financial statements included in Item 1 above in this Report and “Critical Accounting Policies” above in this Item 2 of this Report for additional information regarding our deferred tax asset and the non-cash charge recognized to increase the related valuation allowance in the second quarter of 2010.

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.

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The table below sets forth information concerning our rate sensitive assets and liabilities at September 30, 2010. The assets and liabilities are classified by the earlier of maturity or repricing dates in accordance with their contractual terms. As described above, certain shortcomings are inherent in the method of analysis presented in this table.

	Three Months or Less			Over Three Through Twelve Months			Over One Year Through Five Years			Over Five Years			Non- Interest- Bearing			Total
	(Dollars in thousands)
Assets
Interest-bearing time deposits in other financial institutions	$	8,599		$	444		$	—		$	—		$	—		$	9,043
Investment in unconsolidated trust subsidiaries		—			—			—			682			—			682
Securities available for sale		10,853			12,623			53,220			36,671			—			113,367
Federal Reserve Bank and Federal Home Loan Bank stock		13,459			—			—			—			—			13,459
Interest bearing deposits with financial institutions		205,844			—			—			—			—			205,844
Loans held for sale, at Fair value		19,151			—			—			—			—			19,151
Loans, gross		319,445			47,991			325,190			69,425			—			762,051
Non-interest earning assets, net		—			—			—			—			24,080			24,080
Total assets	$	577,351		$	61,058		$	378,410		$	106,778		$	24,080		$	1,147,677
Liabilities and Shareholders’ Equity
Noninterest-bearing deposits	$	—		$	—		$	—		$	—		$	186,550		$	186,550
Interest-bearing deposits(1)(2)		276,433			273,814			89,230			128,631			—			768,108
Borrowings		23,027			25,000			53,000			—			—			101,027
Junior subordinated debentures		17,527			—			—			—			—			17,527
Other liabilities		—			—			—			—			6,218			6,218
Shareholders’ equity		—			—			—			—			68,247			68,247
Total liabilities and shareholders’ equity	$	316,987		$	298,814		$	142,230		$	128,631		$	261,015		$	1,147,677
Interest rate sensitivity gap	$	260,364		$	(237,756	)	$	236,180		$	(21,853	)	$	(236,935	)	$	—
Cumulative interest rate sensitivity gap	$	260,364		$	22,608		$	258,788		$	236,935		$	—		$	—
Cumulative % of rate sensitive assets in maturity period		50	%		56	%		89	%		98	%		100	%
Rate sensitive assets to rate sensitive liabilities and shareholders’ equity		182	%		20	%		266	%		83	%		9	%
Cumulative ratio		182	%		104	%		134	%		127	%		100	%

(1) Excludes savings accounts we maintain at the Bank totaling $5.2 million and maturing within three months of September 30, 2010.

(2) Excludes a $250,000 certificate of deposit issued to us by the Bank, which matures January 2011.

At September 30, 2010, our rate sensitive balance sheet was shown to be in a positive twelve-month gap position. This would imply that our net interest margin would increase in the short-term if interest rates were to rise and would decrease in the short-term if interest rates were to fall. However, as noted above, the extent to which our net interest margin will be impacted by changes in prevailing interests rates will depend on a number of factors, including how quickly rate sensitive assets and liabilities react to interest rate changes, the mix of our interest earning assets (loans versus other lower yielding interest earning assets, such as securities or federal funds sold) and the mix of our interest bearing deposits (between, for example, lower interest core deposits and higher cost time certificates of deposit) and our other interest-bearing liabilities.

36

Financial Condition

Assets

Our consolidated assets totaled $1.148 billion at September 30, 2010, which represents a $52 million decrease from our total consolidated assets of $1.201 billion at December 31, 2009. That decrease was primarily attributable to a $75 million reduction in the total loans outstanding (net of allowances), and a $57 million decrease in securities, between December 31, 2009 and September 30, 2010, partially offset by an increase in cash and cash equivalents during the nine months ended September 30, 2010.

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

	September 30, 2010		December 31, 2009
Interest-bearing deposits with financial institutions(1)	$	194,738	$	127,785
Interest-bearing time deposits with financial institutions		9,043		9,800
Federal Reserve Bank and Federal Home Loan Bank Stock, at cost		13,459		14,091
Securities available for sale, at fair value		113,367		170,214
Loans held for sale, at lower of cost or market		19,193		7,572
Loans (net of allowances of $23,301 and $20,345, respectively)		738,708		813,194

(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 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. The following table reflects the quarterly activity, in thousands of dollars, of our mortgage loan operations.

	Three Months Ended September 30,		Nine Months Ended September 30,		Nine Months Ended September 30,
	2010		2010		2009(1)
Single family mortgage loans funded	$	58,443	$	154,183	$	72,867
Single family mortgage loan sales		60,863		142,192		65,523
Balance End of Period		19,151		N/A		N/A

(1) Since we commenced our mortgage loan operations in the second quarter of 2009, the results shown for the nine months ended September 30, 2009 are for a period of approximately five months, rather than nine months.

Loans held for sale are carried at the lower of cost or estimated fair value in the aggregate. Net unrealized losses on loans held for sale, if any, would be recognized through a valuation allowance established by a charge to income. As of September 30, 2010, the loans held for sale included $15.4 million of loans with interest rate lock commitments providing a hedge to interest rates and $3.4 million of loans pending investor commitments.

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Loans

The following table sets forth, in thousands of dollars, the composition, by loan category, of our loan portfolio at September 30, 2010 and December 31, 2009, respectively:

	September 30, 2010						December 31, 2009
	Amount			Percent			Amount			Percent
Commercial loans	$	224,421			29.4	%	$	290,406			34.8	%
Commercial real estate loans – owner occupied		175,712			23.0	%		179,682			21.5	%
Commercial real estate loans – all other		140,400			18.4	%		135,152			16.2	%
Residential mortgage loans – multi- family		90,658			11.9	%		101,961			12.2	%
Residential mortgage loans – single-family		74,290			9.7	%		67,023			8.0	%
Construction loans		5,024			0.7	%		20,443			2.6	%
Land development loans		34,049			4.5	%		30,042			3.6	%
Consumer loans		18,147			2.4	%		9,370			1.1	%
Gross loans		762,701			100.0	%		834,079			100.0	%
Deferred fee (income) costs, net		(650	)					(540	)
Allowance for loan losses		(23,301	)					(20,345	)
Loans, net	$	738,750					$	813,194

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, in thousands of dollars, the maturity distribution of our loan portfolio (excluding consumer and residential mortgage loans) at September 30, 2010:

	September 30, 2010
	One Year or Less		Over One Year through Five Years		Over Five Years		Total
Real estate and construction loans(1)
Floating rate	$	58,823	$	111,799	$	2,636	$	173,258
Fixed rate		39,753		92,827		49,347		181,927
Commercial loans
Floating rate		22,126		225		—		22,351
Fixed rate		109,231		75,642		17,197		202,070
Total	$	229,933	$	280,493	$	69,180	$	579,606

(1) Does not include mortgage loans on single and multi-family residences and consumer loans, which totaled $164.9 million and $18.1 million, respectively, at September 30, 2010.

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Non-Performing Loans, Other Non-Performing Assets and Allowance for Loan Losses

Non-Performing Loans. Non-performing loans consist of loans which, as described below, are on non-accrual status. Generally, the accrual of interest is discontinued on a loan when principal or interest becomes more than 90 days past due, at which time they are placed on non-accrual status, unless management believes the loan is adequately collateralized and the loan is in the process of collection. Loans on non-accrual status also include loans that have been restructured, but for which there has not been a history of past performance on debt service in accordance with the contractual terms of such loans. In certain instances, however, we may place a particular loan on non-accrual status earlier, depending on the individual circumstances involved in 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 cash on such loans are applied as principal reductions when received, except when the ultimate collectability of principal is probable, in which case interest payments are credited to income. Non-accrual loans may be restored to accrual status when principal and interest are brought current and full repayment is expected. Any loan that has been restructured will remain in non-accrual status unless and until there has been six months of satisfactory performance by the borrower in accordance with the restructured terms of the loan, at which time the loan usually is returned to accrual status. Interest income is recognized on the accrual basis for impaired loans not meeting the criteria for classification as non-accrual loans.

Other Non-Performing Assets. Other non-performing assets consist of real properties that have been acquired on or in lieu of foreclosure of non-performing loans (which are commonly referred to as “other real estate owned” or “OREO”).

The following table sets forth information regarding nonaccrual loans and other real estate owned (which, together, comprise our nonperforming assets), and restructured loans, at September 30, 2010 and December 31, 2009:

	At September 30, 2010		At December 31, 2009
Nonaccrual loans:
Commercial loans	$	9,414	$	17,150
Commercial real estate		16,591		20,779
Residential real estate		8,408		1,358
Construction and land development		9,398		10,162
Consumer loans		128		—
Total nonaccrual loans		43,939		49,449
Other real estate owned (OREO):
Commercial loans		4,146		—
Commercial real estate		5,018		—
Construction and land development		12,295		10,712
Total other real estate owned		21,459		10,712
Total nonperforming assets	$	65,398	$	60,161
Restructured loans:
Accruing loans	$	1,200	$	1,243
Nonaccruing loans (included in nonaccrual loans above)		15,433		20,114
Total Restructured Loans	$	16,633	$	21,357

As the above table indicates, other real estate owned increased by $10.8 million, from $10.7 million to $21.5 million, and nonaccrual loans decreased by $5.5 million, or 11.1%, from $49.4 million to $43.9 million, during the nine months ended September 30, 2010. The increase in other real estate owned was attributable to our acquisition, by or in lieu of foreclosure, of four real properties that had collateralized loans which had previously been classified as nonaccrual loans. The acquisition of these properties also accounts for the $5.5 million decrease in nonaccrual loans. We have established specific reserves to provide for any losses that we may incur on the real properties that were classified as other real estate owned and on the loans that were classified as nonaccrual loans during the nine months ended September 30, 2010.

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Information Regarding Impaired Loans. A loan is deemed impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. At September 30, 2010, there were $44.9 million of loans deemed impaired, as compared to $57.4 million at December 31, 2009. We had an average investment in impaired loans for the nine months ended September 30, 2010 of $48.6 million as compared to $52.3 million for the year ended December 31, 2009. The interest that would have been earned during the three months ended September 30, 2010 had the impaired loans remained current in accordance with their original terms was $683,000.

The following table sets forth (i) the amounts of impaired loans for which there were related reserves for loan losses determined in accordance with ASC 310-10, (ii) the amounts of those reserves, and (iii) the amounts of impaired loans for which there were no reserves for loan losses, in each case as of September 30, 2010 and December 31, 2009:

	September 30, 2010							December 31, 2009
	Impaired Loans		Reserve for Loan Losses		Percent of Reserves to Loans			Impaired Loans		Reserve for Loan Losses		Percent of Reserves to Loans
Impaired loans with reserves	$	25,247	$	9,726		38.5	%	$	28,237	$	4,779		16.9	%
Impaired loans without reserves		19,648		—		—			29,152		—		—
Total impaired loans	$	44,895	$	9,726		21.7	%	$	57,389	$	4,779		8.3	%

Allowance for Loan Losses. The allowance for loan losses (the “Allowance”) at September 30, 2010 was $23.3 million, which represented approximately 3.06% of the loans outstanding at September 30, 2010, as compared to $20.3 million, or 2.44%, of the loans outstanding at December 31, 2009.

The adequacy of the Allowance is determined through periodic evaluations of the loans in our loan portfolio and other factors that can reasonably be expected to affect the ability of borrowers to meet their loan obligations. However, those factors are inherently subjective as the evaluation process calls for various significant estimates and assumptions, including, among others, estimates of the amounts and timing of expected future cash flows of borrowers of, and the fair value of collateral on, the loans, estimates of loan losses determined on the basis of historical loss experience and industry loss factors, and assessments of various qualitative factors. Moreover, those estimates and assessments are subject to risks and uncertainties and future events that are outside of our control, which could cause the performance of our loan portfolio to differ, possibly significantly, from the performance expected on the basis of those estimates and assessments and, therefore, could require us to increase the Allowance in future periods.

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

On a quarterly basis, we utilize a classification migration model and individual loan review and analytical tools as starting points for determining the adequacy of the Allowance. Our loss migration analysis tracks a 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 Allowance allocation process, applying specific monitoring policies and procedures in analyzing the existing loan portfolio.

40

In determining whether and the extent to which we will make adjustments to our loan loss migration model for purposes of determining the Allowance, 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 portfolio 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 Allowance or that may even exceed the Allowance.

In response to the economic recession, 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 and collecting non-performing loans.

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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, 2010 and December 31, 2009.

							Increase (Decrease)
	September 30, 2010			December 31, 2009			December 31, 2009 to September 30, 2010
Commercial loans	$	224,421		$	290,406		$	(65,985	)
Loans impaired (1)		9,663			20,910			(11,247	)
Loans 90 days past due		7,861			13,158			(5,297	)
Loans 30 days past due		1,296			1,127			169
Allowance for loan losses
General component	$	9,171		$	9,050		$	121
Specific component(1)		4,451			2,069			2,382
Total allowance	$	13,622		$	11,119		$	2,503
Ratio of allowance to loan category		6.07	%		3.83	%		2.24	%
Real estate loans:	$	406,770		$	416,795		$	(10,025	)
Loans impaired(1)		16,591			20,779			(4,188	)
Loans 90 days past due		7,215			11,230			(4,015	)
Loans 30 days past due		4,648			727			4,643
Allowance for loan losses
General component	$	3,612		$	4,003		$	(391	)
Specific component(1)		4,596			1,965			2,631
Total allowance	$	8,208		$	5,968		$	2,240
Ratio of allowance to loan category		2.02	%		1.43	%		0.59	%
Construction loans and land development	$	39,073		$	50,485		$	(11,412	)
Loans impaired(1)		9,837			13,830			(3,993	)
Loans 90 days past due		9,398			5,373			4,025
Loans 30 days past due		—			—			—
Allowance for loan losses
General component	$	208		$	1,702		$	(1,494	)
Specific component(1)		436			477			(41	)
Total allowance	$	644		$	2,179		$	(1,535	)
Ratio of allowance to loan category		1.65	%		4.32	%		(2.67	)%
Consumer loans and family mortgages	$	92,437		$	76,393		$	16,044
Loans impaired(1)		8,804			1,870			6,934
Loans 90 days past due		1,568			87			1,481
Loans 30 days past due		286			91			195
Allowance for loan losses
General component	$	584		$	811		$	(227	)
Specific component(1)		243			268			(25	)
Total allowance	$	827		$	1,079		$	(252	)
Ratio of allowance to loan category		0.89	%		1.41	%		(0.52	)%
Total loans outstanding	$	762,701		$	834,079		$	(71,378	)
Loans impaired(1)		44,895			57,389			(12,494	)
Loans 90 days past due		26,042			29,848			(3,806	)
Loans 30 days past due		6,230			1,945			5,007
Allowance for loan losses
General component	$	13,575		$	15,566		$	(1,991	)
Specific component(1)		9,726			4,779			4,947
Total allowance	$	23,301		$	20,345		$	2,956
Ratio of allowance to total loans outstanding		3.06	%		2.44	%		0.62	%

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

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Set forth below is a summary, in thousands of dollars, of the transactions in the allowance for loan losses in the three and nine months ended September 30, 2010 and the year ended December 31, 2009:

	Three Months Ended September 30, 2010			Nine Months Ended September 30, 2010			Year Ended December 31, 2009
Balance, beginning of period	$	23,307		$	20,345		$	15,453
Provision for loan losses		1,688			7,488			23,673
Recoveries on loans previously charged off		845			2,086			357
Amounts charged off		(2,539	)		(6,618	)		(19,138	)
Balance, end of period	$	23,301		$	23,301		$	20,345

The table below sets forth loan delinquencies, by quarter, from September 30, 2010 to September 30, 2009.

	2010						2009
	At September 30		At June 30		At March 31		At December 31		At September 30
Loans Delinquent:
90 days or more:
Commercial loans	$	7,861	$	5,588	$	5,830	$	13,158	$	15,220
Commercial real estate		1,123		3,834		9,481		10,550		10,049
Residential mortgages		7,660		853		—		767		269
Construction and land development loans		9,398		5,429		5,382		5,373		6,030
Consumer loans		—		—		—		—		—
		26,042		15,704		20,693		29,848		31,568
30-89 days:
Commercial loans		1,296		5,742		4,038		1,127		3,652
Commercial real estate		4,648		3,380		10,963		726		364
Residential mortgages		144		8,129		695		92		1,152
Construction and land development loans		—		3,999		3,228		—		2,215
Consumer loans		142		—		—		—		248
		6,230		21,250		18,924		1,945		7,631
Total Past Due (1):	$	32,272	$	36,954	$	39,617	$	31,793	$	39,199

(1) Past due balances include nonaccrual loans.

As indicated above, loans 90 days or more delinquent increased by $10.3 million, or 65.6%, to $26.0 million at September 30, 2010, from $15.7 million at June 30, 2010. That increase was primarily attributable to the filing of bankruptcy by a group of related borrowers, which stayed the payment of principal and interest on their loans. We are currently seeking bankruptcy court approval to permit us to foreclose and take possession of real properties collateralizing those loans so that we can dispose of those properties and, thereby, reduce our non-performing assets and recover some of the charge-offs that we have taken on those loans.

On the other hand, loans 30 to 89 days delinquent declined by $15.0 million, or 70.7%, to $6.2 million at September 30, 2010, down from $21.3 million at June 30, 2010. As a result, total past due loans decreased $4.7 million, or 12.7%, to $32.3 million at September 30, 2010, from $37.0 million at June 30, 2010.

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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 nine months ended September 30, 2010:

	Nine Months Ended September 30, 2010
	Average Balance		Average Rate
Noninterest-bearing demand deposits	$	166,272		—
Interest-bearing checking accounts		40,770		0.69	%
Money market and savings deposits		132,150		1.17	%
Time deposits		634,733		2.29	%
Average total deposits	$	973,925		1.68	%

Deposit Totals. Deposits totaled $955 million at September 30, 2010 as compared to $960 million at December 31, 2009 and $858 million at September 30, 2009. The following table compares the mix of our deposits, as between lower cost core deposits and higher cost time deposits, at September 30, 2010, December 31, 2009 and September 30, 2009, respectively:

	At September 30, 2010					At December 31, 2009					At September 30, 2009
	Amounts		Percent of Total Deposits			Amounts		Percent of Total Deposits			Amounts		Percent of Total Deposits
	(Dollars in thousands)
Core deposits
Non-interest bearing demand deposits	$	186,550		19.5	%	$	183,789		19.1	%	$	179,270		20.9	%
Savings and other interest-bearing transaction deposits		168,189		17.6	%		154,968		16.2	%		129,483		15.1	%
Time deposits		599,919		62.9	%		621,681		64.7	%		548,785		64.0	%
Total deposits	$	954,658		100.0	%	$	960,438		100.0	%	$	857,538		100.0	%

As indicated in the above table, savings and other interest-bearing deposits increased to 17.6% of total deposits at September 30, 2010, from 16.2% of total deposits at December 31, 2009, while time deposits, which bear higher rates of interest than our core deposits, decreased to 62.9% of total deposits at September 30, 2010 from 64.7% of total deposits at December 31, 2009. That change in the mix of deposits contributed to an improvement in our net interest income and net interest margin in this year’s third quarter and nine months year-to-date, as compared to the same period of 2009. 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, 2010:

	At September 30, 2010
	Certificates of Deposit under $100,000		Certificates of Deposit of $100,000 or More
Maturities
Three months or less	$	29,685	$	191,607
Over three and through twelve months		69,957		214,093
Over twelve months		26,010		68,567
Total certificates of deposit	$	125,652	$	474,267

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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 $237 million, which represented 21% of total assets, at September 30, 2010.

Cash Flow Used in Operating Activities. Although we incurred a net loss of nearly $12.0 million in the nine months ended September 30, 2010, $10.1 million of that loss represented non-cash charges to the provision for income taxes to increase the valuation allowance for our deferred tax assets. See “Critical Accounting Policies – Deferred Tax Assets” above in this Section of this Report. Consequently, during the nine months ended 30, 2010 we used net cash of $15 million from operating activities primarily to fund the origination of $154 million of mortgage loans, substantially offset by $144 million from the cash proceeds provided by sales of mortgage loans.

Cash Flow Provided by Investing Activities. In the nine months ended September 30, 2010, investing activities provided net cash of $120 million, primarily attributable to $227 million of proceeds from sales of securities available for sale and $68 million of loan repayments, partially offset by $195 million of purchases of securities available for sale.

Cash Flow Used by Financing Activities. In the nine months ended September 30, 2010, we used net cash of $41 million in financing activities, primarily to fund a net decrease of $40 million in borrowings and a $5.8 million decrease in deposits, partially offset by $4.6 million of proceeds from our private placement of Series A Shares, which was completed in August 2010.

Ratio of Loans to Deposits. The relationship between gross loans and total deposits can provide a useful measure of a bank’s liquidity. Since repayment of loans tends to be less predictable than the maturity of investments and other liquid resources, the higher the loan-to-deposit ratio the less liquid are our assets. On the other hand, since we realize greater yields on loans than we do on investments, a lower loan-to-deposit ratio can adversely affect interest income and earnings. As a result, our goal is to achieve a loan-to-deposit ratio that appropriately balances the requirements of liquidity and the need to generate a fair return on our assets. At September 30, 2010 and December 31, 2009, the loan-to-deposit ratios were 80% and 86%, respectively. The reduction in that ratio at September 30, 2010, as compared to December 31, 2009, was primarily attributable to a decline in loan demand from qualified borrowers due, we believe, to the sluggishness of the economic recovery, and the uncertainties about the future prospects for the economy, which has led many prospective borrowers to curtail expansion and their spending and, hence, their need for loans.

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, 2010 and December 31, 2009, we were committed to fund certain loans, including letters of credit, amounting to approximately $174 million and $184 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.

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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 long and short term borrowings from the Federal Home Loan Bank (the “FHLB”). As of September 30, 2010, our outstanding FHLB borrowings totaled $101 million, comprised of (i) $53 million of long-term borrowings, with maturities ranging from November 2011 to August 2013, and (ii) $48 million of short-term borrowings, with maturities ranging from November 2010 to August 2011. These borrowings, together with securities sold under agreements to repurchase, have a weighted-average annualized interest rate of 1.43%. By comparison, as of December 31, 2009, our outstanding FHLB borrowings totaled $141 million, comprised of (i) $14 million of long-term borrowings and (ii) $127 million of short-term borrowings which, together with the securities sold under agreements to repurchase, had a weighted-average annualized interest rate of 3.65%.

At September 30, 2010, U.S. agency and mortgage backed securities, U.S. Government agency securities and collateralized mortgage obligations with an aggregate fair market value of $26.6 million and $138 million of residential mortgage and other real estate secured loans were pledged to secure these Federal Home Loan Bank borrowings, repurchase agreements, local agency deposits, and treasury, tax and loan accounts.

The highest amount of borrowings that were outstanding at any month-end during the nine months ended September 30, 2010 consisted of $132 million of FHLB borrowings and $11.8 million of overnight borrowings in the form of securities sold under repurchase agreements. During 2009, the highest amount of borrowings outstanding at any month-end consisted of $208 million of FHLB borrowings and $13 million of overnight borrowings in the form of securities sold under repurchase agreements.

Junior Subordinated Debentures. Pursuant to rulings of the Federal Reserve Board, bank holding companies 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, 2010, 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, 2010. See discussion below under the subcaption “—Capital Resources-Regulatory Capital Requirements.”

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Set forth below is certain information regarding the Debentures:

Original Issue Dates:	Principal Amount		Interest Rates	Maturity Dates(1)
September 2002	$	7,217	Libor plus 3.40%		September 2030
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 have the right to defer those interest payments for up to five years.

As previously reported, in July 2009, we entered into a Memorandum of Understanding (an “MOU”) with the FRB and the DFI which, among other things, required us to obtain prior regulatory approval to pay interest on the Debentures. During the quarter ended September 30, 2010, we were advised by the FRB that it would not approve the payments of interest on the Debentures scheduled to be made on June 24 and July 19, 2010. As a result, we exercised our right, pursuant to the terms of the Debentures, to defer those interest payments. In August 2010, the Company entered into a Written Agreement with the Federal Reserve Bank (the “FRB Agreement”) which, among other things, continues the restriction requiring us to obtain the prior approval of the Federal Reserve Bank to pay interest on the Debentures. Consequently, we expect that it will be necessary for us to exercise our deferral right with respect to subsequent interest payments on the Debentures at least until such time as we are able to return to profitability. Since we have the right, under the terms of the Debentures to defer interest payments for up to five years, the deferral of the June and July 2010 interest payments did not constitute a default under or with respect to the Debentures. Information regarding the FRB Agreement and a companion regulatory order issued by the DFI (the “DFI Order”), and the requirements and restrictions imposed on us by the FRB Agreement and the DFI Order, is set forth below under the subcaption “—Capital Resources— Additional Capital Requirements Imposed by FRB Agreement and DFI Order” and in the Section entitled “Risk Factors” contained in Item 1A of Part II of this Report.

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 may be sold in response to changes in liquidity needs, changes in interest rates, changes in prepayment risks or other similar factors. Such securities are recorded at fair value. Any unrealized gains and losses are reported as “Other Comprehensive Income (Loss)” rather than included in or deducted from earnings.

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The following is a summary of the major components of securities available for sale and a comparison of the amortized cost, estimated fair values and gross unrealized gains and losses, in thousands of dollars, as of September 30, 2010 and December 31, 2009:

	Amortized Cost		Gross Unrealized Gain		Gross Unrealized Loss			Estimated Fair Value
September 30, 2010
Securities Available For Sale:
US Treasury securities	$	5,020	$	29	$	—		$	5,049
Mortgage-backed securities issued by US agencies		94,210		173		(164	)		94,219
Collateralized mortgage obligations issued by US agencies		—		—		—			—
Total securities issued or guaranteed by US government or US agencies		99,230		202		(164	)		99,268
Municipal securities		6,389		103		(10	)		6,482
Non-agency collateralized mortgage obligations		3,665		29		(198	)		3,496
Asset-backed securities		2,493		—		(1,708	)		785
Mutual fund		3,336		—		—			3,336
Total Securities Available For Sale	$	115,113	$	334	$	(2,080	)	$	113,367
December 31, 2009
Securities Available For Sale:
US Treasury securities	$	18,040	$	11	$	—		$	18,051
US agencies and mortgage-backed securities		134,331		89		(1,651	)		132,769
Collateralized mortgage obligations		—		—		—			—
Total government and agencies securities		152,371		100		(1,651	)		150,820
Municipal securities		10,545		13		(431	)		10,127
Non-agency collateralized mortgage obligations		7,094		10		(1,069	)		6,035
Asset backed securities		2,704		—		(1,732	)		972
Mutual fund		2,260		—		—			2,260
Total Securities Available For Sale	$	174,974	$	123	$	(4,883	)	$	170,214

At September 30, 2010, 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 $35 million were pledged to secure Federal Home Loan Bank borrowings, repurchase agreements, local agency deposits, to secure lines of credit at our correspondent banks and treasury, tax and loan accounts.

The amortized cost, at September 30, 2010, of securities available for sale are shown, in thousands of dollars, in the following table, by contractual maturities and historical prepayments based on the prior three months of principal payments. Expected maturities will differ from contractual maturities and historical prepayments, particularly with respect to collateralized mortgage obligations, because borrowers may react to interest rate market conditions differently than the historical prepayment rates.

	September 30, 2010 Maturing in
	One year or less					Over one year through five years					Over five years through ten years					Over ten years					Total
	Book Value		Weighted Average Yield			Book Value		Weighted Average Yield			Book Value		Weighted Average Yield			Book Value		Weighted Average Yield			Book Value		Weighted Average Yield
	(Dollars in thousands)
Securities available for sale:
US Treasury securities	$	—		—		$	5,020		0.75	%	$	—		—		$	—		—		$	5,020		0.75	%
US agency/mortgage-backed securities		5,133		2.66	%		15,461		2.78			15,582		2.91	%		58,034		2.93	%		94,210		2.89
Non-agency collateralized mortgage obligations		1,023		2.79			—		—			1,675		3.46			967		3.90			3,665		3.39
Municipal securities		—		—			—		—			1,348		4.10			5,041		4.29			6,389		4.25
Asset backed securities		—		—			—		—			—		—			2,493		—			2,493		—
Mutual funds		3,336		3.30			—		—			—		—			—		—			3,336		3.30
Total Securities Available for sale	$	9,492		2.90	%	$	20,481		2.28	%	$	18,605		3.05	%	$	66,535		2.94	%	$	115,113		2.84	%

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The table below shows, as of September 30, 2010, the gross unrealized losses and fair values (in thousands of dollars) of our investments, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position.

	Securities With Unrealized Loss as of September 30, 2010
	Less than 12 months					12 months or more					Total
(Dollars In thousands)	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
US agency mortgage backed securities	$	37,509	$	(160	)	$	484	$	(4	)	$	37,993	$	(164	)
Municipal securities		—		—			460		(10	)		460		(10	)
Non-agency collateralized mortgage obligations		—		—			2,444		(198	)		2,444		(198	)
Asset backed securities		—		—			785		(1,708	)		785		(1,708	)
Total temporarily impaired securities	$	37,509	$	(160	)	$	4,173	$	(1,920	)	$	41,682	$	(2,080	)

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

Capital Resources

Capital Regulatory Requirements Applicable to Banking Institutions.

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

• well capitalized

• adequately capitalized

• undercapitalized

• significantly undercapitalized; or

• critically undercapitalized

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

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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, 2010, as compared to the respective regulatory requirements applicable to them.

						Applicable Federal Regulatory Requirement
	Actual					Capital Acquacy Purposes					To be Categorized Well Capitalized
	Amount		Ratio			Amount		Ratio			Amount		Ratio
Total Capital to Risk Weighted Assets:
Company	$	96,737		11.5	%	$	67,389		At least 8.0	%		N/A		N/A
Bank		93,132		11.1	%		67,334		At least 8.0	%	$	84,167		At least 10.0	%
Tier 1 Capital to Risk Weighted Assets:
Company	$	86,047		10.2	%	$	33,694		At least 4.0	%		N/A		N/A
Bank		82,450		9.8	%		33,667		At least 4.0	%	$	50,500		At least 6.0	%
Tier 1 Capital to Average Assets:
Company	$	86,047		7.4	%	$	46,598		At least 4.0	%		N/A		N/A
Bank		82,450		7.1	%		46,492		At least 4.0	%	$	58,115		At least 5.0	%

At September 30, 2010 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 consolidated total capital and Tier 1 capital of the Company, at September 30, 2010, include an aggregate of $16.8 million principal amount of Junior Subordinated Debentures that we issued in 2002 and 2004. We contributed that amount to the Bank over a six 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.

Additional Capital Requirements under FRB Agreement and DFI Order.

On August 31, 2010, the members of the respective Boards of Directors of the Company and the Bank entered into the FRB Agreement and the Bank consented to the issuance of 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, are to require us 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 has 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 conditions that might arise if the improvement in the economy does not materialize or remains sluggish.

The Agreement and Order contain substantially similar provisions. They require the Boards of Directors of the Company and the Bank to prepare and submit written plans to the FRB 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 without the prior approval of the FRB the Company may not declare or pay cash dividends, repurchase any of its shares, make interest or principal payments on its Debentures or incur or guarantee any debt.

Under the FRB Agreement, the Company also must submit a capital plan to the FRB that will meet with its approval and then implement that plan. Under the DFI Order, the Bank is 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. At September 30, 2010, the Bank’s ratio of adjusted tangible shareholders’ equity to tangible assets was 7.1%.

We have begun taking steps to meet the requirements of the FRB Agreement and the DFI Order, including the preparation of a capital augmentation plan for submission to the FRB and we are actively exploring alternatives for raising additional capital to meet the capital requirements of the DFI Order. However, no assurance can be given that we will be able to meet those requirements. Moreover, even if we succeed in raising such capital, doing so may be dilutive of the share ownership of our existing shareholders. See “Risk Factors” in Item 1A of Part II of this Report below.

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Sale of Series A Convertible 10% Cumulative Preferred Stock. As previously reported in a Current Report filed with the SEC on Form 8-K dated October 6, 2009, we commenced a private placement to a limited number of accredited investors (as defined in Regulation D under the Securities Act of 1933, as amended) of a new issue of Series A Convertible 10% Cumulative Preferred Stock (the “Series A Shares”), at $100 per Series A Share. We sold a total of 126,550 Series A Shares, raising gross proceeds of $12.655 million, in the private placement, which we concluded in August 2010. We are using the net proceeds from the sale of the Series A Shares for general corporate purposes, which included a $7 million capital contribution by us to the Bank in order to increase its equity capital and to provide it with cash to fund additional loans and other interest-earning assets and meet working capital requirements.

Dividends cumulate on the Series A Shares at a rate of 10% per annum and, at September 30, 2010, accumulated but unpaid dividends on the Series A Shares totaled $815,000. Each outstanding Series A Share is convertible at the option of its holder, at a conversion price of $7.65 per share, into 13.07 shares of our common stock (as the same may be adjusted pursuant to the anti-dilution provisions applicable to the Series A Shares). On the second anniversary of the original issue date of the Series A Shares (the “Automatic Conversion Date”), all Series A Shares then outstanding will automatically convert into common stock at the then conversion price, subject to the payment by the Company, in cash, of the accumulated, but unpaid, dividends on those Series A Shares. If, however, due to regulatory restrictions or for any other reason, the Company is unable, on the Automatic Conversion Date, to pay the accumulated, but unpaid dividends in cash, then, the Automatic Conversion Date would be extended, and those Shares would remain outstanding and would continue to accumulate dividends, until such time as the Company is able to pay such dividends, in cash. A more detailed description of the rights, preferences and privileges of and restrictions on the Series A Shares is contained in the above-referenced Current Report on Form 8-K dated October 6, 2009, and the foregoing summary is qualified by reference to that description.

Dividend Policy and Share Repurchase Programs. Our Board of Directors has followed the policy of retaining earnings to maintain capital and, thereby, support the growth of the Company’s banking franchise. On occasion, the Board has considered paying cash dividends out of cash generated in excess of those capital requirements and, in February 2008, the Board of Directors declared a one-time cash dividend, in the amount of $0.10 per share of common stock, that was paid on March 14, 2008 to our shareholders.

The Board also authorized share repurchase programs, in June 2005 and in October 2008, when the Board concluded that, at prevailing market prices, the Company’s shares represented an attractive investment opportunity and, therefore, that share repurchases would be a good use of Company funds. No shares were purchased under this program in the nine months ended September 30, 2010.

In the first quarter of 2009, the Board of Directors decided that the prudent course of action, in light of the economic recession, was to preserve cash to enhance the Bank’s capital position and to be in a position to take advantage of improved economic and market conditions in the future. Moreover, the MOU entered into with the FRB and DFI in July 2009 and the FRB Agreement and DFI Order (which superseded the MOU) prohibit the payment of cash dividends and share repurchases without the approval of those regulatory agencies. Accordingly, we do not expect to pay dividends or make share purchases at least for the foreseeable future.

ITEM 3. MARKET RISK

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

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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, 2010. Based on the evaluation, our CEO and CFO have concluded that, as of, September 30, 2010 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, 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting except for the remediation of material weakness disclosed on Form 10-K for the year ended December 31, 2009 and on Form 10-Q for the quarter ended September 30, 2009, relating to our internal controls over the preparation and review of allowance for loan losses.

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PART II

ITEM 1. LEGAL PROCEEDINGS

James Laliberte, et al. vs. Pacific Mercantile Bank. This lawsuit was originally filed in May 2003 in the California Superior Court for the County of Orange (Case No. 030007092). Information regarding this lawsuit is contained in Item 3 of Part I of our Annual Report on Form 10-K for our fiscal year ended December 31, 2009, and there have been no subsequent developments in that case since we filed that Annual Report with the SEC on April 1, 2010.

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.

ITEM 1A.  RISK FACTORS

There have been no material changes from the risk factors that were disclosed under the caption “Risk Factors” in Item 1A of Part I of our Annual Report on Form 10-K for the fiscal year ended December 31, 2009 (the “2009 10-K”), except as follows:

Risks and Uncertainties Posed by the FRB Agreement and the DFI Order.

As previously reported in our Current Report on Form 8-K dated August 31, 2010, the members of the respective Boards of Directors of the Company and the Bank entered into a Written Agreement (the “Agreement”) with the Federal Reserve Bank of San Francisco (the “FRB”). On the same date, the Bank consented to the issuance of a Final Order (the “Order”) by the California Department of Financial Institutions (the “DFI”). The principal purposes of the FRB Agreement and the DFI Order, which constitute formal supervisory actions by the FRB and the DFI, are to require us 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 has 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 conditions that might arise if the hoped-for improvement in the economy does not materialize. Set forth below is a description of material risks and uncertainties created by the FRB Agreement and DFI Order.

We are required to raise additional equity capital, but that capital may not be available or may not be on terms acceptable to us. The DFI Order requires us to increase the Bank’s ratio of tangible shareholder’s equity-to-total tangible assets to 9.0% which, in turn, will require us to raise additional equity capital by January 31, 2011. However, our ability to raise additional capital will depend on conditions in the capital markets, economic conditions and a number of other factors, many of which are outside our control, as well as our financial performance. Accordingly, there is no assurance that we will be able to raise additional capital there is no assurance that, if required, we will be able to raise additional capital in amounts sufficient to meet regulatory requirements on terms acceptable to us or otherwise. If we are unable to raise such additional capital, the DFI and the FRB could (i) require us to reduce the size of our loan portfolio by limiting the volume of new loans that we can make or by selling loans or other interest-earning assets as a means of increasing our capital ratios, or (ii) impose other restrictions on our business operations, either or both of which would adversely affect our results of operations and the market price of our shares.

Our shareholders may be diluted by the sale of additional shares of our common stock in the future. In order to raise the additional capital required by the DFI Order, it will be necessary for us to sell additional shares of our common stock at a time when the market prices of bank stocks, including our own, are at historic lows. As a result, the sale of additional shares is likely to be dilutive of the ownership that our existing shareholders have in the Company.

The Company and the Bank are subject to additional regulatory oversight pursuant to the FRB Agreement and the DFI Order which may increase the costs of doing business and restrict our ability to grow our banking franchise. Under the terms of the FRB Agreement and DFI Order, the Company and the Bank are required to implement certain corrective and remedial measures within strict time frames. Among other things, we are required to maintain certain levels of liquidity and loan loss reserves, which could reduce our operating income. In addition, we are required to increase management oversight of our operations and we will be subject to more frequent regulatory examinations, which may increase our operating expenses. However, at the same time, we will be continuing our efforts to reduce our operating expenses in order to improve our results of operations, which could require cutbacks in staffing and the implementation of other measures, including possibly reducing the scope of our operations or the size of the Bank.

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As a consequence, the FRB Agreement and the DFI Order could have a material adverse effect on our business, financial condition, results of operations, cash flows or future prospects.

The Bank is restricted from paying dividends to us and we are restricted from paying dividends to shareholders and from making payments on our trust preferred securities. The payment of dividends by the Bank to us is our primary source of funds for paying dividends to our shareholders and paying our financial obligations, which currently consist primarily of interest payments on our junior subordinated debentures (the “Debentures”). Pursuant to the FRB Agreement and DFI Order, the Bank may not pay cash dividends to us and we may not pay cash dividends to our shareholders or interest on the Debentures without the prior approval of the FRB and the DFI. As previously reported, we began to defer interest payments on the Debentures earlier this year, when we were advised by the FRB that it would not approve further interest payments pending an improvement in our operating results and we cannot predict when the FRB will permit us to resume such payments. Although we are permitted to defer interest payments on the Debentures for up to 20 consecutive quarters, and we have sufficient cash to make the required interest payments on the Debentures, if we are not permitted by the FRB to pay the deferred interest and resume making interest payments by the end of that five year period, then we would be in default of our obligations under the Debentures, in which event the entire principal amount of and accrued but unpaid interest on the Debentures would become immediately due and payable.

Failure to satisfy the requirements of the FRB Agreement or the DFI Order could subject us to regulatory enforcement actions and additional restrictions on our business. There is no assurance that we will be able to meet the requirements of the FRB Agreement or the DFI Order. If we are unable to do so, the FRB and DFI could subject us to additional regulatory enforcement actions, which could include the assessment of civil money penalties on us and the Bank, as well as our respective directors, officers and other affiliated parties, and the imposition of further restrictions on our business, or even the termination of the Bank’s FDIC deposit insurance in the event we are unable to generate profits or we were to suffer a significant decline in our capital position.

The enactment of the Wall Street Reform and Consumer Protection Act poses uncertainties for our business and is likely to increase our costs of doing business in the future.

On July 21, 2010, the President signed into law the Wall Street Reform and Consumer Protection Act (the “Act”) which requires a restructuring of the bank regulatory system in the United States and will require us to make changes in our business that are likely to increase our operating costs. In addition, the Act presents considerable uncertainties for us, as well as other banking institutions, which will not be resolved until federal regulations are adopted to implement the Act, which will take at least one and possibly two years. As a result, it is not possible to measure or predict, with any degree of certainty, what the full impact of the Act will have on our business and our operating results in the future.

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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

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SIGNATURES

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

	PACIFIC MERCANTILE BANCORP
Date: November 10, 2010	By:	/s/  NANCY A. GRAY
		Nancy A. Gray, Chief Financial Officer

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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

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