SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-KSB/A

(Amendment No. 1)

x Annual report under section 13 or 15(d) of the Securities Exchange Act of 1934

for the fiscal year ended December 31, 2005

o  Transition report under section 13 or 15(d) of the Securities Exchange Act of 1934

for the transition period from        to       .

Commission File Number 0-15982

NATIONAL MERCANTILE BANCORP

(Exact name of small business issuer in its charter)

California	95-3819685
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
1880 Century Park East Los Angeles, California	90067
(Address to principal executive offices)	(Zip Code)
Issuer’s telephone number, including area code: (310) 277-2265
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, No Par Value (Title of Class)

Check whether the issuer:  (1) 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.      o Yes         x  No

Check if there is no disclosure of delinquent filers to Item 405 of Regulation S-B contained herein, and no disclosure will be contained, to the registrant’s knowledge, in definitive in response or information statements incorporated by reference in Part III of this Form 10-KSB. o

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

The issuer’s revenues for its most recent fiscal year:  $27.4 million.

The aggregate market value of the voting common equity held by nonaffiliates of the registrant, based upon the closing sale price of its Common Stock as reported by the National Association of Securities Dealers Automated Quotation System on March 21, 2006, was approximately $35.0 million.

The number of shares of Common Stock, no par value, of the issuer outstanding as of September 18, 2006 was 5,550,767.

DOCUMENTS INCORPORATED BY REFERENCE:

Certain portions of the Company’s Proxy Statement to be filed with the Securities and Exchange Commission pursuant to Rule 14a-6 under the Securities Exchange Act of 1934 in connection with the Company’s 2006 Annual Meeting of Shareholders are incorporated by reference in Part III, Items 9-12 and 14 and is of this Annual Report on Form 10-KSB.

Transitional Small Business Disclosure Format (Check one):      o Yes   x  No

Explanatory Note

National Mercantile Bancorp (the “Company”) is filing this amendment to Form 10-KSB for the year ended December 31, 2005 (and an amendment to Form 10-QSB for the quarter ended March 31, 2006), to amend and restate historical financial statements and other financial information filed with the Securities and Exchange Commission (“SEC”). These amendments are being filed to correct errors in the originally filed Form 10-KSB and Form 10-QSB related to the Company’s derivative accounting under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”).

This amendment restates the consolidated financial statements and the other financial information for the years ended December 31, 2005 and 2004, including the quarters ended March 31, June 30, and September 30, 2005 and 2004. The restatement has the following impact on Net Income and Dilute Earnings Per Common Share by period:

Impact by Period

	Net Income Adjustment			Diluted EPS Adjustment(1)
	(Dollars in thousands)
2003	$	(239	)	$	(0.05	)
2004:
1Q04	188			0.05
2Q04	(412		)	(0.09		)
3Q04	392			0.07
4Q04	(34		)	(0.01		)
Year	134			0.02
2005:
1Q05	(119		)	(0.02		)
2Q05	341			0.05
3Q05	(289		)	(0.05		)
4Q05	(164		)	(0.03		)
Year	(231		)	(0.04		)
Total	$	(336	)	$	(0.07	)

(1)Some quarters have been rounded for presentation purposes.

For additional information relating to the effect of the restatement, see the following items:

Part II

Item 6 – Management’s Discussion and Analysis or Plan of Operation

Item 7 – Financial Statements

Item 8A – Controls and Procedures

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NATIONAL MERCANTILE BANCORP

Table of Contents

Form 10-KSB/A
For the Fiscal Year Ended December 31, 2005

PART I
Item 1.	Description of Business
Item 2.	Description of Property
Item 3.	Legal Proceedings
Item 4.	Submission of Matters to a Vote of Security Holders
PART II
Item 5.	Market for Common Equity and Related Shareholder Matters
Item 6.	Management’s Discussion and Analysis or Plan of Operation
Item 7.	Financial Statements
Item 8.	Changes In and Disagreements With Accountants on Accounting and Financial Disclosure
Item 8A.	Controls and Procedures
Item 8B.	Other Information
PART III
Item 9.	Directors, Executive Officers, Promoters and Control Persons; Compliance With Section 16(a) of the Exchange Act
Item 10.	Executive Compensation
Item 11.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 12.	Certain Relationships and Related Transactions
Item 13.	Exhibits
Item 14.	Principal Accountant Fees and Services
Signatures
Financial Statements
Index to Exhibits

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ANNUAL REPORT ON FORM 10-KSB/A

Certain matters discussed in this Form 10-KSB/A may constitute forward-looking statements within the meaning of the Securities Exchange Act of 1934 (the “Exchange Act”) and as such may involve risks and uncertainties.  These forward-looking statements relate to, among other things, expectations of the business environment in which National Mercantile Bancorp (referred to as “we”, “our” or “the Company” when such reference includes National Mercantile Bancorp and its subsidiaries, collectively, “National Mercantile” when referring only to the parent company and “the Banks” when referring only to National Mercantile’s banking subsidiaries, Mercantile National Bank and South Bay Bank, N.A.) operates, projections of future performance, perceived opportunities in the market and statements regarding our mission and vision.  Our actual results, performance, or achievements may differ significantly from the results, performance, or achievements expressed or implied in such forward-looking statements.  Statements regarding policies and procedures are not intended to imply, and should not be interpreted to mean, that we will conduct our business in accordance with such policies for any particular period of time, as we may at any time and from time to time amend or repeal such policies and adopt new policies.  For discussion of the factors that might cause such a difference, see “Item 6.  Management’s Discussion and Analysis of Financial Condition or Plan of Operation— Factors Which May Affect Future Operating Results”.

PART I

ITEM 1.   DESCRIPTION OF BUSINESS

National Mercantile is a bank holding company whose principal assets are the capital stock of two bank subsidiaries: Mercantile National Bank (“Mercantile”) and South Bay Bank, N.A.  (“South Bay”).  National Mercantile has been authorized by the Federal Reserve Bank of San Francisco to engage in lending activities separate from the Banks but to date has not done so.

Our present business strategy is to attract individual and small- to mid-sized business borrowers in specific market niches located in our primary service areas by offering a variety of loan products and a full range of banking services coupled with highly personalized service.  Our lending products include revolving lines of credit, term loans, commercial real estate loans, construction loans and consumer and home equity loans, which often contain terms and conditions tailored to meet the specific demands of the market niche in which the borrower operates.  Additionally, we provide a wide array of deposit and investment products that are also designed to meet specific customer needs.

We operate throughout the west side of Los Angeles County including the South Bay, Century City and San Fernando Valley with banking offices in Century City, Torrance, Encino and El Segundo and a loan production office in Beverly Hills.  Additionally, we target Orange County businesses through our loan production office in Costa Mesa, California.

Our targeted market niches for businesses include the entertainment industry, the healthcare industry, professional services providers, the real estate escrow industry, property managers, public works contractors and community-based nonprofit organizations.    Entertainment industry clients include television, music and film production companies, talent agencies, individual performers, directors and producers (whom we attract by establishing relationships with business management firms) and others affiliated with the entertainment industry.  Healthcare organizations include primarily outpatient healthcare providers such as physician medical groups, independent practice associations and surgery centers.  Professional service customers include legal, accounting, insurance, advertising firms and their individual directors, officers, partners and shareholders.

We also engage in real estate and construction lending.  Our real estate loans are for the purchase or finance of principally smaller commercial properties, including owner-occupied business facilities and retail properties, and to a lesser extent multi-family and single family residential properties.  We make construction loans for small commercial, multi-family and single residential properties, including tract developments and luxury homes for resale.

In order to grow and expand our array of products and services, we may from time to time open de novo branch banking offices or acquire other financial service-related companies including “in-market” acquisitions with banks of similar size and market presence.  No assurance can be made that we will identify a company which can be acquired on terms and conditions acceptable to us or that we could obtain the necessary regulatory approvals for such an acquisition.

We believe that banking clients value doing business with locally managed institutions that can provide a full service commercial banking relationship through an understanding of the clients’ financial needs and the flexibility to deliver customized solutions through our menu of products and services.  We also believe that our subsidiary Banks are better able to build successful client relationships as the holding company provides cost effective administrative support services while promoting bank autonomy and flexibility in serving client needs.

To implement this philosophy, we operate each of our bank subsidiaries by retaining their independent names.  Each bank subsidiary has established strong client followings in its market areas through attention to client service and an understanding of client needs.

In an effort to capitalize on the identities and reputations of the Banks, we intend to continue to market our services under each Bank’s name, primarily through each Bank’s relationship managers.  The primary focus for the Banks’ relationship managers is to cultivate and nurture their client relationships.  Relationship managers are assigned to each borrowing client to provide continuity in the

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relationship.  This emphasis on personalized relationships requires that all of the relationship managers maintain close ties to the communities or industry niche in which they serve, so they are able to capitalize on their efforts through expanded business opportunities for the Banks.

Client service decisions and day-to-day operations are maintained at the Banks.  National Mercantile offers the advantages of affiliation with a multi-bank holding company by providing expanded client support services, such as increased client lending capacity, business cash management, and centralized administrative functions, including client services, support in credit policy formulation and review, investment management, data processing, accounting, loan servicing and other specialized support functions.  All of these centralized services are designed to enhance the ability of the relationship managers to expand their client relationship base.

At December 31, 2005, we had total assets of $448.5 million, total loans, net, of $334.1 million and total deposits of $363.2 million.

Corporate History

Mercantile was organized in 1981 as a national banking association and commenced operations through an office in Century City in 1982.  In 1983 National Mercantile was organized under the laws of the State of California and registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the ‘‘BHCA’’), to serve as a holding company for Mercantile.

In March 2001, Mercantile opened a regional office in Encino, California which expanded our client-focused niche banking services to the San Fernando Valley area of Los Angeles.  In January 2004, Mercantile opened a loan production office in Beverly Hills, California to focus on providing banking services to those affiliated with the entertainment industry.

In December 2001, National Mercantile acquired South Bay, which had offices in Torrance and El Segundo.   In January 2004, South Bay opened a loan production office in Costa Mesa to expand its lending services to the Orange County area of Southern California.

Competition

The banking and financial services industry in California generally, and in the Banks’ market areas specifically, is highly competitive.  The increasingly competitive environment is primarily a result of changes in regulation, changes in technology and product delivery systems, and the accelerating pace of consolidation among financial services providers.  Our primary service area is dominated by a relatively small number of major banks that have many offices operating over a wide geographical area.  We compete for loans, deposits, and customers with other commercial banks, savings and loan associations, securities and brokerage companies, mortgage companies, insurance companies, finance companies, money market funds, credit unions, and other nonbank financial service providers.  Many of these competitors are much larger in total assets and capitalization, have greater access to capital markets and offer a broader range of financial services than us.  Nondepository institutions can be expected to increase the extent to which they act as financial intermediaries.  Large institutional users and sources of credit may also increase the extent to which they interact directly, meeting business credit needs outside the banking system.  Furthermore, the geographic constraints on portions of the financial services industry can be expected to erode.  In addition, many of the major commercial banks operating in our primary service area offer services, such as trust services, which are not offered directly by us and, by virtue of their greater total capitalization, such banks have substantially higher lending limits.

To compete with other financial institutions in our primary service area, we rely principally upon personal contact by our officers, directors and employees and providing, through third parties, specialized services such as messenger, accounting and other related services.  For clients whose loan demands exceed our legal lending limit, we arrange for such loans on a participation basis with other banks.  We also assist clients requiring other services not offered by us in obtaining such services from other providers.

Economic Conditions and Government Policies

Our profitability, like most financial institutions, is primarily dependent on interest rate differentials.  In general, the difference between the interest rates paid by us on our interest-bearing liabilities, such as deposits and other borrowings, and the interest rates received by us on our interest-earning assets, such as loans and investment securities, comprise the major portion of our earnings.  These rates are highly sensitive to many factors that are beyond our control, such as inflation, recession and unemployment, and the impact which future changes in domestic and foreign economic conditions might have on us cannot be predicted.

The monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Board of Governors of the Federal Reserve System (the “Federal Reserve”), influence our business.  The Federal Reserve implements national monetary policies (with objectives such as curbing inflation and combating recession) through its open-market operations in U.S.  Government securities by adjusting the required level of reserves for depository institutions subject to its reserve requirements, and by varying the target federal funds and discount rates applicable to borrowings by depository institutions.  The actions of the Federal Reserve in these areas influence the growth of bank loans, investments, and deposits and also affect interest rates earned on interest-earning assets and paid on interest-bearing liabilities.  We cannot fully predict the nature and impact on us of any future changes in monetary and fiscal policies.

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Supervision and Regulation

General

Banking is a highly regulated industry.  Congress and the states have enacted numerous laws that govern banks, bank holding companies and the financial services industry, and have created several largely autonomous regulatory agencies which have authority to examine and supervise banks and bank holding companies, and to adopt regulations furthering the purpose of the statutes.  The primary goals of the regulatory scheme are to maintain a safe and sound banking system, to protect depositors and the Federal Deposit Insurance Corporation (“FDIC”) insurance fund, and to facilitate the conduct of sound monetary policy; they were not adopted for the benefit of shareholders of the Company.  As a result, the Company’s financial condition, results of operations, ability to grow and engage in various business activities can be affected not only by management decisions and general economic conditions, but the requirements of applicable federal and state laws, regulations and the policies of the various regulatory authorities.

Further, these laws, regulations and policies are reviewed often by Congress, state legislatures and federal and state regulatory agencies.  Changes in laws, regulations and policies can materially increase the cost of doing business, limit certain business activities, require additional capital, or materially adversely affect competition between banks and other financial intermediaries.  While it can be predicted that significant changes will occur, what changes, when they will occur, and how they will impact the Company cannot be predicted.

Set forth below is a summary description of certain of the material laws and regulations that relate to the operations of National Mercantile and the Banks.  The description does not purport to be a complete description of these laws and regulations and is qualified in its entirety by reference to the applicable laws and regulations.

National Mercantile

As a registered bank holding company, National Mercantile and its subsidiaries are subject to the Federal Reserve’s supervision, regulation and examination under the Bank Holding Company Act.

National Mercantile is required to obtain the Federal Reserve’s prior approval before acquiring ownership or control of more than 5% of the outstanding shares of any class of voting securities, or substantially all the assets, of any company, including a bank or bank holding company.  Further, National Mercantile is generally allowed to engage, directly or indirectly, only in banking and other activities that the Federal Reserve deems to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.

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

The Banks

Both Banks are national banks and members of the Federal Reserve System.  The Banks are subject to primary supervision, examination, and regulation by the Office of the Comptroller of the Currency (the “OCC”) and are also subject to regulations of the FDIC and the Federal Reserve.  The Banks are subject to requirements and restrictions under federal law, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and limitations on the types of investments that may be made and services that may be offered.  Various consumer laws and regulations also affect the Banks’ operations.  These laws primarily protect depositors and other customers of the Banks, rather than National Mercantile and its shareholders.

The OCC and the Federal Reserve have various remedies if they should determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, or other aspects of a bank’s operations are unsatisfactory or that a bank or its management is violating or has violated any law or regulation.  These remedies include the power to enjoin “unsafe or unsound” practices, to require affirmative action to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in capital, to restrict the growth of the bank, to assess civil monetary penalties, to remove officers and directors, and ultimately to terminate the bank’s deposit insurance.

FDIC

The Banks are subject to examination and regulation by the FDIC under the Federal Deposit Insurance Act because their deposit accounts are insured by the FDIC.

Under FDIC regulations, each insured depository institution is assigned to one of three capital groups for insurance premium purposes — “well capitalized,” “adequately capitalized” and “undercapitalized” — which are defined in the same manner as under prompt corrective action rules, as discussed under “Capital Adequacy Requirements” below.  These three groups are then divided into subgroups, which are based on supervisory evaluations by the institution’s primary federal regulator, resulting in nine assessment

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classifications.  Currently, assessment rates for insured banks range from 0% of insured deposits for well-capitalized banks with minor supervisory concerns to 0.027% of insured deposits for undercapitalized banks with substantial supervisory concerns.  The FDIC may increase or decrease the assessment rate schedule semiannually.

The FDIC may terminate the deposit insurance of any insured depository institution if the FDIC determines, after a hearing, that the institution has engaged or is engaging in unsafe or unsound practices.  As with the OCC’s enforcement authority, the FDIC’s authority to terminate deposit insurance is not limited to cases of capital inadequacy, financial weakness rendering an institution unable to continue operations, violations of any applicable law or regulation or violation of any order or any condition imposed in writing by the FDIC.  In addition, FDIC regulations provide that any insured institution that falls below a 2% minimum leverage ratio (see below) will be subject to FDIC deposit insurance termination proceedings unless it has submitted, and is in compliance with, a capital plan with its primary federal regulator and the FDIC.  The FDIC may also suspend deposit insurance temporarily during the hearing process if the institution has no tangible capital.  The FDIC is additionally authorized by statute to appoint itself as conservator or receiver of an insured depository institution (in addition to the powers of the institution’s primary federal regulatory authority) in cases, among others, of unsafe or unsound conditions or practices or willful violations of cease and desist orders.

All FDIC-insured depository institutions must pay an annual assessment to provide funds for the payment of interest on bonds issued by the Financing Corporation ( “FICO”), a federal corporation chartered under the authority of the Federal Housing Finance Board.  The bonds, commonly referred to as FICO bonds, were issued to capitalize the Federal Savings and Loan Insurance Corporation.  The FICO has established assessment rates effective for the first quarter of 2005 at approximately $.0144 per $100 annually for assessable deposits. The FICO assessments are adjusted quarterly to reflect changes in the assessment bases of the FDIC’s insurance funds and do not vary depending on a depository institution’s capitalization or supervisory evaluations.

Dividends and Capital Distributions

Dividends and capital distributions from the Banks constitute the principal ongoing source of cash to National Mercantile.  National Mercantile is a legal entity separate and distinct from the Banks, and as such has separate and distinct financial obligations including debt service and operating expenses.  The Banks are subject to various statutory and regulatory restrictions on their ability to pay dividends and capital distributions to National Mercantile.

OCC approval is required for a national bank to pay a dividend if the total of all dividends declared in any calendar year exceeds the total of the bank’s net profits (as defined) for that year combined with its retained net profits for the preceding two calendar years, less any required transfer to surplus or a fund for the retirement of any preferred stock.  A national bank may not pay any dividend that exceeds its retained net earnings, as defined by the OCC.   The OCC and the Federal Reserve have also issued banking circulars emphasizing that the level of cash dividends should bear a direct correlation to the level of a national bank’s current and expected earnings stream, the bank’s need to maintain an adequate capital base and other factors.

National banks that are not in compliance with regulatory capital requirements generally are not permitted to pay dividends.  The OCC also can prohibit a national bank from engaging in an unsafe or unsound practice in its business.  Depending on the bank’s financial condition, payment of dividends could be deemed to constitute an unsafe or unsound practice.  Except under certain circumstances, and with prior regulatory approval, a bank may not pay a dividend if, after so doing, it would be undercapitalized.  The Banks’ ability to pay dividends in the future is, and could be, further influenced by regulatory policies or agreements and by capital guidelines.

Mercantile has a substantial accumulated deficit and does not anticipate having positive retained earnings for the foreseeable future.  South Bay had retained earnings of $3.0 million as of December 31, 2005.  Mercantile and South Bay may from time to time be permitted to make capital distributions to National Mercantile with the consent of the OCC.  It is not anticipated that such consent could be obtained unless the distributing bank were to remain “well capitalized” following such distribution.

Transactions with Affiliates

The Banks are subject to certain restrictions imposed by federal law on any extensions of credit to, or the issuance of a guarantee or letter of credit on behalf of, National Mercantile or other affiliates, the purchase of, or investments in, stock or other securities thereof, the taking of such securities as collateral for loans, and the purchase of assets of National Mercantile or other affiliates.  Such restrictions prevent National Mercantile and such other affiliates from borrowing from the Banks unless the loans are secured by marketable obligations of designated amounts.  Further, such secured loans and investments by the Banks to or in National Mercantile or to or in any other affiliate are limited, individually, to 10% of the respective Bank’s capital and surplus (as defined by federal regulations), and such secured loans and investments are limited, in the aggregate, to 20% of the respective Bank’s capital and surplus (as defined by federal regulations).

Capital Adequacy Requirements

Both the Federal Reserve and the OCC have adopted similar, but not identical, “risk-based” and “leverage” capital adequacy guidelines for bank holding companies and national banks, respectively.  Under the risk-based capital guidelines, different categories of assets are assigned different risk weights, ranging from zero percent for assets considered risk-free (e.g., cash) to 100% for assets considered relatively high-risk (e.g., commercial loans).  These risk weights are multiplied by corresponding asset balances to determine a risk-adjusted asset base.  Certain off-balance sheet items (e.g., standby letters of credit) are added to the risk-adjusted asset base.  The

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minimum required ratio of total capital to risk-weighted assets for both bank holding companies and national banks is presently 8%.  At least half of the total capital is required to be “Tier 1 capital,” consisting principally of common shareholders’ equity, a limited amount of perpetual preferred stock and minority interests in the equity, less goodwill, intangible assets and certain other items.  The remainder (Tier 2 capital) may consist of a limited amount of subordinated debt, certain hybrid capital instruments and other debt securities, preferred stock and a limited amount of the general loan-loss allowance.

The minimum Tier 1 leverage ratio (Tier 1 capital to average adjusted total assets) is 3% for bank holding companies and national banks that have the highest regulatory examination rating and are not contemplating significant growth or expansion.  All other bank holding companies and national banks are expected to maintain a ratio of at least 1% to 2% or more above the stated minimum.

Prompt Corrective Action Rules

The OCC has adopted regulations establishing capital categories for national banks and prompt corrective actions for undercapitalized institutions.  The regulations create five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized.  A bank may be reclassified by the OCC to the next level below that determined by its regulatory capital if the OCC finds that it is in an unsafe or unsound condition or if it has received a less-than-satisfactory rating for any of the categories of asset quality, management, earnings or liquidity in its most recent examination and the deficiency has not been corrected, except that a bank cannot be reclassified as critically undercapitalized for such reasons.

The OCC may subject national banks which are not at least “adequately capitalized” to a broad range of restrictions and regulatory requirements.  An undercapitalized bank may not pay management fees to any person having control of the institution, nor, except under certain circumstances and with prior regulatory approval, make any capital distribution.  Undercapitalized banks are subject to increased monitoring by the OCC, are restricted in their asset growth, must obtain regulatory approval for certain corporate activities, such as acquisitions, new branches and new lines of business, and, in most cases, must submit to the OCC a plan to bring their capital levels to the minimum required in order to be classified as adequately capitalized.  The OCC may not approve a capital restoration plan unless each company that controls the bank guarantees that the bank will comply with it.  Under Federal Reserve policy, a bank holding company is expected to act as a source of financial strength to its subsidiary banks and to commit resources to support each such bank.  In addition, a bank holding company is required to guarantee that its subsidiary bank will comply with any capital restoration plan.  The amount of such a guarantee is limited to the lesser of (i) 5% of the bank’s total assets at the time it became undercapitalized, or (ii) the amount which is necessary (or would have been necessary) to bring the bank into compliance with all applicable capital standards as of the time the bank fails to comply with the capital restoration plan.  A holding company guarantee of a capital restoration plan results in a priority claim to the holding company’s assets ahead of its other unsecured creditors and shareholders that is enforceable even in the event of the holding company’s bankruptcy or the subsidiary bank’s insolvency.

If any one or more of a bank’s ratios are below the minimum ratios required to be classified as undercapitalized, it will be classified as significantly undercapitalized provided that if its ratio of tangible equity to total assets is 2% or less, it will be classified as critically undercapitalized.  Significantly and critically undercapitalized banks are subject to additional mandatory and discretionary restrictions and, in the case of critically undercapitalized institutions, must be placed into conservatorship or receivership unless the OCC and the FDIC agree otherwise.

Safety and Soundness Standards

The federal banking agencies have adopted guidelines designed to assist the federal banking agencies in identifying and addressing potential safety and soundness concerns before capital becomes impaired. The guidelines set forth operational and managerial standards relating to (i) internal controls, information systems and internal audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) asset growth; (v) earnings; and (vi) compensation, fees and benefits.

In addition, the federal banking agencies have also adopted safety and soundness guidelines with respect to asset quality and earnings standards.  These guidelines provide six standards for establishing and maintaining a system to identify problem assets and prevent those assets from deteriorating.  Under these standards, an insured depository institution should (i) conduct periodic asset quality reviews to identify problem assets; (ii) estimate the inherent losses in problem assets and establish reserves that are sufficient to absorb estimated losses; (iii) compare problem asset totals to capital; (iv) take appropriate corrective action to resolve problem assets; (v) consider the size and potential risks of material asset concentrations; and (vi) provide periodic asset quality reports with adequate information for management and the board of directors to assess the level of asset risk.

These new guidelines also set forth standards for evaluating and monitoring earnings and for ensuring that earnings are sufficient for the maintenance of adequate capital and reserves.

Cross Guarantees

The Banks are also subject to cross-guaranty liability under federal law.  This means that if one FDIC-insured depository institution subsidiary of a multi-institution bank holding company fails or requires FDIC assistance, the FDIC may assess commonly controlled depository institutions for the estimated losses suffered by the FDIC.  Such a liability could have a material adverse effect on the financial condition of any assessed subsidiary institution and on National Mercantile as the common parent.  While the FDIC’s cross-guaranty claim is generally junior to the claim of depositors, holders of secured liabilities, general creditors and subordinated creditors, it is generally superior to the claims of shareholders and affiliates.

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Community Reinvestment Act and Fair Lending

The Banks are subject to certain fair lending requirements and reporting obligations involving home mortgage lending operations and Community Reinvestment Act (“CRA”) activities.  A bank may be subject to substantial penalties and corrective measures for a violation of certain fair lending laws.  The CRA requires the Banks to ascertain and meet the credit needs of the communities it serves, including low- and moderate-income neighborhoods.  The Banks’ compliance with the CRA is reviewed and evaluated by the OCC, which assigns the Banks a publicly available CRA rating at the conclusion of the examination.

The CRA regulations emphasize measurements of performance in the area of lending (specifically, a bank’s home mortgage, small business, small farm and community development loans), investment (a bank’s community development investments) and service (a bank’s community development services and the availability of its retail banking services), although examiners are still given a degree of flexibility in taking into account unique characteristics and needs of a bank’s community and its capacity and constraints in meeting such needs.  The regulations also require certain levels of collection and reporting of data regarding certain kinds of loans.

Further, the federal banking agencies may take compliance with such laws and CRA obligations into account when regulating and supervising other activities.  An assessment of CRA compliance is required in connection with applications for OCC approval of certain activities, including establishing or relocating a branch office that accepts deposits or merging or consolidating with, or acquiring the assets or assuming the liabilities of, a federally regulated financial institution.  An unfavorable rating may be the basis for OCC denial of such an application, or approval may be conditioned upon improvement of the applicant’s CRA record.  In the case of a bank holding company applying for approval to acquire a bank or other bank holding company, the Federal Reserve will assess the CRA record of each subsidiary bank of the applicant, and such records may be the basis for denying the application.  The federal banking agencies have established annual reporting and public disclosure requirements for certain written agreements that are entered into between insured depository institutions or their affiliates and nongovernmental entities or persons that are made pursuant to, or in connection with, the fulfillment of the CRA.

In connection with its assessment of CRA performance, the appropriate bank regulatory agency assigns a rating of “outstanding”, “satisfactory”, “needs to improve” or “substantial noncompliance”.  Each of the Banks received a “satisfactory” rating in its most recent exam.

USA Patriot Act of 2001

The USA Patriot Act of 2001 (“Patriot Act”) is intended to strengthen the U.S law enforcement and the intelligence communities’ abilities to work cohesively to combat terrorism on a variety of fronts. The potential impact of the Patriot Act on financial institutions of all kinds is significant and wide ranging. The Patriot Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations, including: (i) due diligence requirements for financial institutions that administer, maintain, or manage private bank accounts or correspondent accounts for non-US persons; (ii) standards for verifying customer identification at account opening; (iii) rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering; and (iv) reports by non-financial trades and businesses filed with the Treasury Department’s Financial Crimes Enforcement Network for transactions exceeding $10,000, and filing of suspicious activities reports by securities brokers and dealers if they believe a customer may be violating U.S. laws and regulations.

Privacy

Federal banking rules limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. Pursuant to these rules, financial institutions must provide: (i) initial notices to customers about their privacy policies, describing the conditions under which they may disclose nonpublic personal information to nonaffiliated third parties and affiliates; (ii) annual notices of their privacy policies to current customers; and (iii) a reasonable method for customers to “opt out” of disclosures to nonaffiliated third parties.

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

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

Employees

At December 31, 2005, we had 77 full-time equivalent employees.  None of the employees is covered by a collective bargaining agreement.  We consider our employee relations to be satisfactory.

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ITEM 2.  DESCRIPTION OF PROPERTY.

National Mercantile leases approximately 13,880 square feet in an office building at 1880 Century Park East, Los Angeles, California, which serves as its administrative headquarters.  The rent for the period January 2004 to April 2014 is $2.23 per square foot or $30,952 per month, subject to an annual CPI adjustment and for changes in property taxes and operating costs.

Mercantile’s principal banking office is located in 1,800 square feet in an office building at 1880 Century Park East, Los Angeles, California.  The effective rent is $3.00 per square foot or $5,401 per month.  The lease expires in June 2014.

Mercantile leases approximately 1,650 square feet in an office building in Encino, California for the primary purpose of providing branch banking operations in the San Fernando Valley.  The effective rent is $2.73 per square foot or $4,500 per month.  The lease expires in June 2008.  Additionally, Mercantile leases 2,559 square feet in an office building in Beverly Hills as a loan production office, primarily for the entertainment industry.  The effective rent is $2.88 per square foot, or $7,754 per month and the lease expires June 2009.

South Bay owns a two-story stand-alone office building at 2200 Sepulveda Boulevard, Torrance, California, which serves as its principal banking office.  South Bay also leases approximately 3,100 square foot in an office building in El Segundo, California for the primary purpose of providing branch banking operations in the Los Angeles airport area.  The effective rent is $1.85 per month and the lease expires in January 2011.  Additionally, South Bay leases 1,555 square feet in an office building in Costa Mesa, California as a loan production office in Orange County.  The office has been designed to serve as a full service branch banking office in the future.  The effective rent is $1.85 per square foot, or $2,877 per month.  The lease expires February 2009.

We believe our present facilities are adequate for our present needs but anticipate the need for additional facilities as we continue to grow.  We believe that, if necessary, we could secure suitable alternative facilities on similar terms without adversely affecting operations.

ITEM 3.  LEGAL PROCEEDINGS.

From time to time, we are involved in certain legal proceedings arising in the normal course of our business.  We believe that the outcome of these matters existing as of December 31, 2005 will not have a material adverse effect on us.

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

There was no submission of matters to a vote of shareholders during the quarter ended December 31, 2005.

PART II

ITEM 5.   MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS

The Common Stock of National Mercantile is traded on the Nasdaq Small Cap Market under the symbol MBLA.  The following table shows the high and low trade prices of the Common Stock for each quarter of 2004 and 2005 (adjusted for the 5-for 4-stock split paid April 16, 2006) as reported by the Nasdaq.  Additionally, there may have been transactions at prices other than those shown during that time.

	Common Stock
Quarter Ended:	High		Low
March 31, 2004	$	9.44	$	7.39
June 30, 2004	8.36		7.34
September 30, 2004	8.50		7.56
December 31, 2004	11.00		8.33
March 31, 2005	12.56		10.16
June 30, 2005	12.70		9.81
September 30, 2005	12.73		12.04
December 31, 2005	15.68		12.40

At March 21, 2006, National Mercantile had 167 shareholders of record for its Common Stock.  The number of beneficial owners for the Common Stock is higher as many people hold their shares in “street” name.  At March 21, 2006, approximately 40% of the Common Stock was held in street name.

National Mercantile has not paid a cash dividend on its Common Stock for more than 10 years.  As a California corporation, under the California General Corporation Law, generally National Mercantile may not pay dividends in cash or property except (i) out of positive retained earnings or (ii) if, after giving effect to the distribution, National Mercantile’s assets would be at least 1.25 times its liabilities and its current assets would exceed its current liabilities (determined on a consolidated basis under generally accepted accounting principles).  At December 31, 2005, National Mercantile had an accumulated deficit of $7.0 million.  Further, it is unlikely

10

that its assets will ever be at least 1.25 times its liabilities.  Accordingly, National Mercantile must generate net income in excess of $7.0 million before it can pay a dividend in cash or property.

In addition, National Mercantile may not pay dividends on its capital stock if it is in default or has elected to defer payments of interest under its junior subordinated deferred interest debentures.

Outstanding Awards Under All Equity Compensation Plans.  The following table sets forth as of December 31, 2005 information regarding outstanding options under all of our equity compensation plans and the number of shares available for future option grants under equity compensation plans currently in effect.

	(a)	(b)		(c)
Plan category	Number of securities to be issued upon exercise of outstanding options, warrants and rights	Weighted-average exercise price of outstanding options, warrants and rights		Number of securities remaining available for issuance under equity compensation plans (excluding securities reflected in column (a)
Equity compensation plans approved by security holders (1)	519,358	$	9.62	160,059

(1)Includes the 2005 Stock Incentive Plan, 1996 Stock Incentive Plan and two stock option plans which have been terminated but under which there remain outstanding options to purchase an aggregate of 2,200 shares of National Mercantile Common Stock.

ITEM 6.  MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

RESTATEMENT

National Mercantile Bancorp has restated its consolidated financial statements for the years ended December 31, 2005, 2004 and 2003 and for each of the interim periods in 2005, 2004 and 2003. This restatement corrected errors related to the Company’s derivative accounting under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”).

In 2003, the Company entered into an interest rate swap agreement in connection with the trust preferred securities related to the Company’s junior subordinated deferrable interest debentures (Trust Preferred Swap) that was accounted for as a fair value hedge under SFAS No. 133. The Company elected an abbreviated method (the “short-cut” method) of documenting the effectiveness of the swap as a hedge, which allowed the Company to assume no ineffectiveness in this transaction. As a result of later technical interpretations of SFAS 133, the Company subsequently concluded that the Trust Preferred Swap did not qualify for this method in prior periods.  The presence of an interest deferral feature in the interest rate swap was determined, in retrospect, to have caused the interest rate swap to not have a fair value of zero at inception, which is required under SFAS 133 to qualify for short-cut hedge accounting treatment.  Hedge accounting under SFAS No. 133 for this swap transaction is not allowed retrospectively because the hedge documentation required for the long-haul method was not in place at the inception of the hedge. Eliminating the application of fair value hedge accounting reverses the fair value adjustments that were made to the hedged item, the debt, as an adjustment to the par amount of the Trust Preferred debt. This reversal of fair value hedge accounting also results in reclassification of swap net settlements from interest expense to noninterest income as well as recording of swap mark-to-market adjustments in trading gains (losses) on economic derivatives.

The following table shows the statements of operations as originally reported and as restated, with the adjustments, for the years ended December 31, 2005 and 2004.

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	Year Ended
	December 31, 2005						December 31, 2004
	As Originally Reported			Restated			As Originally Reported		Restated
	(Dollars in thousands)
Net interest income before provision for credit losses	$	21,129		$	21,129		$	16,450	$	16,450
Net cash settlement of interest rate swap derivative	—			(347		)	—		(619		)
Net interest income before provision for credit losses	21,129			20,782			16,450		15,831
Provision (benefit) for credit losses	(84		)	(84		)	220		220
Net interest income after provision for credit losses	21,213			20,866			16,230		15,611
Total other operating income	1,166			1,166			1,567		1,567
Net cash settlement of interest rate swap derivative	—			347			—		619
Change in fair value of interest rate swap derivative	—			(395		)	—		229
Total non-interest income	1,166			1,118			1,567		2,415
Total other operating expenses	14,376			14,376			14,028		14,028
Income before taxes	8,003			7,608			3,769		3,998
Income tax expense	3,322			3,322			1,583		1,583
Income tax effect of restatement	—			(164		)	—		95
Total income tax expense	3,322			3,158			1,583		1,678
Net income	$	4,681		$	4,450		$	2,186	$	2,320
Net income per share – basic(1)	$	1.01		$	0.96		$	0.60	$	0.64
Net income per share – diluted(1)	$	0.79		$	0.75		$	0.38	$	0.41

(1)Adjusted for the 5- for 4-stock split paid April 16, 2006

The following tables shows the statements of operations as originally reported and as restated, with the adjustments, for the three months ended March 31, June 30, September 30, and December31, 2005 and 2004.

	Three Months Ended
	December 31, 2005					September 30, 2005						June 30, 2005					March 31, 2005
	As Originally Reported		Restated			As Originally Reported			Restated			As Originally Reported		Restated			As Originally Reported		Restated
	(Dollars in thousands)
Net interest income before provision for credit losses	$	5,739	$	5,739		$	5,456		$	5,456		$	5,073	$	5,073		$	4,861	$	4,861
Net cash settlement of interest rate swap derivative	—		(60		)	—			(70		)	—		(100		)	—		(116		)
Net interest income before provision for credit losses	5,739		5,679			5,456			5,386			5,073		4,973			4,861		4,745
Provision (benefit) for credit losses	40		40			(213		)	(213		)	—		—			89		89
Net interest income after provision for credit losses	5,699		5,639			5,669			5,599			5,073		4,973			4,772		4,656
Total other operating income	267		267			278			278			299		299			322		322
Net cash settlement of interest rate swap derivative	—		60			—			70			—		100			—		116
Change in fair value of interest rate swap derivative	—		(280		)	—			(493		)	—		582			—		(204		)
Total non-interest income	267		47			278			(145		)	299		981			322		234
Total other operating expenses	3,561		3,561			3,730			3,730			3,599		3,599			3,486		3,486
Income before taxes	2,405		2,125			2,217			1,724			1,773		2,355			1,608		1,404
Income tax expense	999		999			920			920			736		736			667		667
Income tax effect of restatement	—		(116		)	—			(205		)	—		242			—		(85		)
Total income tax expense	999		883			920			715			736		978			667		582
Net income	$	1,406	$	1,242		$	1,297		$	1,009		$	1,037	$	1,378		$	941	$	822
Net income per share – basic	$	0.26	$	0.23		$	0.24		$	0.19		$	0.27	$	0.35		$	0.25	$	0.22
Net income per share – diluted	$	0.24	$	0.21		$	0.22		$	0.17		$	0.18	$	0.23		$	0.16	$	0.14

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	Three Months Ended
	December 31, 2004					September 30, 2004					June 30, 2004					March 31, 2004
	As Originally Reported		Restated			As Originally Reported		Restated			As Originally Reported		Restated			As Originally Reported		Restated
	(Dollars in thousands)
Net interest income before provision for credit losses	$	4,682	$	4,682		$	4,695	$	4,695		$	3,622	$	3,622		$	3,451	$	3,451
Net cash settlement of interest rate swap derivative	—		(143		)	—		(137		)	—		(147		)	—		(169		)
Net interest income before provision for credit losses	4,682		4,539			4,695		4,558			3,622		3,475			3,451		3,282
Provision for credit losses	100		100			120		120			—		—			—		—
Net interest income after provision for credit losses	4,582		4,439			4,575		4,438			3,622		3,475			3,451		3,282
Total other operating income	383		383			317		317			402		402			465		465
Net cash settlement of interest rate swap derivative	—		143			—		137			—		147			—		169
Change in fair value of interest rate swap derivative	—		(58		)	—		670			—		(837		)	—		453
Total non-interest income	383		468			317		1,124			402		(288		)	465		1,087
Total other operating expenses	3,788		3,788			3,378		3,378			3,439		3,439			3,423		3,423
Income before taxes	1,177		1,119			1,514		2,184			585		(252		)	493		946
Income tax expense	499		499			642		642			240		240			202		202
Income tax effect of restatement	—		(24		)	—		278			—		(347		)	—		188
Total income tax expense	499		475			642		920			240		(107		)	202		390
Net income	$	678	$	644		$	872	$	1,264		$	345	$	(145	)	$	291	$	556
Net income per share – basic(1)	$	0.18	$	0.17		$	0.24	$	0.35		$	0.09	$	-0.04		$	0.08	$	0.16
Net income per share – diluted(1)	$	0.12	$	0.11		$	0.15	$	0.22		$	0.06	$	-0.03		$	0.05	$	0.10

EXECUTIVE LEVEL OVERVIEW

Table 1

Operations Summary

	Year Ended			Increase					Year Ended
	December 31,			(Decrease)					December 31,
	2005			Amount			%		2004
	(Dollars in thousands, restated)
Interest income	$	26,265		$	6,811		35.0	%	$	19,454
Interest expense	5,482			1,859			51.3	%	3,623
Net interest income	20,783			4,952			31.3	%	15,831
Provision (benefit) for credit losses	(84		)	(304		)	(138.2	)%	220
Other operating income	1,118			(1,297		)	(53.7	)%	2,415
Other operating expense	14,376			348			2.5	%	14,028
Income before income taxes	7,609			3,611			90.3	%	3,998
Income taxes	3,159			1,481			88.3	%	1,678
Net income	$	4,450		$	2,130		91.8	%	$	2,320

We recorded net income of $4.5 million for 2005 compared to net income of $2.3 million for 2004. This represents basic earnings per share of $0.96 and fully-diluted earnings per share of $0.75 for 2005 compared to basic earnings per share of $0.64 per share and fully-diluted earnings per share of $0.41 for 2004. The increase in net income for 2005 was largely due to a $4.9 million increase in net interest income resulting from (i) increases in the prime rate lending index, (ii) a greater volume of interest earning assets, particularly higher yielding loans receivable and securities available-for-sale, (iii) interest rate swaps and (iv) a more rapid rise in yield on earning assets than cost of interest-bearing liabilities. Additionally, for 2005 we recorded a net benefit for credit losses due to a significant recovery of a loan previously charged off resulting in a $304,000 positive change compared to 2004. Other operating income declined $1.3 million primarily due to (i) a $395,000 trading loss on non-hedge interest rate swaps compared to a $229,000 trading gain for 2004, (ii) a $250,000 decline in net settlement payments from an interest rate swap not designated as a hedge, and (iii) lower deposit account fees resulting from greater allowances for compensating balances and changes in deposit fee structures. Other operating expenses increased $348,000 in 2005, largely due to greater salaries and related expense and increased professional services.

Return on average assets for 2005 was 1.10% compared to 0.61% for 2004. Return on average equity for 2005 was 12.15% compared to 7.02% for 2004.

Total assets at December 31, 2005 were $448.5 million compared to $391.3 million at year-end 2004. Loans receivable and

13

securities available-for-sale increased $24.7 million and $34.8 million, respectively. The increase in loans receivable was due to growth in construction and land development loans partially offset by a decline in commercial real estate loans and commercial loans – secured and unsecured.

The allowance for loan and lease losses at December 31, 2005 was $4.5 million compared to $3.5 million at December 31, 2004 reflecting net recoveries of loans previously charged off of $1.2 million during the year less the reversal of provision for credit losses of $84,000.

Total deposits at December 31, 2005 were $363.2 million compared to $313.5 million at year-end 2004. The composition of deposits at December 31, 2005 reflects a $46.4 million increase in certificates of deposit $100,000 and over, a $6.9 million increase in money market accounts, $1.1 million increase in interest-bearing demand deposits and a $2.1 million increase in noninterest-bearing demand deposits offset by a $4.0 million decrease in savings accounts and a $2.7 million decrease in certificates of deposit under $100,000. The significant increase in certificates of deposit $100,000 and over was due to the execution of a securities leverage strategy for the purpose of interest rate risk management. Other borrowed funds were $28.3 million at December 31, 2005 compared to $25.9 million at year-end 2004.

Table 2
Ratios to Average Assets

	2005		2004
	(Restated)
Net interest income	5.13	%	4.16	%
Other operating income	0.28	%	0.63	%
Provision (benefit) for credit losses	(0.02	)%	0.06	%
Other operating expense	3.55	%	3.68	%
Income before income taxes	1.88	%	1.05	%
Net income	1.10	%	0.61	%

CRITICAL ACCOUNTING POLICIES

Our accounting policies are integral to understanding the results reported. These policies are described in detail in Note 1 of the Notes to Consolidated Financial Statements. Our most complex accounting policies require management’s judgment to ascertain the valuation of assets, liabilities, commitments and contingencies. We have established detailed policies and control procedures that are intended to ensure valuation methods are well controlled and applied consistently from period to period. In addition, the policies and procedures are intended to ensure that the process for changing methodologies occurs in an appropriate manner. The following is a brief description of our current accounting policies involving significant management valuation judgments.

Allowance for Loan and Lease Losses

The allowance for loan and lease losses is the sum of the allowance for loan and lease losses and the reserve for contingent losses on unfunded commitments. The allowance for loan and lease losses is a valuation adjustment used to recognize impairment of the recorded investment in the Company’s loans receivable on its balance sheet before losses have been confirmed resulting in a subsequent charge-off or write-down. The reserve for contingent losses on unfunded commitments is a liability accrual for unidentified but probable losses on the Company’s commitments to fund loans. As of September 30, 2005, the reserve for contingent losses on unfunded commitments was reclassified from the allowance for loan and lease losses to other liabilities. The 2004 year end reserve for contingent losses on unfunded commitments was reclassified to conform to the current presentation.

The allowance for loan and lease losses represents management’s best estimate of probable loan losses in our loans receivable and commitments to fund loans. The allowance for loan and lease losses is determined based on management’s assessment of several factors: (i) reviews and evaluation of individual loans including underlying cash flow and collateral values, (ii) the level of and changes in classified and nonperforming loans, (iii) historical loan loss experiences, (iv) changes in the nature and volume of the loan portfolio, and (v) current economic conditions and the related impact on specific borrowers and industry groups.

We review and manage the credit quality of the loan portfolio through a process that includes a risk grading system, uniform underwriting criteria, early identification of problem credits, regular monitoring of any classified assets graded as ‘‘criticized’’ by our internal grading system, and an independent loan review process. The calculation of the adequacy of the allowance for loan and lease losses is based on this internal risk grading system as well as other factors including loan grade migration trends and collateral values.

The internal risk grading utilizes a 10-level grading system – six pass grades for unclassified loans based upon our assessment of the borrower’s ability to service the loan and the quality of the collateral and four classification grades for “criticized” loans depending on the severity of the underwriting weakness and likelihood of loss. We use a statistical grading migration analysis as part of our allowance

14

for loan and lease losses evaluation for unclassified loans, which is a method by which the types and gradings of historical loans charged-off are related to the current loan portfolio. This analysis attempts to use historical trends in loan risk grading, nonperforming assets and concentrations that are characteristic to our portfolio and consider other factors affecting loan losses that are specific to our marketplace and customer demographic.

An allowance based upon the migration analysis is determined for various loan types and unclassified grades based upon loan risk grades and historical charge off experience. Adjustments to these allowance factors are made for consideration of, among others matters, (i) changes in underwriting standards and internal risk grading between the current loan portfolio and the historical sample, (ii) changes in the factors that resulted in historical loans charged-off, such as industry economic condition, and (iii) differences between the current economic environment and the economic environment during the period of historical loans charged-off.

Generally, the allowance for loan and lease losses established for classified loans that are collateral-dependent is based on the net realizable value of the collateral. In measuring the net realizable value of the collateral, management uses current appraisals that, among other techniques, observe market transactions of similar property and adjust for differences. Changes in the financial condition of individual borrowers, in economic conditions, in historical loss experience and in the condition of the various markets in which collateral may be sold may all affect the required level of the allowance for loan and lease losses and the associated provision for credit losses.

On a periodic basis we engage an outside loan review firm to review our loan portfolio, risk grade accuracy and the reasonableness of loan evaluations. Annually, this outside loan review team analyzes our methodology for calculating the allowance for loan and lease losses based on our loss histories and policies.

We utilize our judgment to determine the provision for credit losses and establish the allowance for loan and lease losses. Each Bank’s board of directors reviews the adequacy of that Bank’s allowance for loan and lease losses on a quarterly basis. We believe, based on information known to management, that the allowance for loan and lease losses at December 31, 2005 represents the probable loan losses in loans receivable. However, credit quality is affected by many factors beyond our control, including local and national economies, and facts may exist which are not known to us that adversely affect the likelihood of repayment of various loans in the loan portfolio and realization of collateral upon a default. Accordingly, no assurance can be given that we will not sustain loan losses materially in excess of the allowance for loan and lease losses. In addition, the OCC, as an integral part of its examination process, periodically reviews the allowance for loan and lease losses and could develop an estimate that requires additional provisions for credit losses.

Goodwill and Other Intangible Assets

As discussed in Note 2 of the Notes to Consolidated Financial Statements, we must assess goodwill and other intangible assets each year, or more frequently upon the occurrence of certain events, for impairment. Impairment is the condition that exists when the carrying amount of the asset exceeds its implied fair value.

The goodwill impairment test involves comparing the fair value of South Bay with its carrying amount, including goodwill. We retained an independent valuation consultant to evaluate the goodwill as of October 1, 2005. The valuation consultant conducted the analysis utilizing two valuation methods – the income approach and the market approach.

The income approach measures the present worth of anticipated future net cash flows generated by South Bay. Net cash flow forecasts require analysis of the significant variables influencing revenues, expenses, working capital and capital investment as well as residual value and cost of capital. Our forecasts were for a three-year period reflecting average annual asset growth of 11.8%, an average loan to deposit ratio of 106%, an average net interest margin of 5.36%, and average annual return on assets of 1.57%. A 10.8% cost of capital and a $58.4 million residual value was utilized in the analysis to discount the projected cash flows.

The market approach derives a valuation by analyzing the prices at which shares of capital stock of reasonably similar companies are trading in the public market, or the transaction price at which similar companies have been acquired. The analysis identified eighteen transactions during the period from October 2002 through September 2004 involving acquired companies located in the state of California with similarities to South Bay in size and operating characteristics. Transaction multiples were considered for purchase price to (i) earnings, and (ii) tangible book value. The purchase price to earnings multiple for the South Bay acquisition was 11.38 compared to a range from 6.88 to 91.00 with an average of 28.01 for the transactions studied. The South Bay transaction purchase price to tangible book value multiple was 1.55 compared to a range of 1.35 to 3.93 with an average of 2.53 for the comparable transactions.

The consultant also analyzed our stock price as part of its market approach analysis. This analysis involved applying price multiples based on our stock price at or near the valuation date to the performance measures of South Bay. Additionally, the consultant considered guideline companies operating in the same market segment as South Bay. The stock trading values of similar companies were not considered reliable due to the small volume of trading activity, however, the results were not inconsistent with those of the transaction method.

The fair value indications derived from the income approach was $55.9 million and from the two market approaches, transaction and stock price analysis, $50.2 million and $47.5 million, respectively. The fair value of South Bay under both approaches exceeds the carrying value at October 1, 2005 of $22.3 million, therefore, goodwill is not considered impaired. The testing of goodwill and other intangible assets for impairment requires re-measurement of fair values. If the future fair values were materially less than the recorded

15

value, we would be required to take a charge against earnings to write down the goodwill and other intangible assets to the lower value.

Deferred Tax Assets

At December 31, 2005 we had total deferred tax assets of $4.3 million of which $2.5 million is represented by (i) federal NOLs of $5.0 million, which begin to expire in 2009; and (ii) a federal AMT credit carry forward of $544,000. In order to utilize the benefit of the deferred tax assets related to the NOLs, we must generate aggregate taxable income equal to the amount of the NOLs during the period prior to their expiration.

If future taxable income should prove non-existent or less than the amount of the NOLs that created the deferred tax assets within the tax years to which they may be applied, the asset may not be realized. A valuation allowance may be established to reduce the deferred tax asset to its realizable value. Any adjustment required to the valuation allowance is coupled with a related entry to income tax expense. A charge to earnings will be made in the event that we determine that a valuation allowance to the deferred tax asset is necessary. Our deferred tax assets are described further in Note 6 of the Notes to Consolidated Financial Statements.

We use estimates of future taxable income to evaluate if it is more likely than not that the benefit of our deferred tax assets will be realized. Our analysis utilizes alternative scenarios reflecting a range of assumptions for asset growth rates, loan to deposit ratios, interest rates and inflation rates. The results of the analysis support our position that it is more likely than not that our deferred tax assets will be realized.

Derivative Instruments and Hedging

We utilize derivative instruments to manage our risk to changes in interest rates. Statement of Financial Accounting Standards No. 133 Accounting for Derivative Instruments and Hedging Activities (SFAS 133) requires that an entity recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as a hedge and earnings are affected only to the extent to which the hedge is not effective in achieving offsetting changes in fair value or cash flows of the hedged item. We have designated certain of our derivative instruments as hedges and consider them highly effective. Circumstances may change increasing the extent that the hedge is not effective resulting in a greater portion of the change in value of the derivative instruments being reported in earnings.

We have other derivatives that hedge exposures when it makes economic sense to do so, including circumstances in which the hedging relationship does not qualify for hedge accounting. The changes in the fair value of these derivatives are recorded as trading gains or losses on economic derivatives in the statement of operations.

OPERATIONS SUMMARY ANALYSIS

Net Interest Income

Our earnings depend largely upon the difference between the income earned on our loans and other investments and the interest paid on our deposits and borrowed funds. This difference is net interest income. Our ability to generate net interest income is largely dependent on our ability to maintain sound asset quality and appropriate levels of capital and liquidity. In the event that we are unable to maintain sound asset quality, capital or liquidity it may adversely affect (i) the ability to accommodate desirable borrowing customers, thereby inhibiting growth in quality higher-yielding earning assets; (ii) the ability to attract comparatively stable, lower-cost deposits; and (iii) the costs of wholesale funding sources.

Net interest income increased $5.0 million to $20.8 million during 2005 compared to 2004 due to a $6.8 million increase in interest income offset by a $1.9 million increase in interest expense. The restatement eliminating hedge accounting treatment for the interest rate swap on our junior subordinated debentures resulted in a reclassification of the interest rate swap net settlement payment from interest expense to other operating income increasing interest expense $347,000 and $597,000 for the years ended December 31, 2005 and 2004, respectively.

Loan interest income increased $6.1 million due to $30.7 million greater average volume of loans receivable and a 133 basis point increase in yield, resulting primarily from increases in the prime rate lending index and interest rate swaps. During the second half of 2004, the Federal Reserve Bank increased interest rates 125 basis points on five occasions after a prolonged period of accommodative monetary policy in response to signs of stronger economic activity and perceived higher inflation risk. Continuing in 2005, the Federal Reserve Bank increased interest rates 200 basis points on eight occasions. Approximately 75% of our $338.6 million loans receivable at December 31, 2005, adjustable interest rates; consequently, rising interest rates positively affect interest income. In order to lessen the impact on interest income in the event of a decline in the prime rate lending index, we have entered into interest rate swaps, in which we exchanged an adjustable rate interest based on the prime rate lending index for a fixed rate payment on an aggregate notional amount of $50.0 million. The higher yields earned on our loans receivable during 2005 were partially offset by the rising cost of certain interest rate swaps; however, these interest rate swaps still contributed 12 basis points to the increase in loan yield compared to 2004.

The greater volume of loans receivable was due to a $41.8 million increase in construction and land development loans reflecting stronger residential construction loan demand and the funding of previously approved construction loans. Recent data and events, however, reflect slowing of national residential sales activity and slowing of the growth in residential real estate prices. While real estate activity in western states remains relatively strong, a more pronounced slowing in our lending areas would likely negatively impact the

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growth of our construction loans. Consumer loans increased $4.7 million primarily due to growth in our insurance premium financing.

Offsetting the growth in these loan categories, real estate loans secured by commercial real properties declined $14.3 million during 2005 due to more rapid repayment of loans than funding of newly originated loans. We have experienced rigorous price competition for commercial real estate loans, and an increase in borrower refinancing of our adjustable rate loans for fixed rate loans with other lenders, particularly as rising short-term interest rates have approached longer-term fixed interest rate levels. We have experienced strong activity in developing new business relationships, evidenced by growth in unfunded commitments, however, commercial loans – secured and unsecured, declined $9.0 million due to a decrease in utilization of lines of credit. This decrease in credit utilization is due to greater borrower liquidity resulting from relatively strong local economic activity.

Interest income from securities available-for-sale increased $719,000 during 2005 compared to 2004 due to $10.0 million greater average volume and an 82 basis point increase in yield. During the third and fourth quarter of 2005, we accelerated our investment activity as part of a strategy to further reduce the exposure of net interest income to a declining interest rate environment. The additions to securities available-for-sale have largely been low-coupon, intermediate-term, 15- and 20-year mortgage-backed security pools, purchased at a discount that we expect to have limited prepayment of principal in the event of declining interest rates (and muted term extension in rising interest rates). These investments, as well as loans receivable, have been largely financed with adjustable rate wholesale funds that will decline in cost in a falling interest rate environment. The securities available-for-sale purchased during 2005, in a period of higher interest rates, and the maturity of lower yielding securities in the portfolio, resulted in an increase in the portfolio yield.

Additionally, during 2005 we reallocated short-term lower-yielding federal funds sold, which averaged $6.0 million less than 2004, into higher yielding earning assets. Furthermore, through deposit reclassification utilizing non-transaction sub accounts, we reduced our required reserves at the Federal Reserve Bank resulting in the redeployment of $6.5 million in noninterest-bearing cash and due from banks – demand. Overall, interest-earning assets were $32.3 million greater during 2005 than 2004 while the higher interest rates and favorable change in composition to higher-yielding assets resulted in a 133 basis point increase in weighted average yield on interest-earning assets.

Interest expense increased $1.9 million for 2005 due to a $19.7 million increase in average interest-bearing liabilities and a 64 basis point increase in the weighted average cost of interest-bearing liabilities. Interest expense on deposits increased $1.8 million due to a 75 basis point rise in weighted average cost of interest-bearing deposits in addition to $20.2 million greater average volume than 2004. Time certificates of deposit $100,000 and over averaged $24.8 million greater during 2005 than 2004 due to an increased volume of brokered certificates of deposit (“Brokered CDs”). The volume of money market and savings deposits declined $4.3 million in 2005 and time certificates of deposit under $100,000 declined $1.3 million. Relatively low costing interest-bearing demand deposits averaged $1.0 million greater in 2005 than in 2004.

During the rising interest rate environment experienced during the past six quarters, we strategically elected to only moderately increase transaction deposit rates and to fund asset growth, and runoff of these deposits, with Brokered CDs. Although this type of funding is typically higher costing and exhibits higher interest rate sensitivity, the Brokered CDs facilitate our liquidity and interest rate risk management that we utilize to reduce our net interest income exposure to possible declining interest rates. The greater interest expense on the incremental Brokered CDs needed to fund asset growth, and any decrease in transaction deposits, is less than the impact of increasing rates on the significantly greater volume of transaction accounts. In a sustained rising interest rate environment, nonetheless, increases in deposit interest rates will be required to prevent net deposit withdrawals.

The cost of time certificates of deposit $100,000 and over increased 115 basis points during 2005 compared to 2004. The cost of money market and savings deposits increased 60 basis points while the cost of interest-bearing demand deposits and time certificates of deposit under $100,000 increased 24 basis points and 65 basis points, respectively.

The volume of other borrowings averaged $12.2 million and $12.6 million in 2005 and 2004, respectively. We continue to employ a liquidity strategy of maintaining relatively low levels of short-term assets and utilize Federal Home Loan Bank overnight advances, against pledged loans and securities, to fund asset and deposit fluctuations. Minimizing short-term assets and increasing short-term liabilities furthers the management of our asset sensitive balance sheet. The cost of other borrowings was 3.38% and 2.65% for 2005 and 2004, respectively, representing an increase of 73 basis points in 2005.

Noninterest-bearing demand deposits increased only slightly averaging $124.8 million and $124.7 million in 2005 and 2004, respectively. While we continue to devote resources to growing our business accounts, in a rising interest rate environment depositors generally deploy their funds into higher yielding deposits and alternative investments outside the Banks. Additionally, our escrow company customers maintained lower balances due to reduced mortgage refinancing activity in the higher interest rate environment.

Interest Rate Spread and Net Interest Margin

We analyze earnings performance using, among other measures, the interest rate spread and net interest margin. The interest rate spread represents the difference between the weighted average yield received on interest earning assets and the weighted average rate paid on interest bearing liabilities. Net interest margin (also called the net yield on interest earning assets) is net interest income expressed as a percentage of average total interest earning assets. Our net interest margin is affected by changes in the yields earned on assets and rates paid on liabilities, referred to as rate changes, and changes to the relative amount of interest earning assets and interest bearing liabilities. Interest rates charged on our loans are affected principally by the demand for such loans, the supply of money

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available for lending purposes, and other competitive factors. These factors are in turn affected by general economic conditions and other factors beyond our control, such as federal economic policies, the general supply of money in the economy, legislative tax policies, governmental budgetary matters, and actions of the Federal Reserve Board. Table 3 presents information concerning the change in interest income and interest expense attributable to changes in average volume and average rate. Table 4 presents the weighted average yield on each category of interest earning assets, the weighted average rate paid on each category of interest bearing liabilities, and the resulting interest rate spread and net yield on interest earning assets for 2005, 2004 and 2003. We had no tax exempt interest income for 2005, 2004 or 2003.

	2005 vs 2004								2004 vs 2003
						Net									Net
	Increase (decrease) due to:					Increase			Increase (decrease) due to:						Increase
	Volume			Rate		(Decrease)			Volume			Rate			(Decrease)
	(Dollars in thousands, restated)
Interest Income:
Federal funds sold and securities purchased under agreement to resell	$	(75	)	$	30	$	(45	)	$	(278	)	$	14		$	(264	)
Due from banks - interest bearing	(22		)	67		45			29			10			39
Securities available-for-sale	297			422		719			565			(241		)	324
Securities held-to-maturity	(38		)	6		(32		)	10			105			115
Loans receivable (2)	1,944			4,180		6,124			1,373			743			2,116
Total interest-earning assets	2,106			4,705		6,811			1,699			631			2,330
Interest Expense:
Interest-bearing deposits:
Demand	$	3		$	75	$	78		$	14		$	(60	)	$	(46	)
Money market and savings	(30		)	623		593			84			(240		)	(156		)
Time certificates of deposit:
$100,000 or more	368			594		962			(36		)	(96		)	(132		)
Under $100,000	(23		)	170		147			(140		)	(170		)	(310		)
Total time certificates of deposit	345			764		1,109			(176		)	(266		)	(442		)
Total interest-bearing deposits	318			1,462		1,780			(78		)	(566		)	(644		)
Other borrowings	(10		)	90		80			243			(272		)	(29		)
Junior subordinated debentures (3)	—			—		—			792			—			792
Federal funds purchased and securities sold under agreements to repurchase	(1		)	—		(1		)	(13		)	(2		)	(15		)
Total interest-bearing liabilities	307			1,552		1,859			944			(840		)	104
Net interest income	$	1,799		$	3,153	$	4,952		$	755		$	1,471		$	2,226

(1)The change in interest income or interest expense that is attributable to both changes in average balance and average rate has been allocated to the changes due to (i) average balance and (ii) average rate in proportion to the relationship of the absolute amounts of changes in each.

(2)Table does not include interest income that would have been earned on nonaccrual loans.

(3)The implementation of FASB Interpretation No. 46, effective July 1, 2003 resulted in the reclassification of the Company’s Junior Subordinated Debentures from mezzanine equity to liabilities and the related interest to interest expense after June 30, 2003.

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Table 4
Average Balance Sheet and Analysis of Net Interest Income

	2005							2004							2003
						Weighted							Weighted							Weighted
				Interest		Average					Interest		Average					Interest		Average
	Average			Income/		Yield/		Average			Income/		Yield/		Average			Income/		Yield/
	Amount			Expense		Rate		Amount			Expense		Rate		Amount			Expense		Rate
	(Dollars in thousands, restated)
Assets:
Federal funds sold and securities purchased under agreements to resell	$	1,647		$	50	3.04	%	$	7,651		$	95	1.24	%	$	33,829		$	359	1.06	%
Due from banks - interest bearing	2,187			101		4.62	%	3,566			56		1.57	%	1,304			17		1.30	%
Securities available-for-sale	51,595			1,954		3.79	%	41,603			1,235		2.97	%	25,672			911		3.55	%
Securities held-to-maturity	3,070			121		3.94	%	4,085			153		3.75	%	3,254			38		1.17	%
Loans receivable (1) (2)	314,164			24,039		7.65	%	283,415			17,915		6.32	%	260,756			15,799		6.06	%
Total interest earning assets	372,663			$	26,265	7.05	%	340,320			$	19,454	5.72	%	324,815			$	17,124	5.27	%
Noninterest earning assets:
Cash and due from banks - demand	16,374							22,874							22,171
Other assets	20,775							21,529							21,859
Allowance for loan and lease losses and net unrealized (loss) gain on sales of securities available-for-sale	(4,769		)					(3,753		)					(4,025		)
Total assets	$	405,043						$	380,970						$	364,820
Liabilities and shareholders’ equity:
Interest-bearing deposits:
Demand	$	32,497		$	158	0.49	%	$	31,484		$	80	0.25	%	$	28,269		$	126	0.45	%
Money market and savings	103,648			1,342		1.29	%	107,981			749		0.69	%	98,763			905		0.92	%
Time certificates of deposit:
$100,000 or more	51,995			1,365		2.63	%	27,179			403		1.48	%	29,150			535		1.84	%
Under $100,000	26,031			620		2.38	%	27,345			473		1.73	%	33,316			783		2.35	%
Total time certificates of deposit	78,026			1,985		2.54	%	54,524			876		1.61	%	62,466			1,318		2.11	%
Total interest-bearing deposits	214,171			3,485		1.63	%	193,989			1,705		0.88	%	189,498			2,349		1.24	%
Other borrowings	12,186			412		3.38	%	12,550			332		2.65	%	7,500			361		4.81	%
Junior subordinated debentures (3)	15,464			1,585		10.25	%	15,464			1,585		10.25	%	7,733			793		10.25	%
Federal funds purchased and securities sold under agreements to repurchase	—			—		—		113			1		0.88	%	609			16		2.63	%
Total interest-bearing liabilities	241,821			5,482		2.27	%	222,116			3,623		1.63	%	205,340			3,519		1.71	%
Noninterest-bearing liabilities:
Noninterest bearing demand deposits	124,789							124,699							119,789
Other liabilities	1,811							1,086							845
Guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures, net (3)	—							—							7,267
Shareholders’ equity	36,622							33,069							31,579
Total liabilities and shareholders’ equity	$	405,043						$	380,970						$	364,820
Net interest income (interest rate spread)				$	20,783	4.78	%				$	15,831	4.09	%				$	13,606	3.56	%
Net yield on interest earning assets (2)						5.58	%						4.65	%						4.19	%

(1)The average balance of nonperforming loans has been included in loans receivable.

(2)Yields and amounts earned on loans receivable include loan fees of $1,725,000, $1,383,000 and $882,000 for the years ended December 31, 2005, 2004 and 2003, respectively.

(3)The implementation of FASB Interpretation No. 46, effective July 1, 2003 resulted in the reclassification of the Company’s Junior Subordinated Debentures from mezzanine equity to liabilities and the related interest to interest expense after June 30, 2003.

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Our net interest margin increased 93 basis points from 4.65% during 2004 to 5.58% in 2005. Our net interest margin remains high in comparison with the interest rate spread due to the continued significance of noninterest-bearing demand deposits relative to total funding sources. Average noninterest bearing demand deposits were $124.8 million, representing 36.8% of average deposits, during 2005, compared to $124.7 million, representing 39.1% of average deposits, during 2004. Of these noninterest bearing demand deposits during 2005, $14.7 million or 11.8% of average noninterest bearing deposits were represented by real estate title and escrow company deposits, compared to $16.2 million or 13.0% of average noninterest bearing deposits during 2004. While these deposits are noninterest bearing, they are not cost free funds. Customer service expenses, primarily costs related to external accounting and data processing services provided to title and escrow company depositors are incurred by us to the extent that such depositors maintain certain average noninterest bearing deposits. Customer service expense is classified as other operating expense. If customer service expenses related to escrow customers had been classified as interest expense, our reported net interest income for 2005 and 2004 would have been reduced by $370,000 and $137,000, respectively, and the net interest margin for 2005 and 2004 would have decreased 36 basis points and 4 basis points, respectively. Similarly, this would create identical reductions in other operating expense. The expense associated with these deposits increased in 2005 from 2004 despite the decrease in volume due to a greater allowance for customer services provided for these depositors.

The restatement adjustment increasing interest expense reduced the net yield on interest earning assets and the interest rate spread 9 basis points and 14 basis points, respectively, for the year ended December 31, 2005 and 18 basis points and 27 basis points, respectively, for the year ended December 31, 2004.

Provision/Benefit for Credit Losses

During 2005, we recorded a benefit for credit losses of $84,000 compared to a $220,000 provision for credit losses in 2004 following our valuation assessment of the allowance for loan and lease losses and the reserve for contingent losses on unfunded commitments. Impacting the allowance in 2005, among other items, was a significant recovery of a loan previously charged off partially offset by relatively strong growth in loans receivable and unfunded loan commitments. In 2005 net recoveries were $1.2 million compared to net recoveries $73,000 in 2004.

Assuming continued loan growth, and based on the relative uncertainty regarding the state of the economy, and the level of nonperforming loans, it is anticipated that regular provisions for credit losses will be made during 2006. Credit quality will be influenced by underlying trends in the economic cycle, particularly in Southern California, and other factors, which are beyond management’s control. Accordingly, no assurance can be given that we will not sustain loan losses that in any particular period are sizable in relation to the allowance for loan and lease losses. Subsequent evaluation of the loan portfolio, in light of factors then prevailing, by us and our regulators may indicate a requirement for increases in the allowance for loan and lease losses through additions to the provision for credit losses.

Other Operating Income

Other operating income was $1.1 million and $2.4 million in 2005 and 2004, respectively. The decline was due to (i) a $395,000 trading loss on economic derivatives compared to a $229,000 trading gain for 2004, (ii) a $250,000 decline in net settlement payments from an interest rate swap not designated as a hedge, and (iii) $592,000 lower deposit account fees resulting from greater allowances for compensating balances and changes in deposit fee structures. In 2004, there was a net loss of $197,000 on sales of securities available-for-sale. Fee income related to international services was $52,000 in 2005 compared to $59,000 in 2004. Investment services fees were $54,000 in 2005 compared to $53,000 in 2004.

Other Operating Expenses

Other operating expense increased $348,000 to $14.4 million in 2005, compared to $14.0 million during 2004. Salaries and related benefits increased $280,000 or 3.7% to $7.8 million, primarily due to the addition of business development staff during the year, as well as larger management bonuses and increased commissions paid to business development staff for loan production. Net occupancy expense decreased $130,000 or 11.5% to $1.0 million primarily due to the relocation of our administrative offices and the Century City banking office. Other professional services increased $273,000 or 32.0% largely due to increased audit and tax expense as well as professional services for credit workouts. Other expenses decreased $150,000 largely due to a $250,000 reserve established during 2004 in a dispute over our lien on the collateral for a loan as well as several unrelated and nonrecurring operating losses. The dispute was resolved during 2005.

Income Taxes

Deferred tax assets and liabilities are recognized for the expected future tax consequences of existing differences between financial reporting and tax reporting bases of assets and liabilities, as well as for operating losses and tax credit carryforwards, using enacted tax laws and rates. Deferred tax assets will be reduced through a valuation allowance whenever it becomes more likely than not that all or some portion will not be realized. Deferred income tax expense (benefit) represents the net change in the deferred tax asset or liability balance during the year. This amount, together with income taxes currently payable or refundable in the current year, represents the total tax expense for the year.

At December 31, 2005, our deferred tax asset totaled $4.3 million, respectively, with no recorded valuation allowance.

For tax purposes at December 31, 2005, we had (i) federal NOLs of $5.0 million, which begin to expire in 2009; and (ii) a federal

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alternative minimum tax (“AMT”) credit carryforward of $544,000 that carries forward indefinitely.

An income tax provision of $3.2 million was recorded for 2005 compared to $1.7 million for 2004.

Federal and state income tax laws provide that following an ownership change of a corporation with NOLs, a net unrealized built-in loss or tax credit carryovers, the amount of annual post-ownership change taxable income that can be offset by pre-ownership change NOLs, built-in losses or tax credit carryovers generally cannot exceed a prescribed annual limitation. The annual limitation generally equals the product of the fair market value of the corporation immediately before the ownership change (subject to certain adjustments) and the federal long-term tax-exempt rate prescribed monthly by the Internal Revenue Service. If such limitations were to apply to us, our ability to reduce future taxable income by the NOLs could be severely limited.

Accumulated Other Comprehensive Income

Accumulated other comprehensive income is comprised of the unrealized gain or loss on available-for-sale securities and the unrealized gain or loss on our derivative financial instruments designated as cash flow hedges, net of taxes. At December 31, 2005 the net unrealized loss on available-for-sale securities was $392,000 compared to a net unrealized loss of $39,000 at December 31, 2004. The interest rate swaps designated as cash flow hedges had an unrealized loss of $605,000 at December 31, 2005 compared to an unrealized gain of $314,000 at December 31, 2004. The interest rate floors designated as cash flow hedges had an unrealized loss of $157,000 at December 31, 2005. We had no interest rate floors as of December 31, 2004.

FINANCIAL CONDITION

Regulatory Capital

The following table sets forth (i) the minimum regulatory capital requirements for National Mercantile and the Banks; (ii) the capital requirements for the Banks to be “well capitalized” under the prompt corrective action rules; and (iii) the regulatory capital ratios of National Mercantile and the Banks as of the dates indicted in 2004 and 2005.

Table 5
Regulatory Capital Information of the National Mercantile and Banks

	Minimum
	For Capital		Well
	Adequacy		Capitalized		December 31,
	Purposes		Standards		2005		2004
					(As restated)
National Mercantile Bancorp:
Tier 1 capital to average assets	4.00	%	N/A		10.74	%	9.83	%
Tier 1 capital to risk weighted assets	4.00	%	N/A		11.98	%	10.35	%
Total capital to risk weighted assets	8.00	%	N/A		13.72	%	12.39	%
Mercantile National Bank:
Tier 1 capital to average assets	4.00	%	5.00	%	10.49	%	8.99	%
Tier 1 capital to risk weighted assets	4.00	%	6.00	%	13.59	%	10.44	%
Total capital to risk weighted assets	8.00	%	10.00	%	14.84	%	11.60	%
South Bay Bank, NA:
Tier 1 capital to average assets	4.00	%	5.00	%	9.04	%	9.32	%
Tier 1 capital to risk weighted assets	4.00	%	6.00	%	9.00	%	9.32	%
Total capital to risk weighted assets	8.00	%	10.00	%	10.22	%	10.29	%

National Mercantile’s Tier I capital, which is comprised of shareholders’ equity as modified by certain regulatory adjustments, was $46.5 million and $38.0 million at December 31, 2005 and 2004, respectively. National Mercantile’s Tier 1 capital increased in 2005 as a result of net income, exercised stock options and a reduction of the portion of deferred tax asset disallowed for regulatory capital purposes. Federal Reserve capital rules allow trust preferred securities to represent up to 25% of Tier 1 capital with the balance treated as Tier 2 capital for the Total risk-based Capital ratio. At December 31, 2005 and 2004, Trust Preferred Securities represented $13.1 million and $11.5 million, respectively, of National Mercantile’s Tier 1 capital, and $1.9 million and $3.5 million, respectively, of its Tier 2 capital. Disallowed against National Mercantile’s Tier 1 capital is $3.2 million of goodwill recorded in the acquisition of South Bay, $1.4 million of other intangible assets and $1.1 million of deferred tax asset based upon estimated earnings.

Mercantile’s Tier 1 capital was $24.8 million and $19.4 million at December 31, 2005 and 2004, respectively. The increase in Tier

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1 capital during 2005 was due to net income and the decrease of the portion of deferred tax asset disallowed for regulatory capital purposes.

South Bay’s Tier 1 capital at December 31, 2005 was $18.7 million compared to $17.1 million at December 31, 2004. The increase is due to net income in 2005.

Liquidity Management

The objective of liquidity management is to maintain cash flow adequate to fund our operations and meet obligations and other commitments on a timely and cost effective basis. We manage to this objective primarily through the selection of asset and liability maturity mixes. Our liquidity position is enhanced by the ability to raise additional funds as needed through available borrowings or accessing the wholesale deposit market.

Our deposit base provides the majority of our funding requirements. Deposits, a relatively stable and low-cost source of funds has, along with shareholders’ equity, provided 92.7% and 92.3 % of funding for average total assets during 2005 and 2004, respectively. The other borrowings, specifically Federal Home Loan Bank (“FHLB”) advances, which averaged $12.2 million during 2005 compared to $12.6 million during 2004, and federal funds purchased and securities sold under agreements to repurchase, which had no balances in 2005 compared to $113,000 in 2004, comprise the balance of the liability funding. The other borrowings during 2005 and 2004 were used to fund higher yielding loans and securities.

Also, federal funds sold and securities purchased under resale agreements that may be immediately converted to cash at minimal cost. The aggregate of these assets averaged $1.6 million during 2005, as compared to $7.7 million during 2004.

The portfolio of available-for-sale securities is an additional source of liquidity, which averaged $51.6 million during 2005 compared to $41.6 million in 2004. The securities available-for-sale increased in 2005 due to the deployment of funds into securities pending redeployment into loans. Except for a relatively small amount of securities pledged to collateralize public funds, deposits of bankruptcy estates and our swaps, our securities are pledged to the FHLB to secure immediately available borrowings. At December 31, 2005, $64.4 million of securities were pledged to the FHLB and an additional $38.0 million borrowing capacity remained. There were no unpledged investment securities at December 31, 2005. Maturing loans also provide liquidity, of which $175.6 million of the Banks’ loans are scheduled to mature in 2006.

Net cash provided by operating activities totaled $7.9 million in 2005 compared to $5.4 million in 2004. The primary source of funds is net income from operations adjusted for provision for credit losses and depreciation and amortization. Net cash used in investing activities totaled $61.4 million in 2005 compared to $61.0 million net cash used in investing activities in 2004. The increase in cash used by investing activities was primarily due to an increase in purchases of securities available-for-sale partially offset by a decrease in loan originations, net of loan paydowns and payoffs. Net cash provided by financing activities was $52.9 million in 2005 compared to $33.2 million provided by financing activities in 2004. The increase in 2005 net cash provided resulted primarily from an increase in time certificates of deposit offset by a decrease in other borrowed funds.

Interest Rate Risk Management

Interest rate risk management seeks to maintain a stable growth of income and manage the risk associated with changes in interest rates. Net interest income, the primary source of earnings, is affected by interest rate movements. Changes in interest rates have a lesser impact the more that assets and liabilities reprice in approximately equivalent amounts at basically the same time intervals. Imbalances in these repricing opportunities at any point in time constitute interest sensitivity gaps, which is the difference between interest sensitive assets and interest sensitive liabilities.

Interest rate risk, including interest rate sensitivity and the repricing characteristics of assets and liabilities, is managed by our Balance Sheet Management Committee (“BSMC”). The principal objective of BSMC is to maximize net interest income within acceptable levels of risk established by policy.

We manage interest rate sensitivity by matching the repricing opportunities on our earning assets to those on our funding liabilities. We use various strategies to manage the repricing characteristics of our assets and liabilities to ensure that exposure to interest rate fluctuations is limited within guidelines of acceptable levels of risk-taking. Hedging strategies, including the terms and pricing of loans and deposits, the use of derivative financial instruments and managing the deployment of our securities are used to reduce mismatches in interest rate repricing opportunities of portfolio assets and their funding sources.

Interest rate sensitivities are monitored through the use of simulation modeling techniques that apply alternative interest rate scenarios to periodic forecasts of future business activity and estimate the related impact on net interest income. The use of simulation modeling assists management in its continuing efforts to achieve earnings growth in varying interest environments. Table 6 shows the change in net interest income for one year given a 200 basis point decrease and increase in interest rates at December 31, 2005 based upon our interest rate simulation model:

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Table 6

Net Interest Income at Risk Modeling

	Interest rate scenario
	200 Basis Point  Decrease									200 Basis Point Increase
			Change from					Base				Change from
	Amount		Base Amount			Percent		Amount		Amount		Base Amount		Percent
Change in net interest income:
Months one through twelve	$	22,034	$	(1,191	)	-5.13	%	$	23,225	$	24,187	$	962	2.85	%
Months thirteen through twenty-four	21,100		(2,158		)	-9.28	%	23,258		24,904		1,646		5.94	%
Total for twenty-four months	$	43,134	$	(3,349	)	-5.91	%	$	46,483	$	49,091	$	2,608	4.32	%

The model results reflect a net interest income exposure to declining interest rates.  Our asset sensitivity in a declining interest rate scenario will have a negative effect on our net interest income as changes in the rates of interest bearing deposits historically have not changed proportionately with changes in market interest rates.  Additionally, in low and declining interest rate environments, such as the environment experienced in 2003, the interest rates paid on funding liabilities may begin to reach floors preventing further downward adjustments while rates on earning assets continue to adjust downward.  This condition will likewise have a negative impact on our net interest income.  Conversely, our asset sensitivity in a rising interest rate environment is expected to have a positive affect on earnings as a greater amount of earning assets than funding liabilities reprice upward and historically the rates of interest bearing deposits adjust upward more slowly and in smaller increments.

Key assumptions in the model include anticipated prepayments on mortgage-related instruments, contractual cash flow and maturities of all financial instruments, anticipated future business activity, deposit rate sensitivity and changes in market conditions.  These assumptions are inherently uncertain and, as a result, these models cannot  precisely estimate the impact that higher or lower rate environments will have on net interest income.  Actual results will differ from simulated results due to the timing, magnitude and frequency of interest rate changes, changes in cash flow patterns and market conditions, as well as changes in management’s strategies.

Investment Securities

We invest in investment securities consisting primarily of U.S. agency securities and mortgage-related securities to: (i) generate interest income pending the ability to deploy those funds in loans meeting our lending strategies; (ii) increase net interest income where the rates earned on such investments exceed the related cost of funds, consistent with the management of interest rate risk; and (iii) provide sufficient liquidity in order to maintain cash flow adequate to fund our operations and meet obligations and other commitments on a timely and cost efficient basis.  During 2005 and 2004, we held no tax-exempt securities.

We generally classify our investment securities as available-for-sale except for investment securities we have the ability and the positive intent to hold to maturity which are classified as held-to-maturity securities.

Table 7 provides certain information regarding our investment securities.

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Table 7

Estimated Fair Values of and Unrealized

Gains and Losses on Investment Securities

	December 31, 2005
	Total		Gross		Gross		Estimated
	amortized		unrealized		unrealized		fair
	cost		gains		loss		value
	(Dollars in thousands)
Available-For-Sale:
U.S. Treasury securities	$	599	$	—	$	—	$	599
GNMA-issued/guaranteed mortgage pass through certificates	98		2		—		100
Other U.S. government and federal agency securities	17,931		—		152		17,779
FHLMC/FNMA-issued mortgage pass through certificates	33,982		47		366		33,663
CMO’s and REMIC’s issued by U.S. government-sponsored agencies	2,528		13		—		2,541
Privately issued corporate bonds, CMO and REMIC securities	17,290		3		217		17,076
	$	72,428	$	65	$	735	$	71,758
FRB and other stock	$	3,809	—		—		$	3,809

	December 31, 2005
	Total		Gross		Gross		Estimated
	amortized		unrealized		unrealized		fair
	cost		gains		loss		value
	(Dollars in thousands)
Held-to-Maturity:
FHLMC/FNMA-issued mortgage pass through certificates	$	2,612	$	—	$	40	$	2,572
	$	2,612	$	—	$	40	$	2,572

	December 31, 2004
	Total		Gross		Gross		Estimated
	amortized		unrealized		unrealized		fair
	cost		gains		loss		value
	(Dollars in thousands)
Available-For-Sale:
U.S. Treasury securities	$	696	$	—	$	2	$	694
GNMA-issued/guaranteed mortgage pass through certificates	164		7		—		171
Other U.S. government and federal agency securities	23,958		—		128		23,830
FHLMC/FNMA-issued mortgage pass through certificates	9,288		76		1		9,363
CMO’s and REMIC’s issued by U.S. government-sponsored agencies	38		—		—		38
Privately issued corporate bonds, CMO and REMIC securities	2,876		1		19		2,858
	$	37,020	$	84	$	150	$	36,954
FRB and other stock	$	3,076	—		—		$	3,076

	December 31, 2004
	Total		Gross		Gross		Estimated
	amortized		unrealized		unrealized		fair
	cost		gains		loss		value
	(Dollars in thousands)
Held-to-Maturity:
FHLMC/FNMA-issued mortgage pass through certificates	$	3,507	$	40	$	—	$	3,547
	$	3,507	$	40	$	—	$	3,547

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	December 31, 2003
	Total		Gross		Gross		Estimated
	amortized		unrealized		unrealized		fair
	cost		gains		loss		value
	(Dollars in thousands)
Available-For-Sale:
U.S. Treasury securities	$	600	$	—	$	1	$	599
GNMA-issued/guaranteed mortgage pass through certificates	351		12		—		363
Other U.S. government and federal agency securities	12,758		45		4		12,799
FHLMC/FNMA-issued mortgage pass through certificates	3,828		161		—		3,989
CMO’s and REMIC’s issued by U.S. government-sponsored agencies	56		1		—		57
Mortgage mutual funds	10,000		—		98		9,902
Privately issued corporate bonds, CMO and REMIC securities	3,163		5		—		3,168
	$	30,756	$	224	$	103	$	30,877
FRB and other stock	$	1,872	—		—		$	1,872

	December 31, 2003
	Total		Gross		Gross		Estimated
	amortized		unrealized		unrealized		fair
	cost		gains		loss		value
	(Dollars in thousands)
Held-to-Maturity:
FHLMC/FNMA-issued mortgage pass through certificates	$	4,597	$	43	$	—	$	4,640
	$	4,597	$	43	$	—	$	4,640

At December 31, 2005, we held no securities from any issuer other than by U.S. government agencies and corporations in which the aggregate book value exceeded 10% of our shareholders’ equity.

Our present strategy is to extend the duration of the portfolio to further reduce our balance sheet asset sensitivity with investments with only moderate risk of term extension and only limited prepayments.  Table 8 sets forth information concerning the contractual maturity of and weighted average yield of our investment securities at December 31, 2005.

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Table 8

Maturities of and Weighted Average Yields on

Investment Securities

					After one but				After five but										Weighted
	Within one year				within five years				within ten years				After ten years						Average
	Amount		Yield		Amount		Yield		Amount		Yield		Amount		Yield		Total		Yield
	(Dollars in thousands)
Securities available-for-sale:
U.S Treasury securities	$	—	—		$	599	4.32	%	$	—	—		$	—	—		$	599	4.32	%
GNMA-issued/guaranteed mortgage pass-through certificates	—		—		—		—		—		—		100		5.98	%	100		5.98	%
Other U.S. government and federal agencies	7,867		2.31	%	7,940		3.12	%	—		—		1,972		0		17,779		2.77	%
FHLMC/FNMA-issued mortgage pass-through certificates	—		—		234		4.96	%	2,354		4.41	%	31,075		4.96	%	33,663		4.92	%
CMO’s and REMIC’s issued by U.S. government-sponsored agencies	—		—		2		5.93	%	—		—		2,539		0		2,541		5.49	%
Privately issued corporate bonds, CMO’s and REMIC’s securities	—		—		—		—		—		—		17,076		0		17,076		4.95	%
	$	7,867	2.31	%	$	8,775	3.25	%	$	2,354	4.41	%	$	52,762	4.92	%	$	71,758	4.41	%
Amortized cost	$	7,894			$	8,873			$	2,389			$	53,272			$	72,428
FRB and other stocks	$	3,809	4.94	%	$	—	—		$	—	—		$	—	—		$	3,809	4.94	%

				After one but			After five but									Weighted
	Within one year			within five years			within ten years				After ten years					Average
	Amount		Yield	Amount		Yield	Amount		Yield		Amount		Yield	Total		Yield
	(Dollars in thousands)
Securities held-to-maturity:
FHLMC/FNMA-issued mortgage pass-through certificates	$	—	—	$	—	—	$	2,612	4.29	%	$	—	—	$	2,612	4.29	%
	$	—	—	$	—	—	$	2,612	4.29	%	$	—	—	$	2,612	4.29	%

Actual maturities may differ from contractual maturities to the extent that borrowers have the right to call or prepay obligations with or without call or repayment penalties.

Lending Activities

We engage in commercial banking, serving small to medium-sized businesses in the niche markets of entertainment, healthcare, business banking, real estate development, operations of multi-family and commercial properties, as well as community-based nonprofit organizations, business executives, professionals and other individuals.  Our primary geographic focus is the Los Angeles basin of Los Angeles County, with four branch banking offices consisting of Mercantile Bank’s offices located in Century City and Encino, and South Bay Bank’s offices located in Torrance and El Segundo.  We offer a full range of loan, deposit and investment products, which are designed to meet specific customer needs and are offered with highly personalized service.

Loan products include commercial real estate loans, construction financing, revolving lines of credit, term loans and consumer and home equity loans, along with an array of deposits and investment accounts that often contain terms and conditions tailored to meet the specific demands of the market niche in which the borrower operates, including the ability to evaluate the revenue streams and other sources of repayment supporting the loan.  In order to provide the personalized service required by these customers, we use a team approach to customer service combining an experienced relationship management officer with operations support personnel.

Entertainment industry customers include television, music and film production companies, talent agencies, individual performers, directors and producers (whom we attract by establishing relationships with business management firms), and others affiliated with the entertainment industry.   Professional service customers include legal, accounting, insurance and advertising firms and their individual directors, officers, partners and shareholders.  Healthcare organizations include primarily outpatient healthcare providers such as physician medical groups, independent practice associations and surgery centers.

Loan Portfolio

The following table sets forth the composition of our loan portfolio at the dates indicated:

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Table 9

Loan Portfolio Composition

	December 31,
	2005					2004					2003					2002					2001
	Amount			Percent		Amount			Percent		Amount			Percent		Amount (1)			Percent		Amount			Percent
	(Dollars in thousands)
Commercial loans - secured and unsecured	$	89,474		26	%	$	98,429		31	%	$	76,699		29	%	$	86,015		32	%	$	85,292		33	%
Real estate loans:
Secured by commercial real properties	121,641			36		135,944			43		132,320			51		119,872			44		95,142			36
Secured by one to four family residential properties	10,498			3		9,405			3		8,167			3		10,797			4		27,069			10
Secured by multifamily residential properties	18,663			6		18,330			6		13,071			5		12,596			4		8,492			3
Total real estate loans	150,802			44		163,679			52		153,558			59		143,265			52		130,703			49
Construction and land development	92,077			27		50,289			16		27,210			11		37,934			14		30,811			12
Consumer installment, home equity and unsecured loans to individuals	7,239			2		2,516			1		3,510			1		5,566			2		15,306			6
Total loans outstanding	339,592			100	%	314,913			100	%	260,977			100	%	272,780			100	%	262,112			100	%
Deferred net loan origination fees and purchased loan discount	(1,034		)			(1,066		)			(728		)			(458		)			(144		)
Loans receivable, net	$	338,558				$	313,847				$	260,249				$	272,322				$	261,968

(1) Increase in loans receivable commencing in 2001 reflects the acquisition of South Bay in December, 2001.

Our lending officers have limited authority to originate loans and require approvals from our more senior credit officers or our loan approval committee for loans over $150,000.  The Banks may not make any loan, with certain limited exceptions, in excess of their loan to one borrower limit under applicable regulations ($4.1 million for Mercantile and $3.2 million for South Bay at December 31, 2005).  If a Bank’s borrower requests a loan in excess of these amounts we may originate the loan with the participation of the other Bank or other lenders.  At December 31, 2005 we had $40.4 million in loans originated and serviced by other banks in which we purchased a non-recourse participation.  These participation loans had $30.4 million of unfunded commitments as of December 31, 2005.  We generally purchase participations in loans from other banks in which we have a reciprocal alliance to purchase loan participations from us.  We have not taken a subordinate credit position on any loan participations purchased or sold.  The bank originating the loan services the loan, typically without compensation.

Commercial Loans.  We offer adjustable and fixed rate secured and unsecured commercial loans for working capital, the purchase of assets and other business purposes.  Loan amounts typically  range from $100,000 to $3.0 million. We underwrite these loans primarily on the basis of the borrower’s ability to service the debt from cash flow without reliance on the liquidation of the underlying collateral, where applicable.  These loans generally have maturity terms of 12 months and are typically renewed.

Collateral for commercial loans may include commercial or residential real property, accounts receivable, inventory, equipment, marketable securities or other assets.  Unsecured commercial loans include short-term term loans and lines of credit. Our underwriting guidelines for these loans generally require that the borrower have low levels of existing debt, working capital sufficient to cover the loan and a history of earnings, appropriate liquidity, and positive cash flow from operations. Typically, unsecured lines of credit must be unused for a continuous 30-day period within each year to demonstrate the borrower’s ability to have sufficient funds to operate without the credit line.

Real Estate Loans.  We offer adjustable and fixed rate secured loans to finance the purchase or holding of commercial real estate, single family (one to four) residences and multi-family residences.  These loans generally have maturities ranging from three to fifteen years and payments based on a 15 to 25 years amortization schedule.  The original principal amount of a real estate loan generally does not exceed 65% to 75% of the appraised value of the property (or the lesser of the appraised value or the purchase price for the property if the loan is made to finance the purchase of the property).  We require a current appraisal in connection with the origination of each real estate loan.

Construction and Land Development Loans.  Real estate construction and land development loans are short-term secured loans made to finance the construction of commercial, one to four-family and multifamily residential properties or for improvements to raw land.  These loans include financing for developers for the construction of residential tract homes and custom homes.  Our real estate construction and loan development loans are primarily for properties located in Southern California.  These loans typically have adjustable rates with terms of twelve to fifteen months.  We monitor the progress of the construction and disburse the loan proceeds directly to the various contractors during stages of improvement.  Generally, the amount of a construction loan does not exceed 65% of the appraised completion value and the borrower’s funds are disbursed prior to disbursement of the construction loan.

Consumer Installment Loans and Home Equity Lines of Credit.  We offer consumer loans and home equity lines of credit in

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amounts generally less than $100,000.  Home equity lines of credit provide the borrower with a line of credit in an amount that generally does not exceed 80% of the appraised value of the borrower’s residence net of senior mortgages.  Consumer loans are primarily adjustable rate open ended unsecured loans (such as credit card loans) but also include fixed rate term loans (generally under five years) to purchase personal property, which are secured by that personal property. These loans (other than purchase money loans) generally provide for monthly payments of interest and a portion of the outstanding principal balance.

Industry Concentrations

Our board of directors has limited our exposure to industry concentration by policy and we regularly monitor such concentration based upon our borrowers’ North American Industry Classification System codes.  The limits range from 5% to 50% of total loans depending on industry type.  Loans to the entertainment industry, healthcare industry and community-based nonprofit organizations, individually, were less than 10% of total loans outstanding at December 31, 2005 and 2004.

Loan Rate Composition and Maturities

Of our total loans outstanding, excluding loans on nonaccrual, 73.7% and 77.1% had adjustable rates at December 31, 2005 and 2004, respectively.  Adjustable rate loans generally have interest rates tied to the prime rate and adjust with changes in the rate on a daily, monthly or quarterly basis.

Of our total loans outstanding, excluding nonaccrual loans, at December 31, 2005, 51.1% were due in one year or less, 33.0% were due in 1-5 years and 15.9% were due after 5 years.   As is customary in the banking industry, loans can be renewed by mutual agreement between the borrower and us.  Because we are unable to estimate the extent to which its borrowers will renew their loans, Table 11 is based on contractual maturities.

Table 11

Loan Maturities

	December 31, 2005
	Adjustable		Fixed
	interest rates		Interest rates		Total
	(Dollars in thousands)
Aggregate maturities of total loans outstanding:
Commercial loans -
In one year or less	$	40,703	$	13,669	$	54,372
After one year but within five years	11,801		13,895		25,696
After five years	8,339		748		9,087
Real estate loans -
In one year or less	28,501		5,682		34,183
After one year but within five years	48,295		28,188		76,483
After five years	22,111		18,025		40,136
Construction and land development loans -
In one year or less	79,433		—		79,433
After one year but within five years	3,770		4,103		7,873
After five years	4,771		—		4,771
Consumer installment, home equity lines of credit and unsecured loans to individuals -
In one year or less	1,359		4,022		5,381
After one year but within five years	724		1,134		1,858
After five years	—		—		—
Total loans outstanding (1)	$	249,806	$	89,466	$	339,273

(1) Excluding nonaccrual loans

Off-Balance Sheet Loan Commitments and Contingent Obligations

We are a party to financial instruments with off-balance sheet credit risk in the normal course of business to meet the financing needs of our customers.  In addition to undisbursed commitments to extend credit under loan facilities, these instruments include conditional obligations under standby and commercial letters of credit.  Our  exposure to credit loss in the event of nonperformance by customers is represented by the contractual amount of the instruments.

Loan commitments are agreements to lend to a customer a specified amount subject to certain conditions.  Loan commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  We had outstanding loan commitments aggregating $120.8 million at December 31, 2005, substantially all of which were for construction loans and commercial lines of credit.

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Standby letters of credit are conditional commitments issued by us to secure the financial performance of a customer to a third party and are primarily issued to support private borrowing arrangements. The credit risk involved in issuing a letter of credit for a customer is essentially the same as that involved in extending a loan to that customer. We use the same credit underwriting policies in accepting such contingent obligations as we do for loans. When deemed necessary, we hold appropriate collateral supporting those commitments. The nature of collateral obtained varies and may include deposits held in financial institutions and real properties.  At December 31, 2005 letters of credit amounted to $1.1 million.  Many of these commitments are expected to expire without being drawn upon and, as such, the total commitment amounts do not necessarily represent future cash requirements.

Asset Quality and Credit Risk Management

We assess and manage credit risk on an ongoing basis through diversification guidelines, lending limits, credit review and approval policies and internal monitoring.  As part of the control process, an independent credit review firm regularly examines our loan portfolio, related products, including unused commitments and letters of credit, and other credit processes.  In addition to this credit review process, our loan portfolio is subject to examination by external regulators in the normal course of business.  Underlying trends in the economic and business cycle will influence credit quality.  We seek to manage and control credit risk through diversification of the portfolio by type of loan, industry concentration and type of borrower.

Nonperforming Assets

Nonperforming assets consist of nonperforming loans and other real estate owned.  Nonperforming loans are (i) loans which have been placed on nonaccrual status, (ii) troubled debt restructurings (“TDR’s”), or (iii) loans which are contractually past due ninety days or more with respect to principal or interest, and have not been restructured or placed on nonaccrual status, and are accruing interest as described below.  Other real estate owned consists of real properties securing loans of which we have taken title in partial or complete satisfaction of the loan.  Other than loans included in nonperforming assets at December 31, 2005, we had no loans that cause management to have serious doubts about the ability of the borrower to comply with the present loan repayment terms and we had no other interest earning assets that were considered impaired at December 31, 2005.  Information about nonperforming assets is presented in Table 12.

Table 12

Nonperforming Assets

	December 31,
	2005			2004			2003		2002			2001
	(Dollars in thousands)
Nonaccrual loans	$	319		$	18		438		$	5,787		$	7,807
Troubled debt restructurings	—			—			—		—			953
Loans contractually past due ninety or more days with respect to either principal or interest and still accruing interest	—			1804			—		209			642
Nonperforming loans	319			1822			438		5,996			9,402
Other real estate owned	1,056			1056			925		1,000			—
Other assets-SBA guaranteed loan	—			—			—		—			—
Total nonperforming assets	$	1,375		$	2,878		1,363		$	6,996		$	9,402
Allowance for loan and lease losses as a percent of nonaccrual loans	1400.6		%	21822.2		%	829.9	%	83.7		%	83.8		%
Allowance for loan and lease losses as a percent of nonperforming loans	1400.6		%	215.6		%	829.9	%	80.8		%	69.6		%
Total nonperforming assets as a percent of loans receivable	0.4		%	0.9		%	0.5	%	2.6		%	3.6		%
Total nonperforming assets as a percent of total shareholders’ equity	3.6		%	7.5		%	4.3	%	22.4		%	36.9		%

Nonaccrual Loans. Nonaccrual loans are those loans for which management has discontinued accrual of interest because there exists reasonable doubt as to the full and timely collection of either principal or interest.  Our policy is to place a loan on nonaccrual status if either principal or interest payments are past due in excess of ninety days unless the loan is both well secured and in process of collection, or if full collection of interest or principal becomes uncertain, regardless of the time period involved.

When a loan is placed on nonaccrual status, all interest previously accrued but uncollected is reversed against current period operating results. Income on such loans is then recognized only to the extent that cash is received, and, where the ultimate collection of the carrying amount of the loan is probable, after giving consideration to the borrower’s current financial condition, historical repayment performance and other factors. Accrual of interest is resumed only when (i) principal and interest are brought fully current, and (ii) such loans are either considered, in management’s judgment, to be fully collectible or otherwise become well secured and in the process of collection. (See ‘‘Net Interest Income’’ for a discussion of the effects on operating results of nonperforming loans.)

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Nonaccrual loans increased to $319,000 at December 31, 2005, from $18,000 at December 31, 2004, representing a single secured commercial loan.  The value of the collateral securing this loan may not be adequate to avoid a charge off of a portion of the credit.  The additional interest income that would have been recorded from nonaccrual loans, if the loans had not been on nonaccrual status, was $11,000 and $12,000 for 2005 and 2004, respectively.  Interest payments received on nonaccrual loans are applied to principal unless there is no doubt as to ultimate full repayment of principal, in which case, the interest payment is recognized as interest income.  Interest income not recognized on nonaccrual loans reduced the net yield on earning assets by 1 basis point and 0 basis point for 2005 and 2004, respectively.

Troubled Debt Restructurings. A TDR is a loan for which we have, for economic or legal reasons related to a borrower’s financial difficulties, granted a concession to the borrower we would not otherwise consider, including modifications of loan terms to alleviate the burden of the borrower’s near-term cash flow requirements in order to help the borrower to improve its financial condition and eventual ability to repay the loan.  At December 31, 2005 and 2004 and for the years then ended we had no TDRs and accordingly, no interest income was recorded in 2005 and 2004 on TDRs.

Loans Contractually Past Due 90 or More Days. Loans contractually past due 90 or more days are those loans which have become contractually past due at least ninety days with respect to principal or interest. Interest accruals may be continued on these loans when such loans are well secured and in the process of collection and, accordingly, management has determined such loans to be fully collectible as to both principal and interest.

For this purpose, a loan is considered well secured if the collateral has a realizable value in excess of the amount of principal and accrued interest outstanding and/or is guaranteed by a financially capable party. A loan is considered to be in the process of collection if collection of the loan is proceeding in due course either through legal action or through other collection efforts which management reasonably expects to result in repayment of the loan or its restoration to a current status in the near future.

We had no loans contractually past due 90 days and still accruing interest at December 31, 2005 and had $1.8 million in such loans at December 31, 2004.  This balance at year-end 2004 represented a single loan secured by a commercial real estate property.  Our loan amount represents 67% of the appraised value of the property, which the borrower has entered into an agreement for sale and is pending escrow.

Other Real Estate Owned.  We carry OREO at the lesser of our recorded investment or the fair value less estimated costs to sell. We periodically revalue OREO properties and charge other expenses for any further write-downs.  We had $1.1 million recorded as OREO at December 31, 2005 and December 31, 2004.  The property was sold in February of 2006 with a small gain.

Impaired Loans.  Due to the size and nature of the our loan portfolio, impaired loans are determined by a periodic evaluation on an individual loan basis.  At December 31, 2005 and 2004, and for the years then ended, none of our loans were impaired.

Foregone interest income attributable to nonperforming loans amounted to $11,000 in 2005 and $12,000 in 2004.  This resulted in a reduction in yield on average loans receivable of 0 basis point and 1 basis points for the years ended December 31, 2005 and 2004, respectively.

Other Interest Bearing Assets.  We had no other interest bearing assets that were past due, nonaccrual or experiencing credit difficulties.

Allowance for Loan and Lease Losses

The allowance for credit losses is the sum of the allowance for loan and lease losses and the reserve for contingent losses on unfunded commitments.  The allowance for loan and lease losses is a valuation adjustment used to recognize impairment of the recorded investment in the loans receivable on our balance sheet before losses have been confirmed resulting in a subsequent charge-off or write-down.  The reserve for contingent losses on unfunded commitments is a liability accrual for unidentified but probable losses on our commitments to fund loans.  As of September 30, 2005, the reserve for contingent losses on unfunded commitments was reclassified from the allowance for credit losses to other liabilities.  The 2004 year end reserve for contingent losses on unfunded commitments was reclassified to conform to the current presentation.

The calculation of the adequacy of the allowance for loan and lease losses is based on a variety of factors (see Allowance for Loan and Lease Losses under Critical Accounting Policies).  Table 13 presents, at the dates indicated, the composition of our allocation of the allowance for loan and lease losses to specific loan categories.  Our current practice is to make specific allocations of the allowance for loan and lease losses to criticized and classified loans, and unspecified allocations to each loan category based on our risk assessment.  This allocation should not be interpreted as an indication that loan charge-offs will occur in the future in these amounts or proportions, or as an indication of future charge-off trends.  In addition, the portion of the allowance for loan and lease losses allocated to each loan category does not represent the total amount available for future losses that may occur within such categories, since the total allowance for loan and lease losses is applicable to the entire portfolio.

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Table 13

Allocation of Allowance For Loan and Lease Losses

	December 31,
	2005		%(1)		2004		%(1)		2003		%(1)		2002		%(1)		2001		%(1)
	(Dollars in thousands)
Commercial loans - secured and unsecured	$	1,177	26	%	$	1,097	31	%	$	1,068	29	%	$	1,528	31	%	$	2,128	33	%
Real estate loans:
Secured by commercial real properties	1,600		36		1,516		43		1,843		51		2,129		44		2,376		36
Secured by one to four family residential properties	138		3		105		3		114		3		192		4		675		10
Secured by multifamily residential properties	246		5		204		6		182		5		224		5		212		3
Total real estate loans	1,984		44		1,825		52		2,139		59		2,545		53		3,264		49
Construction and land development	1,211		27		561		16		379		11		674		14		769		12
Consumer installment, home equity lines of credit and unsecured loans to individuals	95		2		28		1		49		1		99		2		381		6
Allowance allocable to loans receivable	$	4,468	100	%	$	3,511	100	%	$	3,635	100	%	$	4,846	100	%	$	6,541	100	%

(1) Percentage of loans in each category to total loans.

The allowance for loan and lease losses at December 31, 2005 was $4.5 million compared to $3.5 million at December 31, 2004.  The allowance was affected by net recoveries of $1.2 million partially offset by a $84,000 benefit for credit losses.  Total net loan recoveries in 2004 were $73,000.  The benefit for credit losses was recorded in 2005 based upon our analysis of the adequacy of allowance for credit losses.

The allowance for loan and lease losses for classified loans graded as “criticized” by our internal grading system that are collateral-dependent is based upon the net realizable value of the collateral that we periodically evaluate.  The allowance for unsecured classified loans is based upon the severity of the credit weakness based upon an analysis of our historical loan loss experience over a 10 year period.  The volume of more severely classified loans — “substandard” and “doubtful” — decreased to $3.5 million at December 31, 2005 from $8.8 million at year end 2004.

Table 14 presents an analysis of changes in the allowance for loan and lease losses during the periods indicated:

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Table 14

Analysis of Changes in Allowance for Loan and Lease Losses

	December 31,
	2005			2004			2003			2002			2001
	(Dollars in thousands)
Balance, beginning of period	$	3,511		$	3,635		$	4,846		$	6,542		$	2,597
Loan charged off:
Commercial loans - secured and unsecured	6			49			2,697			3,849			387
Real estate loans:
Secured by commercial real properties	—			—			75			44			—
Secured by one to four family residential properties	—			—			38			—			—
Secured by multifamily residential properties	—			—			—			—			—
Total real estate loans	—			—			113			44			—
Construction and land development	—			—			—			31			—
Consumer installment, home equity and unsecured loans to individuals	4			8			41			138			104
Total loan charge-offs	10			57			2,851			4,062			491
Recoveries of loans previously charged off:
Commercial loans - secured and unsecured	1,214			94			291			189			227
Real estate loans:
Secured by commercial real properties	—			6			13			—			—
Secured by one to four family residential properties	—			—			1			—			6
Secured by multifamily residential properties	—			—			—			—			—
Total real estate loans	—			6			14			—			6
Construction and land development	—			—			—			191			—
Consumer installment, home equity and unsecured loans to individuals	2			30			70			61			40
Total recoveries of loans previously charged off	1,216			130			375			441			273
Net (recoveries) charge-offs	(1,206		)	(73		)	2,476			3,621			218
Provision (benefit) for credit losses	(84		)	220			1,265			1,925			517
Allowance for unfunded commitments transferred to other liabilities	(165		)	(417		)	—			—			—
Allowance acquired in acquisition of South Bay Bank, N.A	—			—			—			—			3,646
Balance, end of period	$	4,468		$	3,511		$	3,635		$	4,846		$	6,542
Net loan (recoveries) charge-offs as a percentage of allowance for loan and lease losses	-26.99		%	-1.86		%	68.12		%	74.72		%	3.33		%
Net loan (recoveries) charge-offs as a percentage of average gross loans outstanding during the period	-0.38		%	-0.03		%	0.95		%	1.42		%	0.19		%
Recoveries of loans previously charged off as a percentage of loans charged off in the previous year	2133.33		%	4.56		%	9.23		%	89.82		%	231.36		%

The allowance for loan and lease losses increased in 2005 primarily due to (i) the growth in loans receivable during 2005, (ii) expansion of higher risk film production lending, (iii) the increased credit risk to adjustable rate borrowers in a rising interest rate environment, and (iv) an increase in the average size of individual loans in our portfolio.  There was a negative provision of $84,000 to the allowance for loan and lease losses credited to earnings in 2005; based upon our valuation assessment we recorded a benefit for credit losses.  Factors influencing our judgments regarding provisions for credit losses included: 2004 — growth in loans receivable and unfunded commitments; 2003, 2002, and 2001 — the level of problem credits and charge offs.

Deposits

We emphasize developing business client relationships at both Banks in order to increase our core deposit base.  We offer internet-based cash management services and, for many business customers, provide regular courier service between their business locations and our banking offices.  Additionally, we attract deposits in serving the specific market niches of escrow and title companies and community-based nonprofit organizations.  Each Bank offers its own rates in order to compete in its specific markets.  We have entered new geographic markets first with loan production offices with the intention of later converting the offices to full service branch banking offices.

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Table 15

Average Deposit Composition

	December 31,
	2005				2004				2003
	Amount		Percent		Amount		Percent		Amount		Percent
	(Dollars in thousands)
Noninterest-bearing demand deposits:
Real estate title and escrow company customers.	$	14,692	4	%	$	16,247	5	%	$	26,990	8	%
Other noninterest-bearing demand	110,097		32	%	108,452		34	%	92,799		29	%
Interest-bearing demand	32,497		10	%	31,484		10	%	28,269		9	%
Money market and savings	103,648		31	%	107,981		34	%	98,763		31	%
Time certificates of deposit:
Other:
$100,000 or more	51,995		14	%	27,179		9	%	29,150		9	%
Under $100,000	26,031		8	%	27,345		9	%	33,316		10	%
Total time certificates of deposit	78,026		23	%	54,524		17	%	62,466		20	%
Total deposits	$	338,960	100	%	$	318,688	100	%	$	309,287	100	%

During 2005 we increased the use of Brokered CDs which are classified as time certificates of deposits $100,000 and over.  We use Brokered CDs to supplement our liquidity and achieve other asset liability management objectives (see the discussion under Net Interest Income).  Brokered deposits are wholesale certificates of deposit placed by rate sensitive customers that do not have any other significant relationship with us.  Professionals operating under established investment criteria manage most wholesale funds and the brokered deposits are typically in amounts that exceed the FDIC deposit insurance limit.  As a result, these funds are generally very sensitive to credit risk and interest rates, and pose greater liquidity risk to a bank.  They may refuse to renew the certificates of deposit at maturity if higher rates are available elsewhere or if they perceive that creditworthiness is deteriorating.  At December 31, 2005 we had total brokered deposits of $37.5 million all of which had maturities within 12 months.

The Federal Reserve Bank increased the target fed funds rate thirteen times beginning in the second half of 2004 and market short term interest rates likewise increased.  In order to improve net interest margins, we increased the rates paid on our nonmaturity deposits relatively little.  Other financial institutions have increased the rates paid on their deposits more rapidly.  While our customers are typically less rate sensitive due to the business relationships with us, it is difficult to grow deposits without offering very competitive rates.  Consequently, during the second half of 2004 and 2005 we increased Brokered CDs and began offering very competitive rates on certain certificates of deposit targeted to new customers in order to fund our asset growth and any deposit runoff.  While these sources of funds are relatively high costing deposits, the higher rates impact only the incremental deposits acquired through these means.

Additionally, the period 2001 through the first half of 2004 experienced historically low interest rates.    During periods of low interest rates, depositors tend to maintain greater deposit balances in low yielding but readily accessible transaction accounts due to relatively low opportunity costs.  As interest rates rise, and opportunity costs increase, depositors tend to redeploy their funds into higher yielding alternatives.  Assuming rates continue to rise, we expect continued growth in certificates of deposit and a resulting change in the composition of our deposits.

During 2005, competition from other financial institutions and a decline in residential purchase and refinance activity resulted in a decline in noninterest-bearing deposits for real estate title and escrow company customers.

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Table 16

Maturities of Time Certificates of Deposit

$100,000 or more

	December 31,
	2005		2004
	(Dollars in thousands)
Time certificates of deposit maturing:
In three months or less	$	45,027	$	19,680
After three months but within six months	14,459		5,562
After six months but within twelve months	24,377		10,548
After twelve months	3,605		5,321
Total time certificates of deposit $100,000 or more	$	87,468	$	41,111

Deposit Concentrations

At December 31, 2005 a single depositor represented $23.1 million, or 6.8%, of our total deposits.  Our ten largest depositors represented $43.4 million, or 14.3%, of our total deposits.  We maintain contingent sources of liquidity to buffer changes in our deposit balances.

Borrowed Funds

Borrowed funds and related weighted average rates are summarized below in Table 17.

Table 17

Borrowed Funds

	2005								2004								2003
	Year-end				Average				Year-end				Average				Year-end				Average
	Balance		Rate		Balance		Rate		Balance		Rate		Balance		Rate		Balance		Rate		Balance		Rate
	(Dollars in thousands)
Federal funds purchased and securities sold under repurchase agreements	$	—	—		$	—	—		$	—	—		$	113	0.88		$	399	2.20	%	$	609	2.63	%
FHLB advances	28,337		4.10	%	12,186		3.38	%	28,337		4.10	%	12,186		3.38	%	7,500		4.70	%	7,500		4.81	%

We had no securities sold with agreements to repurchase during 2005.  The maximum amount of securities sold with agreements to repurchase at any month end during 2004 and 2003 was zero and $800,000, respectively.

The maximum amount of other borrowings at any month end was $28.3 million during 2005, $31.9 million during 2004 and $7.5 million during 2003.

At December 31, 2005, we had $28.3 million of borrowed funds, all were overnight borrowings and the balances scheduled to mature during 2006.

Junior Subordinated Debentures/Trust Preferred Securities

In 2001, National Mercantile, through National Mercantile Capital Trust I (the “Trust”), issued 15,000 of 10.25% fixed rate securities (the “Trust Preferred Securities”), with an aggregate liquidation amount of $15.0 million due July 25, 2031.  The Trust Preferred Securities represent undivided beneficial interests in the assets of the Trust and are unconditionally guaranteed by National Mercantile with respect to distributions and payments upon liquidation, redemption and otherwise pursuant to the terms of a Guarantee Agreement.  National Mercantile issued the Trust Preferred Securities to generate regulatory capital at a relatively low cost (as payments of interest are deductible for income tax purposes).

The primary assets of the Trust are $15.5 million aggregate principal amount of National Mercantile 10.25% fixed rate junior subordinated deferrable interest debentures due July 25, 2031 (“Junior Subordinated Debentures”) that pay interest each January 26 and July 26.  The interest is deferrable, at National Mercantile’s option, for a period up to ten consecutive semi-annual payments, but in any event not beyond June 25, 2031.  The debentures are redeemable, in whole or in part, at National Mercantile’s option on or after five years from issuance at declining premiums to maturity.

Off-Balance Sheet Arrangements

  Guarantees

National Mercantile has unconditionally guaranteed the Trust Preferred Securities issued by the Trust (see Junior Subordinated Debentures/Trust Preferred Securities above).

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Contractual Obligations

The following table provides the amounts due under specified contractual obligations for the periods indicated as of December 31, 2005.

Table 18

Contractual Obligations

	Payments Due
	Twelve months and less		After one year but within three years		After three years but within five years		After five years		Total
	(Dollars in thousands)
Commitment to fund loans	$	120,822	$	—	$	—	$	—	$	120,822
Commitments under letters of credit	1,052		—		—		—		1,052
Deposits	355,539		7,669		—		—		363,208
Borrowings	28,337		—		—		15,464		43,801
Interest expense	1,307		2,614		2,614		33,434		39,968
Operating lease obligations	693		1,403		1,012		1,563		4,671
Other liabilities	3,288		—		—		—		3,288
Total	$	511,038	$	11,686	$	3,626	$	50,461	$	576,810

The obligations are categorized by their contractual due dates.  Approximately $70.6 million of the commitments to fund loans relate to real estate construction and are expected to fund within the next 12 months.  The balance of the commitments to fund loans is primarily revolving lines of credit or other commercial loans, and many of these commitments are expected to expire without being drawn upon.  Additionally, payments due for deposits reflect the contractual terms with our depositors to withdraw deposits, however, we do not anticipate the withdrawal of these deposits.  Total contractual obligations, therefore, do not necessarily represent future cash requirements.  We may, at our option, prepay certain borrowings prior to their maturity date.  Furthermore, the actual payment of certain current liabilities may be deferred into future periods.

Selected Financial Ratios

The following Table 19 sets forth selected financial ratios:

Table 19

Selected Performance Ratios

	For the Year Ended
	December 31,
	2005		2004		2003
Return on average assets	1.10	%	0.61	%	-0.01	%
Return on average shareholders’ equity	12.15	%	7.02	%	-0.10	%
Average shareholders’ equity to average assets	9.04	%	8.68	%	8.66	%

Recent Accounting Pronouncements

See Recent Accounting Pronouncements in Note 1-Summary of Significant Accounting Policies of Notes to Consolidated Financial Statements.

FACTORS WHICH MAY AFFECT FUTURE OPERATING RESULTS

We face risk from changes in interest rates.

The success of our business depends, to a large extent, on our net interest income.  Changes in market interest rates can affect our net interest income by affecting the spread between our interest-earning assets and interest-bearing liabilities.  This may be due to the different maturities of our interest-earning assets and interest-bearing liabilities, as well as an increase in the general level of interest rates.  Changes in market interest rates also affect, among other things:

·Our ability to originate loans;

·The ability of our borrowers to make payments on their loans;

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·The value of our interest-earning assets and our ability to realize gains from the sale of these assets;

·The average life of our interest-earning assets;

·Our ability to generate deposits instead of other available funding alternatives;

·Our ability to access the wholesale funding market; and

·The fair values of our derivative financial instruments.

Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control.

We face risk from possible declines in the quality of our assets.

Our financial condition depends significantly on the quality of our assets.  While we have developed and implemented underwriting policies and procedures to guide us in the making of loans, compliance with these policies and procedures in making loans does not guarantee repayment of the loans.  If the level of our non-performing assets rises, our results of operations and financial condition will be affected.  A borrower’s ability to pay its loan in accordance with its terms can be adversely affected by a number of factors, such as a decrease in the borrower’s revenues and cash flows due to adverse changes in economic conditions or a decline in the demand for the borrower’s products and/or services.

Our allowances for loan and lease losses may be inadequate.

We establish allowances for loan and lease losses against each segment of our loan portfolio.  At December 31, 2005, our allowance for loan and lease losses equaled 1.32% of loans receivable and 1400.6% of nonperforming loans.  Although we believe that we had established adequate allowances for loan and lease losses as of December 31, 2005, the credit quality or our assets is affected by many factors beyond our control, including local and national economic conditions, and the possible existence of facts which are not known to us which adversely affect the likelihood of repayment of various loans in our loan portfolio and realization of the collateral upon a default.  Accordingly, we can give no assurance that we will not sustain loan losses materially in excess of the allowance for loan and lease losses.  In addition, the Office of the Comptroller of the Currency, as an integral part of its examination process, periodically reviews our allowance for loan and lease losses and could require additional provisions for credit losses.  Material future additions to the allowance for loan and lease losses may also be necessary due to increases in the size and changes in the composition of our loan portfolio.  Increases in our provisions for credit losses would adversely affect our results of operations.

Economic conditions may worsen.

Our business is strongly influenced by economic conditions in our market area (principally, the Greater Los Angeles metropolitan area) as well as regional and national economic conditions and in our niche markets, including the real estate and entertainment industries in Southern California.  During the past several years economic conditions, particularly in the real estate industry, have been favorable.  Should the economic condition in this market area deteriorate, the financial condition of our borrowers could weaken, which could lead to higher levels of loan defaults or a decline in the value of collateral for our loans.  In addition, an unfavorable economy could reduce the demand for our loans and other products and services.

Because a significant amount of the loans we make are to borrowers in Southern California, our operations could suffer as a result of local recession or natural disasters in California.

At December 31, 2005, a large majority of our loans outstanding were collateralized by real properties located in Southern California.  Because of this concentration in California, our financial position and results of operations have been and are expected to continue to be influenced by general trends in the California economy and its real estate market.  Real estate market declines may adversely affect the values of the properties collateralizing loans.  If the principal balances of our loans, together with any primary financing on the mortgaged properties, equal or exceed the value of the mortgaged properties, we could incur higher losses on sales of properties collateralizing foreclosed loans.  In addition, California historically has been vulnerable to certain natural disaster risks, such as earthquakes and erosion-caused mudslides, which are not typically covered by the standard hazard insurance policies maintained by borrowers.  Uninsured disasters may adversely impact our ability to recover losses on properties affected by such disasters and adversely impact our results of operations.

Our business is very competitive.

There is intense competition in Southern California and elsewhere in the United States for banking customers.  We experience competition for deposits from many sources, including credit unions, insurance companies, money market funds and mutual funds, as well as other commercial banks and savings institutions.  We compete for loans and deposits primarily with other commercial banks,  mortgage companies, commercial finance companies and savings institutions.  In recent years out-of-state financial institutions have entered the California market, which has also increased competition.  Many of our competitors have greater financial strength, marketing capability and name recognition than we do, and operate on a statewide or nationwide basis.  In addition, recent developments in technology and mass marketing have permitted larger companies to market loans more aggressively to our small business customers.  Such advantages may give our competitors opportunities to realize greater efficiencies and economies of scale than we can.  We can provide no assurance that we will be able to compete effectively against our competition.

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Our business is heavily regulated.

Both National Mercantile, as a bank holding company, and the Banks, are subject to significant governmental supervision and regulation, which is intended primarily for the protection of depositors.  Statutes and regulations affecting us may be changed at any time, and the interpretation of these statutes and regulations by examining authorities also may change.  We cannot assure you that future changes in applicable statutes and regulations or in their interpretation will not adversely affect our business.

Our ability to use our net operating losses may be limited.

As of December 31, 2005, we had NOLs of $5.0 million for federal tax purposes, which begin to expire in 2009.  Our ability to use the NOLs in the future would be significantly limited if we experience an “ownership change” within the meaning of Section 382 of the Internal  Revenue Code.  If our use of these NOLs is limited, we would be required to charge off the portion of our deferred tax asset related to the NOL limitation, and our net income would be lower.

A significant portion of our loan portfolio consists of construction loans, which have greater risks than loans secured by completed real properties

At December 31, 2005, we had outstanding construction and land development loans in the amount of $92.1 million, representing 27% of our loan portfolio, and commitments to fund an additional $52.6  million of construction loans.  These types of loans generally have greater risks than loans on completed homes, multifamily properties and commercial properties.  A construction loan generally does not cover the full amount of the construction costs, so the borrower must have adequate funds to pay for the balance of the project.  Price increases, delays and unanticipated difficulties can materially increase these costs.  Further, even if completed, there is no assurance that the borrower will be able to sell the project on a timely or profitable basis, as these are closely related to real estate market conditions, which can fluctuate substantially between the start and completion of the project.  If the borrower defaults prior to completion of the project, the value of the project will likely be less than the outstanding loan, and we could be required to complete construction with our own funds to minimize losses on the project.

We have goodwill from the acquisition of South Bay, which must be evaluated regularly for impairment

In connection with the acquisition of South Bay in December 2001, we recorded goodwill in the amount of $3.2 million.  We must evaluate the goodwill regularly for impairment. We had an unaffiliated consultant conduct goodwill impairment testing in the fourth quarter of 2005, and we determined that this goodwill was not impaired.  If in the future we determine that the goodwill is impaired, we would be required to write-off some or all of the goodwill, which could have a material adverse effect on our financial condition and results of operations.

We have a significant deferred tax asset and our ability to realize that asset depends in part on the certainty of future earnings

At December 31, 2005, we had a deferred tax asset of $4.2 million relating primarily to our NOLs.  If future taxable income should be less than the amount of the NOLs within the tax years to which it may be applied, the deferred tax asset may not be realized.  To support our position that the benefits of this asset will be realized, we must estimate future earnings.  These estimates are based on many factors, including prior periods results.  If we are unable to generate future earnings in an amount sufficient to support the asset, we would have to establish a valuation allowance and corresponding charge to earnings to reduce the deferred tax asset to its realizable value.  A material valuation allowance on this asset would have a material adverse effect on our results of operations and financial condition.

ITEM 7.  FINANCIAL STATEMENTS

The consolidated financial statements required by this Item are included herewith as a separate section of this Report as follows:

1.     Financial Statements

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ITEM 8.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

Not applicable.

ITEM 8A.  CONTROLS AND PROCEDURES

The Company maintains disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) that are designed to assure that information required to be disclosed in its Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures.

In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide reasonable assurance only of achieving the desired control objectives, and management necessarily is required to apply its judgment in weighting the costs and benefits of possible new or different controls and procedures.  Limitations are inherent in all control sysytems, so no evaluation of controls can provide absolute assurance that all control issues and any fraud within the company have been detected.

As required by Exchange Act Rule 13a-15(b), as of the end of the period covered by this report the Company, under  the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the Company’s disclosure controls and procedures.  Based on this evaluation, our Chief Executive Officer and Chief financial Officer concluded that the Company’s disclosure controls and procedures were effective as of that date.

As a result of a recent interpretation on the “short cut” method of accounting for derivatives as hedges under of SFAS 133, the Company undertook additional review and testing of its internal controls.  After initial discussions with its auditors, the Audit Committee held a meeting on August 8, 2006 to review with management the potential impact of these matters. After completing further analysis, management recommended to the Audit Committee, at a follow-up meeting held on August 14, 2006, that previously reported financial results be restated to eliminate hedge accounting for the derivative. The Audit Committee agreed with management’s recommendation.

In connection with this amended Form 10-KSB, under the direction of our Chief Executive Officer and Chief Financial Officer, we reevaluated our disclosure controls and procedures.  We considered the reasons why the restatement was necessary and whether the restatement resulted from a material weakness in our disclosure controls and procedures.  Our Chief Executive Officer and Chief Financial Officer determined that the restatement does not affect their conclusion that our disclosure controls and procedures were effective as of December 31, 2005.  Factors that led to this determination included: (i) we had retained and received advice from professional experts in the accounting for derivatives as hedges transactions at the time of the transaction and in connection with subsequent financial reporting, including our Form 10-KSB for the year ended December 31, 2005; (ii) the accounting treatment previously used by us was consistent with industry practice; (iii) our interpretation of the accounting rules under SFAS No. 133 was reasonable; and (iv) management, and our Audit Committee, identified the recent interpretation on the “short cut” method of accounting for derivatives as hedges that resulted in the restatement of our financial statements.

There was no change in the Company’s internal control over financial reporting during the Company’s most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

ITEM 8B.  OTHER INFORMATION

Not applicable.

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PART III

ITEM 9.  DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT

 The information required by this item will appear under the captions “Election of Directors,’’ ‘‘ Executive Officers,’’ ‘‘Section 16(a) Beneficial Ownership Reporting Compliance,’’ and “Code of Ethics” in the Company’s proxy statement for the 2006 Annual Meeting of Shareholders (the ‘‘2006 Proxy Statement’’), and such information shall be deemed to be incorporated herein by reference to that portion of the 2006 Proxy Statement, if filed with the Securities and Exchange Commission not later than 120 days after the end of  our most recently completed fiscal year.

ITEM 10.  EXECUTIVE COMPENSATION

 The information required by this item will appear under the captions “Compensation of Executive Officers,” “Compensation of Directors,’’ ‘‘Summary Compensation Table,’’ “2005 Option Grants,” ‘‘2005 Option Exercises and Year-End Option Values” and “Employment and Severance Agreements” in the 2006 Proxy Statement, and such information shall be deemed to be incorporated herein by reference to those portions of the 2006 Proxy Statement, if filed with the Securities and Exchange Commission not later than 120 days after the end of our most recently completed fiscal year.

ITEM 11.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information required by this item will appear under the caption ‘‘Security Ownership of Principal Shareholders and Management’’ and “Equity Compensation Plan Information” in the 2006 Proxy Statement, and such information either shall be deemed to be incorporated herein by reference to that portion of the 2006 Proxy Statement, if filed with the Securities and Exchange Commission not later than 120 days after the end of our most recently completed fiscal year.

ITEM 12.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this item will appear under the caption ‘‘Certain Relationships and Related Transactions’’ in the 2006 Proxy Statement, and such information shall be deemed to be incorporated herein by reference to that portion of the 2006 Proxy Statement, if filed with the Securities and Exchange Commission not later than 120 days after the end of our most recently completed fiscal year.

ITEM 13.  EXHIBITS

 See Index to Exhibits on page 68 of this Form 10-KSB/A

ITEM 14.  PRINCIPAL ACCOUNTANT FEES AND SERVICES

 The information required by this item will appear under the caption “Independent Public Accountants” in the 2006 Proxy Statement, and such information shall be deemed to be incorporated herein by reference to that portion of the 2006 Proxy Statement, if filed with the Securities and Exchange Commission not later than 120 days after the end of our most recently completed fiscal year.

39

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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.

	NATIONAL MERCANTILE BANCORP
	(Registrant)
	By	/s/ SCOTT A. MONTGOMERY
		Scott A. Montgomery
Date: September 28, 2006		Chief Executive Officer

40

Report of Independent Registered Public Accounting Firm

To the Shareholders and the Board of Directors
of National Mercantile Bancorp and subsidiaries:

We have audited the consolidated balance sheet of National Mercantile Bancorp (a California corporation) and subsidiaries (collectively, the “Company”) as of December 31, 2005, and the related consolidated statements of operations, changes in shareholders’ equity and cash flows for the year ended December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

As discussed more fully in Note 1 to the consolidated financial statements, the Company has restated its consolidated financial statements for the years ended December 31, 2005, and 2004 to correct errors related to the Company’s derivative accounting under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”).

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of National Mercantile Bancorp and subsidiaries as of December 31, 2005, and the consolidated results of their operations and their cash flows for the year ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.

	/s/ Moss Adams LLP
Los Angeles, California
March 31, 2006 except for
Notes 1, 2, 7, 8, 11, 13, 14, 15 and 17 as to which the date is
September 28, 2006

41

Report of Independent Registered Public Accounting Firm

To the Shareholders and the Board of Directors
of National Mercantile Bancorp and subsidiaries:

We have audited the consolidated statements of operations, shareholders’ equity and cash flows of National Mercantile Bancorp (a California corporation) and subsidiaries (collectively, the “Company”) for the year ended December 31, 2004.  These financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  We were not engaged to perform an audit of the Company’s internal control over financial reporting.  Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.  An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated results of operations and cash flows of National Mercantile Bancorp and subsidiaries for the year ended December 31, 2004 in conformity with U.S. generally accepted accounting principles.

	/s/ Ernst & Young LLP
Los Angeles, California
March 28, 2005
except for Notes 1, 2, 7, 13, 14, and 15
as to which the date is September 28, 2006

42

NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEET

	December 31,
	2005
	(Dollars in thousands, restated)
ASSETS
Cash and due from banks-demand	$	13,507
Due from banks-interest bearing	2,000
Federal funds sold	685
Cash and cash equivalents	16,192
Securities available-for-sale, at fair value; aggregate amortized cost of $72,428	71,758
Securities held-to-maturity, at amortized cost; aggregate fair value of $2,572	2,612
Federal Reserve Bank and other stock	3,809
Loans receivable	338,558
Allowance for loan and lease losses	(4,468		)
Net loans receivable	334,090
Premises and equipment, net	5,861
Other real estate owned	1,056
Deferred tax asset, net	4,442
Goodwill	3,225
Intangible assets, net	1,407
Accrued interest receivable and other assets	4,008
Total assets	$	448,460
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Noninterest-bearing demand	$	115,924
Interest-bearing demand	36,018
Money market	76,334
Savings	28,208
Time certificates of deposit:
$100,000 or more	87,468
Under $100,000	19,256
Total deposits	363,208
Other borrowings	28,337
Junior subordinated deferrable interest debentures	15,464
Accrued interest payable and other liabilities	3,288
Total liabilities	410,297
Shareholders’ equity:
Preferred stock, no par value - authorized 1,000,000 shares: Series B non-cumulative convertible perpetual preferred stock; authorized 1,000 shares; outstanding 1,000 shares	1,000
Common stock, no par value; authorized 10,000,000 shares; outstanding 4,403,024 shares	45,697
Accumulated deficit	(7,380		)
Accumulated other comprehensive loss	(1,154		)
Total shareholders’ equity	38,163
Total liabilities and shareholders’ equity	$	448,460

See accompanying notes to consolidated financial statements.

43

NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

	For the Year Ended
	December 31,
	2005			2004
	(Dollars in thousands,
	except per share data, restated)
Interest income:
Loans, including fees	$	24,039		$	17,915
Securities	2,075			1,388
Due from banks	101			56
Federal funds sold and securities purchased under agreements to resell	50			95
Total interest income	26,265			19,454
Interest expense:
Interest-bearing demand	158			80
Money market and savings	1,342			749
Time certificates of deposit:
$100,000 or more	1,365			403
Under $100,000	620			473
Total interest expense on deposits	3,485			1,705
Junior subordinated deferrable interest debentures	1,585			1,585
Other borrowings	412			333
Total interest expense	5,482			3,623
Net interest income before provision for credit losses	20,783			15,831
Provision (benefit) for credit losses	(84		)	220
Net interest income after provision for credit losses	20,867			15,611
Other operating income:
Net loss on sale of securities available-for-sale	—			(197		)
Trading gains (losses) on non-hedge derivatives	(395		)	229
Net settlement on interest rate swap	347			619
International services	52			59
Investment division	54			53
Deposit-related and other customer services	1,060			1,652
Total other operating income	1,118			2,415
Other operating expenses:
Salaries and related benefits	7,788			7,508
Net occupancy	997			1,127
Furniture and equipment	506			485
Printing and communications	537			546
Insurance and regulatory assessments	421			433
Client services	666			590
Computer data processing	882			965
Legal services	540			464
Other professional services	1,127			854
Amortization of core deposit intangible	223			223
Promotion and other expenses	689			833
Total other operating expenses	14,376			14,028
Income before income tax provision	7,609			3,998
Income tax provision	3,159			1,678
Net income	$	4,450		$	2,320
Earnings per share:
Basic	$	0.96		$	0.64
Diluted	$	0.75		$	0.41

See accompanying notes to consolidated financial statements.

44

NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

															Accumulated Other
	Preferred Stock Series A					Preferred Stock Series B			Common Stock			Accumulated			Comprehensive
	# of Shares		Amount			# of Shares	Amount		# of Shares	Amount		Deficit			Income			Total
	(Dollars in thousands, except share data, restated)
Balance at December 31, 2003	729,585		$	5,959		1,000	$	1,000	2,772,279	$	38,602	$	(14,150	)	$	71		$	31,482
Preferred stock converted into common stock on a 2:1 basis	(63,312	)	(517		)				126,624	517								—
Stock options exercised									55,225	372								372
Comprehensive income:
Unrealized holding gain during the period, net															203			203
Net income												2,320						2,320
Comprehensive income																		2,523
Balance at December 31, 2004	666,273		5,442			1,000	1,000		2,954,128	39,491		(11,830		)	274			34,377
Preferred stock converted into common stock on a 2:1 basis	(666,273	)	(5,442		)				1,332,546	5,442								—
Common stock issued																		—
Stock options exercised									116,350	764								764
Cumulative effect of change in accounting principal (Note 1)																		—
Comprehensive income (loss):
Unrealized holding gain during the period, net															(1,428		)	(1,428		)
Net income												4,450						4,450
Comprehensive income																		3,022
Balance at December 31, 2005	—		$	—		1,000	$	1,000	4,403,024	$	45,697	$	(7,380	)	$	(1,154	)	$	38,163

See accompanying notes to consolidated financial statements.

45

NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

	For the Year Ended December 31,
	2005			2004
	(Dollars in thousands, restated)
Cash flows from operating activities:
Net income	$	4,450		$	2,320
Adjustments to reconcile net income to net cash used in operating activities:
Depreciation and amortization	425			409
Provision (benefit) for credit losses	(84		)	220
Trading loss (gain) on non-hedge derivatives	395			(229		)
Loss on sale of securities available for sale	—			197
Net amortization of premium on securities available-for-sale	20			250
Net amortization of premium on securities held-to-maturity	29			47
Net amortization of core deposit intangible	223			223
Net amortization of premium on loans purchased	159			190
Utilization of deferred tax assets	1,083			1,664
Decrease (increase) in accrued interest receivable and other assets	17			(236		)
Increase in accrued interest payable and other liabilities	1,137			329
Net cash provided by operating activities	7,854			5,384
Cash flows from investing activities:
Purchase of securities available-for-sale	(47,884		)	(34,987		)
Proceeds from sales of securities available-for-sale	—			11,759
Proceeds from repayments and maturities of securities available-for-sale	12,457			16,517
Proceeds from repayments and maturities of securities held-to-maturity	866			1,043
Loan originations and principal collections, net	(25,668		)	(53,178		)
Purchase of Federal Reserve stock and other stocks	(733		)	(1,204		)
Expenditures on OREO improvements	—			(132		)
Purchases of premises and equipment	(482		)	(769		)
Net cash used in investing activities	(61,444		)	(60,951		)
Cash flows from financing activities:
Net increase in demand deposits, money market and savings accounts	6,041			6,749
Net increase in time certificates of deposit	43,625			8,076
Net decrease in securities sold under agreements to repurchase and federal funds purchased	—			(399		)
Net increase in other borrowings	2,437			18,400
Net proceeds from exercise of stock options	764			372
Net cash provided by financing activities	52,867			33,198
Net decrease in cash and cash equivalents	(723		)	(22,369		)
Cash and cash equivalents, January 1	16,915			39,284
Cash and cash equivalents, December 31	$	16,192		$	16,915
Supplemental disclosures of cash flow information:
Cash paid for interest	$	4,778		$	3,229
Cash paid for income taxes	1,225			51
Unrealized loss on securitites available-for-sale, net of tax effect	(392		)	(40		)
Unrealized gain (loss) on cash flow hedges, net of tax effect	$	(762	)	$	314

See accompanying notes to consolidated financial statements.

46

NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1—Restatement

National Mercantile Bancorp has restated its consolidated financial statements for the years ended December 31, 2005, 2004 and 2003 and for each of the interim periods in 2005, 2004 and 2003. This restatement corrected errors related to the Company’s derivative accounting under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”).

In 2003, the Company entered into an interest rate swap agreement in connection with the trust preferred securities related to the Company’s junior subordinated deferrable interest debentures (Trust Preferred Swap) that was accounted for as a fair value hedge under SFAS No. 133. The Company elected an abbreviated method (the “short-cut” method) of documenting the effectiveness of the swap as a hedge, which allowed the Company to assume no ineffectiveness in this transaction. As a result of later technical interpretations of SFAS 133, the Company subsequently concluded that the Trust Preferred Swap did not qualify for this method in prior periods.  The presence of an interest deferral feature in the interest rate swap was determined, in retrospect, to have caused the interest rate swap to not have a fair value of zero at inception, which is required under SFAS 133 to qualify for short-cut hedge accounting treatment.  Hedge accounting under SFAS No. 133 for this swap transaction is not allowed retrospectively because the hedge documentation required for the long-haul method was not in place at the inception of the hedge. Eliminating the application of fair value hedge accounting reverses the fair value adjustments that were made to the hedged item, the debt, as an adjustment to the par amount of the Trust Preferred debt. This reversal of fair value hedge accounting also results in reclassification of swap net settlements from interest expense to noninterest income as well as recording of swap mark-to-market adjustments in trading gains (losses) on economic derivatives.

The following table sets forth the effects of the adjustments on net income for the years 2005 and 2004.  Since the Company could not apply hedge accounting for the transaction, the Trust Preferred Swap has been marked-to-market through the consolidated statement of operations with no related offset for hedge accounting.

Increase (Decrease) in Net Income

	Year Ended December 31,
	2005			2004
	(Dollars in thousands)
Net income as previously reported	$	4,681		$	2,186
Trading gains (losses) on non-hedge derivatives	(395		)	229
Benefit (provision) for income taxes	164			(95		)
Total adjustment	(231		)	134
Restated net income	$	4,450		$	2,320
Percent change	(4.93		)%	6.13		%

The following tables reflect the previously reported amounts and the restated results by financial statement line item for the consolidated balance sheet and statement of stockholders’ equity as of December 31, 2005 and the consolidated statements of income for the years ended December 31, 2005 and 2004.

	December 31,
	2005
	As Originally Reported			Restated
	(Dollars in thousands)
Consolidated balance sheets:
Deferred tax asset, net	$	4,203		$	4,442
Accrued interest receivable and other assets	4,583			4,008
Total assets	448,796			448,460
Accumulated deficit	(7,044		)	(7,380		)
Total shareholders’ equity	38,499			38,163
Total liabilities and shareholders’ equity	448,796			448,460

47

	Year Ended December 31,
	2005					2004
	As Originally Reported		As Restated			As Originally Reported		As Restated
	(Dollars in thousands, except per share data)
Consolidated Statements of Operations:
Interest expense:
Junior subordinated deferrable interest debentures	$	1,239	$	1,585		$	966	$	1,585
Total interest expense	5,136		5,482			3,004		3,623
Net interest income before provision for credit losses	21,129		20,783			16,450		15,831
Net interest income after provision for credit losses	21,213		20,867			16,230		15,611
Trading gains (losses) on economic derivatives	—		(395		)	—		229
Net cash settlement of interest rate swap derivative	—		347			—		619
Total other operating income	1,166		1,118			1,567		2,415
Income before income tax provision	8,003		7,609			3,769		3,998
Income tax provision	3,322		3,159			1,583		1,678
Net income	4,681		4,450			2,186		2,320
Earnings per share – basic(1)	1.01		0.96			0.60		0.64
Earnings per share – diluted(1)	0.79		0.75			0.38		0.41

(1) Adjusted for the 5- for 4-stock split paid April 16, 2006

	Accumulated Deficit						Total
	As Originally Reported			Restated			As Originally Reported		Restated
	(Dollars in thousands)
Consolidated Statement of Changes in Shareholders’ Equity:
Balance at December 31, 2003	$	(13,911	)	$	(14,150	)	$	31,721	$	31,482
For the year ended December 31, 2004:
Net income	2,186			2,320			2,186		2,320
Comprehensive income							2,389		2,523
Balance at December 31, 2004	(11,725		)	(11,830		)	34,482		34,377
For the year ended December 31, 2005:
Net income	4,681			4,450			4,681		4,450
Comprehensive income							3,253		3,022
Balance at December 31, 2005	(7,044		)	(7,380		)	38,499		38,163

The following table reflects the previously reported amounts and the restated results by financial statement line item for the consolidated balance sheet as of March 31, June 30, and September 30, 2005.

	March 31,						June 30,						September 30,
	2005						2005						2005
	As Originally Reported			Restated			As Originally Reported			Restated			As Originally Reported			Restated
	(Dollars in thousands)												(Dollars in thousands)
Consolidated balance sheets:
Deferred tax asset, net	$	5,476		$	5,635		$	4,862		$	4,780		$	4,652		$	4,775
Accrued interest receivable and other assets	3,662			3,277			3,996			4,193			3,893			3,595
Total assets	387,006			386,780			403,684			403,799			428,483			428,308
Accumulated deficit	(10,785		)	(11,010		)	(9,747		)	(9,631		)	(8,450		)	(8,623		)
Total shareholders’ equity	34,801			34,576			36,432			36,548			37,087			36,914
Total liabilities and shareholders’ equity	387,006			386,780			403,684			403,799			428,483			428,308

48

The following tables reflect the previously reported amounts and the restated results by financial statement line item for the consolidated statements of income for the three month periods ended March 31, June 30, September 30, and December 31, 2005 and 2004.

	For the three months ended
	March 31, 2005					June 30, 2005				September 30, 2005					December 31, 2005
	As Originally Reported		Restated			As Originally Reported		Restated		As Originally Reported		Restated			As Originally Reported		Restated
	(Dollars in thousands, except per share data)
Consolidated Statements of Operations:
Interest expense:
Junior subordinated deferrable interest debentures	$	280	$	396		$	297	$	396	$	326	$	396		$	335	$	396
Total interest expense	976		1,092			1,016		1,115		1,298		1,368			1,846		1,907
Net interest income before provision for credit losses	4,861		4,745			5,073		4,974		5,456		5,386			5,739		5,678
Net interest income after provision for credit losses	4,772		4,656			5,073		4,974		5,669		5,599			5,699		5,638
Trading gains (losses) on economic derivatives	—		(204		)	—		582		—		(493		)	—		(280		)
Net cash settlement of non-hedge interest rate swap	—		116			—		99		—		70			—		61
Total other operating income	322		234			299		980		278		(145		)	267		48
Income before income tax provision	1,608		1,404			1,773		2,355		2,217		1,724			2,405		2,125
Income tax provision	667		582			736		978		920		715			999		883
Net income	941		822			1,037		1,377		1,297		1,009			1,406		1,242
Earnings per share – basic(1)	0.25		0.22			0.27		0.35		0.24		0.19			0.26		0.23
Earnings per share – diluted(1)	0.16		0.14			0.18		0.23		0.22		0.17			0.24		0.21

(1) Adjusted for the 5- for 4-stock split paid April 16, 2006

	For the three months ended
	March 31, 2004				June 30, 2004					September 30, 2004				December 31, 2004
	As Originally Reported		Restated		As Originally Reported		Restated			As Originally Reported		Restated		As Originally Reported		Restated
	(Dollars in thousands, except per share data)
Consolidated Statements of Operations:
Interest expense:
Junior subordinated deferrable interest debentures	$	226	$	396	$	228	$	375		$	259	$	396	$	253	$	396
Total interest expense	690		860		694		841			792		929		828		971
Net interest income before provision for credit losses	3,451		3,281		3,622		3,475			4,695		4,558		4,682		4,539
Net interest income after provision for credit losses	3,451		3,281		3,622		3,475			4,575		4,438		4,582		4,439
Trading gains (losses) on economic derivatives	—		453		—		(837		)	—		670		—		(58		)
Net cash settlement of non-hedge interest rate swap	—		170		—		147			—		137		—		143
Total other operating income	465		1,088		402		(288		)	317		1,124		383		468
Income before income tax provision	493		946		585		(252		)	1,514		2,184		1,177		1,119
Income tax provision	202		390		240		(107		)	642		920		499		475
Net income	291		556		345		(145		)	872		1,264		678		644
Earnings per share – basic(1)	0.08		0.16		0.09		-0.04			0.24		0.35		0.18		0.17
Earnings per share – diluted(1)	0.05		0.10		0.06		-0.03			0.15		0.22		0.12		0.11

(1) Adjusted for the 5- for 4-stock split paid April 16, 2006

In addition, the following Notes to Consolidated Financial Statements have been restated: 2, 7,13, 14, 15.

Note 2—Summary of Significant Accounting Policies

Basis of Presentation

The consolidated financial statements include the accounts of National Mercantile Bancorp (“National Mercantile” when referring only to the parent company or the “Company” when such reference includes National Mercantile Bancorp and its subsidiaries,

49

collectively) and of its wholly owned subsidiaries, Mercantile National Bank (“Mercantile”) and South Bay Bank, N.A. (“South Bay”) (and collectively, the “Banks”).  All intercompany transactions and balances have been eliminated.  Certain prior year amounts have been reclassified to conform to the current year presentation.

National Mercantile Capital Trust I (the “Trust”), a Delaware business trust, was formed by the Company in 2001 for the sole purpose of issuing certain securities representing undivided beneficial interests in the assets of the Trust and investing the proceeds thereof in the Company’s junior subordinated deferrable interest debentures.  The Trust’s 464 common securities (liquidation amount of $1,000 per common security) are wholly owned by National Mercantile, however, in accordance with FASB Interpretation No. 46R, Consolidation of Variable Interest Entities, the Trust is not consolidated in the Company’s financial statements and it is treated as an equity investment.

The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States and to prevailing practices within the banking industry.  The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make certain estimates and assumptions that affect the reported amounts of assets, liabilities, and contingencies at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  The estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan and lease losses, the assessment of goodwill and core deposit intangible impairment, and the valuation of deferred tax asset. Actual amounts or results could differ from those estimates.

The Company, through the Banks, engages in commercial banking in the Los Angeles area providing commercial and residential real estate financing, real estate construction financing and commercial lending serving niche markets represented by professional service providers, entertainment, healthcare and community-based nonprofit borrowers, and associated individuals with commercial banking and personal banking needs.

Cash and Cash Equivalents

For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks-demand, due from banks — interest bearing, and federal funds sold.

Securities

Securities available-for-sale are carried at fair value.  Unrealized gains or losses on available-for-sale securities are excluded from earnings and reported as accumulated other comprehensive income, net of deferred income taxes, in a separate component of shareholders’ equity until realized.  Realized gains or losses on sales of available-for-sale securities are recorded using the specific identification method.

Securities held-to-maturity are debt instruments in which management has the positive intent and ability to hold to maturity and are carried at amortized cost.

Premiums or discounts on available-for-sale and held-to-maturity securities are amortized or accreted into income using the effective interest method.

Federal Reserve Bank and other stock are equity investments without an active secondary market; however, the issuers typically redeem the membership stock at the stated value.  Accordingly, they are carried at historical cost.

We are obligated to assess, at each reporting date, whether there is an “other-than-temporary” impairment to our investment securities.  Such impairment must be recognized in current earnings rather than in other comprehensive income. We review all individual securities that are in an unrealized loss position at each reporting date for other-than-temporary impairment.  Specific investment level factors we examine to assess impairment include the severity and duration of the loss, an analysis of the issuers of the securities and if there has been any cause for default on the securities and any change in the rating of the securities by the various rating agencies.  Additionally, we review the financial resources and the overall ability that the Company has and the intent that management has to hold the securities until their fair values recover.

Loans

Loans are generally carried at principal amounts outstanding less unearned income.  Unearned income includes deferred unamortized fees net of direct incremental loan origination costs.

Interest income is accrued as earned.  Net deferred fees are accreted into interest income using the effective yield method.

Loans are placed on nonaccrual status when a loan becomes 90 days past due as to interest or principal unless the loan is both well secured and in process of collection.  Loans are also placed on nonaccrual status when the full collection of interest or principal becomes uncertain.  When a loan is placed on nonaccrual status, the accrued and unpaid interest receivable is reversed and the accretion of deferred loan fees is ceased.  Thereafter, interest collected on the loan is accounted for on the cash collection method until qualifying for return to accrual status.  Generally, a loan may be returned to accrual status when all delinquent principal and interest are brought current in accordance with the terms of the loan agreement and certain performance criteria have been met.

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The Company considers a loan to be impaired when it is probable that it will be unable to collect all amounts due according to the contractual terms of the loan agreement.  Once a loan is determined to be impaired, the impairment is measured based on the present value of the expected future cash flows discounted at the loan’s effective interest rate, except that as a practical expedient, the impairment is measured by using the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent.

When the measurement of the impaired loan is less than the recorded amount of the loan, impairment is recognized by creating a valuation allowance with a corresponding charge to the provision for credit losses or by adjusting an existing valuation allowance for the impaired loan with a corresponding charge or credit to the provision for credit losses.

The Company’s policy is to record cash receipts received on impaired and nonaccrual loans first as reductions to principal and then to interest income.

Allowance for Loan and Lease Losses

The provisions for credit losses charged to operations reflect management’s judgment of the adequacy of the allowance for loan and lease losses and are determined through periodic analysis of the loan portfolio, problem loans and consideration of such other factors as the Company’s loan loss experience, trends in problem loans, concentrations of credit risk, and economic conditions (particularly Southern California), as well as the results of the Company’s ongoing examination process and its regulatory examinations.

The calculation of the adequacy of the allowance for loan and lease losses is based on a variety of factors, including loan classifications, migration trends and underlying cash flow and collateral values.  On a periodic basis, management engages an outside loan review firm to review the Company’s loan portfolio, risk grade accuracy and the reasonableness of loan evaluations.  Annually, this outside loan review team analyzes the Company’s methodology for calculating the allowance for loan and lease losses based on the Company’s loss histories and policies.  The Company uses a migration analysis as part of its allowance for loan and lease losses evaluation, which is a method by which specific charge-offs are related to the prior life of the same loan compared to the total loan pools in which the loan was graded.  This method allows for management to use historical trends that are relative to the Company’s portfolio rather than use outside factors that may not take into consideration trends relative to the specific loan portfolio.  In addition, this analysis takes into consideration other trends that are qualitative relative to the Company’s marketplace, demographic trends, amount and trends in nonperforming assets and concentration factors.

Premises and Equipment, Net

Premises and equipment are presented at cost less accumulated amortization and depreciation.  Depreciation of furniture, fixtures and equipment is determined using the straight-line method over the estimated useful lives (3 years to 5 years) of each type of asset.  Leasehold improvements are amortized using the straight-line method over the term of the related leases or the service lives (10 years to 20 years) of the improvements, whichever is shorter.  Gains and losses on dispositions are reflected in current operations.  Maintenance and repairs are charged to other operating expenses as incurred.

Other Real Estate Owned

Other Real Estate Owned (‘‘OREO’’) is comprised of real estate acquired in satisfaction of loans.  Properties acquired by foreclosure or deed in lieu of foreclosure are transferred to OREO and are initially recorded at the lower of the loan balance or fair value at the date of transfer of the property, establishing a new cost basis.  Subsequently, OREO is carried at the lower of cost or fair value less costs to sell.  The fair value of the OREO property is based upon a current appraisal.  Losses that result from the ongoing periodic valuation of these properties are charged to other operating expenses in the period in which they are identified.  Expenses for holding costs are charged to other operating expenses as incurred.

Income Taxes

The Company and the Banks file consolidated federal income tax returns and combined state income tax returns.

Deferred tax assets and liabilities are recognized for the expected future tax consequences of existing differences between financial reporting and tax reporting bases of assets and liabilities, as well as for operating losses and tax credit carryforwards, using enacted tax laws and rates.  Deferred tax assets will be reduced through a valuation allowance whenever it becomes more likely than not that all or some portion will not be realized.  Deferred income taxes (benefit) represents the net change in deferred tax asset or liability balance during the year.  This amount, together with income taxes currently payable or refundable in the current year, represents the total tax expense (benefit) for the year.

Comprehensive Income

Comprehensive income is defined as the change in equity during a period from transactions and other events and circumstances from nonowner sources.  The accumulated balance of other comprehensive income is displayed as a component of equity in the consolidated balance sheet.

Each classification of other comprehensive income together with total comprehensive income is reported in the consolidated statements of changes in shareholders’ equity.  The following table presents the accumulated balances of each classification of other comprehensive income, and the related income tax expense or benefit, as of the dates indicated:

51

	Net gain (loss) on securities available- for-sale			Net gain (loss) on cash flow hedges			Accumulated other comprehensive income (loss)
	(Dollars in thousands)
Balance at December 31, 2003	$	71		$	—		$	71
Gross unrealized holding loss during the period	(260		)	537			277
Less: Income tax benefit (expense).	108			(223		)	(115		)
Less: Reclassification of losses included in net income, net of income tax benefit of $29.	41			—			41
Other comprehensive income (loss).	(111		)	314			203
Balance at December 31, 2004	(40		)	314			274
Gross unrealized holding loss during the period	(604		)	(1,838		)	(2,442		)
Less: Income tax benefit	251			763			1,014
Other comprehensive loss	(353		)	(1,075		)	(1,428		)
Balance at December 31, 2005	$	(392	)	$	(762	)	$	(1,154	)

Earnings per Share

Basic earnings per share is computed using the weighted average number of common shares outstanding during the period.  The following table is a reconciliation of net income and shares used in the computation of basic and diluted earnings per share for the periods indicated (adjusted for the 5- for4-stock split paid April 16, 2006):

			Weighted
			Average	Per Share
	Net Income		Shares	Amount
	(Dollars in thousands, except per share data, restated)
For the year ended December 31, 2005:
Basic EPS	$	4,450	4,630,186	$	0.96
Effect of dilutive securities:
Options			261,544
Convertible preferred stock			1,006,028
Diluted earnings per share	$	4,450	5,897,758	$	0.75
For the year ended December 31, 2004:
Basic EPS	$	2,320	3,619,136	$	0.64
Effect of dilutive securities:
Options			191,826
Convertible preferred stock			1,883,565
Diluted earnings per share	$	2,320	5,694,528	$	0.41

Fair Value of Financial Instruments

Estimated fair value amounts have been determined using available market information and appropriate valuation methodologies.  Considerable judgment is required to interpret market data and to develop the estimates of fair value.  Accordingly, the estimates of fair value in the financial statements are not necessarily indicative of the amounts the Company could realize in a current market exchange.  The use of different market assumptions and estimation methodologies may have a material effect on the estimated fair value amounts.

Stock Options

The Company applies Accounting Principles Board Opinion No. 25 and related Interpretations in accounting for the stock incentive plans.  SFAS No. 123, ‘‘Accounting for Stock-Based Compensation,’’ encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. Compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price.  All options were granted at current market prices, accordingly, no compensation cost has been recognized for the plans.  Pro forma net income and pro forma earnings per share disclosures for employee stock option grants are based on recognition as expense, over the vesting period, the fair value on the date of grant of all stock-based awards made during 2005 and 2004.

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The estimated per share weighted average fair value of options granted was $9.86 and $7.22 during 2005 and 2004.  The Company applies Accounting Principles Board Opinion No. 25 and related Interpretations in accounting for the stock incentive plans.  SFAS No. 123, ‘‘Accounting for Stock-Based Compensation,’’ encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value.  Accordingly, no compensation cost has been recognized for the plans.  Had compensation cost for the options granted been determined based on the fair value at the grant dates for awards under the plans consistent with the method of SFAS No. 123, the Company’s net earnings for 2005 would have been decreased by $267,000 and the net earnings for 2004 would have decreased by $196,000.  Basic and diluted earnings per share would have decreased by $0.07 and $0.06 for 2005, respectively.  Basic and diluted earnings per share would have decreased by $0.05 and $0.03 for 2004, respectively.

The fair values of options granted during 2005 and 2004 were estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used: 2005— no dividend yield, expected volatility of 43%, risk-free interest rate of 4.38%, and an expected life of 10 years; 2004— no dividend yield, expected volatility of 56%, risk-free interest rate of 4.23%, and an expected life of 10 years.

Note 3—Goodwill and Other Intangible Assets

As of December 31, 2005, the Company had goodwill of $3.2 million and core deposit intangibles with a carrying amount of $2.3 million less accumulated amortization of $900,000 from the acquisition of South Bay in 2001.  In accordance with SFAS No. 142 goodwill is not amortized.  SFAS No. 142 also requires an analysis of impairment of goodwill annually or more frequently upon the occurrence of certain events.    The Company has no other indefinite-lived intangible assets.  The core deposit intangibles were estimated to have an original life of 10 years and 4 months. Amortization of the core deposit intangibles for 2005 was, and for each of the next four years is estimated to be, $223,000.  During 2005, the required impairment tests of goodwill and core deposit intangibles were conducted, and based upon these evaluations, the Company’s goodwill and core deposit intangibles were not impaired at December 31, 2005.

Note 4—Investment Securities

The following is a summary of amortized cost, gross unrealized gains, gross unrealized losses, and estimated fair values of the Company’s investment securities available-for-sale and held-to-maturity at the date indicated:

53

	December 31, 2005
	Total		Gross		Gross		Estimated
	amortized		unrealized		unrealized		fair
	cost		gains		loss		value
	(Dollars in thousands)
Available-For-Sale
U.S. Treasury securities	$	599	$	—	$	—	$	599
GNMA-issued/guaranteed mortgage pass through certificates	98		2		—		100
Other U.S. government and federal agency securities	17,931		—		152		17,779
FHLMC/FNMA-issued mortgage pass through certificates	33,982		47		366		33,663
CMO’s and REMIC’s issued by U.S. government-sponsored agencies	2,528		13		—		2,541
Privately issued corporate bonds, CMO’s and REMIC’s securities	17,290		3		217		17,076
	$72,428		$	65	$	735	$	71,758
FRB and other stocks	$	3,809	$	—	$	—	$	3,809

	December 31, 2005
	Total		Gross		Gross		Estimated
	amortized		unrealized		unrealized		fair
	cost		gains		loss		value
	(Dollars in thousands)
Held-to-Maturity
FHLMC/FNMA-issued mortgage pass through certificates	$	2,612	$	—	$	40	$	2,572
	$	2,612	$	—	$	40	$	2,572

The Company had no gross proceeds and gross realized losses related to the sale of investment securities for the year ended December 31, 2005.  The Company had gross proceeds and gross realized losses related to the sale of investment securities of $11.8 million and $197,000, respectively, for the year ended December 31, 2004.

The estimated fair value and amortized cost of securities available-for-sale and held-to-maturity at December 31, 2005 by contractual maturity, are shown below:

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					After one but				After five but										Weighted
	Within one year				within five years				within ten years				After ten years						Average
	Amount		Yield		Amount		Yield		Amount		Yield		Amount		Yield		Total		Yield
	(Dollars in thousands)
Securities available-for-sale:
U.S Treasury securities	$	—	—		$	599	4.32	%	$	—	—		$	—	—		$	599	4.32	%
GNMA-issued/guaranteed mortgage pass-through certificates	—		—		—		—		—		—		100		5.98	%	100		5.98	%
Other U.S. government and federal agencies	7,867		2.31	%	7,940		3.12	%	—		—		1,972		0		17,779		2.77	%
FHLMC/FNMA-issued mortgage pass-through certificates	—		—		234		4.96	%	2,354		4.41	%	31,075		4.96	%	33,663		4.92	%
CMO’s and REMIC’s issued by U.S. government-sponsored agencies	—		—		2		5.93	%	—		—		2,539		0		2,541		5.49	%
Privately issued corporate bonds, CMO’s and REMIC’s securities	—		—		—		—		—		—		17,076		0		17,076		4.95	%
	$	7,867	2.31	%	$	8,775	3.25	%	$	2,354	4.41	%	$	52,762	4.92	%	$	71,758	4.41	%
Amortized Cost	$	7,894			$	8,873			$	2,389			$	53,272			$	72,428
FRB and other stocks	$	3,809	4.94	%	$	—	—		$	—	—		$	—	—		$	3,809	—

				After one but			After five but									Weighted
	Within one year			within five years			within ten years				After ten years					Average
	Amount		Yield	Amount		Yield	Amount		Yield		Amount		Yield	Total		Yield
	(Dollars in thousands)
Securities held-to-maturity:
FHLMC/FNMA-issud mortgage pass-through certificates	$	—	—	$	—	—	$	2,612	4.29	%	$	—	—	$	2,612	4.29	%
	$	—	—	$	—	—	$	2,612	4.29	%	$	—	—	$	2,612	4.29	%

Actual maturities may differ from contractual maturities to the extent that borrowers have the right to call or prepay obligations with or without call or repayment penalties.

Investment securities totaling $3.1 million were pledged to secure government tax deposits, bankruptcy deposits, or for other purposes required or permitted by law at December 31, 2005.  Investment securities totaling $70.0 million were pledged to secure Federal Home Loan Bank (FHLB) borrowings and available credit.

Impaired Securities

The Company assessed whether there is an “other-than-temporary” impairment to any investment securities.  Any security for which the current fair value is less than the carrying value is considered impaired. On a quarterly basis, impaired securities are evaluated to determine if the impairments are other-than-temporary.  For those securities that are identified as having an other-than-temporary impairment, the loss is reported as a reduction in current period income.  For all other temporary impairments, the current period unrealized losses are recorded to other comprehensive income.

As of December 31, 2005, temporarily impaired securities had a fair value of $67.4 million and unrealized losses of $775,000.  Securities that were not impaired had a fair value of $6.8 million and unrealized gains of $65,000 at December 31, 2005.  The following table shows fair value and unrealized loss positions of temporarily impaired securities, categorized by whether the securities have been impaired for less than twelve months or if they have been impaired for twelve months or more as of December 31, 2005.

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	Less than 12 months					12 months or longer					Total
			Unrealized					Unrealized					Unrealized
	Fair value		losses			Fair value		losses			Fair value		losses
	(Dollars in thousands)
U.S. Treasury securities	$	599	$	—		$	—	$	—		$	599	$	—
Other U.S. government and federal agency securities	35,147		(378		)	17,528		(180		)	52,675		(558		)
Privately issued corporate bonds, CMO’s and REMIC's securities	12,440		(169		)	1,709		(48		)	14,149		(217		)
Total temporarily impaired securities	$	48,186	$	(547	)	$	19,237	$	(228	)	$	67,423	$	(775	)

The securities were impaired due to declines in fair values resulting from increases in market interest rates from the time of purchase.  The privately issued securities were collateralized by mortgages.  None of these securities has exhibited a notable decline in value as a result of changes in credit risk.  These debt securities are relatively short in duration, accordingly, any unrealized loss in an individual issue will diminish as the security approaches its maturity, irrespective of market rates of interest.

  Furthermore, the company may borrow funds utilizing these securities as collateral at market rates of interest in amounts representing nearly all of the market value.  For that reason the securities achieve their primary purpose of providing liquidity without being sold.  As such, the company has the ability to hold the securities to maturity and does not consider the impairment of these securities to be other-than-temporary.

Note 5 - Loans Receivable and Allowance for Loan and Lease Losses

The following is a summary of the major categories of loans outstanding at December 31, 2005:

	2005
	(Dollars in thousands)
Commercial loans - secured and unsecured	$	89,474
Real estate loans:
Secured by commercial real properties	121,641
Secured by one to four family residential properties	10,498
Secured by multifamily residential properties	18,663
Total real estate loans	150,802
Construction and land development	92,077
Consumer installment, home equity and unsecured loans to individuals	7,239
Total loans outstanding	339,592
Deferred net loan origination fees and purchased loan discount	(1,034		)
Loans receivable, net	$	338,558
Weighted average yield for loans at December 31	8.09		%

At December 31, 2005 and 2004, the Company had no impaired loans, and therefore, no specific allowances established for impaired loans.  No interest income was recognized on impaired loans during the years ended December 31, 2005 and 2004.

In the normal course of business, the Banks may make loans to officers and directors as well as loans to companies and individuals affiliated with or guaranteed by officers and directors of the Company and the Banks.  Such loans are made in the ordinary course of  business at rates and terms no more favorable than those offered to other customers with a similar credit standing.  The outstanding principal balance of these loans was $4.9 million at December 31, 2005 and $2.0 million at December 31, 2004.  During 2005 there were $3.4 million of advances and $465,000 of repayments.  Interest income recognized on these loans amounted to $199,000 and $374,000 during 2005 and 2004, respectively.  At December 31, 2005, none of these loans were on nonaccrual status. Based on analysis of information presently known to management about the loans to officers and directors and their affiliates, management believes all have the ability to comply with the present loan repayment terms.

Loans receivable totaling $37.6 million were pledged to the FHLB to collateralize borrowing lines.

The following is a summary of activity in the allowance for loan and lease losses for the year ended December 31, 2005:

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	2005
	(Dollars in thousands)
Balance, beginning of year	$	3,928
Provision for credit losses	(84		)
Reserve for unfunded commitments transferred to other liabilities	(582		)
Loan charge offs	(10		)
Recoveries of previous loan charge offs	1,216
Balance, end of year	$	4,468

Total loan charge-offs in 2005 were $10,000.  The additional provision for credit losses was recorded based upon the analysis of the adequacy of allowance for loan and lease losses.  The allowance for loan and lease losses for classified loans graded as “criticized” by the Company’s internal grading system that are collateral-dependent is based upon the net realizable value of the collateral that is periodically evaluated.  The allowance for unsecured classified loans is based upon the severity of the credit weakness.

The following is a summary of nonperforming loans at December 31, 2005:

	2005
	(Dollars in thousands)
Nonaccrual loans	$	319
Troubled debt restructurings	—
Loans contractually past due ninety or more days with respect to either principal or interest and still accruing interest	—
	$	319

Interest foregone on nonperforming loans outstanding at December 31, 2005 and 2004 was $11,000 and $12,000, respectively.  Foregone interest on nonperforming loans does not include interest forgone on loans on nonperforming status that were restored to performing status prior to year end, or subsequent to either being charged off prior to year end or transferred to OREO prior to year end.

The ability of the Company’s borrowers to fulfill their loan agreements is substantially dependent upon economic conditions and real estate market values throughout the Company’s market area.  At December 31, 2005, loans aggregating $242.9 million were collateralized by liens on residential and commercial real properties, nearly all of which are located in California.  While the Company’s loan portfolio is generally diversified with regard to the industries represented, at December 31, 2005, the Company’s loans to businesses and individuals engaged in entertainment industry related activities amounted to $32.0 million.

Troubled Debt Restructurings (“TDRs”).  A TDR is a loan for which the Company has, for economic or legal reasons related to a borrower’s financial difficulties, granted a concession to the borrower it would not otherwise consider, including modifications of loan terms to alleviate the burden of the borrower’s near-term cash flow requirements in order to help the borrower to improve its financial condition and eventual ability to repay the loan.  At December 31, 2005, the Company had no TDRs.

Note 6 – Premises and Equipment and Lease Commitments

The following is a summary of major components of premises and equipment at December 31, 2005:

	2005
	(Dollars in thousands)
Land	$	1,392
Buildings	3,873
Leasehold improvements	1,764
Furniture, fixtures and equipment	6,336
	13,365
Less accumulated amortization and depreciation	(7,504		)
	$	5,861

Depreciation and amortization expense was $425,000 in 2005 and $409,000 in 2004.  Rental expense on operating leases included in occupancy expense in the Consolidated Statements of Operations was $675,000 in 2005 and $669,000 in 2004.

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The future net minimum annual rental commitments at December 31, 2005 are summarized below.

	2005
	(Dollars in thousands)
For the year ended December 31,
2006	$	693
2007	695
2008	708
2009	559
2010	453
Thereafter	1,563
	$	4,671

Note 7—Income Taxes

The components of income tax provision consisted of the following for the years ended December 31:

	2005		2004
	(Dollars in thousands, restated)
Current taxes	$	1,112	$	65
Deferred taxes	2,047		1,613
Total income tax provision	$	3,159	$	1,678

A reconciliation of the amounts computed by applying the federal statutory rate of 34% for 2005 and 2004 to the income before income tax provision and the effective tax rate are as follows:

	2005				2004
	Amount		Rate		Amount		Rate
	(Dollars in thousands, restated)
Tax provision at statutory rate	$	2,587	34.0	%	$	1,359	34.0	%
Increase (reduction) in taxes resulting from:
State taxes	548		6.8	%	287		7.6	%
Permanent differences	24		0.3	%	32		0.8	%
	$	3,159	39.5	%	$	1,678	44.5	%

The major components of the net deferred tax asset at December 31, 2004 are as follows:

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	2005			2004
	(Dollars in thousands, restated)
Deferred tax assets:
Net operating losses	$	1,992		$	4,725
Securities available for sale	818			—
Economic derivatives	239			75
Accrued expenses	413			304
Alternative minimum tax credits	544			384
Nonaccrual interest	116			89
Loan fees	212			285
Bad debt expense	278			313
Core deposits	115			86
Securities acquired in business combination	47			47
State taxes	302			63
Other real estate owned	31			31
Other	49			7
Total deferred tax assets	5,156			6,409
Deferred tax liabilities:
Depreciation	(698		)	(671		)
Securities available for sale	—			(196		)
FHLB stock dividend	(56		)	(42		)
Loan premium amortization	(80		)	(145		)
Total deferred tax liabilities	(834		)	(1,054		)
Net deferred tax asset	$	4,322		$	5,355

For tax purposes at December 31, 2005, the Company had (i) federal NOLs of $5.0 million, which begin to expire in 2009; and (ii) a federal AMT credit of $544,000 that carryforwards indefinitely.  The Company believes that it is more likely than not that the deferred tax asset will be realized.  Accordingly, no valuation allowance has been established against the deferred tax asset.

Note 8—Benefit Plans

Stock Incentive Plans.  At December 31, 2005, the Company had two active stock incentive plans pursuant to which up to a total of 1,148,138 shares of common stock may be issued.  Under these plans, the Company may grant to directors, officers, employees and consultants stock-based incentive compensation in a variety of forms, including without limitation nonqualified options, incentive options, sales and bonuses of common stock and stock appreciation rights, on such terms and conditions as the Board of Directors of the Company determines. However, the exercise price of options granted to nonemployee directors may not be less than the fair market value of the common stock on the date of grant.  At December 31, 2005, the only outstanding awards under these plans were stock options, and at that date 200,074 shares were available for future awards.

At December 31, 2005, there were also outstanding options granted under a prior stock incentive plan.

The following summarizes option grants, cancellations and exercises under the Company’s stock incentive plans for the periods indicated.

			Option Price Range
			Per Share
Outstanding, December 31, 2003	493,308		$	4.31	—	$	11.50
Granted	81,200		9.48		—	11.45
Cancelled	(39,125	)	4.59		—	10.26
Exercised	(55,225	)	4.50		—	9.75
Outstanding, December 31, 2004	480,158		$	4.31	—	$	11.50
Granted	161,950		12.49		—	19.25
Cancelled	(116,350	)	4.31		—	11.20
Exercised	(6,400	)	4.31		—	11.14
Five-for-four stock split paid April 16, 2006	129,840		3.45		—	15.40
Outstanding, December 31, 2005	649,198		$	3.45	—	$	15.40

59

Of the outstanding options at December 31, 2005:  (i) options to purchase 336,158 shares were vested and exercisable; and (ii) the remaining options become exercisable as follows: 2006 —  113,500 and 2007 — 69,700.  Options granted to employees expire on the tenth anniversary of the date of the grant and vest (i) 100% one year from the date of the grant for grants less than 500 shares; and (ii) 50% after one year and 50% after two years from the date of the grant for grants of 500 shares or more.  Options granted to nonemployee directors expire on the sixth anniversary of the date of the grant and vest one year from the date of the grant.

Defined Contribution Retirement Plan. The Company maintains a defined contribution retirement plan under section 401(k) of the Internal Revenue Code. Employees are eligible to participate following six months of continuous employment. Under the plan, the Company has partially matched employee contributions since May 1, 2001.  Such matching contributions become fully vested when the employee reaches three years of service.  The Company’s matching contributions for 2005 and 2004 were $121,000 and $115,000, respectively.

Note 9—Deposits and Borrowed Funds

At December 31, 2005 the scheduled maturity of time deposits are as follows:

	$100,000 and over		Under $100,000
	(Dollars in thousands)
2006	$	83,863	$	15,193
2007	1,472		3,069
2008	2,133		884
2009	—		—
2010	—		69
Thereafter	—		41
Total time certificates of deposit $100,000 or more	$	87,468	$	19,256

The following table shows borrowed funds at December 31, 2005:

	2005
	Year-end				Average
	Balance		Weighted Average Rate		Balance		Weighted Average Rate
	(Dollars in thousands)
Federal funds purchased	$	—	—		$	—	—
Federal Home Loan Bank advances	$	28,337	4.10	%	$	12,186	3.38	%

Other borrowings are comprised of Federal Home Loan Bank (“FHLB”) advances.  At December 31, 2005 FHLB advances included: (i) $28.3 million overnight borrowings maturing  in January 2006 with a fixed annual rate of 4.10%. The maximum amount of other borrowings outstanding at any month-end during 2005 was $28.3 million.

The Banks had $53.0 million of unused borrowing capacity from the FHLB at December 31, 2005 based upon pledged securities and loans.

Note 10—Junior Subordinated Deferrable Interest Debentures

In July 2001 the Company issued $15.5 million aggregate principal amount of 10.25% fixed rate junior subordinated deferrable interest debentures due July 25, 2031 (“Junior Subordinated Debentures’) that pay interest each January 26 and July 26.  The interest is deferrable, at the Company’s option, for a period up to ten consecutive semi-annual payments, but in any event not beyond June 25, 2031.  The debentures are redeemable, in whole or in part, at the Company’s option on or after five years from issuance at declining premiums to maturity.  The recorded balance of Junior Subordinated Debentures was $15.5 million at December 31, 2005.

The Junior Subordinated Debentures are held by National Mercantile Capital Trust I (the “Trust”), a Delaware business trust, formed by the Company for the sole purpose of issuing certain securities representing undivided beneficial interests in the assets of the Trust and investing the proceeds thereof in the Junior Subordinated Debentures.  In July 2001 the Trust issued and sold:  (i) to the Company 464 common securities (liquidation amount of $1,000 per common security) of the Trust, representing common beneficial interests in the assets of the Trust; and (ii) $15,000,000 of 10.25% fixed rate securities due July 26, 2031 (the “Trust Preferred Securities”).  The Trust Preferred Securities are unconditionally guaranteed by the Company with respect to distributions and payments upon liquidation, redemption and otherwise to the extent provided in and pursuant to the terms of a Guarantee Agreement.

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Note 11—Availability to National Mercantile of Funds from Banks; Restrictions on Cash Balances; Capital

National Mercantile is a legal entity separate and distinct from the Banks, and as such has separate and distinct financial obligations including annual deferrable debt service of $1.6 million on the Junior Subordinated Debenture and other modest operating expenses.  While National Mercantile from time to time holds short-term investments,  its assets primarily consist of the common shares of the Banks and it has historically not engaged in any other business activity.  Accordingly, dividends and capital distributions from the Banks constitute the principal source of cash to the Company.  The Banks are subject to various statutory and regulatory restrictions on their ability to pay dividends to the Company.

OCC approval is required for a national bank to pay a dividend if the total of all dividends declared in any calendar year exceeds the total of the bank’s net profits (as defined) for that year combined with its retained net profits for the preceding two calendar years, less any required transfer to surplus or a fund for the retirement of any preferred stock.  A national bank may not pay any dividend that exceeds its retained net earnings, as defined by the OCC.  The OCC and the Federal Reserve Board have also issued banking circulars emphasizing that the level of cash dividends should bear a direct correlation to the level of a national bank’s current and expected earnings stream, the bank’s need to maintain an adequate capital base and other factors.

National banks that are not in compliance with regulatory capital requirements generally are not permitted to pay dividends.  The OCC also can prohibit a national bank from engaging in an unsafe or unsound practice in its business.  Depending on the bank’s financial condition, payment of dividends could be deemed to constitute an unsafe or unsound practice.  Except under certain circumstances, and with prior regulatory approval, a bank may not pay a dividend if, after so doing, it would be undercapitalized.  The Banks’ ability to pay dividends in the future is, and could be, further influenced by regulatory policies or agreements and by capital guidelines.

Mercantile has no retained earnings, and therefore is presently unable to pay dividends.  Mercantile has a substantial accumulated deficit and does not anticipate having positive retained earnings for the foreseeable future.  South Bay had retained earnings of $3.0 million as of December 31, 2005.  Mercantile and South Bay may from time to time be permitted to make capital distributions to National Mercantile with the consent of the OCC.  It is not anticipated that such consent could be obtained unless the distributing bank were to remain “well capitalized” following such distribution.

The Company is authorized to issue 1,000,000 shares of preferred stock. The Company’s Board of Directors has the authority to issue the preferred stock in one or more series, and to fix the designations, rights, preferences, privileges, qualifications and restrictions, including dividend rights, conversion rights, voting rights, rights and terms of redemption, liquidation preferences, and sinking fund terms.

The Company had previously issued 990,000 shares of Series A non-cumulative convertible perpetual preferred stock (the “Series A Preferred”).  During 2005, pursuant to an election of the holders of a majority of the outstanding shares of Series A Preferred, each outstanding share of the Series A Preferred was automatically converted into two shares of the Company’s Common Stock in accordance with the Company’s Amended and Restated Articles of Incorporation, as amended.  As a result of this conversion, as well as earlier conversions during 2005, 666,273 shares of Series A Preferred were converted into 1,332,546 shares of Common Stock.

On December 10, 2001, the Company issued 1,000 shares of Series B non-cumulative convertible perpetual preferred stock (the “Series B Preferred”) with a $1,000 stated value per share. At any time after June 30, 2005 each holder of the Series B Preferred has the right, exercisable at the option of the holder, to convert some or all of such holder’s shares of Series B Preferred into Common Stock at a conversion price of $7.04 per share of Common Stock (the “Conversion Price”).  The number of shares of Common Stock to be issued upon conversion for each share of Series B Preferred is determined by dividing an amount per share then in effect (the “Liquidation Amount”) by the Conversion Price.  The Liquidation Amount per share of Series B Preferred as of any date is the sum of (i) the stated value of each share of Series B Preferred, adjusted to reflect stock splits, stock dividends, reorganizations, consolidations and similar changes, plus (ii) an amount equal to 8.5% per annum of the stated value of the shares of Series B Preferred commencing from the date of issue.  The Company, at its sole option, may redeem all Series B Preferred, at any time, from legally available funds at the Liquidation Amount.  The Series B Preferred contains a liquidation preference over the Common Stock in the amount of the Liquidation Amount. 

Federal law restricts the Banks’ extension of credit to, the issuance of a guarantee or letter of credit on behalf of, investments in or taking as collateral stock or other securities of National Mercantile.  Restrictions prevent National Mercantile from borrowing from the Banks unless the loans are secured by designated amounts of marketable obligations.  Further, secured loans to and investments in National Mercantile or its affiliates by a bank are limited to 10% of  the bank’s capital stock and surplus (as defined by federal regulations) and are limited, in the aggregate, to 20% of the bank’s contributed capital (as defined by federal regulations).

Federal Reserve Board regulations require the Banks to maintain certain minimum reserve balances.  Cash balances maintained to meet reserve requirements are not available for use by the Banks or National Mercantile.  During 2005 and 2004, the average reserve balances for the Banks were approximately $2.7 million and $6.5 million, respectively.  Neither National Mercantile nor the Banks is required to maintain compensating balances to assure credit availability under existing borrowing arrangements.

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National Mercantile and the Banks are subject to various capital requirements administered by the federal banking regulatory agencies. Failure to meet minimum capital requirements can initiate certain mandatory—and possibly additional discretionary—actions by regulators that, if undertaken, could have a direct material effect on National Mercantile’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, National Mercantile and Banks must meet specific capital guidelines that involve quantitative measures of National Mercantile’s and the Banks’ assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. National Mercantile’s and the Banks’ capital amounts and classification are also subject to qualitative judgment by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require National Mercantile and the Banks to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined).  Management believes, as of December 31, 2005, National Mercantile and Banks meet all capital adequacy requirements to which they are subject.

At December 31, 2005, each Bank was categorized as well capitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized under the prompt corrective action rules, each Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following table.  There are no conditions or events since the most recent notification which management believes have changed the Banks’ category.

The following table presents, at the date indicated, certain information regarding the regulatory capital of National Mercantile and the Banks and the required amounts of regulatory capital for National Mercantile and the Banks to meet applicable regulatory capital requirements and, in the case of the Banks, to be well capitalized under the prompt corrective action rules.

									To be Categorized
									as Well
									Capitalized under
					For Capital				Prompt Corrective
	Actual				Adequacy Purposes				Action Rules
	Amount		Ratio		Amount		Ratio		Amount		Ratio
	(Dollars in thousands, restated)
As of December 31, 2005
Total Capital to Risk Weighted Assets
National Mercantile Bancorp	$	53,231	13.72	%	$	29,391	>=8.0	%	$	N/A	N/A
Mercantile National Bank	27,096		14.84	%	14,843		>=8.0	%	18,554		>=10.0	%
South Bay Bank, N.A	21,239		10.22	%	14,718		>=8.0	%	18,398		>=10.0	%
Tier 1 Capital to Risk Weighted Assets
National Mercantile Bancorp	46,483		11.98	%	14,695		>=4.0	%	N/A		N/A	%
Mercantile National Bank	24,811		13.59	%	7,421		>=4.0	%	11,132		>=6.0	%
South Bay Bank, N.A	18,701		9.00	%	7,359		>=4.0	%	11,039		>=6.0	%
Tier 1 Capital to Average Assets
National Mercantile Bancorp	46,483		10.74	%	15,475		>=4.0	%	N/A		N/A	%
Mercantile National Bank	24,811		10.49	%	8,619		>=4.0	%	10,774		>=5.0	%
South Bay Bank, N.A	18,701		9.04	%	7,356		>=4.0	%	9,195		>=5.0	%

Note 12—Commitments and Contingencies

In the normal course of business, the Company is a party to financial instruments with off-balance sheet risk.  These financial instruments include commitments to extend credit, letters of credit and financial guarantees.  These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount reflected in the consolidated balance sheet.

Exposure to credit loss in the event of nonperformance by the other party to the financial instrument for letters of credit and financial guarantees written is represented by the contractual notional amount of those instruments.  The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

The Company had $1.1 million of outstanding letters of credit at December 31, 2005.

Loan commitments are agreements to lend to a customer a specified amount subject to certain conditions.  Loan commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since portions of the commitments are expected to expire without being drawn upon, the total amount of commitments does not necessarily represent future cash requirements. The Company had outstanding loan commitments aggregating $120.8 million at December 31, 2005, substantially all of which were for adjustable rate loans.

The Company from time to time is party to lawsuits that arise in the normal course of business. The Company does not believe that any pending lawsuit at December 31, 2005 will have a material adverse effect on the financial position or results of operations of the Company.

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Note 13—Disclosures about the Fair Value of Financial Instruments

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practical to estimate that value.

Cash and  cash equivalents:  For these short-term investments, the carrying amount is a reasonable estimation of fair value.

Securities available-for-sale and securities held-to-maturity:  For securities classified as available-for-sale and held-to-maturity, fair value equals quoted market prices, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.

Federal Reserve Bank (FRB) and other stock:  FRB and other stock may be redeemed at the carrying amount, therefore, the carrying amount is a reasonable estimation of fair value.

Loans:  Variable rate loans have carrying amounts that approximate fair value. The fair value of fixed rate loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. In establishing the credit risk component of the fair value calculations for loans, the Company concluded the allowance for loan and lease losses represented a reasonable estimate of the credit risk component of the fair value at December 31, 2005.

Interest rate swaps and floors:  The fair value of the interest rate swaps and floors is based upon an estimate derived from broker quotations or proprietary broker models that consider the relevant characteristics of the instrument.

Deposits:  The fair value of demand and interest checking deposits, money market accounts and savings accounts is the amount payable on demand at the reporting date.  The fair value of time certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar maturities.

Federal funds purchased and securities sold under agreements to repurchase:  The fair value of fixed-rate securities sold under agreements to repurchase is estimated by discounting the future cash flows using the rates currently offered for instruments of similar maturities.

Junior subordinated deferrable interest debentures:  The fair value of the junior subordinated deferrable interest debentures is estimated as the sum of the carrying amount and the fair value of the mirrored interest rate swap hedging the debentures.

Other borrowings:  The fair value of fixed-rate borrowings is estimated by discounting the future cash flows using the rates currently offered for borrowings of similar maturities.  Borrowings with maturities greater than one year bear interest at variable rates and approximate fair value.

The estimated fair values of financial instruments at the date indicated are presented below.

	December 31, 2005
	Carrying			Fair
	Amount			Value
	(Dollars in thousands, restated)
Financial assets:
Cash, cash equivalents and deposit with other financial institutions	$	16,192		$	16,192
Securities available-for-sale	71,758			71,758
Securities held-to-maturity	2,612			2,584
FRB and other stock	3,809			3,809
Loans, net of allowance for credit losses	334,090			333,791
Fair value hedges	(41		)	(41		)
Cash flow hedges:
Interest rate swaps	(1,034		)	(1,034		)
Interest rate floors	286			286
Non-hedge derivatives	(575		)	(575		)
Financial liabilities:
Demand deposits, money market and savings	256,484			256,484
Time certificates of deposit	106,724			106,171
Junior subordinated debentures	15,464			16,039
Other borrowings	28,337			28,337

Note 14—Derivatives

The Company holds fixed rate and variable rate financial assets that are funded by fixed rate and variable rate liabilities.

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Consequently, they are subject to the effects of changes in interest rates.  In response to this, the Company has developed an interest rate risk management policy with the objective of mitigating financial exposure to changing interest rates.  These exposures are managed, in part, with the use of derivatives but only to the extent necessary to meet the overall goal of minimizing interest rate risk.

Derivatives are accounted for according to Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended.  This standard requires that all derivative instruments be recognized in the financial statements and measured at fair value regardless of the purpose or intent for holding them.  To qualify for hedge accounting, the details of the hedging relationship must be formally documented at inception of the arrangement, including the risk management objective, hedging strategy, hedged item, specific risks that are being hedged, the derivative instrument and how effectiveness is being assessed.  The derivative must be highly effective in offsetting either changes in fair value or cash flows, as appropriate, for the risk being hedged.  Effectiveness is evaluated on a retrospective and prospective basis.  If a hedge relationship becomes ineffective, it no longer qualifies as a hedge.  Any excess gains or losses attributable to such ineffectiveness, as well as subsequent changes in the fair value of the derivative, are recognized in earnings.

The following is a summary of our risk management strategies and the effect of these strategies on the consolidated financial statements.

	December 31, 2005					December 31, 2004
	Notional Amount		Fair Value			Notional Amount		Fair Value
	(Dollars in thousands, restated)
Fair value hedges:
Interest rate swaps	$	30,000	$	(41	)	$	—	$	—
Cash flow hedges:
Interest rate swaps	$	50,000	$	(1,034	)	$	50,000	$	406
Interest rate floors	$	50,000	$	286		$	—	$	—
Non-hedge derivatives:
Interest rate swaps	15,000		(575		)	15,000		(311		)
Interest rate floors	$	150,000	$	—		$	—	$	—

Fair value hedges are hedges that reduce the risk of changes in the fair values of assets, liabilities and certain types of firm commitments.  The Company uses interest rate swaps to hedge the change in fair value of portions of its wholesale funding.  The interest rate swaps result in the Company paying or receiving the difference between the fixed and floating rates at specified intervals calculated on the notional amounts.  The differential paid or received on such interest rate swaps is recognized as an adjustment to interest expense.  The net change in fair value of the derivatives and the hedged items is reported in earnings.  The fair value hedges are highly effective and therefore no ineffectiveness was recognized in current earnings related to this swap.

Cash flow hedges are hedges that use simple derivatives to offset the variability of expected future cash flows.  The Company’s cash flow hedges include certain interest rate swaps and interest rate floors used to manage the interest rate risk associated with its significant volume of adjustable rate loans.  At December 31, 2005 a loss of $605,000 was recorded in accumulated other comprehensive income and no ineffectiveness was recorded to earnings for the year ended December 31, 2005 related to these interest rate swaps.  As of December 31, 2004, the Company had recorded $314,000 accumulated other comprehensive income related to the interest rate swaps.  At December 31, 2005 a loss of $157,000 was recorded in accumulated other comprehensive income related to the interest rate floors.  Ineffectiveness related to the interest rate floors designated as cash flow hedges of $24,000 was charged to earnings for the year ended December 31, 2005.  There were no interest rate floors at December 31, 2004.

Non-hedge derivatives are interest rate swaps and interest rate floors that do not meet the strict criteria for hedge accounting treatment.  We use derivatives to hedge exposures when it makes economic sense to do so, including circumstances in which the hedging relationship does not qualify for hedge accounting.  Derivatives not designated as hedges are marked to market through earnings.  The Company has entered into an interest rate swap agreement to pay an adjustable rate and receive a fixed rate with terms that mirror its Junior Subordinated Debentures.  At inception of this swap, the Company designated this swap as a fair value hedge of its Junior Subordinated Debentures and established the “short-cut” method of documenting the hedge effectiveness.  As a result of subsequent technical interpretations of the “short-cut” hedge accounting rules, the Company has treated this swap as a non-hedge derivative and restated its financial statements since inception of the transaction accordingly.  The effect of the non-hedge derivative treatment is to reflect the change in fair value of the swap in current income as a trading gain or loss.  There was a $395,000 trading loss recorded in 2005 and a $229,000 trading gain in 2004 reflecting the change in market value of this swap.  During 2005, the Company purchased a one year interest rate floor to help protect its net interest income in the event of a rapid decline in interest rates and permit it to execute other strategies to protect against declining interest rates over time.  There was an $8,000 charge to earnings during the year ended December 31, 2005 writing the value of this floor to zero.

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Note 15—Parent Company Information

The following financial information presents the condensed balance sheet of the Company on a parent-only basis as of December 31, 2005, and the related condensed statements of operations and cash flows for each of the years in the two-year period ended December 31, 2005.

	December 31,
	2005
	(Dollars in thousands, restated)
Cash with Banks	$	137
Due from banks - time	1,015
Securities available-for-sale	974
Investment in the Banks	48,558
Other assets	3,720
Total assets	$	54,404
Junior subordinated deferrable interest debentures	$	15,464
Other liabilities	777
Total liabilities	16,241
Shareholders’ equity:
Preferred stock	1,000
Common stock	45,697
Accumulated deficit	(7,380		)
Accumulated other comprehensive income	(1,154		)
Total shareholders’ equity	38,163
Total liabilities and shareholders’ equity	$	54,404

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Statements of Operations

	Year ended December 31,
	2005			2004
	(Dollars in thousands, restated)
Interest income	$	61		$	33
Interest expense	1,585			1,563
Net interest expense	(1,524		)	(1,530		)
Other operating income	(47		)	970
Other operating expense	374			238
Loss before equity in undistributed net income of the Bank	(1,945		)	(798		)
Equity in undistributed net income of subsidiaries	5,588			2,790
Income before income tax provision (benefit)	3,643			1,992
Income tax benefit	807			328
Net income	$	4,450		$	2,320

Statements of Cash Flow

	Year ended December 31,
	2005			2004
	(Dollars in thousands, restated)
Cash flows from operating activities:
Net income	$	4,450		$	2,320
Adjustment to reconcile net income to net cash provided by operating activities.:
Equity in undistributed net income of subsidiaries, net	(5,588		)	(2,790		)
Trading loss (gain) on economic derivatives	395			(229		)
Net increase in other assets and other liabilities	(1,658		)	(520		)
Net cash used in operations	(2,401		)	(1,219		)
Cash flows from investing activities:
Purchase of available-for-sale securities	(536		)	(1,290		)
Sales and maturities of available-for-sale securities	1,500			1,800
Net cash provided by (used in) investing activities	964			510
Cash flows from financing activities:
Proceeds from stock options exercised	764			372
Net cash provided by financing activities	764			372
Net decrease in cash and cash equivalents	(673		)	(337		)
Cash and cash equivalents, beginning of the year	1,825			2,162
Cash and cash equivalents, end of the year	$	1,152		$	1,825
Supplemental disclosures of cash flow information:
Cash paid for interest	$	1,172		$	1,020
Cash paid for income taxes, net	$	1,225		$	51

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Note 16—Recent Accounting Developments

Accounting for Share-Based Payments

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123R, Accounting for Share-Based Payments (“SFAS No. 123R”), which replaces SFAS No. 123 and supersedes APB Opinion No. 25. SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values, beginning with the first annual period after June 15, 2005, with early adoption encouraged.  In addition, SFAS No. 123R will cause unrecognized expense related to options vesting after the date of initial adoption to be recognized as a charge to results of operations over the remaining vesting period. The Company is required to adopt SFAS No. 123R in its first quarter of 2006, beginning January 1, 2006.  Under SFAS No. 123R, the Company must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at the date of adoption.  The transition alternatives include prospective and retroactive adoption methods.  Under the retroactive methods, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The prospective method requires that compensation expense be recorded for all unvested stock options and share awards at the beginning of the first quarter of adoption of SFAS No. 123R, while the retroactive methods would record compensation expense for all unvested stock options and share awards beginning with the first period restated.  The Company is evaluating the requirements of SFAS No. 123R and expects that the adoption of SFAS No. 123R will have a material impact on its consolidated results of operations and earnings per common share.  The amount of share-based employee compensation cost that would have been determined consistent with SFAS No. 123 and the pro forma earnings per share amounts for the years ended December 31, 2004, 2003 and 2002 are shown in Note 1 of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

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

Note 17—Subsequent Event

Agreement and Plan of Merger

On June 15, 2006, National Mercantile entered into an Agreement and Plan of Merger (the “Merger Agreement”) with FCB Bancorp, a California corporation (“FCB”), and First California Financial Group, Inc. (“FCFG”), a new Delaware corporation formed by National Mercantile for the purpose of the merger transactions.  The Merger Agreement provides for the reincorporation merger of National Mercantile into FCFG immediately followed by the merger of FCB into FCFG (together, the “Mergers”).

Consummation of the Mergers is subject to a number of closing conditions, including approval by the shareholders of both National Mercantile and FCB and regulatory approval.

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INDEX TO EXHIBITS

Exhibit
3.1	Amended and Restated Articles of Incorporation, dated June 20, 1997 (1); Certificate of Amendment of the Articles of Incorporation, filed May 4, 2000 (6); Certificate of Determination of Rights, Preferences and Privileges of Series B Convertible Perpetual Preferred Stock filed December 14, 2001(8); Certificate of Amendment to Article XIII of the Articles of Incorporation filed August 9, 2003 (12); Certificate of Amendment of the Articles of Incorporation, filed June 20, 2005 (13)
3.2	Bylaws of the Company, as amended, restated as of December 18, 1992 (2)
4.1	Indenture for Junior Subordinated Debt Securities dated as of July 16, 2001 (7)
10.1	Employment Agreement dated January 1, 1999 between Mercantile National Bank and Scott A. Montgomery (3); Assignment, Assumption — Amendment of Employment Agreement among National Mercantile Bancorp, Mercantile National Bank and Scott A. Montgomery (11)
10.2	Form of Indemnity Agreement between the Company and its directors (4)
10.3	National Mercantile Bancorp Amended 1996 Stock Incentive Plan (10)
10.4	Form of Agreement for National Mercantile Bancorp Amended 1996 Stock Incentive Plan (10)
10.5	National Mercantile Bancorp 2005 Stock Incentive Plan (13)
10.6	Form of Non-Qualified Stock Option Agreement for National Mercantile Bancorp 2005 Stock Incentive Plan (13)
10.6	Form of Incentive Stock Option Agreement for National Mercantile Bancorp 2005 Stock Incentive Plan (13)
10.6	Amended and Restated Declaration of Trust of National Mercantile Capital Trust I, dated as of June 27, 2001 (7))
10.7	Guarantee Agreement of National Mercantile Bancorp for trust preferred securities dated July 16, 2001 (7)
10.8	Severance Agreement dated November 14, 2002 between National Mercantile Bancorp and David Brown (9)
10.9	Severance Agreement dated September 26, 2003 between National Mercantile Bancorp and Robert Bartlett (11)
10.10	Lease dated as of November 12, 2003 between Century Park and Mercantile National Bank relating to Suite 800 offices at 1880 Century Park East, Los Angeles, California (11)
10.11	Lease dated as of September 19, 2003 between Metropolitan Life Insurance Company and Mercantile National Bank relating to offices at 3070 Bristol Street, Costa Mesa, California (12)
10.12	Lease dated as of November 12, 2003 between Century Park and Mercantile National Bank relating to ground floor offices at 1880 Century Park East, Los Angeles, California (12)
10.13	Lease dated as of March 29, 2005 between Brighton Enterprises, LLC and Mercantile National Bank relating to offices at 9601 Wilshire Boulevard, Beverly Hills, California (12)
10.14	Lease dated as of September 10, 2004 between Encino Corporate Plaza, LP and Mercantile National Bank relating to offices at 16661 Ventura Boulevard, Encino, California (12)
10.15	Mercantile National Bank Deferred Compensation Plan and Form of Agreement (12)
11.	Statement regarding computation of per share earnings (see ‘‘Note 1-Summary of Significant Accounting Policies-Earnings Per Share’’—of the ‘‘Notes to the Consolidated Financial Statements’’ in “Item 7. Financial Statements” in this Annual Report on Form 10-KSB/A)
21.	Subsidiaries of the Registrant

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23.1	Consent of Moss Adams LLP
23.2	Consent of Ernst & Young LLP
31.1	Certification of Scott A. Montgomery under Section 302 of Sarbanes-Oxley Act
31.2	Certification of David R. Brown under Section 302 of Sarbanes-Oxley Act
32.1	Certification of Scott A. Montgomery under Section 906 of Sarbanes-Oxley Act
32.2	Certification of David R. Brown under Section 906 of Sarbanes-Oxley Act

(1)Filed as an exhibit to the Company’s Annual Report on Form 10-K for the year ended December 31, 1997.

(2)Filed as an exhibit to the Company’s Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference.

(3)Filed as an exhibit to the Company’s Report on Form 10-Q for the quarter ended March 31, 1999 and incorporated herein by reference.

(4)Filed as an exhibit to Company’s Annual Report on Form 10-K for the year ended December 31, 1990 and incorporated herein by reference.

(5)Filed as an exhibit to the Company’s Registration Statement on Form S-2 dated February 10, 1997 and amendments thereto and incorporated herein by reference.

(6)Filed as an exhibit to the Company’s Annual Report on Form 10-KSB for the year ended December 21, 2000 and incorporated herein by reference.

(7)Filed as an exhibit to the Company’s Report on Form 10-QSB for the quarter ended September 30, 2001 and incorporated herein by reference.

(8)Filed as an exhibit to the Company’s Annual Report on Form 10-KSB for the year ended December 21, 2001 and incorporated herein by reference.

(9)Filed as an exhibit to the Company’s Annual Report on Form 10-KSB for the year ended December 21, 2002 and incorporated herein by reference.

(10)Filed as an exhibit to the Company’s Registration Statement on Form S-8 dated June 20, 2003 and incorporated herein by reference.

(11)Filed as an exhibit to the Company’s Annual Report on Form 10-KSB for the year ended December 21, 2003 and incorporated herein by reference.

(12)Filed as an exhibit to the Company’s Annual Report on Form 10-KSB for the year ended December 21, 2004 and incorporated herein by reference.

(13)Filed as an exhibit to the Company’s Annual Report on Form 10-QSB for the quarter ended June 30, 20053 and incorporated herein by reference.

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