UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

[ X ]	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended September 30, 2011.

or

[    ]	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the transition period from                to               .

Commission File Number:  000-25020

HERITAGE OAKS BANCORP

(Exact name of registrant as specified in its charter)

California	77-0388249
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

545 12th Street,

Paso Robles, California 93446

(Address of principal executive offices, including zip code)

(805) 369-5200

(Registrant’s telephone number, including area code)

Not Applicable

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve (12) months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES [ X ]     NO [    ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

YES [ X ]     NO [    ]

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

Large accelerated filer [    ]     Accelerated filer [    ]     Non-accelerated filer [    ]    Smaller reporting company [ X ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

YES [    ]      NO [ X ]

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:  As of October 27, 2011 there were 25,145,717 shares outstanding of the Registrant’s common stock.

Heritage Oaks Bancorp  | - 1 -

Heritage Oaks Bancorp

FORM 10-Q for the Quarter Ended September 30, 2011

INDEX

			Page
Part I.		Financial Information
	Item 1.	Financial Statements (unaudited)
		Condensed Consolidated Balance Sheets at September 30, 2011 (unaudited) and December 31, 2010	4
		Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2011 and September 30, 2010 (unaudited)	5
		Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2011 and September 30, 2010 (unaudited)	6
		Notes to Condensed Consolidated Financial Statements (unaudited)	7
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	31
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	60
	Item 4.	Controls and Procedures	62
Part II.		Other Information
	Item 1.	Legal Proceedings	62
	Item 1A.	Risk Factors	63
	Item 2.	Unregistered Sales of Securities and Use of Proceeds	63
	Item 3.	Defaults upon Senior Securities	63
	Item 4.	(Removed and Reserved)	64
	Item 5.	Other Information	64
	Item 6.	Exhibits	64
		Signature	65

Heritage Oaks Bancorp  | - 2 -

Part I.  Financial Information

Item 1. Financial Statements

The financial statements and the notes thereto begin on next page.

Heritage Oaks Bancorp  | - 3 -

Heritage Oaks Bancorp

and Subsidiaries

Condensed Consolidated Balance Sheets

	September 30,			December 31,
(dollars in thousands except per share data)	2011			2010
	(unaudited)
Assets
Cash and due from banks	$	18,339		$	15,187
Interest bearing due from banks	8,383			4,264
Federal funds sold	-			3,500
Total cash and cash equivalents	26,722			22,951
Interest bearing time deposits with other banks	-			119
Securities available for sale	248,854			223,857
Federal Home Loan Bank stock, at cost	4,684			5,180
Loans held for sale	13,130			11,008
Gross loans	648,194			677,303
Net deferred loan fees	(1,210		)	(1,613		)
Allowance for loan losses	(20,409		)	(24,940		)
Net loans	626,575			650,750
Property, premises and equipment	5,764			6,376
Deferred tax assets, net	19,240			21,163
Bank owned life insurance	14,029			13,843
Goodwill	11,049			11,049
Core deposit intangible	1,771			2,127
Other real estate owned	2,191			6,668
Other assets	9,108			7,521
Total assets	$	983,117		$	982,612
Liabilities
Deposits
Demand, non-interest bearing	$	228,236		$	182,658
Savings, NOW, and money market deposits	368,430			384,202
Time deposits of $100 or more	97,108			117,842
Time deposits under $100	107,959			113,504
Total deposits	801,733			798,206
Short term FHLB borrowing	11,000			38,500
Long term FHLB borrowing	25,500			6,500
Junior subordinated debentures	8,248			8,248
Other liabilities	10,605			9,902
Total liabilities	857,086			861,356
Commitments and contingencies
Stockholders’ Equity
Preferred stock, 5,000,000 shares authorized:
Series A senior preferred stock; $1,000 per share stated value issued and outstanding: 21,000 shares as of September 30, 2011 and December 31, 2010	20,068			19,792
Series C preferred stock, $3.25 per share stated value; issued and outstanding: 1,189,538 shares as of September 30, 2011 and December 31, 2010	3,604			3,604
Common stock, no par value; authorized: 100,000,000 shares; issued and outstanding: 25,081,819 shares and 25,082,344 shares as of September 30, 2011 and December 31, 2010, respectively	101,140			101,140
Additional paid in capital	6,920			7,002
Accumulated deficit	(6,543		)	(9,161		)
Accumulated other comprehensive income / (loss), net of tax expense / (benefit) of  $589 and ($783) as of September 30, 2011 and December 31, 2010, respectively	842			(1,121		)
Total stockholders’ equity	126,031			121,256
Total liabilities and stockholders’ equity	$	983,117		$	982,612

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

Heritage Oaks Bancorp | - 4 -

Heritage Oaks Bancorp

and Subsidiaries

Condensed Consolidated Statements of Operations

	For the three months ended						For the nine months ended
	September 30,						September 30,
(dollars in thousands except per share data)	2011			2010			2011			2010
Interest Income	(unaudited)			(unaudited)			(unaudited)			(unaudited)
Interest and fees on loans	$	10,174		$	10,908		$	31,132		$	33,478
Interest on investment securities	1,880			1,771			5,016			4,759
Other Interest Income	18			27			67			95
Total interest income	12,072			12,706			36,215			38,332
Interest Expense
Interest on savings, NOW and money market deposits	361			705			1,171			2,589
Interest on time deposits of $100 or more	363			502			1,212			1,597
Interest on time deposits under $100	350			494			1,138			1,684
Other borrowings	143			163			396			533
Total interest expense	1,217			1,864			3,917			6,403
Net interest income before provision for loan losses	10,855			10,842			32,298			31,929
Provision for loan losses	1,086			4,400			5,370			25,700
Net interest income after provision for loan losses	9,769			6,442			26,928			6,229
Non Interest Income
Fees and service charges	659			581			1,820			1,820
Mortgage gain on sale and origination fees	734			1,027			1,750			2,278
Debit/credit card fee income	430			386			1,211			1,052
Earnings on bank owned life insurance	147			143			444			437
Other than temporary impairment (OTTI) losses on investment securities:
Total impairment loss on investment securities	-			(650		)	-			(650		)
Non credit related losses recognized in other comprehensive income	-			544			-			544
Net impairment losses on investment securities	-			(106		)	-			(106		)
Gain on sale of investment securities	595			807			1,187			710
(Loss) / gain on sale of other real estate owned	(266		)	(28		)	(587		)	34
Gain on extinguishment of debt	-			-			-			1,700
Other income	258			93			691			627
Total non interest income	2,557			2,903			6,516			8,552
Non Interest Expense
Salaries and employee benefits	4,434			5,195			13,371			14,374
Equipment	399			433			1,327			1,131
Occupancy	888			966			2,768			2,840
Promotional	156			173			491			525
Data processing	801			497			2,253			1,832
OREO related costs	162			168			556			430
Write-downs of foreclosed assets	89			651			968			867
Regulatory assessment costs	503			669			1,834			1,971
Audit and tax advisory costs	188			143			514			428
Directors fees	102			132			338			388
Outside services	296			412			1,035			1,247
Telephone / communications costs	89			99			268			260
Amortization of intangible assets	96			128			356			385
Stationery and supplies	87			114			294			343
Other general operating costs	760			490			1,724			1,393
Total non interest expense	9,050			10,270			28,097			28,414
Income / (loss) before provision for income taxes	3,276			(925		)	5,347			(13,633		)
Provision for income taxes	1,157			9,978			1,753			4,444
Net income / (loss)	2,119			(10,903		)	3,594			(18,077		)
Dividends and accretion on preferred stock	373			357			1,108			4,517
Net income / (loss) available to common shareholders	$	1,746		$	(11,260	)	$	2,486		$	(22,594	)
Basic	$	0.07		$	(0.45	)	$	0.10		$	(1.54	)
Diluted	$	0.07		$	(0.45	)	$	0.10		$	(1.54	)

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

Heritage Oaks Bancorp  | - 5 -

Heritage Oaks Bancorp

and Subsidiaries

Condensed Consolidated Statements of Cash Flows

	For the nine months
	ended September 30,
(dollars in thousands)	2011			2010
	(unaudited)			(unaudited)
Cash flows from operating activities:
Net income / (loss)	$	3,594		$	(18,077	)
Adjustments to reconcile net income / (loss) to net cash provided by / (used in) operating activities:
Depreciation and amortization	959			967
Provision for loan losses	5,370			25,700
Provision of unfunded loan commitments	29			-
Amortization of premiums / discounts on investment securities, net	2,352			1,206
Amortization of intangible assets	356			385
Share-based compensation expense	213			182
Gain on sale of available for sale securities	(1,187		)	(710		)
Loss on sale of property, premises and equipment	4			-
Other than temporary impairment	-			106
Gain on extinguishment of debt	-			(1,700		)
Origination of loans held for sale	(96,360		)	(114,280		)
Proceeds from sale of loans held for sale	109,766			111,393
Net increase in bank owned life insurance	(186		)	(388		)
Decrease / (increase) in deferred tax asset, net	551			(12,427		)
Deferred tax assets valuation allowance adjustment	-			10,519
Loss / (gain) on sale of foreclosed collateral	587			(34		)
Write-downs on other real estate owned	968			867
Increase in other assets	(1,482		)	(10,899		)
Increase in other liabilities	263			1,037
NET CASH PROVIDED BY / (USED IN) OPERATING ACTIVITIES	25,797			(6,153		)
Cash flows from investing activities:
Purchase of securities, available for sale	(161,222		)	(105,382		)
Sale of available for sale securities	108,617			8,088
Maturities and calls of available for sale securities	452			556
Proceeds from principal reductions and maturities of available for sale securities	29,326			17,627
Redemption of Federal Home Loan Bank stock	496			433
(Increase) / decrease in loans, net	(2,167		)	34,266
Allowance for loan and lease loss recoveries	1,960			1,810
Purchase of property, premises and equipment, net	(351		)	(404		)
Proceeds from sale of foreclosed collateral	6,130			3,099
NET CASH USED IN INVESTING ACTIVITIES	(16,759		)	(39,907		)
Cash flows from financing activities:
Increase in deposits, net	3,527			20,159
Proceeds from Federal Home Loan Bank borrowing	177,500			35,000
Repayments of Federal Home Loan Bank borrowing	(186,000		)	(45,000		)
Decrease in junior subordinated debentures	-			(3,455		)
Proceeds from exercise of stock options	-			42
Preferred stock dividends paid	-			(262		)
Proceeds from issuance of preferred stock and common stock warrants, net	-			55,955
Tax impact of share based compensation expense	(294		)	-
NET CASH (USED) IN / PROVIDED BY FINANCING ACTIVITIES	(5,267		)	62,439
Net increase in cash and cash equivalents	3,771			16,379
Cash and cash equivalents, beginning of period	22,951			40,738
Cash and cash equivalents, end of period	$	26,722		$	57,117
Supplemental Cash Flow Disclosures:
Cash Flow information
Interest paid	$	3,923		$	6,519
Income taxes paid	$	2,645		$	5,475
Non-Cash Flow Information
Change in unrealized gain on available for sale securities	$	3,335		$	2,529
Loans transferred to foreclosed collateral	$	3,484		$	12,114
Loans transferred to held for sale	$	15,528		$	-
Preferred stock dividends accrued not paid	$	701		$	529
Accretion of preferred stock discount	$	276		$	3,726
Conversion of preferred stock	$	-		$	52,351

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

Heritage Oaks Bancorp  | - 6 -

Heritage Oaks Bancorp

And Subsidiaries

Notes to Condensed Consolidated Financial Statements (unaudited)

Note 1.  Condensed Consolidated Financial Statements

Description of Business

Heritage Oaks Bancorp is a California corporation organized in 1994 to act as a holding company of Heritage Oaks Bank.  Heritage Oaks Bank conducts commercial banking business in branch offices serving San Luis Obispo and Santa Barbara Counties.  As such, the Company operations are concentrated in one business segment and are concentrated to a single geographic region.

Basis of Presentation

The following unaudited condensed financial statements of Heritage Oaks Bancorp and subsidiaries (the “Company”) have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and note disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to those rules and regulations, although the Company believes that the disclosures made are adequate to make the information not misleading. In the opinion of Management, all adjustments (which consist solely of normal recurring accruals) considered necessary for a fair presentation of results for the interim periods presented have been included. These interim condensed consolidated financial statements should be read in conjunction with the financial statements and related notes contained in the Company’s 2010 Annual Report filed on Form 10-K, filed with the Securities and Exchange Commission on March 10, 2011, file number 000-25020.

The condensed consolidated financial statements include the accounts of Heritage Oaks Bancorp and its wholly-owned financial subsidiary, Heritage Oaks Bank.  All significant inter-company balances and transactions have been eliminated. Heritage Oaks Capital Trust II, which was formed solely for the purpose of issuing trust preferred securities, is an unconsolidated subsidiary as the Company is not the primary beneficiary of the trust and it is not a variable interest entity. Operating results for the three and nine months ended September 30, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011. Certain amounts in the consolidated financial statements for the year ended December 31, 2010 and for the three and nine months ended September 30, 2010 may have been reclassified to conform to the presentation of the condensed consolidated financial statements in 2011.

The preparation of consolidated financial statements in conformity with U.S. GAAP requires Management to make estimates and assumptions.  These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from these estimates.

The Company has performed an evaluation of subsequent events through the date on which these financial statements in this Form 10-Q were filed with the SEC. Based on all currently available information, the Company is not aware of any subsequent events that need to be recognized or disclosed.

Summary of Significant Accounting Policies

The significant accounting policies that the Company applies are detailed in Note 1 of the Company’s Annual Report filed on Form 10-K.  There have been no changes to these policies or their application other than as noted below.

Recent Accounting Guidance Adopted

On July 21, 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2010-20, “Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.” The new disclosures require significantly more information about credit quality in a financial institution’s loan portfolio. This statement addresses only disclosures and does not change recognition or measurement of the allowance for loan losses. The provisions under this statement were effective for interim and annual reporting periods beginning after December 15, 2010. Adoption of this ASU did not have a significant impact on the Company’s consolidated financial statements.

Heritage Oaks Bancorp | - 7 -

In January 2010, the FASB issued ASU 2010-06, Improving Disclosure about Fair Value Measurements. This standard requires new disclosures on the amount and reason for transfers in and out of Level 1 and Level 2 recurring fair value measurements. The standard also requires disclosure of activities (i.e., on a gross basis), including purchases, sales, issuances, and settlements, in the reconciliation of Level 3 fair value recurring measurements. The standard clarifies existing disclosure requirements on levels of disaggregation and disclosures about inputs and valuation techniques. The new disclosures regarding Level 1 and Level 2 fair value measurements and clarification of existing disclosures are effective for periods beginning after December 15, 2009. The disclosures about the reconciliation of information in Level 3 recurring fair value measurements were required for periods beginning after December 15, 2010. Adoption of this standard did not have a significant impact on the Company’s quarterly disclosures.

In April 2011, the FASB issued ASU No. 2011-02, Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring (“ASU No. 2011-02”). The new standard provides clarification on what types of loan modifications constitute a troubled debt restructuring. The new standard provides that in evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist: (a) the restructuring constitutes a concession; and (b) the debtor is experiencing financial difficulties. The new standard also enacts the additional troubled debt restructuring disclosure requirements of ASU No. 2010-20. The Company adopted the provisions of ASU No. 2011-02 in its quarter ending September 30, 2011, and applied its provisions retrospectively to any restructurings that occurred since the beginning of 2011.  Adoption of this standard did not have a significant impact on the Company’s consolidated financial statements.

Recent Accounting Guidance Not Yet Effective

In June 2011, the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 220), Presentation of Comprehensive Income.  The new standard requires the disclosure of comprehensive income on the face of the income statement or in a stand-alone statement of comprehensive income, as opposed to the more common historical practice of disclosure as a component of the statement of stockholders’ equity.  The new presentation is effective for interim and annual periods beginning on or after December 15, 2011.  The Company does not expect that adoption of this standard will have a significant impact on the Company’s consolidated financial statements.

On May 12, 2011, the FASB, together with the International Accounting Standards Board (IASB), jointly issued ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS. ASU 2011-04 is intended to converge the definition of fair value between U.S. generally accepted accounting principles (U.S. GAAP) and International Financial Reporting Standards (IFRS), and improves consistency of disclosures relating to fair value. The provisions of ASU 2011-04 will be effective for years beginning after December 15, 2011 for both public and nonpublic entities. The Company is still evaluating the impacts that adoption of this standard in the first quarter of 2012 will have on the Company’s consolidated financial statements.

In September 2011, the FASB issued ASU 2011-08, Intangibles-Goodwill and Other – Testing Goodwill for Impairment.  ASU 2011-08 provides guidance on the application of a qualitative assessment of impairment indicators in the review of goodwill impairment. The ASU provides that in the event that the qualitative review indicates that it is more likely than not that no impairment has occurred, the Company would not be required to perform a quantitative review. The provisions of ASU 2011-08 will be effective for years beginning after December 15, 2011 for both public and nonpublic entities, although earlier adoption is allowed. The Company does not expect that adoption of this standard will have a significant impact on the Company’s consolidated financial statements.

Comprehensive Income (Loss)

For the three and nine months ended September 30, 2011, comprehensive income was $1.8 million and $5.6 million, respectively, and included the impact of unrealized gains and losses on available for sale investments, net of applicable taxes. For the three and nine months ended September 30, 2010, comprehensive loss was $10.5 million and $16.6 million, respectively, and included the impact of unrealized gains and losses on available for sale investments, net of applicable taxes.

Heritage Oaks Bancorp | - 8 -

Note 2.  Investment Securities

The following table sets forth the amortized cost and fair values of the Company’s investment securities, all of which are reported as available for sale at September 30, 2011 and December 31, 2010:

(dollars in thousands)			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
As of September 30, 2011	Cost		Gains		Losses			Value
Obligations of U.S. government agencies	$	4,268	$	134	$	(2	)	$	4,400
Mortgage-backed securities
Agency	139,038		1,153		(303		)	139,888
Non-agency	32,218		506		(1,297		)	31,427
State and municipal securities	45,232		2,735		(13		)	47,954
Corporate debt securities	24,607		33		(1,580		)	23,060
Other	2,060		65		-			2,125
Total	$	247,423	$	4,626	$	(3,195	)	$	248,854
As of December 31, 2010
Obligations of U.S. government agencies	$	6,684	$	-	$	(248	)	$	6,436
Mortgage-backed securities
Agency	159,448		1,653		(484		)	160,617
Non-agency	10,170		233		(1,344		)	9,059
State and municipal securities	49,459		242		(1,956		)	47,745
Total	$	225,761	$	2,128	$	(4,032	)	$	223,857

At September 30, 2011, the Company owned five Whole Loan Private Label Single Family Residential Mortgage Backed Securities (“PMBS”) with a remaining principal balance of approximately $4.4 million, which are included in Non-agency mortgage backed securities in the above table. PMBS do not carry a government guarantee (explicit or implicit) and require much more detailed due diligence in the form of pre and post purchase analysis.  All PMBS bonds were rated AAA by one or more of the major rating agencies at the time of purchase.  However, due to the severe and prolonged downturn in the economy, PMBS bonds along with other asset classes have seen deterioration in price, credit quality, and liquidity.  Rating agencies have been reassessing all ratings associated with bonds starting with lower tranche or subordinate pieces (which have increased loss exposure), then moving on to senior and super senior bonds, which are what the Company owns with the exception of one mezzanine bond (subordinate).  At September 30, 2011, one bond with an aggregate fair value of $0.3 million is deemed to be non-investment grade.

The Company’s evaluations of PMBS, with the assistance of an independent third party, compile relevant collateral details and performance statistics on a security-by-security basis.  These evaluations also include assumptions about prepayment rates, future delinquencies, and loss severities based on the underlying collateral characteristics and vintage.  Additionally, evaluations include consideration of actual recent collateral performance, the structuring of the security (including the Company’s position within that structure) and expectations of relevant market and economic data as of the end of the reporting period.  Assumptions made concerning the items listed above allow the Company to then derive an estimate for the net present value of each security’s expected future cash flows.  This amount is then compared to the amortized cost of each security to determine the amount of any possible credit loss. As of September 30, 2011, net unrealized gains on PMBS within the Company’s investment portfolio totaled $0.1 million compared to net unrealized losses of $1.1 million reported at December 31, 2010.

Heritage Oaks Bancorp | - 9 -

Other than Temporary Impairment

As of September 30, 2011, the Company continues to hold two PMBS securities in which OTTI losses had been recognized.  These securities had an aggregate recorded fair value of $0.6 million ($1.1 million historical cost) at both September 30, 2011 and December 31, 2010.  The aggregate OTTI recorded on these two securities as of both September 30, 2011 and December 31, 2010 was approximately $0.5 million, comprised of $0.1 million of OTTI associated with credit risk and $0.4 million associated with OTTI for all other factors.  In March 2011, the Company sold one of the three securities on which OTTI had previously been recognized.  The Company realized a loss of approximately $0.5 million on the sale of the security.  Although the Company continues to have the ability and intent to hold these securities for the foreseeable future, the results of the analysis performed on these securities indicated that the present value of the expected future cash flows was not sufficient to recover their entire amortized cost basis, thus indicating a credit loss had occurred. It is possible that the underlying loan collateral of these securities will perform worse than is currently expected, which could lead to adverse changes in cash flows on these securities and future OTTI losses.  Events that could trigger material unrecoverable declines in fair values, and therefore potential OTTI losses for these securities in the future include, but are not limited to: further significantly weakened economic conditions; deterioration of credit metrics; significantly higher levels of default; loss in value on the underlying collateral; deteriorating credit support from subordinated tranches; and further uncertainty and illiquidity in the financial markets. The Company will continue to engage an independent third party to review these securities on a quarterly basis for the foreseeable future.

As of September 30, 2011, the Company believes that unrealized losses on all other mortgage related securities such as agency securities, including those issued by the Federal Home Loan Mortgage Corporation (“FHLMC”), the Federal National Mortgage Association (“FNMA”) and the Government National Mortgage Association (“GNMA”), as well as corporate bonds, are not attributable to credit quality, but rather fluctuations in market prices for these types of investments.  Additionally, these securities have maturity dates that range from 1 to 30 years and in the case of the agency mortgage related securities have contractual cash flows guaranteed by agencies of the U.S. Government.  As of September 30, 2011, the Company does not believe unrealized losses related to these securities are other than temporary.

The following table provides a roll forward of the OTTI balances against the investment securities for both credit loss and all other factor components, for the nine months ended September 30, 2011:

				OTTI Related
	OTTI Related			to All Other			Total
(dollars in thousands)	to Credit Loss			Factors			OTTI
Balance, beginning of the period	$	534		$	943		$	1,477
Less: losses related to OTTI securities sold	(425		)	(518		)	(943		)
Change in value attributable to other factors	-			(54		)	(54		)
Balance, end of the period	$	109		$	371		$	480

The following table provides additional information related to the OTTI losses the Company recognized during the year ended December 31, 2010:

				OTTI Related
	OTTI Related			to All Other			Total
(dollar amounts in thousands)	to Credit Loss			Factors			OTTI
Balance, beginning of the period	$	372		$	1,584		$	1,956
Additional charges on securities for which OTTI
was previously recognized	207			(571		)	(364		)
Less: losses related to OTTI securities sold	(45		)	(70		)	(115		)
Balance, end of the period	$	534		$	943		$	1,477

Heritage Oaks Bancorp | - 10 -

The following table provides a summary of investment securities in an unrealized loss position as of September 30, 2011 and December 31, 2010:

	Securities In A Loss Position
	Less Than Twelve Months					Twelve Months or More					Total
(dollars in thousands)	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
As of September 30, 2011	Value		Loss			Value		Loss			Value		Loss
Obligations of U.S. government agencies	$	-	$	-		$	90	$	(2	)	$	90	$	(2	)
Mortgage-backed securities
Agency	47,525		(303		)	-		-			47,525		(303		)
Non-agency	22,150		(926		)	604		(371		)	22,754		(1,297		)
State and municipal securities	654		(5		)	392		(8		)	1,046		(13		)
Corporate debt securities	20,946		(1,580		)	-		-			20,946		(1,580		)
Total	$	91,275	$	(2,814	)	$	1,086	$	(381	)	$	92,361	$	(3,195	)
As of December 31, 2010
Obligations of U.S. government agencies	$	6,339	$	(245	)	$	96	$	(3	)	$	6,435	$	(248	)
Mortgage backed securities
Agency	56,164		(469		)	2,094		(15		)	58,258		(484		)
Non-agency	-		-			4,780		(1,344		)	4,780		(1,344		)
State and municipal securities	38,731		(1,936		)	136		(20		)	38,867		(1,956		)
Total	$	101,234	$	(2,650	)	$	7,106	$	(1,382	)	$	108,340	$	(4,032	)

The following table summarizes earnings on both taxable and tax-exempt investment securities for the three and nine months ended September 30, 2011 and 2010:

	For the three months				For the nine months
	September 30,				September 30,
(dollar amounts in thousands)	2011		2010		2011		2010
Taxable Earnings on Investment Securities
Obligations of U.S. government agencies	$	32	$	1	$	137	$	2
Mortgage Backed Securities	1,176		1,441		3,192		3,885
State and municipal securities	121		35		377		83
Corporate debt Securities	149		-		154		-
Other	20		-		20		-
Non-taxable Earnings on Investment Securities
State and municipal securities	382		294		1,136		789
Total	$	1,880	$	1,771	$	5,016	$	4,759

Heritage Oaks Bancorp | - 11 -

Note 3.  Loans

The following table provides a summary of outstanding loan balances as of September 30, 2011 compared to December 31, 2010:

	September 30,		December 31,
(dollars in thousands)	2011		2010
Real Estate Secured
Multi-family residential	$	15,931	$	17,637
Residential 1 to 4 family	21,418		21,804
Home equity lines of credit	30,388		30,801
Commercial	363,486		348,583
Farmland	10,432		15,136
Total real estate secured	441,655		433,961
Commercial
Commercial and industrial	134,048		145,811
Agriculture	15,864		15,168
Other	101		153
Total commercial	150,013		161,132
Construction
Single family residential	11,513		11,525
Single family residential - Spec.	250		2,391
Tract	-		-
Multi-family	1,687		2,218
Hospitality	-		-
Commercial	7,107		27,785
Total construction	20,557		43,919
Land	29,130		30,685
Installment loans to individuals	6,644		7,392
All other loans (including overdrafts)	195		214
Total gross loans	648,194		677,303
Deferred loan fees	1,210		1,613
Allowance for loan losses	20,409		24,940
Total net loans	$	626,575	$	650,750
Loans held for sale	$	13,130	$	11,008

Loans held for sale are primarily single-family residential mortgage loans under contract to be sold in the secondary market. In most cases, loans in this category are sold within thirty days.  Buyers have the option to require the Company to repurchase loans sold in the event losses are incurred, which are determined to have been directly caused by fraud in the origination, breach of representations or warranties or documentation deficiencies.  At September 30, 2011, the Company has one loan for which the buyer has notified the Company of their intent to exercise their repurchase option due to losses sustained as a result of perceived deficiencies in our underwriting of the loan. Although, the Company intends to vigorously challenge this and any future claims, the Company has recorded a reserve of $0.2 million for this potential repurchase at September 30, 2011.  In the current year, only one loan has been proven to be deficient, which the Company settled for $0.2 million in the third quarter of 2011.

Concentration of Credit Risk

At September 30, 2011 and December 31, 2010, $491.3 million and $508.6 million, respectively, of the Company’s loan portfolio were collateralized by various forms of real estate.  Such loans are generally made to borrowers located in the counties of San Luis Obispo and Santa Barbara.  The Company attempts to reduce its concentration of credit risk by making loans which are diversified by product type.  While Management believes that the collateral presently securing this portfolio is adequate, there can be no assurances that further deterioration in the California real estate market would not expose the Company to significantly greater credit risk.

Heritage Oaks Bancorp | - 12 -

At September 30, 2011, the Company was contingently liable for financial and performance standby letters of credit to its customers totaling approximately $14.6 million and un-disbursed loan commitments in the amount of $160.3 million, exclusive of letters of credit. The Company makes commitments to extend credit in the normal course of business to meet the financing needs of its customers. Commitments to extend credit are agreements to lend to a customer, as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since many of the commitments are expected to expire without being drawn upon, the total outstanding commitment amount does not necessarily represent future cash requirements. Letters of credit written are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as those involved in extending loan facilities to customers. The Company currently anticipates no losses as a result of such transactions.

Impaired Loans

The following table provides a summary of the Company’s investment in impaired loans as of September 30, 2011.  The decline in the overall level of impaired loans and more specifically the real estate secured and construction segments is largely the result of the loan sales completed in the first nine months of 2011.

			Unpaid		Impaired Loans				Specific		Average		Interest
	Recorded		Principal		With Specific		Without Specific		Allowance for		Recorded		Income
(dollar amounts in thousands)	Investment		Balance		Allowance		Allowance		Impaired Loans		Investment		Recognized
Real Estate Secured
Residential 1 to 4 family	$	661	$	743	$	417	$	244	$	182	$	568	$	-
Home equity lines of credit	360		-		31		329		6		808		-
Commercial	4,855		5,547		4,484		371		851		10,354		-
Farmland	-		-		-		-		-		577		-
Commercial													-
Commercial and industrial	2,633		3,175		2,633		-		1,600		2,992		22
Agriculture	1,209		1,365		153		1,056		126		883		-
Construction													-
Single family residential	937		937		-		937		-		1,174		-
Land	3,211		3,589		2,110		1,101		327		3,669		-
Installment loans to individuals	-		-		-		-		-		4		-
Totals	$	13,866	$	15,356	$	9,828	$	4,038	$	3,092	$	21,029	$	22

The following table summarizes impaired loan balances as of December 31, 2010:

			Unpaid		Impaired Loans				Specific		Average		Interest
	Recorded		Principal		With Specific		Without Specific		Allowance for		Recorded		Income
(dollar amounts in thousands)	Investment		Balance		Allowance		Allowance		Impaired Loans		Investment		Recognized
Real Estate Secured
Residential 1 to 4 family	$	748	$	896	$	-	$	748	$	-	$	988	$	-
Home equity lines of credit	1,019		1,019		-		1,019		-		508		-
Commercial	18,322		20,539		4,706		13,616		1,085		18,890		67
Farmland	2,626		2,773		-		2,626		-		2,745		-
Commercial
Commercial and industrial	5,858		6,474		903		4,955		461		8,010		150
Agriculture	246		384		-		246		-		1,294		-
Construction
Single family residential	1,311		1,310		952		359		476		945		-
Single family residential - Spec.	1,250		1,250		-		1,250		-		1,108		-
Tract	-		-		-		-		-		311		-
Multi-family	479		896		-		479		-		481		-
Commercial	-		100		-		-		-		245		-
Land	3,371		3,771		1,478		1,893		235		6,935		-
Installment loans to individuals	370		502		-		370		-		396		17
Totals	$	35,600	$	39,913	$	8,039	$	27,561	$	2,257	$	42,855	$	234

Heritage Oaks Bancorp | - 13 -

The Company considers a loan impaired when, based on certain information and events surrounding a borrower, it is probable that the Company will not receive all scheduled payments, including interest.  All troubled debt restructurings are also considered impaired even if current borrower information indicates that recovery of all scheduled payments, including interest is likely.

The Company classifies non-accruing loans, loans 90 days or more past due and still accruing, and loans recently classified as troubled debt restructurings as impaired loans.  When loans are placed on non-accrual status, all accrued but uncollected interest is reversed from earnings.  Once on non-accrual status, payments received on such loans are generally applied as a reduction of the loan principal balance.  Interest on such loans is only recognized on a cash basis, and is generally not recognized on specific impaired loans unless the likelihood of further loss is remote.  Loans may be returned to accruing status if the Company believes that all remaining principal and interest is fully collectible and there has been at least six months of sustained repayment performance since the loan was placed on non-accrual.  The Company did not record income from the receipt of cash payments related to non-accruing loans during the three and nine month periods ended September 30, 2011 and 2010.  Interest income recognized on impaired loans in the table above, if any, represents interest the Company recognized on performing troubled debt restructurings.

The provisions of U.S. GAAP permit the valuation allowances reported in the table above to be determined on a loan-by-loan basis or by aggregating loans with similar risk characteristics.  Because substantially all of the loans currently identified as impaired have unique risk characteristics, a significant majority of valuation allowances for loans the Company recorded were determined on a loan-by-loan basis.  As such, a significant portion of the Company’s impaired loans were carried at fair value as of September 30, 2011 and December 31, 2010.

Troubled debt restructurings (“TDRs”) completed for the three and nine months ended September 30, 2011 included:

	For the Three Months Ended September 30, 2011					For the Nine Months Ended September 30, 2011
		Pre-Modification		Post-Modification			Pre-Modification		Post-Modification
	Number of	Outstanding Recorded		Outstanding Recorded		Number of	Outstanding Recorded		Outstanding Recorded
(dollar amounts in thousands)	TDRs	Investment		Investment		TDRs	Investment		Investment
Trouble Debt Restructurings
Real Estate Secured
Commercial	1	$	500	$	500	1	$	500	$	500
Commercial
Commercial and industrial	1	200		200		6	923		923
Land	1	788		742		1	788		742
Totals	3	$	1,488	$	1,442	8	$	2,211	$	2,165

There were no TDRs that originated in 2011 that became delinquent during the three and nine months ended September 30, 2011.

As a result of adopting the amendments in ASU No. 2011-02 in the third quarter of 2011, the Company reassessed all restructurings that occurred on or after January 1, 2011, for which the borrower was determined to be troubled, for identification as TDRs. The Company identified as TDRs certain receivables for which the allowance for credit losses had previously been measured under a general allowance for credit losses methodology. Upon identifying those receivables as TDRs, the Company identified them as impaired under the guidance in Section 310-10-35 of the Accounting Standards Codification. The amendments in ASU No. 2011-02 require prospective application of the impairment measurement guidance in Section 310-10-35 for those receivables newly identified as impaired. At the end of the first interim period of adoption (September 30, 2011), the recorded investment in receivables that have been identified as TDRs under the newly adopted provisions of ASU No. 2011-02, for which the allowance for credit losses was previously measured under a general allowance for credit losses methodology and are now impaired under the provisions of Section 310-10-35 was $0.8 million, and the allowance for credit losses associated with those receivables, on the basis of a current evaluation of loss, was $0.2 million.

Total forgone interest related to impaired loans, includes (1) the initial accrued interest reversal when a loan is transferred to non-accrual status and (2) interest lost prospectively for the period of time a loan is on non-accrual status.  Total forgone interest was $0.3 million and $0.7 million for the three month periods ended September 30, 2011 and 2010, respectively, and $1.4 million and $2.4 million for the nine months ended September 30, 2011 and 2010, respectively.  In addition to forgone interest, the Company lost interest related to rate concessions on certain TDRs of $13 thousand and $120 thousand for the three months ended September 30, 2011 and 2010, respectively, and $62 thousand and $197 thousand for the nine months ended September 30, 2011 and 2010, respectively.  As of September 30, 2011, the Company was not committed to lend any additional funds to borrowers whose obligations to the Company were classified as TDRs.

Heritage Oaks Bancorp | - 14 -

Credit Quality and Credit Risk Management

The Company manages credit risk not only through extensive risk analyses performed prior to a loan’s funding, but also through the ongoing monitoring of loans within the portfolio, and more specifically certain types of loans that generally involve a greater degree of risk, such as commercial real estate, commercial lines of credit, and construction/land loans.  The Company monitors loans in the portfolio through an exhaustive internal process, at least quarterly, as well as with the assistance of a semi-annual independent loan review.  These reviews generally not only focus on problem loans, but also pass credits within certain pools of loans that may be expected to experience stress due to economic conditions.

This process allows the Company to validate credit ratings, underwriting structure, and the Company’s estimated exposure in the current economic environment as well as enhance communications with borrowers where necessary in an effort to mitigate potential future losses.

The Company conducts an analysis on all significant problem loans at least quarterly, in order to properly estimate its potential exposure to loss associated with such credits in a timely manner.  Pursuant to the Company’s lending policy, all loans in the portfolio are assigned a risk rating, which allows Management, among other things, to identify the risk associated with each credit in the portfolio, and to provide a basis for estimating credit losses inherent in the portfolio.  Risk grades are generally assigned based on information concerning the borrower and the strength of the collateral.  Risk grades are reviewed regularly by the Company’s credit committee and are scrutinized by independent loan reviews performed semi-annually, as well as by regulatory agencies during scheduled examinations.

The following provides brief definitions for credit ratings assigned to loans in the portfolio:

·Pass – strong credit quality with adequate collateral or secondary source of repayment and little existing or known weaknesses.  However, pass may include credits with exposure to certain potential factors that may adversely impact the credit, if they materialize, resulting in these credits being put on a watch list to monitor more closely than other pass rated credits.  Such factors may be credit / relationship specific or general to an entire industry.

·Special Mention – credits that have potential weaknesses that deserve Management’s close attention.  If not corrected, these potential weaknesses may result in deterioration of the repayment prospects for the credit at some future date.

·Substandard – credits that have a defined weakness or weaknesses which may jeopardize the orderly liquidation of the loan through cash flows, making it likely that repayment may have to come from some other source, such as the liquidation of collateral.  The Company is more likely to incur losses on substandard credits if the weakness or weaknesses identified in the credit are not corrected.

·Doubtful – credits that possess the characteristics of a substandard credit, but because of certain existing deficiencies related to the credit, full collection is highly questionable.  The probability of incurring some loss on such credits is high, but because of certain important and reasonably specific pending factors which may work to the advantage of strengthening the credit, charge-off is deferred until such time the Company becomes reasonably certain that certain pending factors related to the credit will no longer provide some form of benefit.

Loans typically move to non-accruing status from the Company’s substandard risk grade.  When a loan is first classified as substandard, the Company obtains financial information in order to determine if any evidence of impairment exists.  If impairment is determined to exist, the Company obtains updated appraisal information on the underlying collateral. Once the updated appraisal is obtained and analyzed by Management, a valuation allowance, if necessary, is established against such loan or a loss is recognized by a charge to the allowance for loan losses, if Management believes that the full amount of the Company’s recorded investment in the loan is no longer collectable.  Therefore, at the time a loan moves into non-accruing status, a valuation allowance typically has already been established or balances deemed uncollectable on such loan have been charged-off.  If upon a loan’s migration to non-accruing status, the appraisals obtained while the loan was classified as substandard are deemed to be out-dated, the Company typically orders new appraisals on underlying collateral in order to have the most current indication of fair value.  If a complete appraisal is expected to take a significant amount of time to complete, the Company may also rely on a broker’s price opinion or other meaningful market data, such as comparable sales, in order to derive its best estimate of a property’s fair value, while waiting for an appraisal at the time of the decision to classify the loan as substandard and/or non-accruing.  An analysis of the underlying collateral is performed for loans on non-accruing status at least quarterly, and corresponding changes in any related valuation allowance are made or balances deemed to be fully uncollectable are charged-off.

Heritage Oaks Bancorp | - 15 -

The Company typically moves to charge-off loan balances when, based on various evidence, it believes those balances are no longer collectable.  Such evidence may include updated information related to a borrower’s financial condition or updated information related to collateral securing such loans.  Such loans are monitored internally on a regular basis by the Special Assets department, which is responsible for obtaining updated periodic appraisal information for collateral securing problem loans.  If a loan’s credit quality deteriorates to the point that collection of principal through traditional means is believed by Management to be doubtful, and the value of collateral securing the obligation is sufficient, the Company generally takes steps to protect and liquidate the collateral.  Any loss resulting from the difference between the Company’s recorded investment in the loan and the fair market value of the collateral obtained through repossession is recognized by a charge to the allowance for loan losses.  In those cases where Management has determined that it is in the best interest of the Bank to attempt to broker a troubled loan rather than to continue to hold it in its portfolio, additional charge-offs have been realized as distressed loan buyers that typically purchase these types of loans tend to require a higher rate of return than would be built into the Company’s traditional hold to maturity model, resulting in the sales price for these loans being less than the adjusted carrying cost.

The following table stratifies the loan portfolio by the Company’s internal risk grading system as well as certain other information concerning the credit quality of the loan portfolio as of September 30, 2011:

			Credit Risk Grades								Days Past Due
	Total Gross				Special										90+ and Still		Non-		Accruing
(dollar amounts in thousands)	Loans		Pass		Mention		Substandard		Doubtful		30-59		60-89		Accruing		Accruing		TDR
Real Estate Secured
Multi-family residential	$	15,931	$	15,931	$	-	$	-	$	-	$	-	$	-	$	-	$	-	$	-
Residential 1 to 4 family	21,418		20,748		-		670		-		-		-		-		661		-
Home equity lines of credit	30,388		28,642		-		1,746		-		-		65		-		360		-
Commercial	363,486		323,231		13,614		26,641		-		-		-		-		4,840		-
Farmland	10,432		7,773		-		2,659		-		-		-		-		-		-
Commercial
Commercial and industrial	134,048		120,916		5,704		6,962		466		186		187		-		1,874		759
Agriculture	15,864		12,735		500		2,629		-		-		-		-		1,208		-
Other	101		101		-		-		-		-		-		-		-		-
Construction
Single family residential	11,513		10,576		-		937		-		-		-		-		937		-
Single family residential - Spec.	250		-		-		250		-		-		-		-		-		-
Multi-family	1,687		-		-		1,687		-		-		-		-		-		-
Commercial	7,107		2,553		4,554		-		-		-		-		-		-		-
Land	29,130		18,593		-		10,537		-		-		65		-		3,206		-
Installment loans to individuals	6,644		6,241		334		69		-		-		57		-		-		-
All other loans (including overdrafts)	195		193		1		1		-		-		-		-		-		-
Totals	$	648,194	$	568,233	$	24,707	$	54,788	$	466	$	186	$	374	$	-	$	13,086	$	759

Heritage Oaks Bancorp | - 16 -

The following table stratifies the loan portfolio by the Company’s internal risk grading system as well as certain other information concerning the credit quality of the loan portfolio as of December 31, 2010:

			Credit Risk Grades								Days Past Due
	Total Gross				Special										90+ and Still		Non-		Accruing
(dollar amounts in thousands)	Loans		Pass		Mention		Substandard		Doubtful		30-59		60-89		Accruing		Accruing		TDR
Real Estate Secured
Multi-family residential	$	17,637	$	17,637	$	-	$	-	$	-	$	-	$	-	$	-	$	-	$	-
Residential 1 to 4 family	21,804		20,054		282		1,468		-		-		-		-		748		-
Home equity lines of credit	30,801		29,575		89		1,137		-		40		24		-		1,019		-
Commercial	348,583		266,232		33,786		47,000		1,565		1,212		-		-		17,752		570
Farmland	15,136		8,980		2,693		3,463		-		-		-		-		2,626		-
Commercial
Commercial and industrial	145,811		131,594		2,166		10,835		1,216		284		26		-		3,921		1,937
Agriculture	15,168		12,062		2,555		551		-		-		-		-		246		-
Other	153		153		-		-		-		-		-		-		-		-
Construction
Single family residential	11,525		9,399		816		1,310		-		-		-		-		1,311		-
Single family residential - Spec.	2,391		-		1,141		1,250		-		-		-		-		1,250		-
Tract	-		-		-		-		-		-		-		-		-		-
Multi-family	2,218		-		1,739		-		479		-		-		-		479		-
Hospitality	-		-		-		-		-		-		-		-		-		-
Commercial	27,785		27,287		498		-		-		-		-		-		-		-
Land	30,685		16,618		9,213		4,854		-		-		-		-		3,371		-
Installment loans to individuals	7,392		7,009		8		375		-		10		-		-		96		274
All other loans (including overdrafts)	214		214		-		-		-		-		-		-		-		-
Totals	$	677,303	$	546,814	$	54,986	$	72,243	$	3,260	$	1,546	$	50	$	-	$	32,819	$	2,781

Note 4.  Allowance for Loan Losses

The Company has established an allowance for loan losses to account for probable incurred losses inherent in the loan portfolio as of the date of the balance sheet.  The allowance is comprised of three components: specific credit allocation, general portfolio allocation, and a qualitatively determined allocation.  The specific credit allocation is assigned to loans that have been individually evaluated for impairment, such as loans placed on non-accrual status and any other loan which Management has identified as impaired, including TDRs.  The general portfolio allocation is determined by collectively evaluating pools of loans and applying historical loss factors across the various credit risk grades and loan segments in the portfolio.  The qualitatively determined allocation is determined through judgments the Company makes regarding certain qualitative factors that may impact the credit quality of various segments of the loan portfolio.

Specific Credit Allocation

The specific credit allocation of the allowance is determined through the measurement of impairment on certain loans that have been identified during each reporting period as impaired.  A loan is considered impaired when, based on certain information and events surrounding a borrower, it is determined that it is probable that the Company will not receive all scheduled payments, including interest.  Once a loan is classified as substandard, the Company places the loan under the supervision of its Special Assets department.  The Special Assets department is responsible for performing comprehensive analyses of impaired loans, including obtaining updated financial information regarding the borrower, obtaining updated appraisals on any collateral securing such loans and ultimately determining the extent to which such loans are impaired.  Once the amount of impairment on specific impaired loans has been determined, the Company establishes a corresponding valuation allowance which then becomes a component of the Company’s specific credit allocation in the allowance for loan losses.

General Portfolio Allocation

The general portfolio allocation of the allowance is determined by pooling performing loans by collateral type and purpose, such as the stratification presented in Note 3.  These loans are then further segmented by an internal loan grading system that classifies loans as: pass, special mention, substandard and doubtful.  Estimated loss rates are then applied to each segment according to loan grade to determine the amount of the general portfolio allocation.  Estimated loss rates are determined through an analysis of historical loss rates for each segment of the loan portfolio, based on the Company’s prior experience with such loans.

Heritage Oaks Bancorp | - 17 -

Qualitative Portfolio Allocation

The qualitatively determined allocation of the allowance is determined by estimates the Company makes in regard to certain internal and external factors that may have either a positive or negative impact on the overall credit quality of the loan portfolio.  Internal factors include trends in credit quality of the loan portfolio, the existence and the effects of concentrations, the composition and volume of the loan portfolio and the scope and frequency of the loan review process as well as any other factor determined by Management to have an impact on the credit quality of the loan portfolio.  External factors include local, state and national economic and business conditions.  While Management regularly reviews the estimated impact these internal and external factors are expected to have on the loan portfolio, there can be no assurance that an adverse change in any one or combination of these factors will not be in excess of Management’s expectations.

The determination of the amount of the allowance and any corresponding increase or decrease in the level of provisions for loan losses is based on Management’s best estimate of the current credit quality of the loan portfolio and any probable inherent losses as of the balance sheet date.  The nature of the process in which Management determines the appropriate level of the allowance involves the exercise of considerable judgment and the use of estimates.  While Management utilizes its best judgment and all available information in determining the adequacy of the allowance, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Company’s control, including but not limited to, the performance of the loan portfolio, changes in current and future economic conditions and the view of regulatory agencies regarding the level of classified assets.  Continued weakness in economic conditions and any other factor that may adversely affect credit quality, result in higher levels of past due and non-accruing loans, defaults, and additional loan charge-offs, which may require additional provisions for loan losses in future periods and a higher balance in the Company’s allowance for loan losses.

Each segment of loans in the portfolio possess varying degrees of risk, based on, among other things, the type of loan being made, the purpose of the loan, the type of collateral securing the loan, and the sensitivity the borrower has to changes in certain external factors such as economic conditions.  The following provides a summary of the risks associated with various segments of the Company’s loan portfolio, which are factors Management regularly considers when evaluating the adequacy of the allowance:

·  Real estate secured – consist primarily of loans secured by commercial real estate, multi-family, farmland, and 1-4 family residential properties.  Also included in this segment are equity lines of credit secured by real estate.  As the majority of this segment is comprised of commercial real estate loans, risks associated with this segment lie primarily within that loan type.  Adverse economic conditions may result in a decline in business activity and increased vacancy rates for commercial properties.  These factors, in conjunction with a decline in real estate prices, may expose the Company to the potential for losses if a borrower cannot continue to service the loan with operating revenues, and the value of the property has declined to a level such that it no longer fully covers the Company’s recorded investment in the loan.

·  Commercial and Industrial – consist primarily of commercial and industrial loans (business lines of credit), agriculture loans, and other commercial purpose loans.  Repayment of commercial and industrial loans is generally provided from the cash flows of the related business to which the loan was made.  Adverse changes in economic conditions may result in a decline in business activity, which can impact a borrower’s ability to continue to make scheduled payments.  The risk of repayment of agriculture loans arises largely from factors beyond the control of the Company or the related borrower, such as commodity prices and weather conditions.

·  Construction / Land segments – although construction and land loans generally possess a higher inherent risk of loss than other portfolio segments, improvements in the mix, collateral and nature of loans in this segment have resulted in an improvement in the risk profile of this segment of the portfolio.  Risk arises from the necessity to complete projects within specified cost and time limits.  Trends in the construction industry may also impact the credit quality of these loans, as demand drives construction activity.  In addition, trends in real estate values significantly impact the credit quality of these loans, as property values determine the economic viability of future construction projects.

·  Installment – the installment loan portfolio is comprised primarily of a large number of small loans with scheduled amortization over a specific period. The majority of installment loans are made for consumer and business purchases.  Weakened economic conditions may result in an increased level of delinquencies within this segment, as economic pressures may impact the capacity of such borrowers to repay their obligations.

Heritage Oaks Bancorp | - 18 -

The following table summarizes the allocation of the allowance, as well as the activity in the allowance attributed to various segments in the loan portfolio as of and for the three and nine months ended September 30, 2011:

	Real Estate															All Other
(dollar amounts in thousands)	Secured			Commercial			Construction			Land			Installment			Loans			Total
Balance, June 30, 2011	$	10,048		$	8,070		$	500		$	2,886		$	174		$	22		$	21,700
Charge-offs	(1,646		)	(1,203		)	(47		)	(25		)	(66		)	-			(2,987		)
Recoveries	305			262			1			20			22			-			610
Provision for loan losses	1,845			(169		)	76			(738		)	74			(2		)	1,086
Balance, September 30, 2011	$	10,552		$	6,960		$	530		$	2,143		$	204		$	20		$	20,409

	Real Estate															All Other
(dollar amounts in thousands)	Secured			Commercial			Construction			Land			Installment			Loans			Total
Balance, December 31, 2010	$	11,885		$	9,507		$	1,353		$	2,000		$	166		$	29		$	24,940
Charge-offs	(6,474		)	(4,057		)	(338		)	(793		)	(199		)	-			(11,861		)
Recoveries	347			1,313			112			149			39			-			1,960
Provision for loan losses	4,794			197			(597		)	787			198			(9		)	5,370
Balance, September 30, 2011	$	10,552		$	6,960		$	530		$	2,143		$	204		$	20		$	20,409
Amount of allowance attributed to:
Specifically evaluated impaired loans	$	1,039		$	1,726		$	-		$	327		$	-		$	-		$	3,092
General portfolio allocation	$	9,513		$	5,234		$	530		$	1,816		$	204		$	20		$	17,317
Loans individually evaluated for impairment	$	5,861		$	3,843		$	937		$	3,205		$	-		$	-		$	13,846
Specific reserves to total loans individually evaluated for impairment	17.73%			44.91%			0.00%			10.20%			0.00%			0.00%			22.33%
Loans collectively evaluated for impairment	$	435,794		$	146,170		$	19,620		$	25,925		$	6,644		$	195		$	634,348
General reserves to total loans collectively evaluated for impairment	2.18%			3.58%			2.70%			7.00%			3.07%			10.26%			2.73%
Total gross loans	$	441,655		$	150,013		$	20,557		$	29,130		$	6,644		$	195		$	648,194
Total allowance to gross loans	2.39%			4.64%			2.58%			7.36%			3.07%			10.26%			3.15%

The following table summarizes the allocation of the allowance, as well as the activity in the allowance attributed to various segments in the loan portfolio as of and for the year ended December 31, 2010:

	Real Estate															All Other
(dollar amounts in thousands)	Secured			Commercial			Construction			Land			Installment			Loans		Total
Balance, December 31, 2009	$	6,851		$	4,814		$	1,007		$	1,644		$	40		$	16	$	14,372
Charge-offs	(5,500		)	(13,738		)	(1,259		)	(2,985		)	(371		)	-		(23,853		)
Recoveries	120			1,436			10			1,311			13			-		2,890
Provisions for loan losses	10,414			16,995			1,595			2,030			484			13		31,531
Balance, December 31, 2010	$	11,885		$	9,507		$	1,353		$	2,000		$	166		$	29	$	24,940
Amount of allowance attributed to:
Specifically evaluated impaired loans	$	1,085		$	461		$	476		$	235		$	-		$	-	$	2,257
General portfolio allocation	$	10,800		$	9,046		$	877		$	1,765		$	166		$	29	$	22,683
Loans individually evaluated for impairment	$	20,260		$	2,503		$	2,560		$	3,372		$	94		$	-	$	28,789
Specific reserves to total loans individually evaluated for impairment	5.36%			18.42%			18.59%			6.97%			0.00%			0.00%		7.84%
Loans collectively evaluated for impairment	$	413,701		$	158,629		$	41,359		$	27,313		$	7,298		$	214	$	648,514
General reserves to total loans collectively evaluated for impairment	2.61%			5.70%			2.12%			6.46%			2.27%			13.55%		3.50%
Total gross loans	$	433,961		$	161,132		$	43,919		$	30,685		$	7,392		$	214	$	677,303
Total allowance to gross loans	2.74%			5.90%			3.08%			6.52%			2.25%			13.55%		3.68%

Heritage Oaks Bancorp | - 19 -

For comparative purposes, the following table summarizes activity in the allowance for loan losses for the three and nine months ended September 30, 2010:

	For the three months ended		For the nine months  ended
(dollars in thousands)	September 30, 2010		September 30, 2010
Balance at beginning of period	$	22,134	$	14,372
Provisions for loan losses	4,400		25,700
Loans charged-off:
Residential 1-4 family	316		598
Home equity line of credit	1		1
Commercial real estate	523		3,106
Farmland	-		235
Commercial and industrial	2,530		11,348
Agriculture	44		1,253
Construction	21		1,009
Land	1,673		2,629
Other	25		132
Total loan charge-offs	5,133		20,311
Recoveries of loans previously charged off	170		1,810
Balance at end of period	$	21,571	$	21,571

Note 5.  Other Real Estate Owned (“OREO”)

The following tables provide a summary of the change in the balance of OREO for the three and nine months ended September 30, 2011:

	Balance										Balance
	June 30,										September 30,
(dollars in thousands)	2011		Additions		Disposals			Writedowns			2011
Real Estate Secured
Residential 1 to 4 family	$	-	$	865	$	(865	)	$	-		$	-
Commercial	2,385		-		(1,124		)	(56		)	1,205
Construction
Single family residential - Spec.	444		-		-			(21		)	423
Tract	242		-		-			-			242
Land	516		-		(183		)	(12		)	321
Totals	$	3,587	$	865	$	(2,172	)	$	(89	)	$	2,191

	Balance										Balance
	December 31,										September 30,
(dollars in thousands)	2010		Additions		Disposals			Writedowns			2011
Real Estate Secured
Residential 1 to 4 family	$	160	$	865	$	(1,025	)	$	-		$	-
Commercial	3,953		2,578		(4,510		)	(816		)	1,205
Commercial
Commercial and industrial	464		-		(464		)	-			-
Construction
Single family residential - Spec.	475		-		-			(52		)	423
Tract	251		-		-			(9		)	242
Land	1,365		41		(994		)	(91		)	321
Totals	$	6,668	$	3,484	$	(6,993	)	$	(968	)	$	2,191

Heritage Oaks Bancorp | - 20 -

The following table provides a summary of the change in the balance of OREO for the year ended December 31, 2010:

(dollar amounts in thousands)
Beginning balance	$	946
Additions	13,280
Dispositions	(3,906		)
Write-downs	(3,652		)
Ending balance	$	6,668

Note 6.  Income Taxes

The tax provision for the three and nine months ended September 30, 2011 resulted in an effective tax rate of 35.3% and 32.8%, respectively.  The tax provision for the three and nine months ended September 30, 2010 resulted in an effective tax rate 1,078.7% and 32.6%, respectively.  The primary item affecting the effective tax rate for the first nine months of 2011 is the impact of non-taxable municipal interest.  The effective tax rate for the first nine months of 2010 was primarily impacted by the establishment of a $10.5 million valuation allowance against a portion of the Company’s deferred tax asset, as more fully discussed below.

The Company performs a quarterly analysis of the recoverability of its net deferred tax asset position, which takes into account a number of factors including but not limited to recent historical operating performance, projected future operating performance, the impacts if any of Section 382 of the Internal Revenue Code on changes in control, and the likely timing of the reversal of its deferred tax assets.   As such, the accounting for deferred taxes is based on the application of estimates and is therefore subject to change.  Differences between anticipated and actual outcomes of these future tax consequences could result in adjustments to the level of valuation allowance against the Company’s net deferred tax asset position and would therefore have an impact on the Company’s consolidated results of operations or financial position.   As a result of the Company’s quarterly analysis, it recorded an initial valuation allowance of $10.5 million in the third quarter of 2010, which was subsequently adjusted to $7.1 million at December 31, 2010.  As of September 30, 2011, the quarterly assessments completed in 2011 did not yield any differences that warranted an adjustment to the valuation allowance established in 2010.

Note 7.  Earnings / (Loss) Per Share

Basic earnings / (loss) per common share are computed by dividing net income / (loss) available to common shareholders by the weighted-average number of common shares outstanding for the reporting period.  Diluted earnings / (loss) per common share are computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding over the reporting period, adjusted to include the effect of potentially dilutive common shares.  Potentially dilutive common shares are calculated using the Treasury Stock Method and include incremental shares issuable upon exercise of outstanding stock options, other share-based compensation awards and any other security in which its conversion / exercise may result in the issuance of common stock, such as the warrant the Company issued to the U.S. Treasury during 2009 or the Series C Perpetual Preferred Stock the Company issued during 2010.  U.S. GAAP prohibits the computation of diluted loss per common share from assuming exercise or issuance of securities that would have an anti-dilutive effect, which can occur when the Company reports a net loss or when the market price for the Company’s stock falls below the exercise price of equity awards issued by the Company.  As a result, any potential dilution associated with share-based compensation awards, the warrant issued to the U.S. Treasury, and the Series C Perpetual Preferred Stock were not included in the calculation of diluted loss per common share for the three months and nine months ended September 30, 2010, because the Company reported a net loss. For the three months ended September 30, 2011 and 2010, common stock equivalents, primarily options, totaling approximately 672,000 shares and 741,000 shares, respectively, were excluded from the calculation of diluted earnings/(loss) per share, as their impact would be anti-dilutive.  The diluted earnings per share for the for the three and nine months ended September 30, 2011 and 2010 also excludes the impact of approximately 612,000 shares potentially issuable under the warrant issued as part of the Preferred Share issuance (see Note 10).  For the nine months ended September 30, 2011 and 2010, common stock equivalents, primarily options, totaling approximately 561,000 shares and 533,000 shares, respectively, were excluded from the calculation of diluted earnings/(loss) per share, as their impact would be anti-dilutive.

Heritage Oaks Bancorp | - 21 -

The following table sets forth the number of shares used in the calculation of both basic and diluted earnings/ (loss) per common share for the three and nine months ended September 30, 2011 and 2010:

	For the three months ending,
		September 30, 2011			September 30, 2010
		Net			Net
(dollars in thousands except per share data)		Income		Shares	Loss			Shares
Net income / (loss)		$	2,119		$	(10,903	)
Dividends and accretion on preferred stock		373			(357		)
Net income / (loss) applicable to common shareholders		$	1,746		$	(11,260	)
Weighted average shares outstanding				25,054,027				25,004,479
Basic income / (loss) per common share		$	0.07		$	(0.45	)
Dilutive effect of share-based compensation awards, common stock warrants, and convertible perpetual preferred stock				1,200,018				-
Weighted average diluted shares outstanding				26,254,045				25,004,479
Diluted income / (loss) per common share		$	0.07		$	(0.45	)

	For the nine months ended
		September 30, 2011			September 30, 2010
		Net				Net
(dollars in thousands except per share data)		Income		Shares		Loss			Shares
Net income / (loss)		$	3,594			$	(18,077	)
Dividends and accretion on preferred stock		1,108				(4,517		)
Net income / (loss) applicable to common shareholders		$	2,486			$	(22,594	)
Weighted average shares outstanding				25,046,569					14,719,951
Basic income / (loss) per common share		$	0.10			$	(1.54	)
Dilutive effect of share-based compensation awards, common stock warrants, and convertible perpetual preferred stock				1,206,032					-
Weighted average diluted shares outstanding				26,252,601					14,719,951
Diluted income / (loss) per common share		$	0.10			$	(1.54	)

Note 8.  Share-Based Compensation Plans

As of September 30, 2011, the Company had two share-based employee compensation plans, which are more fully described in Note 15 of the consolidated financial statements in the Company’s Annual Report filed on Form 10-K for the year ended December 31, 2010.  These plans include the “1997 Stock Option Plan” and the “2005 Equity Based Compensation Plan.”

Heritage Oaks Bancorp | - 22 -

The following table provides a summary of the expenses the Company has recognized related to share-based compensation for the periods indicated below:

	For the three months ended					For the nine months ended
	September 30,					September 30,
(dollars in thousands)	2011		2010			2011		2010
Share-based compensation expense
Stock option expense	$	58	$	57		$	179	$	149
Restricted stock expense	8		(63		)	34		33
Total expense	$	66	$	(6	)	$	213	$	182
Unrecognized compensation expense
Stock option expense	$	435	$	562
Restricted stock expense	56		152
Total unrecognized expense	$	491	$	714

At September 30, 2011, there was a total of $0.4 million of unrecognized compensation expense related to non-vested stock option awards. That expense is expected to be recognized over a weighted-average period of 2.0 years.

The Company grants restricted share awards periodically for the benefit of employees. These restricted shares generally “cliff vest” after five years of issuance.  Recipients of restricted shares have the right to vote all shares subject to such grant, and receive all dividends with respect to such shares, whether or not the shares have vested.  Recipients do not pay any cash consideration for the shares.  The total unrecognized compensation expense related to restricted share awards at September 30, 2011 was $0.1 million.  That expense is expected to be recognized over the next 1.9 years.

The aggregate intrinsic value in the following table represents the total pretax intrinsic value, which is subject to change based on the fair market value of the Company’s stock. The following table provides a summary of the aggregate intrinsic value of options exercised, outstanding and exercisable as well as a summary of activity related to options granted, exercised, and forfeited during the year to date period ended September 30, 2011:

					Average
			Weighted		Remaining	Total
			Average		Contractual	Intrinsic
	Number of		Exercise		Term	Value
	Shares		Price		(in years)	(in 000’s)
Options outstanding, January 1, 2011	740,537		$	6.53
Granted	55,484		3.67
Expired	(100,076	)	10.84
Forfeited	(24,116	)	6.93
Options outstanding, September 30, 2011	671,829		$	5.66	6.67	$	61
Exercisable at September 30, 2011	379		$	7.42	4.90	$	20

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The following table presents the assumptions used in the calculation of the weighted average fair value of options granted during the first nine months of 2011 and 2010:

	2011		2010
Expected volatility	50.73%		43.75%
Expected term (years)	7		7
Dividend yield	0.00%		0.00%
Risk free rate	2.74%		2.02%
Weighted-average grant date fair value	$	2.00	$	1.48

Note 9.  Fair Value of Assets and Liabilities

The Company determines the fair market values of certain financial instruments based on the fair value hierarchy established in U.S. GAAP.  The fair value of a financial instrument is the amount at which the asset or obligation could be exchanged in a current transaction between willing parties, other than a forced or liquidation sale.  Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instrument.  These estimates do not reflect any premium or discount that could result from offering for sale at one time the entire holdings or a particular financial instrument. Pursuant to U.S. GAAP, the Company is required to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  Specifically, U.S. GAAP describes three levels of inputs that may be used to measure fair value, as outlined below:

Level 1 - Quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 1 assets and liabilities may include debt and equity securities that are traded in an active exchange market and that are highly liquid and are actively traded in over the counter markets.

Level 2 - Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

Fair Value Measurements

The following methods and assumptions were used by the Company in estimating fair values of financial instruments.  Many of these estimates are subjective in nature, involve uncertainties and matters of judgment and, therefore, cannot be determined with precision.  Changes in assumptions could significantly affect these estimates.

Cash and Cash Equivalents

The carrying amounts reported in the balance sheet for cash and cash equivalents approximate the fair values of those assets due to the short-term nature of the assets.

Interest Bearing Deposits at Other Financial Institutions

The carrying amounts reported in the balance sheet for interest bearing deposits at other financial institutions approximates the fair value of these assets due to the short-term nature of the assets.

Investments Including Federal Home Loan Bank Stock and Mortgage-Backed Securities

Fair values are based upon quoted market prices, where available. If quoted market prices are not available, fair values are extrapolated from the quoted prices of similar instruments or through the use of other observable data supporting a valuation model.  Fair values for holdings of Federal Home Loan Bank stock is based on carrying amounts due to redemption provisions.

Heritage Oaks Bancorp | - 24 -

Loans, Loans Held for Sale, and Accrued Interest Receivable

For variable-rate loans that re-price frequently and with no significant change in credit risk, fair values are based on carrying amounts.  The fair values for other loans (for example, fixed rate loans and loans that possess a rate variable other than daily) are estimated using discounted cash flow analysis, based on interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.  Loan fair value estimates include judgments regarding future expected loss experience and risk characteristics.

The fair value of loans held for sale is determined, when possible, using quoted secondary market prices.  If no such quoted price exists, the fair value of the loan is determined using quoted prices for a similar asset or assets, adjusted for the specific attributes of that loan.  The carrying amount of accrued interest receivable approximates its fair value.

Impaired Loans

A loan is considered impaired when it is probable that payment of interest and principal will not be made in accordance with the original contractual terms of the loan agreement.  Impairment is measured based on the fair value of the underlying collateral or the discounted expected future cash flows.  The Company measures impairment on all non-accrual loans for which it has established specific reserves as part of the specific credit allocation component of the allowance for loan losses. As such, the Company records impaired loans as non-recurring Level 2 when the fair value of the underlying collateral is based on an observable market price or current appraised value.  When current market prices are not available or the Company determines that the fair value of the underlying collateral is further impaired below appraised values, the Company records impaired loans as non-recurring Level 3.  At September 30, 2011, a significant majority of the Company’s impaired loans were evaluated based on the fair value of their underlying collateral as determined by the most recent appraisal available to Management.

Other Real Estate Owned and Foreclosed Collateral

Other real estate owned and foreclosed collateral are adjusted to fair value, less any estimated costs to sell, at the time the loans are transferred into this category.  The fair value of these assets is based on independent appraisals, observable market prices for similar assets, or Management’s estimation of value.  When the fair value is based on independent appraisals or observable market prices for similar assets, the Company records other real estate owned or foreclosed collateral as non-recurring Level 2 assets.  When appraised values are not available, there is no observable market price for similar assets, or Management determines the fair value of the asset is further impaired below appraised values or observable market prices, the Company records other real estate owned or foreclosed collateral as non-recurring Level 3 assets.

Bank Owned Life Insurance

Fair values are based on current cash surrender values at each reporting date provided by the underlying insurers.

Federal Home Loan Bank Advances

The fair value disclosed for FHLB advances is determined by discounting contractual cash flows at current market interest rates for similar instruments.

Non-Interest Bearing Deposits

The fair values disclosed for non-interest bearing deposits are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts).

Interest Bearing Deposits and Accrued Interest Payable

The fair values disclosed for interest bearing deposits (for example, interest-bearing checking accounts and passbook accounts) are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts).  The fair values for certificates of deposit are estimated using a discounted cash flow analysis that applies interest rates currently being offered on certificates to a schedule of aggregated contractual maturities on such time deposits.  The carrying amount of accrued interest payable approximates its fair value.

Heritage Oaks Bancorp | - 25 -

Junior Subordinated Debentures

The fair value disclosed for junior subordinated debentures is based on market price of similar instruments issued with similar contractual terms and by issuers with a similar credit profile as the Company.

Off-Balance Sheet Instruments

Fair values of commitments to extend credit and standby letters of credit are based upon fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreement and the counterparties’ credit standing.

The following table provides a summary of the financial instruments the Company measures at fair value on a recurring basis as of September 30, 2011 and December 31, 2010:

	Fair Value Measurements Using
	Quoted Prices in		Significant Other		Significant
	Active Markets for		Observable		Unobservable
(dollars in thousands)	Identical Assets		Inputs		Inputs		Assets At
As of September 30, 2011	(Level 1)		(Level 2)		(Level 3)		Fair Value
Assets
Obligations of U.S. government agencies	$	-	$	4,400	$	-	$	4,400
Mortgage backed securities
Agency	-		139,888		-		139,888
Non-agency	-		31,427		-		31,427
State and municipal securities	-		47,695		259		47,954
Corporate debt securities	-		23,060		-		23,060
Other	-		2,125		-		2,125
Total assets measured on a recurring basis	$	-	$	248,595	$	259	$	248,854
As of December 31, 2010
Assets
Obligations of U.S. government agencies	$	-	$	6,436	$	-	$	6,436
Mortgage backed securities
Agency	-		160,617		-		160,617
Non-agency	-		9,059		-		9,059
State and municipal securities	-		47,462		283		47,745
Total assets measured on a recurring basis	$	-	$	223,574	$	283	$	223,857

The following table provides a summary of the changes in balance sheet carrying values associated with recurring Level 3 financial instruments during the three and nine months ended September 30, 2011 and 2010:

						Purchases,
	Beginning		(Losses) / Gains			Issuances, and		Sales and			Ending
(dollars in thousands)	Balance		Included in OCI (1)			Settlements		Maturities			Balance
Septmeber 30, 2011
State and municipal securities	$	283	$	(24	)	$	-	$	-		$	259
September 30, 2010
State and municipal securities	$	737	$	3		$	-	$	(444	)	$	296

(1) Realized or unrealized (losses) / gains on Level 3 financial instruments represent changes in values of financial instruments only for the period(s) in which the instruments were classified as Level 3.

The assets presented under Level 3 of the fair value hierarchy classified as obligations of state and municipal subdivisions represent available for sale investment securities in the form of certificates of participation, where an active market for such securities is not currently available.

Heritage Oaks Bancorp | - 26 -

The following table provides a summary of assets the Company measures at fair value on a non-recurring basis as of September 30, 2011 and December 31, 2010:

	Fair Value Measurements Using
	Quoted Prices in		Significant Other		Significant
	Active Markets for		Observable		Unobservable
(dollars in thousands)	Identical Assets		Inputs		Inputs		Assets At		Total
As of September 30, 2011	(Level 1)		(Level 2)		(Level 3)		Fair Value		Gains / (Losses)
Assets
Impaired loans
Residential 1 to 4 family	$	-	$	236	$	97	$	333	$	126
Home equity lines of credit	-		-		-		-		-
Commercial real estate	-		368		3,620		3,988		444
Commercial and industrial	-		335		735		1,070		113
Agriculture	-		235		-		235		117
Land	-		60		1,777		1,837		113
Loans held for sale	-		13,130		-		13,130		-
Foreclosed Assets	-		1,699		535		2,234		(307		)
Total assets measured on a non-recurring basis	$	-	$	16,063	$	6,764	$	22,827	$	606
As of December 31, 2010
Assets
Impaired loans
Residential 1 to 4 family	$	-	$	748	$	-	$	748	$	(48	)
Home equity lines of credit	-		1,019		-		1,019		-
Commercial real estate	-		17,237		-		17,237		(1,556		)
Farmland	-		2,626		-		2,626		-
Commercial and industrial	-		5,397		-		5,397		(161		)
Agriculture	-		246		-		246		(117		)
Construction	-		2,564		-		2,564		(417		)
Land	-		3,136		-		3,136		(304		)
Installment loans to individuals	-		370		-		370		(88		)
Loans held for sale	-		11,008		-		11,008		-
Other real estate owned	-		6,668		-		6,668		(3,447		)
Total assets measured on a non-recurring basis	$	-	$	51,019	$	-	$	51,019	$	(6,138	)

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Fair Value of Financial Instruments

The following table provides a summary of the estimated fair value of financial instruments at September 30, 2011 and December 31, 2010:

	September 30, 2011				December 31, 2010
	Carrying				Carrying
(dollars in thousands)	Amount		Fair Value		Amount		Fair Value
Assets
Cash and cash equivalents	$	26,722	$	26,722	$	22,951	$	22,951
Interest bearing deposits	-		-		119		119
Securities available for sale	248,854		248,854		223,857		223,857
Federal Home Loan Bank stock	4,684		4,684		5,180		5,180
Loans receivable, net of deferred fees and costs	646,984		646,180		675,690		678,916
Loans held for sale	13,130		13,130		11,008		11,008
Bank owned life insurance	14,029		14,029		13,843		13,843
Accrued interest receivable	3,718		3,718		3,986		3,986
Liabilities
Non-interest bearing deposits	228,236		228,236		182,658		182,658
Interest bearing deposits	573,497		574,688		615,548		617,296
Federal Home Loan Bank advances	36,500		37,110		45,000		45,025
Junior subordinated debentures	8,248		6,051		8,248		7,713
Accrued interest payable	417		417		423		423
	Notional		Cost to Cede		Notional		Cost to Cede
	Amount		or Assume		Amount		or Assume
Off-balance sheet instruments, commitments to extend credit and standby letters of credit	$	174,933	$	1,749	$	157,411	$	1,574

Note 10.  Preferred Stock

U.S Treasury’s Capital Purchase Program (“CPP”)

Under its Amended Articles of Incorporation, the Company is authorized to issue up to 5,000,000 shares of preferred stock, in one or more series, having such voting powers, designations, preferences, rights, qualifications, limitations and restrictions as determined by the Board of Directors.

On March 20, 2009, the Company issued 21,000 shares of Series A Senior Preferred Stock to the U.S. Treasury under the terms of the CPP for $21.0 million with a liquidation preference of $1,000 per share.  The preferred stock carries a coupon of 5% for five years and 9% thereafter.  Senior preferred stock issued to the U.S. Treasury is non-voting, cumulative, and perpetual and may be redeemed at 100% of their liquidation preference plus accrued and unpaid dividends following three years from the date of issue.  In addition, the Company issued a warrant to the U.S. Treasury to purchase shares of the Company’s common stock in an amount equal to 15% of the preferred equity issuance or approximately $3.2 million (611,650 shares).  The warrant is exercisable immediately at a price of $5.15 per share, will expire after a period of 10 years from issuance and is transferable by the U.S. Treasury.  The warrant may be dilutive to earnings per common share during reporting periods in which the warrant is not anti-dilutive.

The U.S. Treasury may transfer a portion or portions of the warrant, and/or exercise the warrant at any time.  The U.S. Treasury has agreed not to exercise voting power with respect to any common shares issued to it upon exercise of the warrant.  At September 30, 2011, there had been no changes to the number of common shares covered by the warrant nor had the U.S. Treasury exercised any portion of the warrant.

The Company is subject to certain limitations during its participation in the CPP including:

· The requirement to obtain consent from the U.S. Treasury for any proposed increases in common stock dividends prior to the third anniversary date of the preferred equity issuance.

· The Series A Senior Preferred Stock cannot be redeemed for three years unless the Company obtains proceeds to replace the Series A Senior Preferred Stock through a qualified equity offering.

· The U.S. Treasury must consent to any buy back of our common stock.

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The Company must adhere to restrictions placed on the amount and type of compensation paid to its executives while participating in the CPP, pursuant to section 111 of the Emergency Economic Stabilization Act of 2008, as amended (“EESA”).

Beginning in the second quarter of 2010, the Company was required to defer dividend payments on its Series A Senior Preferred Stock to comply with the terms of the Written Agreement entered into between the Company and the Federal Reserve Bank of San Francisco.  As a result, as of September 30, 2011, the Company has accrued for but has not paid approximately $1.6 million in dividends on its Series A Senior Preferred Stock.  If the Company fails to pay dividends on Series A Senior Preferred Stock for a total of six quarters, whether or not consecutive, the U.S. Treasury will have the right to elect two members of the Company’s Board of Directors, voting together with any other holders of preferred shares ranking pari passu with the Series A Senior Preferred Stock. These directors would serve on the Company’s Board of Directors until such time as the Company has paid in full all dividends not previously paid, at which time these directors’ terms of office would immediately terminate.

As of September 30, 2011, the Company has not paid dividends on Series A Preferred Stock for six consecutive quarters.  During the second quarter of 2011, the U.S. Treasury notified the Company of its intent to exercise their option to assign an observer to the Company’s Board.  This observation role has no Board or Committee voting rights and is limited strictly to observation privileges.  Through the filing date of this Form 10-Q the Treasury has not appointed a board member to serve on the Company’s Board.  For more information concerning the Written Agreement, please refer to Note 11, Regulatory Order and Written Agreement of these condensed consolidated financial statements.

Private Placement and Preferred Stock Conversion

On March 12, 2010, the Company announced that it completed a private placement of 52,088 shares of its Series B Mandatorily Convertible Adjustable Cumulative Perpetual Preferred Stock (“Series B Preferred Stock”) and 1,189,538 shares of its Series C Convertible Perpetual Preferred Stock (“Series C Preferred Stock”), raising gross proceeds of approximately $56.0 million. In addition, approximately $4.0 million was placed in escrow for a second closing of 4,072 shares of Series B Preferred Stock, which then closed during the second quarter of 2010.  Total gross proceeds raised in the private placement were approximately $60.0 million and total costs associated with the capital raising efforts were approximately $4.0 million, which represent a reduction of the addition to equity from the private placement.

In June 2010, the Company received shareholder approval to convert all outstanding shares of Series B Preferred Stock to common stock and as a result the Company issued 17,279,995 shares of common stock in June 2010.  The conversion price of $3.25 per common share was less than the fair market value of the Company’s common stock of $3.45 on March 10, 2010, the date the Company made a firm commitment to issue the Series B Preferred Stock (the “commitment date”).  Therefore, the Series B Preferred Stock was issued with a contingent beneficial conversion feature that had an intrinsic value equal to the $0.20 per share difference between the share price on the commitment date and the conversion price of the Series B Preferred Stock.   This beneficial conversion feature, with an aggregate value of $3.5 million, was recognized in June 2010, upon shareholder approval of the conversion of the Series B Preferred Stock.  This recognition resulted in an increase in additional paid in capital of $3.5 million.  In addition, the Company recorded the immediate accretion of the then outstanding Series B Preferred Stock discount through a charge to retained earnings, upon the conversion of the Series B Preferred Stock.

Series C Preferred Stock is a non-voting class of stock substantially similar in priority to the common stock of the Company, except for a liquidation preference over the Company’s common stock.  The Series C Preferred Stock will convert to shares of common stock on a one share for one share basis if the original holder of such shares transfers them to an unaffiliated third party or otherwise makes a “Permissible Transfer”, as defined in the terms of the Series C Preferred Stock. The Series C Preferred Stock will not be redeemable by either the Company or by the holders.  Holders of the Series C Preferred Stock do not have any voting rights, including the right to elect any directors, other than the customary limited voting rights with respect to matters significantly and adversely affecting the rights and privileges of the Series C Preferred Stock.

As is the case with the Series B Preferred Stock, the fair market value of the Company’s common stock was higher than the conversion price of $3.25 per share of the Series C Preferred Stock on the date the Company made a firm commitment to issue the Series C Preferred Stock.  Therefore, the Series C Preferred Stock also has a contingent beneficial conversion feature associated with it.  However, since the conversion of the Series C Preferred Stock remains contingent upon the holder’s transfer of the securities to an unaffiliated third party with no specified date for its conversion to common stock, the Company will record the contingent beneficial conversion feature as an initial discount on Series C Preferred Stock and additional paid in capital, with a concurrent immediate accretion of the established discount and corresponding charge to retained earnings on the date the Series C Preferred Stock converts to common stock.  The amount of the contingent beneficial conversion feature is approximately $0.2 million and will be recorded as described upon the original holder’s transfer of Series C Preferred Stock through a Permissible Transfer.  Such transfer has not occurred as of September 30, 2011.

Two investors in the Company’s March 2010 private placement have Board observation rights, while one of the two investors also has Board nomination rights.

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Note 11.  Regulatory Order and Written Agreement

On March 4, 2010, the FDIC and the DFI issued a Consent Order (the “Order”) to the Bank that requires, among other things, the Bank to increase its capital ratios, reduce its classified assets and increase Board oversight of Management. The Board and Management are aggressively responding to the Order to ensure full compliance and have taken actions necessary to comply with the Order within the required time frames. Such actions include the completion of the capital raise discussed above which, following a contribution of a portion of the proceeds to the Bank, brought the Bank into compliance with the capital requirements of the Order.  Additionally, a Written Agreement was entered into between the Company and the Federal Reserve Bank of San Francisco on March 4, 2010.  Although the Company and Bank believe that the requirements of both the Order and the Written Agreement have been addressed, neither the 2010 full scope examination performed in late 2010 nor the recently completed limited scope examination altered any of the provisions of the Order or the Written Agreement.

Please also refer to the Company’s current reports filed on Form 8-K with the SEC on March 10, 2010 and March 8, 2010 and the Company’s Note 22 to the consolidated financial statements filed as part of its Annual Report on Form 10-K with the SEC on March 10, 2011, for a more complete description of the provisions of the Order and Written Agreement, respectively.

Note 12.  Junior Subordinated Debentures

On June 8, 2010, the Company repurchased $5.0 million in face amount trust preferred securities issued by Heritage Oaks Capital Trust III, and the related $5.2 million junior subordinated debentures issued by the Company. The repurchase resulted in a pre-tax gain of approximately $1.7 million, recognized in the second quarter of 2010. The repurchase was made pursuant to the non-objection of the Federal Reserve Bank of San Francisco and approval of the United States Treasury Department.

In the second quarter of 2010, the Company began to defer interest payments on $8.2 million of junior subordinated debentures to comply with the terms of the Written Agreement entered into between the Company and the Federal Reserve Bank of San Francisco.  As a result, the Company has accrued for but has not paid approximately $0.3 million in interest payments on these debentures, as of September 30, 2011, associated with payments due on these debentures since June 2010. For more information concerning the Written Agreement, please refer to Note 11, Regulatory Order and Written Agreement of these condensed consolidated financial statements.  For such time as the Company continues the deferral of interest, it will be prevented from, among other things, paying dividends on its preferred and common stock.

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

Certain statements contained in this Quarterly Report on Form 10-Q (“Quarterly Report”), including, without limitation, statements containing the words “believes”, “anticipates”, “intends”, “expects”, and words of similar impact, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities and Exchange Act of 1934. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others, the following: the ongoing financial crisis in the United States, including the continuing downturn in the California real estate market, and the response of the federal and state government and our regulators thereto, general economic conditions in those areas in which the Company operates, demographic changes, competition, fluctuations in interest rates, changes in business strategy or development plans, changes in governmental regulation, credit quality, the impact of the recent capital raise to support the Company’s business, as well as economic, political and global changes arising from the war on terrorism, the Company’s ability to increase profitability, sustain growth, the Company’s beliefs as to the adequacy of its existing and anticipated allowance for loan losses, beliefs and expectations about, and requirements to comply with the terms of Consent Order and Written Agreement issued by regulatory authorities having oversight of the Company’s and Bank’s operations, and financial policies of the United States government. (Refer to the Company’s December 31, 2010 10-K, ITEM 1A. Risk Factors). The Company disclaims any obligation to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements contained herein to reflect future events or developments.

Overview

The Company

Heritage Oaks Bancorp (the “Company”) is a California corporation organized in 1994 to act as a holding company of Heritage Oaks Bank (“Bank”), a 14 branch bank serving San Luis Obispo and Santa Barbara counties.  In 1994, the Company acquired all of the outstanding common stock of the Bank in a holding company formation transaction.

In October 2006, the Company formed Heritage Oaks Capital Trust II (“Trust II”). Trust II is a statutory business trust formed under the laws of the State of Delaware and is a wholly-owned, non-financial, non-consolidated subsidiary of the Company.

In September 2007, the Company formed Heritage Oaks Capital Trust III (“Trust III”). Trust III is a statutory business trust formed under the laws of the State of Delaware and is a wholly-owned, non-financial, non-consolidated subsidiary of the Company.  In June 2010 the Company re-purchased all the outstanding securities related to Trust III and dissolved Trust III in the fourth quarter of 2010.

On October 12, 2007, the Company acquired Business First National Bank (“Business First”).  Business First was merged with and into Heritage Oaks Bank.  In connection with the acquisition, two additional branches were added to the Bank’s network.  For additional information regarding this acquisition, please see Note 23 to the consolidated financial statements of the Company’s 2008 annual report, which was filed on Form 10-K.

Other than holding the shares of the Bank, the Company conducts no significant activities, although it is authorized, with the prior approval of the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”), the Company’s principal regulator, to engage in a variety of activities which are deemed closely related to the business of banking. The Company has also caused to be incorporated a subsidiary, CCMS Systems, Inc. which is currently inactive and has not been capitalized. The Company has no present plans to activate the proposed subsidiary.

The Bank continues to operate under the Consent Order issued on March 4, 2010 by the FDIC and DFI and the Company remains subject to the Written Agreement entered into on March 4, 2010 with the FRB.  Management believes it has taken the required steps to address the terms of the Order and Written Agreement, as discussed in Note 11 of the condensed consolidated financial statements filed on this form 10-Q.  Compliance with the Order and Written Agreement will continue to be determined by the issuing regulatory agencies through quarterly monitoring and future examinations.

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Executive Summary of Operating Results

Net income for the three and nine months ended September 30, 2011, when compared to the same periods ended a year earlier, improved by $13.0 million and $21.7 million, respectively.  These improvements were largely driven by lower loan loss provision expense in both the three and nine month periods of 2011, and by the lack of any deferred tax valuation allowance provisions in 2011. Loan loss provision expense was $1.1 million and $5.4 million for the three and nine months ended September 30, 2011, respectively, which represented a decline of $3.3 million and $20.3 million from that reported in the corresponding periods in 2010.  The lower provisioning requirements in 2011 were driven by overall improvements in the credit quality of the loan portfolio and lower net charge-offs during the three and nine months ended September 30, 2011, which totaled $2.4 million and $9.9 million, respectively.  This represented a reduction of $2.6 million and $8.6 million from the levels recognized in the corresponding periods in 2010.  Furthermore, $1.1 million and $5.5 million of the charge-offs for the three and nine months ended September 30, 2011, respectively, were recorded to adjust the values of classified loans transferred to held for sale status to their estimated sales prices.  These loans were sold shortly after their transfer to held for sale status, at such market prices, as part of Management’s attempt to reduce nonperforming and classified assets.  Adjusting for charge-offs related to loan sales, the Company would have reported $1.3 million and $4.3 million in net charge-offs for the three and nine months ended September 30, 2011, respectively, representing a reduction of $3.7 million and $14.1 million when compared to the same periods a year earlier.  At September 30, 2011, we reported a 3.15% allowance for loan losses to total gross loans, which represented a decrease of 5 basis points when compared to 3.20% reported a year earlier.  See “Provision for Loan Losses” under Results of Operation, below, for additional information related to the provision for loan losses.

Operating results for the three and nine months ended September 30, 2011 as compared to the corresponding periods in  2010 were also favorably impacted by decreases in non-interest expense levels, which were $1.2 million and $0.3 million lower than in the three and nine months ended September 30, 2010, respectively.  The favorable impacts from reductions in non-interest expense were offset by declines in non-interest income of $0.3 million and $2.0 million, respectively.  The quarterly decline in non-interest income was primarily due to lower levels of gains recognized on the sale of investment securities. The year-to-date decline was largely due to a one-time gain on the extinguishment of debt, totaling $1.7 million, which was recognized in the second quarter of 2010 related to retirement of junior subordinated debentures. Please see  “Non-Interest Income”, and “Non-Interest Expense” under Results of Operations, below, for additional information related to these components of operating income.

The Company believes that the operating results for the three and nine months ended September 30, 2011, reflect the beginning of some positive trends in financial performance for the Company.  These trends are not only a result of what appears to be the first signs of some degree of stabilization in the local economy in which the Company operates, but also from improvements realized in asset quality through a combination of sales of classified assets and improvement in credit quality during the first nine months of the year.

The improvements in asset quality since December 31, 2010 are evidenced by:

·the $24.6 million decline in classified assets,

·the improvement in the coverage of the allowance for loan loss as a percentage of non-accrual loans to 156% from 76% at December 31, 2010,

·the decline in special mention risk graded loan balances from $55.0 million at December 31, 2010 to $24.7 million at September 30, 2011,

·the decline in OREO balances outstanding from $6.7 million at December 31, 2010 to $2.2 million at September 30, 2011.

While the Company is cautiously optimistic about the current positive trends in credit quality that we have experienced thus far in 2011, it is unclear as to how the uncertainties in the global economy could impact the local economy, if at all.

Local Economy

The economy in the Company’s primary market area (San Luis Obispo and Santa Barbara Counties) is based primarily on agriculture, tourism, light industry, oil and retail trade. Additionally, the local economy in San Luis Obispo County and to a lesser degree Santa Barbara County is dependent on the level of employment generated by state and local government agencies.  Services supporting these industries have also developed in the areas of medical, financial and educational services.  The population of San Luis Obispo County, the City of Santa Maria (in Northern Santa Barbara County), and the City of Santa Barbara totaled approximately 270,000, 100,000, and 88,000 respectively, according to the most recent economic data provided by the U.S. Census Bureau.  The moderate climate allows a year round growing season in the local economy’s agricultural sector.  The Central Coast’s leading agricultural industry is the production of wine grapes and the related production of premium quality wines. Vineyards in production have grown significantly over the past several years throughout the Company’s service area.  In addition, cattle ranching represents a major part of the agriculture industry in the Company’s market.

Heritage Oaks Bancorp | - 32 -

Furthermore, access to numerous recreational activities and destinations including lakes, mountains and beaches, provide a relatively stable tourist industry from many areas including the Los Angeles/Orange County basin, the San Francisco Bay area and the San Joaquin Valley. The economy in the Company’s primary markets of San Luis Obispo and Santa Barbara counties has not been immune to the current downturn in national and state economic conditions.  Weakened economic conditions have resulted in, among other things, increased unemployment, increased commercial and industrial vacancy rates, and lower occupancy rates in the hospitality industry within the Company’s primary markets.  However, the abundant tourism industry that has developed over the past decade in the Company’s market area, especially in the wine industry and coastal communities, has provided support for the local economy in previous economic downturns and has, to some degree, provided support in the current economic environment.

The general business climate in 2008 through 2010 proved to be challenging not only on the national level, but within the state of California and more specifically the Company’s primary market area.  As the real estate market and general economic conditions waned throughout those years, the ability of borrowers to satisfy their obligations to the financial sector languished.  Although the Company’s primary market area has historically witnessed a more stable level of economic activity, the weakened state of the real estate market in conjunction with a decline in economic activity in the Company’s primary market negatively impacted the credit quality of the loan portfolio up through the beginning of 2011.  Recent indications show the unemployment rate within California to be approximately 11.9%, which is down modestly from its recent highs.  Within the Company’s primary market area, recent indications show the unemployment rate within San Luis Obispo and Santa Barbara major metropolitan areas continue to be below the state average, but are still in excess of the longer term average that we have experienced.

Real estate prices fell significantly in California and within the Company’s market area during the 2008 through 2010 period from the highs seen during 2006 and 2007.  Recent information provided by DataQuick Information Systems indicates that housing prices in San Luis Obispo and Santa Barbara counties have declined in excess of 38% from the highs seen in 2006 and 2007.  Although prices in the Company’s market area remain well below the highs witnessed in 2006 and 2007, a lack of oversupply in the Company’s market relative to other areas of California, desirable climate, and close proximity to popular tourist destinations, for both San Luis Obispo and Santa Barbara Counties have resulted in lower percentage declines in prices for the local real estate market, relative to other areas of California.

Looking forward into the remainder of 2011, although Management remains cautiously optimistic that there are signs that the local market in which the Company operates may be beginning to stabilize as compared to the significant downward trends experienced during 2008, 2009 and 2010, there can be no guarantee that the impacts of growing concerns about the global economy may not have trickle down effects on the local economy in which the Company operates. Should global economic conditions worsen and eventually effect our local economy, it could negatively impact the financial condition of borrowers to whom the Company has extended credit and as a result the Company may be required to make further significant provisions to the allowance for loan losses during 2011.  That said, Management has and will continue to be proactive in looking for signs of deterioration within the loan portfolio in an effort to manage credit quality and work with borrowers where possible to mitigate any further losses.

Critical Accounting Policies

The Company’s significant accounting policies are set forth in the 2010 Annual Report, Note 1 of the consolidated financial statements, which was filed on Form 10-K.

The following is a brief description of the Company’s current accounting policies involving significant Management valuation judgments.

Loans and Interest on Loans

Loans receivable that Management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at their outstanding unpaid principal balances reduced by any charge-offs of specific valuation allowances and net of any deferred fees or costs on originated loans, or unamortized premiums or discounts on purchased loans.

Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment in yield over the life of the related loan.

Heritage Oaks Bancorp | - 33 -

Loans on which the accrual of interest has been discontinued are designated as non-accruing loans.  The accrual of interest on loans is discontinued when principal and/or interest is past due 90 days based on contractual terms of the loan and/or when, in the opinion of Management, there is reasonable doubt as to collectability unless such loans are well collateralized and in the process of collection.  When loans are placed on non-accrual status, all interest previously accrued but not collected is reversed against current period interest income.  Interest income generally is not recognized on specific non-accruing loans unless the likelihood of further loss is remote.  Interest payments received on such loans are generally applied as a reduction to the loan principal balance, unless the likelihood of further loss is remote whereby cash interest payments may be recorded during the time the loan is on non-accrual status.  Interest accruals are resumed on such loans only when they are brought current with respect to interest and principal and when, in the judgment of Management, all remaining principal and interest is estimated to be fully collectible, there has been at least six months of sustained repayment performance since the loan was placed on non-accrual and/or Management believes, based on current information, that such loan is no longer impaired.  When a loan is returned to accrual status from non-accrual, the interest that had accumulated while on nonaccrual is recognized ratably over the remaining term of the loan using an effective interest calculation.

The Company considers a loan to be impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement.  Measurement of impairment is based on the expected future cash flows of an impaired loan which are discounted at the loan’s original effective interest rate, or measured by reference to an observable market value, if one exists, or the fair value of the collateral for a collateral-dependent loan.  The Company selects the measurement method on a loan-by-loan basis except that collateral-dependent loans for which foreclosure is probable are measured at the fair value of the collateral.  The Company recognizes interest income on impaired loans based on its existing methods of recognizing interest income on non-accrual loans.  All loans are generally charged-off at such time that it is highly certain a loss has been realized.

Allowance for Loan Losses

The allowance for loan losses is maintained at a level which, in Management’s judgment, is adequate to absorb probable credit losses inherent in the loan portfolio as of the balance sheet date.  The amount of the allowance is based on Management’s evaluation of the collectability of the loan portfolio, including the nature and volume of the portfolio, credit concentrations, trends in historical loss experience, the level of certain classified balances and specific impaired loans, and economic conditions and the related impact on specific borrowers and industry groups.  The allowance is increased by provisions for loan losses, which are charged to earnings and reduced by charge-offs, net of recoveries.  Changes in the allowance relating to impaired loans, including TDRs, are charged or credited to the provision for loan losses.  Because of uncertainties inherent in the estimation process, Management’s estimate of credit losses inherent in the loan portfolio and the related allowance may change.

As mentioned, loans are considered impaired if, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement.  In certain instances the Company may work with the borrower to modify the terms of the loan agreement or otherwise restructure the loan in a way that would allow the borrower to continue to perform under the modified terms of the loan agreement and constitute a TDR.  Loans such as these are considered impaired and require the Company to measure the amount of impairment, if any, at the time the loan is restructured.  The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate stipulated in the loan agreement, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral less the cost to sell such collateral.  In measuring the fair value of the collateral, Management uses assumptions and methodologies consistent with those that would be utilized by unrelated third parties.  Allowances for impaired loans are generally determined based on collateral values or the present value of estimated cash flows.

As mentioned, changes in the financial condition of individual borrowers, economic conditions, historical loss experience and the condition of the various markets in which collateral may be sold may all affect the required level of the allowance for loan losses and the associated provision for loan losses.

Other Real Estate Owned

Real estate and other property acquired in full or partial settlement of loan obligations is referred to as other real estate owned (“OREO”).  OREO is originally recorded in the Company’s financial statements at fair value less any estimated costs to sell.  When property is acquired through foreclosure or surrendered in lieu of foreclosure, the Company measures the fair value of the property acquired against its recorded investment in the loan.  If the fair value of the property at the time of acquisition is less than the recorded investment in the loan, the difference is charged to the allowance for loan losses.  Any subsequent fluctuations in the fair value of OREO are recorded against a valuation allowance for foreclosed assets, established through a charge to non-interest expense.  All related operating or maintenance costs are charged to non-interest expense as incurred. Any subsequent gains or losses on the sale of OREO are recorded in other income or expense as incurred.

Heritage Oaks Bancorp | - 34 -

Appraisals for Collateral Dependent Loans

Once a loan has been funded, the Company has a policy to perform an annual review of the borrower’s financial condition and of any real estate securing the loan.  This review includes, among other things, a physical inspection of the real estate securing the loan, an analysis of any related rent rolls, an analysis of all borrower and guarantor tax returns and financial statements.  This information is used internally by the Company to validate all covenants and the risk grade assigned to the loan.  If during the review process the Company learns of additional information that would suggest that the value of the collateral may have declined from the original underwriting of the loan, or the most recent appraisal, an additional independent appraisal of the collateral is requested.  If based on the updated appraisal information it is determined the value of the collateral is impaired and the Company no longer expects to collect all previously determined amounts related to the loan as stipulated in the loan’s original agreement, the Company typically moves to establish a valuation allowance for such loans or charge-off such differences.

Once a loan is deemed to be impaired and/or the loan was downgraded to substandard status, the loan becomes the responsibility of the Company’s Special Assets Department, which provides more diligent oversight of problem credits.  This oversight includes, among other things, a review of all previous appraisals of collateral securing such loans and determining in the Company’s best judgment if those appraisals still represent the current fair value of the loan.  Additional appraisals may be ordered at this time if deemed necessary.

Securities Available for Sale

In accordance with U.S. GAAP, securities  are classified in three categories and accounted for as follows:  debt and mortgage-backed securities that the Company has the positive intent and ability to hold to maturity are classified as held-to-maturity and are measured at amortized cost; debt and equity securities bought and held principally for the purpose of selling in the near term are classified as trading securities and are measured at fair value, with unrealized gains and losses included in earnings; debt and equity securities not classified as either held-to-maturity or trading securities are deemed as available-for-sale and are measured at fair value, with unrealized gains and losses, net of applicable taxes, reported in a separate component of stockholders’ equity.   Where available, the fair values of available for sale securities are based on quoted market prices.  If quoted market prices are not available, fair values are extrapolated from the quoted prices of similar instruments or through the use of other observable data supporting a valuation model.  Gains or losses on sales of investment securities are determined on the specific identification method.  Premiums and discounts are amortized or accreted using the interest method over the expected lives of the related securities.

Declines in the fair value of individual held-to-maturity and available-for-sale securities, below their cost and that are other than temporary, result in write-downs of individual securities to their fair value.  The related write-downs are included in earnings as realized losses. In estimating other-than-temporary impairment losses, Management considers: (1) the length of time the security has been in an unrealized loss position, (2) the extent to which the security’s fair value is less than its cost, (3) the financial condition of the issuer, (4) any adverse changes in ratings issued by various rating agencies, (5) the intent and ability of the Company to hold such securities for a period of time sufficient to allow for any anticipated recovery in fair value and (6) in the case of mortgage related securities, current cash flows, credit enhancements, loan-to-values, credit scores, delinquency and default rates.

Goodwill and Other Intangible Assets

As discussed in the 2010 Annual Report, Note 1 of the consolidated financial statements, which was filed on Form 10-K, the Company assesses goodwill and other intangible assets each year for impairment.  The Company’s assessment at December 31, 2010, pursuant to its Goodwill Impairment Testing Policy, was performed with the assistance of an independent third party and resulted in no impairment.

Deferred Tax Assets

Deferred income taxes reflect the tax effect of temporary differences between the financial statement carrying amounts and the corresponding tax basis of assets and liabilities.  The Company uses an estimate of future earnings to support its position that the benefit of its deferred tax assets will be realized.  If future income should prove non-existent or less than the amount of the deferred tax assets within the tax years to which they may be applied, the asset may not be realized and a valuation allowance may be established and the Company’s net income will be reduced.  The Company initially performed an in-depth analysis of its deferred tax assets in the third quarter of 2010 to determine if the current carrying value would be realized in future periods, which resulted in a $10.5 million partial valuation allowance being established as of September 30, 2010.  In the fourth quarter of 2010, the Company updated its analysis and  determined that the valuation allowance should be reduced to approximately $7.1 million  as of December 31, 2010.  On a go-forward basis the Company will analyze its deferred tax assets and related valuation allowance on a quarterly basis, first by determining if actual results are tracking to projections utilized in the December 31, 2010 analysis and will perform more in-depth analysis if: a) actual results are not tracking to projected amounts, thereby suggesting that additional valuation allowance increases may be in order, or b) at such a time that reversal of the valuation allowance may be in order.  The analysis for the three and nine months ended September 30, 2011, did not result in any adjustment to the valuation allowance established in 2010.  Please see Note 6. Deferred Tax Assets of the consolidated financial statements, filed on this Form 10-Q for additional information related to its deferred tax assets and the related valuation allowance.

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Where You Can Find More Information

Under the Securities Exchange Act of 1934 Sections 13 and 15(d), periodic and current reports must be filed with the SEC. The Company electronically files the following reports with the SEC: Form 10-K (Annual Report), Form 10-Q (Quarterly Report), Form 8-K (Current Report), and Form DEF 14A (Proxy Statement). The Company may file additional forms. The SEC maintains an internet site, www.sec.gov, in which all forms filed electronically may be accessed. Additionally, all forms filed with the SEC and additional shareholder information is available free of charge on the Company’s website: www.heritageoaksbancorp.com.

The Company posts these reports to its website as soon as reasonably practicable after filing them with the SEC.  None of the information on or hyperlinked from the Company’s website is incorporated into this Quarterly Report on Form 10-Q.

Selected Financial Data

The table below provides selected financial data that highlights the Company’s quarterly performance results:

	For the quarters ended,
(dollars in thousands except per share data)	09/30/11		06/30/11		03/31/11		12/31/10		09/30/10			06/30/10			03/31/10			12/31/09
Return on average assets	0.85%		0.40%		0.22%		0.21%		-4.29%			-2.32%			-0.56%			-1.43%
Return on average equity	6.67%		3.10%		1.73%		1.67%		-32.20%			-17.35%			-5.70%			-15.27%
Return on average common equity	6.83%		2.37%		0.65%		0.10%		-40.70%			-55.46%			-10.93%			-22.05%
Average equity to average assets	12.80%		12.86%		12.51%		12.29%		13.32%			13.36%			9.88%			9.35%
Average common equity to average assets	10.30%		10.29%		10.00%		9.94%		10.88%			6.91%			6.57%			7.14%
Net interest margin	4.67%		4.80%		4.73%		4.58%		4.56%			4.69%			4.43%			4.81%
Efficiency ratio*	66.52%		68.78%		70.56%		73.84%		70.42%			59.38%			73.64%			68.31%
Average loans to average deposits	81.64%		85.76%		86.41%		85.42%		87.99%			91.82%			93.67%			93.45%
Net income / (loss)	$	2,119	$	954	$	522	$	517	$	(10,903	)	$	(5,835	)	$	(1,339	)	$	(3,416)
Net income / (loss) available to common shareholders	$	1,746	$	584	$	157	$	26	$	(11,260	)	$	(9,644	)	$	(1,690	)	$	(3,767)
Earnings / (loss) per common share:
Basic	$	0.07	$	0.02	$	0.01	$	—	$	(0.45	)	$	(0.86	)	$	(0.22	)	$	(0.48)
Diluted	$	0.07	$	0.02	$	0.01	$	—	$	(0.45	)	$	(0.86	)	$	(0.22	)	$	(0.48)
Weighted average outstanding shares:
Basic	25,054,027		25,050,584		25,035,012		25,004,697		25,004,479			11,250,989			7,717,194			7,704,060
Diluted	26,254,045		26,252,066		26,251,608		26,247,491		25,004,479			11,250,989			7,717,194			7,704,060

* The efficiency ratio is defined as total non interest expense as a percent of the combined net interest income plus non interest income, exclusive of gains and losses on securities sales, other than temporary impairment losses, gains and losses on sale of OREO and other OREO related costs, gain on extinguishment of debt and gains and losses on sale of fixed assets.

Results of Operations

Net Interest Income and Margin

Net interest income, the primary component of the net earnings of a financial institution, refers to the difference between the interest earned on loans and investments and the interest paid on deposits and borrowings.  The net interest margin is the amount of net interest income expressed as a percentage of average earning assets.  Factors considered in the analysis of net interest income are the composition and volume of earning assets and interest-bearing liabilities, the amount of non-interest bearing liabilities and non-accrual loans, and changes in market interest rates.

Heritage Oaks Bancorp | - 36 -

Forgone interest on non-accrual loans continues to be a strain on interest income though this trend is stabilizing due to the combined impacts of a deceleration of inflow of new non-accrual loans, reduction of non-accrual loans through loan sales, foreclosure and disposition of collateral and credit work-out processes.  Total forgone interest related to impaired loans, which includes (1) the initial accrued interest reversal when a loan is transferred to non-accrual status, (2) interest lost prospectively for the period of time a loan is on non-accrual status and (3) lost interest due to restructuring terms below original note terms or below current market-rate terms, was approximately $0.3 million and $0.8 million during the three months ended September 30, 2011 and 2010, respectively, and $1.5 million and $2.6 million for the nine months ended September 30, 2011 and 2010, respectively.

Our earnings are highly influenced by changes in short term interest rates.  The nature of our balance sheet can be summarily described as consisting of short duration assets and liabilities and it is slightly net liability sensitive. A large percentage of its interest sensitive assets and liabilities re-price immediately with changes in Federal Funds and other capital markets’ interest rates.  However, over the last three years interest rates have fallen to unprecedented levels and as a result a significant portion of loans in our loan portfolio are currently at their floors.

Given that current interest rates are considerably lower than most floors in the loan portfolio, we would need to see a notable rise in interest rates before the overall yield on the portfolio would begin to rise.  Additionally, as a result of promotions over the last two years designed to attract lower cost core deposits, we were able to significantly increase the level of floating rate liabilities in the form of money market and short term certificate accounts, bringing the balance sheet to its current slightly liability sensitive position, regarding interest rate sensitivity.  This tactic was instrumental in mitigating substantial year over year declines in the net interest margin as a result of dramatic declines in the overnight Federal Funds and other capital market rates during 2008, which are still in place as of September 30, 2011.  Given our current slightly liability sensitive position, an upward movement in interest rates will result in a reduction in net interest income until such time as interest rates related to our variable-rate priced loans move back above their floor rates.  At such time as the loan rates, for a substantial portion of the loan portfolio, move above their floors our balance sheet should return to its more traditional net asset sensitive profile, all other things being equal.  During 2011, we restructured our balance sheet by locking in more term FHLB borrowings, which independent of other shifts, should partially mitigate the current net liability sensitive profile.  See Item 3. Qualitative and Quantitative Disclosures About Market Risk included in this report on Form 10-Q for further discussion of the Company’s sensitivity to interest rate movements based on our current net liability sensitive profile.

For the three months ended September 30, 2011 and September 30, 2010, the net interest margin was 4.67% and 4.56%, respectively.  This represents an increase of 11 basis points when compared to that reported for the same period ended a year earlier.  For the nine months ended September 30, 2011 and September 30, 2010, the net interest margin was 4.73% and 4.56%, respectively.  This represents an increase of 17 basis points when compared to that reported for the same period ended a year earlier.

Decreases in funding costs were the primary driver for the year over year increase in the net interest margin for both the three and nine months ended September 30, 2011.  However, this was partially offset by a moderate decline in asset yields during the first nine months of 2011 primarily related to a modest shift in earning asset mix from loans to investment securities and continued downward pressure on interest rates on new loans funded and investments purchased.

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The tables below set forth average balance sheet information, interest income and expense, average yields and rates and net interest income and margin for the three months ended September 30, 2011 and 2010.  The average balance of non-accruing loans has been included in loan totals:

	For the three months ending					For the three months ending
	September 30, 2011					September 30, 2010
			Yield/	Income/				Yield/	Income/
(dollars in thousands)	Balance		Rate (3)	Expense		Balance		Rate (3)	Expense
Interest Earning Assets:
Investments with other banks	$	33	2.64%	$	-	$	119	1.41%	$	-
Interest bearing due from banks	16,368		0.17%	7		32,708		0.24%	20
Federal funds sold	-		0.00%	-		5,500		0.11%	1
Investment securities taxable	208,415		2.87%	1,509		178,833		3.29%	1,483
Investment securities non taxable	38,355		3.95%	382		28,080		4.15%	294
Loans (1)	659,443		6.12%	10,174		697,053		6.21%	10,908
Total interest earning assets	922,614		5.19%	12,072		942,293		5.35%	12,706
Allowance for loan losses	(21,530)					(21,814)
Other assets	83,012					88,315
Total assets	$	984,096				$	1,008,794
Interest Bearing Liabilities:
Interest bearing demand	$	64,063	0.12%	$	20	$	66,885	0.27%	$	45
Savings	36,337		0.12%	11		27,701		0.16%	11
Money market	270,596		0.48%	330		287,389		0.90%	649
Time deposits	210,154		1.35%	713		229,961		1.72%	996
Total interest bearing deposits	581,150		0.73%	1,074		611,936		1.10%	1,701
Federal Home Loan Bank borrowing	31,810		1.27%	102		63,370		0.73%	116
Junior subordinated debentures	8,248		1.97%	41		8,248		2.26%	47
Total borrowed funds	40,058		1.42%	143		71,618		0.90%	163
Total interest bearing liabilities	621,208		0.78%	1,217		683,554		1.08%	1,864
Non interest bearing demand	226,595					180,284
Total funding	847,803		0.57%	1,217		863,838		0.86%	1,864
Other liabilities	10,291					10,602
Total liabilities	$	858,094				$	874,440
Stockholders’ Equity:
Total stockholders’ equity	126,002					134,354
Total liabilities and stock holder’s equity	$	984,096				$	1,008,794
Net interest income				$	10,855				$	10,842
Net interest margin (2)			4.67%					4.56%

(1) Nonaccrual loans have been included in total loans.

(2) Net interest margin has been calculated by dividing the net interest income by total average earning assets.

(3) Yield / Rate is annualized using actual number of days in period.

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The tables below set forth average balance sheet information, interest income and expense, average yields and rates and net interest income and margin for the nine months ended September 30, 2011 and 2010.  The average balance of non-accruing loans has been included in loan totals:

	For the nine months ended					For the nine months ended
	September 30, 2011					September 30, 2010
			Yield/	Income/				Yield/	Income/
(dollars in thousands)	Balance		Rate (4)	Expense		Balance		Rate (4)	Expense
Interest Earning Assets:
Investments with other banks	$	77	1.74%	$	1	$	119	1.12%	$	1
Interest bearing due from banks	16,337		0.20%	24		41,216		0.23%	72
Federal funds sold	936		0.00%	-		4,070		0.10%	3
Investment securities taxable	185,547		2.83%	3,922		149,588		3.57%	3,989
Investment securities non taxable	39,535		3.84%	1,136		22,956		4.60%	789
Loans (1) (2)	670,710		6.21%	31,132		717,571		6.24%	33,478
Total interest earning assets	913,142		5.30%	36,215		935,520		5.48%	38,332
Allowance for loan losses	(23,702)					(20,362)
Other assets	84,994					79,515
Total assets	$	974,434				$	994,673
Interest Bearing Liabilities:
Interest bearing demand	$	64,362	0.16%	$	79	$	72,987	0.58%	$	315
Savings	32,020		0.15%	37		27,659		0.27%	55
Money market	274,112		0.51%	1,055		277,954		1.07%	2,219
Time deposits	219,764		1.43%	2,350		232,465		1.89%	3,281
Total interest bearing deposits	590,258		0.80%	3,521		611,065		1.28%	5,870
Other secured borrowing	-		0.00%	-		595		4.94%	22
Federal Home Loan Bank borrowing	38,783		0.93%	271		64,451		0.64%	308
Junior subordinated debentures	8,248		2.03%	125		11,231		2.42%	203
Total borrowed funds	47,031		1.13%	396		76,277		0.93%	533
Total interest bearing liabilities	637,289		0.82%	3,917		687,342		1.25%	6,403
Non interest bearing demand	202,936					176,401
Total funding	840,225		0.62%	3,917		863,743		0.99%	6,403
Other liabilities	10,225					9,265
Total liabilities	$	850,450				$	873,008
Stockholders’ Equity:
Total stockholders’ equity	123,984					121,665
Total liabilities and stockholders’ equity	$	974,434				$	994,673
Net interest income				$	32,298				$	31,929
Net interest margin (3)			4.73%					4.56%

(1)	Nonaccrual loans have been included in total loans.
(2)	Loan fees of $306 and $496 for the nine months ending September 30, 2011 and 2010, respectively have been included in interest income computation.
(3)	Net interest margin has been calculated by dividing the net interest income by total average earning assets.
(4)	Yield / Rate is annualized using actual number of days in period.

For the three and nine months ended September 30, 2011, average interest earning assets were $19.7 million and $22.4 million, respectively, lower than that reported over the same periods a year earlier.  The primary driver behind the decrease in average interest earning assets for the three and nine months ended September 30, 2011 was the $37.6 million and $46.9 million, respectively, decrease in average loan balances and a $16.3 million and $24.9 million, respectively, decrease in interest bearing due from bank balances as compared to the same periods a year earlier.  These declines were only partially offset by growth in the Company’s securities portfolio for the three and nine months ended September 30, 2011, which increased by $39.9 million and $52.5 million, respectively, as compared to corresponding periods in 2010.

The yield on earning assets for the three and nine months ended September 30, 2011 was 5.19% and 5.30%, respectively compared to 5.35% and 5.48% for corresponding periods last year.  The primary driver in the decline in yield on earning assets was the shift in asset mix away from traditionally higher yielding loans to securities.  Compounding the decline in yield was a 74 basis point drop in taxable securities yields from 3.57% in the first nine months of 2010 to 2.83% for the first nine months of 2011, due to the continued downward pressure on capital markets’ interest rates for invested funds.

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The yield on the loan portfolio for the three months ended September 30, 2011 decreased 9 basis points to 6.12% from the corresponding period in 2010.  For the nine months ended September 30, 2011, the yield on the loan portfolio was 6.21% which was a decline of 3 basis points from that reported for the same period ended a year earlier.  The declines for both the three and nine month periods were largely attributable to changes in the mix of loans to lower yielding loan types and to declines in market interest rates on new loans issued and loans renewed in the last year, partially offset by a decline in the level of foregone interest from $0.8 million to $0.3 million for the three month period and from $2.6 million to $1.5 million for the nine month period.  The improvement in the impacts of foregone interest during the nine months ended September 30, 2011 was partially offset by changes in the mix of loans to lower yielding loan types and to declines in market interest rates on new loans issued and loans renewed in the last year. Total forgone interest reduced the yield on the loan portfolio by 22 basis points for the third quarter of 2011 and 42 basis points for the corresponding period in 2010. Total forgone interest reduced the yield on the loan portfolio by 30 basis points for the first nine months of 2011 and 54 basis points for the corresponding period in 2010.

Over the past two years, new loan originations have slowed due in part to a decline in loan demand and in part due to the impact of tighter underwriting standards resulting in fewer loans that meet our underwriting criteria in the current economic environment.  As a result, in an effort to maximize the yield on interest earning assets in the absence of significant new loan originations, we have been investing excess liquidity primarily in shorter-termed, agency mortgage backed securities, municipal securities and more recently in short to intermediate duration corporate bonds.  These purchases account for the majority of the year over year increase in the average balance of the investment portfolio and the decline in the overall yield of taxable investment securities as they currently yield considerably less than other investments in the portfolio.  These relatively short term investments have allowed the Company to maximize yields on excess liquidity, while ensuring adequate cash flow to support potential loan growth in future periods.

The average balance of interest bearing liabilities was $62.3 million and $50.1 million lower for the three and nine months ended September 30, 2011, respectively, than that reported for the same periods a year earlier.  Year over year decreases in the average balance of interest bearing liabilities can be attributed in large part to time deposits and Federal Home Loan Bank borrowings.  We attribute the decrease in time deposits in part to migration to other interest bearing account categories, such as savings as our customers evaluate their options to maximize their returns on their invested cash in the current depressed interest rate market.  Second, the decrease in Federal Home Loan Bank borrowings can be attributed to planned reductions in borrowings driven both by the need for less borrowed funds due to the large flow of funds into our deposit portfolio over 2009 and the earlier part of 2010, as well as the funds derived from our March 2010 capital raise.

The yield on interest bearing deposits declined by 37 basis points, to 0.73% for the three months ended September 30, 2011 and 48 basis points, to 0.80% for the nine months ended September 30, 2011 as compared to the same periods a year earlier.  These significant declines are in part due to the historically low interest rate environment, which existed throughout 2010 and the first nine months of 2011, but are also due to our efforts to systematically lower our cost of deposits throughout 2010 and particularly during the fourth quarter of 2010 and first nine months of 2011.  Such efforts have contributed to a moderate decline in interest bearing deposit accounts, and time deposits.  However, the overall composition and cost of our deposit portfolio has greatly improved as a result of this strategy.

In addition, while on a comparative basis we have experienced a decline in interest bearing deposits for the first nine months of 2011 as compared to the same period a year earlier, our average non-interest bearing demand deposit balances have increased on a comparative basis by $46.3 million to $226.6 million for the quarter ended September 30, 2011 from $180.3 million for the same period ended a year earlier.  The average non-interest bearing demand deposits for the nine months ended September 30, 2011, increased $26.5 million to $202.9 million, when compared to the same period in 2010.  This increase in non-interest bearing demand balances has served to significantly reduce our overall cost of funds, thereby decreasing such by 21 basis points and 20 basis, for the three and nine months ended September 30, 2011, respectively, as compared to the cost of our interest bearing liabilities alone. Management believes that the increase in non-interest bearing demand deposits is indicative of money being held in highly liquid accounts pending the customer’s determination of how best to invest the funds in light of today’s low returns on traditional investments.  As such, it is difficult to determine how long the increased levels of non-interest bearing demand deposits will remain at or near the current levels and therefore how long we will benefit from this low cost source of funds. Our total cost of funds for the three months ended September 30, 2011 was 0.57%, a decrease of 29 basis points as compared to the same period ended a year earlier when our total cost of funds was 0.86%.  For the nine months ended September 30, 2011, our total cost of funds was 0.62%, a decrease of 37 basis points as compared to the same period ended a year earlier when our total cost of funds was 0.99%.

For the three and nine months ended September 30, 2011 the average rate paid on interest bearing liabilities was 0.78% and 0.82%, respectively, as compared to 1.08% and 1.25%, respectively, for the corresponding periods in 2010.  The year over year declines can be attributed in large part to the deposit portfolio rate reductions previously discussed, but also to decreases in higher cost funds such as junior subordinated debentures. These declines were partially offset by an increase in funding costs for the Federal Home Loan Bank borrowings due to a strategy to lock in historical low rates on longer term borrowings as compared to the Company’s traditional reliance on a heavier mix of lower cost short-term borrowings.

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The volume and rate variances table below sets forth the dollar difference in interest earned and paid for each major category of interest-earning assets and interest-bearing liabilities for the three and nine month periods ended September 30, 2011 over the same periods ended in 2010, and the amount of such change attributable to changes in average balances (volume) or changes in average yields and rates:

	For the three months ended									For the nine months ended
	September 30, 2011 over 2010									September 30, 2011 over 2010
(dollars in thousands)	Volume			Rate			Total				Volume			Rate			Total
Interest Income:
Investments with other banks	$	-		$	-		$	-			$	-		$	-		$	-
Interest bearing due from banks	(8		)	(5		)	(13		)		(38		)	(10		)	(48		)
Federal funds sold	(1		)	-			(1		)		(1		)	(2		)	(3		)
Investment securities taxable	227			(201		)	26				852			(919		)	(67		)
Investment securities non-taxable (1)	156			(22		)	134				747			(221		)	526
Taxable equivalent adjustment (1)	(53		)	7			(46		)		(254		)	75			(179		)
Loans	(580		)	(154		)	(734		)		(2,176		)	(170		)	(2,346		)
Net decrease	(259		)	(375		)	(634		)		(870		)	(1,247		)	(2,117		)
Interest expense:
Savings, NOW, money market	(19		)	(325		)	(344		)		(54		)	(1,364		)	(1,418		)
Time deposits	(81		)	(202		)	(283		)		(171		)	(760		)	(931		)
Other secured borrowings	2			(2		)	-				(11		)	(11		)	(22		)
Federal Home Loan Bank borrowing	(75		)	61			(14		)		(149		)	112			(37		)
Junior subordinated debentures	-			(6		)	(6		)		(48		)	(30		)	(78		)
Net decrease	(173		)	(474		)	(647		)		(433		)	(2,053		)	(2,486		)
Total net increase / (decrease)	$	(86	)	$	99		$	13			$	(437	)	$	806		$	369

(1) Adjusted to a fully taxable equivalent basis using a tax rate of 34%.

Provision for Loan Losses

As more fully discussed in Note 4 of the notes to the condensed consolidated financial statements in this Form 10-Q, the allowance for loan losses has been established by Management in order to provide for those loans, which for a variety of reasons, may not be repaid in their entirety.  The allowance is maintained at a level considered by Management to be adequate to provide for probable losses during the holding period of the loan and is based on methodologies applied on a consistent basis with the prior year.  Management’s review of the adequacy of the allowance includes, among other things, an analysis of past loan loss experience and Management’s evaluation of the loan portfolio under current economic conditions.

The allowance for loan losses is based on estimates, and ultimate losses will vary from current estimates. The Company recognizes that credit losses will be experienced and the risk of loss will vary with, among other things: general economic conditions; the type of loan being made; the creditworthiness of the borrower over the term of the loan and in the case of a collateralized loan, the quality of the collateral for such loan.  The allowance for loan losses represents the Company’s best estimate of the allowance necessary to provide for probable estimable losses in the portfolio as of the balance sheet date.

The Company’s provision for loan losses was $1.1 million and $5.4 million for the three and nine months ended September 30, 2011, respectively.  This represents a decrease of $3.3 million and $20.3 million as compared to that reported in the same periods last year.  The Company believes that the decrease in the provisions for loan losses can be attributed to: 1) a deceleration in the amount of required provisions due to efforts taken to date to identify and address potential credit issues, 2) a decrease in the amount of classified and non-performing loans through structured problem loan sales executed in the first nine months of 2011, 3) enhanced procedures around the issuance of new credit over the last couple of years and 4) early signs that the local economy may be stabilizing after a prolonged period of recession and stagnant recovery, based on recent reports on improved unemployment levels and modest upward trends in commercial real estate leasing activity.  As of September 30, 2011, the Company’s allowance for loan losses represented 3.15% of total gross loans and 156% of loans identified as non-performing.  For additional information see the “Allowance for Loan Losses” discussion in the Financial Condition section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Heritage Oaks Bancorp  | - 41 -

Non-Interest Income

The table below set forth changes in non-interest income for the three and nine month periods ended September 30, 2011 compared to the same periods ended in 2010:

	For the three months ended						For the nine months eded						Variances					Variances
	September 30,						September 30,						For the three months					For the nine months
(dollar amounts in thousands)	2011			2010			2011			2010			dollar			percentage		dollar			percentage
Fees and service charges	$	659		$	581		$	1,820		$	1,820		$	78		13.4	%	$	-		0.0	%
Mortgage gain on sale and origination fees	734			1,027			1,750			2,278			(293		)	-28.5	%	(528		)	-23.2	%
Debit/credit card fee income	430			386			1,211			1,052			44			11.4	%	159			15.1	%
Earnings on bank owned life insurance	147			143			444			437			4			2.8	%	7			1.6	%
Other than temporary impairment (OTTI) losses on investment securities:
Total impairment loss on investment securities	-			(650		)	-			(650		)	650			-97.8	%	650			-91.7	%
Non credit related losses recognized in other comprehensive income	-			544			-			544			(544		)	-97.4	%	(544		)	-90.1	%
Net impairment losses on investment securities	-			(106		)	-			(106		)	106			-100.0	%	106			-100.0	%
Gain / (loss) on sale of investment securities	595			807			1,187			710			(212		)	-26.3	%	477			67.2	%
(Loss) / gain on sale of other real estate owned	(266		)	(28		)	(587		)	34			(238		)	850.0	%	(621		)	-1826.5	%
Gain on extinguishment of debt	-			-			-			1,700			-			0.0	%	(1,700		)	-100.0	%
Other Income	258			93			691			627			165			177.4	%	64			10.2	%
Total	$	2,557		$	2,903		$	6,516		$	8,552		$	(346	)	-11.9	%	$	(2,036	)	-23.8	%

Non-interest income totaled $2.6 million and $6.5 million for the three and nine months ended September 30, 2011, respectively, and represented a decline of $0.3 million and $2.0 million, respectively, when compared to the prior year.  The decline in non-interest income for the three months ended September 30, 2011 was largely due to a decline in the level of gains and fees on mortgage loan sales, as well as gains realized on the sale of investment securities and increased losses on the increased OREO sales activity in 2011, as compared to the corresponding period in 2010.  The primary driver which contributed to the year-to-date decrease of non-interest income was the one-time $1.7 million gain in 2010 related to the retirement of junior subordinated debentures. The year-to-date period was also impacted to a lesser degree by losses on the sale of foreclosed assets, which increased by $0.6 million for nine month period.

Non-Interest Expenses

The tables below set forth changes in non-interest expenses for the three and nine month periods ended September 30, 2011 compared to the same periods ended in 2010:

	For the three months ended				For the nine months eded				Variances					Variances
	September 30,				September 30,				For the three months					For the nine months
(dollar amounts in thousands)	2011		2010		2011		2010		dollar			percentage		dollar			percentage
Salaries and employee benefits	$	4,434	$	5,195	$	13,371	14,374		$	(761	)	-14.6	%	$	(1,003	)	-7.0	%
Equipment	399		433		1,327		1,131		(34		)	-7.9	%	196			17.3	%
Occupancy	888		966		2,768		2,840		(78		)	-8.1	%	(72		)	-2.5	%
Promotional	156		173		491		525		(17		)	-9.8	%	(34		)	-6.5	%
Data processing	801		497		2,253		1,832		304			61.2	%	421			23.0	%
OREO related costs	162		168		556		430		(6		)	-3.6	%	126			29.3	%
Write-downs of foreclosed assets	89		651		968		867		(562		)	-86.3	%	101			11.6	%
Regulatory assessment costs	503		669		1,834		1,971		(166		)	-24.8	%	(137		)	-7.0	%
Audit and tax advisory costs	188		143		514		428		45			31.5	%	86			20.1	%
Directors fees	102		132		338		388		(30		)	-22.7	%	(50		)	-12.9	%
Outside services	296		412		1,035		1,247		(116		)	-28.2	%	(212		)	-17.0	%
Telephone / communications costs	89		99		268		260		(10		)	-10.1	%	8			3.1	%
Amortization of intangible assets	96		128		356		385		(32		)	-25.0	%	(29		)	-7.5	%
Stationery and supplies	87		114		294		343		(27		)	-23.7	%	(49		)	-14.3	%
Other general operating costs	760		490		1,724		1,393		270			55.1	%	331			23.8	%
Total	$	9,050	$	10,270	$	28,097	$	28,414	$	(1,220	)	-11.9	%	$	(317	)	-1.1	%

Below is a discussion of the more significant changes in the components of non-interest expense.

Salaries and Employee Benefits

The declines in salaries and employee benefits for the three and nine months ended September 30, 2011, as compared to the corresponding periods in 2010, is largely due to reductions in commission expense related to mortgage underwriting as part of new compensation plans put in place in 2011 of $0.2 million for both the three and nine months periods, a reduction of $0.4 million due to the establishment of an accrual for compensated absences during the third quarter of 2010 and reductions in other benefit costs of $0.1 million and $0.2 million for the three and nine month periods.

Heritage Oaks Bancorp  | - 42 -

Equipment Expense

The $0.2 million increase within equipment expense for the nine months ended September 30, 2011, as compared to the corresponding period in 2010, is primarily due to upgrades in certain software licenses and systems, as well as maintenance costs on the Company’s ATM network.

Occupancy Expense

The $0.1 million decrease in occupancy expense for the three and nine months ended September 30, 2011 is largely due to declines in property tax expense due to the receipt of partial refunds of previously paid taxes as a result of petitioning the local tax authorities to reassess the Company’s leased and owned properties to reflect the decline in market value of real estate on the Central Coast.

Data Processing Expense

The $0.3 million and $0.4 million increase in data processing expenses for the three and nine months ended September 30, 2011, respectively, is largely due to costs attributable to expanded service offerings for our E-banking systems, including new online banking, telephone banking and mobile banking systems, back office automation software, and increased data analytics software all implemented via the Company’s core processing and electronic banking systems over the last year.

OREO Related Costs

The $0.1 million increase in OREO related costs for the nine months ended September 30, 2011, as compared to the corresponding period in 2010, is largely due to an increase in the level of property taxes paid on the OREO holdings in the second quarter of 2011, due both to the nature of the properties held and as a result of settling certain delinquent taxes owed by the prior owners of the properties upon the transfer of ownership to the Bank.

Write-downs of Foreclosed Assets

For the three months ended September 30, 2011, write-downs of foreclosed assets decreased approximately $0.6 million from that reported in the same period last year.  The decrease in the quarterly level of write-downs was primarily due to a significant level of revaluations done in the third quarter of 2010 and the first half of 2011, which indicated further impairment in asset values.  On a year-to-date basis, of write-downs made on foreclosed assets increased $0.1 million as a result of write-downs in the first half of 2011 due to the receipt of new market data on certain OREO assets held for sale, including sales contracts, which suggested that further declines in value had occurred since the assets had been transferred into the OREO pool.

Regulatory Assessment Expense

The decline in regulatory assessments of $0.2 million and $0.1 million for the three and nine months ended September 30, 2011, respectively, as compared to the corresponding periods in 2010 is largely due to changes to the assessment calculation, which went into effect in 2011.

Other General Operating Costs

The increase in other general operating costs is primarily due to provisions taken for loss contingencies related to mortgages previously sold, for which the buyer has claimed there was a deficiency in the underwriting process that resulted in a loss to the buyer.

Provision for Income Taxes

For the three and nine month periods ended September 30, 2011, the Company recorded income tax expense of approximately $1.2 million and $1.8 million, respectively.  This compares to $10.0 million and $4.4 million of income tax expense recorded for the same periods ended in 2010.  The year over year variances for both the three and nine months ended September 30, 2011 can be attributed to the Company’s establishment of a $10.5 million partial valuation allowance against the Company’s deferred tax assets in 2010.  The Company’s effective tax rate was 35.3% and 32.8% for the three and nine months ended September 30, 2011.  The effective tax rate for the first nine months of 2011 is the result of permanent items, such as tax free interest on municipal securities, representing a relatively larger portion of the Company’s pretax income, as the Company returns to profitability.  The effective tax rates for the same periods ended a year earlier, which were directly impacted by the $10.5 million valuation allowance established in the third quarter of 2010, were provisions of 1,078.7% and 32.6%, respectively.

Heritage Oaks Bancorp  | - 43 -

Financial Condition

At September 30, 2011, total assets were approximately $983.1 million.  This represents an increase of approximately $0.5 million or less than 0.1% over that reported at December 31, 2010.  The increase in total assets is primarily attributable to the $28.8 million increase in cash and investment securities due to proceeds from the repayment and sale of net loans, which declined $24.2 million.  In addition to the decline in loans, the increase in cash and investments was offset by a $4.5 million decline in other real estate owned due to sales of several properties during 2011.

At September 30, 2011, total deposits were approximately $801.7 million or approximately $3.5 million higher than that reported at December 31, 2010.  The increase in deposits was tied to increases in non-interest bearing deposits, which were partially offset by declines in all types of interest bearing deposits.  The increase in the non-interest bearing deposits was attributable to large inflows of cash near the end of the second quarter, which have remained on deposit with the Bank.  The Company believes the decline in interest bearing deposits can be attributed to customers who are looking for higher yields moving out of the traditionally more conservative investment vehicles offered by the Bank, into higher risk/higher yield investments outside the bank, such as the stock market.

Loans

Impact of Market Condition on Lending

Despite the recent signs of some stabilization in the local economic conditions loan demand remains soft, which has been the primary factor in the contraction in the loan portfolio during 2010 and the first nine months of 2011.  The secondary factor that has contributed to 2011 declines in net loans is the problem loan sales which have occurred over the first three quarters of the year.  Although the Company believes that it may be starting to see some signs of stabilization in the local economy in which it operates, the Company realizes that a renewed decline in the national, state and local economies may further impact local borrowers, as well as the values of real estate within our market footprint used to secure certain loans. As such, Management continues to closely monitor credit within the Company’s commercial and commercial real estate segments of the loan portfolio for additional signs of deterioration. The Bank employs stringent lending standards and remains very selective with regard to loan originations, including commercial real estate, real estate construction, land and commercial loans that it chooses to originate, in an effort to effectively manage risk in this difficult credit environment. The Company has devoted considerable resources to monitoring credit in order to take appropriate steps when and if necessary to mitigate any material adverse impacts on the Company.

Credit Quality

The Company’s primary business is the extension of credit to individuals and businesses and safekeeping of customers’ deposits. The Company’s policies concerning the extension of credit require risk analyses including an extensive evaluation of the purpose for the loan request and the borrower’s ability and willingness to repay the Bank as agreed. The Company also considers other factors when evaluating whether or not to extend new credit to a potential borrower. These factors include the current level of diversification in the loan portfolio and the impact that funding a new loan will have on that diversification, legal lending limit constraints, current concentrations of credit and any regulatory limitations concerning the extension of certain types of credit.

The credit quality of the loan portfolio is impacted by numerous factors including the economic environment in the markets the Company operates, which can have a direct impact on the value of real estate securing collateral dependent loans. Weak economic conditions have also impacted certain borrowers the Company has extended credit to, making it difficult for those borrowers to continue to make timely repayment on their loans. An inability of certain borrowers to continue to perform under the original terms of their respective loan agreements in conjunction with declines in real estate collateral values may result in increases in provisions for loan losses that have an adverse impact on the Company’s operating results.

See also Note 3, Loans, of the condensed consolidated financial statements, filed on this Form 10-Q, for a more detailed discussion concerning credit quality, including the Company’s related policy.

Heritage Oaks Bancorp  | - 44 -

Summary of Loan Portfolio

At September 30, 2011, total gross loan balances were $648.2 million.  This represents a decline of approximately $29.1 million or 4.3% from the $677.3 million reported at December 31, 2010.  The current year decline in total gross loans was most significantly impacted by $20.1 million in problem loan sales.  Loan pay-downs, charge-offs and transfers to foreclosed collateral associated with the work through of certain problem credits, were only partially offset by new loans issued during the period.

The following table provides a summary of year to date variances in the loan portfolio as of September 30, 2011:

	September 30,		December 31,		Variance
(dollars in thousands)	2011		2010		dollar			percentage
Real Estate Secured
Multi-family residential	$	15,931	$	17,637	$	(1,706	)	-9.67	%
Residential 1 to 4 family	21,418		21,804		(386		)	-1.77	%
Home equity line of credit	30,388		30,801		(413		)	-1.34	%
Commercial	363,486		348,583		14,903			4.28	%
Farmland	10,432		15,136		(4,704		)	-31.08	%
Total real estate secured	441,655		433,961		7,694			1.77	%
Commercial
Commercial and industrial	134,048		145,811		(11,763		)	-8.07	%
Agriculture	15,864		15,168		696			4.59	%
Other	101		153		(52		)	-33.99	%
Total commercial	150,013		161,132		(11,119		)	-6.90	%
Construction
Single family residential	11,513		11,525		(12		)	-0.10	%
Single family residential - Spec.	250		2,391		(2,141		)	-89.54	%
Tract	-		-		-			0.00	%
Multi-family	1,687		2,218		(531		)	-23.94	%
Hospitality	-		-		-			0.00	%
Commercial	7,107		27,785		(20,678		)	-74.42	%
Total construction	20,557		43,919		(23,362		)	-53.19	%
Land	29,130		30,685		(1,555		)	-5.07	%
Installment loans to individuals	6,644		7,392		(748		)	-10.12	%
All other loans (including overdrafts)	195		214		(19		)	-8.88	%
Total gross loans	648,194		677,303		(29,109		)	-4.30	%
Deferred loan fees	1,210		1,613		(403		)	-24.98	%
Reserve for loan losses	20,409		24,940		(4,531		)	-18.17	%
Total net loans	$	626,575	$	650,750	$	(24,175	)	-3.71	%
Loans held for sale	$	13,130	$	11,008	$	2,122		19.28	%

Heritage Oaks Bancorp  | - 45 -

Real Estate Secured

The following table provides a break-down of the real estate secured segment of the Company’s loan portfolio as of September 30, 2011:

	September 30, 2011							Percent of Bank			Single
			Undisbursed		Total Bank		Percent	Total Risk		Number	Largest
(dollar amounts in thousands)	Balance		Commitment		Exposure		Composition	Based Capital		of Loans	Loan (1)
Real Estate Secured
Retail	$	41,801	$	346	$	42,147	9.1%	35.8	%	52	$	5,000
Professional	57,747		148		57,895		12.5%	49.2	%	86	10,000
Hospitality	102,042		725		102,767		22.1%	87.3	%	45	10,692
Multi-family	15,931		-		15,931		3.4%	13.5	%	20	3,128
Home equity lines of credit	30,388		19,891		50,279		10.8%	42.7	%	327	1,340
Residential 1 to 4 family	21,418		359		21,777		4.7%	18.5	%	62	2,400
Farmland	10,432		470		10,902		2.3%	9.3	%	18	2,693
Healthcare / medical	26,430		-		26,430		5.7%	22.4	%	32	7,500
Restaurants / hospitality	8,070		-		8,070		1.7%	6.9	%	12	2,541
Commercial	115,248		576		115,824		25.0%	98.2	%	125	6,720
Other	12,148		163		12,311		2.7%	10.5	%	20	2,100
Total real estate secured	$	441,655	$	22,678	$	464,333	100.0%	394.3	%	799	$	10,692

(1) Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of September 30, 2011.

As of September 30, 2011, real estate secured balances, exclusive of construction and land loans discussed separately below, represented approximately $441.7 million or 68.1% of total gross loans.  When compared to that reported at December 31, 2010, this represents an increase of approximately $7.7 million or 1.8%.  The primary factor behind the year to date increase can be attributed to the increase in the commercial component of the real estate secured segment due to transfers from the construction segment upon project completion and new loans issued, net of pay downs, totaling $36.9 million, which were partially offset by a $15.9 million reduction due to the problem loan sales, $2.6 million of loans transferred to OREO and $3.5 million in loan charge-offs on non-performing loans, during the first nine months of 2011.  The increase in secured commercial loans was partially offset by declines in farmland loans due to the pay-off of a large loan and other net pay-downs totaling $4.5 million, and in residential 1-4 loans due in part to the sale of a $0.2 million loan as part of the problem loan sales in 2011, while the balance of the year to date change was due to pay downs, net of new loans issued during 2011.  In addition, home equity lines of credit declined approximately $0.4 million due to charge-offs and transfers to OREO totaling $0.7 million, partially offset by new net line draws of $0.6 million.

At September 30, 2011, real estate secured balances, including undisbursed commitments, represented 394.3% of the Bank’s total risk-based capital, compared to the 412.4% reported at December 31, 2010. The decrease in this ratio can be attributed to the year-to-date improvement in risk free capital, due to year-to-date earnings in 2011.

At September 30, 2011, approximately $161.8 million or 36.6% of the real estate secured segment of the loan portfolio was considered owner occupied.

The Company has generally seen an increase in the capitalization rates (the rate at which a stream of cash flows is discounted to find their present value when valuing commercial properties) in our primary market area for the last three years. This increasing trend in capitalization rates would indicate that we are seeing pressure on commercial real estate prices within our market, primarily resulting from weakened economic conditions.

Heritage Oaks Bancorp  | - 46 -

Commercial

The following table provides a break-down of the commercial and industrial (“C&I”) segment of the Company’s commercial loan portfolio as of September 30, 2011:

	September 30, 2011								Percent of Bank			Single
			Undisbursed		Total Bank		Percent		Total Risk		Number	Largest
(dollar amounts in thousands)	Balance		Commitment		Exposure		Composition		Based Capital		of Loans	Loan (1)
Commercial and Industrial
Agriculture	$	2,676	$	2,984	$	5,660	2.8	%	4.8	%	32	$	2,000
Oil gas and utilities	1,577		954		2,531		1.2	%	2.1	%	5	988
Construction	20,357		18,572		38,929		19.0	%	33.1	%	158	5,438
Manufacturing	13,242		8,448		21,690		10.6	%	18.4	%	95	1,675
Wholesale and retail	10,114		5,689		15,803		7.7	%	13.4	%	117	1,174
Transportation and warehousing	2,222		508		2,730		1.3	%	2.3	%	37	596
Media and information services	3,876		902		4,778		2.3	%	4.1	%	24	1,662
Financial services	6,282		2,434		8,716		4.3	%	7.4	%	44	1,000
Real estate / rental and leasing	18,591		10,309		28,900		14.1	%	24.5	%	105	3,500
Professional services	18,493		8,919		27,412		13.4	%	23.3	%	163	2,845
Healthcare / medical	11,948		7,258		19,206		9.4	%	16.3	%	112	11,464
Restaurants / hospitality	20,570		3,103		23,673		11.5	%	20.1	%	94	6,000
All other	4,100		920		5,020		2.4	%	4.3	%	75	1,200
Commercial and industrial	$	134,048	$	71,000	$	205,048	100.0	%	174.1	%	1,061	$	11,464

(1) Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of September 30, 2011.

At September 30, 2011, commercial and industrial loans represented approximately $134.0 million or 20.7% of total gross loan balances.  This represents a decline of approximately $11.8 million or 8.1%.  The year to date decline can be attributed to pay-downs and payoffs, net of new advances, across all loan types within the segment, which totaled $7.4 million in the first nine months of 2011, the impacts of the loan sales during the first nine months of the year which resulted in a $0.4 million reduction in commercial and industrial loan balances, as well as charge-offs totaling approximately $4.0 million during the first nine months of 2011.  As a result of these factors, the ratio of total commercial and industrial loan balances, including undisbursed commitments to risk-based capital, declined from 195.1% at December 31, 2010 to 174.1% at September 30, 2011. The Company’s credit exposure within the C&I segment remains diverse with respect to the industries, to which that credit has been extended.

Agriculture

At September 30, 2011, agriculture balances totaled approximately $15.9 million or 2.5% of total gross loan balances, which represents an approximate $0.7 million increase when compared to that reported at December 31, 2010.  At September 30, 2011 and December 31, 2010, agriculture balances represented 13.5% and 13.6%, respectively, of the Bank’s total risk-based capital.

Construction

The following table provides a break-down of the construction segment of the Company’s loan portfolio as of September 30, 2011:

	September 30, 2011							Percent of Bank		Single
			Undisbursed		Total Bank		Percent	Total Risk	Number	Largest
(dollar amounts in thousands)	Balance		Commitment		Exposure		Composition	Based Capital	of Loans	Loan (1)
Construction
Single family residential	$	11,513	$	8,488	$	20,001	50.2%	17.0%	18	$	5,250
Single family residential - Spec.	250		-		250		0.6%	0.2%	1	500
Multi-family	1,687		-		1,687		4.2%	1.4%	1	1,698
Commercial	7,107		10,865		17,972		45.0%	15.3%	6	7,600
Total construction	$	20,557	$	19,353	$	39,910	100.0%	33.9%	26	$	7,600

(1) Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of September 30, 2011.

Heritage Oaks Bancorp  | - 47 -

At September 30, 2011, construction balances represented approximately $20.6 million or 3.2% of total gross loan balances, a decrease of $23.4 million or 53.1% from that reported at December 31, 2010. This decline is related to the transfer of loans into other categories upon the completion of projects, primarily $2.2 million transferred to real estate secured residential and $16.7 million transferred to real estate secured commercial, upon completion of projects, as well as a $1.2 million residential – spec. real estate construction loan, which was sold as part of the problem loan sales during the first nine months of 2011 and net pay-downs in excess of  new funds advanced on construction loans of $3.2 million.  As a result of these factors, the ratio of total construction loan balances, including undisbursed commitments, to risk-based capital declined from 48.1% at December 31, 2010 to 33.9% at September 30, 2011.

Construction loans are typically granted for a one year period and then refinanced into permanent loans with varying maturities.

Land

The following table provides a break-down of the land segment of the Company’s loan portfolio as of September 30, 2011:

	September 30, 2011								Percent of Bank			Single
			Undisbursed		Total Bank		Percent		Total Risk		Number	Largest
(dollar amounts in thousands)	Balance		Commitment		Exposure		Composition		Based Capital		of Loans	Loan (1)
Land
Single family residential	$	5,393	-		$	5,393	18.6	%	4.6	%	32	$	1,000
Single family residential - Spec.	217		-		217		0.7	%	0.2	%	2	165
Tract	13,296		-		13,296		45.7	%	11.2	%	9	10,673
Commercial	9,336		-		9,336		32.0	%	7.9	%	17	1,500
Hospitality	888		-		888		3.0	%	0.8	%	2	644
Total land	$	29,130	$	-	$	29,130	100.0	%	24.7	%	62	$	10,673

(1)  Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of September 30, 2011.

At September 30, 2011, land balances represented approximately $29.1 million or 4.5% of total gross loan balances, a decline of $1.6 million or 5.1% from the corresponding balance reported at December 31, 2010.  The decline in land loans is due primarily to the sale of a $1.3 million loan as part of the problem loan sales completed during the first nine months of 2011.  As a result of these factors, the ratio of total construction loan balances, including undisbursed commitments, to risk-based capital declined from 28.9% at December 31, 2010 to 24.7% at September 30, 2011.

Installment

At September 30, 2011, the installment loan balances were approximately $6.6 million compared to the $7.4 million reported at December 31, 2010.  Installment loans include revolving credit plans, consumer loans, as well as credit card balances obtained in the acquisition of Business First.

Loans Held for Sale

Loans held for sale consist of mortgage originations that have already been specifically designated for sale pursuant to correspondent mortgage loan investor agreements. There is minimal interest rate risk associated with these loans as the purchase commitments are in place at the time the Company funds them. Settlement from the correspondents is typically within 30 to 45 days of funding the mortgage.  At September 30, 2011, mortgage correspondent loans (loans held for sale) totaled approximately $13.1 million, $2.1 million more than that reported at December 31, 2010.

Foreign Loans

At September 30, 2011, the Company had no foreign loans outstanding.

Heritage Oaks Bancorp  | - 48 -

Allowance for Loan Losses

As previously mentioned, the Company maintains an allowance for loan losses at a level considered by Management to be adequate to provide for probable losses incurred as of the balance sheet date. The allowance is comprised of three components: specific credit allocation, general portfolio allocation and subjectively determined allocation. The allowance is increased by provisions for loan losses charged to earnings and decreased by loan charge-offs, net of recovered balances. Please see Note 4. Allowance for Loan Losses, of the condensed consolidated financial statements, filed on this Form 10-Q for a detailed discussion concerning the Company’s methodology for determining an adequate allowance for loan losses. Please also see Note 1. Summary of Significant Accounting Policies of the consolidated financial statements, filed as part of the Form 10-K for the year ended December 31, 2010, for additional discussion concerning the allowance for loan losses, loan charge-offs, and credit risk management.

For reporting purposes, the Company allocates the allowance for loan losses across product types within the loan portfolio. However, substantially all of the allowance is available to absorb all credit losses without restriction, unless specific reserves have been established.

The following table provides a summary of the allowance for loan losses and its allocation to each major loan category of the loan portfolio, as well as the percentage that each major category’s allowance represents as a percentage of the gross loan balances in the category as of September 30, 2011, September 30, 2010 and December 31, 2010.

	September 30,						December 31,
	2011			2010			2010
			Percent			Percent			Percent
	Amount		of Loan	Amount		of Loan	Amount		of Loan
(dollars amounts in thousands)	Allocated		Segment	Allocated		Segment	Allocated		Segment
Real Estate Secured
Multi-family residential	$	82	0.5%	$	453	2.2%	$	118	0.7%
Residential 1 to 4 family	388		1.8%	431		1.8%	447		2.1%
Home equity line of credit	551		1.8%	280		0.9%	219		0.7%
Commercial	9,245		2.5%	11,109		3.2%	10,862		3.1%
Farmland	286		2.7%	173		1.1%	239		1.6%
Commercial
Commercial and industrial	6,613		4.9%	5,975		4.3%	9,024		6.2%
Agriculture	347		2.2%	518		3.5%	482		3.2%
Other	-		0.0%	-		0.0%	1		0.7%
Construction
Single family residential	122		1.1%	237		2.6%	632		5.5%
Single family residential - Spec.	61		24.4%	65		2.3%	75		3.1%
Tract	-		0.0%	-		0.0%	-		0.0%
Multi-family	143		8.5%	86		4.6%	349		15.7%
Hospitality	-		0.0%	-		0.0%	-		0.0%
Commercial	204		2.9%	626		1.9%	297		1.1%
Land	2,143		7.4%	1,467		4.6%	2,000		6.5%
Installment loans to individuals	204		3.1%	86		1.2%	166		2.2%
All other loans (including overdrafts)	20		10.3%	65		14.2%	29		13.6%
Total allowance for loan losses	$	20,409	3.1%	$	21,571	3.2%	$	24,940	3.7%

The allowance for loan losses decreased in the first nine months of 2011 as compared to December 31, 2010 and the corresponding period in 2010 by $4.5 million and $1.2 million, respectively, due in large part to management’s efforts in the first nine months of 2011 to reduce classified loans, including non-performing loans, through loan sales and working out of credit matters with borrowers.  The decline in the allowance also reflects improvements in the level of special mention risk graded loans over the last nine months, due in large part to upgrades related to the improvement in the credit quality of several large borrowers and the workout of credit issues on other loans.  During the first nine months of 2011, the Company has also experienced some stabilization in both general economic conditions and real estate valuations, and a reduced level of new transfers of loans to non-performing status, which when combined with the sale of non-performing loans in the first nine months of 2011 has resulted in a decline in the overall allowance for loan losses and in particular the allocation to the commercial real estate segment of the portfolio.  Despite the decline in the total dollar amount of the allowance for loan losses, it has increased as a percentage of non-accrual loans to 156.0% at September 30, 2011, as compared to 76.0% at December 31, 2010 and 80.4% as of September 30, 2010 due to the reduction of non-performing loans.

Heritage Oaks Bancorp  | - 49 -

The balance of the allowance for loan losses peaked in 2010 in large part due to actions taken in the last three quarters of 2010.  These actions in 2010 were targeted in three main segments: real estate secured, commercial and industrial, and land. The allocation of the allowance for loan losses to the real estate secured segment of the loan portfolio in 2010 increased due in large part to higher balances of classified real estate loans, an increase in specific credit reserves within this segment, increased levels of credit losses and the continued weakness in local and state economic conditions.  Contributing further to the 2010 increase in the allocation to the real estate secured segment of the portfolio was an increase in watch list credits within this segment, specifically within commercial real estate.  Increases in the allocation to commercial and industrial balances in 2010 can be attributed in large part to higher credit losses within this segment in conjunction with the continued weakened state of economic conditions. A reduction in the allocation to the land segment of the loan portfolio in 2010 can be attributed in part to lower levels of classified balances within this segment as well as the charge-off of specific reserves within this segment.

Although we have experienced some stabilization in general economic conditions and real estate values in 2011, should the local market experience further deterioration in economic conditions or credit quality of the segments mentioned above it may result in additional significant provisions for loan losses and increases in the allocation of the allowance to those categories.

At September 30, 2011, the balance of classified loans was approximately $55.3 million.  This compares to the $75.5 million in classified loan balances reported at December 31, 2010.  The decline in the level of classified loans is due in part to the upgrade of several loans, totaling $23.4 million, in 2011 due to the improved condition of the borrower and the impacts of the loan sales and pay downs, which aggregated $31.0 million in the first nine months of 2011. These reductions in classified loans were partially offset by net downgrades of $34.2 million of new loans to substandard status during the period.

Although the improvement in classified assets has had a direct impact on the level of calculated general portfolio allocation, under the Company’s methodology for determining an appropriate level for the allowance for loan losses, other factors, such as elevated recent historical charge-off levels, and continued concerns over the speed and level of recovery of the local economy and real estate values require us to maintain a historically high allowance for loan losses.

Loans charged-off during the three and nine months ended September 30, 2011 totaled approximately $3.0 million and $11.9 million, respectively.  This compares to charge-offs of approximately $5.1 million and $20.3 million reported for the corresponding periods last year.  The decrease in charge-offs in the three and nine months ended September 30, 2011 as compared to prior year is due in large part to elevated charge-off levels in the second and third quarters of 2010, when we recorded charge-offs equal to 100% of our current basis in several loans in our portfolio.  These 100% charge-offs were recorded due to the prolonged deterioration in the borrowers’ ability to repay and the lack of viable collateral to continue to justify any level of recoverability against these loans.  The comparative decline in current year charge-offs was partially offset by $1.1 million and $5.5 million, respectively in charge-offs related to problem loans sold during the first nine months of 2011.

Net charge-offs to average loans for the three and nine months ended September 30, 2011 were 1.43% and 1.97%, respectively, on an annualized basis.  This compares to the 2.82% and 3.45% reported for the corresponding periods in 2010.  At September 30, 2011, the allowance for loan losses represented 3.15% of total gross loans compared to the 3.68% reported at December 31, 2010.  The decline in the allowance as a percentage of gross loans reflects management’s efforts to reduce the level of non-accruing loans over the last 9 months, as well as trends in the overall loan portfolio in which we have seen declines in the levels of past due loans and loans that are identified as special mention, substandard and doubtful (See Note 3 and Note 4, of the notes to the condensed consolidated financial statements, included in this Form 10-Q filing for additional details).  While the allowance for loan losses as a percentage of gross loans declined over the last nine months, the allowance for loan losses as a percentage of non-performing loans increased significantly to 156% at September 30, 2011 from 76% at December 31, 2010.

As of September 30, 2011 Management believes the allowance for loan losses was sufficient to cover current estimable losses in the Company’s loan portfolio.

Heritage Oaks Bancorp  | - 50 -

The following table provides an analysis of the allowance for loan losses for the periods indicated:

	For the nine months
	ended September 30,
(dollars amounts in thousands)		2011		2010
Balance, beginning of period		$	24,940	$	14,372
Provision for loan losses		5,370		25,700
Loan charge-offs
Residential 1 to 4 family		-		598
Home equity line of credit		407		1
Commercial real estate		1,356		3,106
Farmland		226		235
Commercial and industrial		3,940		11,348
Agriculture		59		1,253
Construction		47		1,009
Land		103		2,629
Installment loans to individuals		199		132
Total loan charge-offs		6,337		20,311
Recoveries of loans previously charged-off
Residential 1 to 4 family		24		87
Home equity line of credit		2		-
Commercial real estate		312		25
Farmland		9		6
Commercial and industrial		1,294		308
Agriculture		19		73
Construction		112		27
Land		149		1,272
Installment loans to individuals		39		12
Total recoveries		1,960		1,810
Loan sale charge-offs
Residential 1 to 4 family		3		-
Home equity line of credit		57		-
Commercial real estate		4,136		-
Farmland		289
Commercial and industrial		58		-
Construction		291		-
Land		690		-
Net loan sale charge-offs		5,524		-
Total charge-offs		11,861		20,311
Balance, end of period		$	20,409	$	21,571
Net charge-offs		9,901		18,501
Gross loans, end of period		$	648,194	$	673,882
Net charge-offs to average loans		1.48%		2.58%

Non-Performing Assets

Non-performing assets comprise loans placed on non-accrual, loans that are 90 days or more past due and still accruing, and foreclosed assets (OREO and other assets owned). Generally, the Company places loans on non-accruing status when (1) the full and timely collection of all amounts due become uncertain, (2) a loan becomes 90 days or more past due (unless well-secured and in the process of collection) or (3) any portion of outstanding principal has been charged-off.  See also Note 3.

Heritage Oaks Bancorp  | - 51 -

Loans of the consolidated financial statements, filed on this Form 10-Q, for additional discussion concerning non-performing loans, as well as discussion concerning credit quality.

The following table provides a summary of non-accruing loans and foreclosed assets as of September 30, 2011 and December 31, 2010:

	September 30,		December 31,
(dollars in thousands)	2011		2010
Loans delinquent 90 days or more and still accruing	$	-	$	-
Non-Accruing Loans
Residential 1-4 family	$	661	$	748
Home equity lines of credit	360		1,019
Commercial real estate	4,840		17,752
Farmland	-		2,626
Commercial and industrial	1,874		3,921
Agriculture	1,208		246
Construction	937		3,040
Land	3,206		3,371
Installment	-		96
Total non-accruing loans	$	13,086	$	32,819
Other real estate owned	$	2,191	$	6,668
Other repossessed assets	$	43	$	27
Total non-performing assets	$	15,320	$	39,514
Ratio of allowance for loan losses to total gross loans	3.15%		3.68%
Ratio of allowance for loan losses to total non-performing loans	155.96%		75.99%
Ratio of non-performing loans to total gross loans	2.02%		4.85%
Ratio of non-performing assets to total assets	1.56%		4.02%

At September 30, 2011, the balance of non-accruing loans was approximately $13.1 million or $19.7 million lower than that reported at December 31, 2010.  Year to date changes in non-accruing balances can be attributed in part to Management’s work-through of problem credits and the sale of certain problem loans during 2011. While a portion of these balances were charged-off, the Company saw approximately $3.3 million in balances return to accruing status following the Company’s efforts to work with certain borrowers to bring resolution to problem credits.  Additionally, the Company transferred approximately $3.7 million to the OREO portfolio and has been actively marketing such assets for eventual sale. The Company also received approximately $6.4 million in principal payments on non-accruing loans during the first nine months of 2011.  Non-performing assets totaled approximately $15.3 million at September 30, 2011, approximately $24.2 million lower than that reported at December 31, 2010.  The decline in non-performing assets is primarily due to the declines in non-accruing loans discussed above as well as a $4.5 million reduction in OREO, largely due to sale of OREO assets in 2011.

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The following table reconciles the change in total non-accruing balances for the nine months ended September 30, 2011:

	Balance		Additions to							Transfers			Returns to									Balance
	December 31,		Non-Accruing		Net					to Foreclosed			Performing			Net			Transferred to			September 30,
(dollars in thousands)	2010		Balances		Paydowns			Advances		Collateral			Status			Charge-offs			Held for Sale (1)			2011
Real Estate Secured
Residential 1 to 4 family	$	748	$	165	$	(30	)	$	-	$	-		$	-		$	(3	)	$	(219	)	$	661
Home equity line of credit	1,019		621		(44		)	-		(683		)	-			(464		)	(89		)	360
Commercial	17,752		4,942		(2,915		)	-		(2,578		)	(1,374		)	(3,590		)	(7,397		)	4,840
Farmland	2,626		226		(92		)	-		-			(1,695		)	(515		)	(550		)	-
Commercial
Commercial and industrial	3,921		4,079		(1,996		)	10		(276		)	(77		)	(3,476		)	(311		)	1,874
Agriculture	246		977		(42		)	87		-			-			(60		)	-			1,208
Construction
Single family residential	1,311		-		(327		)	-		-			-			(47		)	-			937
Single family residential - Spec.	1,250		-		-			-		-			-			(291		)	(959		)	-
Multi-family	479		-		(479		)	-		-			-			-			-			-
Land	3,371		838		(433		)	-		-			(163		)	(127		)	(280		)	3,206
Installment loans to individuals	96		219		(21		)	-		(135		)	-			(159		)	-			-
Totals	$	32,819	$	12,067	$	(6,379	)	$	97	$	(3,672	)	$	(3,309	)	$	(8,732	)	$	(9,805	)	$	13,086

(1) All loans transferred to held for sale had been sold as of September 30, 2011.

The additions to non-accruing status reflect a decline of over 50%, on an annualized basis, from the level of additions to non-accrual in all of 2010, which totaled $54.4 million.

Other Real Estate Owned (“OREO”)

At September 30, 2011, OREO balances totaled approximately $2.2 million, approximately $4.5 million lower than that reported at December 31, 2010.  This decline in OREO, reflected $7.0 million of disposals during the first nine months of 2011 and to a lesser degree $1.0 million of write-down activity related to OREO, which were partially offset by $3.5 million of new additions to the OREO pool. Although additions to OREO are initially recorded at their fair value, based on appraisal information obtained at the time of the transfer, ongoing evaluation of market data while the assets are being marketed for sale does from time to time indicate that further erosion in value has occurred, which leads to further write-downs to the fair value of the OREO assets.  See also Note 5. Other Real Estate Owned of the condensed consolidated financial statements, filed on this Form 10-Q, for additional discussion concerning OREO.

Total Cash and Cash Equivalents

Total cash and cash equivalents were $26.7 million and $23.0 million at September 30, 2011 and December 31, 2010, respectively. This line item will vary depending on daily cash settlement activities, the amount of highly liquid assets needed based on known events such as the repayment of borrowings, and actual cash on hand in the branches.  The year to date increase is attributable to a combination of the December 2010 balance being lower than normal due to the pay down of various obligations prior to the end of the year and elevated balances at September 2011 due to the timing lag between receipt of deposit inflows and redeployment of such funds into the investment portfolio.

Investment Securities and Other Earning Assets

Other earning assets are comprised of Interest Bearing Due from Federal Reserve, Federal Funds Sold (funds the Company lends on a short-term basis to other banks), investments in securities and short-term interest bearing deposits at other financial institutions.  These assets are maintained for liquidity needs of the Company, collateralization of public deposits, and diversification of the earning asset mix.

Securities Available for Sale

The Company manages its securities portfolio to provide a source of both liquidity and earnings.  The Company has invested in a mix of securities including obligations of U.S government agencies, mortgage backed securities, state and municipal securities and most recently corporate debt securities. The Company has an Asset/Liability Committee that develops current investment policies based upon its operating needs and market circumstance.  The Company’s investment policy is formally reviewed and approved annually by the Board of Directors.  The Asset/Liability Committee of the Company is responsible for reporting and monitoring compliance with the investment policy.  Reports are provided to the Bank’s Board of Directors on a regular basis.

Heritage Oaks Bancorp  | - 53 -

At September 30, 2011, the balance of the investment portfolio was approximately $248.9 million or $25.0 million higher than that reported at December 31, 2010.  The change in the balance of the portfolio can be attributed in large part to the  Company actively investing cash received from the inflow of deposits and the net pay-down in loans in securities, The Company made securities purchases during the first nine months of 2011 in the aggregate amount $161.2 million, which were partially offset by proceeds from the sale, principal payments, call and maturity of investments totaling approximately $138.4 million.  During the three and nine months ended September 30, 2011, the Company recorded a net pre-tax gain of approximately $0.6 million and $1.2 million, respectively, on the sale of various investment securities.

Securities available for sale are carried at fair value, with related unrealized net gains or losses, net of deferred income taxes, recorded as an adjustment to equity capital.  At September 30, 2011, the securities portfolio had net unrealized gains, net of taxes of approximately $0.8 million, an increase in the level of unrealized gains of approximately $2.0 million from the unrealized loss position reported at December 31, 2010.  Changes in the fair value of the investment portfolio in the last three years can be attributed to extreme market turbulence and volatility in capital markets interest rates, stemming in part from continued weakened economic conditions and uncertain market conditions.

During the last three years, the credit markets came under significant stress as investor and consumer confidence in the U.S. financial system became significantly destabilized.  As a result, many financial institutions in severe need of liquidity were forced to de-leverage for a variety of reasons, selling significant portions of their investment holdings which in turn placed considerable pressure on the values of many classes of investment securities.  In particular, mortgage related securities came under substantial pressure and the Company’s portfolio was not immune to this.

Although substantially all of the Company’s mortgage related securities are considered “investment grade,” overall lack of confidence in the housing market, the inability of many consumers to meet their mortgage related obligations, and the strong need for liquidity during the last two years have, among other things, been influential in placing pressure on the prices of these types of securities.

As more fully discussed in Note 2. of the Notes to the condensed consolidated financial statements, at September 30, 2011, we owned five Whole Loan Private Label Mortgage Backed Securities (“PMBS”) with a remaining principal balance of approximately $4.4 million.  At September 30, 2011, one bond with an aggregate fair value of approximately $0.3 million remained below investment grade.  This bond is in a senior tranche of its respective bond structure, meaning the Company has priority in cash flows and has subordinate tranches below its position providing credit support.  During the fourth quarter of 2009 the Company performed an analysis, with the assistance of an independent third party, on several PMBS in the investment portfolio for other than temporary impairment (“OTTI”), including those previously mentioned.  Based on that analysis, the Company determined four securities to be other than temporarily impaired.  As a result, the Company realized approximately $372 thousand in aggregate pre-tax losses related to these securities during the fourth quarter of 2009.  Since that time, the Company has recognized a loss of $0.2 million in the second quarter of 2010 and an additional $0.5 million in the first quarter of 2011 associated with the sale of two of the PMBS on which it had previously recognized OTTI. The losses recognized on the sale of these securities were due to changes in market pricing and did not indicate further credit related deterioration impacted the ultimate value received upon sale.

The Company continues to perform regular extensive analyses on PMBS bonds in the portfolio, including but not limited to updates on: credit enhancements, loan-to-values, credit scores, delinquency rates and default rates.  These investment securities continue to demonstrate cash flows as expected, based on pre-purchase analyses.  As of September 30, 2011, Management does not believe that losses on PMBS in the portfolio, other than those previously discussed, are other than temporary.

The majority of the Company’s mortgage securities were issued by: The Government National Mortgage Association (“Ginnie Mae”), The Federal National Mortgage Association (“Fannie Mae”), and The Federal Home Loan Mortgage Corporation (“Freddie Mac”).  These securities carry the guarantee of the issuing agencies.  At September 30, 2011, approximately $139.9 million or 81.7% of the Company’s mortgage related securities were issued by a government agency such as those listed above.

All fixed and adjustable rate mortgage pools contain a certain amount of risk related to the uncertainty of prepayments of the underlying mortgages.  Interest rate changes have a direct impact upon prepayment rates.  The Company uses computer simulation models to test the average life, duration, market volatility and yield volatility of adjustable rate mortgage pools under various interest rate assumptions to monitor volatility.  Stress tests are performed quarterly.

Heritage Oaks Bancorp  | - 54 -

Federal Home Loan Bank (“FHLB”) Stock

As a member of the Federal Home Loan Bank of San Francisco, the Company is required to hold a specified amount of FHLB capital stock based on the level of borrowings the Company has obtained from the FHLB.  As such, the amount of FHLB stock the Company carries can vary from one period to another based on among other things the current liquidity needs of the Company.  At September 30, 2011 and December 31, 2010, the Company held approximately $4.7 million and $5.2 million in FHLB stock, respectively.  The year to date decline in the balance of FHLB stock can be attributed to redemptions of approximately $0.5 million, during the first nine months of 2011.

Deposits and Borrowed Funds

Deposits

The following table provides a summary for the year to date change in various categories of deposit balances as of September 30, 2011 and December 31, 2010:

	September 30,		December 31,		Variance
(dollars in thousands)	2011		2010		dollar			percentage
Demand, non-interest bearing	$	228,236	$	182,658	$	45,578		24.95	%
Interest bearing demand	62,036		67,938		(5,902		)	-8.69	%
Savings	33,125		29,144		3,981			13.66	%
Money market	273,269		287,120		(13,851		)	-4.82	%
Time deposits	205,067		231,346		(26,279		)	-11.36	%
Total deposits	$	801,733	$	798,206	$	3,527		0.44	%

As indicated in the table above total deposit balances at September 30, 2011 were approximately $801.7 million.  This represents an increase of approximately $3.5 million when compared to that reported at December 31, 2010.  During the first nine months of 2011, we saw core deposit balances (non-interest and interest bearing demand, savings, money market and time certificate accounts with balances less than $100 thousand) increase approximately $24.3 million from that reported at December 31, 2010. The increase in core deposits is mostly being driven by increases in non-interest bearing demand, deposits due in large part to deposits made late in the second quarter by existing customers, partially offset by a decline in money market deposits and time certificates.  We believe customer movement out of certain interest bearing accounts is due to depositors moving their investments into higher risk/higher return investment vehicles outside of the traditional offerings provided by us, due to the continued depressed rates of return on traditional savings, money market and time deposit offerings.

Borrowed Funds

The Company has a variety of sources from which it may obtain secondary funding.  These sources include, among others, the FHLB, Federal Reserve Bank and credit lines established with correspondent banks.  Borrowings are obtained for a variety of reasons which include, but are not limited to, funding loan growth and the purchase of investments in the absence of core deposits and to provide additional liquidity to meet the demands of depositors.

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At September 30, 2011, borrowings obtained from the FHLB comprised the majority of borrowed funds.  The following table provides a summary of FHLB borrowings the Company had outstanding as of September 30, 2011:

(dollars in thousands)

Amount		Interest		Maturity
Borrowed		Rate	Advance Type	Date
$	2,000	0.13%	Variable	Open
3,000		0.13%	Variable	Open
2,500		0.13%	Variable	Open
1,500		1.19%	Fixed	5/12/2014
2,500		1.68%	Fixed	5/11/2015
2,500		2.02%	Fixed	2/24/2015
2,500		1.50%	Fixed	2/24/2014
2,500		1.90%	Fixed	2/2/2015
2,500		1.37%	Fixed	2/3/2014
2,500		1.92%	Fixed	1/13/2015
2,500		1.37%	Fixed	1/13/2014
3,000		1.28%	Fixed	12/10/2013
3,500		0.85%	Fixed	12/10/2012
3,500		0.46%	Fixed	12/12/2011
$	36,500	1.11%

The balance of FHLB borrowing as of September 30, 2011 reflects a pay down of outstanding borrowings of $8.5 million as compared to December 31, 2010. In an effort to lock in current historically low rates and to mitigate some of its net liability sensitivity, the Company shifted the duration of the FHLB borrowings away from shorter term maturities with variable rates to longer term, fix rate borrowings during the first half of the 2011.

On September 17, 2004, the Company issued a letter of credit in the amount of approximately $11.7 million, which has since been reduced to $11.4 million, to a customer to support the primary financing of a senior care facility.  The letter of credit was issued pursuant to a Letter of Credit Reimbursement Agreement between the Company and the FHLB.  It is collateralized by a blanket lien with the FHLB that includes all qualifying loans on the Company’s balance sheet.  The letter of credit was renewed in September 2011 and will expire in September 2012.  The letter of credit was undrawn as of September 30, 2011.

Capital

At September 30, 2011, the balance of stockholders’ equity was approximately $126.0 million.  This represents an increase of approximately $4.8 million over that reported at December 31, 2010.  The year to date change is attributed to increases in equity due to net income for the first nine months of 2011 of $3.6 million; accumulated other comprehensive income/ (loss) moving to an unrealized gain position of $0.8 million as of September 30, 2011 as compared to an unrealized loss position of $1.1 million at December 31, 2010; and the impact of year to date share-based compensation expense in the amount of $0.2 million.  These increases were partially offset by dividends accrued on Series A Senior Preferred stock in the amount of $0.7 million and the reversal of previously recognized tax benefits totaling $0.2 million related to stock-based compensation.

Private Placement and Preferred Stock Conversion

On March 12, 2010 the Company completed a private placement of 52,088 shares of its Series B Mandatorily Convertible Adjustable Cumulative Perpetual Preferred Stock (“Series B Preferred Stock”) and 1,189,538 shares of its Series C Convertible Perpetual Preferred Stock, raising gross proceeds of approximately $56.0 million.  In addition, approximately $4.0 million was placed in escrow for a second closing of 4,072 shares of Series B Preferred Stock.  The second closing was later completed in the second quarter of 2010. Following the receipt of shareholder approval at the Company’s June 2010 annual meeting, the Company converted to common stock all Series B Preferred shares issued in its private placement.  The total number of common shares issued in the conversion was 17,279,995. For additional information regarding the Company’s private placement, please see Note 10. Preferred Stock, of the condensed consolidated financial statements filed on this Form 10-Q.

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U.S. Treasury CPP Series A Senior Preferred Stock

On March 20, 2009, the Company issued $21.0 million in Series A Senior Preferred Stock to the U.S. Treasury as part of its participation in the CPP. Pursuant to an interim rule issued by the Federal Reserve Board, effective October 17, 2008, all $21.0 million of preferred stock the Company issued under the CPP qualifies as Tier I Capital.  Under the terms of the CPP, the Company is required to pay dividends on the Senior Preferred Stock in an amount equal to 5% per annum for five years and 9% per annum thereafter.  Dividends are cumulative and payable quarterly.  In the second quarter of 2010, the Company notified the U.S. Treasury that pursuant to a Written Agreement entered into between the Company and the Federal Reserve Bank of San Francisco, the Company was required to defer dividend payments on its Senior Preferred Stock.  If the Company fails to pay dividends on Series A Senior Preferred Stock for a total of six quarters, whether or not consecutive, the U.S. Treasury will have the right to elect two members of the Company’s Board of Directors, voting together with any other holders of preferred shares ranking pari passu with the Series A Senior Preferred Stock. These directors would serve on the Company’s Board of Directors until such time as the Company has paid in full all dividends not previously paid, at which time these directors’ terms of office would immediately terminate.  As of September 30, 2011, the Company had deferred a total of six quarterly payments and had been notified by the U.S. Treasury of its intent to exercise their option to assign an observer to the Company’s Board; this role has no voting rights at the Board meeting, only observation privileges.  Through the filing date of this Form 10-Q the Treasury has not appointed a board member to serve on the Company’s Board.

Pursuant to the terms outlined under the CPP, the Company issued a warrant to the U.S. Treasury in an amount equal to 15% of the preferred issuance or approximately $3.2 million (611,650 shares).  The warrant is exercisable immediately for a period of ten years at a price equal to the average closing price of the Company’s common stock over the twenty day period ending the day prior to the Company’s preliminary approval to participate in the CPP ($5.15 per share).

For additional information regarding the Company’s Series A Senior Preferred Stock and its participation in the CPP, see Note 10. of the condensed consolidated financial statements filed on this Form 10-Q.

Dividends and Stock Repurchases

During the first nine months of 2011, the Company was required to defer dividend payments on its Series A Senior Preferred Stock to comply with the terms of the Written Agreement entered into between the Company and the Federal Reserve Bank of San Francisco.  See Note 10. Preferred Stock, of the condensed consolidated financial statements filed on this form 10-Q for additional information about dividends on the Company’s Series A Senior Preferred Stock.  For more information concerning the Written Agreement, please refer to Note 11. Regulatory Order and Written Agreement of the condensed consolidated financial statements filed on this Form 10-Q.

The Company paid no dividends on or made repurchases of its common stock during the first nine months of 2011 or during the entire year of 2010.

Trust Preferred Securities

On October 27, 2006 the Company issued $8.2 million of Floating Rate Junior Subordinated Debt Securities to Heritage Oaks Capital Trust II (“Trust II”), a statutory trust created under the laws of the State of Delaware.  The debt securities issued to Trust II are subordinated to effectively all borrowings of the Company.  The debt can be redeemed at par if certain events occur that impact the tax treatment, regulatory treatment or the capital treatment of the issuance.  Upon the issuance of the debt securities, the Company purchased a 3.1% minority interest in Trust II, totaling $248 thousand.  The balance of the equity of Trust II is comprised of mandatory redeemable preferred securities and is included in other assets.  The Company used the proceeds from the issuance for general corporate purposes, which included, but not limited: capital contributions to the Bank, investments, payment of dividends, and repurchases of the Company’s common stock.  Interest associated with the securities issued to Trust II is payable quarterly and varies at 3-month LIBOR plus 1.72%.

The following table provides a summary of the securities the Company has issued to Trust II as of September 30, 2011:

	Amount		Current	Issue	Scheduled	Call
(dollars in thousands)	Issued		Rate	Date	Maturity	Date	Rate Type
Heritage Oaks Capital Trust II	$	8,248	2.09%	27-Oct-06	Aug-37	Nov-11	Variable 3-month LIBOR + 1.72%

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The Company has the right under the indenture to defer interest payments for a period not to exceed twenty consecutive quarterly periods (each an “Extension Period”) provided that no extension period may extend beyond the maturity of the debt securities.  If the Company elects to defer interest payments pursuant to terms of the agreements, then the Company may not (i) declare or pay any dividends or distributions on, or redeem, purchase, acquire or make a liquidation payment with respect to any of the Company’s capital stock, or (ii) make any payment of principal or premium, if any, or interest on or repay, repurchase or redeem any debt securities of the Company that rank pari passu with or junior in interest to the Debt Securities, other than, among other items, a dividend in the form of stock, warrants, options or other rights in the same stock as that on which the dividend is being paid or ranks pari passu with or junior to such stock.  The prohibition on payment of dividends and payments on pari passu or junior debt also applies in the case of an event of default under the agreement.

Pursuant to U.S. GAAP, the Company is not allowed to consolidate Trust II into the Company’s financial statements.  On February 28, 2005, the Federal Reserve Board issued a rule which provides that, notwithstanding the deconsolidation of such trusts, junior subordinated debentures, such as those issued by the Company, may continue to constitute up to 25% of a bank holding company’s Tier I capital, subject to certain limitations which were to become effective on March 31, 2009.  However, on March 17, 2009, the Federal Reserve Board issued a ruling to delay the effective date of limitations on trust preferred securities until March 31, 2011.  As of March 31, 2011, the new limitation is in effect.  As of September 30, 2011, the Company is including $8.0 million of the net junior subordinated debt in its Tier I Capital for regulatory capital purposes.

At September 30, 2011, the Company had sufficient cash to service the $8.2 million in junior subordinated debenture interest payments and other obligations, such as the payment of dividends on the preferred stock issued to the U.S. Treasury, for over 1.5 years without dividends from subsidiaries.  However, beginning in the second quarter of 2010, the Company elected to defer interest payments on its trust preferred securities, in order to comply with the terms of the Written Agreement entered into with the Federal Reserve Bank of San Francisco. As of September 30, 2011, the Company had deferred six quarterly interest payments totaling $0.3 million.  For more information concerning the Written Agreement, please refer to Note 11. Regulatory Order and Written Agreement of the condensed consolidated financial statements filed on this Form 10-Q.

Regulatory Capital Requirements

Capital ratios for commercial banks in the United States are generally calculated using three different formulas.  These calculations are referred to as the “Leverage Ratio” and two “risk-based” calculations known as: “Tier One Risk Based Capital Ratio” and the “Total Risk Based Capital Ratio.”  These standards were developed through joint efforts of Banking authorities from different countries around the world.  The standards essentially take into account that different types of assets have different levels of risk associated with them and the off-balance sheet exposures of banks when assessing capital adequacy.

The Leverage Ratio calculation simply divides common stockholders’ equity (reduced by any goodwill a Company may have) by the total assets.  In the Tier One Risk Based Capital Ratio, the numerator is the same as the leverage ratio, but the denominator is the total “risk-weighted assets.”  Risk weighted assets are determined by segregating all the assets and off balance sheet exposures into different risk categories and weighting them by a percentage ranging from 0% (lowest risk) to 100% (highest risk).  The Total Risk Based Capital Ratio again uses “risk-weighted assets” in the denominator, but expands the numerator to include other capital items besides equity such as a limited amount of the loan loss reserve, long-term capital debt, preferred stock and other instruments.

The minimum regulatory capital ratios are as set forth in the table below. However, on February 26, 2010, the Bank stipulated to the issuance of an Order that was issued March 4, 2010, by the FDIC and DFI that requires higher levels of Tier I Leverage and Total Risk Based ratios.  Under the Order the Bank must maintain a Tier I Leverage ratio of 10.0% and a Total Risk-Based Capital ratio of 11.5%.  While the Bank is subject to the Consent Order, it will be considered adequately capitalized as long as it maintains these minimum capital ratios. See also Note 11. Regulatory Order and Written Agreement of the consolidated financial statements for additional information related to the Consent Oder as they pertain to these requirements.

The following table provides a summary of Company and Bank regulatory capital ratios at September 30, 2011 and 2010:

	Regulatory Standard		Consent Order	September 30, 2011		September 30, 2010
	Adequately	Well	Prescribed	Heritage Oaks		Heritage Oaks
Ratio	Capitalized	Capitalized	Ratios	Bancorp	Bank	Bancorp	Bank
Leverage ratio	4.00%	5.00%	10.00%	11.56%	11.30%	11.48%	10.95%
Tier I capital to risk weighted assets	4.00%	6.00%	N/A	14.37%	14.01%	15.41%	14.64%
Total risk based capital to risk weighted assets	8.00%	10.00%	11.50%	15.63%	15.28%	16.68%	15.91%

Regulatory capital ratios as of September 30, 2011 fully reflect the $60.0 million in gross proceeds the Company raised through the issuance of Series B and Series C Preferred Stock in a private placement during the first six months of 2010 as well as a return to positive earnings in 2011. Following the receipt of shareholder approval at the Company’s June 2010 annual meeting, the Company converted to common stock all Series B Preferred shares issued in its private placement.  The conversion of preferred to common stock is fully reflected in the capital ratios above. Following the receipt of proceeds from the private placement, the Company down-streamed $48.0 million to the Bank as Tier I capital.  These regulatory ratios also fully reflect the issuance of $21.0 million in Series A Senior Preferred Stock to the U.S. Treasury as part of the Company’s participation in the U.S. Treasury’s CPP.

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Liquidity

The objective of liquidity management is to ensure the continuous availability of funds to meet the demands of depositors, investors and borrowers.  Asset liquidity is primarily derived from loan payments and the maturity of other earning assets.  Liquidity from liabilities is obtained primarily from the receipt of new deposits.  The Company’s Asset Liability Committee (“ALCO”) is responsible for managing the on and off-balance sheet commitments to meet the needs of customers while achieving the Company’s financial objectives.  ALCO meets regularly to assess the projected funding requirements by reviewing historical funding patterns, current and forecasted economic conditions and individual customer funding needs.  Deposits generated from the Company’s customers serve as the primary source of liquidity.  The Company has credit arrangements with correspondent banks that serve as a secondary liquidity source.  At September 30, 2011, these credit lines totaled $15.0 million and the Company had no borrowings against those lines.  As previously mentioned the Company is a member of the FHLB and has collateralized borrowing capacities remaining of approximately $161.2 million at September 30, 2011. Additionally, the Company has established and tested an $8.7 million borrowing facility with the Federal Reserve.  The amount of available credit is determined by the collateral provided by the Company at the time of a transaction. Due to the Consent Order, the Bank is limited to 75 basis points above the national average rate for similar products.  Although this may impact our ability to compete for more rate sensitive deposits, we expect to continue to reduce our need to utilize rate sensitive deposits. In addition, the Bank cannot accept, renew or rollover any brokered deposits unless it has applied and been granted a waiver of this prohibition by the FDIC.  The Bank has not accepted or renewed brokered deposits since May 2009.

The Company manages liquidity by maintaining a majority of the investment portfolio in Interest Bearing Due from Federal Reserve and other liquid investments.  Most of these investments include obligations of state and political subdivisions (municipal bonds) and mortgage related securities that provide a relatively steady stream of cash flows.  As of September 30, 2011, the Company believes investments in the portfolio can be liquidated at their current fair values in the event they are needed to provide liquidity.  The ratio of liquid assets not pledged for collateral and other purposes to deposits and other liabilities was 34.0% and 30.5% at September 30, 2011 and December 31, 2010, respectively.  At September 30, 2011, the Company was within its internal guideline for liquidity.  As of September 30, 2011, the fair market value of the Company’s investment portfolio was approximately $248.9 million, of which approximately $6.8 million was pledged to secure public deposits and other purposes. The ratio of gross loans to deposits (“LTD”), another key liquidity ratio, was 80.9% and 84.9% at September 30, 2011 and December 31, 2010, respectively, both of which are and were within the Company’s policy guidelines.

Inflation

The assets and liabilities of a financial institution are primarily monetary in nature.  As such they represent obligations to pay or receive fixed and determinable amounts of money that are not affected by future changes in prices.  Generally, the impact of inflation on a financial institution is reflected by fluctuations in interest rates, the ability of customers to repay their obligations and upward pressure on operating expenses.  Although inflationary pressures are not considered to be of any particular hindrance in the current economic environment, they may however have an impact on the Company’s future earnings in the event those pressures do become more prevalent.

Off-Balance Sheet Arrangements

Off-balance sheet arrangements are any contractual arrangement to which an unconsolidated entity is a party, under which the Company has: (1) any obligation under a guarantee contract; (2) a retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement that serves as credit, liquidity or market risk support to that entity for such assets; (3) any obligation under certain derivative instruments; or (4) any obligation under a material variable interest held by the Company in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support to the Company, or engages in leasing, hedging or research and development services with the Company.

In the ordinary course of business, the Company has entered into off-balance sheet arrangements consisting of commitments to extend credit, commercial letters of credit, and standby letters of credit.  Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received.  For a more detailed discussion of these financial instruments, refer to Note 11 to the Company’s Consolidated Financial Statements under Item 8 of Part II of the Company’s December 31, 2010 Annual Report filed on Form 10-K.

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In the ordinary course of business, the Company is a party to various operating leases.  For a more detailed discussion of these financial instruments, refer to Note 11 to the Company’s Consolidated Financial Statements under Item 8 of Part II of the Company’s December 31, 2010 Annual Report filed on Form 10-K.

In connection with the $8.2 million in debt securities discussed under “Capital,” the Company issued the full and unconditional payment guarantee of certain accrued distributions.

Item 3.  Quantitative and Qualitative Disclosure About Market Risk

As a financial institution, the Company’s primary component of market risk is interest rate volatility. Fluctuations in interest rates will ultimately impact both the level of interest income and interest expense recorded on a large portion of the Company’s assets and liabilities, and the market value of all interest earning assets and interest bearing liabilities, other than those which possess a short term to maturity. Virtually all of the Company’s interest earning assets and interest bearing liabilities are located at the banking subsidiary level. Thus, virtually all of the Company’s interest rate risk exposure lies at the banking subsidiary level other than $8.2 million in subordinated debentures issued by the Company’s subsidiary grantor trust. As a result, all significant interest rate risk procedures are performed at the banking subsidiary level. The subsidiary Company’s real estate loan portfolio, concentrated primarily within Santa Barbara and San Luis Obispo Counties, California, are subject to risks associated with the local economy.

The fundamental objective of the Company’s management of its assets and liabilities is to maximize the Company’s economic value while maintaining adequate liquidity and an exposure to interest rate risk deemed by Management to be acceptable. Management believes an acceptable degree of exposure to interest rate risk results from the management of assets and liabilities through maturities, pricing and mix to attempt to neutralize the potential impact of changes in market interest rates. The Company’s profitability is dependent to a large extent upon its net interest income, which is the difference between its interest income on interest earning assets, such as loans and investments, and its interest expense on interest bearing liabilities, such as deposits and borrowings. The Company is subject to interest rate risk to the degree that its interest earning assets re-price differently than its interest bearing liabilities. The Company manages its mix of assets and liabilities with the goals of limiting its exposure to interest rate risk, ensuring adequate liquidity, and coordinating its sources and uses of funds.

The Company seeks to control interest rate risk exposure in a manner that will allow for adequate levels of earnings and capital over a range of possible interest rate environments. The Company has adopted formal policies and practices to monitor and manage interest rate risk exposure.  Management believes historically it has effectively managed the effect of changes in interest rates on its operating results and believes that it can continue to manage the short-term effect of interest rate changes under various interest rate scenarios.

Management employs the use of an Asset and Liability Management software that is used to measure the Company’s exposure to future changes in interest rates. This model measures the expected cash flows and re-pricing of each financial asset/liability separately in measuring the Company’s interest rate sensitivity.  Based on the results of this model, Management believes the Company’s balance sheet is slightly “liability sensitive.”  This means that until such time as a substantial portion of the Company’s variable rate loan portfolio returns to rates above their floor levels, the Company would expect (all other things being equal) to experience a contraction in its net interest income if rates rise and conversely to experience expansion in net interest income, if rates fall.  The level of potential or expected contraction indicated by the tables below is considered acceptable by Management and is compliant with the Company’s ALCO policies.  Management will continue to perform this analysis each quarter to further validate the expected results against actual data.

The hypothetical impacts of sudden interest rate movements applied to the Company’s asset and liability balances are modeled monthly. The results of these models indicate how much of the Company’s net interest income is “at risk” from various rate changes over a one year horizon. This exercise is valuable in identifying risk exposures. Management believes the results for the Company’s September 30, 2011 balances indicate that the net interest income at risk over a one year time horizon for a 1% and 2% rate increase and decrease is acceptable and within policy guidelines at this time.

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The results in the table below indicate the change in net interest income the Company would expect to see as of September 30, 2011, if interest rates were to change in the amounts set forth:

	Rate Shock Scenarios
(dollars in thousands)	-200bp		-100bp		Base		+100bp		+200bp
Net interest income	$	44,212	$	45,748	$	45,096	$	43,715	$	42,730
$ Change from base	$	(884)	$	652	$	-	$	(1,381)	$	(2,366)
% Change from base	-1.96%		1.45%		0.00%		-3.06%		-5.25%

It is important to note that the above table is a summary of several forecasts and actual results may vary. The forecasts are based on estimates and assumptions of Management that may turn out to be different and may change over time. Factors affecting these estimates and assumptions include, but are not limited to 1) competitor behavior, 2) economic conditions both locally and nationally, 3) actions taken by the Federal Reserve Board, 4) customer behavior and 5) Management’s responses. Changes that vary significantly from the assumptions and estimates may have significant effects on the Company’s net interest income; therefore, the results of this analysis should not be relied upon as indicative of actual future results.

The following table shows Management’s estimates of how the loan portfolio is segregated between variable-daily, variable at various time lines, fixed rate loans and estimates of re-pricing opportunities for the entire loan portfolio at September 30, 2011:

(dollars in thousands)
			Percent of
Rate Type	Balance		Total
Variable - daily	$	187,673	29.0	%
Variable other than daily	341,203		52.6	%
Fixed rate	119,318		18.4	%
Total gross loans	$	648,194	100.0	%

The table above identifies approximately 29.0% of the loan portfolio that will re-price immediately in a changing rate environment.  At September 30, 2011, approximately $528.9 million or 81.6% of the Company’s loan portfolio is considered variable.

The following table shows the repricing categories of the Company’s loan portfolio at September 30, 2011:

(dollars in thousands)
			Percent of
Re-Pricing	Balance		Total
< 1 Year	$	349,551	54.0	%
1-3 Years	194,557		30.0	%
3-5 Years	79,397		12.2	%
> 5 Years	24,689		3.8	%
Total gross loans	$	648,194	100.0	%

The following table provides a summary of the loans the Company can expect to see adjust above floor rates based on given movements in the Prime Rate as of September 30, 2011:

	Move in Prime Rate (bps)
(dollars in thousands)	+200		+250		+300		+350
Variable daily	$	282	$	14,462	$	52,618	$	101,187
Variable other than daily	2,131		15,657		87,927		208,464
Cumulative total variable at floor	$	2,413	$	30,119	$	140,545	$	309,651

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Given the significant decline in Prime rate over the last two years, many loans in the portfolio possess floors significantly higher than the current Prime rate.  As indicated in the table above, the Company will need to see rates increase by 300 to 350 basis points before the majority of variable rate loans in the portfolio start to come off their floors thereby ending their fixed-rate interest rate risk profile and returning them to a fully variable interest rate risk profile.  When such occurs, holding all other interest rate risk variables constant, the Company will become more net asset sensitive.

Item 4.  Controls and Procedures

Limitations of Disclosure Controls and Procedures and Internal Control Over Financial Reporting

It should be noted that a control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. For example, controls can be circumvented by a person’s individual acts, by collusion of two or more people or by management override of the control. Because a cost-effective control system can only provide reasonable assurance that the objectives of the control system are met, misstatements due to error or fraud may occur and not be detected.

Disclosure Controls and Procedures

The Company maintains disclosure controls and procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that are designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act 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 our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate, to allow timely decisions regarding required financial disclosure. In connection with the preparation of this Quarterly Report on Form 10-Q, we carried out an evaluation under the supervision and with the participation of our management, including our CEO and CFO, as of September 30, 2011 of the effectiveness of the design and operation of our disclosure controls and procedures. Based upon this evaluation, our CEO and CFO concluded that as of September 30, 2011, our disclosure controls and procedures were effective.

Change in Internal Control over Financial Reporting

There has been no change in internal control over financial reporting in the quarter ended September 30, 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Part II.  Other Information

Item 1.  Legal Proceedings

The Bank is party to the following litigation:

Alpert, et al v. Cuesta Title Company, et al.  San Luis Obispo County Sup. Ct. case no. CV 098220.  Plaintiffs have sued a title company, title insurer, Hurst Financial and related individuals on a variety of claims related to Hurst Financial’s lending practices.  The Bank, which made a commercial loan to a developer which also borrowed from Hurst Financial, was named in two causes of action alleging (1) negligence and (2) aiding and abetting Hurst Financial’s allegedly illegal lending practices.  The Bank did not lend to any of the plaintiffs or to Hurst Financial, nor did the Bank have any contact whatsoever with the plaintiffs in relation to their transactions with Hurst Financial.  The Bank has foreclosed upon and now owns one of the properties Hurst Financial purportedly financed for the developer using funds raised from the plaintiffs.  The Bank believes the action against it is without merit.  The matter has been tendered to the Bank’s insurance carrier, and the Bank is actively defending the case, which is now in the discovery phase.  The Bank has successfully demurred to the cause of action for negligence.  As such, the Bank anticipates a favorable outcome to the case and does not expect the litigation to have any significant financial impact to the Bank.

Gardality v. Heritage Oaks Bank, et al.  San Diego County Sup. Ct. case no. 37-2010-00055218-CU-NC. Plaintiff sued the Bank and 157 other defendants.  The pleading indicates the plaintiff’s claim is connected to funds he borrowed from Estate Financial, Inc. (“EFI”) as the developer of a real estate project.  EFI was a customer of the Bank and is now a debtor in a bankruptcy proceeding.  The complaint was poorly written and legally deficient to the point where it is impossible to determine the nature or validity of the claim.  The Bank had no contact with the plaintiff prior to service of the complaint and believes that plaintiff’s action against it is without merit.  The matter has been tendered to the Bank’s insurance carrier and the Bank actively defended the case.

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The plaintiff dismissed the defective complaint against the Bank at the Bank’s request, and had not filed a new complaint as of December 31, 2010. However, on February 3, 2011, the Bank learned that Mr. Gardality filed a cross-complaint in San Luis Obispo County with similar allegations, San Luis Obispo County Sup. Ct. case no. CV 100365, which is a case filed against Mr. Gardality by the bankruptcy Trustee for EFI. The Bank appeared in that matter and challenged the sufficiency of the pleadings. The Court ruled in favor of the Bank on May 18, 2011 and dismissed the cross-complaint, awarding attorney’s fees to the Bank. At this time there is no litigation pending with Mr. Gardality and the Bank does not expect his claim to have any material financial impact to the Bank.

Joao-Bock Transaction Systems, LLC v. Bank of Stockton, et al. USDC, Central District, Los Angeles case no. CV11 03526 DSF. Plaintiff sued the Bank and 15 other California banks claiming patent infringement relating to plaintiff’s claimed patent of certain on-line banking systems.  The plaintiff has a history of filing infringement claims against banks relating to on-line banking software and systems. The Bank outsources its on-line banking systems from third party vendors, and has tendered the matter to those providers, as well as to its insurance carriers, for a defense.  As of September 30, 2011, one of the vendors has agreed to defend the infringement claim, and the Bank is negotiating with the other vendor. Based on preliminary contact and negotiations with the plaintiff, the Bank does not expect the litigation to have any material financial impact to the bank.

Except as indicated above, neither the Company nor the Bank is involved in any legal proceedings other than routine legal proceedings occurring in the ordinary course of business.  The majority of such proceedings have been initiated by the Bank in the process of collecting on delinquent loans.  To the extent any such matters are defense matters, they are each covered by one or more policies of insurance carried by the Bank and do not carry an exposure to loss in excess of the coverage available. Such routine legal proceedings, in the aggregate, are believed by Management to be immaterial to the financial condition, results of operations and cash flows of the Company as of September 30, 2011.

Item 1A.  Risk Factors

During the period covered by this report there were no material changes from risk factors as previously disclosed in the Company’s December 31, 2010 Annual Report filed on Form 10-K in response to Item A to Part I of Form 10-K.

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds

Unregistered Sale of Equity Securities

None.

Purchases of Equity Securities

None.

Item 3.  Defaults upon Senior Securities

(a)None.

(b)In the second quarter of 2010 the Company was required to defer dividend payments on its Series A Senior Preferred Stock issued to the U.S. Treasury under the CPP in order to comply with the terms of the Written Agreement entered into between the Company and the Federal Reserve Company of San Francisco.  For more information concerning the Written Agreement, please refer to Note 11. Regulatory Order and Written Agreement of the consolidated financial statements filed on this Form 10-Q.  As of September 30, 2011, the Company has deferred six dividend payments on its Series A Senior Preferred Stock totaling approximately $1.6 million.

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Item 4.  (Removed and Reserved)

None.

Item 5.  Other Information

Not applicable.

Item 6.  Exhibits

(a) Exhibits:

Exhibit (31.1) Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit (31.2) Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit (32.1) Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit (32.2) Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101 The following materials from the Company’s quarterly report on Form 10-Q for the three months ended September 30, 2011, formatted in XBRL (eXtensible Business Reporting Language): (i) Condensed Consolidated Balance Sheets as of September 30, 2011 and December 31, 2010 (unaudited), (ii) Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2011 and 2010 (unaudited), (iii) Condensed Consolidated Statements of Cash Flows, for the nine months ended September 30, 2011 and 2010 (unaudited), and (iv) Notes to Condensed Consolidated Financial Statements (unaudited), tagged as blocks of text.

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Signatures

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

Heritage Oaks Bancorp

Date: November 1, 2011

/s/ Simone Lagomarsino	/s/ Thomas J. Tolda
Simone Lagomarsino	Thomas J. Tolda,
President and Chief Executive Officer	Executive Vice President and Chief Financial
(Principle Executive Officer)	And Principal Accounting Officer

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