10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

[ X ]QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2012.

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	(I.R.S. Employer
incorporation or organization)	Identification No.)

1222 Vine Street,

Paso Robles, California 93446

(Address of principal executive offices) (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 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 Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

YES [ X ]     NO [    ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or 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 (Do not check if a smaller reporting company)[    ]

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 ]

As of October 26, 2012 there were 25,288,430 shares outstanding of the registrant’s common stock.

Heritage Oaks Bancorp |- 1 -

Heritage Oaks Bancorp

FORM 10-Q for the Quarter Ended September 30, 2012

INDEX

			Page
Part I.		Financial Information
	Item 1.	Financial Statements (unaudited).
		Condensed Consolidated Balance Sheets at September 30, 2012 (unaudited) and December 31, 2011	3
		Condensed Consolidated Statements of Income for the three and nine months ended September 30, 2012 (unaudited) and September 30, 2011 (unaudited)	4
		Condensed Consolidated Statement of Comprehensive Income for the three and nine months ended September 30, 2012 (unaudited) and September 30, 2011 (unaudited)	5
		Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2012 (unaudited) and September 30, 2011 (unaudited)	6
		Notes to Condensed Consolidated Financial Statements (unaudited)	8
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations.	37
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk.	66
	Item 4.	Controls and Procedures.	68
Part II.		Other Information
	Item 1.	Legal Proceedings.	68
	Item 1A.	Risk Factors.	69
	Item 2.	Unregistered Sales of Securities and Use of Proceeds.	69
	Item 3.	Defaults upon Senior Securities.	69
	Item 4.	Mine Safety Disclosures.	69
	Item 5.	Other Information.	69
	Item 6.	Exhibits.	70
		Signatures	71

Heritage Oaks Bancorp |- 2 -

Part I.  Financial Information

Item 1. Financial Statements

Heritage Oaks Bancorp

and Subsidiaries

Condensed Consolidated Balance Sheets

	September 30,			December 31,
(dollar amounts in thousands except per share data)	2012			2011
	(unaudited)
Assets
Cash and due from banks	$	22,917		$	18,858
Interest bearing due from banks	21,259			16,034
Total cash and cash equivalents	44,176			34,892
Securities available for sale, at fair value	261,451			236,982
Federal Home Loan Bank stock, at cost	4,575			4,685
Loans held for sale	12,590			21,947
Gross loans	678,348			646,286
Net deferred loan fees	(977		)	(1,111		)
Allowance for loan losses	(17,987		)	(19,314		)
Net loans	659,384			625,861
Property, premises and equipment	15,238			5,528
Deferred tax assets, net	22,897			18,226
Bank owned life insurance	15,223			14,835
Goodwill	11,049			11,049
Core deposit intangible	1,424			1,682
Other real estate owned	615			917
Other assets	10,057			10,534
Total assets	$	1,058,679		$	987,138
Liabilities
Deposits
Demand, non-interest bearing	$	267,199		$	217,245
Savings, NOW and money market deposits	410,147			376,252
Time deposits under $100	88,738			102,628
Time deposits of $100 or more	88,948			90,083
Total deposits	855,032			786,208
Short term FHLB borrowing	9,500			29,500
Long term FHLB borrowing	36,500			22,000
Junior subordinated debentures	8,248			8,248
Other liabilities	7,114			11,628
Total liabilities	916,394			857,584
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, 2012 and December 31, 2011.	20,441			20,160
Series C preferred stock, $3.25 per share stated value; issued and outstanding: 1,189,538 shares as of September 30, 2012 and December 31, 2011	3,604			3,604
Common stock, no par value; authorized: 100,000,000 shares; issued and outstanding: 25,288,430 shares and 25,145,717 shares as of September 30, 2012 and December 31, 2011, respectively	101,296			101,140
Additional paid in capital	7,240			7,006
Retained earnings/(accumulated deficit)	6,004			(2,794		)
Accumulated other comprehensive income, net of tax expense of $ 2,589 and $307 as of September 30, 2012 and December 31, 2011, respectively	3,700			438
Total stockholders’ equity	142,285			129,554
Total liabilities and stockholders’ equity	$	1,058,679		$	987,138

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

Heritage Oaks Bancorp |- 3 -

Heritage Oaks Bancorp

and Subsidiaries

Condensed Consolidated Statements of Income

	For the three months ended						For the nine months ended
	September 30,						September 30,
(dollar amounts in thousands except per share data)	2012			2011			2012			2011
	(unaudited)			(unaudited)			(unaudited)			(unaudited)
Interest Income
Interest and fees on loans	$	9,716		$	10,174		$	29,289		$	31,132
Interest on investment securities	1,783			1,880			5,311			5,016
Other interest income	20			18			72			67
Total interest income	11,519			12,072			34,672			36,215
Interest Expense
Interest on savings, NOW and money market deposits	288			361			874			1,171
Interest on time deposits under $100	205			350			707			1,138
Interest on time deposits in denominations of $100 or more	226			363			734			1,212
Other borrowings	215			143			617			396
Total interest expense	934			1,217			2,932			3,917
Net interest income before provision for loan losses	10,585			10,855			31,740			32,298
Provision for loan losses	1,286			1,086			7,681			5,370
Net interest income after provision for loan losses	9,299			9,769			24,059			26,928
Non-Interest Income
Fees and service charges	611			659			1,948			1,820
Mortgage gain on sale and origination fees	1,181			734			3,071			1,750
Debit/credit card fee income	460			430			1,322			1,211
Earnings on bank owned life insurance	148			147			452			444
Gain on sale of investment securities	329			595			1,696			1,187
Gain / (loss) on sale of other real estate owned	102			(266		)	112			(587		)
Other income	153			258			399			691
Total non-interest income	2,984			2,557			9,000			6,516
Non-Interest Expense
Salaries and employee benefits	4,532			4,434			13,522			13,371
Equipment	395			399			1,223			1,327
Occupancy	728			888			2,542			2,768
Promotional	171			156			432			491
Data processing	551			801			1,911			2,253
OREO related costs	54			162			217			556
Write-downs of foreclosed assets	53			89			86			968
Regulatory assessment costs	371			503			1,238			1,834
Audit and tax advisory costs	146			188			473			514
Directors fees	126			102			358			338
Outside services	730			296			1,572			1,035
Provision for potential mortgage repurchases	125			329			982			329
Amortization of intangible assets	86			96			258			356
Other general operating costs	727			607			1,843			1,957
Total non-interest expense	8,795			9,050			26,657			28,097
Income before (benefit from) / provision for income taxes	3,488			3,276			6,402			5,347
(Benefit from) / provision for income taxes	(2,940		)	1,157			(3,508		)	1,753
Net income	6,428			2,119			9,910			3,594
Dividends and accretion on preferred stock	357			373			1,113			1,108
Net income available to common shareholders	$	6,071		$	1,746		$	8,797		$	2,486
Earnings Per Common Share
Basic	$	0.24		$	0.07		$	0.35		$	0.10
Diluted	$	0.23		$	0.07		$	0.33		$	0.10

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 Comprehensive Income

	For the three months						For the nine months
	ended September 30,						ended September 30,
(dollar amounts in thousands)	2012			2011			2012			2011
	(unaudited)			(unaudited)			(unaudited)			(unaudited)
Net income	$	6,428		$	2,119		$	9,910		$	3,594
Other comprehensive income:
Unrealized security holding gains	2,477			137			7,240			4,519
Reclassification for net gains on investments included in earnings	(329		)	(595		)	(1,696		)	(1,187		)
Other comprehensive income / (loss), before tax	2,148			(458		)	5,544			3,332
Income tax expense / (benefit) related to items of other comprehensive income	883			(189		)	2,281			1,369
Other comprehensive income / (loss)	1,265			(269		)	3,263			1,963
Comprehensive income	$	7,693		$	1,850		$	13,173		$	5,557

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,
(dollar amounts in thousands)	2012			2011
	(unaudited)			(unaudited)
Cash flows from operating activities:
Net income	$	9,910		$	3,594
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	1,007			959
Provision for loan losses	7,681			5,370
Amortization of premiums / discounts on investment securities, net	2,488			2,352
Amortization of intangible assets	258			356
Share-based compensation expense	234			213
Gain on sale of available for sale securities	(1,696		)	(1,187		)
Loss on sale of property, premises and equipment	25			4
Originations of loans held for sale	(132,905		)	(96,360		)
Proceeds from sale of loans held for sale	142,262			109,766
Net increase in bank owned life insurance	(388		)	(186		)
(Increase) / decrease in deferred tax asset	(1,349		)	551
Deferred tax assets valuation allowance adjustment	(5,605		)	-
(Gain) / loss on sale of foreclosed collateral	(112		)	587
Write-downs on other real estate owned	86			968
Decrease / (increase) in other assets	479			(1,482		)
(Decrease) / increase in other liabilities	(2,835		)	292
Net Cash Provided By Operating Activities	19,540			25,797
Cash flows from investing activities:
Purchase of securities, available for sale	(150,783		)	(161,222		)
Sale of available for sale securities	95,786			108,617
Maturities and calls of available for sale securities	3			452
Proceeds from principal paydowns of available for sale securities	35,278			29,326
Redemption of Federal Home Loan Bank stock	110			496
Increase in loans, net	(42,710		)	(2,167		)
Allowance for loan and lease loss recoveries	737			1,960
Purchase of property, premises and equipment, net	(10,761		)	(351		)
Proceeds from sale of property, premises and equipment	19			-
Proceeds from sale of foreclosed collateral	1,335			6,130
Net Cash Used In Investing Activities	(70,986		)	(16,759		)
Cash flows from financing activities:
Increase in deposits, net	68,824			3,527
Proceeds from Federal Home Loan Bank borrowing	166,500			177,500
Repayments of Federal Home Loan Bank borrowing	(172,000		)	(186,000		)
Tax impact of share based compensation expense	26			(294		)
Proceeds from exercise of stock options	131			-
Preferred stock dividends paid	(2,751		)	-
Net Cash Provided By / (Used In) Financing Activities	60,730			(5,267		)
Net increase in cash and cash equivalents	9,284			3,771
Cash and cash equivalents, beginning of period	34,892			22,951
Cash and cash equivalents, end of period	$	44,176		$	26,722

Heritage Oaks Bancorp |- 6 -

Supplemental Cash Flow Information

	For the nine months
	ended September 30,
(dollar amounts in thousands)	2012		2011
Cash Flow Information
Interest paid	$	3,176	$	3,923
Income taxes paid	$	2,735	$	2,645
Non-Cash Flow Information
Change in unrealized gain on avalable for sale securities	$	5,545	$	3,335
Loans transferred to foreclosed collateral	$	769	$	3,484
Loans transferred to held for sale	$	-	$	15,528
Preferred stock dividends accrued not paid	$	-	$	701
Accretion of preferred stock discount	$	281	$	276

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

Heritage Oaks Bancorp | - 7 -

Heritage Oaks Bancorp

And Subsidiaries

Notes to Condensed Consolidated Financial Statements (unaudited)

Note 1.  Condensed Consolidated Financial Statements

Description of Business

Heritage Oaks Bancorp (“the Company”) is a California corporation organized in 1994 to act as the holding company for Heritage Oaks Bank (“the Bank”).  The Bank operates branches within San Luis Obispo and Santa Barbara counties.  The Bank offers traditional banking products such as checking, savings, money market accounts and certificates of deposit, as well as mortgage loans and commercial and consumer loans to customers who are predominately small to medium-sized businesses and individuals.  As such, the Company is subject to a concentration risk associated with its banking operations in San Luis Obispo and Santa Barbara Counties. No one customer accounts for more than 10% of revenue or assets in any period presented and the Company has no assets nor does it generate any revenue from outside of the United States. While the chief decision-makers of the Company monitor the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Company-wide basis.  Accordingly, all of the financial service operations are considered by management to be aggregated in one reportable operating segment.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of Heritage Oaks Bancorp and subsidiaries (the “Company”) have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and notes required by accounting principles generally accepted in the United States of America (“U.S. GAAP”) for annual financial statements are not included herein. 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 2011 Annual Report filed on Form 10-K, filed with the Securities and Exchange Commission on February 28, 2012, 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. Operating results for the three and nine months ended September 30, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012. Certain amounts in the consolidated financial statements for the year ended December 31, 2011 and for the three and nine months ended September 30, 2011 may have been reclassified to conform to the presentation of the condensed consolidated financial statements in 2012.

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.  Estimates that are particularly susceptible to significant change relate to the calculation and inputs which are the basis for the allowance for loan losses, the valuation of real estate acquired through foreclosure, the carrying value of the Company’s deferred tax assets and estimates used in the determination of the fair value of certain financial instruments.

The significant accounting policies that the Company applies are detailed in Note 1. Summary of Significant Accounting Policies, 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, related to the adoption of standard updates issued by the Financial Accounting Standards Board (“FASB”).

Recent Accounting Guidance Adopted

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.

Heritage Oaks Bancorp |- 8 -

The new presentation is effective for interim and annual periods beginning on or after December 15, 2011.  Other than the additional disclosure included in the new stand-alone statement of other comprehensive income, the Company’s adoption of this standard in the first quarter of 2012 did not 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. Other than the additional disclosures included in Note 9. Fair Value of Assets and Liabilities, the Company’s adoption of this standard in the first quarter of 2012 did not have a significant impact on the Company’s consolidated financial statements.

Recent Accounting Guidance Not Yet Effective

On July 27, 2012, the FASB issued ASU No. 2012-02, Intangibles-Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment.  This update, like ASU 2011-08 which the Company adopted in 2011, allows companies the option to first evaluate qualitative factors to determine if events or circumstances exist that indicate that it is more likely than not that an indefinite-lived intangible asset is impaired.  If based on this assessment, a company concludes that there are no indicators that suggest an indefinitely-lived asset is more likely than not of having been impaired, then no further quantitative analysis is required.  The amendments are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted, including for annual and interim impairment tests performed as of a date before July 27, 2012, if a public entity’s financial statements for the most recent annual or interim period have not yet been issued or, for nonpublic entities, have not yet been made available for issuance. The Company currently does not have any indefinitely-lived intangible assets, other than goodwill, therefore adoption of this ASU is not expected to have a material impact on the Company’s consolidated financial statements.

On October 1, 2012, the FASB issued ASU No. 2012-04, Technical Corrections and Improvements.  The amendments in ASU 2012-04 cover a wide range of Topics in the Codification and address technical corrections and improvements and conforming amendments related to fair value measurements.  For public entities, the amendments that are subject to the transition guidance will be effective for fiscal periods beginning after December 15, 2012.  The Company is evaluating the impacts of these corrections but does not expect them to have a material impact on the Company’s consolidated financial statements.

Heritage Oaks Bancorp | - 9 -

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, 2012 and December 31, 2011:

(dollar amounts in thousands)			Gross		Gross
	Amortized		Unrealized		Unrealized
As of September 30, 2012	Cost		Gains		Losses			Fair Value
Obligations of U.S. government agencies	$	3,838	$	121	$	(2	)	$	3,957
Mortgage backed securities
U.S. government sponsored entities and agencies	108,660		963		(402		)	109,221
Non-agency	42,752		1,313		(159		)	43,906
State and municipal securities	59,427		3,913		(69		)	63,271
Corporate debt securities	30,321		388		(34		)	30,675
Other	10,164		307		(50		)	10,421
Total	$	255,162	$	7,005	$	(716	)	$	261,451
As of December 31, 2011
Obligations of U.S. government agencies	$	4,209	$	118	$	(1	)	$	4,326
Mortgage backed securities
U.S. government sponsored entities and agencies	116,732		890		(297		)	117,325
Non-agency	34,667		465		(600		)	34,532
State and municipal securities	49,661		2,262		-			51,923
Corporate debt securities	28,909		-		(2,053		)	26,856
Other	2,059		-		(39		)	2,020
Total	$	236,237	$	3,735	$	(2,990	)	$	236,982

At September 30, 2012, the Company continued to own five Whole Loan Private Label Single Family Residential Mortgage Backed Securities (“PMBS”) with a remaining principal balance of approximately $3.6 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 between 2008 and 2011, PMBS bonds along with other asset classes experienced a deterioration in price, credit quality, and liquidity.  Rating agencies have been reassessing all ratings associated with bonds starting with the lower tranche or subordinate pieces (which have increased loss exposure), followed by senior and super senior bonds, which are what the Company owns with the exception of one mezzanine bond (subordinate).  At September 30, 2012, one bond with an aggregate fair value of $0.3 million is deemed to be non-investment grade. The Company’s investment portfolio holdings of PMBS securities had a net unrealized gain of $64 thousand at September 30, 2012 and a net unrealized loss of $34 thousand at December 31, 2011.

Other than Temporary Impairment (“OTTI”)

As of September 30, 2012, the Company continues to hold two PMBS securities in which OTTI losses were recognized in prior years.  These securities had an aggregate recorded fair value of $0.8 million ($1.1 million historical cost) at September 30, 2012 and $0.6 million ($1.1 million historical cost) at December 31, 2011.  Although the Company continues to have the ability and intent to hold these securities for the foreseeable future, the results of the analysis performed in 2009 and 2010 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.

Heritage Oaks Bancorp | - 10 -

The following table provides a roll forward of the OTTI balances against the PMBS investment securities for both credit loss and all other factor components, for the three months ended September 30, 2012 and 2011:

	Three months ended September 30, 2012								Three months ended September 30, 2011
			OTTI Related								OTTI Related
	OTTI Related		to All Other			Total			OTTI Related		to All Other			Total
(dollars in thousands)	to Credit Loss		Factors			OTTI			to Credit Loss		Factors			OTTI
Balance, beginning of the period	$	109	$	283		$	392		$	109	$	385		$	494
Change in value attributable to other factors	-		(140		)	(140		)	-		(14		)	(14		)
Balance, end of the period	$	109	$	143		$	252		$	109	$	371		$	480

The following table provides additional information related to the OTTI losses the Company recognized during the nine months ended September 30, 2012 and 2011:

	Nine months ended September 30, 2012								Nine months ended September 30, 2011
			OTTI Related									OTTI Related
	OTTI Related		to All Other			Total			OTTI Related			to All Other			Total
(dollars in thousands)	to Credit Loss		Factors			OTTI			to Credit Loss			Factors			OTTI
Balance, beginning of the period	$	109	$	361		$	470		$	534		$	943		$	1,477
Less: losses related to OTTI securities sold	-		-			-			(425		)	(518		)	(943		)
Change in value attributable to other factors	-		(218		)	(218		)	-			(54		)	(54		)
Balance, end of the period	$	109	$	143		$	252		$	109		$	371		$	480

The following table provides a summary of investment securities in an unrealized loss position as of September 30, 2012 and December 31, 2011:

	Securities In A Loss Position For
(dollar amounts in thousands)	Less Than Twelve Months					Twelve Months or More					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
As of September 30, 2012	Value		Loss			Value		Loss			Value		Loss
Obligations of U.S. government agencies	$	-	$	-		$	44	$	(2	)	$	44	$	(2	)
Mortgage backed securities
U.S. government sponsored entities and agencies	39,271		(402		)	-		-			39,271		(402		)
Non-agency	5,231		(8		)	3,780		(151		)	9,011		(159		)
State and municipal securities	3,897		(69		)	-		-			3,897		(69		)
Corporate debt securities	-		-			3,781		(34		)	3,781		(34		)
Other	3,561		(50		)	-		-			3,561		(50		)
Total	$	51,960	$	(529	)	$	7,605	$	(187	)	$	59,565	$	(716	)
As of December 31, 2011
Obligations of U.S. government agencies	$	-	$	-		$	89	$	(1	)	$	89	$	(1	)
Mortgage backed securities
U.S. government sponsored entities and agencies	39,895		(297		)	-		-			39,895		(297		)
Non-agency	17,396		(238		)	586		(362		)	17,982		(600		)
Corporate debt securities	26,857		(2,053		)	-		-			26,857		(2,053		)
Other	2,020		(39		)	-		-			2,020		(39		)
Total	$	86,168	$	(2,627	)	$	675	$	(363	)	$	86,843	$	(2,990	)

As of September 30, 2012, the Company believes that unrealized losses on all mortgage related securities, exclusive of the PMBS securities previously discussed, including U.S. government sponsored entity and agency securities, such as those issued by the Federal Home Loan Mortgage Corporation (“FHLMC”), the Federal National Mortgage Association (“FNMA”) and the Government National Mortgage Association (“GNMA”), 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 40 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, 2012, the Company does not believe unrealized losses related to these securities are other than temporary.

Heritage Oaks Bancorp | - 11 -

The majority of the corporate debt securities in an unrealized loss position are securities that the Company began investing in just prior to the downgrade of the U.S. debt by the S&P in 2011.  As a result of the U.S. debt’s downgrade, there was increased pressure on the price of all types of debt securities but most notably corporate and CMBS securities, as investors liquidated their positions in favor of higher quality and more liquid investments.  However, the value of these securities has shown signs of strengthening in recent months, as evidenced by the improvement in fair value since the end of 2011.  The Company’s investments in the corporate debt portion of the portfolio are focused on investment grade variable rate instruments, which provide some degree of principal protection from movements in market interest rates.  We do not believe that any of the unrealized losses reflect on the credit quality of the issuer but rather are short-term market fluctuations due to the reaction to the U.S. debt downgrade.  As the Company has the ability and intent to hold these securities until their value recovers, and it is more likely than not that it will not be required to sell these securities, the Company does not believe there has been an other than temporary decline in their value.

The amortized cost and fair value maturities of available for sale investment securities at September 30, 2012 are shown below. The table reflects the expected lives of investment securities based on projected cash flows. Mortgage backed securities project cash flows based on a combination of historical and projected prepayment speeds because borrowers have the right to prepay their underlying obligations without prepayment penalties. Contractual maturities or call dates are reflected for all other security types. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Projected prepayment speeds are lower for certain bonds as compared to that experienced over the last few months and therefore the yield shown on these projected maturities is higher than the historical yields.

(dollar amounts in thousands)	One Year Or Less		Over 1 Through 5 Years		Over 5 Years Through 10 Years		Over 10 Years		Total
Obligations of U.S. government agencies	$	7	$	30	$	3,917	$	3	$	3,957
Mortgage backed securities
U.S. government sponsored entities and agencies	20,327		48,094		22,944		17,856		109,221
Non-agency	9,122		21,646		11,193		1,945		43,906
State and municipal securities	1,004		9,280		44,351		8,636		63,271
Corporate debt securities	-		18,999		9,346		2,330		30,675
Other	1,504		4,289		4,628		-		10,421
Total available for sale securities	$	31,964	$	102,338	$	96,379	$	30,770	$	261,451
Amortized cost	$	31,916	$	100,746	$	92,221	$	30,279	$	255,162
Weighted average yield	2.24%		2.65%		3.31%		4.15%		3.04%

Securities having an amortized cost and a fair value of $6.2 million and $6.4 million, respectively at September 30, 2012, and $5.1 million and $5.2 million, respectively at December 31, 2011 were pledged to secure public deposits.

The following table summarizes earnings on both taxable and tax-exempt investment securities for the three and nine months ended September 30, 2012 and 2011:

	For the three months				For the nine months
	ended September 30,				ended September 30,
(dollar amounts in thousands)	2012		2011		2012		2011
Taxable earnings on investment securities
Obligations of U.S. government agencies	$	25	$	32	$	79	$	137
Mortgage backed securities	973		1,176		2,971		3,192
State and municipal securities	5		121		183		377
Corporate debt securities	181		149		504		154
Other	72		20		146		20
Non-taxable earnings on investment securities
State and municipal securities	527		382		1,428		1,136
Total	$	1,783	$	1,880	$	5,311	$	5,016

Heritage Oaks Bancorp | - 12 -

Note 3.  Loans

The following table provides a summary of outstanding loan balances as of September 30, 2012 compared to December 31, 2011:

	September 30,		December 31,
(dollar amounts in thousands)	2012		2011
Real Estate Secured
Multi-family residential	$	16,429	$	15,915
Residential 1 to 4 family	37,837		20,839
Home equity lines of credit	32,422		31,047
Commercial	374,799		357,499
Farmland	23,416		8,155
Total real estate secured	484,903		433,455
Commercial
Commercial and industrial	119,496		141,065
Agriculture	17,948		15,740
Other	66		89
Total commercial	137,510		156,894
Construction
Single family residential	11,267		13,039
Single family residential - Spec.	420		8
Multi-family	787		1,669
Commercial	14,401		8,015
Total construction	26,875		22,731
Land	23,633		26,454
Installment loans to individuals	5,146		6,479
All other loans (including overdrafts)	281		273
Total gross loans	678,348		646,286
Deferred loan fees	977		1,111
Allowance for loan losses	17,987		19,314
Total net loans	$	659,384	$	625,861
Loans held for sale	$	12,590	$	21,947

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.  Under the terms of the mortgage purchase agreements, the purchaser has the right to require the Company to either repurchase the mortgage or reimburse losses incurred by the purchaser, which are determined to have been directly caused by borrower fraud or misrepresentation.  At September 30, 2012, the Company has four related loans for which the purchaser is seeking reimbursement from the Company for losses sustained as a result of borrower fraud and/or misrepresentation.  Although the Company intends to vigorously challenge these and any future claims, the Company has recorded a reserve of $0.9 million for these potential repurchases at September 30, 2012.  Although the Company has generally been successful in its defense of these types of claims, the Company has incurred losses of $0.3 million related to the settlement of 3 loans since the beginning of 2011.

Concentration of Credit Risk

At September 30, 2012 and December 31, 2011, $535.4 million and $482.6 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. 

Heritage Oaks Bancorp |- 13 -

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.

Loans serviced for others are not included in the accompanying balance sheets.  The unpaid principal balance of loans serviced for others, exclusive of Small Business Administration (“SBA”) loans, was $8.6 million at both September 30, 2012 and December 31, 2011.

From time to time, the Company also originates SBA loans for sale to governmental agencies and institutional investors.  At September 30, 2012 and December 31, 2011, the unpaid principal balance of SBA loans serviced for others totaled $4.7 million and $5.4 million, respectively.  The Company did not recognize any gains from the sale of SBA loans in the first nine months of 2012 or 2011.

At September 30, 2012, the Company was contingently liable for financial and performance standby letters of credit to its customers totaling approximately $13.9 million and un-disbursed loan commitments in the amount of $119.8 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, 2012:

			Unpaid		Impaired Loans				Specific
	Recorded		Principal		With Specific		Without Specific		Allowance for
(dollar amounts in thousands)	Investment (1)		Balance		Allowance		Allowance		Impaired Loans
Real Estate Secured
Residential 1 to 4 family	$	904	$	1,163	$	139	$	765	$	11
Home equity lines of credit	381		473		62		319		7
Commercial	4,468		8,265		255		4,213		27
Farmland	1,089		1,089		1,089		-		5
Commercial
Commercial and industrial	3,247		4,473		2,656		591		1,096
Agriculture	1,075		1,253		50		1,025		21
Construction
Commercial	1,840		2,508		-		1,840		-
Land	7,301		10,829		6,197		1,104		3,434
Installment loans to individuals	205		225		205		-		16
Totals	$	20,510	$	30,278	$	10,653	$	9,857	$	4,617

(1)The recorded investment in loans includes the book value of impaired loans as adjusted for the net deferred costs and fees related to the impaired loans.

Heritage Oaks Bancorp |- 14 -

The following table provides a summary of the Company’s investment in impaired loans as of December 31, 2011:

			Unpaid		Impaired Loans				Specific
	Recorded		Principal		With Specific		Without Specific		Allowance for
(dollar amounts in thousands)	Investment (1)		Balance		Allowance		Allowance		Impaired Loans
Real Estate Secured
Residential 1 to 4 family	$	622	$	895	$	153	$	469	$	53
Home equity lines of credit	359		443		-		359		-
Commercial	4,567		5,513		3,876		691		738
Farmland	-		-		-		-		-
Commercial
Commercial and industrial	2,183		2,879		1,928		255		1,169
Agriculture	2,789		2,932		2,166		623		140
Construction
Single family residential	937		937		-		937		-
Land	1,886		2,258		729		1,157		114
Installment loans to individuals	61		61		61		-		3
Totals	$	13,404	$	15,918	$	8,913	$	4,491	$	2,217

(1)The recorded investment in loans includes the book value of impaired loans as adjusted for the net deferred costs and fees related to the impaired loans.

The average recorded investment in impaired loans and the interest income recognized on impaired loans for the three and nine months ended September 30, 2012 and 2011 was:

	For the three months ended September 30,								For the nine months ended September 30,
	2012				2011				2012				2011
	Average		Interest		Average		Interest		Average		Interest		Average		Interest
	Recorded		Income		Recorded		Income		Recorded		Income		Recorded		Income
(dollar amounts in thousands)	Investment		Recognized		Investment		Recognized		Investment		Recognized		Investment		Recognized
Real Estate Secured
Residential 1 to 4 family	$	801	$	-	$	568	$	-	$	756	$	-	$	613	$	-
Home equity lines of credit	384		-		808		-		378		-		861		-
Commercial	3,492		-		10,354		-		3,757		-		12,346		-
Farmland	363		-		577		-		272		-		1,090		-
Commercial
Commercial and industrial	4,129		-		2,992		21		3,644		4		3,708		22
Agriculture	1,905		-		883		-		2,010		-		724		-
Construction
Single family residential	-		-		1,174		-		234		-		1,209		-
Single family residential - Spec.	-		-		-		-		-		-		313		-
Multi-family	-		-		-		-		-		-		120		-
Commercial	1,257		-		-		-		943		-		-		-
Land	7,189		-		3,669		-		5,863		-		3,780		-
Installment loans to individuals	89		-		4		-		82		-		96		-
Totals	$	19,609	$	-	$	21,029	$	21	$	17,939	$	4	$	24,860	$	22

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, 2012 and 2011. If interest on non-accruing loans had been recognized at the original interest rates stipulated in the respective loan agreements, interest income would have increased $0.3 million for the both three months ended September 30, 2012 and 2011, and $1.0 million and $1.4 million for the nine months ended September 30, 2012 and 2011, respectively.  Interest income recognized on impaired loans in the table above, if any, represents interest the Company recognized on performing troubled debt restructurings.

Because the loans currently identified as impaired have unique risk characteristics, the Company determined the related valuation allowances for such loans on a loan-by-loan basis.  It should be noted that a significant portion of the Company’s impaired loans were carried at the fair value of the underlying collateral, net of estimated selling costs as of September 30, 2012 and December 31, 2011.

Heritage Oaks Bancorp |- 15 -

At September 30, 2012 and December 31, 2011, $11.5 million and $3.7 million, respectively, in loans were classified as troubled debt restructurings (“TDRs”).  Of those balances $18 thousand and $0.8 million were accruing as of September 30, 2012 and December 31, 2011, respectively.  In a majority of these loans, the Company has granted concessions regarding interest rates, payment structure and maturity.  During the three and nine months ending September 30, 2012 and 2011, the terms of certain loans were modified as troubled debt restructurings. These term modifications included a combination of a partial charge-off of principal along with extensions of the maturity date at the loan’s original interest rate, which was lower than the current market rate for new debt with similar risk.  The maturity date extensions granted were for periods ranging from 12 months to 18 months. Forgone interest related to concessions granted on TDRs totaled $46 thousand and $13 thousand for the three months ended September 30, 2012 and 2011, respectively, and $85 thousand and $62 thousand for the nine months ended September 30, 2012 and 2011, respectively.  As of September 30, 2012, the Company was not committed to lend any additional funds to borrowers whose obligations to the Company were restructured.

The following table presents loan modifications by class which resulted in TDRs during the three and nine months ending September 30, 2012:

	For the three months ended September 30, 2012					For the nine months ended September 30, 2012
		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
Residential 1 to 4 family	-	$	-	$	-	1	$	439	$	439
Farmland	1	1,089		1,089		1	1,089		1,089
Commercial
Commercial and industrial	6	1,120		1,099		9	2,115		2,094
Construction
Land	1	63		63		3	8,433		7,063
Totals	8	$	2,272	$	2,251	14	$	12,076	$	10,685

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

Heritage Oaks Bancorp |- 16 -

The following table summarizes TDRs that were completed in the last twelve months and became delinquent during the three and nine months ended September 30, 2012:

	For the three months ended September 30, 2012			For the nine months ended September 30, 2012
	Number of			Number of
(dollar amounts in thousands)	TDRs	Recorded Investment		TDRs	Recorded Investment
Trouble Debt Restructurings
That Subsequently Defaulted
Commercial
Commercial and industrial	0	$	-	3	$	254
Totals	0	$	-	3	$	254

The Bank is actively working with the borrowers to resolve their delinquencies.

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

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 and management 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 a detailed internal process, at least quarterly, as well as with the assistance of independent loan reviews.  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 and take timely action 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, guarantors and the strength of the collateral.  Risk grades are reviewed regularly by the Company’s credit committee and are scrutinized during independent loan reviews performed semi-annually, as well as by regulatory agencies during scheduled examinations.  In the second quarter of 2012, the Company implemented a more detailed risk grading system that provided for a more granular break down of loans within the Company’s four primary credit risk ratings, discussed below.

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.

Heritage Oaks Bancorp |- 17 -

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 (appraisal or cash flow 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 for collateral dependent loans and updated cash-flow information if the loan is unsecured or primarily dependent on future operating or other cash-flows. Once the updated financial information is obtained and analyzed by Management, a valuation allowance, if necessary, is established against such loans 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 loans have been charged-off.  If upon a loan’s migration to non-accruing status, the financial information obtained while the loan was classified as substandard are deemed to be outdated, the Company typically orders new appraisals on underlying collateral or obtains the most recent cash-flow information in order to have the most current indication of fair value.  For collateral dependent loans, 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-accrual status at least quarterly, and corresponding changes in any related valuation allowance are made or balances deemed to be fully uncollectable are charged-off. Cash-flow information for impaired loans dependent primarily on future operating or other cash-flows are updated quarterly as well, with subsequent shortfalls resulting in valuation allowance adjustments.

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 experienced line managers, with the oversight of the Chief Credit Officer and/or the Special Assets department, which is responsible for obtaining updated periodic appraisal information for collateral securing problem loans as well as updated cash-flow information.  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 sell a troubled loan rather than to continue to hold it in its portfolio, additional charge-offs have been realized as buyers of distressed loans typically 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.

Heritage Oaks Bancorp |- 18 -

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, 2012:

			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	$	16,429	$	15,883	$	-	$	546	$	-	$	-	$	-	$	-	$	-	$	-
Residential 1 to 4 family	37,837		36,918		7		912		-		-		-		-		907		-
Home equity lines of credit	32,422		30,807		-		1,615		-		81		262		-		381		-
Commercial	374,799		328,209		16,138		30,452		-		216		233		-		4,428		-
Farmland	23,416		16,742		3,270		3,404		-		-		-		-		1,089		-
Commercial
Commercial and industrial	119,496		105,111		5,770		8,615		-		435		-		-		3,243		18
Agriculture	17,948		15,925		107		1,916		-		-		-		-		1,075		-
Other	66		66		-		-		-		-		-		-		-		-
Construction
Single family residential	11,267		11,267		-		-		-		-		-		-		-		-
Single family residential - Spec.	420		420		-		-		-		-		-		-		-		-
Multi-family	787		787		-		-		-		-		-		-		-		-
Commercial	14,401		12,561		-		1,840		-		-		-		-		1,840		-
Land	23,633		11,034		4,567		8,032		-		-		-		-		7,300		-
Installment loans to individuals	5,146		4,707		222		217		-		40		3		-		206		-
All other loans (including overdrafts)	281		276		1		4		-		-		-		-		-		-
Totals	$	678,348	$	590,713	$	30,082	$	57,553	$	-	$	772	$	498	$	-	$	20,469	$	18

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, 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	$	15,915	$	15,915	$	-	$	-	$	-	$	-	$	-	$	-	$	-	$	-
Residential 1 to 4 family	20,839		20,209		-		630		-		-		-		-		622		-
Home equity lines of credit	31,047		29,274		56		1,717		-		267		65		-		359		-
Commercial	357,499		311,234		17,795		28,470		-		-		-		-		4,551		-
Farmland	8,155		5,830		-		2,325		-		-		-		-		-		-
Commercial
Commercial and industrial	141,065		122,964		11,630		6,416		55		329		92		-		1,625		561
Agriculture	15,740		11,326		-		4,414		-		-		-		-		2,327		-
Other	89		89		-		-		-		-		-		-		-		-
Construction																	-
Single family residential	13,039		12,102		-		937		-		-		-		-		937		-
Single family residential - Spec.	8		8		-		-		-		-		-		-		-		-
Multi-family	1,669		-		-		1,669		-		-		-		-		-		-
Commercial	8,015		3,714		4,301		-		-		-		-		-		-		-
Land	26,454		13,985		5,234		7,235		-		41		-		-		1,886		-
Installment loans to individuals	6,479		6,148		247		84		-		-		2		-		61		-
All other loans (including overdrafts)	273		271		1		1		-		-		-		-		-		-
Totals	$	646,286	$	553,069	$	39,264	$	53,898	$	55	$	637	$	159	$	-	$	12,368	$	561

Note 4.  Allowance for Loan Losses

The Company has established an allowance for loan losses to account for probable losses inherent in the loan portfolio as of the date of the balance sheet.  The allowance is comprised of two components: specific credit allocation and general portfolio allocation, which includes a qualitatively determined adjustment.  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 quantitative portfolio allocation is then adjusted for qualitatively determined adjustments that are determined through judgments the Company makes regarding certain qualitative factors that may positively or negatively impact the credit quality of various segments of the loan portfolio relative to the historical performance of those segments.

Heritage Oaks Bancorp |- 19 -

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 and placed on non-accrual, the Company places the loan under the supervision of its Special Assets department.  The Special Assets department, with oversight from the Chief Credit Officer, 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. Loans, of the notes to the condensed consolidated financial statements.  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.

The qualitatively determined adjustment to the general portfolio 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 possesses 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.

Heritage Oaks Bancorp |- 20 -

·    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.

The following table summarizes the activity in the allowance attributed to various segments in the loan portfolio for the three months ended September 30, 2012 and 2011:

	Real Estate															All Other
(dollar amounts in thousands)	Secured			Commercial			Construction			Land			Installment			Loans			Total
Balance, June 30, 2012	$	6,897		$	6,261		$	381		$	4,483		$	91		$	36		$	18,149
Charge-offs	(106		)	(1,511		)	(92		)	-			(9		)	-			(1,718		)
Recoveries	12			246			1			5			5			1			270
Provisions for loan losses	1,184			75			268			(225		)	(15		)	(1		)	1,286
Balance, September 30, 2012	$	7,987		$	5,071		$	558		$	4,263		$	72		$	36		$	17,987
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
Provisions 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

Heritage Oaks Bancorp |- 21 -

The following table summarizes the activity in the allowance attributed to various segments in the loan portfolio for the nine months ended September 30, 2012 and 2011:

	Real Estate															All Other
(dollar amounts in thousands)	Secured			Commercial			Construction			Land			Installment			Loans			Total
Balance, December 31, 2011	$	9,645		$	6,549		$	488		$	2,416		$	175		$	41		$	19,314
Charge-offs	(2,471		)	(4,272		)	(668		)	(2,168		)	(29		)	(137		)	(9,745		)
Recoveries	74			623			1			18			18			3			737
Provisions for loan losses (1)	739			2,171			737			3,997			(92		)	129			7,681
Balance, September 30, 2012	$	7,987		$	5,071		$	558		$	4,263		$	72		$	36		$	17,987
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
Provisions 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

(1) The provision for loan losses includes the transfer of $3.9 million from C&I to land related to the re-characterization of a loan as part of a TDR in the second quarter of 2012, as the restructured loan became more collateral dependent on a parcel of land.

The following tables summarize comparative metrics about the allowance attributed to various segments in the loan portfolio as of September 30, 2012 and December 31, 2011:

	As of September 30, 2012
	Real Estate										All Other
(dollar amounts in thousands)	Secured		Commercial		Construction		Land		Installment		Loans		Total
Amount of allowance attributed to:
Specifically evaluated impaired loans	$	50	$	1,117	$	-	$	3,434	$	16	$	-	$	4,617
General portfolio allocation	$	7,937	$	3,954	$	558	$	829	$	56	$	36	$	13,370
Loans individually evaluated for impairment	$	6,805	$	4,336	$	1,840	$	7,300	$	206	$	-	$	20,487
Loans collectively evaluated for impairment	$	478,098	$	133,174	$	25,035	$	16,333	$	4,940	$	281	$	657,861
General reserves to total loans collectively evaluated for impairment	1.66%		2.97%		2.23%		5.08%		1.13%		12.81%		2.03%
Total gross loans	$	484,903	$	137,510	$	26,875	$	23,633	$	5,146	$	281	$	678,348
Total allowance to gross loans	1.65%		3.69%		2.08%		18.04%		1.40%		12.81%		2.65%

	As of December 31, 2011
	Real Estate										All Other
(dollar amounts in thousands)	Secured		Commercial		Construction		Land		Installment		Loans		Total
Amount of allowance attributed to:
Specifically evaluated impaired loans	$	791	$	1,309	$	-	$	114	$	3	$	-	$	2,217
General portfolio allocation	$	8,854	$	5,240	$	488	$	2,302	$	172	$	41	$	17,097
Loans individually evaluated for impairment	$	5,532	$	4,963	$	937	$	1,886	$	61	$	-	$	13,379
Loans collectively evaluated for impairement	$	427,923	$	151,931	$	21,794	$	24,568	$	6,418	$	273	$	632,907
General reserves to total loans collectively evaluated evaluated for impairment	2.07%		3.45%		2.24%		9.37%		2.68%		15.02%		2.70%
Total gross loans	$	433,455	$	156,894	$	22,731	$	26,454	$	6,479	$	273	$	646,286
Total allowance to gross loans	2.23%		4.17%		2.15%		9.13%		2.70%		15.02%		2.99%

Heritage Oaks Bancorp | - 22 -

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, 2012:

	Balance										Balance
	June 30,										September 30,
(dollar amounts in thousands)	2012		Additions		Disposals			Writedowns			2012
Real Estate Secured
Residential 1 to 4 family	$	431	$	-	$	-		$	(31	)	$	400
Commercial	215		-		-			-			215
Construction
Single family residential - Spec.	397		-		(397		)	-			-
Land	32		-		-			(32		)	-
Totals	$	1,075	$	-	$	(397	)	$	(63	)	$	615

	Balance										Balance
	December 31,										September 30,
(dollar amounts in thousands)	2011		Additions		Disposals			Writedowns			2012
Real Estate Secured
Residential 1 to 4 family	$	-	$	607	$	(176	)	$	(31	)	$	400
Commercial	215		-		-			-			215
Construction
Single family residential - Spec.	423		-		(397		)	(26		)	-
Tract	100		-		(100		)	-			-
Land	179		162		(300		)	(41		)	-
Totals	$	917	$	769	$	(973	)	$	(98	)	$	615

The Company realized a gain of $0.1 million on the disposal of OREO during both the three and nine months ended September 30, 2012.

The following table provides 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,
(dollar amounts 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,
(dollar amounts 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 | - 23 -

The Company realized a loss of $0.3 million and $0.6 million related to disposals of OREO during the three and nine months ended September 30, 2011, respectively.

Note 6.  Income Taxes

The tax provision for the three and nine months ended September 30, 2012 resulted in an effective tax rate of (84.3)% and (54.8)%, respectively.  The tax provision for the three and nine months ended September 30, 2011 resulted in an effective tax rate 35.3% and 32.8%, respectively.  The primary items affecting the effective tax rate for the three and nine months ended September 30, 2012 are the reversal $4.1 million and $5.6 million, respectively, of deferred tax valuation allowance and the impact of non-taxable municipal interest. The reversal of the Company’s deferred tax asset valuation allowance is discussed more fully below. The primary item affecting the effective tax rate for the first nine months of 2011 is the impact of non-taxable municipal interest.

Deferred Tax Assets Valuation Allowance

U.S. GAAP requires that companies assess whether a valuation allowance should be established against deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard.  In making such judgments, significant weight is given to evidence, both positive and negative, that can be objectively verified.  U.S. GAAP provides that a cumulative loss in recent years is significant negative evidence in considering whether deferred tax assets are realizable, and also limits projections of future taxable income to that which can be estimated over a reasonable amount of time.

The pre-tax losses the Company reported in 2010 and 2009 resulted in a three year cumulative loss position, which provided significant negative evidence as to the realizability of a portion of the Company’s deferred tax assets as of December 31, 2010.  As a result of this negative evidence, the Company recorded a partial valuation allowance of approximately $7.1 million for its deferred tax assets in 2010 through a charge to income tax expense. The Company’s determination of the valuation allowance for a portion of its deferred tax assets was based on: (1) an analysis of cumulative pre-tax losses over a three year horizon, through December 31, 2010; (2) a projection of future taxable income over a period of time the Company believed to be reasonably estimable (“the projection period”); and (3) a detailed analysis to determine the amount of the deferred tax asset expected to be realized over the projection period of five years.

The ultimate realization of the Company’s deferred tax assets is dependent on the generation of future taxable income during the periods in which those temporary differences reverse.  The Company established a valuation allowance against a portion of the deferred tax asset in 2010 because it had a three year cumulative pre-tax loss position as of December 31, 2010 and management believed that it was not more likely than not that the Company would generate enough future taxable income over the projection period in order for all of its deferred tax assets to be realized.

The Company’s return to profitability in 2011 and continued profits through September 30, 2012 substantially eliminated the three year cumulative loss position.  In addition, declines in the level of deferred tax assets and changes in their composition, along with projections of profitability for the foreseeable future and an improvement in the credit quality of the Company’s loan portfolio have combined to improve the outlook for the recovery of the valuation allowance provided for in 2010.  As a result of this improved outlook, the Company reduced the level of valuation allowance in the fourth quarter of 2011 by $1.5 million. During the first nine months of 2012, these favorable trends led the Company to further reduce the level of valuation allowance by an additional $1.5 million in the first half of the year and to ultimately conclude in the third quarter of 2012 that it was now more likely than not that its entire deferred tax asset position would be realized.

Heritage Oaks Bancorp | - 24 -

Therefore, after giving effect to the portion of the deferred tax asset valuation allowance related to timing differences that would reverse in the current year and therefore should be reflected as an adjustment to the 2012 effective tax rate, a discrete reversal of the remaining $4.1 million of valuation allowance was recorded in the third quarter of 2012.

The deferred tax assets for which there is no valuation allowance relate to amounts that are expected to be realized through reversals of existing taxable temporary differences over the projection period.  The accounting for deferred taxes is based on an estimate of future results.  Differences between anticipated and actual outcomes of these future tax consequences could have an impact on the Company’s consolidated results of operations or financial position. See Note 10. Income Taxes, of the Company’s Annual Report filed on Form 10-K for additional discussion of the accounting for deferred taxes.

Note 7.  Earnings Per Share

Basic earnings per common share are computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding for the reporting period.  Diluted earnings 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.  The computation of diluted earnings per common share excludes the impacts of the assumed 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.  For the three months ended September 30, 2012 and 2011, common stock equivalents, primarily options, totaling approximately 299,000 shares and 672,000 shares, respectively, were excluded from the calculation of diluted earnings per share, as their impact would be anti-dilutive.  For the nine months ended September 30, 2012 and 2011, common stock equivalents, primarily options, totaling approximately 278,000 shares and 561,000 shares, respectively, were excluded from the calculation of diluted earnings 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 also excludes the impact of approximately 612,000 shares potentially issuable under the warrant issued as part of the Series A Preferred Share issuance (see Note 10. Preferred Stock, of these condensed consolidated financial statements), as their impact would also be anti-dilutive.

Heritage Oaks Bancorp | - 25 -

The following table sets forth the number of shares used in the calculation of both basic and diluted earnings per common share for the three and nine months ended September 30, 2012 and 2011:

	For the three months ended September 30,
	2012				2011
	Net				Net
(dollar amounts in thousands except per share data)	Income			Shares	Income			Shares
Net income	$	6,428			$	2,119
Dividends and accretion on preferred stock	(357		)		(373		)
Net income  available to common shareholders	$	6,071			$	1,746
Weighted average shares outstanding				25,089,325				25,054,027
Basic earnings per common share	$	0.24			$	0.07
Dilutive effect of share-based compensation awards, common stock warrants, and convertible perpetual preferred stock				1,341,392				1,200,018
Weighted average diluted shares outstanding				26,430,717				26,254,045
Diluted earnings per common share	$	0.23			$	0.07

	For the nine months ended September 30,
	2012				2011
	Net				Net
(dollar amounts in thousands except per share data)	Income			Shares	Income			Shares
Net income	$	9,910			$	3,594
Dividends and accretion on preferred stock	(1,113		)		(1,108		)
Net applicable to common shareholders	$	8,797			$	2,486
Weighted average shares outstanding				25,074,405				25,046,569
Basic earnings per common share	$	0.35			$	0.10
Dilutive effect of share-based compensation awards, common stock warrant, and convertible perpetual preferred stock				1,280,238				1,206,032
Weighted average diluted shares outstanding				26,354,643				26,252,601
Diluted earnings per common share	$	0.33			$	0.10

Note 8.  Share-Based Compensation Plans

As of September 30, 2012, the Company had two share-based employee compensation plans, which are more fully described in Note 15. Share-Based Compensation Plans, of the consolidated financial statements in the Company’s Annual Report filed on Form 10-K for the year ended December 31, 2011.  These plans include the “1997 Stock Option Plan” and the “2005 Equity Based Compensation Plan.”

Heritage Oaks Bancorp | - 26 -

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,
(dollar amounts in thousands)	2012		2011		2012		2011
Share-based compensation expense:
Stock option expense	$	39	$	58	$	92	$	179
Restricted stock expense	67		8		142		34
Total expense	$	106	$	66	$	234	$	213
Unrecognized compensation expense:
Stock option expense	$	620	$	435
Restricted stock expense	624		56
Total unrecognized expense	$	1,244	$	491

At September 30, 2012, there was a total of $0.6 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 3.2 years.

The Company grants restricted share awards periodically for the benefit of employees. These restricted shares generally vest over a period of three to five years depending on the terms of the grant.  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, 2012 was $0.6 million.  That expense is expected to be recognized over the next 2.8 years.

The following table provides a summary of activity related to options granted, exercised, and forfeited during the year to date period ended September 30, 2012:

	Options Outstanding				Options
	Number		Weighted Average		Available for
	of Shares		Exercise Price		Grant
Balance, December 31, 2011	636,406		$	5.40	1,826,516
Granted	195,441		5.42
Forfeited	(196,249	)	4.16
Expired	(36,480	)	5.92
Exercised	(40,999	)	3.17
Balance, September 30, 2012	558,119		$	5.97	1,674,924

The following table provides a summary of activity related to restricted stock granted, vested and forfeited during the year to date period ended September 30, 2012:

	Number of		Average Grant
	Shares		Date Fair Value
Balance December 31, 2011	91,513		$	3.23
Granted	108,514		5.11
Forfeited	(6,800	)	4.22
Balance September 30, 2012	193,227		$	4.25

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 aggregate intrinsic value of options exercised was $67 thousand for the year to date period ended September 30, 2012.  The following table provides a summary of the aggregate intrinsic value of options vested and expected to vest and exercisable.

				Weighted Average
		Weighted		Remaining	Aggregate
		Average		Contractual Life	Intrinsic
	Shares	Exercise Price		(Years)	Value
Vested or expected to vest	530,213	$	5.97	7.75	$	636,975
Exerciseable at September 30, 2012	274,229	$	7.21	3.24	$	387,744

Heritage Oaks Bancorp | - 27 -

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 2012 and 2011:

	For the nine months ended
	September 30,
	2012		2011
Expected volatility	52.26%		50.73%
Expected term (years)	7		7
Dividend yield	0.00%		0.00%
Risk free rate	1.11%		2.74%
Weighted-average grant date fair value	$	2.87	$	2.00

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.

Heritage Oaks Bancorp | - 28 -

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 in Available for Sale 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.  The fair value of newly issued securities, for which there is not a sufficient history of market transactions on which to base a fair value determination under Level 1 or 2 of the hierarchy, are initially valued under Level 3 of the hierarchy.  At such time that sufficient history of market transactions is established, the securities’ fair value is determined under Level 1 or 2 of the hierarchy and accordingly the security is transferred out of Level 3 and into the applicable level.

Federal Home Loan Bank Stock

The fair value of Federal Home Loan Bank stock is not readily determinable due to the lack of its transferability.

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, which is based on the appraised value of the collateral less any estimated costs to sell, or the discounted expected future cash flows.  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 based on Company specific experience with similar collateral, the Company records impaired loans as non-recurring Level 3.  The most common adjustment to reported appraised values of collateral is a monthly discount linked to the passage of time since the last appraisal.  This discount factor ranges between 1% and 3% per month and is consistent with that used in the appraisals to discount for the passage of time between the transaction date for comparable properties used in the appraisal and the appraisal date. At September 30, 2012, 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 based on Company specific experience with similar assets, the Company records other real estate owned or foreclosed collateral as non-recurring Level 3 assets.  The most common adjustment to reported appraised values of collateral is a monthly discount linked to the passage of time since the last appraisal.  This discount factor ranges between 1% and 3% per month and is consistent with that used in the appraisals to discount for the passage of time between the transaction date for comparable properties used in the appraisal and the appraisal date.

Heritage Oaks Bancorp | - 29 -

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.

Junior Subordinated Debentures

The fair value disclosed for junior subordinated debentures is based on market prices 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, 2012 and December 31, 2011:

	Fair Value Measurements Using
	Quoted Prices in		Significant Other		Significant
	Active Markets for		Observable		Unobservable
(dollar amounts in thousands)	Inputs		Inputs		Inputs		Assets At
As of September 30, 2012	(Level 1)		(Level 2)		(Level 3)		Fair Value
Assets
Obligations of U.S. government agencies	$	-	$	3,957	$	-	$	3,957
Mortgage backed securities:
Agency	-		109,221		-		109,221
Non-agency	-		43,906		-		43,906
Obligations of state and municipal securities	-		63,271		-		63,271
Corporate debt securities	-		30,675		-		30,675
Other securities	-		10,421		-		10,421
Total assets measured on a recurring basis	$	-	$	261,451	$	-	$	261,451
As of December 31, 2011
Assets
Obligations of U.S. government agencies	$	-	$	4,326	$	-	$	4,326
Mortgage backed securities:
Agency	-		117,325		-		117,325
Non-agency	-		31,458		3,074		34,532
Obligations of state and municipal securities	-		51,664		259		51,923
Corporate debt securities			26,856		-		26,856
Other securities	-		2,020		-		2,020
Total assets measured on a recurring basis	$	-	$	233,649	$	3,333	$	236,982

Heritage Oaks Bancorp | - 30 -

In determining the fair value of Level 3 instruments on a recurring basis the Company takes into consideration several variables, including but not limited to: expectations about interest rate movements, prepayment speeds of the underlying mortgages for mortgage backed securities, expected default rates, and credit spreads over the risk free rate.  Of these variables, default rates and credit spreads are perhaps the least observable and most impactful on the long-term value of a Level 3 security.  Since a bond’s value is represented by its yield which reflects the risk-free yield curve plus compensation for various risks incurred in buying the bond, changes to the risk assumptions including probability of default and timing of future cash flows can materially impact the market value. As of September 30, 2012, there were no Level 3 instruments.

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, 2012 and 2011:

					Purchases,
	Beginning		Gain / (Loss)		Issuances, and		Sales and		Transfers to / (from)			Ending
(dollar amounts in thousands)	Balance		Included in OCI (1)		Settlements		Maturities		Level III			Balance
For the three months ended
September 30, 2012
Obligations of state and municipal securities	$	262	$	-	$	-	$	-	$	(262	)	$	-
September 30, 2011
Obligations of state and municipal securities	$	257	$	2	$	-	$	-	$	-		$	259

						Purchases,
	Beginning		Gain / (Loss)			Issuances, and		Sales and		Transfers to / (from)			Ending
(dollar amounts in thousands)	Balance		Included in OCI (1)			Settlements		Maturities		Level III			Balance
For the nine months ended
September 30, 2012
Obligations of state and municipal securities	$	259	$	3		$	-	$	-	$	(262	)	$	-
Agency mortgage baked securities	-		(191		)	4,674		-		(4,483		)	-
Non-agency mortgage backed securities	3,074		-			-		-		(3,074		)	-
September 30, 2011
Obligations of state and municipal securities	$	283	$	(24	)	$	-	$	-	$	-		$	259

(1) Realized or unrealized gains from the changes in values of Level 3 financial instruments represent gains from changes invalues 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, which are 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.

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The following table provides a summary of assets the Company measures at fair value on a non-recurring basis as of September 30, 2012 and December 31, 2011:

	Fair Value Measurements Using
	Quoted Prices in		Significant Other		Significant
	Active Markets for		Observable		Unobservable
(dollar amounts in thousands)	Identical Assets		Inputs		Inputs		Assets At		Total
As of September 30, 2012	(Level 1)		(Level 2)		(Level 3)		Fair Value		(Gains) / Losses
Assets
Impaired loans
Commercial real estate	$	-	$	-	$	185	$	185	$	(152	)
Farmland	-		-		1,084		1,084		5
Commercial and industrial	-		196		794		990		799
Land	-		-		2,546		2,546		3,379
Foreclosed assets	-		615		-		615		-
Total assets measured on a non-recurring basis	$	-	$	811	$	4,609	$	5,420	$	4,031
As of December 31, 2011
Assets
Impaired loans
Residential 1 to 4 family	$	-	$	-	$	95	$	95	$	126
Home equity lines of credit	-		7		-		7		82
Commercial real estate	-		-		3,813		3,813		458
Commercial and industrial	-		511		-		511		113
Agriculture	-		668		1,250		1,918		117
Land	-		56		615		671		113
Installment loans to individuals	-		58		-		58		-
Loans held for sale	-		4,279		-		4,279		-
Foreclosed assets	-		959		-		959		-
Total assets measured on a non-recurring basis	$	-	$	6,538	$	5,773	$	12,311	$	1,009

There were no transfers in or out of Level 1 and Level 2 for assets reported at fair value on either a recurring and nonrecurring basis during the three and nine months ended September 30, 2012, other than transfers of securities from Level 3 into Level 2 once sufficient market data was accumulated to value these new security issues.  There were no significant transfers in or out of Level 1 and Level 2 for assets reported at fair value on both a recurring and nonrecurring basis during the three and nine months ended September 30, 2011.

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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, 2012 and December 31, 2011:

			Fair Value Measurements Using
			Quoted Prices in		Significant Other		Significant
			Active Markets for		Observable		Unobservable
(dollar amounts in thousands)	Carrying		Identical Assets		Inputs		Inputs
As of September 30, 2012	Amount		(Level 1)		(Level 2)		(Level 3)		Fair Value
Assets
Cash and cash equivalents	$	44,176	$	44,176	$	-	$	-	$	44,176
Investments and mortgage-backed securities	261,451		-		261,451		-		261,451
Federal Home Loan Bank stock	4,575		-		-		-		N/A
Loans receivable, net of deferred fees and costs	677,371		-		196		687,826		688,022
Loans held for sale	12,590		-		12,590		-		12,590
Accrued interest receivable	3,898		-		1,429		2,469		3,898
Liabilities
Non interest-bearing deposits	267,199		267,199		-		-		267,199
Interest-bearing deposits	587,833		-		588,790		-		588,790
Federal Home Loan Bank advances	46,000		-		46,626		-		46,626
Junior subordinated debentures	8,248		-		-		7,716		7,716
Accrued interest payable	211		-		211		-		211
As of December 31, 2011
Assets
Cash and cash equivalents	$	34,892	$	34,892	$	-	$	-	$	34,892
Investments and mortgage-backed securities	236,982		-		233,649		3,333		236,982
Federal Home Loan Bank stock	4,685		-		-		-		N/A
Loans receivable, net of deferred fees and costs	645,175		-		1,300		645,491		646,791
Loans held for sale	21,947		-		21,947		-		21,947
Accrued interest receivable	3,854		-		1,241		2,613		3,854
Liabilities
Non interest-bearing deposits	217,245		217,245		-		-		217,245
Interest-bearing deposits	568,963		-		569,988		-		569,988
Federal Home Loan Bank advances	51,500		-		52,110		-		52,110
Junior subordinated debentures	8,248		-		-		4,096		4,096
Accrued interest payable	455		-		455		-		455

Information on off-balance sheet instruments as of September 30, 2012 and December 31, 2011 follows:

	September 30, 2012				December 31, 2011
	Notional		Cost to Cede		Notional		Cost to Cede
(dollar amounts in thousands)	Amount		or Assume		Amount		or Assume
Off-balance sheet instruments, commitments to extend credit and standby letters of credit	$	179,726	$	1,797	$	161,987	$	1,620

Note 10.  Preferred Stock

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.

Heritage Oaks Bancorp | - 33 -

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

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 market price of the Company’s stock is above the warrant’s exercise price.

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, 2012, 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.

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.  During the second quarter of 2012, the Company received regulatory approval to pay its second quarter 2012 dividend and all prior deferred dividends and has remained current as to the payment of dividends  as of September 30, 2012. The Treasury’s rights relative to electing two members to the Company’s Board of Directors and their Board observation rights lapsed upon the payment of the dividends in arrears in the second quarter of 2012.

Series C Convertible Perpetual Preferred Stock

On March 12, 2010, the Company sold 1,189,538 shares of its Series C Convertible Perpetual Preferred Stock (“Series C Preferred Stock”) for $3.6 million as part of the overall $60 million private placement of securities completed at that time.  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.  There is no stated dividend rate for shares of Series C Preferred Stock.  However, in the event that a common stock dividend is declared, holders of Series C Preferred Stock are entitled to a per share dividend equivalent to that declared for each common share into which Series C Preferred Stock is then convertible.

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 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.

Heritage Oaks Bancorp | - 34 -

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, 2012.

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.

Note 11.  Regulatory Matters

On March 4, 2010, the FDIC and the DFI issued a Consent Order (the “Order”) to the Bank that required, among other things, the Bank to increase its capital ratios, reduce its classified assets and increase Board oversight of Management. The Board and Management aggressively responded to the Order to ensure full compliance and took actions necessary to substantially comply with the Order within the required time frames.

Such actions included the completion of the capital raise that was addressed by the Company’s 2010 $60 million private placement, from which a contribution of a portion of the proceeds were made to the Bank. This contribution brought the Bank into compliance with the capital requirements of the Order.

In April 2012, in conjunction with the completion of their most recent full scope review, the FDIC and California Department of Financial Institutions (“DFI”) terminated the Joint Consent Order (“Order”) issued March 4, 2010. In connection with the termination of the Order, the Bank’s Board of Directors executed a Memorandum of Understanding (“MOU”) with the FDIC and DFI. In the MOU, the Company committed to, among other things, continue to make progress in improving credit quality and processes as well as to continue to comply with the 10% Leverage Ratio as originally established by the Order.  The Bank’s leverage ratio was 11.75% as of September 30, 2012.

On March 4, 2010, the Company entered into a written agreement (the “Written Agreement”) with the Federal Reserve Bank of San Francisco (“FRB”), which required the Company to take certain measures to improve its safety and soundness. Under the Written Agreement, the Company was required to develop and submit for approval, a plan to maintain sufficient capital at the Company and the Bank within 60 days of the date of the Written Agreement. The Written Agreement further provided, among other things, that the Company would not: declare or pay dividends without prior approval of the FRB, take dividends from the Bank, make any distribution of interest, principal or other sums on subordinated debt or trust preferred securities, incur, increase, or guarantee any debt.

In July 2012, the FRB terminated the Written Agreement issued on March 4, 2010.  In connection with the termination of the Written Agreement, the Company executed a MOU with FRB.  In the MOU the Company committed among other things to continue to seek FRB approval prior to: paying any dividends on its common and preferred stock; paying interest, principal or other sums on subordinated debt or trust preferred securities; or incurring, increasing, or guaranteeing any debt.

Note 12.  Junior Subordinated Debentures

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 FRB.  During the second quarter of 2012, based on the Company’s receipt of regulatory approval to pay interest currently due and all previously deferred interest, the Company paid all amounts due on May 25, 2012 and has remained current on its interest payments as of September 30, 2012.  For more information concerning the Written Agreement, please refer to Note 11. Regulatory Matters, of these condensed consolidated financial statements.

Note 13.  Asset Acquisition

In September 2012, the Company announced that it had entered into a definitive agreement with Coast National Bank to purchase its branch facilities and related fixed assets and a major portion of its deposit base in Morro Bay, California.  The asset acquisition is expected to be completed in the fourth quarter of 2012.  The purchase price is dependent on the level of deposits that exist at the closing date, but is expected to be approximately $1.7 million and is comprised of approximately $1.0 million allocable to the building and related assets being purchased and $0.7 million related to the deposit premium being paid for the deposits being assumed.

Heritage Oaks Bancorp | - 35 -

Based on recent deposit reports provided by Coast National Bank, the Company expects to receive approximately $30 million of cash related to the deposits, which it will invest in new loans and investment securities.

Note 14.  Subsequent Events

In October 2012, a $3.9 million loan which had been reported as classified and non-performing as of September 30, 2012 was paid off, which resulted in a $1.1 million recovery to the allowance for loan losses.

Heritage Oaks Bancorp | - 36 -

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

This Quarterly Report on Form 10-Q may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended.  You can find many but not all of these statements by looking for words such as “approximates,” “believes,” “expects,” “anticipates,” “estimates,” “intends,” “plans,” “would,” “may” and other similar expressions in this Quarterly Report on Form 10-Q.  The Company claims the protection of the safe harbor contained in the Private Securities Litigation Reform Act of 1995.  The Company cautions investors that any forward-looking statements presented in this Quarterly Report on Form 10-Q, or those that the Company may make orally or in writing from time to time, are based on the Company’s beliefs, and on assumptions made by, and information available to management at the time such statements are first made.  The actual outcome will be affected by known and unknown risks, trends, uncertainties and factors that are beyond the Company’s control or ability to predict.  Although the Company believes that management’s assumptions are reasonable, they are not guarantees of future performance and some will inevitably prove to be incorrect.  As a result, the Company’s actual future results can be expected to differ from management’s expectations, and those differences may be material and adverse to the Company’s business, results of operations and financial condition.  Accordingly, investors should use caution in relying on forward-looking statements to anticipate future results or trends.

Some of the risk and uncertainties that may cause the Company’s actual results, performance or achievements to differ materially from those expressed include the following: the ongoing financial crisis in the United States, including the continuing softness in the California real estate market, and the response of federal and state government and our regulators thereto, general economic conditions in those areas in which the Company operates, competition, fluctuations in interest rates, changes in the Company’s business strategy or development plans, changes in governmental regulation, changes in the credit quality of our loan portfolio, as well as economic, political and global changes arising from the war on terrorism, social unrest and other civil disturbances, 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 the Memoranda of Understanding issued by regulatory authorities having oversight of the Company’s and Bank’s operations, and financial policies of the United States government.  For further discussion of these and other factors, see “Item 1A. Risk Factors” in the Company’s 2011 Annual Report on Form 10-K.

Any forward-looking statements in this report and all subsequent written and oral forward-looking statements attributable to the Company or any person acting on behalf of the Company are expressly qualified in their entirety by the cautionary statements contained or referred to in this section.  The Company does not undertake any obligation to release publicly any revisions to forward-looking statements in this report to reflect events or circumstances after the date of this report.

Overview

The Company

Heritage Oaks Bancorp (the “Company”) is a California corporation organized in 1994 to act as a holding company for Heritage Oaks Bank (“Bank”), a bank serving San Luis Obispo and Santa Barbara Counties.  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.

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 formed a subsidiary, CCMS Systems, Inc. which is currently inactive and has not been capitalized. The Company has no present plans to utilize CCMS Systems, Inc.

Between March 2010 and mid-April 2012, the Company operated under a Consent Order with the Federal Deposit Insurance Corporation (“FDIC”) and the California Department of Financial Institutions (“DFI”) and a Written Agreement with the Federal Reserve Bank of San Francisco (“FRB”).  In April 2012, the Bank’s Consent Order was terminated and replaced with an informal Memorandum of Understanding.  Similarly in July 2012, the Company’s Written Agreement was terminated and replaced with an informal memorandum of understanding.

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The regulatory environment is discussed in more detail in Note 11.  Regulatory Matters, of the condensed consolidated financial statements filed with this Quarterly Report on Form 10-Q.

In September 2012, the Company announced that the Bank has entered into a definitive agreement with Coast National Bank to purchase its Morro Bay, California branch facilities, related fixed assets and a major portion of the  deposit base maintained at the branch.  The acquisition is expected to be completed in the fourth quarter of 2012, subject to various customary conditions to closing, most notably regulatory approval by the bank regulatory agencies with authority over each of the banks. The Bank will pay market value for the building and the fixed assets, and a blended deposit premium of 2.2% for the deposits, which includes approximately 35.5% non-interest bearing demand deposits. No loans will be transferred.   The Bank expects to receive approximately $30 million of cash in connection with the acquisition, which it will invest in new loans and investment securities.

Executive Summary of Operating Results

Net income for the three and nine months ended September 30, 2012, when compared to the same periods ended a year earlier, improved by $4.3 million and $6.3 million, respectively.  These improvements were largely driven by the reversal of the valuation allowance related to our deferred tax assets and improvements in the levels of non-interest income and non-interest expense, which improvements were partially offset by higher loan loss provisions and a modest reduction in net interest income.

The reversal of the valuation allowance related to our deferred tax assets was the result of our ongoing evaluation of the recoverability of our deferred tax assets during the three and nine months ended September 30, 2012. As part of this evaluation, it was determined that $4.1 million and $5.6 million, respectively, of the previously established valuation allowance for deferred tax assets were now more likely than not recognizable as future tax benefits.  The reversal of the deferred tax asset valuation allowance over the first nine months of 2012 reflects the impact of improved earnings and loan portfolio credit quality over the past eight quarters, which management believes provided adequate positive evidence as to the full recoverability of these deferred tax assets.  See Note 6. Income Taxes, of the notes to the condensed consolidated financial statements filed with this Quarterly Report on Form 10-Q for a more detailed discussion of the accounting for the Company’s deferred tax asset valuation allowance.

Non-interest income increased by $0.4 million and $2.5 million during the three and nine months ended September 30, 2012, respectively, as compared to the corresponding periods in 2011.  The increases in the three and nine month non-interest income were largely due to improvements in the amount of gains on the sale of mortgage loans and improvements in the gain/(loss) on sale of OREO. In addition, the nine month period benefitted from an increase in the amount of gains on sale of available for sale securities.  Non-interest expense declined by $0.3 million and $1.4 million in the three and nine months ended September 30, 2012, respectively, as compared to the corresponding periods in 2011, largely due to declines in the level of OREO valuation allowances and OREO related expenses, reductions in the level of regulatory assessment costs and occupancy costs.  For the nine months ended September 30, 2012, these reductions in non-interest expense were substantially offset by increases in the provision for potential mortgage repurchases. See “Non-Interest Income” and “Non-Interest Expense” under Results of Operations, below, for additional information on improvements in these two components of earnings.

Loan loss provision expense was $1.3 million and $7.7 million for the three and nine months ended September 30, 2012, respectively, which represents an increase of $0.2 million and $2.3 million from that reported in the corresponding periods in 2011.  As more fully discussed in the Provision for Loan Loss section of Results of Operations, below, the higher provisioning requirements in 2012 were largely due to provisioning in conjunction with charge-offs from updated specific reserve calculations. While we continue to see a general stabilization in the credit quality of the portfolio, we remain subject to loan specific credit events such as those which occurred in the first nine months of 2012, the effects of which can be and have been material.  See “Provision for Loan Losses” under Results of Operations, below, for additional information related to the provision for loan losses.

Management believes that the operating results for the first nine months of 2012 continue to reflect positive trends in financial performance including growth in the loan portfolio and deposits, improvements in our operating efficiency and improvements in asset quality, despite the elevated level of charge-offs related to the updating of specific reserves recorded, primarily in the first two quarters of 2012.  These trends are not only a result of what appears to be continued signs of stabilization in the local economy first seen in 2011, but also management’s focus on controlling costs, and from improvements in asset quality realized through a combination of sales of classified assets and improvement in credit quality in the loan portfolio in general throughout 2011 and continuing during the first nine months of 2012.

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Although we experienced a temporary set-back in overall asset quality due to the impact of the credit issues addressed in the first two quarters of 2012, we have seen some stabilization and improvement in classified and non-accrual loans in the third quarter of 2012.  Further in October 2012, one of the largest loans that moved to non-accrual status in the first half of 2012 was paid-off and will result in a $1.1 million recovery being recorded to the allowance for loan losses in the fourth quarter.  This pay-off will also result in a $3.9 million reduction in non-accrual and classified loans in the fourth quarter. That said, management believes that the improvements in asset quality, since asset quality issues peaked at December 31, 2010, are a meaningful indicator of overall positive trends for the Company as evidenced by:

· the decrease in classified assets from $87.9 million at December 31, 2010 to $58.5 million at September 30, 2012;

· the decline in special mention risk graded loan balances from $55.0 million at December 31, 2010 to $30.1 million at September 30, 2012; and

· the decline in OREO balances outstanding from $6.7 million at December 31, 2010 to $0.6 million at September 30, 2012.

While the Company is cautiously optimistic about the current positive trends in credit quality that we experienced in 2011 and thus far in 2012, it is unclear as to how uncertainties in the U.S. and global economy, such as continued high levels of unemployment, could impact the local economy.

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 89,000, respectively, according to the 2011 estimated economic data provided by the U.S. Census Bureau based on the 2010 Census.  The moderate climate allows a year round growing season in the local economy’s agricultural sector.  The leading agricultural industry in the Company’s primary market area 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 primary market area.  Furthermore, access to numerous recreational activities and destinations including lakes, mountains and beaches provide a relatively stable tourism industry from many areas including the Los Angeles/Orange County basin, the San Francisco Bay area and the San Joaquin Valley.

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 in 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 area negatively impacted the credit quality of the loan portfolio.  The labor market information published by the California Employment Development Department in September 2012 shows the unemployment rate within California to be approximately 10.6%, showing continued improvement from its recent high.  Within the Company’s primary market area, the labor market information also shows the unemployment rate within San Luis Obispo and Santa Barbara counties continuing to improve in 2011 and into 2012, as these areas reported unemployment levels of approximately 8% in September 2012.

Management remains cautiously optimistic that early signs show that the Company’s primary market area is beginning to stabilize as compared to the significant downward trends experienced during 2008 through 2010.  The signs of stabilization are not only reflected in the improving unemployment rates mentioned above, but also include a general improvement in the financial information being provided by our customers as part of their regular loan reviews.  Additionally, several local economists have recently reported that the improvements in unemployment, the tourism industry, housing and household income are all indicators of stabilization in our primary market area.  However, there can be no assurances that the impact 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, it could negatively impact, among other things, the financial condition of borrowers to whom the Company has extended credit.

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In this instance, the Company may suffer credit losses and be required to make further, and possibly significant, provisions to the allowance for loan losses, which would have a direct and adverse impact on our earnings and profitability.

Critical Accounting Policies

Our accounting policies are integral to understanding the Company’s financial condition and results of operations.  Accounting policies that management considers to be significant, including newly issued standards to be adopted in future periods, are disclosed in Note 1. Summary of Significant Accounting Policies, of the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2011.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ materially from those estimates.

Estimates that are particularly susceptible to significant change because they require management to make material estimates and assumptions related to the determination of the allowance for loan losses, the valuation of real estate acquired through foreclosure, the carrying value of the Company’s deferred tax assets and estimates used in the determination of the fair value of certain financial instruments.

Allowance for Loan Losses and Valuation of Foreclosed Real Estate

In connection with the determination of the specific credit component of the allowance for loan losses for non-performing loans in the loan portolio and the value of foreclosed real estate, management obtains independent appraisals for significant properties.  While management uses available information to recognize losses on non-performing loans and foreclosed real estate, future additions to the allowance may be necessary based on changes in local economic conditions.

The general portfolio allocation of the allowance is determined by pooling performing loans by collateral type and purpose.  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.  In addition qualitatively determined adjustments are made to the historical loss history to give effect to certain internal and external factors that may have either a positive or negative impact on the overall credit quality of the loan portfolio.

Because of all of the variables that go into the determination of both the specific and general allocation components of the allowance for loan losses, as well as the valuation of foreclosed real estate, it is reasonably possible that the allowance for loan losses and foreclosed real estate values may change in future periods.  See also Note 4. Allowance for Loan Losses, of the condensed consolidated financial statements filed with this Quarterly Report on Form 10-Q.

Realizability of Deferred Tax Assets

The Company uses an estimate of its future earnings in determining if it is more likely than not that the carrying value of its deferred tax assets will be realized over the period they are expected to reverse.  If based on all available evidence, the Company believes that a portion or all of its deferred tax assets will not be realized, a valuation allowance must be established.  During 2010, the Company established a valuation allowance against a portion of its deferred tax assets. Based on management’s ongoing assessment of the realizability of its deferred tax assets, it reduced the level of the valuation allowance in 2011.  In 2012, the Company determined that it was more likely than not that the entire deferred tax asset balance would be fully realized and therefore reversed the remaining valuation allowance over the first nine months of 2012.  See also Note 6. Income Taxes, of the condensed consolidated financial statements filed with this Quarterly Report on Form 10-Q.

Fair Value of Financial Instruments

The degree of judgment utilized by management in measuring the fair value of financial instruments generally correlates to the level of pricing observability.  Financial instruments with readily available actively quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of observable pricing and a lesser degree of judgment utilized in measuring fair value.

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Conversely, financial instruments rarely traded or not quoted will generally have little or no observable pricing and a higher degree of judgment is utilized in measuring the fair value of such instruments.  Observable pricing is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and the characteristics specific to the transaction.  See also Note 9. Fair Value of Assets and Liabilities, of the condensed consolidated financial statements filed with this Quarterly Report on Form 10-Q.

Where You Can Find More Information

Under Sections 13 and 15(d) of the Securities Exchange Act of 1934, as amended, periodic and current reports must be filed with the SEC. The Company electronically files the following reports with the SEC: Annual Report on Form 10-K; Quarterly Report on Form 10-Q; Current Report on Form 8-K; and a Proxy Statement on Form DEF 14A. The Company may file additional forms from time to time. The SEC maintains an internet site, www.sec.gov, from 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 and other filings 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,
(dollar amounts in thousands except per share data)	09/30/12		06/30/12		03/31/12		12/31/11		09/30/11		06/30/11		03/31/11		12/31/10
Return on average assets, annualized	2.46%		0.75%		0.65%		1.66%		0.85%		0.40%		0.22%		0.21%
Return on average equity, annualized	18.60%		5.66%		4.82%		12.87%		6.67%		3.10%		1.73%		1.67%
Return on average common equity, annualized	21.40%		5.55%		4.49%		14.98%		6.83%		2.37%		0.65%		0.10%
Average equity to average assets	13.22%		13.25%		13.51%		12.93%		12.80%		12.86%		12.51%		12.29%
Average common equity to average assets	10.85%		10.83%		11.00%		10.43%		10.30%		10.29%		10.00%		9.94%
Net interest margin	4.36%		4.41%		4.72%		4.67%		4.67%		4.80%		4.73%		4.58%
Efficiency ratio*	65.47%		69.75%		65.70%		66.17%		66.52%		68.78%		70.56%		73.84%
Average loans to average deposits	80.76%		81.80%		84.13%		82.29%		81.64%		85.76%		86.41%		85.42%
Net income	$	6,428	$	1,897	$	1,585	$	4,130	$	2,119	$	954	$	522	$	517
Net income available to common shareholders	$	6,071	$	1,522	$	1,204	$	3,879	$	1,746	$	584	$	157	$	26
Earnings per common share:
Basic	$	0.24	$	0.06	$	0.05	$	0.16	$	0.07	$	0.02	$	0.01	$	-
Diluted	$	0.23	$	0.06	$	0.05	$	0.15	$	0.07	$	0.02	$	0.01	$	-
Weighted average outstanding shares:
Basic	25,089,325		25,076,226		25,057,664		25,054,204		25,054,027		25,050,584		25,035,012		25,004,697
Diluted	26,430,717		26,399,117		26,290,370		26,261,179		26,254,045		26,252,066		26,251,608		26,247,491

* 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 and gains and losses on sale of fixed assets.

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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 interest-earning assets and interest-bearing liabilities, the amount of non-interest bearing liabilities and non-accrual loans, and changes in market interest rates. For the three months ended September 30, 2012 and 2011, the net interest margin was 4.36% and 4.67%, respectively.  For the nine months ended September 30, 2012 and 2011, the net interest margin was 4.49% and 4.73%, respectively.

For the three and nine months ended September 30, 2012 as compared to the corresponding periods in 2011, increased competition, coupled with the impact of a fragile economic and low interest rate environment, has had an adverse impact on yields on new and renewing loans. In addition, the low interest rate environment has had a two-fold impact on securities’ yields as new investments are typically providing lower yields and existing investments in mortgage backed securities are seeing increased levels of refinancing of the underlying mortgages, which is resulting in acceleration of the amortization of premiums paid on these securities.  All of these factors have combined to reduce the yield on earning assets for the three and nine months ended September 30, 2012 by 44 basis points and 39 basis points, respectively. The mix of average earning assets for the nine months ended September 30, 2012 has also contributed to the decline in the yield on earning assets, as a larger percentage of earning assets was invested in lower yielding securities as opposed to higher yielding loans.  However, the return to growth in the loan portfolio late in the second quarter and on into the third quarter has begun to contribute to a more favorable earning asset mix in the third quarter of 2012.  Decreases in funding costs related to shifts in the composition of deposits from interest bearing accounts to more liquid and fully insured non-interest bearing deposit accounts, along with reduced rates of interest paid on interest bearing deposits, have resulted in a lower cost of funds that has partially offset the reduced yields on interest-earning assets.

Forgone interest on non-accrual loans continues to be a strain on interest income for the three and nine months ended September 30, 2012, largely due to the increase in non-accrual loans during the first half of 2012, which increase largely reversed the favorable trend seen in 2011. Total forgone interest related to non-accrual 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 $0.3 million during the three months ended September 30, 2012 and 2011, respectively, and $1.0 million and $1.4 million during the nine months ended September 30, 2012 and 2011, respectively.

Our earnings are influenced by changes in interest rates.  The nature of our balance sheet can be summarily described as consisting of short duration assets and liabilities and it is once again slightly net asset sensitive. A large percentage of our interest sensitive assets and liabilities re-price immediately with changes in Federal Funds and other capital markets’ interest rates.  While declines in interest rates has resulted in a significant portion of the loan portfolio being at floor rates, modifications in the loan floor terms over the last twelve months as part of loan renewals have effectively reduced the level of upward interest rate movement required to see improvement in yields on impacted loans.     See Item 3. Qualitative and Quantitative Disclosures About Market Risk, included in this Quarterly Report on Form 10-Q for further discussion of the Company’s sensitivity to interest rate movements based on our current net asset sensitive profile, as well as the impacts of interest rate floors on our the variable rate component of our loan portfolio.

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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, 2012 and 2011:

	For the three months ended						For the three months ended
	September 30, 2012						September 30, 2011
				Yield/	Income/					Yield/	Income/
(dollar amounts in thousands)	Balance			Rate (4)	Expense		Balance			Rate (4)	Expense
Interest Earning Assets
Investments with other banks	$	-		0.00%	$	-	$	33		2.64%	$	-
Interest bearing due from banks	13,042			0.15%	5		16,368			0.17%	7
Federal funds sold	-			0.00%	-		-			0.00%	-
Investment securities taxable	204,291			2.45%	1,256		201,756			2.94%	1,497
Investment securities non taxable	62,634			3.35%	527		38,355			3.95%	382
Other investments	6,478			0.92%	15		6,659			0.71%	12
Loans (1) (2)	678,655			5.70%	9,716		659,443			6.12%	10,174
Total interest earning assets	965,100			4.75%	11,519		922,614			5.19%	12,072
Allowance for loan losses	(18,207		)				(21,530		)
Other assets	92,880						83,012
Total assets	$	1,039,773					$	984,096
Interest Bearing Liabilities
Interest bearing demand	$	70,664		0.13%	$	23	$	64,063		0.12%	$	20
Savings	36,454			0.10%	9		36,337			0.12%	11
Money market	295,792			0.34%	256		270,596			0.48%	330
Time deposits	182,138			0.94%	431		210,154			1.35%	713
Total interest bearing deposits	585,048			0.49%	719		581,150			0.73%	1,074
Federal Home Loan Bank borrowing	45,527			1.48%	169		31,810			1.27%	102
Junior subordinated debentures	8,248			2.22%	46		8,248			1.97%	41
Total borrowed funds	53,775			1.59%	215		40,058			1.42%	143
Total interest bearing liabilities	638,823			0.58%	934		621,208			0.78%	1,217
Non interest bearing demand	255,241						226,595
Total funding	894,064			0.42%	934		847,803			0.57%	1,217
Other liabilities	8,252						10,291
Total liabilities	902,316						858,094
Stockholders’ Equity
Total stockholders’ equity	137,457						126,002
Total liabilities and stockholders’ equity	$	1,039,773					$	984,096
Net interest margin (3)				4.36%						4.67%
Interest rate spread				4.17%	$	10,585				4.41%	$	10,855

(1) Non-accruing loans have been included in total loans.

(2) Loan fees 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.

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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, 2012 and 2011:

	For the nine months ended						For the nine months ended
	September 30, 2012						September 30, 2011
				Yield/	Income/					Yield/	Income/
(dollar amounts in thousands)	Balance			Rate (4)	Expense		Balance			Rate (4)	Expense
Interest Earning Assets:
Investments with other banks	$	-		0.00%	$	-	$	77		1.74%	$	1
Interest bearing due from banks	14,920			0.16%	18		16,337			0.20%	24
Federal funds sold	-			0.00%	-		936			0.00%	-
Investment securities taxable	201,517			2.57%	3,883		178,095			2.91%	3,880
Investment securities non taxable	54,901			3.47%	1,428		39,535			3.84%	1,136
Other investments	6,532			1.10%	54		7,452			0.75%	42
Loans (1) (2)	665,365			5.88%	29,289		670,710			6.21%	31,132
Total interest earning assets	943,235			4.91%	34,672		913,142			5.30%	36,215
Allowance for loan losses	(19,227		)				(23,702		)
Other assets	88,317						84,994
Total assets	$	1,012,325					$	974,434
Interest Bearing Liabilities:
Interest bearing demand	$	66,474		0.11%	$	55	$	64,362		0.16%	$	79
Savings	35,251			0.10%	27		32,020			0.15%	37
Money market	286,040			0.37%	792		274,112			0.51%	1,055
Time deposits	186,264			1.03%	1,442		219,764			1.43%	2,350
Total interest bearing deposits	574,029			0.54%	2,316		590,258			0.80%	3,521
Federal Home Loan Bank borrowing	50,115			1.25%	468		38,783			0.93%	271
Junior subordinated debentures	8,248			2.40%	148		8,248			2.03%	125
Total borrowed funds	58,363			1.41%	616		47,031			1.13%	396
Total interest bearing liabilities	632,392			0.62%	2,932		637,289			0.82%	3,917
Non interest bearing demand	235,588						202,936
Total funding	867,980			0.45%	2,932		840,225			0.62%	3,917
Other liabilities	9,454						10,225
Total liabilities	877,434						850,450
Stockholders’ Equity:
Total stockholders’ equity	134,891						123,984
Total liabilities and stockholders’ equity	$	1,012,325					$	974,434
Net interest margin (3)				4.49%						4.73%
Interest rate spread				4.29%	$	31,740				4.48%	$	32,298

(1) Non-accruing loans have been included in total loans.

(2) Loan fees have been included in interest income computation.

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

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

For the three months ended September 30, 2012, average interest-earning assets were $42.5 million higher than that reported in the corresponding period in 2011.  The Company’s average investment in its securities portfolio increased by $26.8 million for the quarter ended September 30, 2012 as compared to the corresponding period in 2011.  In addition, during the third quarter of 2012 the Company’s average loan balances increased by $19.2 million as compared to the corresponding period in 2011.

For the nine months ended September 30, 2012, average interest-earning assets were $30.1 million higher than that reported over the corresponding period in 2011.  The Company’s average investment in its securities portfolio increased by $38.8 million for the nine months ended September 30, 2012 as compared to the corresponding period in 2011.  Increases in the average balance of the securities portfolio during the first nine months of 2012 were partially offset by the $5.3 million decrease in average loan balances, and $1.9 million decrease in Federal Funds Sold and other investments as compared to the same period ended a year earlier.

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The decline in the yield on interest-earning assets for both the three and nine months ended September 30, 2012 can be attributed to three key factors: declines in the average returns on the loan portfolio due to continued downward rate pressure on new loans and renewals;  the change of the mix of interest-earning assets away from higher yielding loans to lower yielding investment securities, discussed above; and declines in the yields on the investment securities purchased over the last year due to continued market pressures on interest rates.  For the nine months ended September 30, 2012, the adverse impacts of the shift in interest-earning assets and declines in investment security and loan yields were partially offset by the declines in the level of interest reversals and forgone interest on non-accruing loans and lost interest due to troubled debt restructuring (“TDR”) rate concessions associated with declines in non-performing loans.

The yield on the loan portfolio for the three months ended September 30, 2012 decreased 42 basis points to 5.70% from the corresponding period in 2011.  For the nine months ended September 30, 2012, the yield on the loan portfolio declined 33 basis points to 5.88% from the corresponding period in 2011. These declines were largely attributable to declines in interest rates on new loans issued and loans renewed in the last year, which were driven by increased competition in the Company’s primary market area and the historically low interest rates being set by the government to spur economic recovery.  In addition, the nine months ended September 30, 2011 included $0.2 million of prepayment penalties and related accelerations of unearned fees on loan payoffs in 2011, for which there were no comparable amounts in 2012. This decline in prepayment income in 2012 represented 3 basis points of the decline in yield in nine months ended September 30, 2012 as compared to the corresponding period in 2011. These downward pressures on loan yields were partially offset by a decline in the level of forgone interest on non-accrual loans from $1.4 million to $1.0 million for the nine month periods ended September 30, 2011 and 2012, respectively. Total forgone interest on non-accrual loans reduced the yield on the loan portfolio by 21 basis points and 16 basis points for the three and nine months ended September 30, 2012, respectively, as compared to 22 basis points and 30 basis points for the corresponding periods in 2011.

Beginning in 2009 and continuing through the first quarter of 2012, new loan originations 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 invested excess liquidity primarily in shorter-termed, agency mortgage backed securities, municipal securities and 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 these recently acquired investment securities 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.  Beginning in the second quarter of 2012, we began to experience renewed loan demand and growth in our loan portfolio.  Assuming this loan growth continues over the next several quarters, we should begin to realize an improved mix in earning assets which should help to stabilize our net interest margin.

The average balance of interest bearing liabilities was $17.6 million higher for the three months ended September 30, 2012, than that reported for the same period a year earlier.  Year over year increases in the average balance of interest bearing liabilities can be attributed in large part to Federal Home Loan Bank borrowings, which have increased $13.7 million as we have locked in historically low long-term fixed interest rates to fund cash needs for loan growth and to repurchase three of the Bank’s branches and our administrative offices.  In addition, we have also experienced a net increase in interest bearing deposits as increases in interest bearing demand and money market balances have more than offset the decrease in time deposits, as it appears our customers have deferred renewal decisions on certificates of deposit while they evaluate their options to maximize their returns on their invested cash in the current low interest rate environment.

The average balance of interest bearing liabilities was $4.9 million lower for the nine months ended September 30, 2012, than that reported for the same period a year earlier.  The year to date decrease in the average balance of interest bearing liabilities can be attributed to $16.2 million in declines in interest bearing deposits, most notably time deposits.  We attribute the decrease in time deposits in part to the previously mentioned migration to other interest bearing account categories, such as savings, and non-interest bearing deposits.  The decrease in interest bearing deposits was partially offset by the increase in Federal Home Loan Bank borrowings, noted above, as we locked in historically low, long-term fixed rate funds.

The rate paid on interest bearing deposits declined by 24 basis points, to 0.49% for the three months ended September 30, 2012 as compared to the same period a year earlier.  The rate paid on interest bearing deposits declined by 26 basis points, to 0.54% for the nine months ended September 30, 2012 as compared to the same period a year earlier.  These declines are in part due to the historically low interest rate environment that has existed for the last few years, but is also due to our efforts to systematically lower our cost of deposits over this same time period.

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Although such efforts have contributed to a moderate decline in time deposits, the overall deposit mix and cost of our deposit portfolio has greatly improved as a result of these factors.

In addition, while on a comparative basis we have experienced a decline in interest bearing deposits for the three and nine months ended September 30, 2012 as compared to the same periods a year earlier, our average non-interest bearing demand deposit balances have increased on a comparative basis by $28.6 million and $32.7 million, respectively, to $255.2 million and $235.6 million for the three and nine months ended September 30, 2012, respectively.  These increases in non-interest bearing demand balances have served to reduce our total funding cost by 16 basis points and 17 basis points, for the three and nine months ended September 30, 2012, 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, and to a lesser degree the impacts of unlimited deposit insurance coverage on non-interest bearing demand accounts, which coverage is currently scheduled to expire at the end of this year.  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 and nine months ended September 30, 2012 was 0.42% and 0.45%, respectively, a decrease of 15 basis points and 17 basis points, respectively, as compared to the same periods ended a year earlier.

For the three and nine months ended September 30, 2012, the average rate paid on interest bearing liabilities was 0.58% and 0.62%, respectively, as compared to 0.78% and 0.82%, respectively, for the corresponding periods in 2011.  The year over year decline can be attributed in large part to the deposit portfolio rate reductions previously discussed. This decline was partially offset by an increase in funding costs for the Federal Home Loan Bank borrowings due to a strategy designed to lock in historically low fixed rates on longer term borrowings as compared to the Company’s traditional reliance on a heavier mix of lower cost, variable rate short-term borrowings.

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, 2012 over the same periods ended in 2011, 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, 2012 over 2011									September 30, 2012 over 2011
(dollar amounts in thousands)	Volume			Rate			Total			Volume			Rate			Total
Interest income:
Investments with other banks	$	-		$	-		$	-		$	(1	)	$	-		$	(1	)
Interest bearing due from banks	(1		)	(1		)	(2		)	(2		)	(4		)	(6		)
Federal funds sold	-			-			-			-			-			-
Investment securities taxable	18			(259		)	(241		)	481			(478		)	3
Investment securities non-taxable (1)	320			(100		)	220			620			(177		)	443
Taxable equivalent adjustment (1)	(109		)	34			(75		)	(211		)	60			(151		)
Other investments	-			3			3			(4		)	16			12
Loans	310			(768		)	(458		)	(243		)	(1,600		)	(1,843		)
Net increase / (decrease)	538			(1,091		)	(553		)	640			(2,183		)	(1,543		)
Interest expense:
Savings, NOW, money market	33			(106		)	(73		)	57			(354		)	(297		)
Time deposits	(87		)	(195		)	(282		)	(323		)	(585		)	(908		)
Federal Home Loan Bank borrowing	39			28			67			66			131			197
Junior subordinated debentures	-			5			5			-			23			23
Net decrease	(15		)	(268		)	(283		)	(200		)	(785		)	(985		)
Total net increase / (decrease)	$	553		$	(823	)	$	(270	)	$	840		$	(1,398	)	$	(558	)

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

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Provision for Loan Losses

As more fully discussed in Note 4. Allowance for Loan Losses, of the condensed consolidated financial statements, filed with this Quarterly Report on 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 incurred credit losses 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 likely vary from current estimates and these variances could be material and have an adverse effect on the Company’s performance.

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 $1.3 million and $7.7 million in the three and nine months ended September 30, 2012, respectively.  This represents increases of $0.2 million and $2.3 million, respectively, as compared to the amount reported for the same periods a year earlier.  The Company recently migrated to a more granular loan risk grading scale after completing a grade recertification and full review of all loan relationships equal to or greater than $500 thousand, which represented 74% of gross loans. While this review was primarily focused on ensuring existing loans were properly graded based on the new methodology, it provided additional insights on the overall credit quality of this portion of the portfolio.  The increases in the provision for loan losses are primarily attributable to increased reserve requirements associated with updated specific reserve calculations and related charge-offs. The incremental provision requirements for these increases in specific reserves during the first nine months of 2012 were partially offset by reduced provision requirements on the majority of the remaining loan portfolio amounting to $1.9 million due to: continued improvement in our historical loss data as older higher loss level periods roll out of the loss history window and are replaced by more recent losses at lower loss rates; and  improvements in the qualitative portfolio factors which resulted from improvements in both the national and local economic indicators. Both of these factors form the basis for the general reserve portion of the allowance for loan losses.  As of September 30, 2012, the Company’s allowance for loan losses represented 2.65% of total gross loans.  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.

Non-Interest Income

The table below set forth changes in non-interest income for the three and nine month periods ended September 30, 2012 compared to the same periods ended in 2011:

	For the three months ended					For the nine months ended					Variances					Variances
	September 30,					September 30,					For the three months					For the nine months
(dollar amounts in thousands)	2012		2011			2012		2011			dollar			percentage		dollar			percentage
Fees and service charges	$	611	$	659		$	1,948	$	1,820		$	(48	)	-7.3	%	$	128		7.0	%
Mortgage gain on sale and origination fees	1,181		734			3,071		1,750			447			60.9	%	1,321			75.5	%
Debit/credit card fee income	460		430			1,322		1,211			30			7.0	%	111			9.2	%
Earnings on bank owned life insurance	148		147			452		444			1			0.7	%	8			1.8	%
Gain on sale of investment securities	329		595			1,696		1,187			(266		)	-44.7	%	509			42.9	%
Gain / (loss) on sale of other real estate owned	102		(266		)	112		(587		)	368			-138.3	%	699			-119.1	%
Other Income	153		258			399		691			(105		)	-40.7	%	(292		)	-42.3	%
Total	$	2,984	$	2,557		$	9,000	$	6,516		$	427		16.7	%	$	2,484		38.1	%

Non-interest income increased by $0.4 million and $2.5 million for the three and nine months ended September 30, 2012, respectively, from that reported for the corresponding periods in 2011.  The primary drivers for the increases in both the three and nine month periods, as compared to the corresponding periods in 2011 were increases in mortgage gain on sale and origination fees and improvements in the gain/(loss) on sale of OREO.   In addition for the nine months ended September 30, 2012, we realized improved gains on sale of investment securities.  The increase in gains on sales of investment securities was driven by improvements in the fair market value of the securities portfolio over the last year which translated into greater gains on sale of such securities.

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Specifically, during the three and nine months ended September 30, 2012, the Company sold $41.9 million and $95.8 million, respectively, of securities that resulted in gains of $0.3 million and $1.7 million, respectively. This compares to $30.0 million and $108.6 million of securities sold in the three and nine months ended September 30, 2011, respectively, that resulted in gains of $0.6 million and $1.2 million, respectively. The increases in the mortgage related income for both the three and nine months ended September 30, 2012 were driven by investments we have made over the past year in the infrastructure and staffing levels of our mortgage business, which when combined with the current favorable interest rate environment led to increased refinancing and new home purchase loan activity and correspondingly to increased mortgage gain on sale and fee income as compared to the corresponding periods last year.   The improvements in the gain/(loss) on sale of OREO is attributable to a more stable real estate market and reduced risk of loss in value due to the passage of time as on average OREO assets have been turning over more quickly in the last twelve months.

Non-Interest Expenses

The tables below set forth changes in non-interest expenses for the three and nine month periods ended September 30, 2012 compared to the same periods ended in 2011:

	For the three months ended				For the nine months ended				Variances					Variances
	September 30,				September 30,				For the three months					For the nine months
(dollar amounts in thousands)	2012		2011		2012		2011		dollar			percentage		dollar			percentage
Salaries and employee benefits	$	4,532	$	4,434	$	13,522	13,371		$	98		2.2	%	$	151		1.1	%
Equipment	395		399		1,223		1,327		(4		)	-1.0	%	(104		)	-7.8	%
Occupancy	728		888		2,542		2,768		(160		)	-18.0	%	(226		)	-8.2	%
Promotional	171		156		432		491		15			9.6	%	(59		)	-12.0	%
Data processing	551		801		1,911		2,253		(250		)	-31.2	%	(342		)	-15.2	%
OREO related costs	54		162		217		556		(108		)	-66.7	%	(339		)	-61.0	%
Write-downs of foreclosed assets	53		89		86		968		(36		)	-40.4	%	(882		)	-91.1	%
Regulatory assessment costs	371		503		1,238		1,834		(132		)	-26.2	%	(596		)	-32.5	%
Audit and tax advisory costs	146		188		473		514		(42		)	-22.3	%	(41		)	-8.0	%
Directors fees	126		102		358		338		24			23.5	%	20			5.9	%
Outside services	730		296		1,572		1,035		434			146.6	%	537			51.9	%
Provision for potential mortgage repurchases	125		329		982		329		(204		)	-62.0	%	653			198.5	%
Amortization of intangible assets	86		96		258		356		(10		)	-10.4	%	(98		)	-27.5	%
Other general operating costs	727		607		1,843		1,957		120			19.8	%	(114		)	-5.8	%
Total	$	8,795	$	9,050	$	26,657	$	28,097	$	(255	)	-2.8	%	$	(1,440	)	-5.1	%

The declines in non-interest expense for the three and nine months ended September 30, 2012 were largely driven by:

Write-downs of Foreclosed Assets and OREO Related Costs

For the three and nine months ended September 30, 2012, write-downs of foreclosed assets and OREO related costs in total decreased approximately $0.1 million and $1.2 million, respectively from that reported in the same periods a year earlier.  These decreases were primarily a result of the OREO portfolio being significantly larger in 2011 than it was in 2012 and therefore subject to more valuation risk and more operating costs to carry the OREO properties.  The size of the OREO portfolio diminished over 2011, as the Company entered into and closed several OREO sales over the year.  However, updated market valuation data on the properties sold during 2011 drove additional valuation allowance adjustments leading up to the sale of the properties.

Regulatory Assessment Costs

For the three and nine months ended September 30, 2012, regulatory assessment costs decreased  approximately $0.1 million and $0.6 million, respectively over amounts reported for the same three and nine month periods a year ago.  The year over year decreases within this category can be attributed in large part to the FDIC’s new insurance assessment model that went into effect in the second quarter of 2011 as well as reductions triggered by the lifting of the Consent Order in the first part of the second quarter 2012.

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Occupancy

For both the three and nine months ended September 30, 2012, occupancy costs decreased approximately $0.2 million. This decline is largely due to reductions in facility rental costs attributable to the repurchase of three branches and our administrative office building in the first quarter of 2012 and the completion of the consolidation of three branch offices into near-by locations in the latter half of the second quarter of 2012.  The savings in rental costs were only partially offset by increased depreciation costs associated with owning the buildings as opposed to leasing them.  The net savings resulting from buying the buildings back and the branch consolidation totaled $0.2 million for both the three and nine months ended September 30, 2012.  The year to date savings were partially offset by provisions for lease terminations associated with the three branch closures.

The declines in non-interest expense for the nine months ended September 30, 2012 discussed above were partially offset by a $0.7 million increase in provision for potential mortgage repurchases.  This increase was largely driven by estimated losses related to potential mortgage repurchases based on new claims of fraudulent borrower activities in the second quarter of 2012.  Repurchase requests are relatively rare for the Bank, in fact the total expense for mortgage repurchases has been less than $1 million in the last 8 years.  Our internal review has identified that the recent claims relate to loans made to related borrowers over five years ago. We do not believe the requests are in any way indicative of systemic problems with the Bank’s underwriting or origination process or that there is significant exposure to repurchase requests other than those arising from the loans to the borrowers in question, which totaled $2.8 million inclusive of the mortgages provided for in the second and third quarters of 2012.  In addition, our outside service costs increased by $0.4 million and $0.5 million in the three and nine months ended September 30, 2012, as compared to the corresponding periods in 2011 largely due to the timing of legal services provided related to the preparation for the annual shareholder meeting, our filing of registration statements related to our Series A Preferred Stock and related warrants and our Series C Preferred Stock and consulting services related to identifying operating efficiencies within the Bank.  Although there have been some benefits already realized from the operating efficiency studies, the majority of the identified savings are not expected to begin to be realized until the first quarter of 2013.

Provision for Income Taxes

For the three and nine month periods ended September 30, 2012, the Company recorded an income tax benefit of approximately $2.9 million and $3.5 million, respectively.  This compares to $1.2 million and $1.8 million of income tax expense the Company recorded for the same periods in 2011.  The changes in the provision for income taxes for the three and nine months ended September 30, 2012, as compared to the corresponding periods in 2011, can be attributed to the Company’s reversal of $4.1 million and $5.6 million for the three and nine months ended September 2012, respectively, of deferred tax asset valuation allowance partially offset by increased taxes provided on improved year over year pre-tax earnings.  The Company’s effective tax rate was (84.3)% and (54.8)% for the three and nine months ended September 30, 2012, respectively.  The effective tax rate for the corresponding periods in 2011 was 35.3% and 32.8%, respectively.

The determination as to whether a valuation allowance should be established against deferred tax assets is based on the consideration of all available evidence using a “more likely than not” standard.  Management evaluates the realizability of the deferred tax assets on a quarterly basis.  As a result of this analysis for the three and nine months ended September 30, 2012, it was determined that $4.1 million and $5.6 million, respectively, of the partial valuation allowance on the Company’s deferred tax assets were now more likely than not that they would be realizable.  The reversal of allowance in 2012 reflected the impacts of numerous factors, such as continued quarterly earnings and improvements in credit quality that provided adequate positive evidence as to the incremental recoverability of these deferred tax assets.   Please see Note 6. Income Taxes, of the condensed consolidated financial statements, filed with this Quarterly Report on Form 10-Q for additional information concerning the Company’s deferred tax assets.

Financial Condition

At September 30, 2012, total assets were approximately $1,058.7 million.  This represents an increase of approximately $71.5 million or 7.2% over that reported at December 31, 2011.  The increase in total assets is primarily attributable to the investment of funds received from the inflow of deposits during 2012 in loans and securities, and the repurchase of three branch buildings and our administrative building in an effort to reduce our occupancy costs.

At September 30, 2012, total deposits were approximately $855.0 million or approximately $68.8 million higher than that reported at December 31, 2011.  The Company’s deposit gathering success is benefiting from both the very liquid nature of the market, as well as a series of branch-based deposit campaigns that began with the start of 2012 and are focused on relationship deepening and cross selling.

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Loans

Summary of Market Conditions

Despite the recent signs of stabilization in the local economies in which the Company operates, loan demand remained tepid for much of 2011 and into the first quarter of 2012.  However, with the addition of our new sales team that is focused on our region’s largest industry, agriculture, as well as the commercial and small business segments of the market and expanded efforts by our mortgage lending team, the Bank was able to generate net loan growth in the both the second and third quarters of 2012, marking the first quarterly growth since the fourth quarter of 2009.  We continue to see the early signs of borrower activity and we anticipate that this increased activity in our existing markets, coupled with our new sales team and our expansion into Ventura County with the opening of a new loan production office in August, followed by a second loan production office to open in Goleta in the fourth quarter 2012, could contribute to continued growth in our loan portfolio for the foreseeable future. Although the Company believes that it may be starting to see some signs of stabilization in the local economies in which it operates, the Company realizes that a renewed decline in the global, 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 trends and leading indicators 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 with this Quarterly Report on Form 10-Q, for a more detailed discussion concerning credit quality, including the Company’s related policy.

Summary of Loan Portfolio

At September 30, 2012, total gross loan balances were $678.3 million.  This represents an increase of approximately $32.0 million or 5.0% from the $646.3 million reported at December 31, 2011.  The growth in loans that occurred in the second and third quarters of 2012 represents the first reported net increases in gross loans since the fourth quarter of 2009.

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The following table provides a summary of year to date variances in the loan portfolio as of September 30, 2012:

	September 30,		December 31,		Variance
(dollar amounts in thousands)	2012		2011		dollar			percentage
Real Estate Secured
Multi-family residential	$	16,429	$	15,915	$	514		3.23	%
Residential 1 to 4 family	37,837		20,839		16,998			81.57	%
Home equity line of credit	32,422		31,047		1,375			4.43	%
Commercial	374,799		357,499		17,300			4.84	%
Farmland	23,416		8,155		15,261			187.14	%
Total real estate secured	484,903		433,455		51,448			11.87	%
Commercial
Commercial and industrial	119,496		141,065		(21,569		)	-15.29	%
Agriculture	17,948		15,740		2,208			14.03	%
Other	66		89		(23		)	-25.84	%
Total commercial	137,510		156,894		(19,384		)	-12.35	%
Construction
Single family residential	11,267		13,039		(1,772		)	-13.59	%
Single family residential - Spec.	420		8		412			5150.00	%
Multi-family	787		1,669		(882		)	-52.85	%
Commercial	14,401		8,015		6,386			79.68	%
Total construction	26,875		22,731		4,144			18.23	%
Land	23,633		26,454		(2,821		)	-10.66	%
Installment loans to individuals	5,146		6,479		(1,333		)	-20.57	%
All other loans (including overdrafts)	281		273		8			2.93	%
Total gross loans	678,348		646,286		32,062			4.96	%
Deferred loan fees	977		1,111		(134		)	-12.06	%
Reserve for loan losses	17,987		19,314		(1,327		)	-6.87	%
Total net loans	$	659,384	$	625,861	$	33,523		5.36	%
Loans held for sale	$	12,590	$	21,947	$	(9,357	)	-42.63	%

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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, 2012:

	September 30, 2012							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	$	36,971	$	719	$	37,690	7.5%	29.3%	47	$	5,000
Professional	50,536		100		50,636		10.0%	39.4%	80	9,710
Hospitality	105,173		1,099		106,272		21.0%	82.6%	47	10,692
Multi-family	16,429		-		16,429		3.2%	12.8%	20	3,128
Home equity lines of credit	32,422		18,417		50,839		10.0%	39.5%	348	1,340
Residential 1 to 4 family	37,837		79		37,916		7.5%	29.4%	94	2,760
Farmland	23,416		771		24,187		4.8%	18.8%	22	4,800
Healthcare / medical	27,103		-		27,103		5.4%	21.1%	33	7,500
Restaurants / hospitality	7,206		105		7,311		1.4%	5.7%	13	2,541
Other commercial	123,186		77		123,263		24.3%	95.8%	131	6,720
Other	24,624		164		24,788		4.9%	19.3%	20	13,813
Total real estate secured	$	484,903	$	21,531	$	506,434	100.0%	393.6%	855	$	13,813

(1)Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of September 30, 2012.

As of September 30, 2012, real estate secured balances represented approximately $484.9 million or 71.5% of total gross loans.  When compared to that reported at December 31, 2011, this represents an increase of approximately $51.4 million or 11.9%.  The primary factor behind the year to date increase can be attributed to increases across all real estate components, but most significantly in the residential 1 to 4 family component, commercial real estate and farmland components.  Residential 1 to 4 family increased $17.0 million in the first nine months of 2012 as new residential mortgage originations identified for portfolio growth, as opposed to sale, expanded this portfolio in the second and third quarters of 2012. The increase in the commercial component is primarily tied to new loan originations during 2012, which exceeded payments on existing loans by $19.7 million.  These increases in commercial real estate were partially offset by $2.4 million in year to date charge-offs in the commercial component.  Farmland increased by $15.3 million, which was driven by $15.9 million of new loans originated and advances on existing loans in the first nine months of 2012 as part of the Bank’s increased focus on agriculture related lending, partially offset by payment activity against existing loans.

As of September 30, 2012, a total of $56.3 million of the real estate secured balance was risk graded as special mention or substandard, with the largest single component being the commercial segment which represented $46.6 million.  This compares to $51.0 million of the real estate secured balance and $46.3 million of commercial real estate being risk graded special mention or substandard as of December 31, 2011.  The change in both the real estate segment in total and the more specifically the commercial real estate segment is attributable to a few credits being categorized as special mention during the third quarter of 2012.  As previously noted, in early October 2012, one of the largest credits in the commercial real estate component made a material pay-down against their outstanding balance which would have resulted in the combined level of special mention and substandard being effectively flat with the reported December 31, 2011 balance had the payment been received in September as originally expected.  Also impacting the overall increase in real estate secured and more specifically the farmland component was the transfer of a loan that had been reported as special mention in the construction segment in prior periods into farmland, as special mention, upon the completion of construction during the second quarter of 2012.

At September 30, 2012, real estate secured balances, including undisbursed commitments, represented 393.6% of the Bank’s total risk-based capital, compared to the 368.8% reported at December 31, 2011. The increase in this ratio can be attributed to the increases seen in all components of the real estate secured loan segment.

At September 30, 2012, approximately $174.1 million or 35.9% of the real estate secured segment of the loan portfolio was considered owner occupied.

Heritage Oaks Bancorp | - 52 -

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, 2012:

	September 30, 2012							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	$	4,043	$	5,361	$	9,404	4.8%	7.3%	36	$	2,500
Oil gas and utilities	1,305		1,233		2,538		1.3%	2.0%	5	988
Construction	15,971		18,521		34,492		17.7%	26.8%	153	5,000
Manufacturing	11,219		8,684		19,903		10.2%	15.5%	89	2,000
Wholesale and retail	9,341		6,973		16,314		8.4%	12.7%	115	1,174
Transportation and warehousing	2,649		850		3,499		1.8%	2.7%	37	625
Media and information services	4,180		2,554		6,734		3.5%	5.2%	27	1,700
Financial services	6,353		2,276		8,629		4.4%	6.7%	48	1,580
Real estate / rental and leasing	16,154		7,386		23,540		12.1%	18.3%	95	1,800
Professional services	13,761		10,701		24,462		12.6%	19.0%	143	2,845
Healthcare / medical	11,364		6,693		18,057		9.3%	14.0%	112	11,464
Restaurants / hospitality	18,688		3,095		21,783		11.2%	16.9%	86	6,000
All other	4,468		886		5,354		2.7%	4.2%	82	1,200
Commercial and industrial	$	119,496	$	75,213	$	194,709	100.0%	151.3%	1,028	$	11,464

(1) Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of September 30, 2012.

At September 30, 2012, commercial and industrial (“C&I”) loans represented approximately $119.5 million or 17.6% of total gross loan balances.  This represents a decline of approximately $21.6 million or 15.3% from December 31, 2011.  The year to date decline can be attributed in part to the transfer of $3.9 million of the C&I loan balance to land segment related to the large credit issue addressed in the first quarter of 2012, which was modified in the second quarter of 2012 resulting in the entire modified loan relationship being classified as a land loan at September 30, 2012.  In addition, pay-downs and payoffs exceeded new advances and the funding of new loans during the first nine months of 2012 across several components of the C&I segment.  As a result of these factors, the ratio of total commercial and industrial loan balances, including undisbursed commitments, to risk-based capital declined from 173.2% at December 31, 2011 to 151.3% at September 30, 2012. The Company’s credit exposure within the C&I segment remains diverse with respect to the industries to which credit has been extended.

As of September 30, 2012, a total of $14.4 million of the C&I balance was risk graded as special mention or substandard.  This compares to $18.0 million of the C&I balance being risk graded special mention or substandard as of December 31, 2011.  The improvement in the credit risk grade profile of C&I is attributable to pay downs and pay offs of loans in these higher risk grades primarily during the third quarter of 2012.

Agriculture

At September 30, 2012, agriculture balances totaled approximately $17.9 million or 2.6% of total gross loan balances, which represents an approximate $2.2 million increase when compared to that reported at December 31, 2011.  The increase in the balance associated with loan production from our new lending team was partially offset by $1.7 million of charge-offs as well as payment activity of $3.5 million.  At September 30, 2012 and December 31, 2011, agriculture balances, including undisbursed commitments, represented 25.1% and 12.7%, respectively, of the Bank’s total risk-based capital.  The increase in the percentage of risk-based capital is largely due to a significant increase in the level of undisbursed commitments related to new loan production in the second and third quarters of 2012.

As of September 30, 2012, a total of $2.0 million of the agriculture balance was risk graded as special mention or substandard.  This compares to $4.4 million of the agriculture balance being risk graded special mention or substandard as of December 31, 2011.  The improvement in the credit risk grade profile of agriculture is largely attributable to the charge-offs during the first nine months of 2012.

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Construction

The following table provides a break-down of the construction segment of the Company’s loan portfolio as of September 30, 2012:

	September 30, 2012							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	$	11,267	$	3,513	$	14,780	44.9%	11.5%	11	$	5,250
Single family residential - Spec.	420		415		835		2.5%	0.6%	1	835
Multi-family	787		-		787		2.4%	0.6%	1	1,698
Commercial	14,401		2,106		16,507		50.2%	12.8%	5	5,460
Total construction	$	26,875	$	6,034	$	32,909	100.0%	25.6%	18	$	5,460

(1)Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of September 30, 2012.

At September 30, 2012, construction balances represented approximately $26.9 million or 4.0% of total gross loan balances, an increase of $4.1 million or 18.2% from that reported at December 31, 2011. This increase is in part the result of draws on existing construction loans outpacing payment activity and transfers out of construction and into other real estate loan types by $4.2 million.  The balance of the increase is tied to new loan originations, partially offset by $0.7 million of charge-offs. The ratio of total construction loan balances, including undisbursed commitments, to risk-based capital declined from 32.2% at December 31, 2011 to 25.6% at September 30, 2012. The decline in this ratio can be attributed to the level of risk based capital increasing at a disproportionally higher rate than the increase seen in the construction loan segment.

As of September 30, 2012, a total of $1.8 million of the construction balance was risk graded as special mention or substandard, all of which was related to commercial real estate construction.  This compares to $6.9 million of the construction balance at December 31, 2011 and $4.3 million of commercial real estate construction being risk graded special mention or substandard as of December 31, 2011. The improvements in both the construction segment in total and more specifically the commercial real estate segment is attributable to a combination of the previously mentioned transfer to farmland, improving credit quality, and pay downs and pay offs of loans in these higher risk grades.

Construction loans are typically granted for a one year period and then refinanced into permanent loans with varying maturities at the completion of the construction project.

Land

The following table provides a break-down of the land segment of the Company’s loan portfolio as of September 30, 2012:

	September 30, 2012							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	$	3,789	$	769	$	4,558	18.7%	3.5%	28	$	867
Single family residential - Spec.	662		-		662		2.7%	0.5%	4	379
Tract	11,299		-		11,299		46.3%	8.9%	8	10,673
Commercial	7,263		-		7,263		29.8%	5.6%	18	1,500
Hospitality	620		-		620		2.5%	0.5%	1	644
Total land	$	23,633	$	769	$	24,402	100.0%	19.0%	59	$	10,673

(1)Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of September 30, 2012.

At September 30, 2012, land balances represented approximately $23.6 million or 3.5% of total gross loan balances, a decline of $2.8 million or 10.7% from the corresponding balance reported at December 31, 2011.  The decline in land loans is largely due to the charge offs of $ 2.2 million during the first nine months of the year. The balance of the decline is tied to payment activity exceeding new land loans closed during the first nine months of 2012, which was offset by the transfer of $3.9 million from C&I related to the results of the loan modification related to the large credit relationship addressed in the first quarter of 2012.  As a result of these factors, the ratio of total land loan balances, including undisbursed commitments, to risk-based capital declined from 21.4% at December 31, 2011 to 19.0% at September 30, 2012.

Heritage Oaks Bancorp | - 54 -

As of September 30, 2012, a total of $12.6 million of the land balance was risk graded as special mention or substandard.  This compares to $12.5 million of the land balance being risk graded special mention or substandard as of December 31, 2011.  The modest deterioration in the land segment is largely attributable to the transfer discussed above partially offset by the charge-off related to terms of the modification of that credit relationship, negotiated in the second quarter of 2012 and pay-downs received against this loan relationship in the third quarter of 2012.  As of September 30, 2012, approximately half of the balance is attributable to this single credit relationship, which is now performing in accordance with the terms of its restructured note.

Installment

At September 30, 2012, installment loan balances were approximately $5.1 million compared to the $6.5 million reported at December 31, 2011.  Installment loans include revolving credit plans, consumer loans and credit card balances.

Loans Held for Sale

Loans held for sale primarily consist of mortgage originations that have already been sold pursuant to correspondent mortgage loan agreements. There is minimal interest rate risk associated with these loans as the commitments are in place at the time the Company funds them. Settlement from the correspondents is typically within 30 to 60 days.  At September 30, 2012, mortgage correspondent loans (loans held for sale) totaled approximately $12.6 million, $9.4 million less than that reported at December 31, 2011.  The decline in the balance primarily reflects the timing of mortgage closures during the third quarter of 2012 as compared to the fourth quarter of 2011, as 2011 closures accelerated near year end which resulted in a larger balance of loans held for sale as of December 31, 2011. In addition to the mortgage correspondent loans, the Company also had $4.3 million of loans, primarily commercial real estate loans that were under contract for sale as of December 31, 2011, which subsequently closed in mid-January 2012.  There were no similar loan sale transactions pending at the end of the third quarter of 2012.

Foreign Loans

At September 30, 2012, the Company had no foreign loans outstanding.

Allowance for Loan Losses

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 two components: specific credit allocation and general portfolio allocation which includes a quantitatively determined adjustment. 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 with this Quarterly Report on Form 10-Q for a detailed discussion concerning the Company’s methodology for determining an adequate allowance. Please also see Note 1. Summary of Significant Accounting Policies of the consolidated financial statements, filed as part of the Annual Report on Form 10-K for the year ended December 31, 2011, for additional discussion concerning the allowance for loan losses, loan charge-offs, and credit risk management.

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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, 2012, September 30, 2011 and December 31, 2011:

	September 30,						December 31,
	2012			2011			2011
			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	$	108	0.7%	$	82	0.5%	$	87	0.5	%
Residential 1 to 4 family	378		1.0%	388		1.8%	397		1.9	%
Home equity line of credit	450		1.4%	551		1.8%	421		1.4	%
Commercial	6,691		1.8%	9,245		2.5%	8,511		2.4	%
Farmland	360		1.5%	286		2.7%	229		2.8	%
Commercial
Commercial and industrial	4,316		3.6%	6,613		4.9%	6,200		4.4	%
Agriculture	755		4.2%	347		2.2%	349		2.2	%
Construction
Single family residential	144		1.3%	122		1.1%	139		1.1	%
Single family residential - Spec.	-		0.0%	61		24.4%	-		0.0	%
Multi-family	18		2.3%	143		8.5%	148		8.9	%
Commercial	396		2.7%	204		2.9%	201		2.5	%
Land	4,263		18.0%	2,143		7.4%	2,416		9.1	%
Installment loans to individuals	72		1.4%	204		3.1%	175		2.7	%
All other loans (including overdrafts)	36		12.8%	20		10.3%	41		15.0	%
Total allowance for loan losses	$	17,987	2.7%	$	20,409	3.1%	$	19,314	3.0	%

The allowance for loan losses as of September 30, 2012 decreased $1.3 million from December 31, 2011, largely due to a decline in the general reserve requirements driven by reductions in charge-offs incurred over the look-back period utilized in the historical loss portion of our model and reductions in the qualitative factor related to local economic conditions that were previously described (see Local Economy). The improvements were partially offset by increased specific allowance requirements due largely to the updated specific reserve calculations and related charge-offs in the first nine months of 2012.

The allowance for loan losses allocated to the commercial real estate segment of the portfolio declined by $1.8 million from $8.5 million at December 31, 2011 to $6.7 million at September 30, 2012.  This decline was driven primarily by an improvement in the loss history and improvements in the qualitative factors, which were a result of improvements in both the national and local economic indicators, both of which form the basis for our general reserve for the commercial real estate segment.  The decline was also impacted by the charge-down associated with updated specific reserve calculations during the second quarter. The C&I segment’s allowance for loan loss allocation decreased by $1.9 million from $6.2 million at December 31, 2011 to $4.3 million at September 30, 2012.  This decrease was driven primarily by the reclassification of the C&I component of the single large credit relationship issue, which arose in the first quarter of 2012, to land based on the terms of a modification agreement put in place in the second quarter of 2012, which effectively re-characterized the entire relationship to a land based loan.  The reclassification of this credit, and the related allowance for loan losses to land, net of the charge-off related to the modification of this credit, combined with the allowance established in the first quarter of 2012 for the original land component, contributed to substantially all of the $1.8 million increase in the land component of the allowance for loan losses as compared to December 31, 2011.

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Although we have experienced some stabilization in general economic conditions and real estate values over the last year, 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, 2012, the balance of classified loans was approximately $57.6 million.  This compares to the $53.9 million in classified loan balances reported at December 31, 2011.  Although the balance of classified loans has increased compared to that reported at December 31, 2011, the increase is largely due to the single large credit relationship that arose in the first quarter of 2012.  As previously discussed, one of the larger loan relationships making up our classified loan balance paid-off their outstanding loan balance in early October 2012.  Had that payment been received in September, as was originally expected, the September balance of classified loans would have been modestly down from that reported at December 31, 2011.

Loans charged-off during the three and nine months ended September 30, 2012 totaled approximately $1.7 million and $9.7 million, respectively.  This compares to charge-offs of approximately $3.0 million and $11.9 million, respectively, reported for the corresponding periods last year.  The decrease in charge-offs during the three and nine months of 2012 is largely due to 2011 charge-offs being elevated due to the sale of non-performing loans.  These sales accounted for $1.1 million and $5.5 million of the charge-offs in the three and nine months ended September 30, 2011, resulting in charge-offs from normal loan portfolio processing of $1.9 million and $6.3 million, respectively.  Loan charge-offs for the three and nine months ended September 30, 2012 were driven by the partial charge-offs based on updated specific reserve calculations with the year to date increase in 2012 charge-offs being largely driven by credit issues address in the first half of the year and $1.3 million of the third quarter 2012 charge-offs being attributable to single credit relationship for which the borrower is under investigation of fraud.

Annualized net charge-offs to average loans for the three and nine months ended September 30, 2012 were 0.85% and 1.81%, respectively.  This compares to the 1.43% and 1.97% reported for the corresponding periods in 2011.  At September 30, 2012, the allowance for loan losses represented 2.65% of total gross loans compared to the 2.99% reported at December 31, 2011.

As of September 30, 2012, management believes that the allowance for loan losses was sufficient to cover current estimable losses in the Company’s loan portfolio.

Non-Performing Assets

Non-performing assets comprise loans placed on non-accrual 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. Loans of the condensed consolidated financial statements, filed with this Quarterly Report on Form 10-Q, for additional discussion concerning non-performing loans, as well as a discussion concerning credit quality.

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The following table provides a summary of non-performing loans and foreclosed assets as of September 30, 2012 and December 31, 2011:

	September 30,		December 31,
(dollar amounts in thousands)	2012		2011
Non-Performing Loans:
Residential 1-4 family	$	907	$	622
Home equity lines of credit	381		359
Commercial real estate	4,428		4,551
Farmland	1,089		-
Commercial and industrial	3,243		1,625
Agriculture	1,075		2,327
Construction	1,840		937
Land	7,300		1,886
Installments	206		61
Total non-performing loans	$	20,469	$	12,368
Other real estate owned	$	615	$	917
Other repossessed assets	-		42
Total non-performing assets	$	21,084	$	13,327
Ratio of allowance for loan losses to total gross loans	2.65%		2.99%
Ratio of non-performing loans to total gross loans	3.02%		1.91%
Ratio of non-performing assets to total assets	1.99%		1.35%

At September 30, 2012, the balance of non-accruing loans was approximately $20.5 million or $8.1 million higher than that reported at December 31, 2011.  As previously noted, the vast majority of the increase in non-accruing loans is due to two large credit relationships, one of which deteriorated during the first quarter of 2012 and the second that moved to non-accrual in the second quarter of 2012. Offsetting the increase in non-accruing loans in the first nine months of 2012 related to these two credit relationships and $8.5 million of other loans transferred to nonaccrual status, primarily associated with trouble debt restructurings, the Company saw approximately $3.6 million in balances return to accruing status following the Company’s efforts to work with certain borrowers to bring resolution to problem credits.  The Company also received approximately $4.1 million in principal payments on non-accruing loans, charged-off $9.6 million, a majority of which was related to the two large credit relationship addressed during the first six months of 2012 and transferred $0.5 million to OREO.

Substantially all of the increase in non-performing assets can be attributed to the changes in the non-performing loans discussed above, partially offset by a $0.3 million decrease in OREO related to property sales during the first nine months of 2012 exceeding new additions to OREO.

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The following tables reconcile the change in total non-accruing balances for the three and nine months ended September 30, 2012:

	Balance		Additions to							Transfers to			Returns to								Balance
	June 30,		Non-Accruing		Net					Foreclosed			Performing			Net			Transferred		September 30,
(dollar amounts in thousands)	2012		Balances		Paydowns			Advances		Collateral			Status			Charge-offs			to Held for Sale		2012
Real Estate Secured
Residential 1 to 4 family	$	511	$	514	$	(12	)	$	-	$	-		$	-		$	(106	)	$	-	$	907
Home equity line of credit	384		-		(3		)	-		-			-			-			-		381
Commercial	4,884		-		(456		)	-		-			-			-			-		4,428
Farmland	-		1,089		-			-		-			-			-			-		1,089
Commercial
Commercial and industrial	2,401		1,299		(196		)	-		-			-			(261		)	-		3,243
Agriculture	2,332		-		(7		)	-		-			-			(1,250		)	-		1,075
Construction
Commercial	1,932		-		-			-		-			-			(92		)	-		1,840
Land	8,352		63		(1,115		)	-		-			-			-			-		7,300
Installment loans to individuals	82		137		(4		)	-		-			-			(9		)	-		206
Totals	$	20,878	$	3,102	$	(1,793	)	$	-	$	-		$	-		$	(1,718	)	$	-	$	20,469
	Balance		Additions to							Transfers to			Returns to								Balance
	December 31,		Non-Accruing		Net					Foreclosed			Performing			Net			Transferred		September 30,
(dollar amounts in thousands)	2011		Balances		Paydowns			Advances		Collateral			Status			Charge-offs			to Held for Sale		2012
Real Estate Secured
Residential 1 to 4 family	$	527	$	514	$	(28	)	$	-	$	-		$	-		$	(106	)	$	-	$	907
Home equity line of credit	359		65		(43		)	-		-			-			-			-		381
Commercial	4,551		6,592		(805		)	-		-			(3,556		)	(2,354		)	-		4,428
Farmland	-		1,089		-			-		-			-			-			-		1,089
Commercial
Commercial and industrial	1,625		5,236		(703		)	-		(344		)	-			(2,571		)	-		3,243
Agriculture	2,327		484		(36		)	-		-			-			(1,700		)	-		1,075
Construction
Single family residential	937		-		(937		)	-		-			-			-			-		-
Commercial	-		2,508		-			-		-			-			(668		)	-		1,840
Land	1,981		9,217		(1,582		)	-		(162		)	-			(2,154		)	-		7,300
Installment loans to individuals	61		180		(6		)	-		-			-			(29		)	-		206
Totals	$	12,368	$	25,885	$	(4,140	)	$	-	$	(506	)	$	(3,556	)	$	(9,582	)	$	-	$	20,469

Other Real Estate Owned (“OREO”)

At September 30, 2012, OREO balances totaled approximately $0.6 million, a decrease of $0.3 million from that reported at December 31, 2011.  As was previously noted, the decline was driven by property sales in the first nine months of the year outpacing additions to OREO.  The remaining properties making up the OREO balance at September 30, 2012 were all sold in October 2012 resulting in a small net gain.

See also Note 5. Other Real Estate Owned, of the condensed consolidated financial statements, filed with this Quarterly Report on Form 10-Q, for additional discussion concerning OREO.

Total Cash and Cash Equivalents

Total cash and cash equivalents were $44.2 million and $34.9 million at September 30, 2012 and December 31, 2011, 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 or loans pending to be funded, and actual cash on hand in the branches.

The year to date increase is attributable to a large in flow of deposits in the last couple of days of September that were pending investment in new loan fundings and/or investment securities.

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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 the liquidity needs of the Company, collateralization of public deposits, and diversification of the earning asset mix.

Investment Securities

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 corporate debt securities. The Company has an Asset/Liability Committee that develops investment policies based upon the Company’s 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 is responsible for reporting and monitoring compliance with the investment policy.  Reports are provided to the Company’s Board of Directors on a regular basis.

Investment securities as of September 30, 2012 and December 31, 2011 were comprised of:

	As of September 30, 2012				As of December 31, 2011
	Amortized				Amortized
(dollar amounts in thousands)	Cost		Fair Value		Cost		Fair Value
Obligations of U.S. government agencies	$	3,838	$	3,957	$	4,209	$	4,326
Mortgage backed securities
U.S. government sponsored entities and agencies	108,660		109,221		116,732		117,325
Non-agency	42,752		43,906		34,667		34,532
State and municipal securities	59,427		63,271		49,661		51,923
Corporate debt securities	30,321		30,675		28,909		26,856
Other	10,164		10,421		2,059		2,020
Total	$	255,162	$	261,451	$	236,237	$	236,982

The following table includes an analysis of the expected maturities of the investment portfolio and the related yields by maturity period:

			Over 1		Over 5 Years
	One Year Or		Through 5		Through 10
(dollar amounts in thousands)	Less		Years		Years		Over 10 Years		Total
Obligations of U.S. government agencies	$	7	$	30	$	3,917	$	3	$	3,957
Mortgage backed securities
U.S. government sponsored entities and agencies	20,327		48,094		22,944		17,856		109,221
Non-agency	9,122		21,646		11,193		1,945		43,906
State and municipal securities	1,004		9,280		44,351		8,636		63,271
Corporate debt securities	-		18,999		9,346		2,330		30,675
Other	1,504		4,289		4,628		-		10,421
Total available for sale securities	$	31,964	$	102,338	$	96,379	$	30,770	$	261,451
Amortized cost	$	31,916	$	100,746	$	92,221	$	30,279	$	255,162
Weighted average yield	2.24%		2.65%		3.31%		4.15%		3.04%

At September 30, 2012, the fair value of the investment portfolio was approximately $261.5 million or $24.5 million higher than that reported at December 31, 2011.  The change in the balance of the portfolio can be attributed in large part to an increased level of net investments in securities in the first nine months of 2012, both from excess cash balances held at December 31, 2011, as previously noted, and net inflows of deposits during the year, which were invested in securities.

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The Company made securities purchases during the first nine months of 2012 in the aggregate amount of $150.8 million, which were partially offset by proceeds from the sale, pay down, call and maturity of investments totaling approximately $131.1 million.  During the nine months ended September 30, 2012, the Company recorded a net pre-tax gain of approximately $1.7 million 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, 2012, the securities portfolio had unrealized gains, net of taxes, of approximately $3.7 million, an increase of approximately $3.3 million from that reported at December 31, 2011.  Fluctuations 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. Investment Securities, of the condensed consolidated financial statements, filed with  this Quarterly Report on Form 10-Q, at September 30, 2012, we owned five Whole Loan Private Label Mortgage Backed Securities (“PMBS”) with a remaining principal balance of approximately $3.6 million.  At September 30, 2012, 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.  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, 2012, 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, 2012, approximately $108.7 million or 71.8% of the Company’s mortgage related securities were issued by a government agency and government sponsored entities, 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.

Federal Home Loan Bank (“FHLB”) Stock

As a member of the FHLB 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, 2012, the Company held approximately $4.6 million in FHLB stock as compared to $4.7 million at December 31, 2011.  The decline was due to share repurchases by the FHLB during 2012.

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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, 2012 and December 31, 2011:

	September 30,		December 31,		Variance
(dollar amounts in thousands)	2012		2011		dollar			percentage
Demand, non-interest bearing	$	267,199	$	217,245	$	49,954		22.99%
Interest bearing demand	75,187		64,298		10,889			16.94%
Savings	36,940		33,740		3,200			9.48%
Money market	298,020		278,214		19,806			7.12%
Time deposits	177,686		192,711		(15,025		)	-7.80%
Total deposits	$	855,032	$	786,208	$	68,824		8.75%

As indicated in the table above total deposit balances at September 30, 2012 were approximately $855.0 million.  This represents an increase of approximately $68.8 million when compared to that reported at December 31, 2011.  As previously noted, the Company’s deposit gathering success is benefiting from both the very liquid nature of the market, as well as a series of branch-based deposit campaigns that began with the start of 2012 and are focused on relationship deepening and cross selling.

The Company continues to focus on gathering and retaining core relationships, which has helped to reduce the overall cost of funding for each of the last two years.  During the first nine months of 2012, the Company 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 $70.0 million from that reported at December 31, 2011.  Management’s continued focus on lower cost core deposit gathering in 2011 and into the first nine months of 2012 helped to reduce overall cost of funds by 17 basis points to 0.45% in the first nine months of 2012 from 0.62% reported in first nine months of 2011.

Borrowed Funds

The Company has a variety of sources from which it may obtain secondary funding.  These sources include, among others, the FHLB and credit lines established with correspondent banks and the FRB.  Borrowings are obtained for a variety of reasons which include, but are not limited to, asset-liability management, funding loan growth, 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, 2012, 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, 2012:

(dollar amounts in thousands)

Amount		Interest		Maturity
Borrowed		Rate	Advance Type	Date
$	3,000	0.32%	Variable	Open
2,000		0.32%	Variable	Open
2,000		0.32%	Variable	Open
2,500		0.32%	Variable	Open
9,500		Total Short-Term
3,000		1.28%	Fixed	12/10/2013
2,500		1.37%	Fixed	1/13/2014
2,500		1.37%	Fixed	2/3/2014
2,500		1.50%	Fixed	2/24/2014
1,500		1.19%	Fixed	5/12/2014
2,500		1.92%	Fixed	1/13/2015
2,500		1.90%	Fixed	2/2/2015
2,500		2.02%	Fixed	2/24/2015
2,500		1.68%	Fixed	5/11/2015
2,500		1.19%	Fixed	5/2/2017
2,500		1.80%	Fixed	5/2/2019
2,500		1.71%	Fixed	5/10/2019
3,500		2.52%	Fixed	1/18/2022
3,500		2.40%	Fixed	1/31/2022
36,500		Total Long-Term
$	46,000	1.46%

The balance of FHLB borrowing as of September 30, 2012 reflects a $5.5 million decrease from the $51.5 million reported at December 31, 2011. The decline in borrowings as compared to December 31, 2011 was largely due to the pay down of borrowings with funds made available from increasing deposit levels.  As previously noted there has been a shift in the composition of the borrowings from short-term variable borrowings to longer-term fixed rate borrowings in an effort to lock in the historically low fixed rates currently being offered by the FHLB.

Commitments

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 and will expire in September 2016.  The letter of credit was undrawn as of September 30, 2012.

Capital

At September 30, 2012, the balance of stockholders’ equity was approximately $142.3 million.  This represents an increase of approximately $12.7 million over that reported at December 31, 2011.  The year to date change is attributed to increases in equity due to net income for the first nine months of 2012 of $9.9 million, an increase in the balance of accumulated other comprehensive income in the amount of $3.3 million, and the impact of year to date share-based compensation expense and proceeds of option exercises totaling $0.3 million.  These increases were partially offset by dividends accrued on Series A Senior Preferred stock in the amount of $0.8 million.

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Dividends

The Company, pursuant to a Written Agreement between it and FRB of San Francisco was required to defer dividend payments on the Series A Preferred Stock issued to the U.S. Department of the Treasury under the Capital Purchase Program through the first quarter of 2012.    During the second quarter of 2012, the Company’s request to the FRB of San Francisco to allow it to pay all dividends in arrears on the Series A Preferred Stock, as well as the $0.3 million of interest in arrears on the junior subordinated debentures was approved and the Company brought both the dividends on its Series A Preferred Stock and the interest on its junior subordinated debentures current. The Company also received approval from the FRB to pay dividends on the Series A Preferred Stock and interest on the junior subordinated debentures for the third quarter of 2012, resulting in the Company being current in its servicing of these instruments. For more information concerning the Written Agreement, please refer to Note 11. Regulatory Matters, of the condensed consolidated financial statements, filed with this Quarterly Report on Form 10-Q.

Regulatory Capital

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 “Total Risk Based Capital Ratio.”  These standards were developed through joint efforts of banking authorities from different countries around the world.  The standards are based on the premise that different types of assets have different levels of risk associated with them and take into consideration the off-balance sheet exposures of banks when assessing capital adequacy.

The Company and the Bank seek to maintain strong levels of capital in order to be considered “well-capitalized” as determined by regulatory agencies by an amount commensurate with our risk profile.  The Company’s potential sources of capital include retained earnings and the issuance of equity.  Although the Company and the Bank rely primarily on earnings from its operations to generate capital, the absence of earnings in 2009 and 2010 required the Company to obtain additional capital through the issuance of preferred and common equity in 2010.

At September 30, 2012, the Company had $8.2 million in Junior Subordinated Deferrable Interest Debentures (the “debt securities”) issued and outstanding.  These securities were issued to Heritage Oaks Capital Trust II.  At September 30, 2012, the Company included $8.0 million of the net Junior Subordinated Debt in its Tier I Capital for regulatory reporting purposes.  For a more detailed discussion regarding these debt securities, see Note 12. Junior Subordinated Debentures, of the condensed consolidated financial statements, filed with this Quarterly Report on Form 10-Q.

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, which required higher levels of Tier I Leverage and Total Risk Based ratios.  Under the Order the Bank was required to maintain a Tier I Leverage ratio of 10.0% and a Total Risk-Based Capital ratio of 11.5%.  As a result of the termination of the Order in April 2012 and the Board of Directors’ execution of a Memorandum of Understanding with the FDIC and DFI, the Bank will no longer be subject to the Total Risk-Based Capital requirement of 11.5% but has agreed to continue to adhere to the 10.0% Tier 1 Leverage Ratio. Subsequent to the termination of the Order, the Bank should be considered “well capitalize” as long as it maintains this minimum Leverage Ratio. See also Note 11. Regulatory Matters, of the condensed consolidated financial statements, filed with this Quarterly Report on Form 10-Q for additional information related to the Order and Written Agreement as they pertain to these requirements.

The following table provides a summary of Company and Bank regulatory capital ratios at September 30, 2012 and December 31, 2011:

	Regulatory Standard		September 30, 2012		December 31, 2011
	Adequately	Well	Heritage Oaks		Heritage Oaks
Ratio	Capitalized	Capitalized	Bancorp	Bank	Bancorp	Bank
Leverage ratio	4.00%	5.00%	12.15%	11.75%	12.06%	11.85%
Tier I capital to risk weighted assets	4.00%	6.00%	14.92%	14.40%	14.81%	14.51%
Total risk based capital to risk weighted assets	8.00%	10.00%	16.19%	15.66%	16.07%	15.77%

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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 Bank has credit arrangements with correspondent banks that serve as a secondary liquidity source.  At September 30, 2012, these credit lines totaled $37.0 million and are unsecured.  Additionally, the Bank also has a borrowing facility with the FRB. The amount of available credit under the FRB facility is determined by the collateral provided by the Bank.  As of September 30, 2012, the borrowing availability related to this facility was $7.4 million. At September 30, 2012, the Bank had no borrowings against these lines.  As previously mentioned, the Bank is a member of the FHLB and has available collateralized borrowing capacity of $173.6 million at September 30, 2012.

The Bank also manages liquidity by maintaining an investment portfolio of readily marketable and liquid securities. These investments include mortgage backed securities, obligations of state and political subdivisions (municipal bonds) and corporate debt securities that provide a steady stream of cash flows.  As of September 30, 2012, 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 35.1% at September 30, 2012 compared to 35.1% at December 31, 2011.

The ratio of gross loans to deposits, another key liquidity ratio, declined to 79.3% at September 30, 2012 compared to 82.2% at December 31, 2011.

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 have an impact on the Company’s future earnings in the event those pressures 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. Commitments and Contingencies, in the Company’s consolidated financial statements under Item 8 of Part II of the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

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. Commitments and Contingencies, in the Company’s consolidated financial statements under Item 8 of Part II of the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

In connection with the $8.2 million in Junior Subordinated Debt Securities issued to Heritage Oaks Capital Trust II the Company issued the full and unconditional payment guarantee of certain accrued distributions by Heritage Oaks Capital Trust II.

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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 rateswill 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 bank subsidiary level. Thus, virtually all of the Company’s interest rate risk exposure lies at the bank subsidiary level other than with respect to $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 bank subsidiary level. In addition to risk related to interest rate changes, the Bank’s real estate loan portfolio, concentrated primarily within Santa Barbara and San Luis Obispo Counties, California, is subject to risks of changes in the underlying value of collateral as a result of changes in 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 asset and liability management software to measure the Company’s exposure to potential future changes in interest rates. The software 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 the software’s output, management believes the Company’s balance sheet is evenly matched over the short term and slightly asset sensitive over the longer term as of September 30, 2012.  This means that the Company would expect (all other things being equal) to experience a limited change in its net interest income if rates rise or 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.

The hypothetical impact of sudden interest rate movements applied to the Company’s asset and liability balances are modeled quarterly.  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 interest rate risk exposure. Management believes the results for the Company’s September 30, 2012 balances indicate that the net interest income at risk over a one year time horizon for a 1% and 2% rate increase and a 1% decrease is acceptable and within policy guidelines at this time. Given the low interest rate environment, a 2% decrease is not considered a realistic possibility and is therefore not modeled.

The results in the table below indicate the change in net interest income the Company would expect to see as of September 30, 2012, if interest rates were to change in the amounts set forth:

		Rate Shock Scenarios
(dollar amounts in thousands)		-100bp		Base		+100bp		+200bp
Net interest income		$	42,826	$	42,866	$	43,050	$	43,773
$	Change from base	$	(40)	$	-	$	184	$	907
% Change from base		-0.09%		0.00%		0.43%		2.12%

It is important to note that the above table is a summary of several forecasts and actual results may vary from any of the forecasted amounts and such difference may be material. The forecasts are based on estimates and assumptions made by management that may turn out to be different and may change over time.

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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 to each of the foregoing. Actual occurrences and results that vary significantly from the assumptions and estimates may have a significant impact on the Company’s net interest income; and therefore, the results of this analysis should not be relied upon as indicative of likely actual future results.

The following table shows management’s estimates of how the loan portfolio is segregated between variable-daily, variable other than daily and fixed rate loans at September 30, 2012:

(dollar amounts in thousands)

			Percent of
Rate Type	Balance		Total
Variable - daily	$	134,062	19.7	%
Variable other than daily	348,554		51.4	%
Fixed rate	195,732		28.9	%
Total gross loans	$	678,348	100.0	%

The table above identifies approximately 19.7% of the loan portfolio that will re-price immediately in a changing rate environment.  At September 30, 2012, approximately $482.6 million or 71.1% 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, 2012:

(dollars in thousands)

			Percent of
Re-Pricing	Balance		Total
< 1 Year	$	335,981	49.6	%
1-3 Years	155,615		22.9	%
3-5 Years	140,719		20.7	%
> 5 Years	46,033		6.8	%
Total gross loans	$	678,348	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, 2012:

	Move in Prime Rate (bps)
(dollar amounts in thousands)	+200		+250		+300		+350
Variable daily	$	4,769	$	16,009	$	42,693	$	76,969
Variable other than daily	36,362		93,828		160,408		228,330
Cumulative total variable at floor	$	41,131	$	109,837	$	203,101	$	305,299

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 250 to 350 basis points before the majority of variable rate loans in the portfolio experience a rise in their interest rates above their floors, thereby ending their fixed-rate interest rate risk profile and returning them to a fully variable interest rate risk profile.  When such event occurs, holding all other interest rate risk variables constant, the Company will become more net asset sensitive.  During the last several years, the Company moved to protect net interest margin by implementing floors on new loan originations.  Management believes this strategy proved successful in insulating net interest margin in the declining interest rate environment experienced over the last several years.  However in a rising rate environment, management believes that these loan floors could result in compression of net interest margin and potentially a decline in net interest income.

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The Company also utilizes rate shock scenarios to attempt to quantify the impact of interest rate changes on borrowers’ ability to pay on loans and the impact of similar rate changes on the value of collateral held against loans.  To this end, the Company, from time to time, will sample loans and analyze them under a rate shock scenario to specifically assess the impact of the rate shock on financial ratios such as interest rate coverage and loan-to-value.  The results of the analysis have generally revealed that in the case of a rate shock, a high percentage of the loans tested would continue to express ratios within current underwriting guidelines. The results of these analyses are considered acceptable by management.

Item 4.  Controls and Procedures

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 Exchange Act), designed to ensure that information required to be disclosed by the Company in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to management, including the Principal Executive Officer and the Principal Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure.

In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Management, with the participation of the Principal Executive Officer and the Principal Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on such evaluation, the Principal Executive Officer and the Principal Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures are effective in ensuring that information required to be disclosed by the Company in the reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms, and is accumulated and communicated to management, including the Principal Executive Officer and the Principal Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

There have been no changes in internal control over financial reporting in the quarter ended September 30, 2012 that have materially affected, or are reasonably likely to materially affect, the Company’s 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; 3rd amended complaint filed 8/3/2010.  Plaintiffs have sued a title company, a 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 who 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 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 challenged the legal sufficiency of the cause of action for negligence.  The Bank believes the remaining action against it for aiding and abetting Hurst Financial’s fraudulent scheme is without merit in that Hurst’s loans and attendant fraudulent representations to the plaintiffs were made long before the Bank made loans to the developer.  As such, the Bank does not expect the litigation to have a material impact on the Bank.

Heritage Oaks Bancorp| - 68 -

Corona Fruits & Veggies, Inc., et al v. Heritage Oaks Bank, et al, Santa Barbara County Sup. Ct. case no. 1390870, filed 2/8/2012. Corona Fruits & Veggies, Inc. and related entities are seeking in excess of $2,000,000 in damages for a variety of claims including breach of contract, misrepresentation, interference with contractual relations and promissory estoppel.  The alleged factual basis underlying the claims is that the Bank promised to extend agricultural and equipment financing to the plaintiffs and ultimately failed to do so, causing the plaintiffs’ damages. The Bank denies that it acted improperly in any respect toward plaintiffs or that it breached a loan commitment to the plaintiffs and is vigorously defending the matter. The case is now entering the discovery phase.

Except as indicated above, neither the Company nor the Bank is involved in any legal proceedings other than routine litigation incidental to the business of the Company or the Bank.

Item 1A.  Risk Factors

Management is not aware of any material changes to the risk factors discussed in Part 1, Item 1A of the Annual Report on Form 10-K for the year ended December 31, 2011.

In addition to the other information set forth in this report, you should carefully consider the risk factors discussed in Part I, Item 1A of the Annual Report on Form 10-K for the year ended December 31, 2011, which could materially and adversely affect the Company’s business, financial condition and results of operations. The risks described in the Annual Report on Form 10-K, are not the only risks facing the Company. Additional risks and uncertainties not presently known to management or that management currently believes to be immaterial may also materially and adversely affect the Company’s business, financial condition or results of operations.

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

Unregistered Sales of Equity Securities

None.

Purchases of Equity Securities

None.

Item 3.  Defaults upon Senior Securities

(a)  None.

(b)  None.

Item 4.   Mine Safety Disclosures

None.

Item 5.  Other Information

None.

Heritage Oaks Bancorp| - 69 -

Item 6.  Exhibits

(a) Exhibits:

Exhibit 31.1 Rule 13a-14(a) Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*

Exhibit 31.2 Rule 13a-14(a)  Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*

Exhibit 32.1 Section 1350 Certification of Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002**

Exhibit 32.2 Section 1350  Certification of Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002**

Exhibit 101 The following materials from the Company’s Quarterly Report on Form 10-Q for the three months ended September 30, 2012, formatted in XBRL (eXtensible Business Reporting Language): (i) Condensed Consolidated Balance Sheets as of September 30, 2012 (unaudited) and December 31, 2011, (ii) Condensed Consolidated Statements of Income for the three and nine months ended September 30, 2012 and 2011 (unaudited), (iii) Condensed Consolidated Statements of Cash Flows, for the nine months ended September 30, 2012 and 2011 (unaudited), and (iv) Notes to Condensed Consolidated Financial Statements (unaudited), tagged as blocks of text.

* Filed herewith.

**Furnished herewith.

Heritage Oaks Bancorp| - 70 -

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 2, 2012

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

Heritage Oaks Bancorp| - 71 -

EX-31.1

EXHIBIT 31.1

CERTIFICATIONS

I, Simone Lagomarsino, certify that:

1.	I have reviewed this quarterly report on Form 10-Q of Heritage Oaks Bancorp;
2.	Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.	Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.	I am responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d -15(e)) and internal control over financial reporting (as defined in the Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
	a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under my supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to me by others within those entities, particularly during the period in which this quarterly report is being prepared;
	b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under my supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
	c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report my conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
	d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and
5.	I have disclosed, based on my most recent evaluation of internal controls over financial reporting, to the registrant’s auditors and audit committee of the registrant’s board of directors (or persons performing the equivalent function);
	a) all significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
	b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date:  November 2, 2012

/s/ Simone Lagomarsino

Simone Lagomarsino

President and Chief Executive Officer

(Principal Executive Officer)

Heritage Oaks Bancorp| - 72 -

EX-31.2

EXHIBIT 31.2

CERTIFICATIONS

I, Thomas J. Tolda, certify that:

1.	I have reviewed this quarterly report on Form 10-Q of Heritage Oaks Bancorp;
2.	Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.	Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.	I am responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d -15(e)) and internal control over financial reporting (as defined in the Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
	a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under my supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to me by others within those entities, particularly during the period in which this quarterly report is being prepared;
	b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under my supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
	c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report my conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
	d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and
5.	I have disclosed, based on my most recent evaluation of internal controls over financial reporting, to the registrant’s auditors and audit committee of the registrant’s board of directors (or persons performing the equivalent function);
	a) all significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
	b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date:  November 2, 2012

/s/ Thomas J. Tolda

Thomas J. Tolda,

Executive Vice President and Chief Financial Officer

(Principal Financial Officer)

Heritage Oaks Bancorp| - 73 -

EX-32.1

EXHIBIT 32.1

HERITAGE OAKS BANCORP

Quarterly report on Form 10Q

for the quarter ended September 30, 2012

CERTIFICATION

Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

The undersigned, who is the President and Chief Executive Officer of Heritage Oaks Bancorp (the “Company”), hereby certifies, pursuant to 18 USC Section 1350, that to my knowledge, (i) the Quarterly Report on Form 10-Q for the quarter ended September 30, 2012, as filed by the Company with the Securities and Exchange Commission (the “Quarterly Report”), to which this Certification is an Exhibit, fully complies with the applicable requirements of Section 13(a) and 15(d) of the Exchange Act; and (ii) the information contained in this Quarterly Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Dated: November 2, 2012	/s/ Simone Lagomarsino
	Simone Lagomarsino,
	President and Chief Executive Officer
	(Principal Executive Officer)

A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to Heritage Oaks Bancorp, and will be retained by Heritage Oaks Bancorp and furnished to the Securities and Exchange Commission or its staff upon request.

Heritage Oaks Bancorp| - 74 -

EX-32.2

EXHIBIT 32.2

HERITAGE OAKS BANCORP

Quarterly report on Form 10Q

for the quarter ended September 30, 2012

CERTIFICATION

Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

The undersigned, who is the Chief Financial Officer of Heritage Oaks Bancorp (the “Company”), hereby certifies, pursuant to 18 USC Section 1350, that to my knowledge, (i) the Quarterly Report on Form 10-Q for the quarter ended September 30, 2012, as filed by the Company with the Securities and Exchange Commission (the “Quarterly Report”), to which this Certification is an Exhibit, fully complies with the applicable requirements of Section 13(a) and 15(d) of the Exchange Act; and (ii) the information contained in this Quarterly Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Dated: November 2, 2012	/s/ Thomas J. Tolda
	Thomas J. Tolda,
	Executive Vice President and Chief Financial Officer
	(Principal Financial Officer)

A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to Heritage Oaks Bancorp, and will be retained by Heritage Oaks Bancorp and furnished to the Securities and Exchange Commission or its staff upon request.

Heritage Oaks Bancorp| - 75 -

XML

Income Taxes (Details) (USD $) In Millions, unless otherwise specified	3 Months Ended			9 Months Ended		12 Months Ended
	Sep. 30, 2012	Dec. 31, 2011	Sep. 30, 2011	Sep. 30, 2012	Sep. 30, 2011	Dec. 31, 2010
Income Taxes
Effective tax rate as a result of tax provision (as a percent)	(84.30%)		35.30%	(54.80%)	32.80%
Reversal of deferred tax valuation allowance	$ 4.1	$ 1.5		$ 5.6
Cumulative loss position period				3 years
Change in deferred tax asset valuation allowance						$ 7.1
Determination of the valuation allowance, cumulative pre-tax losses period				3 years
Determination of the valuation allowance, expected deferred tax assets realization period				5 years

XML

Junior Subordinated Debentures (Details) (USD $) In Thousands, unless otherwise specified	Sep. 30, 2012	Dec. 31, 2011	Jun. 30, 2010
Junior Subordinated Debentures
Junior subordinated debentures on which interest payment has been deferred	$ 8,248	$ 8,248	$ 8,200

XML

Preferred Stock (Details) (USD $) In Millions, except Share data, unless otherwise specified	12 Months Ended			9 Months Ended	1 Months Ended	9 Months Ended		1 Months Ended	9 Months Ended
	Dec. 31, 2010	Sep. 30, 2012	Dec. 31, 2011	Sep. 30, 2012 Minimum item	Mar. 31, 2009 Series A senior preferred stock	Sep. 30, 2012 Series A senior preferred stock item	Mar. 20, 2009 Series A senior preferred stock	Mar. 31, 2010 Series C preferred stock	Sep. 30, 2012 Series C preferred stock item
Preferred Stock
Preferred stock, shares authorized		5,000,000	5,000,000
Number of series of preferred stock				1
Issuance of stock (in shares)					21,000			1,189,538
Value of stock issued to U.S. Treasury under CPP					$ 21.0
Liquidation preference per share						$ 1,000
Coupon rate for five years (as a percent)						5.00%
Coupon rate thereafter (as a percent)						9.00%
Percentage of liquidation preference amount at which the stock may be redeemed						100.00%
Period of redemption from the date of issue						3 years
Warrants issued as a percentage of preferred equity issuance amount					15.00%
Value of warrants issued to U.S. Treasury to purchase shares of common stock							3.2
Issuance of warrants (in shares)							611,650
Exercise price of warrants outstanding (in dollars per share)						$ 5.15
Expiration period of warrants issued						10 years
Period from issuance of preferred stock during which consent of U.S. Treasury is required for any proposed increase in common stock dividends						3 years
Number of directors who can be elected by U.S. Treasury upon failure to pay dividend for six quarters						2
Gross proceeds from private placement	60.0							3.6
Preferred stock conversion ratio, numerator									1
Preferred stock conversion ratio, denominator									1
Conversion price (in dollars per share)									$ 3.25
Value of contingent beneficial conversion feature to be recognized upon conversion									$ 0.2
Number of investors having board observation rights									2
Number of investors having board nomination rights									1

XML

Loans (Details) (USD $)	9 Months Ended	21 Months Ended
	Sep. 30, 2012 item	Sep. 30, 2012 item	Jun. 30, 2012	Dec. 31, 2011	Sep. 30, 2011	Jun. 30, 2011	Dec. 31, 2010
Outstanding loan balances
Total gross loans	$ 678,348,000	$ 678,348,000		$ 646,286,000
Deferred loan fees	977,000	977,000		1,111,000
Allowance for loan losses	17,987,000	17,987,000	18,149,000	19,314,000	20,409,000	21,700,000	24,940,000
Net loans	659,384,000	659,384,000		625,861,000
Loans held for sale	12,590,000	12,590,000		21,947,000
Period for sale of loans categorized as held for sale	30 days
Reserve maintained for the exercise of repurchase option by buyer	900,000	900,000
Number of loans for which the purchaser is seeking reimbursement	4
Number of loans settled		3
Losses incurred on settlement		(300,000)
Concentration of Credit Risk
Loan portfolio collateralized by various forms of real estate	535,400,000	535,400,000		482,600,000
Unpaid principal balance of loans serviced for others, exclusive of SBA loans	8,600,000	8,600,000		8,600,000
Unpaid principal balance of SBA loans serviced for others	4,700,000	4,700,000		5,400,000
Contingent liability for financial and performance standby letters of credit	13,900,000	13,900,000
Un-disbursed loan commitments	119,800,000	119,800,000
Real Estate Secured
Outstanding loan balances
Total gross loans	484,903,000	484,903,000		433,455,000
Allowance for loan losses	7,987,000	7,987,000	6,897,000	9,645,000	10,552,000	10,048,000	11,885,000
Real Estate Secured | Multi-family residential
Outstanding loan balances
Total gross loans	16,429,000	16,429,000		15,915,000
Real Estate Secured | Residential 1 to 4 family
Outstanding loan balances
Total gross loans	37,837,000	37,837,000		20,839,000
Real Estate Secured | Home equity lines of credit
Outstanding loan balances
Total gross loans	32,422,000	32,422,000		31,047,000
Real Estate Secured | Commercial
Outstanding loan balances
Total gross loans	374,799,000	374,799,000		357,499,000
Real Estate Secured | Farmland
Outstanding loan balances
Total gross loans	23,416,000	23,416,000		8,155,000
Commercial
Outstanding loan balances
Total gross loans	137,510,000	137,510,000		156,894,000
Allowance for loan losses	5,071,000	5,071,000	6,261,000	6,549,000	6,960,000	8,070,000	9,507,000
Commercial | Commercial and industrial
Outstanding loan balances
Total gross loans	119,496,000	119,496,000		141,065,000
Commercial | Agriculture
Outstanding loan balances
Total gross loans	17,948,000	17,948,000		15,740,000
Commercial | Other
Outstanding loan balances
Total gross loans	66,000	66,000		89,000
Construction
Outstanding loan balances
Total gross loans	26,875,000	26,875,000		22,731,000
Allowance for loan losses	558,000	558,000	381,000	488,000	530,000	500,000	1,353,000
Construction | Single family residential
Outstanding loan balances
Total gross loans	11,267,000	11,267,000		13,039,000
Construction | Single family residential - Spec.
Outstanding loan balances
Total gross loans	420,000	420,000		8,000
Construction | Multi-family
Outstanding loan balances
Total gross loans	787,000	787,000		1,669,000
Construction | Commercial
Outstanding loan balances
Total gross loans	14,401,000	14,401,000		8,015,000
Land
Outstanding loan balances
Total gross loans	23,633,000	23,633,000		26,454,000
Allowance for loan losses	4,263,000	4,263,000	4,483,000	2,416,000	2,143,000	2,886,000	2,000,000
Installment loans to individuals
Outstanding loan balances
Total gross loans	5,146,000	5,146,000		6,479,000
Allowance for loan losses	72,000	72,000	91,000	175,000	204,000	174,000	166,000
All other loans (including overdrafts)
Outstanding loan balances
Total gross loans	281,000	281,000		273,000
Allowance for loan losses	$ 36,000	$ 36,000	$ 36,000	$ 41,000	$ 20,000	$ 22,000	$ 29,000

XML

Other Real Estate Owned ("OREO") (Tables)

9 Months Ended

Sep. 30, 2012

Other Real Estate Owned ("OREO")

Summary of the changes in the balance of OREO

	Balance										Balance
	June 30,										September 30,
(dollar amounts in thousands)	2012		Additions		Disposals			Writedowns			2012
Real Estate Secured
Residential 1 to 4 family	$	431	$	-	$	-		$	(31	)	$	400
Commercial	215		-		-			-			215
Construction
Single family residential - Spec.	397		-		(397		)	-			-
Land	32		-		-			(32		)	-
Totals	$	1,075	$	-	$	(397	)	$	(63	)	$	615

	Balance										Balance
	December 31,										September 30,
(dollar amounts in thousands)	2011		Additions		Disposals			Writedowns			2012
Real Estate Secured
Residential 1 to 4 family	$	-	$	607	$	(176	)	$	(31	)	$	400
Commercial	215		-		-			-			215
Construction
Single family residential - Spec.	423		-		(397		)	(26		)	-
Tract	100		-		(100		)	-			-
Land	179		162		(300		)	(41		)	-
Totals	$	917	$	769	$	(973	)	$	(98	)	$	615

	Balance										Balance
	June 30,										September 30,
(dollar amounts 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,
(dollar amounts 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

XML

Subsequent Events (Details) (USD $)	3 Months Ended		9 Months Ended		1 Months Ended
	Sep. 30, 2012	Sep. 30, 2011	Sep. 30, 2012	Sep. 30, 2011	Oct. 31, 2012 Subsequent event
Subsequent Events
Non-performing loan paid-off					$ 3,900,000
Recoveries	$ 270,000	$ 610,000	$ 737,000	$ 1,960,000	$ 1,100,000

XML

Fair Value of Assets and Liabilities (Details) (USD $) In Thousands, unless otherwise specified																																										9 Months Ended
	Sep. 30, 2012	Sep. 30, 2012 Obligations of U.S. government agencies	Sep. 30, 2012 Mortgage-backed securities - Agency	Sep. 30, 2012 Mortgage-backed securities - Non-agency	Sep. 30, 2012 Obligations of state and municipal securities	Sep. 30, 2012 Corporate debt securities	Sep. 30, 2012 Other securities	Sep. 30, 2012 Significant Other Observable Inputs (Level 2)	Dec. 31, 2011 Significant Other Observable Inputs (Level 2)	Dec. 31, 2011 Significant Unobservable Inputs (Level 3)	Sep. 30, 2012 Recurring basis Significant Other Observable Inputs (Level 2)	Dec. 31, 2011 Recurring basis Significant Other Observable Inputs (Level 2)	Sep. 30, 2012 Recurring basis Significant Other Observable Inputs (Level 2) Obligations of U.S. government agencies	Dec. 31, 2011 Recurring basis Significant Other Observable Inputs (Level 2) Obligations of U.S. government agencies	Sep. 30, 2012 Recurring basis Significant Other Observable Inputs (Level 2) Mortgage-backed securities - Agency	Dec. 31, 2011 Recurring basis Significant Other Observable Inputs (Level 2) Mortgage-backed securities - Agency	Sep. 30, 2012 Recurring basis Significant Other Observable Inputs (Level 2) Mortgage-backed securities - Non-agency	Dec. 31, 2011 Recurring basis Significant Other Observable Inputs (Level 2) Mortgage-backed securities - Non-agency	Sep. 30, 2012 Recurring basis Significant Other Observable Inputs (Level 2) Obligations of state and municipal securities	Dec. 31, 2011 Recurring basis Significant Other Observable Inputs (Level 2) Obligations of state and municipal securities	Sep. 30, 2012 Recurring basis Significant Other Observable Inputs (Level 2) Corporate debt securities	Dec. 31, 2011 Recurring basis Significant Other Observable Inputs (Level 2) Corporate debt securities	Sep. 30, 2012 Recurring basis Significant Other Observable Inputs (Level 2) Other securities	Dec. 31, 2011 Recurring basis Significant Other Observable Inputs (Level 2) Other securities	Dec. 31, 2011 Recurring basis Significant Unobservable Inputs (Level 3)	Dec. 31, 2011 Recurring basis Significant Unobservable Inputs (Level 3) Mortgage-backed securities - Non-agency	Dec. 31, 2011 Recurring basis Significant Unobservable Inputs (Level 3) Obligations of state and municipal securities	Sep. 30, 2012 Recurring basis Assets At Fair Value	Dec. 31, 2011 Recurring basis Assets At Fair Value	Sep. 30, 2012 Recurring basis Assets At Fair Value Obligations of U.S. government agencies	Dec. 31, 2011 Recurring basis Assets At Fair Value Obligations of U.S. government agencies	Sep. 30, 2012 Recurring basis Assets At Fair Value Mortgage-backed securities - Agency	Dec. 31, 2011 Recurring basis Assets At Fair Value Mortgage-backed securities - Agency	Sep. 30, 2012 Recurring basis Assets At Fair Value Mortgage-backed securities - Non-agency	Dec. 31, 2011 Recurring basis Assets At Fair Value Mortgage-backed securities - Non-agency	Sep. 30, 2012 Recurring basis Assets At Fair Value Obligations of state and municipal securities	Dec. 31, 2011 Recurring basis Assets At Fair Value Obligations of state and municipal securities	Sep. 30, 2012 Recurring basis Assets At Fair Value Corporate debt securities	Dec. 31, 2011 Recurring basis Assets At Fair Value Corporate debt securities	Sep. 30, 2012 Recurring basis Assets At Fair Value Other securities	Dec. 31, 2011 Recurring basis Assets At Fair Value Other securities	Sep. 30, 2012 Minimum	Sep. 30, 2012 Maximum
Financial instruments of the Company measured at fair value on a recurring basis
Discount rate for impaired loans (as a percent)																																										1.00%	3.00%
Discount rate for other real estate owned and foreclosed collateral (as a percent)																																										1.00%	3.00%
Total assets measured on recurring basis	$ 261,451	$ 3,957	$ 109,221	$ 43,906	$ 63,271	$ 30,675	$ 10,421	$ 261,451	$ 233,649	$ 3,333	$ 261,541	$ 233,649	$ 3,957	$ 4,326	$ 109,221	$ 117,325	$ 43,906	$ 31,458	$ 63,271	$ 51,664	$ 30,675	$ 26,856	$ 10,421	$ 2,020	$ 3,333	$ 3,074	$ 259	$ 261,541	$ 236,982	$ 3,957	$ 4,326	$ 109,221	$ 117,325	$ 43,906	$ 34,532	$ 63,271	$ 51,923	$ 30,675	$ 26,856	$ 10,421	$ 2,020

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Allowance for Loan Losses (Details) (USD $)	3 Months Ended		9 Months Ended
	Sep. 30, 2012	Sep. 30, 2011	Sep. 30, 2012 item	Sep. 30, 2011	Dec. 31, 2011
Allowance for Loan Losses
Components in allowance for loan losses			2
Allocation of the allowance to various segments in the loan portfolio
Balance, at the beginning of the period	$ 18,149,000	$ 21,700,000	$ 19,314,000	$ 24,940,000
Charge-offs	(1,718,000)	(2,987,000)	(9,745,000)	(11,861,000)
Recoveries	270,000	610,000	737,000	1,960,000
Provision for loan losses	1,286,000	1,086,000	7,681,000	5,370,000
Balance, at the end of the period	17,987,000	20,409,000	17,987,000	20,409,000
Provision for loan losses, transfer from C&I to land related to the re-characterization of a loan as part of a TDR	3,900,000		3,900,000
Amount of allowance attributed to:
Specifically evaluated impaired loans	4,617,000		4,617,000		2,217,000
General portfolio allocation	13,370,000		13,370,000		17,097,000
Loans individually evaluated for impairment	20,487,000		20,487,000		13,379,000
Loans collectively evaluated for impairment	657,861,000		657,861,000		632,907,000
General reserves to total loans collectively evaluated for impairment (as a percent)	2.03%		2.03%		2.70%
Total gross loans	678,348,000		678,348,000		646,286,000
Total allowance to gross loans (as a percent)	2.65%		2.65%		2.99%
Real Estate Secured
Allocation of the allowance to various segments in the loan portfolio
Balance, at the beginning of the period	6,897,000	10,048,000	9,645,000	11,885,000
Charge-offs	(106,000)	(1,646,000)	(2,471,000)	(6,474,000)
Recoveries	12,000	305,000	74,000	347,000
Provision for loan losses	1,184,000	1,845,000	739,000	4,794,000
Balance, at the end of the period	7,987,000	10,552,000	7,987,000	10,552,000
Amount of allowance attributed to:
Specifically evaluated impaired loans	50,000		50,000		791,000
General portfolio allocation	7,937,000		7,937,000		8,854,000
Loans individually evaluated for impairment	6,805,000		6,805,000		5,532,000
Loans collectively evaluated for impairment	478,098,000		478,098,000		427,923,000
General reserves to total loans collectively evaluated for impairment (as a percent)	1.66%		1.66%		2.07%
Total gross loans	484,903,000		484,903,000		433,455,000
Total allowance to gross loans (as a percent)	1.65%		1.65%		2.23%
Commercial
Allocation of the allowance to various segments in the loan portfolio
Balance, at the beginning of the period	6,261,000	8,070,000	6,549,000	9,507,000
Charge-offs	(1,511,000)	(1,203,000)	(4,272,000)	(4,057,000)
Recoveries	246,000	262,000	623,000	1,313,000
Provision for loan losses	75,000	(169,000)	2,171,000	197,000
Balance, at the end of the period	5,071,000	6,960,000	5,071,000	6,960,000
Amount of allowance attributed to:
Specifically evaluated impaired loans	1,117,000		1,117,000		1,309,000
General portfolio allocation	3,954,000		3,954,000		5,240,000
Loans individually evaluated for impairment	4,336,000		4,336,000		4,963,000
Loans collectively evaluated for impairment	133,174,000		133,174,000		151,931,000
General reserves to total loans collectively evaluated for impairment (as a percent)	2.97%		2.97%		3.45%
Total gross loans	137,510,000		137,510,000		156,894,000
Total allowance to gross loans (as a percent)	3.69%		3.69%		4.17%
Construction
Allocation of the allowance to various segments in the loan portfolio
Balance, at the beginning of the period	381,000	500,000	488,000	1,353,000
Charge-offs	(92,000)	(47,000)	(668,000)	(338,000)
Recoveries	1,000	1,000	1,000	112,000
Provision for loan losses	268,000	76,000	737,000	(597,000)
Balance, at the end of the period	558,000	530,000	558,000	530,000
Amount of allowance attributed to:
General portfolio allocation	558,000		558,000		488,000
Loans individually evaluated for impairment	1,840,000		1,840,000		937,000
Loans collectively evaluated for impairment	25,035,000		25,035,000		21,794,000
General reserves to total loans collectively evaluated for impairment (as a percent)	2.23%		2.23%		2.24%
Total gross loans	26,875,000		26,875,000		22,731,000
Total allowance to gross loans (as a percent)	2.08%		2.08%		2.15%
Land
Allocation of the allowance to various segments in the loan portfolio
Balance, at the beginning of the period	4,483,000	2,886,000	2,416,000	2,000,000
Charge-offs		(25,000)	(2,168,000)	(793,000)
Recoveries	5,000	20,000	18,000	149,000
Provision for loan losses	(225,000)	(738,000)	3,997,000	787,000
Balance, at the end of the period	4,263,000	2,143,000	4,263,000	2,143,000
Amount of allowance attributed to:
Specifically evaluated impaired loans	3,434,000		3,434,000		114,000
General portfolio allocation	829,000		829,000		2,302,000
Loans individually evaluated for impairment	7,300,000		7,300,000		1,886,000
Loans collectively evaluated for impairment	16,333,000		16,333,000		24,568,000
General reserves to total loans collectively evaluated for impairment (as a percent)	5.08%		5.08%		9.37%
Total gross loans	23,633,000		23,633,000		26,454,000
Total allowance to gross loans (as a percent)	18.04%		18.04%		9.13%
Installment
Allocation of the allowance to various segments in the loan portfolio
Balance, at the beginning of the period	91,000	174,000	175,000	166,000
Charge-offs	(9,000)	(66,000)	(29,000)	(199,000)
Recoveries	5,000	22,000	18,000	39,000
Provision for loan losses	(15,000)	74,000	(92,000)	198,000
Balance, at the end of the period	72,000	204,000	72,000	204,000
Amount of allowance attributed to:
Specifically evaluated impaired loans	16,000		16,000		3,000
General portfolio allocation	56,000		56,000		172,000
Loans individually evaluated for impairment	206,000		206,000		61,000
Loans collectively evaluated for impairment	4,940,000		4,940,000		6,418,000
General reserves to total loans collectively evaluated for impairment (as a percent)	1.13%		1.13%		2.68%
Total gross loans	5,146,000		5,146,000		6,479,000
Total allowance to gross loans (as a percent)	1.40%		1.40%		2.70%
All Other Loans
Allocation of the allowance to various segments in the loan portfolio
Balance, at the beginning of the period	36,000	22,000	41,000	29,000
Charge-offs			(137,000)
Recoveries	1,000		3,000
Provision for loan losses	(1,000)	(2,000)	129,000	(9,000)
Balance, at the end of the period	36,000	20,000	36,000	20,000
Amount of allowance attributed to:
General portfolio allocation	36,000		36,000		41,000
Loans collectively evaluated for impairment	281,000		281,000		273,000
General reserves to total loans collectively evaluated for impairment (as a percent)	12.81%		12.81%		15.02%
Total gross loans	$ 281,000		$ 281,000		$ 273,000
Total allowance to gross loans (as a percent)	12.81%		12.81%		15.02%

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Regulatory Matters (Details) (USD $) In Millions, unless otherwise specified	1 Months Ended	12 Months Ended
	Mar. 31, 2010	Dec. 31, 2010	Sep. 30, 2012
Regulatory Matters
Proceeds from private placement		$ 60
Leverage Ratio as originally established by the Order (as a percent)			10.00%
Leverage ratio (as a percent)			11.75%
Period over which plan to maintain sufficient capital is to be submitted for approval from date of the written agreement	60 days

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Loans

9 Months Ended

Sep. 30, 2012

Loans

Loans

Note 3.  Loans

The following table provides a summary of outstanding loan balances as of September 30, 2012 compared to December 31, 2011:

	September 30,		December 31,
(dollar amounts in thousands)	2012		2011
Real Estate Secured
Multi-family residential	$	16,429	$	15,915
Residential 1 to 4 family	37,837		20,839
Home equity lines of credit	32,422		31,047
Commercial	374,799		357,499
Farmland	23,416		8,155
Total real estate secured	484,903		433,455
Commercial
Commercial and industrial	119,496		141,065
Agriculture	17,948		15,740
Other	66		89
Total commercial	137,510		156,894
Construction
Single family residential	11,267		13,039
Single family residential - Spec.	420		8
Multi-family	787		1,669
Commercial	14,401		8,015
Total construction	26,875		22,731
Land	23,633		26,454
Installment loans to individuals	5,146		6,479
All other loans (including overdrafts)	281		273
Total gross loans	678,348		646,286
Deferred loan fees	977		1,111
Allowance for loan losses	17,987		19,314
Total net loans	$	659,384	$	625,861
Loans held for sale	$	12,590	$	21,947

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.  Under the terms of the mortgage purchase agreements, the purchaser has the right to require the Company to either repurchase the mortgage or reimburse losses incurred by the purchaser, which are determined to have been directly caused by borrower fraud or misrepresentation.  At September 30, 2012, the Company has four related loans for which the purchaser is seeking reimbursement from the Company for losses sustained as a result of borrower fraud and/or misrepresentation.  Although the Company intends to vigorously challenge these and any future claims, the Company has recorded a reserve of $0.9 million for these potential repurchases at September 30, 2012.  Although the Company has generally been successful in its defense of these types of claims, the Company has incurred losses of $0.3 million related to the settlement of 3 loans since the beginning of 2011.

Concentration of Credit Risk

At September 30, 2012 and December 31, 2011, $535.4 million and $482.6 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.

Loans serviced for others are not included in the accompanying balance sheets.  The unpaid principal balance of loans serviced for others, exclusive of Small Business Administration (“SBA”) loans, was $8.6 million at both September 30, 2012 and December 31, 2011.

From time to time, the Company also originates SBA loans for sale to governmental agencies and institutional investors.  At September 30, 2012 and December 31, 2011, the unpaid principal balance of SBA loans serviced for others totaled $4.7 million and $5.4 million, respectively.  The Company did not recognize any gains from the sale of SBA loans in the first nine months of 2012 or 2011.

At September 30, 2012, the Company was contingently liable for financial and performance standby letters of credit to its customers totaling approximately $13.9 million and un-disbursed loan commitments in the amount of $119.8 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, 2012:

			Unpaid		Impaired Loans				Specific
	Recorded		Principal		With Specific		Without Specific		Allowance for
(dollar amounts in thousands)	Investment (1)		Balance		Allowance		Allowance		Impaired Loans
Real Estate Secured
Residential 1 to 4 family	$	904	$	1,163	$	139	$	765	$	11
Home equity lines of credit	381		473		62		319		7
Commercial	4,468		8,265		255		4,213		27
Farmland	1,089		1,089		1,089		-		5
Commercial
Commercial and industrial	3,247		4,473		2,656		591		1,096
Agriculture	1,075		1,253		50		1,025		21
Construction
Commercial	1,840		2,508		-		1,840		-
Land	7,301		10,829		6,197		1,104		3,434
Installment loans to individuals	205		225		205		-		16
Totals	$	20,510	$	30,278	$	10,653	$	9,857	$	4,617

(1)The recorded investment in loans includes the book value of impaired loans as adjusted for the net deferred costs and fees related to the impaired loans.

The following table provides a summary of the Company’s investment in impaired loans as of December 31, 2011:

			Unpaid		Impaired Loans				Specific
	Recorded		Principal		With Specific		Without Specific		Allowance for
(dollar amounts in thousands)	Investment (1)		Balance		Allowance		Allowance		Impaired Loans
Real Estate Secured
Residential 1 to 4 family	$	622	$	895	$	153	$	469	$	53
Home equity lines of credit	359		443		-		359		-
Commercial	4,567		5,513		3,876		691		738
Farmland	-		-		-		-		-
Commercial
Commercial and industrial	2,183		2,879		1,928		255		1,169
Agriculture	2,789		2,932		2,166		623		140
Construction
Single family residential	937		937		-		937		-
Land	1,886		2,258		729		1,157		114
Installment loans to individuals	61		61		61		-		3
Totals	$	13,404	$	15,918	$	8,913	$	4,491	$	2,217

(1)The recorded investment in loans includes the book value of impaired loans as adjusted for the net deferred costs and fees related to the impaired loans.

The average recorded investment in impaired loans and the interest income recognized on impaired loans for the three and nine months ended September 30, 2012 and 2011 was:

	For the three months ended September 30,								For the nine months ended September 30,
	2012				2011				2012				2011
	Average		Interest		Average		Interest		Average		Interest		Average		Interest
	Recorded		Income		Recorded		Income		Recorded		Income		Recorded		Income
(dollar amounts in thousands)	Investment		Recognized		Investment		Recognized		Investment		Recognized		Investment		Recognized
Real Estate Secured
Residential 1 to 4 family	$	801	$	-	$	568	$	-	$	756	$	-	$	613	$	-
Home equity lines of credit	384		-		808		-		378		-		861		-
Commercial	3,492		-		10,354		-		3,757		-		12,346		-
Farmland	363		-		577		-		272		-		1,090		-
Commercial
Commercial and industrial	4,129		-		2,992		21		3,644		4		3,708		22
Agriculture	1,905		-		883		-		2,010		-		724		-
Construction
Single family residential	-		-		1,174		-		234		-		1,209		-
Single family residential - Spec.	-		-		-		-		-		-		313		-
Multi-family	-		-		-		-		-		-		120		-
Commercial	1,257		-		-		-		943		-		-		-
Land	7,189		-		3,669		-		5,863		-		3,780		-
Installment loans to individuals	89		-		4		-		82		-		96		-
Totals	$	19,609	$	-	$	21,029	$	21	$	17,939	$	4	$	24,860	$	22

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, 2012 and 2011. If interest on non-accruing loans had been recognized at the original interest rates stipulated in the respective loan agreements, interest income would have increased $0.3 million for the both three months ended September 30, 2012 and 2011, and $1.0 million and $1.4 million for the nine months ended September 30, 2012 and 2011, respectively.  Interest income recognized on impaired loans in the table above, if any, represents interest the Company recognized on performing troubled debt restructurings.

Because the loans currently identified as impaired have unique risk characteristics, the Company determined the related valuation allowances for such loans on a loan-by-loan basis.  It should be noted that a significant portion of the Company’s impaired loans were carried at the fair value of the underlying collateral, net of estimated selling costs as of September 30, 2012 and December 31, 2011.

At September 30, 2012 and December 31, 2011, $11.5 million and $3.7 million, respectively, in loans were classified as troubled debt restructurings (“TDRs”).  Of those balances $18 thousand and $0.8 million were accruing as of September 30, 2012 and December 31, 2011, respectively.  In a majority of these loans, the Company has granted concessions regarding interest rates, payment structure and maturity.  During the three and nine months ending September 30, 2012 and 2011, the terms of certain loans were modified as troubled debt restructurings. These term modifications included a combination of a partial charge-off of principal along with extensions of the maturity date at the loan’s original interest rate, which was lower than the current market rate for new debt with similar risk.  The maturity date extensions granted were for periods ranging from 12 months to 18 months. Forgone interest related to concessions granted on TDRs totaled $46 thousand and $13 thousand for the three months ended September 30, 2012 and 2011, respectively, and $85 thousand and $62 thousand for the nine months ended September 30, 2012 and 2011, respectively.  As of September 30, 2012, the Company was not committed to lend any additional funds to borrowers whose obligations to the Company were restructured.

The following table presents loan modifications by class which resulted in TDRs during the three and nine months ending September 30, 2012:

	For the three months ended September 30, 2012					For the nine months ended September 30, 2012
		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
Residential 1 to 4 family	-	$	-	$	-	1	$	439	$	439
Farmland	1	1,089		1,089		1	1,089		1,089
Commercial
Commercial and industrial	6	1,120		1,099		9	2,115		2,094
Construction
Land	1	63		63		3	8,433		7,063
Totals	8	$	2,272	$	2,251	14	$	12,076	$	10,685

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

The following table summarizes TDRs that were completed in the last twelve months and became delinquent during the three and nine months ended September 30, 2012:

	For the three months ended September 30, 2012			For the nine months ended September 30, 2012
	Number of			Number of
(dollar amounts in thousands)	TDRs	Recorded Investment		TDRs	Recorded Investment
Trouble Debt Restructurings
That Subsequently Defaulted
Commercial
Commercial and industrial	0	$	-	3	$	254
Totals	0	$	-	3	$	254

The Bank is actively working with the borrowers to resolve their delinquencies.

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

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 and management 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 a detailed internal process, at least quarterly, as well as with the assistance of independent loan reviews.  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 and take timely action 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, guarantors and the strength of the collateral.  Risk grades are reviewed regularly by the Company’s credit committee and are scrutinized during independent loan reviews performed semi-annually, as well as by regulatory agencies during scheduled examinations.  In the second quarter of 2012, the Company implemented a more detailed risk grading system that provided for a more granular break down of loans within the Company’s four primary credit risk ratings, discussed below.

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 (appraisal or cash flow 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 for collateral dependent loans and updated cash-flow information if the loan is unsecured or primarily dependent on future operating or other cash-flows. Once the updated financial information is obtained and analyzed by Management, a valuation allowance, if necessary, is established against such loans 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 loans have been charged-off.  If upon a loan’s migration to non-accruing status, the financial information obtained while the loan was classified as substandard are deemed to be outdated, the Company typically orders new appraisals on underlying collateral or obtains the most recent cash-flow information in order to have the most current indication of fair value.  For collateral dependent loans, 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-accrual status at least quarterly, and corresponding changes in any related valuation allowance are made or balances deemed to be fully uncollectable are charged-off. Cash-flow information for impaired loans dependent primarily on future operating or other cash-flows are updated quarterly as well, with subsequent shortfalls resulting in valuation allowance adjustments.

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 experienced line managers, with the oversight of the Chief Credit Officer and/or the Special Assets department, which is responsible for obtaining updated periodic appraisal information for collateral securing problem loans as well as updated cash-flow information.  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 sell a troubled loan rather than to continue to hold it in its portfolio, additional charge-offs have been realized as buyers of distressed loans typically 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, 2012:

			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	$	16,429	$	15,883	$	-	$	546	$	-	$	-	$	-	$	-	$	-	$	-
Residential 1 to 4 family	37,837		36,918		7		912		-		-		-		-		907		-
Home equity lines of credit	32,422		30,807		-		1,615		-		81		262		-		381		-
Commercial	374,799		328,209		16,138		30,452		-		216		233		-		4,428		-
Farmland	23,416		16,742		3,270		3,404		-		-		-		-		1,089		-
Commercial
Commercial and industrial	119,496		105,111		5,770		8,615		-		435		-		-		3,243		18
Agriculture	17,948		15,925		107		1,916		-		-		-		-		1,075		-
Other	66		66		-		-		-		-		-		-		-		-
Construction
Single family residential	11,267		11,267		-		-		-		-		-		-		-		-
Single family residential - Spec.	420		420		-		-		-		-		-		-		-		-
Multi-family	787		787		-		-		-		-		-		-		-		-
Commercial	14,401		12,561		-		1,840		-		-		-		-		1,840		-
Land	23,633		11,034		4,567		8,032		-		-		-		-		7,300		-
Installment loans to individuals	5,146		4,707		222		217		-		40		3		-		206		-
All other loans (including overdrafts)	281		276		1		4		-		-		-		-		-		-
Totals	$	678,348	$	590,713	$	30,082	$	57,553	$	-	$	772	$	498	$	-	$	20,469	$	18

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, 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	$	15,915	$	15,915	$	-	$	-	$	-	$	-	$	-	$	-	$	-	$	-
Residential 1 to 4 family	20,839		20,209		-		630		-		-		-		-		622		-
Home equity lines of credit	31,047		29,274		56		1,717		-		267		65		-		359		-
Commercial	357,499		311,234		17,795		28,470		-		-		-		-		4,551		-
Farmland	8,155		5,830		-		2,325		-		-		-		-		-		-
Commercial
Commercial and industrial	141,065		122,964		11,630		6,416		55		329		92		-		1,625		561
Agriculture	15,740		11,326		-		4,414		-		-		-		-		2,327		-
Other	89		89		-		-		-		-		-		-		-		-
Construction																	-
Single family residential	13,039		12,102		-		937		-		-		-		-		937		-
Single family residential - Spec.	8		8		-		-		-		-		-		-		-		-
Multi-family	1,669		-		-		1,669		-		-		-		-		-		-
Commercial	8,015		3,714		4,301		-		-		-		-		-		-		-
Land	26,454		13,985		5,234		7,235		-		41		-		-		1,886		-
Installment loans to individuals	6,479		6,148		247		84		-		-		2		-		61		-
All other loans (including overdrafts)	273		271		1		1		-		-		-		-		-		-
Totals	$	646,286	$	553,069	$	39,264	$	53,898	$	55	$	637	$	159	$	-	$	12,368	$	561

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Fair Value of Assets and Liabilities (Details 2) (USD $) In Thousands, unless otherwise specified	3 Months Ended		9 Months Ended
	Sep. 30, 2012	Sep. 30, 2011	Sep. 30, 2012	Sep. 30, 2011
Obligations of state and municipal securities
Changes in balance sheet carrying values associated with recurring Level 3 financial instruments
Beginning balance	$ 262	$ 257	$ 259	$ 283
Gain / (Loss) Included in OCI		2	3	(24)
Transfers to / (from) Level III	(262)		(262)
Ending Balance		259		259
Agency mortgage backed securities
Changes in balance sheet carrying values associated with recurring Level 3 financial instruments
Gain / (Loss) Included in OCI			(191)
Purchases, Issuances, and Settlements			4,674
Transfers to / (from) Level III			(4,483)
Non-agency mortgage backed securities
Changes in balance sheet carrying values associated with recurring Level 3 financial instruments
Beginning balance			3,074
Transfers to / (from) Level III			$ (3,074)

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Condensed Consolidated Financial Statements (Details)	9 Months Ended
	Sep. 30, 2012 item
Description of Business
Number of business segments	1

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Fair Value of Assets and Liabilities (Tables)

9 Months Ended

Sep. 30, 2012

Fair Value of Assets and Liabilities

Summary of the financial instruments the Company measures at fair value on a recurring basis

	Fair Value Measurements Using
	Quoted Prices in		Significant Other		Significant
	Active Markets for		Observable		Unobservable
(dollar amounts in thousands)	Inputs		Inputs		Inputs		Assets At
As of September 30, 2012	(Level 1)		(Level 2)		(Level 3)		Fair Value
Assets
Obligations of U.S. government agencies	$	-	$	3,957	$	-	$	3,957
Mortgage backed securities:
Agency	-		109,221		-		109,221
Non-agency	-		43,906		-		43,906
Obligations of state and municipal securities	-		63,271		-		63,271
Corporate debt securities	-		30,675		-		30,675
Other securities	-		10,421		-		10,421
Total assets measured on a recurring basis	$	-	$	261,451	$	-	$	261,451
As of December 31, 2011
Assets
Obligations of U.S. government agencies	$	-	$	4,326	$	-	$	4,326
Mortgage backed securities:
Agency	-		117,325		-		117,325
Non-agency	-		31,458		3,074		34,532
Obligations of state and municipal securities	-		51,664		259		51,923
Corporate debt securities			26,856		-		26,856
Other securities	-		2,020		-		2,020
Total assets measured on a recurring basis	$	-	$	233,649	$	3,333	$	236,982

Summary of the changes in balance sheet carrying values associated with recurring Level 3 financial instruments

					Purchases,
	Beginning		Gain / (Loss)		Issuances, and		Sales and		Transfers to / (from)			Ending
(dollar amounts in thousands)	Balance		Included in OCI (1)		Settlements		Maturities		Level III			Balance
For the three months ended
September 30, 2012
Obligations of state and municipal securities	$	262	$	-	$	-	$	-	$	(262	)	$	-
September 30, 2011
Obligations of state and municipal securities	$	257	$	2	$	-	$	-	$	-		$	259

						Purchases,
	Beginning		Gain / (Loss)			Issuances, and		Sales and		Transfers to / (from)			Ending
(dollar amounts in thousands)	Balance		Included in OCI (1)			Settlements		Maturities		Level III			Balance
For the nine months ended
September 30, 2012
Obligations of state and municipal securities	$	259	$	3		$	-	$	-	$	(262	)	$	-
Agency mortgage baked securities	-		(191		)	4,674		-		(4,483		)	-
Non-agency mortgage backed securities	3,074		-			-		-		(3,074		)	-
September 30, 2011
Obligations of state and municipal securities	$	283	$	(24	)	$	-	$	-	$	-		$	259

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

Summary of assets the Company measures at fair value on a non-recurring basis

	Fair Value Measurements Using
	Quoted Prices in		Significant Other		Significant
	Active Markets for		Observable		Unobservable
(dollar amounts in thousands)	Identical Assets		Inputs		Inputs		Assets At		Total
As of September 30, 2012	(Level 1)		(Level 2)		(Level 3)		Fair Value		(Gains) / Losses
Assets
Impaired loans
Commercial real estate	$	-	$	-	$	185	$	185	$	(152	)
Farmland	-		-		1,084		1,084		5
Commercial and industrial	-		196		794		990		799
Land	-		-		2,546		2,546		3,379
Foreclosed assets	-		615		-		615		-
Total assets measured on a non-recurring basis	$	-	$	811	$	4,609	$	5,420	$	4,031
As of December 31, 2011
Assets
Impaired loans
Residential 1 to 4 family	$	-	$	-	$	95	$	95	$	126
Home equity lines of credit	-		7		-		7		82
Commercial real estate	-		-		3,813		3,813		458
Commercial and industrial	-		511		-		511		113
Agriculture	-		668		1,250		1,918		117
Land	-		56		615		671		113
Installment loans to individuals	-		58		-		58		-
Loans held for sale	-		4,279		-		4,279		-
Foreclosed assets	-		959		-		959		-
Total assets measured on a non-recurring basis	$	-	$	6,538	$	5,773	$	12,311	$	1,009

Summary of the estimated fair value of financial instruments

			Fair Value Measurements Using
			Quoted Prices in		Significant Other		Significant
			Active Markets for		Observable		Unobservable
(dollar amounts in thousands)	Carrying		Identical Assets		Inputs		Inputs
As of September 30, 2012	Amount		(Level 1)		(Level 2)		(Level 3)		Fair Value
Assets
Cash and cash equivalents	$	44,176	$	44,176	$	-	$	-	$	44,176
Investments and mortgage-backed securities	261,451		-		261,451		-		261,451
Federal Home Loan Bank stock	4,575		-		-		-		N/A
Loans receivable, net of deferred fees and costs	677,371		-		196		687,826		688,022
Loans held for sale	12,590		-		12,590		-		12,590
Accrued interest receivable	3,898		-		1,429		2,469		3,898
Liabilities
Non interest-bearing deposits	267,199		267,199		-		-		267,199
Interest-bearing deposits	587,833		-		588,790		-		588,790
Federal Home Loan Bank advances	46,000		-		46,626		-		46,626
Junior subordinated debentures	8,248		-		-		7,716		7,716
Accrued interest payable	211		-		211		-		211
As of December 31, 2011
Assets
Cash and cash equivalents	$	34,892	$	34,892	$	-	$	-	$	34,892
Investments and mortgage-backed securities	236,982		-		233,649		3,333		236,982
Federal Home Loan Bank stock	4,685		-		-		-		N/A
Loans receivable, net of deferred fees and costs	645,175		-		1,300		645,491		646,791
Loans held for sale	21,947		-		21,947		-		21,947
Accrued interest receivable	3,854		-		1,241		2,613		3,854
Liabilities
Non interest-bearing deposits	217,245		217,245		-		-		217,245
Interest-bearing deposits	568,963		-		569,988		-		569,988
Federal Home Loan Bank advances	51,500		-		52,110		-		52,110
Junior subordinated debentures	8,248		-		-		4,096		4,096
Accrued interest payable	455		-		455		-		455

Summary of off-balance sheet commitments

	September 30, 2012				December 31, 2011
	Notional		Cost to Cede		Notional		Cost to Cede
(dollar amounts in thousands)	Amount		or Assume		Amount		or Assume
Off-balance sheet instruments, commitments to extend credit and standby letters of credit	$	179,726	$	1,797	$	161,987	$	1,620

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Fair Value of Assets and Liabilities (Details 3) (USD $) In Thousands, unless otherwise specified	9 Months Ended	12 Months Ended
	Sep. 30, 2012	Dec. 31, 2011
Significant Other Observable Inputs (Level 2)
Assets
Loans held for sale	$ 12,590	$ 21,947
Nonrecurring basis
Total Gains/(Losses) for assets measured at fair value on a non-recurring basis
Total Gains/(Losses)	4,031	1,009
Nonrecurring basis | Residential 1 to 4 family
Total Gains/(Losses) for assets measured at fair value on a non-recurring basis
Total Gains/(Losses) on impaired loans		126
Nonrecurring basis | Commercial real estate
Total Gains/(Losses) for assets measured at fair value on a non-recurring basis
Total Gains/(Losses) on impaired loans	(152)	458
Nonrecurring basis | Commercial and industrial
Total Gains/(Losses) for assets measured at fair value on a non-recurring basis
Total Gains/(Losses) on impaired loans	799	113
Nonrecurring basis | Agriculture
Total Gains/(Losses) for assets measured at fair value on a non-recurring basis
Total Gains/(Losses) on impaired loans		117
Nonrecurring basis | Land
Total Gains/(Losses) for assets measured at fair value on a non-recurring basis
Total Gains/(Losses) on impaired loans	3,379	113
Nonrecurring basis | Home equity lines of credit
Total Gains/(Losses) for assets measured at fair value on a non-recurring basis
Total Gains/(Losses) on impaired loans		82
Nonrecurring basis | Significant Other Observable Inputs (Level 2)
Assets
Loans held for sale		4,279
Foreclosed assets	615	959
Total assets measured on a non-recurring basis	811	6,538
Nonrecurring basis | Significant Other Observable Inputs (Level 2) | Commercial and industrial
Assets
Impaired loans	196	511
Nonrecurring basis | Significant Other Observable Inputs (Level 2) | Agriculture
Assets
Impaired loans		668
Nonrecurring basis | Significant Other Observable Inputs (Level 2) | Land
Assets
Impaired loans		56
Nonrecurring basis | Significant Other Observable Inputs (Level 2) | Home equity lines of credit
Assets
Impaired loans		7
Nonrecurring basis | Significant Other Observable Inputs (Level 2) | Installment loans to individuals
Assets
Impaired loans		58
Nonrecurring basis | Significant Unobservable Inputs (Level 3)
Assets
Total assets measured on a non-recurring basis	4,609	5,773
Nonrecurring basis | Significant Unobservable Inputs (Level 3) | Residential 1 to 4 family
Assets
Impaired loans		95
Nonrecurring basis | Significant Unobservable Inputs (Level 3) | Commercial real estate
Assets
Impaired loans	185	3,813
Nonrecurring basis | Significant Unobservable Inputs (Level 3) | Commercial and industrial
Assets
Impaired loans	794
Nonrecurring basis | Significant Unobservable Inputs (Level 3) | Agriculture
Assets
Impaired loans		1,250
Nonrecurring basis | Significant Unobservable Inputs (Level 3) | Land
Assets
Impaired loans	2,546	615
Nonrecurring basis | Significant Unobservable Inputs (Level 3) | Farmland
Assets
Impaired loans	1,084
Nonrecurring basis | Assets At Fair Value
Assets
Loans held for sale		4,279
Foreclosed assets	615	959
Total assets measured on a non-recurring basis	5,420	12,311
Nonrecurring basis | Assets At Fair Value | Residential 1 to 4 family
Assets
Impaired loans		95
Nonrecurring basis | Assets At Fair Value | Commercial real estate
Assets
Impaired loans	185	3,813
Nonrecurring basis | Assets At Fair Value | Commercial and industrial
Assets
Impaired loans	990	511
Nonrecurring basis | Assets At Fair Value | Agriculture
Assets
Impaired loans		1,918
Nonrecurring basis | Assets At Fair Value | Land
Assets
Impaired loans	2,546	671
Nonrecurring basis | Assets At Fair Value | Home equity lines of credit
Assets
Impaired loans		7
Nonrecurring basis | Assets At Fair Value | Installment loans to individuals
Assets
Impaired loans		58
Nonrecurring basis | Assets At Fair Value | Farmland
Assets
Impaired loans	$ 1,084

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Investment Securities (Details) (USD $)											9 Months Ended
	Sep. 30, 2012	Dec. 31, 2011	Sep. 30, 2012 Obligations of U.S. government agencies	Dec. 31, 2011 Obligations of U.S. government agencies	Sep. 30, 2012 Mortgage-backed securities - U.S. government sponsored entities and agencies	Dec. 31, 2011 Mortgage-backed securities - U.S. government sponsored entities and agencies	Sep. 30, 2012 Mortgage-backed securities - Non-agency	Dec. 31, 2011 Mortgage-backed securities - Non-agency	Sep. 30, 2012 PMBS item	Dec. 31, 2011 PMBS	Sep. 30, 2012 PMBS Minimum item	Sep. 30, 2012 State and municipal securities	Dec. 31, 2011 State and municipal securities	Sep. 30, 2012 Corporate debt securities	Dec. 31, 2011 Corporate debt securities	Sep. 30, 2012 Other	Dec. 31, 2011 Other
Reconciliation of amortized cost to fair value of investment securities reported as available for sale
Amortized Cost	$ 255,162,000	$ 236,237,000	$ 3,838,000	$ 4,209,000	$ 108,660,000	$ 116,732,000	$ 42,752,000	$ 34,667,000				$ 59,427,000	$ 49,661,000	$ 30,321,000	$ 28,909,000	$ 10,164,000	$ 2,059,000
Gross Unrealized Gains	7,005,000	3,735,000	121,000	118,000	963,000	890,000	1,313,000	465,000				3,913,000	2,262,000	388,000		307,000
Gross Unrealized Losses	(716,000)	(2,990,000)	(2,000)	(1,000)	(402,000)	(297,000)	(159,000)	(600,000)				(69,000)		(34,000)	(2,053,000)	(50,000)	(39,000)
Fair Value	261,451,000	236,982,000	3,957,000	4,326,000	109,221,000	117,325,000	43,906,000	34,532,000	3,600,000			63,271,000	51,923,000	30,675,000	26,856,000	10,421,000	2,020,000
Number of Whole Loan Private Label Single Family Residential Mortgage Backed Securities (PMBS)									5
Number of credit rating agencies which rated all PMBS bonds as AAA											1
Number of mezzanine subordinate bonds, whose rating is reassessed by rating agencies									1
Number of bonds deemed to be of non-investment grade									1
Fair value of bond deemed to be of non-investment grade									300,000
Net unrealized gains (losses)									$ 64,000	$ (34,000)

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Investment Securities (Details 2) (USD $)	3 Months Ended		9 Months Ended							3 Months Ended		9 Months Ended
	Sep. 30, 2012	Sep. 30, 2011	Sep. 30, 2012	Sep. 30, 2011	Sep. 30, 2011 OTTI Related to Credit Loss	Sep. 30, 2012 OTTI Related to Credit Loss	Jun. 30, 2012 OTTI Related to Credit Loss	Dec. 31, 2011 OTTI Related to Credit Loss	Jun. 30, 2011 OTTI Related to Credit Loss	Sep. 30, 2012 OTTI Related to All Other Factors	Sep. 30, 2011 OTTI Related to All Other Factors	Sep. 30, 2012 OTTI Related to All Other Factors	Sep. 30, 2011 OTTI Related to All Other Factors	Sep. 30, 2012 PMBS item	Dec. 31, 2011 PMBS
Other than Temporary Impairment
Number of investment securities in which other than temporary impairment losses were recognized														2
Other than temporary impairment investments, fair value														$ 800,000	$ 600,000
Other than temporary impairment investments, historical cost														1,100,000	1,100,000
Roll forward of the OTTI balances against the investment securities for both credit loss and all other factor components
Balance, beginning of the period	392,000	494,000	470,000	1,477,000	534,000	109,000	109,000	109,000	109,000	283,000	385,000	361,000	943,000
Less: losses related to OTTI securities sold				(943,000)	(425,000)								(518,000)
Change in value attributable to other factors	(140,000)	(14,000)	(218,000)	(54,000)						(140,000)	(14,000)	(218,000)	(54,000)
Balance, end of the period	$ 252,000	$ 480,000	$ 252,000	$ 480,000	$ 109,000	$ 109,000	$ 109,000	$ 109,000	$ 109,000	$ 143,000	$ 371,000	$ 143,000	$ 371,000

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Investment Securities

9 Months Ended

Sep. 30, 2012

Investment Securities

Investment Securities

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, 2012 and December 31, 2011:

(dollar amounts in thousands)			Gross		Gross
	Amortized		Unrealized		Unrealized
As of September 30, 2012	Cost		Gains		Losses			Fair Value
Obligations of U.S. government agencies	$	3,838	$	121	$	(2	)	$	3,957
Mortgage backed securities
U.S. government sponsored entities and agencies	108,660		963		(402		)	109,221
Non-agency	42,752		1,313		(159		)	43,906
State and municipal securities	59,427		3,913		(69		)	63,271
Corporate debt securities	30,321		388		(34		)	30,675
Other	10,164		307		(50		)	10,421
Total	$	255,162	$	7,005	$	(716	)	$	261,451
As of December 31, 2011
Obligations of U.S. government agencies	$	4,209	$	118	$	(1	)	$	4,326
Mortgage backed securities
U.S. government sponsored entities and agencies	116,732		890		(297		)	117,325
Non-agency	34,667		465		(600		)	34,532
State and municipal securities	49,661		2,262		-			51,923
Corporate debt securities	28,909		-		(2,053		)	26,856
Other	2,059		-		(39		)	2,020
Total	$	236,237	$	3,735	$	(2,990	)	$	236,982

At September 30, 2012, the Company continued to own five Whole Loan Private Label Single Family Residential Mortgage Backed Securities (“PMBS”) with a remaining principal balance of approximately $3.6 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 between 2008 and 2011, PMBS bonds along with other asset classes experienced a deterioration in price, credit quality, and liquidity.  Rating agencies have been reassessing all ratings associated with bonds starting with the lower tranche or subordinate pieces (which have increased loss exposure), followed by senior and super senior bonds, which are what the Company owns with the exception of one mezzanine bond (subordinate).  At September 30, 2012, one bond with an aggregate fair value of $0.3 million is deemed to be non-investment grade. The Company’s investment portfolio holdings of PMBS securities had a net unrealized gain of $64 thousand at September 30, 2012 and a net unrealized loss of $34 thousand at December 31, 2011.

Other than Temporary Impairment (“OTTI”)

As of September 30, 2012, the Company continues to hold two PMBS securities in which OTTI losses were recognized in prior years.  These securities had an aggregate recorded fair value of $0.8 million ($1.1 million historical cost) at September 30, 2012 and $0.6 million ($1.1 million historical cost) at December 31, 2011.  Although the Company continues to have the ability and intent to hold these securities for the foreseeable future, the results of the analysis performed in 2009 and 2010 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.

The following table provides a roll forward of the OTTI balances against the PMBS investment securities for both credit loss and all other factor components, for the three months ended September 30, 2012 and 2011:

	Three months ended September 30, 2012								Three months ended September 30, 2011
			OTTI Related								OTTI Related
	OTTI Related		to All Other			Total			OTTI Related		to All Other			Total
(dollars in thousands)	to Credit Loss		Factors			OTTI			to Credit Loss		Factors			OTTI
Balance, beginning of the period	$	109	$	283		$	392		$	109	$	385		$	494
Change in value attributable to other factors	-		(140		)	(140		)	-		(14		)	(14		)
Balance, end of the period	$	109	$	143		$	252		$	109	$	371		$	480

The following table provides additional information related to the OTTI losses the Company recognized during the nine months ended September 30, 2012 and 2011:

	Nine months ended September 30, 2012								Nine months ended September 30, 2011
			OTTI Related									OTTI Related
	OTTI Related		to All Other			Total			OTTI Related			to All Other			Total
(dollars in thousands)	to Credit Loss		Factors			OTTI			to Credit Loss			Factors			OTTI
Balance, beginning of the period	$	109	$	361		$	470		$	534		$	943		$	1,477
Less: losses related to OTTI securities sold	-		-			-			(425		)	(518		)	(943		)
Change in value attributable to other factors	-		(218		)	(218		)	-			(54		)	(54		)
Balance, end of the period	$	109	$	143		$	252		$	109		$	371		$	480

The following table provides a summary of investment securities in an unrealized loss position as of September 30, 2012 and December 31, 2011:

	Securities In A Loss Position For
(dollar amounts in thousands)	Less Than Twelve Months					Twelve Months or More					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
As of September 30, 2012	Value		Loss			Value		Loss			Value		Loss
Obligations of U.S. government agencies	$	-	$	-		$	44	$	(2	)	$	44	$	(2	)
Mortgage backed securities
U.S. government sponsored entities and agencies	39,271		(402		)	-		-			39,271		(402		)
Non-agency	5,231		(8		)	3,780		(151		)	9,011		(159		)
State and municipal securities	3,897		(69		)	-		-			3,897		(69		)
Corporate debt securities	-		-			3,781		(34		)	3,781		(34		)
Other	3,561		(50		)	-		-			3,561		(50		)
Total	$	51,960	$	(529	)	$	7,605	$	(187	)	$	59,565	$	(716	)
As of December 31, 2011
Obligations of U.S. government agencies	$	-	$	-		$	89	$	(1	)	$	89	$	(1	)
Mortgage backed securities
U.S. government sponsored entities and agencies	39,895		(297		)	-		-			39,895		(297		)
Non-agency	17,396		(238		)	586		(362		)	17,982		(600		)
Corporate debt securities	26,857		(2,053		)	-		-			26,857		(2,053		)
Other	2,020		(39		)	-		-			2,020		(39		)
Total	$	86,168	$	(2,627	)	$	675	$	(363	)	$	86,843	$	(2,990	)

As of September 30, 2012, the Company believes that unrealized losses on all mortgage related securities, exclusive of the PMBS securities previously discussed, including U.S. government sponsored entity and agency securities, such as those issued by the Federal Home Loan Mortgage Corporation (“FHLMC”), the Federal National Mortgage Association (“FNMA”) and the Government National Mortgage Association (“GNMA”), 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 40 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, 2012, the Company does not believe unrealized losses related to these securities are other than temporary.

The majority of the corporate debt securities in an unrealized loss position are securities that the Company began investing in just prior to the downgrade of the U.S. debt by the S&P in 2011.  As a result of the U.S. debt’s downgrade, there was increased pressure on the price of all types of debt securities but most notably corporate and CMBS securities, as investors liquidated their positions in favor of higher quality and more liquid investments.  However, the value of these securities has shown signs of strengthening in recent months, as evidenced by the improvement in fair value since the end of 2011.  The Company’s investments in the corporate debt portion of the portfolio are focused on investment grade variable rate instruments, which provide some degree of principal protection from movements in market interest rates.  We do not believe that any of the unrealized losses reflect on the credit quality of the issuer but rather are short-term market fluctuations due to the reaction to the U.S. debt downgrade.  As the Company has the ability and intent to hold these securities until their value recovers, and it is more likely than not that it will not be required to sell these securities, the Company does not believe there has been an other than temporary decline in their value.

The amortized cost and fair value maturities of available for sale investment securities at September 30, 2012 are shown below. The table reflects the expected lives of investment securities based on projected cash flows. Mortgage backed securities project cash flows based on a combination of historical and projected prepayment speeds because borrowers have the right to prepay their underlying obligations without prepayment penalties. Contractual maturities or call dates are reflected for all other security types. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Projected prepayment speeds are lower for certain bonds as compared to that experienced over the last few months and therefore the yield shown on these projected maturities is higher than the historical yields.

(dollar amounts in thousands)	One Year Or Less		Over 1 Through 5 Years		Over 5 Years Through 10 Years		Over 10 Years		Total
Obligations of U.S. government agencies	$	7	$	30	$	3,917	$	3	$	3,957
Mortgage backed securities
U.S. government sponsored entities and agencies	20,327		48,094		22,944		17,856		109,221
Non-agency	9,122		21,646		11,193		1,945		43,906
State and municipal securities	1,004		9,280		44,351		8,636		63,271
Corporate debt securities	-		18,999		9,346		2,330		30,675
Other	1,504		4,289		4,628		-		10,421
Total available for sale securities	$	31,964	$	102,338	$	96,379	$	30,770	$	261,451
Amortized cost	$	31,916	$	100,746	$	92,221	$	30,279	$	255,162
Weighted average yield	2.24%		2.65%		3.31%		4.15%		3.04%

Securities having an amortized cost and a fair value of $6.2 million and $6.4 million, respectively at September 30, 2012, and $5.1 million and $5.2 million, respectively at December 31, 2011 were pledged to secure public deposits.

The following table summarizes earnings on both taxable and tax-exempt investment securities for the three and nine months ended September 30, 2012 and 2011:

	For the three months				For the nine months
	ended September 30,				ended September 30,
(dollar amounts in thousands)	2012		2011		2012		2011
Taxable earnings on investment securities
Obligations of U.S. government agencies	$	25	$	32	$	79	$	137
Mortgage backed securities	973		1,176		2,971		3,192
State and municipal securities	5		121		183		377
Corporate debt securities	181		149		504		154
Other	72		20		146		20
Non-taxable earnings on investment securities
State and municipal securities	527		382		1,428		1,136
Total	$	1,783	$	1,880	$	5,311	$	5,016

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Investment Securities (Details 3) (USD $) In Thousands, unless otherwise specified	3 Months Ended		9 Months Ended
	Sep. 30, 2012	Sep. 30, 2011	Sep. 30, 2012	Sep. 30, 2011	Dec. 31, 2011
Securities in an unrealized loss position
Less Than Twelve Months, Fair Value	$ 51,960		$ 51,960		$ 86,168
Less Than Twelve Months, Unrealized Loss	(529)		(529)		(2,627)
Twelve Months or More, Fair Value	7,605		7,605		675
Twelve Months or More, Unrealized Loss	(187)		(187)		(363)
Total, Fair Value	59,565		59,565		86,843
Total, Unrealized Loss	(716)		(716)		(2,990)
Available for sale securities
One Year Or Less	31,964		31,964
Over 1 Through 5 Years	102,338		102,338
Over 5 Through 10 Years	96,379		96,379
Over 10 Years	30,770		30,770
Total	261,451		261,451
Available for sale securities, Amortized cost
One Year Or Less	31,916		31,916
Over 1 Through 5 Years	100,746		100,746
Over 5 Through 10 Years	92,221		92,221
Over 10 Years	30,279		30,279
Total	255,162		255,162		236,237
Weighted average yield
One Year Or Less (as a percent)			2.24%
Over 1 Through 5 Years (as a percent)			2.65%
Over 5 Through 10 Years (as a percent)			3.31%
Over 10 Years (as a percent)			4.15%
Total (as a percent)			3.04%
Earnings on both taxable and tax-exempt investment securities
Total	1,783	1,880	5,311	5,016
Maximum
Securities in an unrealized loss position
Maturity period of other than temporary impairment securities			40 years
Minimum
Securities in an unrealized loss position
Maturity period of other than temporary impairment securities			1 year
Obligations of U.S. government agencies
Securities in an unrealized loss position
Twelve Months or More, Fair Value	44		44		89
Twelve Months or More, Unrealized Loss	(2)		(2)		(1)
Total, Fair Value	44		44		89
Total, Unrealized Loss	(2)		(2)		(1)
Available for sale securities
One Year Or Less	7		7
Over 1 Through 5 Years	30		30
Over 5 Through 10 Years	3,917		3,917
Over 10 Years	3		3
Total	3,957		3,957
Available for sale securities, Amortized cost
Total	3,838		3,838		4,209
Earnings on both taxable and tax-exempt investment securities
Taxable earnings on investment securities	25	32	79	137
Mortgage Backed Securities
Earnings on both taxable and tax-exempt investment securities
Taxable earnings on investment securities	973	1,176	2,971	3,192
Mortgage-backed securities - U.S. government sponsored entities and agencies
Securities in an unrealized loss position
Less Than Twelve Months, Fair Value	39,271		39,271		39,895
Less Than Twelve Months, Unrealized Loss	(402)		(402)		(297)
Total, Fair Value	39,271		39,271		39,895
Total, Unrealized Loss	(402)		(402)		(297)
Available for sale securities
One Year Or Less	20,327		20,327
Over 1 Through 5 Years	48,094		48,094
Over 5 Through 10 Years	22,944		22,944
Over 10 Years	17,856		17,856
Total	109,221		109,221
Available for sale securities, Amortized cost
Total	108,660		108,660		116,732
Mortgage-backed securities - Non-agency
Securities in an unrealized loss position
Less Than Twelve Months, Fair Value	5,231		5,231		17,396
Less Than Twelve Months, Unrealized Loss	(8)		(8)		(238)
Twelve Months or More, Fair Value	3,780		3,780		586
Twelve Months or More, Unrealized Loss	(151)		(151)		(362)
Total, Fair Value	9,011		9,011		17,982
Total, Unrealized Loss	(159)		(159)		(600)
Available for sale securities
One Year Or Less	9,122		9,122
Over 1 Through 5 Years	21,646		21,646
Over 5 Through 10 Years	11,193		11,193
Over 10 Years	1,945		1,945
Total	43,906		43,906
Available for sale securities, Amortized cost
Total	42,752		42,752		34,667
State and municipal securities
Securities in an unrealized loss position
Less Than Twelve Months, Fair Value	3,897		3,897
Less Than Twelve Months, Unrealized Loss	(69)		(69)
Total, Fair Value	3,897		3,897
Total, Unrealized Loss	(69)		(69)
Available for sale securities
One Year Or Less	1,004		1,004
Over 1 Through 5 Years	9,280		9,280
Over 5 Through 10 Years	44,351		44,351
Over 10 Years	8,636		8,636
Total	63,271		63,271
Available for sale securities, Amortized cost
Total	59,427		59,427		49,661
Earnings on both taxable and tax-exempt investment securities
Taxable earnings on investment securities	5	121	183	377
Non-taxable earnings on investment securities	527	382	1,428	1,136
Corporate debt securities
Securities in an unrealized loss position
Less Than Twelve Months, Fair Value					26,857
Less Than Twelve Months, Unrealized Loss					(2,053)
Twelve Months or More, Fair Value	3,781		3,781
Twelve Months or More, Unrealized Loss	(34)		(34)
Total, Fair Value	3,781		3,781		26,857
Total, Unrealized Loss	(34)		(34)		(2,053)
Available for sale securities
Over 1 Through 5 Years	18,999		18,999
Over 5 Through 10 Years	9,346		9,346
Over 10 Years	2,330		2,330
Total	30,675		30,675
Available for sale securities, Amortized cost
Total	30,321		30,321		28,909
Earnings on both taxable and tax-exempt investment securities
Taxable earnings on investment securities	181	149	504	154
Other
Securities in an unrealized loss position
Less Than Twelve Months, Fair Value	3,561		3,561		2,020
Less Than Twelve Months, Unrealized Loss	(50)		(50)		(39)
Total, Fair Value	3,561		3,561		2,020
Total, Unrealized Loss	(50)		(50)		(39)
Available for sale securities
One Year Or Less	1,504		1,504
Over 1 Through 5 Years	4,289		4,289
Over 5 Through 10 Years	4,628		4,628
Total	10,421		10,421
Available for sale securities, Amortized cost
Total	10,164		10,164		2,059
Earnings on both taxable and tax-exempt investment securities
Taxable earnings on investment securities	72	20	146	20
Securities pledged to secure public deposits
Available for sale securities
Total	6,400		6,400		5,200
Available for sale securities, Amortized cost
Total	$ 6,200		$ 6,200		$ 5,100

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Earnings Per Share (Details) (USD $) In Thousands, except Share data, unless otherwise specified	3 Months Ended		9 Months Ended
	Sep. 30, 2012	Sep. 30, 2011	Sep. 30, 2012	Sep. 30, 2011
Calculation of both basic and diluted earnings/ (loss) per common share
Net income	$ 6,428	$ 2,119	$ 9,910	$ 3,594
Dividends and accretion on preferred stock	357	373	1,113	1,108
Net income available to common shareholders	$ 6,071	$ 1,746	$ 8,797	$ 2,486
Weighted average shares outstanding	25,089,325	25,054,027	25,074,405	25,046,569
Basic earnings per common share	$ 0.24	$ 0.07	$ 0.35	$ 0.10
Dilutive effect of share-based compensation awards, common stock warrants, and convertible perpetual preferred stock (in shares)	1,341,392	1,200,018	1,280,238	1,206,032
Weighted average diluted shares outstanding	26,430,717	26,254,045	26,354,643	26,252,601
Diluted earnings per common share	$ 0.23	$ 0.07	$ 0.33	$ 0.10
Options
Shares excluded from the calculation of diluted earnings/ (loss) per share
Shares excluded from the calculation of diluted earnings/ (loss) per share	299,000	672,000	278,000	561,000
Warrant
Shares excluded from the calculation of diluted earnings/ (loss) per share
Shares excluded from the calculation of diluted earnings/ (loss) per share		612,000		612,000

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Condensed Consolidated Balance Sheets (USD $) In Thousands, unless otherwise specified	Sep. 30, 2012	Dec. 31, 2011
Assets
Cash and due from banks	$ 22,917	$ 18,858
Interest bearing due from banks	21,259	16,034
Total cash and cash equivalents	44,176	34,892
Securities available for sale, at fair value	261,451	236,982
Federal Home Loan Bank stock, at cost	4,575	4,685
Loans held for sale	12,590	21,947
Gross loans	678,348	646,286
Net deferred loan fees	(977)	(1,111)
Allowance for loan losses	(17,987)	(19,314)
Net loans	659,384	625,861
Property, premises and equipment	15,238	5,528
Deferred tax assets, net	22,897	18,226
Bank owned life insurance	15,223	14,835
Goodwill	11,049	11,049
Core deposit intangible	1,424	1,682
Other real estate owned	615	917
Other assets	10,057	10,534
Total assets	1,058,679	987,138
Deposits
Demand, non-interest bearing	267,199	217,245
Savings, NOW and money market deposits	410,147	376,252
Time deposits under $100	88,738	102,628
Time deposits of $100 or more	88,948	90,083
Total deposits	855,032	786,208
Short term FHLB borrowing	9,500	29,500
Long term FHLB borrowing	36,500	22,000
Junior subordinated debentures	8,248	8,248
Other liabilities	7,114	11,628
Total liabilities	916,394	857,584
Stockholders' Equity
Common stock, no par value; authorized: 100,000,000 shares; issued and outstanding: 25,288,430 shares and 25,145,717 shares as of September 30, 2012 and December 31, 2011, respectively	101,296	101,140
Additional paid in capital	7,240	7,006
Retained earnings/(accumulated deficit)	6,004	(2,794)
Accumulated other comprehensive income, net of tax expense of $ 2,589 and $307 as of September 30, 2012 and December 31, 2011, respectively	3,700	438
Total stockholders' equity	142,285	129,554
Total liabilities and stockholders' equity	1,058,679	987,138
Series A senior preferred stock
Stockholders' Equity
Preferred stock	20,441	20,160
Series C preferred stock
Stockholders' Equity
Preferred stock	$ 3,604	$ 3,604

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Fair Value of Assets and Liabilities (Details 4) (USD $) In Thousands, unless otherwise specified	Sep. 30, 2012	Dec. 31, 2011	Jun. 30, 2010
Assets
Investments and mortgage-backed securities	$ 261,451
Liabilities
Non interest-bearing deposits	267,199	217,245
Interest-bearing deposits	410,147	376,252
Junior subordinated debentures	8,248	8,248	8,200
Off-balance sheet instruments, commitments to extend credit and standby letters of credit, Notional Amount	179,726	161,987
Off-balance sheet instruments, commitments to extend credit and standby letters of credit, Cost to Cede or Assume	1,797	1,620
Quoted Prices in Active Markets for Identical Assets (Level 1)
Assets
Cash and cash equivalents	44,176	34,892
Liabilities
Non interest-bearing deposits	267,199	217,245
Significant Other Observable Inputs (Level 2)
Assets
Investments and mortgage-backed securities	261,451	233,649
Loans receivable, net of deferred fees and costs	196	1,300
Loans held for sale	12,590	21,947
Accrued interest receivable	1,429	1,241
Liabilities
Interest-bearing deposits	588,790	569,988
Federal Home Loan Bank advances	46,626	52,110
Accrued interest payable	211	455
Significant Unobservable Inputs (Level 3)
Assets
Investments and mortgage-backed securities		3,333
Loans receivable, net of deferred fees and costs	687,826	645,491
Accrued interest receivable	2,469	2,613
Liabilities
Junior subordinated debentures	7,716	4,096
Carrying Amount
Assets
Cash and cash equivalents	44,176	34,892
Investments and mortgage-backed securities	261,451	236,982
Federal Home Loan Bank stock	4,575	4,685
Loans receivable, net of deferred fees and costs	677,371	645,175
Loans held for sale	12,590	21,947
Accrued interest receivable	3,898	3,854
Liabilities
Non interest-bearing deposits	267,199	217,245
Interest-bearing deposits	587,833	568,963
Federal Home Loan Bank advances	46,000	51,500
Junior subordinated debentures	8,248	8,248
Accrued interest payable	211	455
Fair Value
Assets
Cash and cash equivalents	44,176	34,892
Investments and mortgage-backed securities	261,451	236,982
Loans receivable, net of deferred fees and costs	688,022	646,791
Loans held for sale	12,590	21,947
Accrued interest receivable	3,898	3,854
Liabilities
Non interest-bearing deposits	267,199	217,245
Interest-bearing deposits	588,790	569,988
Federal Home Loan Bank advances	46,626	52,110
Junior subordinated debentures	7,716	4,096
Accrued interest payable	$ 211	$ 455

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Condensed Consolidated Statements of Cash Flows (USD $) In Thousands, unless otherwise specified	9 Months Ended
	Sep. 30, 2012	Sep. 30, 2011
Cash flows from operating activities:
Net income	$ 9,910	$ 3,594
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	1,007	959
Provision for loan losses	7,681	5,370
Amortization of premiums / discounts on investment securities, net	2,488	2,352
Amortization of intangible assets	258	356
Share-based compensation expense	234	213
Gain on sale of available for sale securities	(1,696)	(1,187)
Loss on sale of property, premises and equipment	25	4
Originations of loans held for sale	(132,905)	(96,360)
Proceeds from sale of loans held for sale	142,262	109,766
Net increase in bank owned life insurance	(388)	(186)
(Increase) / decrease in deferred tax asset	(1,349)	551
Deferred tax assets valuation allowance adjustment	(5,605)
(Gain) / loss on sale of foreclosed collateral	(112)	587
Write-downs on other real estate owned	86	968
Decrease / (increase) in other assets	479	(1,482)
(Decrease) / increase in other liabilities	(2,835)	292
Net Cash Provided By Operating Activities	19,540	25,797
Cash flows from investing activities:
Purchase of securities, available for sale	(150,783)	(161,222)
Sale of available for sale securities	95,786	108,617
Maturities and calls of available for sale securities	3	452
Proceeds from principal paydowns of available for sale securities	35,278	29,326
Redemption of Federal Home Loan Bank stock	110	496
Increase in loans, net	(42,710)	(2,167)
Allowance for loan and lease loss recoveries	737	1,960
Purchase of property, premises and equipment, net	(10,761)	(351)
Proceeds from sale of property, premises and equipment	19
Proceeds from sale of foreclosed collateral	1,335	6,130
Net Cash Used In Investing Activities	(70,986)	(16,759)
Cash flows from financing activities:
Increase in deposits, net	68,824	3,527
Proceeds from Federal Home Loan Bank borrowing	166,500	177,500
Repayments of Federal Home Loan Bank borrowing	(172,000)	(186,000)
Tax impact of share based compensation expense	26	(294)
Proceeds from exercise of stock options	131
Preferred stock dividends paid	(2,751)
Net Cash Provided By / (Used In) Financing Activities	60,730	(5,267)
Net increase in cash and cash equivalents	9,284	3,771
Cash and cash equivalents, beginning of period	34,892	22,951
Cash and cash equivalents, end of period	44,176	26,722
Cash Flow Information
Interest paid	3,176	3,923
Income taxes paid	2,735	2,645
Non-Cash Flow Information
Change in unrealized gain on available for sale securities	5,545	3,335
Loans transferred to foreclosed collateral	769	3,484
Loans transferred to held for sale		15,528
Preferred stock dividends accrued not paid		701
Accretion of preferred stock discount	$ 281	$ 276

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Loans (Details 3) (USD $)	3 Months Ended		9 Months Ended
	Sep. 30, 2012 item	Sep. 30, 2011 item	Sep. 30, 2012 item	Sep. 30, 2011 item	Dec. 31, 2011
Troubled debt restructurings
Loans classified as TDRs	$ 11,500,000		$ 11,500,000		$ 3,700,000
Accruing loans that were classified as TDRs	18,000		18,000		800,000
Interest loss related to rate concessions on certain TDRs	46,000	13,000	85,000	62,000
Number of TDRs	8	3	14	8
Pre-Modification Outstanding Recorded Investment	2,272,000	1,488,000	12,076,000	2,211,000
Post-Modification Outstanding Recorded Investment	2,251,000	1,442,000	10,685,000	2,165,000
Trouble Debt Restructurings That Subsequently Defaulted
Number of TDRs	0		3
Recorded Investment			254,000
Minimum
Troubled debt restructurings
Period of maturity date extensions			12 months
Maximum
Troubled debt restructurings
Period of maturity date extensions			18 months
Real Estate Secured | Residential 1 to 4 family
Troubled debt restructurings
Number of TDRs			1
Pre-Modification Outstanding Recorded Investment			439,000
Post-Modification Outstanding Recorded Investment			439,000
Real Estate Secured | Farmland
Troubled debt restructurings
Number of TDRs	1		1
Pre-Modification Outstanding Recorded Investment	1,089,000		1,089,000
Post-Modification Outstanding Recorded Investment	1,089,000		1,089,000
Real Estate Secured | Commercial real estate
Troubled debt restructurings
Number of TDRs		1		1
Pre-Modification Outstanding Recorded Investment		500,000		500,000
Post-Modification Outstanding Recorded Investment		500,000		500,000
Commercial | Commercial and industrial
Troubled debt restructurings
Number of TDRs	6	1	9	6
Pre-Modification Outstanding Recorded Investment	1,120,000	200,000	2,115,000	923,000
Post-Modification Outstanding Recorded Investment	1,099,000	200,000	2,094,000	923,000
Trouble Debt Restructurings That Subsequently Defaulted
Number of TDRs	0		3
Recorded Investment			254,000
Land
Troubled debt restructurings
Number of TDRs	1	1	3	1
Pre-Modification Outstanding Recorded Investment	63,000	788,000	8,433,000	788,000
Post-Modification Outstanding Recorded Investment	$ 63,000	$ 742,000	$ 7,063,000	$ 742,000

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Investment Securities (Tables)

9 Months Ended

Sep. 30, 2012

Investment Securities

Schedule of amortized cost and fair values of the Company's investment securities, all of which are reported as available for sale

(dollar amounts in thousands)			Gross		Gross
	Amortized		Unrealized		Unrealized
As of September 30, 2012	Cost		Gains		Losses			Fair Value
Obligations of U.S. government agencies	$	3,838	$	121	$	(2	)	$	3,957
Mortgage backed securities
U.S. government sponsored entities and agencies	108,660		963		(402		)	109,221
Non-agency	42,752		1,313		(159		)	43,906
State and municipal securities	59,427		3,913		(69		)	63,271
Corporate debt securities	30,321		388		(34		)	30,675
Other	10,164		307		(50		)	10,421
Total	$	255,162	$	7,005	$	(716	)	$	261,451
As of December 31, 2011
Obligations of U.S. government agencies	$	4,209	$	118	$	(1	)	$	4,326
Mortgage backed securities
U.S. government sponsored entities and agencies	116,732		890		(297		)	117,325
Non-agency	34,667		465		(600		)	34,532
State and municipal securities	49,661		2,262		-			51,923
Corporate debt securities	28,909		-		(2,053		)	26,856
Other	2,059		-		(39		)	2,020
Total	$	236,237	$	3,735	$	(2,990	)	$	236,982

Schedule of roll forward of the OTTI balances against the investment securities for both credit loss and all other factor components

	Three months ended September 30, 2012								Three months ended September 30, 2011
			OTTI Related								OTTI Related
	OTTI Related		to All Other			Total			OTTI Related		to All Other			Total
(dollars in thousands)	to Credit Loss		Factors			OTTI			to Credit Loss		Factors			OTTI
Balance, beginning of the period	$	109	$	283		$	392		$	109	$	385		$	494
Change in value attributable to other factors	-		(140		)	(140		)	-		(14		)	(14		)
Balance, end of the period	$	109	$	143		$	252		$	109	$	371		$	480

	Nine months ended September 30, 2012								Nine months ended September 30, 2011
			OTTI Related									OTTI Related
	OTTI Related		to All Other			Total			OTTI Related			to All Other			Total
(dollars in thousands)	to Credit Loss		Factors			OTTI			to Credit Loss			Factors			OTTI
Balance, beginning of the period	$	109	$	361		$	470		$	534		$	943		$	1,477
Less: losses related to OTTI securities sold	-		-			-			(425		)	(518		)	(943		)
Change in value attributable to other factors	-		(218		)	(218		)	-			(54		)	(54		)
Balance, end of the period	$	109	$	143		$	252		$	109		$	371		$	480

Summary of investment securities in an unrealized loss position

	Securities In A Loss Position For
(dollar amounts in thousands)	Less Than Twelve Months					Twelve Months or More					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
As of September 30, 2012	Value		Loss			Value		Loss			Value		Loss
Obligations of U.S. government agencies	$	-	$	-		$	44	$	(2	)	$	44	$	(2	)
Mortgage backed securities
U.S. government sponsored entities and agencies	39,271		(402		)	-		-			39,271		(402		)
Non-agency	5,231		(8		)	3,780		(151		)	9,011		(159		)
State and municipal securities	3,897		(69		)	-		-			3,897		(69		)
Corporate debt securities	-		-			3,781		(34		)	3,781		(34		)
Other	3,561		(50		)	-		-			3,561		(50		)
Total	$	51,960	$	(529	)	$	7,605	$	(187	)	$	59,565	$	(716	)
As of December 31, 2011
Obligations of U.S. government agencies	$	-	$	-		$	89	$	(1	)	$	89	$	(1	)
Mortgage backed securities
U.S. government sponsored entities and agencies	39,895		(297		)	-		-			39,895		(297		)
Non-agency	17,396		(238		)	586		(362		)	17,982		(600		)
Corporate debt securities	26,857		(2,053		)	-		-			26,857		(2,053		)
Other	2,020		(39		)	-		-			2,020		(39		)
Total	$	86,168	$	(2,627	)	$	675	$	(363	)	$	86,843	$	(2,990	)

Schedule of amortized cost and fair value maturities of available for sale investment securities

(dollar amounts in thousands)	One Year Or Less		Over 1 Through 5 Years		Over 5 Years Through 10 Years		Over 10 Years		Total
Obligations of U.S. government agencies	$	7	$	30	$	3,917	$	3	$	3,957
Mortgage backed securities
U.S. government sponsored entities and agencies	20,327		48,094		22,944		17,856		109,221
Non-agency	9,122		21,646		11,193		1,945		43,906
State and municipal securities	1,004		9,280		44,351		8,636		63,271
Corporate debt securities	-		18,999		9,346		2,330		30,675
Other	1,504		4,289		4,628		-		10,421
Total available for sale securities	$	31,964	$	102,338	$	96,379	$	30,770	$	261,451
Amortized cost	$	31,916	$	100,746	$	92,221	$	30,279	$	255,162
Weighted average yield	2.24%		2.65%		3.31%		4.15%		3.04%

Summary of earnings on both taxable and tax-exempt investment securities

	For the three months				For the nine months
	ended September 30,				ended September 30,
(dollar amounts in thousands)	2012		2011		2012		2011
Taxable earnings on investment securities
Obligations of U.S. government agencies	$	25	$	32	$	79	$	137
Mortgage backed securities	973		1,176		2,971		3,192
State and municipal securities	5		121		183		377
Corporate debt securities	181		149		504		154
Other	72		20		146		20
Non-taxable earnings on investment securities
State and municipal securities	527		382		1,428		1,136
Total	$	1,783	$	1,880	$	5,311	$	5,016

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Loans (Details 4) (USD $) In Thousands, unless otherwise specified	9 Months Ended
	Sep. 30, 2012 item	Dec. 31, 2011
Loans
Number of primary credit risk ratings	4
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	$ 678,348	$ 646,286
Days Past Due
30-59	772	637
60-89	498	159
Non-Accruing	20,469	12,368
Accruing TDR	18	561
Credit Risk Grades, Pass
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	590,713	553,069
Credit Risk Grades, Special Mention
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	30,082	39,264
Credit Risk Grades, Substandard
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	57,553	53,898
Credit Risk Grades, Doubtful
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans		55
Real Estate Secured
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	484,903	433,455
Real Estate Secured | Multi-family residential
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	16,429	15,915
Real Estate Secured | Multi-family residential | Credit Risk Grades, Pass
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	15,883	15,915
Real Estate Secured | Multi-family residential | Credit Risk Grades, Substandard
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	546
Real Estate Secured | Residential 1 to 4 family
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	37,837	20,839
Days Past Due
Non-Accruing	907	622
Real Estate Secured | Residential 1 to 4 family | Credit Risk Grades, Pass
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	36,918	20,209
Real Estate Secured | Residential 1 to 4 family | Credit Risk Grades, Special Mention
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	7
Real Estate Secured | Residential 1 to 4 family | Credit Risk Grades, Substandard
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	912	630
Real Estate Secured | Home equity lines of credit
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	32,422	31,047
Days Past Due
30-59	81	267
60-89	262	65
Non-Accruing	381	359
Real Estate Secured | Home equity lines of credit | Credit Risk Grades, Pass
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	30,807	29,274
Real Estate Secured | Home equity lines of credit | Credit Risk Grades, Special Mention
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans		56
Real Estate Secured | Home equity lines of credit | Credit Risk Grades, Substandard
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	1,615	1,717
Real Estate Secured | Commercial
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	374,799	357,499
Days Past Due
30-59	216
60-89	233
Non-Accruing	4,428	4,551
Real Estate Secured | Commercial | Credit Risk Grades, Pass
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	328,209	311,234
Real Estate Secured | Commercial | Credit Risk Grades, Special Mention
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	16,138	17,795
Real Estate Secured | Commercial | Credit Risk Grades, Substandard
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	30,452	28,470
Real Estate Secured | Farmland
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	23,416	8,155
Days Past Due
Non-Accruing	1,089
Real Estate Secured | Farmland | Credit Risk Grades, Pass
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	16,742	5,830
Real Estate Secured | Farmland | Credit Risk Grades, Special Mention
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	3,270
Real Estate Secured | Farmland | Credit Risk Grades, Substandard
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	3,404	2,325
Commercial
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	137,510	156,894
Commercial | Commercial and industrial
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	119,496	141,065
Days Past Due
30-59	435	329
60-89		92
Non-Accruing	3,243	1,625
Accruing TDR	18	561
Commercial | Commercial and industrial | Credit Risk Grades, Pass
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	105,111	122,964
Commercial | Commercial and industrial | Credit Risk Grades, Special Mention
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	5,770	11,630
Commercial | Commercial and industrial | Credit Risk Grades, Substandard
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	8,615	6,416
Commercial | Commercial and industrial | Credit Risk Grades, Doubtful
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans		55
Commercial | Agriculture
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	17,948	15,740
Days Past Due
Non-Accruing	1,075	2,327
Commercial | Agriculture | Credit Risk Grades, Pass
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	15,925	11,326
Commercial | Agriculture | Credit Risk Grades, Special Mention
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	107
Commercial | Agriculture | Credit Risk Grades, Substandard
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	1,916	4,414
Commercial | Other
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	66	89
Commercial | Other | Credit Risk Grades, Pass
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	66	89
Construction
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	26,875	22,731
Construction | Single family residential
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	11,267	13,039
Days Past Due
Non-Accruing		937
Construction | Single family residential | Credit Risk Grades, Pass
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	11,267	12,102
Construction | Single family residential | Credit Risk Grades, Substandard
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans		937
Construction | Single family residential - Spec.
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	420	8
Construction | Single family residential - Spec. | Credit Risk Grades, Pass
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	420	8
Construction | Multi-family
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	787	1,669
Construction | Multi-family | Credit Risk Grades, Pass
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	787
Construction | Multi-family | Credit Risk Grades, Substandard
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans		1,669
Construction | Commercial
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	14,401	8,015
Days Past Due
Non-Accruing	1,840
Construction | Commercial | Credit Risk Grades, Pass
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	12,561	3,714
Construction | Commercial | Credit Risk Grades, Special Mention
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans		4,301
Construction | Commercial | Credit Risk Grades, Substandard
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	1,840
Land
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	23,633	26,454
Days Past Due
30-59		41
Non-Accruing	7,300	1,886
Land | Credit Risk Grades, Pass
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	11,034	13,985
Land | Credit Risk Grades, Special Mention
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	4,567	5,234
Land | Credit Risk Grades, Substandard
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	8,032	7,235
Installment loans to individuals
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	5,146	6,479
Days Past Due
30-59	40
60-89	3	2
Non-Accruing	206	61
Installment loans to individuals | Credit Risk Grades, Pass
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	4,707	6,148
Installment loans to individuals | Credit Risk Grades, Special Mention
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	222	247
Installment loans to individuals | Credit Risk Grades, Substandard
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	217	84
All other loans (including overdrafts)
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	281	273
All other loans (including overdrafts) | Credit Risk Grades, Pass
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	276	271
All other loans (including overdrafts) | Credit Risk Grades, Special Mention
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	1	1
All other loans (including overdrafts) | Credit Risk Grades, Substandard
Loan portfolio by internal risk grading system as well as certain other information concerning the credit quality
Total Gross loans	$ 4	$ 1

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Allowance for Loan Losses (Tables)

9 Months Ended

Sep. 30, 2012

Allowance for Loan Losses

Summary of activity in the allowance attributed to various segments in the loan portfolio

	Real Estate															All Other
(dollar amounts in thousands)	Secured			Commercial			Construction			Land			Installment			Loans			Total
Balance, June 30, 2012	$	6,897		$	6,261		$	381		$	4,483		$	91		$	36		$	18,149
Charge-offs	(106		)	(1,511		)	(92		)	-			(9		)	-			(1,718		)
Recoveries	12			246			1			5			5			1			270
Provisions for loan losses	1,184			75			268			(225		)	(15		)	(1		)	1,286
Balance, September 30, 2012	$	7,987		$	5,071		$	558		$	4,263		$	72		$	36		$	17,987
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
Provisions 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, 2011	$	9,645		$	6,549		$	488		$	2,416		$	175		$	41		$	19,314
Charge-offs	(2,471		)	(4,272		)	(668		)	(2,168		)	(29		)	(137		)	(9,745		)
Recoveries	74			623			1			18			18			3			737
Provisions for loan losses (1)	739			2,171			737			3,997			(92		)	129			7,681
Balance, September 30, 2012	$	7,987		$	5,071		$	558		$	4,263		$	72		$	36		$	17,987
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
Provisions 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

(1) The provision for loan losses includes the transfer of $3.9 million from C&I to land related to the re-characterization of a loan as part of a TDR in the second quarter of 2012, as the restructured loan became more collateral dependent on a parcel of land.

Summary of comparative metrics about the allowance attributed to various segments in the loan portfolio

	As of September 30, 2012
	Real Estate										All Other
(dollar amounts in thousands)	Secured		Commercial		Construction		Land		Installment		Loans		Total
Amount of allowance attributed to:
Specifically evaluated impaired loans	$	50	$	1,117	$	-	$	3,434	$	16	$	-	$	4,617
General portfolio allocation	$	7,937	$	3,954	$	558	$	829	$	56	$	36	$	13,370
Loans individually evaluated for impairment	$	6,805	$	4,336	$	1,840	$	7,300	$	206	$	-	$	20,487
Loans collectively evaluated for impairment	$	478,098	$	133,174	$	25,035	$	16,333	$	4,940	$	281	$	657,861
General reserves to total loans collectively evaluated for impairment	1.66%		2.97%		2.23%		5.08%		1.13%		12.81%		2.03%
Total gross loans	$	484,903	$	137,510	$	26,875	$	23,633	$	5,146	$	281	$	678,348
Total allowance to gross loans	1.65%		3.69%		2.08%		18.04%		1.40%		12.81%		2.65%

	As of December 31, 2011
	Real Estate										All Other
(dollar amounts in thousands)	Secured		Commercial		Construction		Land		Installment		Loans		Total
Amount of allowance attributed to:
Specifically evaluated impaired loans	$	791	$	1,309	$	-	$	114	$	3	$	-	$	2,217
General portfolio allocation	$	8,854	$	5,240	$	488	$	2,302	$	172	$	41	$	17,097
Loans individually evaluated for impairment	$	5,532	$	4,963	$	937	$	1,886	$	61	$	-	$	13,379
Loans collectively evaluated for impairement	$	427,923	$	151,931	$	21,794	$	24,568	$	6,418	$	273	$	632,907
General reserves to total loans collectively evaluated evaluated for impairment	2.07%		3.45%		2.24%		9.37%		2.68%		15.02%		2.70%
Total gross loans	$	433,455	$	156,894	$	22,731	$	26,454	$	6,479	$	273	$	646,286
Total allowance to gross loans	2.23%		4.17%		2.15%		9.13%		2.70%		15.02%		2.99%

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Condensed Consolidated Financial Statements

9 Months Ended

Sep. 30, 2012

Condensed Consolidated Financial Statements

Condensed Consolidated Financial Statements

Note 1.  Condensed Consolidated Financial Statements

Description of Business

Heritage Oaks Bancorp (“the Company”) is a California corporation organized in 1994 to act as the holding company for Heritage Oaks Bank (“the Bank”).  The Bank operates branches within San Luis Obispo and Santa Barbara counties.  The Bank offers traditional banking products such as checking, savings, money market accounts and certificates of deposit, as well as mortgage loans and commercial and consumer loans to customers who are predominately small to medium-sized businesses and individuals.  As such, the Company is subject to a concentration risk associated with its banking operations in San Luis Obispo and Santa Barbara Counties. No one customer accounts for more than 10% of revenue or assets in any period presented and the Company has no assets nor does it generate any revenue from outside of the United States. While the chief decision-makers of the Company monitor the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Company-wide basis.  Accordingly, all of the financial service operations are considered by management to be aggregated in one reportable operating segment.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of Heritage Oaks Bancorp and subsidiaries (the “Company”) have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and notes required by accounting principles generally accepted in the United States of America (“U.S. GAAP”) for annual financial statements are not included herein. 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 2011 Annual Report filed on Form 10-K, filed with the Securities and Exchange Commission on February 28, 2012, 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. Operating results for the three and nine months ended September 30, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012. Certain amounts in the consolidated financial statements for the year ended December 31, 2011 and for the three and nine months ended September 30, 2011 may have been reclassified to conform to the presentation of the condensed consolidated financial statements in 2012.

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.  Estimates that are particularly susceptible to significant change relate to the calculation and inputs which are the basis for the allowance for loan losses, the valuation of real estate acquired through foreclosure, the carrying value of the Company’s deferred tax assets and estimates used in the determination of the fair value of certain financial instruments.

The significant accounting policies that the Company applies are detailed in Note 1. Summary of Significant Accounting Policies, 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, related to the adoption of standard updates issued by the Financial Accounting Standards Board (“FASB”).

Recent Accounting Guidance Adopted

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.  Other than the additional disclosure included in the new stand-alone statement of other comprehensive income, the Company’s adoption of this standard in the first quarter of 2012 did not 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. Other than the additional disclosures included in Note 9. Fair Value of Assets and Liabilities, the Company’s adoption of this standard in the first quarter of 2012 did not have a significant impact on the Company’s consolidated financial statements.

Recent Accounting Guidance Not Yet Effective

On July 27, 2012, the FASB issued ASU No. 2012-02, Intangibles-Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment.  This update, like ASU 2011-08 which the Company adopted in 2011, allows companies the option to first evaluate qualitative factors to determine if events or circumstances exist that indicate that it is more likely than not that an indefinite-lived intangible asset is impaired.  If based on this assessment, a company concludes that there are no indicators that suggest an indefinitely-lived asset is more likely than not of having been impaired, then no further quantitative analysis is required.  The amendments are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted, including for annual and interim impairment tests performed as of a date before July 27, 2012, if a public entity’s financial statements for the most recent annual or interim period have not yet been issued or, for nonpublic entities, have not yet been made available for issuance. The Company currently does not have any indefinitely-lived intangible assets, other than goodwill, therefore adoption of this ASU is not expected to have a material impact on the Company’s consolidated financial statements.

On October 1, 2012, the FASB issued ASU No. 2012-04, Technical Corrections and Improvements.  The amendments in ASU 2012-04 cover a wide range of Topics in the Codification and address technical corrections and improvements and conforming amendments related to fair value measurements.  For public entities, the amendments that are subject to the transition guidance will be effective for fiscal periods beginning after December 15, 2012.  The Company is evaluating the impacts of these corrections but does not expect them to have a material impact on the Company’s consolidated financial statements.

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Condensed Consolidated Balance Sheets (Parenthetical) (USD $) In Thousands, except Share data, unless otherwise specified	9 Months Ended	12 Months Ended
	Sep. 30, 2012	Dec. 31, 2011
Preferred stock
Preferred stock, shares authorized	5,000,000	5,000,000
Common stock, shares authorized	100,000,000	100,000,000
Common stock, shares issued	25,288,430	25,145,717
Common stock, shares outstanding	25,288,430	25,145,717
Accumulated other comprehensive income, tax expense (in dollars)	$ 2,589	$ 307
Series A senior preferred stock
Preferred stock
Preferred stock, per share stated value (in dollars per share)	$ 1,000	$ 1,000
Preferred stock, shares issued	21,000	21,000
Preferred stock, shares outstanding	21,000	21,000
Series C preferred stock
Preferred stock
Preferred stock, per share stated value (in dollars per share)	$ 3.25	$ 3.25
Preferred stock, shares issued	1,189,538	1,189,538
Preferred stock, shares outstanding	1,189,538	1,189,538

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Regulatory Matters

9 Months Ended

Sep. 30, 2012

Regulatory Matters

Regulatory Matters

Note 11.  Regulatory Matters

On March 4, 2010, the FDIC and the DFI issued a Consent Order (the “Order”) to the Bank that required, among other things, the Bank to increase its capital ratios, reduce its classified assets and increase Board oversight of Management. The Board and Management aggressively responded to the Order to ensure full compliance and took actions necessary to substantially comply with the Order within the required time frames.

Such actions included the completion of the capital raise that was addressed by the Company’s 2010 $60 million private placement, from which a contribution of a portion of the proceeds were made to the Bank. This contribution brought the Bank into compliance with the capital requirements of the Order.

In April 2012, in conjunction with the completion of their most recent full scope review, the FDIC and California Department of Financial Institutions (“DFI”) terminated the Joint Consent Order (“Order”) issued March 4, 2010. In connection with the termination of the Order, the Bank’s Board of Directors executed a Memorandum of Understanding (“MOU”) with the FDIC and DFI. In the MOU, the Company committed to, among other things, continue to make progress in improving credit quality and processes as well as to continue to comply with the 10% Leverage Ratio as originally established by the Order.  The Bank’s leverage ratio was 11.75% as of September 30, 2012.

On March 4, 2010, the Company entered into a written agreement (the “Written Agreement”) with the Federal Reserve Bank of San Francisco (“FRB”), which required the Company to take certain measures to improve its safety and soundness. Under the Written Agreement, the Company was required to develop and submit for approval, a plan to maintain sufficient capital at the Company and the Bank within 60 days of the date of the Written Agreement. The Written Agreement further provided, among other things, that the Company would not: declare or pay dividends without prior approval of the FRB, take dividends from the Bank, make any distribution of interest, principal or other sums on subordinated debt or trust preferred securities, incur, increase, or guarantee any debt.

In July 2012, the FRB terminated the Written Agreement issued on March 4, 2010.  In connection with the termination of the Written Agreement, the Company executed a MOU with FRB.  In the MOU the Company committed among other things to continue to seek FRB approval prior to: paying any dividends on its common and preferred stock; paying interest, principal or other sums on subordinated debt or trust preferred securities; or incurring, increasing, or guaranteeing any debt.

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Document and Entity Information	9 Months Ended
	Sep. 30, 2012	Oct. 26, 2012
Document and Entity Information
Entity Registrant Name	HERITAGE OAKS BANCORP
Entity Central Index Key	0000921547
Document Type	10-Q
Document Period End Date	Sep. 30, 2012
Amendment Flag	false
Current Fiscal Year End Date	--12-31
Entity Current Reporting Status	Yes
Entity Filer Category	Smaller Reporting Company
Entity Common Stock, Shares Outstanding		25,288,430
Document Fiscal Year Focus	2012
Document Fiscal Period Focus	Q3

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Junior Subordinated Debentures

9 Months Ended

Sep. 30, 2012

Junior Subordinated Debentures

Junior Subordinated Debentures

Note 12.  Junior Subordinated Debentures

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 FRB.  During the second quarter of 2012, based on the Company’s receipt of regulatory approval to pay interest currently due and all previously deferred interest, the Company paid all amounts due on May 25, 2012 and has remained current on its interest payments as of September 30, 2012.  For more information concerning the Written Agreement, please refer to Note 11. Regulatory Matters, of these condensed consolidated financial statements.

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Condensed Consolidated Statements of Income (USD $) In Thousands, except Per Share data, unless otherwise specified	3 Months Ended		9 Months Ended
	Sep. 30, 2012	Sep. 30, 2011	Sep. 30, 2012	Sep. 30, 2011
Interest Income
Interest and fees on loans	$ 9,716	$ 10,174	$ 29,289	$ 31,132
Interest on investment securities	1,783	1,880	5,311	5,016
Other interest income	20	18	72	67
Total interest income	11,519	12,072	34,672	36,215
Interest Expense
Interest on savings, NOW and money market deposits	288	361	874	1,171
Interest on time deposits under $100	205	350	707	1,138
Interest on time deposits in denominations of $100 or more	226	363	734	1,212
Other borrowings	215	143	617	396
Total interest expense	934	1,217	2,932	3,917
Net interest income before provision for loan losses	10,585	10,855	31,740	32,298
Provision for loan losses	1,286	1,086	7,681	5,370
Net interest income after provision for loan losses	9,299	9,769	24,059	26,928
Non-Interest Income
Fees and service charges	611	659	1,948	1,820
Mortgage gain on sale and origination fees	1,181	734	3,071	1,750
Debit/credit card fee income	460	430	1,322	1,211
Earnings on bank owned life insurance	148	147	452	444
Gain on sale of investment securities	329	595	1,696	1,187
Gain / (loss) on sale of other real estate owned	102	(266)	112	(587)
Other income	153	258	399	691
Total non-interest income	2,984	2,557	9,000	6,516
Non-Interest Expense
Salaries and employee benefits	4,532	4,434	13,522	13,371
Equipment	395	399	1,223	1,327
Occupancy	728	888	2,542	2,768
Promotional	171	156	432	491
Data processing	551	801	1,911	2,253
OREO related costs	54	162	217	556
Write-downs of foreclosed assets	53	89	86	968
Regulatory assessment costs	371	503	1,238	1,834
Audit and tax advisory costs	146	188	473	514
Directors fees	126	102	358	338
Outside services	730	296	1,572	1,035
Provision for potential mortgage repurchases	125	329	982	329
Amortization of intangible assets	86	96	258	356
Other general operating costs	727	607	1,843	1,957
Total non-interest expense	8,795	9,050	26,657	28,097
Income before (benefit from) / provision for income taxes	3,488	3,276	6,402	5,347
(Benefit from) / provision for income taxes	(2,940)	1,157	(3,508)	1,753
Net income	6,428	2,119	9,910	3,594
Dividends and accretion on preferred stock	357	373	1,113	1,108
Net income available to common shareholders	$ 6,071	$ 1,746	$ 8,797	$ 2,486
Earnings Per Common Share
Basic (in dollars per share)	$ 0.24	$ 0.07	$ 0.35	$ 0.10
Diluted (in dollars per share)	$ 0.23	$ 0.07	$ 0.33	$ 0.10

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Income Taxes

9 Months Ended

Sep. 30, 2012

Income Taxes

Income Taxes

Note 6.  Income Taxes

The tax provision for the three and nine months ended September 30, 2012 resulted in an effective tax rate of (84.3)% and (54.8)%, respectively.  The tax provision for the three and nine months ended September 30, 2011 resulted in an effective tax rate 35.3% and 32.8%, respectively.  The primary items affecting the effective tax rate for the three and nine months ended September 30, 2012 are the reversal $4.1 million and $5.6 million, respectively, of deferred tax valuation allowance and the impact of non-taxable municipal interest. The reversal of the Company’s deferred tax asset valuation allowance is discussed more fully below. The primary item affecting the effective tax rate for the first nine months of 2011 is the impact of non-taxable municipal interest.

Deferred Tax Assets Valuation Allowance

U.S. GAAP requires that companies assess whether a valuation allowance should be established against deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard.  In making such judgments, significant weight is given to evidence, both positive and negative, that can be objectively verified.  U.S. GAAP provides that a cumulative loss in recent years is significant negative evidence in considering whether deferred tax assets are realizable, and also limits projections of future taxable income to that which can be estimated over a reasonable amount of time.

The pre-tax losses the Company reported in 2010 and 2009 resulted in a three year cumulative loss position, which provided significant negative evidence as to the realizability of a portion of the Company’s deferred tax assets as of December 31, 2010.  As a result of this negative evidence, the Company recorded a partial valuation allowance of approximately $7.1 million for its deferred tax assets in 2010 through a charge to income tax expense. The Company’s determination of the valuation allowance for a portion of its deferred tax assets was based on: (1) an analysis of cumulative pre-tax losses over a three year horizon, through December 31, 2010; (2) a projection of future taxable income over a period of time the Company believed to be reasonably estimable (“the projection period”); and (3) a detailed analysis to determine the amount of the deferred tax asset expected to be realized over the projection period of five years.

The ultimate realization of the Company’s deferred tax assets is dependent on the generation of future taxable income during the periods in which those temporary differences reverse.  The Company established a valuation allowance against a portion of the deferred tax asset in 2010 because it had a three year cumulative pre-tax loss position as of December 31, 2010 and management believed that it was not more likely than not that the Company would generate enough future taxable income over the projection period in order for all of its deferred tax assets to be realized.

The Company’s return to profitability in 2011 and continued profits through September 30, 2012 substantially eliminated the three year cumulative loss position.  In addition, declines in the level of deferred tax assets and changes in their composition, along with projections of profitability for the foreseeable future and an improvement in the credit quality of the Company’s loan portfolio have combined to improve the outlook for the recovery of the valuation allowance provided for in 2010.  As a result of this improved outlook, the Company reduced the level of valuation allowance in the fourth quarter of 2011 by $1.5 million. During the first nine months of 2012, these favorable trends led the Company to further reduce the level of valuation allowance by an additional $1.5 million in the first half of the year and to ultimately conclude in the third quarter of 2012 that it was now more likely than not that its entire deferred tax asset position would be realized.

Therefore, after giving effect to the portion of the deferred tax asset valuation allowance related to timing differences that would reverse in the current year and therefore should be reflected as an adjustment to the 2012 effective tax rate, a discrete reversal of the remaining $4.1 million of valuation allowance was recorded in the third quarter of 2012.

The deferred tax assets for which there is no valuation allowance relate to amounts that are expected to be realized through reversals of existing taxable temporary differences over the projection period.  The accounting for deferred taxes is based on an estimate of future results.  Differences between anticipated and actual outcomes of these future tax consequences could have an impact on the Company’s consolidated results of operations or financial position. See Note 10. Income Taxes, of the Company’s Annual Report filed on Form 10-K for additional discussion of the accounting for deferred taxes.

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Other Real Estate Owned ("OREO")

9 Months Ended

Sep. 30, 2012

Other Real Estate Owned ("OREO")

Other Real Estate Owned ("OREO")

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, 2012:

	Balance										Balance
	June 30,										September 30,
(dollar amounts in thousands)	2012		Additions		Disposals			Writedowns			2012
Real Estate Secured
Residential 1 to 4 family	$	431	$	-	$	-		$	(31	)	$	400
Commercial	215		-		-			-			215
Construction
Single family residential - Spec.	397		-		(397		)	-			-
Land	32		-		-			(32		)	-
Totals	$	1,075	$	-	$	(397	)	$	(63	)	$	615

	Balance										Balance
	December 31,										September 30,
(dollar amounts in thousands)	2011		Additions		Disposals			Writedowns			2012
Real Estate Secured
Residential 1 to 4 family	$	-	$	607	$	(176	)	$	(31	)	$	400
Commercial	215		-		-			-			215
Construction
Single family residential - Spec.	423		-		(397		)	(26		)	-
Tract	100		-		(100		)	-			-
Land	179		162		(300		)	(41		)	-
Totals	$	917	$	769	$	(973	)	$	(98	)	$	615

The Company realized a gain of $0.1 million on the disposal of OREO during both the three and nine months ended September 30, 2012.

The following table provides 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,
(dollar amounts 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,
(dollar amounts 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

The Company realized a loss of $0.3 million and $0.6 million related to disposals of OREO during the three and nine months ended September 30, 2011, respectively.

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Loans (Tables)

9 Months Ended

Sep. 30, 2012

Loans

Summary of outstanding loan balances

	September 30,		December 31,
(dollar amounts in thousands)	2012		2011
Real Estate Secured
Multi-family residential	$	16,429	$	15,915
Residential 1 to 4 family	37,837		20,839
Home equity lines of credit	32,422		31,047
Commercial	374,799		357,499
Farmland	23,416		8,155
Total real estate secured	484,903		433,455
Commercial
Commercial and industrial	119,496		141,065
Agriculture	17,948		15,740
Other	66		89
Total commercial	137,510		156,894
Construction
Single family residential	11,267		13,039
Single family residential - Spec.	420		8
Multi-family	787		1,669
Commercial	14,401		8,015
Total construction	26,875		22,731
Land	23,633		26,454
Installment loans to individuals	5,146		6,479
All other loans (including overdrafts)	281		273
Total gross loans	678,348		646,286
Deferred loan fees	977		1,111
Allowance for loan losses	17,987		19,314
Total net loans	$	659,384	$	625,861
Loans held for sale	$	12,590	$	21,947

Summary of the Company's investment in impaired loans

The following table provides a summary of the Company’s investment in impaired loans as of September 30, 2012:

			Unpaid		Impaired Loans				Specific
	Recorded		Principal		With Specific		Without Specific		Allowance for
(dollar amounts in thousands)	Investment (1)		Balance		Allowance		Allowance		Impaired Loans
Real Estate Secured
Residential 1 to 4 family	$	904	$	1,163	$	139	$	765	$	11
Home equity lines of credit	381		473		62		319		7
Commercial	4,468		8,265		255		4,213		27
Farmland	1,089		1,089		1,089		-		5
Commercial
Commercial and industrial	3,247		4,473		2,656		591		1,096
Agriculture	1,075		1,253		50		1,025		21
Construction
Commercial	1,840		2,508		-		1,840		-
Land	7,301		10,829		6,197		1,104		3,434
Installment loans to individuals	205		225		205		-		16
Totals	$	20,510	$	30,278	$	10,653	$	9,857	$	4,617

(1)The recorded investment in loans includes the book value of impaired loans as adjusted for the net deferred costs and fees related to the impaired loans.

The following table provides a summary of the Company’s investment in impaired loans as of December 31, 2011:

			Unpaid		Impaired Loans				Specific
	Recorded		Principal		With Specific		Without Specific		Allowance for
(dollar amounts in thousands)	Investment (1)		Balance		Allowance		Allowance		Impaired Loans
Real Estate Secured
Residential 1 to 4 family	$	622	$	895	$	153	$	469	$	53
Home equity lines of credit	359		443		-		359		-
Commercial	4,567		5,513		3,876		691		738
Farmland	-		-		-		-		-
Commercial
Commercial and industrial	2,183		2,879		1,928		255		1,169
Agriculture	2,789		2,932		2,166		623		140
Construction
Single family residential	937		937		-		937		-
Land	1,886		2,258		729		1,157		114
Installment loans to individuals	61		61		61		-		3
Totals	$	13,404	$	15,918	$	8,913	$	4,491	$	2,217

(1)The recorded investment in loans includes the book value of impaired loans as adjusted for the net deferred costs and fees related to the impaired loans.

Schedule of average recorded investment in impaired loans and the interest income recognized on impaired loans

	For the three months ended September 30,								For the nine months ended September 30,
	2012				2011				2012				2011
	Average		Interest		Average		Interest		Average		Interest		Average		Interest
	Recorded		Income		Recorded		Income		Recorded		Income		Recorded		Income
(dollar amounts in thousands)	Investment		Recognized		Investment		Recognized		Investment		Recognized		Investment		Recognized
Real Estate Secured
Residential 1 to 4 family	$	801	$	-	$	568	$	-	$	756	$	-	$	613	$	-
Home equity lines of credit	384		-		808		-		378		-		861		-
Commercial	3,492		-		10,354		-		3,757		-		12,346		-
Farmland	363		-		577		-		272		-		1,090		-
Commercial
Commercial and industrial	4,129		-		2,992		21		3,644		4		3,708		22
Agriculture	1,905		-		883		-		2,010		-		724		-
Construction
Single family residential	-		-		1,174		-		234		-		1,209		-
Single family residential - Spec.	-		-		-		-		-		-		313		-
Multi-family	-		-		-		-		-		-		120		-
Commercial	1,257		-		-		-		943		-		-		-
Land	7,189		-		3,669		-		5,863		-		3,780		-
Installment loans to individuals	89		-		4		-		82		-		96		-
Totals	$	19,609	$	-	$	21,029	$	21	$	17,939	$	4	$	24,860	$	22

Schedule of troubled debt restructurings ("TDRs")

	For the three months ended September 30, 2012					For the nine months ended September 30, 2012
		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
Residential 1 to 4 family	-	$	-	$	-	1	$	439	$	439
Farmland	1	1,089		1,089		1	1,089		1,089
Commercial
Commercial and industrial	6	1,120		1,099		9	2,115		2,094
Construction
Land	1	63		63		3	8,433		7,063
Totals	8	$	2,272	$	2,251	14	$	12,076	$	10,685

	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

Summary of TDRs that completed in the last twelve months and became delinquent

	For the three months ended September 30, 2012			For the nine months ended September 30, 2012
	Number of			Number of
(dollar amounts in thousands)	TDRs	Recorded Investment		TDRs	Recorded Investment
Trouble Debt Restructurings
That Subsequently Defaulted
Commercial
Commercial and industrial	0	$	-	3	$	254
Totals	0	$	-	3	$	254

Schedule of loan portfolio by the Company's internal risk grading system as well as certain other information concerning the credit quality of the loan portfolio

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, 2012:

			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	$	16,429	$	15,883	$	-	$	546	$	-	$	-	$	-	$	-	$	-	$	-
Residential 1 to 4 family	37,837		36,918		7		912		-		-		-		-		907		-
Home equity lines of credit	32,422		30,807		-		1,615		-		81		262		-		381		-
Commercial	374,799		328,209		16,138		30,452		-		216		233		-		4,428		-
Farmland	23,416		16,742		3,270		3,404		-		-		-		-		1,089		-
Commercial
Commercial and industrial	119,496		105,111		5,770		8,615		-		435		-		-		3,243		18
Agriculture	17,948		15,925		107		1,916		-		-		-		-		1,075		-
Other	66		66		-		-		-		-		-		-		-		-
Construction
Single family residential	11,267		11,267		-		-		-		-		-		-		-		-
Single family residential - Spec.	420		420		-		-		-		-		-		-		-		-
Multi-family	787		787		-		-		-		-		-		-		-		-
Commercial	14,401		12,561		-		1,840		-		-		-		-		1,840		-
Land	23,633		11,034		4,567		8,032		-		-		-		-		7,300		-
Installment loans to individuals	5,146		4,707		222		217		-		40		3		-		206		-
All other loans (including overdrafts)	281		276		1		4		-		-		-		-		-		-
Totals	$	678,348	$	590,713	$	30,082	$	57,553	$	-	$	772	$	498	$	-	$	20,469	$	18

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, 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	$	15,915	$	15,915	$	-	$	-	$	-	$	-	$	-	$	-	$	-	$	-
Residential 1 to 4 family	20,839		20,209		-		630		-		-		-		-		622		-
Home equity lines of credit	31,047		29,274		56		1,717		-		267		65		-		359		-
Commercial	357,499		311,234		17,795		28,470		-		-		-		-		4,551		-
Farmland	8,155		5,830		-		2,325		-		-		-		-		-		-
Commercial
Commercial and industrial	141,065		122,964		11,630		6,416		55		329		92		-		1,625		561
Agriculture	15,740		11,326		-		4,414		-		-		-		-		2,327		-
Other	89		89		-		-		-		-		-		-		-		-
Construction																	-
Single family residential	13,039		12,102		-		937		-		-		-		-		937		-
Single family residential - Spec.	8		8		-		-		-		-		-		-		-		-
Multi-family	1,669		-		-		1,669		-		-		-		-		-		-
Commercial	8,015		3,714		4,301		-		-		-		-		-		-		-
Land	26,454		13,985		5,234		7,235		-		41		-		-		1,886		-
Installment loans to individuals	6,479		6,148		247		84		-		-		2		-		61		-
All other loans (including overdrafts)	273		271		1		1		-		-		-		-		-		-
Totals	$	646,286	$	553,069	$	39,264	$	53,898	$	55	$	637	$	159	$	-	$	12,368	$	561

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Asset Acquisition

9 Months Ended

Sep. 30, 2012

Asset Acquisition

Asset Acquisition

Note 13.  Asset Acquisition

In September 2012, the Company announced that it had entered into a definitive agreement with Coast National Bank to purchase its branch facilities and related fixed assets and a major portion of its deposit base in Morro Bay, California.  The asset acquisition is expected to be completed in the fourth quarter of 2012.  The purchase price is dependent on the level of deposits that exist at the closing date, but is expected to be approximately $1.7 million and is comprised of approximately $1.0 million allocable to the building and related assets being purchased and $0.7 million related to the deposit premium being paid for the deposits being assumed.

Based on recent deposit reports provided by Coast National Bank, the Company expects to receive approximately $30 million of cash related to the deposits, which it will invest in new loans and investment securities.

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Fair Value of Assets and Liabilities

9 Months Ended

Sep. 30, 2012

Fair Value of Assets and Liabilities

Fair Value of Assets and Liabilities

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 in Available for Sale 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.  The fair value of newly issued securities, for which there is not a sufficient history of market transactions on which to base a fair value determination under Level 1 or 2 of the hierarchy, are initially valued under Level 3 of the hierarchy.  At such time that sufficient history of market transactions is established, the securities’ fair value is determined under Level 1 or 2 of the hierarchy and accordingly the security is transferred out of Level 3 and into the applicable level.

Federal Home Loan Bank Stock

The fair value of Federal Home Loan Bank stock is not readily determinable due to the lack of its transferability.

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, which is based on the appraised value of the collateral less any estimated costs to sell, or the discounted expected future cash flows.  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 based on Company specific experience with similar collateral, the Company records impaired loans as non-recurring Level 3.  The most common adjustment to reported appraised values of collateral is a monthly discount linked to the passage of time since the last appraisal.  This discount factor ranges between 1% and 3% per month and is consistent with that used in the appraisals to discount for the passage of time between the transaction date for comparable properties used in the appraisal and the appraisal date. At September 30, 2012, 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 based on Company specific experience with similar assets, the Company records other real estate owned or foreclosed collateral as non-recurring Level 3 assets.  The most common adjustment to reported appraised values of collateral is a monthly discount linked to the passage of time since the last appraisal.  This discount factor ranges between 1% and 3% per month and is consistent with that used in the appraisals to discount for the passage of time between the transaction date for comparable properties used in the appraisal and the appraisal date.

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.

Junior Subordinated Debentures

The fair value disclosed for junior subordinated debentures is based on market prices 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, 2012 and December 31, 2011:

	Fair Value Measurements Using
	Quoted Prices in		Significant Other		Significant
	Active Markets for		Observable		Unobservable
(dollar amounts in thousands)	Inputs		Inputs		Inputs		Assets At
As of September 30, 2012	(Level 1)		(Level 2)		(Level 3)		Fair Value
Assets
Obligations of U.S. government agencies	$	-	$	3,957	$	-	$	3,957
Mortgage backed securities:
Agency	-		109,221		-		109,221
Non-agency	-		43,906		-		43,906
Obligations of state and municipal securities	-		63,271		-		63,271
Corporate debt securities	-		30,675		-		30,675
Other securities	-		10,421		-		10,421
Total assets measured on a recurring basis	$	-	$	261,451	$	-	$	261,451
As of December 31, 2011
Assets
Obligations of U.S. government agencies	$	-	$	4,326	$	-	$	4,326
Mortgage backed securities:
Agency	-		117,325		-		117,325
Non-agency	-		31,458		3,074		34,532
Obligations of state and municipal securities	-		51,664		259		51,923
Corporate debt securities			26,856		-		26,856
Other securities	-		2,020		-		2,020
Total assets measured on a recurring basis	$	-	$	233,649	$	3,333	$	236,982

In determining the fair value of Level 3 instruments on a recurring basis the Company takes into consideration several variables, including but not limited to: expectations about interest rate movements, prepayment speeds of the underlying mortgages for mortgage backed securities, expected default rates, and credit spreads over the risk free rate.  Of these variables, default rates and credit spreads are perhaps the least observable and most impactful on the long-term value of a Level 3 security.  Since a bond’s value is represented by its yield which reflects the risk-free yield curve plus compensation for various risks incurred in buying the bond, changes to the risk assumptions including probability of default and timing of future cash flows can materially impact the market value. As of September 30, 2012, there were no Level 3 instruments.

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, 2012 and 2011:

					Purchases,
	Beginning		Gain / (Loss)		Issuances, and		Sales and		Transfers to / (from)			Ending
(dollar amounts in thousands)	Balance		Included in OCI (1)		Settlements		Maturities		Level III			Balance
For the three months ended
September 30, 2012
Obligations of state and municipal securities	$	262	$	-	$	-	$	-	$	(262	)	$	-
September 30, 2011
Obligations of state and municipal securities	$	257	$	2	$	-	$	-	$	-		$	259

						Purchases,
	Beginning		Gain / (Loss)			Issuances, and		Sales and		Transfers to / (from)			Ending
(dollar amounts in thousands)	Balance		Included in OCI (1)			Settlements		Maturities		Level III			Balance
For the nine months ended
September 30, 2012
Obligations of state and municipal securities	$	259	$	3		$	-	$	-	$	(262	)	$	-
Agency mortgage baked securities	-		(191		)	4,674		-		(4,483		)	-
Non-agency mortgage backed securities	3,074		-			-		-		(3,074		)	-
September 30, 2011
Obligations of state and municipal securities	$	283	$	(24	)	$	-	$	-	$	-		$	259

(1) Realized or unrealized gains from the changes in values of Level 3 financial instruments represent gains from changes invalues 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, which are 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.

The following table provides a summary of assets the Company measures at fair value on a non-recurring basis as of September 30, 2012 and December 31, 2011:

	Fair Value Measurements Using
	Quoted Prices in		Significant Other		Significant
	Active Markets for		Observable		Unobservable
(dollar amounts in thousands)	Identical Assets		Inputs		Inputs		Assets At		Total
As of September 30, 2012	(Level 1)		(Level 2)		(Level 3)		Fair Value		(Gains) / Losses
Assets
Impaired loans
Commercial real estate	$	-	$	-	$	185	$	185	$	(152	)
Farmland	-		-		1,084		1,084		5
Commercial and industrial	-		196		794		990		799
Land	-		-		2,546		2,546		3,379
Foreclosed assets	-		615		-		615		-
Total assets measured on a non-recurring basis	$	-	$	811	$	4,609	$	5,420	$	4,031
As of December 31, 2011
Assets
Impaired loans
Residential 1 to 4 family	$	-	$	-	$	95	$	95	$	126
Home equity lines of credit	-		7		-		7		82
Commercial real estate	-		-		3,813		3,813		458
Commercial and industrial	-		511		-		511		113
Agriculture	-		668		1,250		1,918		117
Land	-		56		615		671		113
Installment loans to individuals	-		58		-		58		-
Loans held for sale	-		4,279		-		4,279		-
Foreclosed assets	-		959		-		959		-
Total assets measured on a non-recurring basis	$	-	$	6,538	$	5,773	$	12,311	$	1,009

There were no transfers in or out of Level 1 and Level 2 for assets reported at fair value on either a recurring and nonrecurring basis during the three and nine months ended September 30, 2012, other than transfers of securities from Level 3 into Level 2 once sufficient market data was accumulated to value these new security issues.  There were no significant transfers in or out of Level 1 and Level 2 for assets reported at fair value on both a recurring and nonrecurring basis during the three and nine months ended September 30, 2011.

Fair Value of Financial Instruments

The following table provides a summary of the estimated fair value of financial instruments at September 30, 2012 and December 31, 2011:

			Fair Value Measurements Using
			Quoted Prices in		Significant Other		Significant
			Active Markets for		Observable		Unobservable
(dollar amounts in thousands)	Carrying		Identical Assets		Inputs		Inputs
As of September 30, 2012	Amount		(Level 1)		(Level 2)		(Level 3)		Fair Value
Assets
Cash and cash equivalents	$	44,176	$	44,176	$	-	$	-	$	44,176
Investments and mortgage-backed securities	261,451		-		261,451		-		261,451
Federal Home Loan Bank stock	4,575		-		-		-		N/A
Loans receivable, net of deferred fees and costs	677,371		-		196		687,826		688,022
Loans held for sale	12,590		-		12,590		-		12,590
Accrued interest receivable	3,898		-		1,429		2,469		3,898
Liabilities
Non interest-bearing deposits	267,199		267,199		-		-		267,199
Interest-bearing deposits	587,833		-		588,790		-		588,790
Federal Home Loan Bank advances	46,000		-		46,626		-		46,626
Junior subordinated debentures	8,248		-		-		7,716		7,716
Accrued interest payable	211		-		211		-		211
As of December 31, 2011
Assets
Cash and cash equivalents	$	34,892	$	34,892	$	-	$	-	$	34,892
Investments and mortgage-backed securities	236,982		-		233,649		3,333		236,982
Federal Home Loan Bank stock	4,685		-		-		-		N/A
Loans receivable, net of deferred fees and costs	645,175		-		1,300		645,491		646,791
Loans held for sale	21,947		-		21,947		-		21,947
Accrued interest receivable	3,854		-		1,241		2,613		3,854
Liabilities
Non interest-bearing deposits	217,245		217,245		-		-		217,245
Interest-bearing deposits	568,963		-		569,988		-		569,988
Federal Home Loan Bank advances	51,500		-		52,110		-		52,110
Junior subordinated debentures	8,248		-		-		4,096		4,096
Accrued interest payable	455		-		455		-		455

Information on off-balance sheet instruments as of September 30, 2012 and December 31, 2011 follows:

	September 30, 2012				December 31, 2011
	Notional		Cost to Cede		Notional		Cost to Cede
(dollar amounts in thousands)	Amount		or Assume		Amount		or Assume
Off-balance sheet instruments, commitments to extend credit and standby letters of credit	$	179,726	$	1,797	$	161,987	$	1,620

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Earnings Per Share

9 Months Ended

Sep. 30, 2012

Earnings Per Share

Earnings Per Share

Note 7.  Earnings Per Share

Basic earnings per common share are computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding for the reporting period.  Diluted earnings 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.  The computation of diluted earnings per common share excludes the impacts of the assumed 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.  For the three months ended September 30, 2012 and 2011, common stock equivalents, primarily options, totaling approximately 299,000 shares and 672,000 shares, respectively, were excluded from the calculation of diluted earnings per share, as their impact would be anti-dilutive.  For the nine months ended September 30, 2012 and 2011, common stock equivalents, primarily options, totaling approximately 278,000 shares and 561,000 shares, respectively, were excluded from the calculation of diluted earnings 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 also excludes the impact of approximately 612,000 shares potentially issuable under the warrant issued as part of the Series A Preferred Share issuance (see Note 10. Preferred Stock, of these condensed consolidated financial statements), as their impact would also be anti-dilutive.

The following table sets forth the number of shares used in the calculation of both basic and diluted earnings per common share for the three and nine months ended September 30, 2012 and 2011:

	For the three months ended September 30,
	2012				2011
	Net				Net
(dollar amounts in thousands except per share data)	Income			Shares	Income			Shares
Net income	$	6,428			$	2,119
Dividends and accretion on preferred stock	(357		)		(373		)
Net income  available to common shareholders	$	6,071			$	1,746
Weighted average shares outstanding				25,089,325				25,054,027
Basic earnings per common share	$	0.24			$	0.07
Dilutive effect of share-based compensation awards, common stock warrants, and convertible perpetual preferred stock				1,341,392				1,200,018
Weighted average diluted shares outstanding				26,430,717				26,254,045
Diluted earnings per common share	$	0.23			$	0.07

	For the nine months ended September 30,
	2012				2011
	Net				Net
(dollar amounts in thousands except per share data)	Income			Shares	Income			Shares
Net income	$	9,910			$	3,594
Dividends and accretion on preferred stock	(1,113		)		(1,108		)
Net applicable to common shareholders	$	8,797			$	2,486
Weighted average shares outstanding				25,074,405				25,046,569
Basic earnings per common share	$	0.35			$	0.10
Dilutive effect of share-based compensation awards, common stock warrant, and convertible perpetual preferred stock				1,280,238				1,206,032
Weighted average diluted shares outstanding				26,354,643				26,252,601
Diluted earnings per common share	$	0.33			$	0.10

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Share-Based Compensation Plans

9 Months Ended

Sep. 30, 2012

Share-Based Compensation Plans

Share-Based Compensation Plans

Note 8.  Share-Based Compensation Plans

As of September 30, 2012, the Company had two share-based employee compensation plans, which are more fully described in Note 15. Share-Based Compensation Plans, of the consolidated financial statements in the Company’s Annual Report filed on Form 10-K for the year ended December 31, 2011.  These plans include the “1997 Stock Option Plan” and the “2005 Equity Based Compensation Plan.”

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,
(dollar amounts in thousands)	2012		2011		2012		2011
Share-based compensation expense:
Stock option expense	$	39	$	58	$	92	$	179
Restricted stock expense	67		8		142		34
Total expense	$	106	$	66	$	234	$	213
Unrecognized compensation expense:
Stock option expense	$	620	$	435
Restricted stock expense	624		56
Total unrecognized expense	$	1,244	$	491

At September 30, 2012, there was a total of $0.6 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 3.2 years.

The Company grants restricted share awards periodically for the benefit of employees. These restricted shares generally vest over a period of three to five years depending on the terms of the grant.  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, 2012 was $0.6 million.  That expense is expected to be recognized over the next 2.8 years.

The following table provides a summary of activity related to options granted, exercised, and forfeited during the year to date period ended September 30, 2012:

	Options Outstanding				Options
	Number		Weighted Average		Available for
	of Shares		Exercise Price		Grant
Balance, December 31, 2011	636,406		$	5.40	1,826,516
Granted	195,441		5.42
Forfeited	(196,249	)	4.16
Expired	(36,480	)	5.92
Exercised	(40,999	)	3.17
Balance, September 30, 2012	558,119		$	5.97	1,674,924

The following table provides a summary of activity related to restricted stock granted, vested and forfeited during the year to date period ended September 30, 2012:

	Number of		Average Grant
	Shares		Date Fair Value
Balance December 31, 2011	91,513		$	3.23
Granted	108,514		5.11
Forfeited	(6,800	)	4.22
Balance September 30, 2012	193,227		$	4.25

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 aggregate intrinsic value of options exercised was $67 thousand for the year to date period ended September 30, 2012.  The following table provides a summary of the aggregate intrinsic value of options vested and expected to vest and exercisable.

				Weighted Average
		Weighted		Remaining	Aggregate
		Average		Contractual Life	Intrinsic
	Shares	Exercise Price		(Years)	Value
Vested or expected to vest	530,213	$	5.97	7.75	$	636,975
Exerciseable at September 30, 2012	274,229	$	7.21	3.24	$	387,744

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 2012 and 2011:

	For the nine months ended
	September 30,
	2012		2011
Expected volatility	52.26%		50.73%
Expected term (years)	7		7
Dividend yield	0.00%		0.00%
Risk free rate	1.11%		2.74%
Weighted-average grant date fair value	$	2.87	$	2.00

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Preferred Stock

9 Months Ended

Sep. 30, 2012

Preferred Stock

Preferred Stock

Note 10.  Preferred Stock

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.

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

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 market price of the Company’s stock is above the warrant’s exercise price.

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, 2012, 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.

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.  During the second quarter of 2012, the Company received regulatory approval to pay its second quarter 2012 dividend and all prior deferred dividends and has remained current as to the payment of dividends  as of September 30, 2012. The Treasury’s rights relative to electing two members to the Company’s Board of Directors and their Board observation rights lapsed upon the payment of the dividends in arrears in the second quarter of 2012.

Series C Convertible Perpetual Preferred Stock

On March 12, 2010, the Company sold 1,189,538 shares of its Series C Convertible Perpetual Preferred Stock (“Series C Preferred Stock”) for $3.6 million as part of the overall $60 million private placement of securities completed at that time.  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.  There is no stated dividend rate for shares of Series C Preferred Stock.  However, in the event that a common stock dividend is declared, holders of Series C Preferred Stock are entitled to a per share dividend equivalent to that declared for each common share into which Series C Preferred Stock is then convertible.

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 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, 2012.

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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Loans (Details 2) (USD $)	3 Months Ended		9 Months Ended
	Sep. 30, 2012	Sep. 30, 2011	Sep. 30, 2012	Sep. 30, 2011	Dec. 31, 2011
Investment in impaired loans
Recorded Investment	$ 20,510,000		$ 20,510,000		$ 13,404,000
Unpaid Principal Balance	30,278,000		30,278,000		15,918,000
Impaired Loans With Specific Allowance	10,653,000		10,653,000		8,913,000
Impaired Loans Without Specific Allowance	9,857,000		9,857,000		4,491,000
Specific Allowance for Impaired Loans	4,617,000		4,617,000		2,217,000
Average Recorded Investment	19,609,000	21,029,000	17,939,000	24,860,000
Interest Income Recognized		21,000	4,000	22,000
Increase in interest income if interest on non-accruing loans had been recognized at original interest rates stipulated in the respective loan agreements	300,000	300,000	1,000,000	1,400,000
Real Estate Secured | Residential 1 to 4 family
Investment in impaired loans
Recorded Investment	904,000		904,000		622,000
Unpaid Principal Balance	1,163,000		1,163,000		895,000
Impaired Loans With Specific Allowance	139,000		139,000		153,000
Impaired Loans Without Specific Allowance	765,000		765,000		469,000
Specific Allowance for Impaired Loans	11,000		11,000		53,000
Average Recorded Investment	801,000	568,000	756,000	613,000
Real Estate Secured | Home equity lines of credit
Investment in impaired loans
Recorded Investment	381,000		381,000		359,000
Unpaid Principal Balance	473,000		473,000		443,000
Impaired Loans With Specific Allowance	62,000		62,000
Impaired Loans Without Specific Allowance	319,000		319,000		359,000
Specific Allowance for Impaired Loans	7,000		7,000
Average Recorded Investment	384,000	808,000	378,000	861,000
Real Estate Secured | Commercial
Investment in impaired loans
Recorded Investment	4,468,000		4,468,000		4,567,000
Unpaid Principal Balance	8,265,000		8,265,000		5,513,000
Impaired Loans With Specific Allowance	255,000		255,000		3,876,000
Impaired Loans Without Specific Allowance	4,213,000		4,213,000		691,000
Specific Allowance for Impaired Loans	27,000		27,000		738,000
Average Recorded Investment	3,492,000	10,354,000	3,757,000	12,346,000
Real Estate Secured | Farmland
Investment in impaired loans
Recorded Investment	1,089,000		1,089,000
Unpaid Principal Balance	1,089,000		1,089,000
Impaired Loans With Specific Allowance	1,089,000		1,089,000
Specific Allowance for Impaired Loans	5,000		5,000
Average Recorded Investment	363,000	577,000	272,000	1,090,000
Commercial | Commercial and industrial
Investment in impaired loans
Recorded Investment	3,247,000		3,247,000		2,183,000
Unpaid Principal Balance	4,473,000		4,473,000		2,879,000
Impaired Loans With Specific Allowance	2,656,000		2,656,000		1,928,000
Impaired Loans Without Specific Allowance	591,000		591,000		255,000
Specific Allowance for Impaired Loans	1,096,000		1,096,000		1,169,000
Average Recorded Investment	4,129,000	2,992,000	3,644,000	3,708,000
Interest Income Recognized		21,000	4,000	22,000
Commercial | Agriculture
Investment in impaired loans
Recorded Investment	1,075,000		1,075,000		2,789,000
Unpaid Principal Balance	1,253,000		1,253,000		2,932,000
Impaired Loans With Specific Allowance	50,000		50,000		2,166,000
Impaired Loans Without Specific Allowance	1,025,000		1,025,000		623,000
Specific Allowance for Impaired Loans	21,000		21,000		140,000
Average Recorded Investment	1,905,000	883,000	2,010,000	724,000
Construction | Single family residential
Investment in impaired loans
Recorded Investment					937,000
Unpaid Principal Balance					937,000
Impaired Loans Without Specific Allowance					937,000
Average Recorded Investment		1,174,000	234,000	1,209,000
Construction | Single family residential - Spec.
Investment in impaired loans
Average Recorded Investment				313,000
Construction | Multi-family
Investment in impaired loans
Average Recorded Investment				120,000
Construction | Commercial
Investment in impaired loans
Recorded Investment	1,840,000		1,840,000
Unpaid Principal Balance	2,508,000		2,508,000
Impaired Loans Without Specific Allowance	1,840,000		1,840,000
Average Recorded Investment	1,257,000		943,000
Land
Investment in impaired loans
Recorded Investment	7,301,000		7,301,000		1,886,000
Unpaid Principal Balance	10,829,000		10,829,000		2,258,000
Impaired Loans With Specific Allowance	6,197,000		6,197,000		729,000
Impaired Loans Without Specific Allowance	1,104,000		1,104,000		1,157,000
Specific Allowance for Impaired Loans	3,434,000		3,434,000		114,000
Average Recorded Investment	7,189,000	3,669,000	5,863,000	3,780,000
Installment loans to individuals
Investment in impaired loans
Recorded Investment	205,000		205,000		61,000
Unpaid Principal Balance	225,000		225,000		61,000
Impaired Loans With Specific Allowance	205,000		205,000		61,000
Specific Allowance for Impaired Loans	16,000		16,000		3,000
Average Recorded Investment	$ 89,000	$ 4,000	$ 82,000	$ 96,000

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Condensed Consolidated Financial Statements (Policies)

9 Months Ended

Sep. 30, 2012

Condensed Consolidated Financial Statements

Recent Accounting Guidance Adopted

Recent Accounting Guidance Adopted

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.  Other than the additional disclosure included in the new stand-alone statement of other comprehensive income, the Company’s adoption of this standard in the first quarter of 2012 did not 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. Other than the additional disclosures included in Note 9. Fair Value of Assets and Liabilities, the Company’s adoption of this standard in the first quarter of 2012 did not have a significant impact on the Company’s consolidated financial statements.

Recent Accounting Guidance Not Yet Effective

Recent Accounting Guidance Not Yet Effective

On July 27, 2012, the FASB issued ASU No. 2012-02, Intangibles-Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment.  This update, like ASU 2011-08 which the Company adopted in 2011, allows companies the option to first evaluate qualitative factors to determine if events or circumstances exist that indicate that it is more likely than not that an indefinite-lived intangible asset is impaired.  If based on this assessment, a company concludes that there are no indicators that suggest an indefinitely-lived asset is more likely than not of having been impaired, then no further quantitative analysis is required.  The amendments are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted, including for annual and interim impairment tests performed as of a date before July 27, 2012, if a public entity’s financial statements for the most recent annual or interim period have not yet been issued or, for nonpublic entities, have not yet been made available for issuance. The Company currently does not have any indefinitely-lived intangible assets, other than goodwill, therefore adoption of this ASU is not expected to have a material impact on the Company’s consolidated financial statements.

On October 1, 2012, the FASB issued ASU No. 2012-04, Technical Corrections and Improvements.  The amendments in ASU 2012-04 cover a wide range of Topics in the Codification and address technical corrections and improvements and conforming amendments related to fair value measurements.  For public entities, the amendments that are subject to the transition guidance will be effective for fiscal periods beginning after December 15, 2012.  The Company is evaluating the impacts of these corrections but does not expect them to have a material impact on the Company’s consolidated financial statements.

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Earnings Per Share (Tables)

9 Months Ended

Sep. 30, 2012

Earnings Per Share

Schedule of calculation of both basic and diluted earnings/ (loss) per common share

	For the three months ended September 30,
	2012				2011
	Net				Net
(dollar amounts in thousands except per share data)	Income			Shares	Income			Shares
Net income	$	6,428			$	2,119
Dividends and accretion on preferred stock	(357		)		(373		)
Net income  available to common shareholders	$	6,071			$	1,746
Weighted average shares outstanding				25,089,325				25,054,027
Basic earnings per common share	$	0.24			$	0.07
Dilutive effect of share-based compensation awards, common stock warrants, and convertible perpetual preferred stock				1,341,392				1,200,018
Weighted average diluted shares outstanding				26,430,717				26,254,045
Diluted earnings per common share	$	0.23			$	0.07

	For the nine months ended September 30,
	2012				2011
	Net				Net
(dollar amounts in thousands except per share data)	Income			Shares	Income			Shares
Net income	$	9,910			$	3,594
Dividends and accretion on preferred stock	(1,113		)		(1,108		)
Net applicable to common shareholders	$	8,797			$	2,486
Weighted average shares outstanding				25,074,405				25,046,569
Basic earnings per common share	$	0.35			$	0.10
Dilutive effect of share-based compensation awards, common stock warrant, and convertible perpetual preferred stock				1,280,238				1,206,032
Weighted average diluted shares outstanding				26,354,643				26,252,601
Diluted earnings per common share	$	0.33			$	0.10

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Asset Acquisition (Details) (Coast National Bank, Scenario forecast, USD $) In Millions, unless otherwise specified	Sep. 30, 2012
Coast National Bank | Scenario forecast
Asset acquisition
Expected purchase price	$ 1.7
Purchase price of building and related assets	1.0
Purchase price of deposit being assumed	0.7
Expected receipt of cash related to the deposits	$ 30

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Share-Based Compensation Plans (Details) (USD $)	3 Months Ended		9 Months Ended
	Sep. 30, 2012	Sep. 30, 2011	Sep. 30, 2012	Sep. 30, 2011	Dec. 31, 2011
Share-Based Compensation Plans
Number of share-based employee compensation plans	2		2
Summary of the expenses the Company has recognized related to share-based compensation
Share-based compensation expense	$ 106,000	$ 66,000	$ 234,000	$ 213,000
Unrecognized compensation expense	1,244,000	491,000	1,244,000	491,000
Stock option
Summary of the expenses the Company has recognized related to share-based compensation
Share-based compensation expense	39,000	58,000	92,000	179,000
Unrecognized compensation expense	620,000	435,000	620,000	435,000
Weighted-average period over which expense is expected to be recognized			3 years 2 months 12 days
Options Available for Grant (in shares)	1,674,924		1,674,924		1,826,516
Number of shares
Options outstanding, at the beginning of the period (in shares)			636,406
Granted (in shares)			195,441
Forfeited (in shares)			(196,249)
Expired (in shares)			(36,480)
Exercised (in shares)			(40,999)
Options outstanding, at the end of the period (in shares)	558,119		558,119
Weighted Average Exercise Price
Options outstanding, at the beginning of the period (in dollars per share)			$ 5.40
Granted (in dollars per share)			$ 5.42
Forfeited (in dollars per share)			$ 4.16
Expired (in dollars per share)			$ 5.92
Exercised (in dollars per share)			$ 3.17
Options outstanding, at the end of the period (in dollars per share)	$ 5.97		$ 5.97
Aggregate intrinsic of options exercised
Aggregate intrinsic of options exercised			67,000
Aggregate intrinsic value of options vested and expected to vest
Shares	530,213		530,213
Weighted Average Exercise Price (in dollars per share)	$ 5.97		$ 5.97
Weighted Average Remaining Contractual Life			7 years 9 months
Aggregate Intrinsic Value	636,975		636,975
Aggregate intrinsic value of options exercisable
Shares	274,229		274,229
Weighted Average Exercise Price (in dollars per share)	$ 7.21		$ 7.21
Weighted Average Remaining Contractual Life			3 years 2 months 26 days
Aggregate Intrinsic Value	387,744		387,744
Assumptions used in the calculation of the weighted average fair value of options granted
Expected volatility (as a percent)			52.26%	50.73%
Expected term			7 years	7 years
Dividend yield (as a percent)			0.00%	0.00%
Risk free rate (as a percent)			1.11%	2.74%
Weighted-average grant date fair value (in dollars per share)			$ 2.87	$ 2.00
Restricted stock
Summary of the expenses the Company has recognized related to share-based compensation
Share-based compensation expense	67,000	8,000	142,000	34,000
Unrecognized compensation expense	$ 624,000	$ 56,000	$ 624,000	$ 56,000
Weighted-average period over which expense is expected to be recognized			2 years 9 months 18 days
Number of Shares
Balance at the beginning of the period (in shares)			91,513
Granted (in shares)			108,514
Forfeited (in shares)			(6,800)
Balance at the end of the period (in shares)	193,227		193,227
Average Grant Date fair Value
Balance at the beginning of the period (in dollars per share)			$ 3.23
Granted (in dollars per share)			$ 5.11
Forfeited (in dollars per share)			$ 4.22
Balance at the end of the period (in dollars per share)	$ 4.25		$ 4.25
Restricted stock | Minimum
Summary of the expenses the Company has recognized related to share-based compensation
Period of vesting of shares after issuance			3 years
Restricted stock | Maximum
Summary of the expenses the Company has recognized related to share-based compensation
Period of vesting of shares after issuance			5 years

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Condensed Consolidated Statements of Comprehensive Income (USD $) In Thousands, unless otherwise specified	3 Months Ended		9 Months Ended
	Sep. 30, 2012	Sep. 30, 2011	Sep. 30, 2012	Sep. 30, 2011
Net income	$ 6,428	$ 2,119	$ 9,910	$ 3,594
Other comprehensive income:
Unrealized security holding gains	2,477	137	7,240	4,519
Reclassification for net gains on investments included in earnings	(329)	(595)	(1,696)	(1,187)
Other comprehensive income / (loss), before tax	2,148	(458)	5,544	3,332
Income tax expense / (benefit) related to items of other comprehensive income	883	(189)	2,281	1,369
Other comprehensive income / (loss)	1,265	(269)	3,263	1,963
Comprehensive income	$ 7,693	$ 1,850	$ 13,173	$ 5,557

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Allowance for Loan Losses

9 Months Ended

Sep. 30, 2012

Allowance for Loan Losses

Allowance for Loan Losses

Note 4.  Allowance for Loan Losses

The Company has established an allowance for loan losses to account for probable losses inherent in the loan portfolio as of the date of the balance sheet.  The allowance is comprised of two components: specific credit allocation and general portfolio allocation, which includes a qualitatively determined adjustment.  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 quantitative portfolio allocation is then adjusted for qualitatively determined adjustments that are determined through judgments the Company makes regarding certain qualitative factors that may positively or negatively impact the credit quality of various segments of the loan portfolio relative to the historical performance of those segments.

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 and placed on non-accrual, the Company places the loan under the supervision of its Special Assets department.  The Special Assets department, with oversight from the Chief Credit Officer, 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. Loans, of the notes to the condensed consolidated financial statements.  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.

The qualitatively determined adjustment to the general portfolio 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 possesses 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.

The following table summarizes the activity in the allowance attributed to various segments in the loan portfolio for the three months ended September 30, 2012 and 2011:

	Real Estate															All Other
(dollar amounts in thousands)	Secured			Commercial			Construction			Land			Installment			Loans			Total
Balance, June 30, 2012	$	6,897		$	6,261		$	381		$	4,483		$	91		$	36		$	18,149
Charge-offs	(106		)	(1,511		)	(92		)	-			(9		)	-			(1,718		)
Recoveries	12			246			1			5			5			1			270
Provisions for loan losses	1,184			75			268			(225		)	(15		)	(1		)	1,286
Balance, September 30, 2012	$	7,987		$	5,071		$	558		$	4,263		$	72		$	36		$	17,987
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
Provisions 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

The following table summarizes the activity in the allowance attributed to various segments in the loan portfolio for the nine months ended September 30, 2012 and 2011:

	Real Estate															All Other
(dollar amounts in thousands)	Secured			Commercial			Construction			Land			Installment			Loans			Total
Balance, December 31, 2011	$	9,645		$	6,549		$	488		$	2,416		$	175		$	41		$	19,314
Charge-offs	(2,471		)	(4,272		)	(668		)	(2,168		)	(29		)	(137		)	(9,745		)
Recoveries	74			623			1			18			18			3			737
Provisions for loan losses (1)	739			2,171			737			3,997			(92		)	129			7,681
Balance, September 30, 2012	$	7,987		$	5,071		$	558		$	4,263		$	72		$	36		$	17,987
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
Provisions 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

(1) The provision for loan losses includes the transfer of $3.9 million from C&I to land related to the re-characterization of a loan as part of a TDR in the second quarter of 2012, as the restructured loan became more collateral dependent on a parcel of land.

The following tables summarize comparative metrics about the allowance attributed to various segments in the loan portfolio as of September 30, 2012 and December 31, 2011:

	As of September 30, 2012
	Real Estate										All Other
(dollar amounts in thousands)	Secured		Commercial		Construction		Land		Installment		Loans		Total
Amount of allowance attributed to:
Specifically evaluated impaired loans	$	50	$	1,117	$	-	$	3,434	$	16	$	-	$	4,617
General portfolio allocation	$	7,937	$	3,954	$	558	$	829	$	56	$	36	$	13,370
Loans individually evaluated for impairment	$	6,805	$	4,336	$	1,840	$	7,300	$	206	$	-	$	20,487
Loans collectively evaluated for impairment	$	478,098	$	133,174	$	25,035	$	16,333	$	4,940	$	281	$	657,861
General reserves to total loans collectively evaluated for impairment	1.66%		2.97%		2.23%		5.08%		1.13%		12.81%		2.03%
Total gross loans	$	484,903	$	137,510	$	26,875	$	23,633	$	5,146	$	281	$	678,348
Total allowance to gross loans	1.65%		3.69%		2.08%		18.04%		1.40%		12.81%		2.65%

	As of December 31, 2011
	Real Estate										All Other
(dollar amounts in thousands)	Secured		Commercial		Construction		Land		Installment		Loans		Total
Amount of allowance attributed to:
Specifically evaluated impaired loans	$	791	$	1,309	$	-	$	114	$	3	$	-	$	2,217
General portfolio allocation	$	8,854	$	5,240	$	488	$	2,302	$	172	$	41	$	17,097
Loans individually evaluated for impairment	$	5,532	$	4,963	$	937	$	1,886	$	61	$	-	$	13,379
Loans collectively evaluated for impairement	$	427,923	$	151,931	$	21,794	$	24,568	$	6,418	$	273	$	632,907
General reserves to total loans collectively evaluated evaluated for impairment	2.07%		3.45%		2.24%		9.37%		2.68%		15.02%		2.70%
Total gross loans	$	433,455	$	156,894	$	22,731	$	26,454	$	6,479	$	273	$	646,286
Total allowance to gross loans	2.23%		4.17%		2.15%		9.13%		2.70%		15.02%		2.99%

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Share-Based Compensation Plans (Tables)

9 Months Ended

Sep. 30, 2012

Share-Based Compensation Plans

Summary of recognized and unrecognized share based compensation expense

	For the three months ended				For the nine months ended
	September 30,				September 30,
(dollar amounts in thousands)	2012		2011		2012		2011
Share-based compensation expense:
Stock option expense	$	39	$	58	$	92	$	179
Restricted stock expense	67		8		142		34
Total expense	$	106	$	66	$	234	$	213
Unrecognized compensation expense:
Stock option expense	$	620	$	435
Restricted stock expense	624		56
Total unrecognized expense	$	1,244	$	491

Summary of activity related to options granted, exercised, and forfeited

	Options Outstanding				Options
	Number		Weighted Average		Available for
	of Shares		Exercise Price		Grant
Balance, December 31, 2011	636,406		$	5.40	1,826,516
Granted	195,441		5.42
Forfeited	(196,249	)	4.16
Expired	(36,480	)	5.92
Exercised	(40,999	)	3.17
Balance, September 30, 2012	558,119		$	5.97	1,674,924

Summary of activity related to restricted stock granted, vested and forfeited during the year

	Number of		Average Grant
	Shares		Date Fair Value
Balance December 31, 2011	91,513		$	3.23
Granted	108,514		5.11
Forfeited	(6,800	)	4.22
Balance September 30, 2012	193,227		$	4.25

Summary of the aggregate intrinsic value of options vested and expected to vest and exercisable

				Weighted Average
		Weighted		Remaining	Aggregate
		Average		Contractual Life	Intrinsic
	Shares	Exercise Price		(Years)	Value
Vested or expected to vest	530,213	$	5.97	7.75	$	636,975
Exerciseable at September 30, 2012	274,229	$	7.21	3.24	$	387,744

Schedule of assumptions used in the calculation of weighted average fair value of options granted

	For the nine months ended
	September 30,
	2012		2011
Expected volatility	52.26%		50.73%
Expected term (years)	7		7
Dividend yield	0.00%		0.00%
Risk free rate	1.11%		2.74%
Weighted-average grant date fair value	$	2.87	$	2.00

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Other Real Estate Owned ("OREO") (Details) (USD $) In Thousands, unless otherwise specified	3 Months Ended		9 Months Ended		3 Months Ended		9 Months Ended		3 Months Ended	9 Months Ended				9 Months Ended	3 Months Ended		9 Months Ended					3 Months Ended		9 Months Ended
	Sep. 30, 2012	Sep. 30, 2011	Sep. 30, 2012	Sep. 30, 2011	Sep. 30, 2012 Real Estate Secured Residential 1 to 4 family	Sep. 30, 2011 Real Estate Secured Residential 1 to 4 family	Sep. 30, 2012 Real Estate Secured Residential 1 to 4 family	Sep. 30, 2011 Real Estate Secured Residential 1 to 4 family	Sep. 30, 2011 Real Estate Secured Commercial	Sep. 30, 2011 Real Estate Secured Commercial	Sep. 30, 2012 Real Estate Secured Commercial	Jun. 30, 2012 Real Estate Secured Commercial	Dec. 31, 2011 Real Estate Secured Commercial	Sep. 30, 2011 Commercial Commercial and industrial	Sep. 30, 2012 Construction Single family residential - Spec.	Sep. 30, 2011 Construction Single family residential - Spec.	Sep. 30, 2012 Construction Single family residential - Spec.	Sep. 30, 2011 Construction Single family residential - Spec.	Sep. 30, 2012 Construction Tract	Sep. 30, 2011 Construction Tract	Jun. 30, 2011 Construction Tract	Sep. 30, 2012 Land	Sep. 30, 2011 Land	Sep. 30, 2012 Land	Sep. 30, 2011 Land
Other Real Estate Owned ("OREO")
Other Real Estate Owned, balance at the beginning of the period	$ 1,075	$ 3,587	$ 917	$ 6,668	$ 431			$ 160	$ 2,385	$ 3,953	$ 215	$ 215	$ 215	$ 464	$ 397	$ 444	$ 423	$ 475	$ 100	$ 251	$ 242	$ 32	$ 516	$ 179	$ 1,365
Additions		865	769	3,484		865	607	865		2,578														162	41
Disposals	(397)	(2,172)	(973)	(6,993)		(865)	(176)	(1,025)	(1,124)	(4,510)				(464)	(397)		(397)		(100)				(183)	(300)	(994)
Writedowns	(63)	(89)	(98)	(968)	(31)		(31)		(56)	(816)						(21)	(26)	(52)		(9)		(32)	(12)	(41)	(91)
Other Real Estate Owned, balance at the end of the period	615	2,191	615	2,191	400		400		1,205	1,205	215	215	215			423		423		242	242		321		321
Gain (loss) on disposals of OREO	$ 102	$ (266)	$ 112	$ (587)

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Subsequent Events

9 Months Ended

Sep. 30, 2012

Subsequent Events

Subsequent Events

Note 14.  Subsequent Events

In October 2012, a $3.9 million loan which had been reported as classified and non-performing as of September 30, 2012 was paid off, which resulted in a $1.1 million recovery to the allowance for loan losses.