10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2009.

or

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

For the transition period from _______ to _______.

Commission File Number:  000-25020

HERITAGE OAKS BANCORP

 (Exact name of registrant as specified in its charter)

California	77-0388249
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
545 12th Street,
Paso Robles, California	93446
(Address of principal 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 twelve (12) months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES x     NO ¨

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

YES ¨     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 x     Non-accelerated filer ¨    Smaller reporting company ¨

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

YES ¨      NO x

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:  As of November 2, 2009 there were 7,759,718 shares outstanding of the Registrant’s common stock.

	Page
Part I.  Financial Information	3
Item 1.  Consolidated Financial Statements (un-audited, except for Balance Sheet as of 12/31/2008)	3
Consolidated Balance Sheets	4
Consolidated Statements of Income	5
Consolidated Statements of Stockholders' Equity	6
Consolidated Statements of Comprehensive Income	7
Consolidated Statements of Cash Flows	8
Notes to Consolidated Financial Statements	9
Note 1.  Consolidated Financial Statements	9
Note 2.  Investment Securities	9
Note 3.  Loans and the Allowance for Loan Losses	11
Note 4.  Earnings Per Share	12
Note 5.  Recent Accounting Pronouncements	13
Note 6.  Share-Based Compensation	16
Note 7.  Fair Value Disclosures	18
Note 8.  Fair Value of Financial Instruments	20
Note 9.  Preferred Stock	22
Note 10.  Subsequent Events	23
Note 11.  Reclassifications	23
Forward Looking Statements	24
Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations	25
The Company	25
Where You Can Find More Information	25
Executive Summary	26
Recent Developments	28
Dividends and Stock Repurchases	29
Selected Financial Data	29
Local Economy	30
Critical Accounting Policies	30
Results of Operations	32
Net Interest Income and Margin	33
Non-Interest Income	38
Non-Interest Expenses	40
Provision for Income Taxes	41
Provision for Loan Losses	42
Financial Condition	44
Loans	44
Allowance for Loan Losses	49
Non-Performing Assets	50
Total Cash and Cash Equivalents	54
Investment Securities and Other Earning Assets	54
Deposits and Borrowed Funds	56
Capital	57
Liquidity	60
Inflation	61
Off-Balance Sheet Arrangements	61
Item 3.  Quantative and Qualitative Disclosure About Market Risk	62
Item 4.  Controls and Procedures	63
Part II.  Other Information	64
Item 1.  Legal Proceedings	64
Item 1A.  Risk Factors	64
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds	68
Item 3.  Defaults upon Senior Securities	68
Item 4.  Submission of Matters to a Vote of Security Holders	68
Item 5.  Other Information	68
Item 6.  Exhibits	68
Signatures	69

Heritage Oaks Bancorp | - 2 -

Part I.  Financial Information

Item 1. Consolidated Financial Statements

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

Heritage Oaks Bancorp | - 3 -

Heritage Oaks Bancorp

and Subsidiaries

Consolidated Balance Sheets

				(audited)
	September 30,			December 31,
(dollars in thousands except per share data)	2009			2008
Assets
Cash and due from banks	$	18,155		$	17,921
Federal funds sold		45,740			6,650
Total cash and cash equivalents		63,895			24,571
Interest bearing deposits with other banks		119			119
Securities available for sale		102,871			50,762
Federal Home Loan Bank stock, at cost		5,828			5,123
Loans held for sale		7,778			7,939
Loans, net of deferred fees of $1,635 and $1,701 and allowance for loan loss of $15,873 and $10,412 at September 30, 2009 and		692,359			668,034
December 31, 2008, respectively.
Property, premises and equipment, net		6,984			6,827
Deferred tax assets		12,379			7,708
Bank owned life insurance		11,432			10,737
Goodwill		11,049			11,049
Core deposit intangible		2,904			3,691
Other real estate owned		2,607			1,337
Other assets		6,600			7,691
Total assets	$	926,805		$	805,588
Liabilities
Deposits
Demand, non-interest bearing	$	181,670		$	147,044
Savings, NOW, and money market deposits		329,186			296,488
Time deposits of $100 or more		125,230			75,111
Time deposits under $100		117,443			84,878
Total deposits		753,529			603,521
Short term FHLB borrowing		65,000			99,000
Long term FHLB borrowing		-			10,000
Securities sold under agreement to repurchase		-			2,796
Junior subordinated debentures		13,403			13,403
Other liabilities		7,087			6,836
Total liabilities		839,019			735,556
Commitments and contingencies		-			-
Stockholders' Equity
Senior preferred stock, no par value; $1,000 per share stated value 5,000,000 shares authorized, 21,000 and 0 issued and outstanding as of September 30, 2009 and December 31, 2008, respectively.		19,341			-
Common stock, no par value; 20,000,000 shares authorized, issued and outstanding 7,760,505 and 7,753,078 as of September 30, 2009 and December 31, 2008, respectively.		48,695			48,649
Additional paid in capital		3,172			1,055
Retained earnings		17,174			21,420
Accumulated other comprehensive loss, net of tax benefit of $417 and $763 as of September 30, 2009 and December 31, 2008, respectively.		(596	)		(1,092	)
Total stockholders' equity		87,786			70,032
Total liabilities and stockholders' equity	$	926,805		$	805,588

See notes to condensed consolidated financial statements.

Heritage Oaks Bancorp | - 4 -

Heritage Oaks Bancorp

and Subsidiaries

Consolidated Statements of Income

	For the three months					For the nine months
	ended September 30,					ended September 30,
(dollars in thousands except per share data)	2009			2008		2009			2008
Interest Income
Interest and fees on loans	$	10,703		$	11,731	$	33,266		$	35,554
Interest on investment securities
Mortgage backed securities		871			515		2,044			1,481
Obligations of state and political subdivisions		247			186		641			555
Interest on time deposits with other banks		1			1		3			7
Interest on federal funds sold		21			18		38			130
Interest on other securities		17			85		33			200
Total interest income		11,860			12,536		36,025			37,927
Interest Expense
Interest on savings, NOW and money market deposits		984			886		2,640			3,412
Interest on time deposits in denominations of $100 or more		695			620		1,870			1,825
Interest on time deposits under $100		675			702		1,903			2,276
Other borrowings		241			803		938			2,180
Total interest expense		2,595			3,011		7,351			9,693
Net interest income before provision for possible loan losses		9,265			9,525		28,674			28,234
Provision for possible loan losses		9,756			3,200		14,566			6,215
Net interest (loss) / income after provision for possible loan losses		(491	)		6,325		14,108			22,019
Non Interest Income
Fees and service charges		750			878		2,214			2,487
Gain on sale of investment securities		211			-		333			37
Loss on sale of OREO		(200	)		-		(331	)		-
Gain on sale of SBA loans		70			-		70			-
Other		762			635		2,467			2,184
Total non interest income		1,593			1,513		4,753			4,708
Non Interest Expenses
Salaries and employee benefits		3,969			3,651		11,517			11,897
Equipment		365			335		1,066			1,053
Occupancy		843			741		2,521			2,291
Other		5,074			2,381		10,586			6,985
Total non interest expenses		10,251			7,108		25,690			22,226
(Loss) / income before provision for income taxes		(9,149	)		730		(6,829	)		4,501
Provision for income taxes		(3,907	)		196		(3,196	)		1,601
Net (loss) / income		(5,242	)		534		(3,633	)		2,900
Dividends and accretion on preferred stock		352			-		613			-
Net (loss) / income available to common shareholders	$	(5,594	)	$	534	$	(4,246	)	$	2,900
(Loss) / Earnings Per Common Share
Basic	$	(0.73	)	$	0.07	$	(0.56	)	$	0.38
Diluted	$	(0.73	)	$	0.07	$	(0.56	)	$	0.37

See notes to condensed consolidated financial statements.

Heritage Oaks Bancorp | - 5 -

Heritage Oaks Bancorp

and Subsidiaries

Consolidated Statements of Stockholders' Equity

																		Accumulated
	Preferred Stock				Common Stock					Additional								Other			Total
	Number of				Number of					Paid-In		Comprehensive			Retained			Comprehensive			Stockholders'
(dollars in thousands)	Shares		Amount		Shares			Amount		Capital		Income			Earnings			Income			Equity
Balance, December 31, 2008		-	$	-		7,753,078		$	48,649	$	1,055				$	21,420		$	(1,092	)	$	70,032
Issuance of preferred stock and common stock warrant		21,000		19,152							1,848											21,000
Amortization of discount on preferred stock				189												(189	)					-
Dividends paid on preferred stock																(424	)					(424	)
Exercise of stock options																						-
(including $9 excess tax benefit																						-
from exercise of stock options)						10,050			46													46
Share-based compensation expense											269											269
Retirement of restricted share awards						(2,623	)
Comprehensive income:
Net loss												$	(3,633	)		(3,633	)					(3,633	)
Unrealized security holding gains (net of $483 tax)													692						692			692
Realized gains on sale of securities (net of $137 tax)													(196	)					(196	)		(196	)
Total comprehensive loss												$	(3,137	)
Balance, September 30, 2009		21,000	$	19,341		7,760,505		$	48,695	$	3,172				$	17,174		$	(596	)	$	87,786
Balance, December 31, 2007		-	$	-		7,317,932		$	43,996	$	672				$	24,598		$	184		$	69,450
Exercise of stock options (including $88 excess tax benefit from exercise of stock options)						31,228			228													228
5% Stock Dividend distributed May 16, 2008						366,344			4,232							(4,232	)					-
Cash paid in lieu of fractional shares																(5	)					(5	)
Cash dividends - $0.08 per share																(586	)					(586	)
Share-based compensation expense											275											275
Issuance of restricted stock awards						1,000																-
Retirement of restricted share awards						(6,904	)															-
Comprehensive income:
Net income												$	2,900			2,900						2,900
Unrealized security holding losses (net of $900 tax benefit)													(1,286	)					(1,286	)		(1,286	)
Realized gains on sale of securities (net of $15 tax)													(22	)					(22	)		(22	)
Total comprehensive income												$	1,592
Balance, September 30, 2008		-	$	-		7,709,600		$	48,456	$	947				$	22,675		$	(1,124	)	$	70,954

See notes to condensed consolidated financial statements.

Heritage Oaks Bancorp | - 6 -

Heritage Oaks Bancorp

and Subsidiaries

Consolidated Statements of Comprehensive Income

	For the three months						For the nine months
	ended September 30,						ended September 30,
(dollars in thousands)	2009			2008			2009			2008
Net (loss) / income	$	(5,242	)	$	534		$	(3,633	)	$	2,900
Other comprehensive gain / (loss) before taxes
Unrealized gains / (losses) on securities available for sale		3,427			(953	)		1,175			(2,186	)
Realized (gains) on sale of available for sale securities		(211	)		-			(333	)		(37	)
Total other comprehensive gain / (loss) before taxes		3,216			(953	)		842			(2,223	)
Unrealized income tax (expense) / benefit related to items in comprehensive (loss) / income		(1,410	)		392			(483	)		900
Income tax related to the sale of available for sale securities		87			-			137			15
Total other comprehensive income / (loss), net of taxes		1,893			(561	)		496			(1,308	)
Total comprehensive (loss) / income	$	(3,349	)	$	(27	)	$	(3,137	)	$	1,592

See notes to condensed consolidated financial statements.

Heritage Oaks Bancorp | - 7 -

Heritage Oaks Bancorp

and Subsidiaries

Consolidated Statements of Cash Flows

	For the nine month periods
	ended September 30,
(dollars in thousands)	2009			2008
Cash flows from operating activities:
Net (loss) / income	$	(3,633	)	$	2,900
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		844			803
Provision for possible loan losses		14,566			6,215
Amortization of premiums / discounts on investment securities, net		64			(105	)
Amortization of intangible assets		787			645
Share-based compensation expense		269			275
Federal Home Loan Bank dividends received		-			(162	)
Gain on sale of available for sale securities		(333	)		(37	)
Decrease / (increase) in loans held for sale		161			(2,053	)
Net increase in bank owned life insurance		(318	)		(308	)
Increase in deferred tax asset		(5,017	)		(880	)
Loss on sale and write-downs on other real estate owned		1,780			-
Increase in other assets		(8,218	)		(823	)
Increase / (decrease) in other liabilities		260			(1,277	)
Excess tax benefit related to share-based compensation expense		(9	)		(88	)
NET CASH PROVIDED IN OPERATING ACTIVITIES		1,203			5,105
Cash flows from investing activities:
Purchase of securities, available for sale		(76,600	)		(18,417	)
Sale of available for sale securities		16,040			1,537
Maturities and calls of available for sale securities		1,138			2,186
Maturities of time deposits with other banks		-			211
Proceeds from principal reductions and maturities of available for sale securities		8,424			7,535
Purchase of Federal Home Loan Bank stock		(705	)		(1,799	)
Increase in loans, net		(38,921	)		(55,403	)
Allowance for loan and lease loss recoveries		30			127
Purchase of property, premises and equipment, net		(1,011	)		(1,231	)
Purchase of bank owned life insurance		(377	)		(400	)
Proceeds from sale of other real estate owned		6,269			-
NET CASH (USED) IN INVESTING ACTIVITIES		(85,713	)		(65,654	)
Cash flows from financing activities:
Increase / (decrease) in deposits, net		150,008			(55,557	)
Proceeds from Federal Home Loan Bank borrowing		75,000			330,000
Repayments of Federal Home Loan Bank borrowing		(119,000	)		(231,500	)
Decrease in repurchase agreements		(2,796	)		(701	)
Excess tax benefit related to share-based compensation expense		9			88
Proceeds from exercise of stock options		37			140
Cash dividends paid		(424	)		(586	)
Cash paid in lieu of fractional shares		-			(5	)
Proceeds from issuance of preferred stock and common stock warrants, net		21,000			-
NET CASH PROVIDED BY FINANCING ACTIVITIES		123,834			41,879
Net increase / (decrease) in cash and cash equivalents		39,324			(18,670	)
Cash and cash equivalents, beginning of period		24,571			46,419
Cash and cash equivalents, end of period	$	63,895		$	27,749
Supplemental Cash Flow Disclosures:
Cash Flow information
Interest paid	$	7,433		$	9,927
Income taxes paid	$	460		$	2,405
Non-Cash Flow Information
Change in other valuation allowance for investment securities	$	842		$	(2,223	)
Loans transferred to OREO or foreclosed collateral	$	9,595		$	197

See notes to condensed consolidated financial statements.

Heritage Oaks Bancorp | - 8 -

Notes to Consolidated Financial Statements

Note 1.  Consolidated Financial Statements

The accompanying un-audited 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 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 2008 Annual Report filed on Form 10-K.

The condensed consolidated financial statements include the accounts of the Company and its wholly-owned financial subsidiary, Heritage Oaks Bank (“the Bank”).  All significant inter-company balances and transactions have been eliminated. Heritage Oaks Capital Trusts II and III are unconsolidated subsidiaries formed solely for the purpose of issuing trust preferred securities. Operating results for the three and nine months ended September 30, 2009 are not necessarily indicative of the results that may be expected for the year ending December 31, 2009. Certain amounts in the consolidated financial statements for the year ended December 31, 2008 and for the three and nine months ended September 30, 2008 may have been reclassified to conform to the presentation of the consolidated financial statements in 2009.

The preparation of consolidated financial statements in conformity with the accounting principles generally accepted in the United States of America 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.

Management evaluated subsequent events through November 6, 2009, the date the financial statements were available to be issued.  Events or transactions occurring after September 30, 2009, but prior to November 6, 2009 that provided additional evidence about conditions that existed at September 30, 2009, have been recognized in the financial statements for the quarter ended September 30, 2009.  Events or transactions that provided evidence about conditions that did not exist at September 30, 2009, but arose before the financial statements were available to be issued have not been recognized in the financial statements for the period ended September 30, 2009.

Note 2.  Investment Securities

In accordance with U.S. GAAP, investment securities are classified in three categories and accounted for as follows: debt and mortgage-backed securities that the Company has the positive intent and ability to hold to maturity are classified as held-to-maturity and are measured at amortized cost; debt and equity securities bought and held principally for the purpose of selling in the near term are classified as trading securities and are measured at fair value, with the unrealized gains and losses included in earnings; debt and equity securities not classified as either held-to-maturity or trading securities are deemed as available-for-sale and are measured at fair value, with the unrealized gains and losses, net of applicable taxes, reported in a separate component of stockholders’ equity. Any gains and losses on sales of investments are computed on a specific identification basis.  Premiums and discounts are amortized or accreted using the interest method over the lives of the related securities.

Heritage Oaks Bancorp | - 9 -

Notes to Consolidated Financial Statements

The following table sets forth the amortized cost and fair values of investment securities available for sale at September 30, 2009 and December 31, 2008:

(dollars in thousands)			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
As of September 30, 2009	Cost		Gains		Losses			Value
Obligations of U.S. government agencies and corporations	$	110	$	-	$	(4	)	$	106
Mortgage backed securities		81,644		1,861		(4,034	)		79,471
Obligations of state and political subdivisions		22,021		1,165		(1	)		23,185
Other securities		109		-		-			109
Total	$	103,884	$	3,026	$	(4,039	)	$	102,871
As of December 31, 2008
Obligations of U.S. government agencies and corporations	$	149	$	-	$	(1	)	$	148
Mortgage-backed securities		35,339		166		(2,102	)		33,403
Obligations of state and political subdivisions		17,020		373		(291	)		17,102
Other securities		109		-		-			109
Total	$	52,617	$	539	$	(2,394	)	$	50,762

During the three months ended September 30, 2009 the Bank sold approximately $11.3 million in investment securities.  In connection with these sales, the Bank recognized a gain of approximately $0.2 million.  Sales of investment securities during the first nine months of 2009 totaled approximately $16.0 million.  Gains recognized in connection with these sales totaled approximately $0.3 million.  During the first nine months of 2008, the Bank sold approximately $5.2 million in securities and recognized a pre-tax gain of $37 thousand.

The following table provides a summary of investment securities in an unrealized loss position as of September 30, 2009:

	Securities In A Loss Position
(dollars in thousands)	For Less Than 12 Months					For 12 Months or More					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
As of September 30, 2009	Value		Loss			Value		Loss			Value		Loss
Obligations of U.S. government agencies and corporations	$	-	$	-		$	106	$	(4	)	$	106	$	(4	)
Mortgage-backed securities		21,341		(793	)		11,862		(3,241	)		33,203		(4,034	)
Obligations of state and political subdivisions		146		(1	)		-		-			146		(1	)
Other securities		-		-			-		-			-		-
Total	$	21,487	$	(794	)	$	11,968	$	(3,245	)	$	33,455	$	(4,039	)

Management periodically evaluates investments in the portfolio for other than temporary impairment and more specifically when conditions warrant such an evaluation.  When evaluating whether impairment is other than temporary, Management considers, among other things, the following: (1) the length of time the security has been in an unrealized loss position, (2) the extent to which the security’s fair value is less than its cost, (3) the financial condition of the issuer, (4) any adverse changes in ratings issued by various rating agencies, (5) the intent and ability of the Bank to hold such securities for a period of time sufficient to allow for any anticipated recovery in fair value and (6) in the case of mortgage related securities, credit enhancements, loan-to-values, credit scores, delinquency and default rates, cash flows and the extent to which those cash flows are within Management’s initial expectations based on pre-purchase analyses.

At September 30, 2009, the Bank owned twelve Whole Loan Private Label Mortgage Backed Securities (“PMBS”) with a principal balance of approximately $23.4 million.   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.  At September 30, 2009, six bonds in the approximate amount of $14.7 million, have been reassessed by one or more of the rating agencies (the Bank must use the most recent and lowest rating when there are discrepancies between the agencies) and subsequently downgraded below investment grade.  All six of these bonds are in Senior or Super Senior Tranche positions of their respective deals, meaning the Bank has priority in cash flows and has subordinate tranches below its position providing credit support. The more credit support or enhancement, the more protection is provided from possible losses on non-performing collateral and the credit enhancement has actually increased from the original amount through September 30, 2009 on all but one bond.  As the Bank receives cash flow on its senior position and principle is reduced quicker than default losses are applied to the subordinate positions, the credit enhancement percentage grows.

Heritage Oaks Bancorp | - 10 -

Notes to Consolidated Financial Statements

The Bank continues to perform extensive analyses on the PMBS bonds in the portfolio. These investment securities, including the six downgraded bonds mentioned above, continue to demonstrate cash flows as expected, based on pre-purchase analyses, and the credit support component of these tranches has actually increased from the origination date through September 30, 2009.  As of September 30, 2009, Management does not believe unrealized losses in the investment portfolio are other than temporary.

Note 3.  Loans and the Allowance for Loan Losses

The following table provides a summary of outstanding loan balances as of September 30, 2009 compared to December 31, 2008:

	September 30,		December 31,
(dollars in thousands)	2009		2008
Real Estate Secured
Multi-family residential	$	17,323	$	16,206
Residential 1 to 4 family		24,580		23,910
Home equity lines of credit		29,189		26,409
Commercial		317,811		285,631
Farmland		9,842		10,723
Commercial
Commercial and industrial		166,618		157,674
Agriculture		14,819		13,744
Other		368		620
Construction
Single family residential		14,669		11,414
Single family residential - Spec.		5,757		15,395
Tract		2,215		2,431
Multi-family		5,575		5,808
Hospitality		14,252		18,630
Commercial		22,997		21,484
Land		54,619		61,681
Installment loans to individuals		8,863		7,851
All other loans (including overdrafts)		370		536
Total loans, gross		709,867		680,147
Deferred loan fees		1,635		1,701
Allowance for loan losses		15,873		10,412
Total loans, net	$	692,359	$	668,034
Loans held for sale		7,778		7,939

Concentration of Credit Risk

At September 30, 2009, approximately $518.8 million or 73.1% of the Bank’s loan portfolio was collateralized by various forms of real estate, this represents an increase of approximately $19.1 million when compared to the $499.7 million or 73.5% reported at December 31, 2008.  Such loans are generally made to borrowers located in San Luis Obispo and Santa Barbara Counties. The Bank attempts to reduce its concentration of credit risk by making loans which are diversified by industry and project type.  While Management believes that the collateral presently securing this portfolio is adequate, there can be no assurances that further significant deterioration in the California real estate market would not expose the Bank to significantly greater credit risk.

At September 30, 2009, the Bank was contingently liable for letters of credit accommodations made to its customers totaling approximately $17.7 million and un-disbursed loan commitments in the approximate amount of $185.9 million. The Bank 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. Standby letters of credit written are conditional commitments issued by the Bank 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 Bank currently anticipates no losses as a result of such transactions.  For more detailed information on concentrations of credit risk, please refer to “Loans” of “Financial Condition” under “Management’s Discussion and Analysis of Results and Operations” contained within this document.

Heritage Oaks Bancorp | - 11 -

Notes to Consolidated Financial Statements

Allowance for Loan Losses

An allowance for loan losses has been established by Management to provide for those loans that may not be repaid in their entirety for a variety of reasons.  The allowance is maintained at a level considered by Management to be adequate to provide for probable incurred losses.  The allowance is increased by provisions charged to earnings and is reduced by charge-offs, net of recoveries. The provision for loan losses is based upon past loan loss experience and Management’s evaluation of the loan portfolio under current economic conditions.  Loans are charged to the allowance for loan losses when, and to the extent, they are deemed by Management to be un-collectible.

The following table provides a summary for the activity in the allowance for loan losses during the periods indicated:

	For the three months ended				For the nine months ended				For the year ended
	September 30,				September 30,				December 31,
(dollars in thousands)	2009		2008		2009		2008		2008
Balance at beginning of period	$	11,106	$	8,128	$	10,412	$	6,143	$	6,143
Provision expense		9,756		3,200		14,566		6,215		12,215
Loans charged-off
Commercial real estate		41		-		41		305		340
Residential 1-4 family		304		-		304		-		555
Commercial and industrial		503		282		1,728		849		3,854
Agriculture		1,909		-		1,909		-		-
Construction		397		717		2,218		923		1,837
Land		1,801		-		2,792		-		1,434
Other		42		34		143		58		56
Total charge-offs		4,997		1,033		9,135		2,135		8,076
Recoveries of loans previously charged off		8		55		30		127		130
Balance at end of period	$	15,873	$	10,350	$	15,873	$	10,350	$	10,412

During the three and nine months ended September 30, 2009, the Company made provisions for loan losses in the amounts of $9.8 million and $14.6 million, respectively.  This when compared to the $3.2 million and $6.2 million reported for the same periods ended a year earlier, represents respective increases of approximately $6.6 million and $8.4 million.  Elevated provision expenses are reflective of, among other things, additional loan balances charged-off during the first nine months of 2009, continued weakness in local, state and national economic conditions and the number and dollar volume of loans placed on non-accruing status when compared to the same period ended in 2008.

Note 4.  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 and other share-based compensation awards, exclusive of any award that may have an anti-dilutive affect on earnings per common share.  As disclosed in Note 9 of these consolidated financial statements, the Company issued a warrant to the U.S. Treasury to purchase 611,650 shares of its common stock.  The warrant was not included in the Company’s calculation of diluted earnings per common share for the three and nine months ended September 30, 2009, since it was anti-dilutive.

Heritage Oaks Bancorp | - 12 -

Notes to Consolidated Financial Statements

The following table sets forth the number of shares used in the calculation of both basic and diluted earnings per share for the three months ended September 30, 2009 and 2008:

	For the three months ending,
	September 30, 2009					September 30, 2008
	Net					Net
(dollar amounts in thousands except per share data)	Income			Shares		Income		Shares
Net (loss) / income	$	(5,242	)			$	534
Dividends and accretion on preferred stock		(352	)				-
Net (loss) / income available to common shareholders	$	(5,594	)			$	534
Weighted average shares outstanding					7,699,377				7,709,600
Basic (loss) / earnings per common share	$	(0.73	)			$	0.07
Dilutive effect of share-based compensation awards					-				88,721
Dilutive effect of common stock warrant					-				-
Weighted average diluted shares outstanding					7,699,377				7,798,321
Diluted (loss) / earnings per common share	$	(0.73	)			$	0.07

The following table sets forth the number of shares used in the calculation of both basic and diluted earnings per share for the nine months ended September 30, 2009 and 2008:

	For the nine months ending,
	September 30, 2009					September 30, 2008
	Net					Net
(dollar amounts in thousands except per share data)	Income			Shares		Income		Shares
Net (loss) / income	$	(3,633	)			$	2,900
Dividends and accretion on preferred stock		(613	)				-
Net (loss) / income available to common shareholders	$	(4,246	)			$	2,900
Weighted average shares outstanding					7,694,969				7,703,107
Basic (loss) / earnings per common share	$	(0.56	)			$	0.38
Dilutive effect of share-based compensation awards					-				129,708
Dilutive effect of common stock warrant					-				-
Weighted average diluted shares outstanding					7,694,969				7,832,815
Diluted (loss) / earnings per common share	$	(0.56	)			$	0.37

On April 24, 2008, the Company’s Board of Directors declared a 5% stock dividend which was paid on May 16, 2008.  As a result of this dividend, the Company issued 366,294 shares of its common stock to holders of record on May 2, 2008.  The basic and diluted shares presented in the tables above as well as shares for all prior periods have been adjusted to fully reflect the May 2008 stock dividend.

Note 5.  Recent Accounting Pronouncements

In June 2009, the Financial Accounting Standards Board (“FASB”) issued an accounting standard regarding The FASB Accounting Standards Codification TM (“Codification” or “ASC”) that will become the source of authoritative U.S. generally accepted accounting principles (“GAAP”) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants.  On the effective date of this standard, all interim and annual reporting periods ending after September 15, 2009, the Codification will supersede all then-existing non-SEC accounting and reporting standards. All other non-grandfathered non-SEC accounting literature not included in the Codification will become non-authoritative.  The adoption of this standard did not have a material impact on the Company’s financial statements.  

Heritage Oaks Bancorp | - 13 -

Notes to Consolidated Financial Statements

In June 2009, the FASB issued an accounting standard, incorporated into ASC topic 810 “Consolidation,” that seeks to improve financial reporting by companies involved with variable interest entities. Also addressed under this standard are concerns about the application of certain key provisions, including those in which the accounting and disclosures do not always provide timely and useful information about a company’s involvement in a variable interest entity.  The standard requires a company to perform analyses to determine if its variable interest(s) give it a controlling financial interest in a variable interest entity.  These analyses identify the primary beneficiary of the a variable interest entity as the company that has both of the following characteristics: (a) the power to direct the activities of a variable interest entity that most significantly impact the company’s economic performance; and (b) the obligation to absorb losses of the entity that could potentially be significant to the variable interest entity or the right to receive benefits from the entity that could potentially be significant to the variable interest entity.  This standard is effective for all annual and interim reporting periods beginning after November 15, 2009 with earlier application prohibited.  The Company has not yet determined the impact that this standard will have on its financial statements.

In June 2009, the FASB issued an accounting standard which was incorporated into ASC topic 860 “Transfers and Servicing.”  This standard seeks to improve the relevance, representational faithfulness and comparability of the information that a reporting entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets.  The Company is required to adopt this standard for all interim and annual reporting periods beginning after November 15, 2009.  The Company does not currently expect the adoption of this standard to have a material impact on its financial statements.

In May 2009, the FASB issued an accounting standard which was incorporated into ASC topic 855 “Subsequent Events.”  This standard sets forth principles and requirements for disclosing and recognizing subsequent events in the financial statements.  This standard also outlines circumstances under which an entity shall recognize those events or transactions occurring after the balance sheet date.  The Company is required to adopt this standard for all interim and annual reporting periods after June 15, 2009, prospectively.  The Company’s adoption of this standard did not have a material impact on its financial statements.

In April 2009, the FASB issued the following accounting standards (subsequently incorporated into the Accounting Standards Codification):

The FASB issued an accounting standard which was incorporated into ASC topic 820 “Fair Value Measurements and Disclosures.”  This standard provides guidelines for making fair value measurements more consistent. This standard provides additional authoritative guidance in determining whether a market is active or inactive, and whether a transaction is distressed, is applicable to all assets and liabilities (i.e. financial and nonfinancial) and will require enhanced disclosures.

The FASB issued accounting standards which were subsequently incorporated into ASC topics 320 “Investments – Debt and Equity Securities” and 835 “Interest.”  These standards seek to make the other-than-temporary impairment guidance more operational and to improve the presentation of other-than-temporary impairments in the financial statements.  These standards apply to other-than-temporary impairments of debt and equity securities and requires a company to assert that (a) it does not have the intent to sell the security in question and (b) it is more likely than not that it will not have to sell the security in question before recovery of its cost basis to avoid an impairment being considered other-than-temporary.  These standards also change the amount of impairment losses recognized in earnings.  Under these standards impairments are separated into two components: (i) the amount of impairments related to credit losses and (ii) and the amount related to other factors.  The amount of impairment related to credit losses is reflected as a charge to earnings, while the amount deemed to be related to other factors is reflected as an adjustment to shareholders’ equity through other comprehensive income.

The FASB issued accounting standards which were subsequently incorporated into ASC topic 825 “Financial Instruments.” These standards require disclosures about fair value of financial instruments in interim as well as in annual financial statements.

The accounting guidance summarized in the preceding paragraphs is effective for periods ending after June 15, 2009.  The adoption of which has not had a material impact in the Company’s financial statements.

On April 1, 2009, the FASB issued an accounting standard which was subsequently incorporated into ASC topic 805 “Business Combinations.”This standard provides additional guidance regarding the recognition, measurement and disclosure of assets and liabilities arising from contingencies in a business combination.  This standard is effective for assets or liabilities arising from contingencies in business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008.  The standard also addresses other accounting issues regarding business combinations including the measurement of acquirer shares issued in consideration for a business combination, the recognition of contingent consideration, the accounting for pre-acquisition gain and loss contingencies, the recognition of capitalized in-process research and development, the accounting for acquisition-related restructuring cost accruals, the treatment of acquisition related transaction costs and the recognition of changes in the acquirer’s income tax valuation allowance. The impact of adopting this standard will depend on the timing of future acquisitions, as well as the nature and existence of contingencies associated with such acquisitions.

Heritage Oaks Bancorp | - 14 -

Notes to Consolidated Financial Statements

In December 2008, the FASB issued an accounting standard which was subsequently incorporated into ASC topic 715 “Compensation – Retirement Benefits.”  This standard seeks to provide users of financial statements with an understanding of: how investment allocation decisions are made, the major categories of plan assets, the inputs and valuations techniques used to measure the fair value of those assets, the effect of fair value measurements using unobservable inputs on changes in plan assets during a reporting period, and significant concentrations of risk within plan assets.  The Company is required to adopt this standard no later than January 1, 2010.  The Company does not believe the adoption of this standard will have a material impact on its financial statements.

On October 10, 2008, the FASB issued an accounting standard which was subsequently incorporated into ASC topic 820 “Fair Value Measurements and Disclosures.” The standard clarifies the application of accounting guidance for fair value measurements in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. The standard is effective immediately, and includes prior periods for which financial statements have not been issued, and therefore the Company is subject to the provisions under the standard effective September 30, 2008. The implementation of this standard did not affect the Company's fair value measurements as of September 30, 2009.

In June 2008, the FASB issued an accounting standard which was subsequently incorporated into ASC topic 260 “Earnings Per Share.”  The standard addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing EPS under the two-class method. This standard affects entities that accrue cash dividends on share-based payment awards during the awards' service period when the dividends do not need to be returned if the employees forfeit the awards.  This standard is effective for fiscal years beginning after December 15, 2008.  The adoption of this standard did not have material impact on the Company’s financial position, results of operations or cash flows.

In May 2008, the FASB issued an accounting standard which was subsequently incorporated into ASC topic 944 “Financial Services – Insurance.”   This standard seeks to bring consistency in the recognition and measurement of claim liabilities.  This standard applies to financial guarantee contracts, including the recognition and measurement to be used to account for premium revenue and claim liabilities, increasing the comparability in financial reporting of financial guarantee contracts by insurance enterprises.  The Company adopted the standard on January 1, 2009.  The Company’s adoption of this standard did not have a material impact on its financial position, results of operations or cash flows.

In March 2008, the FASB issued an accounting standard which was subsequently incorporated into ASC topic 815 “Derivatives and Hedging.”  This standard seeks to provide users of financial statements with an enhanced understanding of: how and why an entity uses derivative instruments; how derivative instruments and related hedged items are accounted for and how derivative instruments and related hedged items affect an entity’s financial position, results of operations, and cash flows.  This standard requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. This standard is effective for fiscal years and interim periods beginning after November 15, 2008. The Company’s adoption of this standard did not have a material impact on its financial position, results of operations or cash flows.

In December 2007, the FASB issued an accounting standard which was subsequently incorporated into ASC topic 810 “Consolidation.”  This standard addresses the accounting for non-controlling (minority) interests in consolidated financial statements including the requirements to classify non-controlling interests as a component of consolidated stockholders’ equity, and the elimination of “minority interest” accounting in results of operations with earnings attributable to non-controlling interests reported as part of consolidated earnings.  The Company adopted this standard on January 1, 2009, the adoption of which did not have a material impact on the Company’s financial position, results of operations or cash flows.

Heritage Oaks Bancorp | - 15 -

Notes to Consolidated Financial Statements

Note 6.  Share-Based Compensation

As of September 30, 2009, the Company had two share-based employee compensation plans, which are more fully described in Note 14 of the Consolidated Financial Statements in the Company's Annual Report filed on Form 10-K for the year ended December 31, 2008. These plans include the “1997 Stock Option Plan” and the “2005 Equity Based Compensation Plan.” Share-based compensation expense for all share-based compensation awards granted after January 1, 2006, is based on the grant-date fair value. For all awards except stock option awards, the grant date fair value is either the fair market value per share or book value per share (corresponding to the type of stock awarded) as of the grant date.  For stock option awards, the grant date fair value is estimated using the Black-Scholes option pricing model. For all awards, the Company recognizes these compensation costs only for those shares expected to vest on a straight-line basis over the requisite service period of the award, for which we use the related vesting term.  The Company estimates forfeiture rates based on historical employee option exercise and employee termination experience.

The share-based compensation expense recognized in the consolidated statements of income for the three and nine month periods ended September 30, 2009 and 2008 is based on awards ultimately expected to vest, and accordingly has been adjusted by the amount of estimated forfeitures.  U.S. GAAP requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

The following table provides a summary of the expenses the Company has recognized related to share-based compensation as well as the impact those expenses have had on diluted earnings per share for the periods indicated below:

	For the three months ended				For the nine months ended
	September 30,				September 30,
(dollars in thousands except share and per share data)	2009		2008		2009		2008
Share-based compensation expense:
Stock option expense	$	43	$	51	$	129	$	152
Restricted stock expense		42		57		140		123
Total share-based compensation expense		85	$	108		269	$	275
Total share-based compensation expense, net of tax	$	52	$	72	$	165	$	186
Diluted shares outstanding		7,699,377		7,798,321		7,694,969		7,832,815
Impact on diluted earnings per share	$	-	$	0.009	$	-	$	0.024
Unrecognized compensation expense:
Stock option expense	$	274	$	315
Restricted stock expense		307		547
Total unrecognized share-based compensation expense	$	581	$	862
Total unrecognized share-based compensation expense, net of tax	$	376	$	525

At September 30, 2009, there was a total of $274 thousand of unrecognized compensation expense related to non-vested stock option awards. That expense is expected to be recognized over a weighted-average period of 2.3 years.

The Company grants restricted share awards periodically for the benefit of employees. These restricted shares generally “cliff vest” after five years of issuance. Recipients of restricted shares have the right to vote all shares subject to such grant, and receive all dividends with respect to such shares, whether or not the shares have vested. Recipients do not pay any cash consideration for the shares.  The total unrecognized compensation expense related to restricted share awards at September 30, 2009 was $307 thousand. That expense is expected to be recognized over the next 1.4 years.

The aggregate intrinsic value in the table below represents the total pretax intrinsic value (the difference between the Company’s closing stock price on the last trading day of the third quarter of 2009 and the exercise price, multiplied by the number of in-the-money options that would have been received by the option holders had all option holders exercised their options on September 30, 2009).  The aggregate pretax intrinsic value is subject to change based on the fair market value of the Company's stock.  The aggregate intrinsic value of options exercised for the nine month period ended September 30, 2009 was $22 thousand.  The aggregate intrinsic value of options exercised during the nine month period ended September 30, 2008 was $214 thousand.  There were no options exercised during the three months ended September 30, 2009 and 2008.

Heritage Oaks Bancorp | - 16 -

Notes to Consolidated Financial Statements

The following table provides a summary of the aggregate intrinsic value of options outstanding and exercisable as well as options granted, exercised, and forfeited during the year-to-date periods ended September 30, 2009 and 2008:

						Average
				Weighted		Remaining		Total
				Average		Contractual		Intrinsic
	Number of			Exercise		Term		Value
	Shares			Price		(in years)		(in 000's)
Options outstanding, January 1, 2009		408,830		$	9.34
Granted		49,741			5.41
Exercised		(10,050	)		3.73
Options outstanding, September 30, 2009		448,521		$	9.03		4.33	$	484
Exercisable at September 30, 2009		347,172		$	8.92		3.03	$	385
Options outstanding, January 1, 2008		463,160		$	8.36
Granted		26,250			11.48
Exercised		(32,090	)		4.37
Forfeited		(7,912	)		8.20
Options outstanding, September 30, 2008		449,408		$	8.83		4.15	$	622
Exercisable at September 30, 2008		358,673		$	7.76		3.10	$	622

During the first nine months of 2009, the Company granted 49,741 options to various non-management members of the Company’s Board of Directors as well as to certain officers of the Bank.  Of the options granted in 2009, 25,000 were granted to non-management members of the Company’s Board of Directors.  Similar grants were made to the Company’s Board of Directors during the first quarter of 2008.  The following table presents the assumptions used in the calculation of the weighted average fair value of options granted during 2009 and 2008 on the date of grant using the Black-Scholes options pricing model:

	2009			2008
Expected volatility		37.66	%		35.07	%
Expected term (years)		10			10
Dividend yield		0.00	%		2.66	%
Risk free rate		3.16	%		3.62	%
Weighted-average grant date fair value	$	2.87		$	3.93

The Black-Scholes model incorporates a range of assumptions for inputs that are disclosed in the table above.  Expected volatilities are based on, among other things, the daily historical stock price over the expected life of the option.  The expected term of options granted is derived from the output of the model and represents the period of time that options granted are expected to be outstanding.  Dividend yields are estimated based on the dividend yield on the Company’s common stock at the time of grant.  The risk-free rate for periods within the contractual life of the stock option is based on the U.S. Treasury yield curve in effect at the time of grant.

Estimates of fair value derived from the Company’s use of the Black-Scholes pricing model are theoretical values for stock options and changes in the assumptions used in the models could result in different fair value estimates.  The actual value of the stock options granted will depend on the market value of the Company’s common stock when the options are exercised.

Heritage Oaks Bancorp | - 17 -

Notes to Consolidated Financial Statements

Note 7.  Fair Value Disclosures

Effective January 1, 2008, the Company determines the fair market values of certain financial instruments based on the fair value hierarchy established in U.S. GAAP under Accounting Standard Codification (“ASC”) topic 820, “Fair Value Measurements and Disclosures.  U.S GAAP requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value and describes three levels of inputs that may be used to measure fair value.

The following provides a summary of the hierarchical levels used to measure fair value:

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 2 assets and liabilities may include debt securities with quoted prices that are traded less frequently than exchange-traded instruments and other instruments whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. This category generally includes U.S. Government and agency mortgage-backed debt securities, corporate debt securities, derivative contracts, residential mortgage and loans held-for-sale.

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. This category generally includes certain private equity investments, retained residual interests in securitizations, residential MSRs, asset-backed securities (“ABS”), highly structured or long-term derivative contracts and certain collateralized debt obligations (“CDO”) where independent pricing information was not able to be obtained for a significant portion of the underlying assets.

Fair Value Measurements

The Company used the following methods and significant assumptions to estimate fair value:

Securities

The fair value of securities available-for-sale are determined by obtaining quoted prices on nationally recognized exchanges or matrix pricing which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather relying on the security’s relationship to other benchmark quoted securities.

Loans Held For Sale

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.

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 contractual terms of the loan agreement.  Impairment is measured based on the fair value of the underlying collateral or the discounted expected future cash flows.  The Company measures impairment on all non-accruing loans for which it has established specific reserves as part of the specific allocated allowance component of the allowance for loan losses.  As such, the Company records impaired loans as non-recurring Level 2 when the fair value of the underlying collateral is based on an observable market price or current appraised value.  When current market prices are not available or the Company determines that the fair value of the underlying collateral is further impaired below appraised values, the Company records impaired loans as non-recurring Level 3.  At September 30, 2009, substantially all of the Company’s impaired loans were evaluated based on the fair value of their underlying collateral with the most recent appraisal available to Management.

Heritage Oaks Bancorp | - 18 -

Notes to Consolidated Financial Statements

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.  When appraised values are not available, there is no observable market price for similar assets, or Management determines the fair value of the asset is further impaired below appraised values or observable market prices, the Company records other real estate owned or foreclosed collateral as non-recurring Level 3.

The following table provides a summary of the financial instruments the Company measures at fair value on a recurring basis as of September 30, 2009:

	Fair Value Measurments Using
							Assets At
(dollars in thousands)	Level 1		Level 2		Level 3		Fair Value
Assets:
Available for sale investment securities	$	-	$	102,127	$	744	$	102,871
Total assets measured on a recurring basis	$	-	$	102,127	$	744	$	102,871

The following table provides a summary of the changes in balance sheet carrying values associated with Level 3 financial instruments during the nine months ended September 30, 2009:

	Available For
	Sale Investment
(dollars in thousands)	Securities
Beginning balance	$	774
Total gains or losses (realized/unrealized)(1):
Included in earnings		-
Included in other comprehensive loss		(30	)
Purchases		-
Transfers in and/or out of Level 3		-
Non-trading activity		-
Ending balance	$	744

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

The assets presented under level 3 of the fair value hierarchy 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 the financial instruments the Company measures at fair value on a non-recurring basis as of September 30, 2009:

	Fair Value Measurments Using
							Assets At
(dollars in thousands)	Level 1		Level 2		Level 3		Fair Value
Assets:
Impaired loans	$	-	$	39,135	$	-	$	39,135
Loans held for sale		-		7,778		-		7,778
Other real estate owned		-		2,607		-		2,607
Total assets measured on a non-recurring basis	$	-	$	49,520	$	-	$	49,520

Heritage Oaks Bancorp | - 19 -

Notes to Consolidated Financial Statements

In addition to the assets presented in the table above, the Company uses fair value measurements on a non-recurring basis in its assessment of assets classified as Goodwill.  These assets are recorded at fair value initially and assessed for impairment periodically thereafter under the provisions set forth in U.S. GAAP.  During the fiscal year ended December 31, 2008, the carrying amount of goodwill assets were compared to their fair value.  No change in carrying amount resulted in accordance with the provisions set forth in U.S. GAAP.  Additionally, the Company has certain other loans that are measured at fair value on a non-recurring basis such as loans that were acquired in the acquisition of Business First National Bank.

Note 8.  Fair Value of Financial Instruments

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.  Because no market value exists for a significant portion of the financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors.  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.

Fair value estimates are based on financial instruments both on and off the balance sheet without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments.  Additionally, tax consequences related to the realization of the unrealized gains and losses can have a potential effect on fair value estimates and have not been considered in many of the estimates.

The following table provides a summary of the estimated fair value of financial instruments at September 30, 2009:

	September 30, 2009
	Carrying
(dollars in thousands)	Amount		Fair Value
Assets
Cash and cash equivalents	$	63,895	$	63,895
Interest bearing deposits		119		119
Investments and mortgage-backed securities		102,871		102,871
Federal Home Loan Bank and Federal Reserve Bank stock		5,828		5,828
Loans receivable, net of deferred fees and costs		708,232		714,772
Loans held for sale		7,778		7,778
Bank owned life insurance		11,432		11,432
Accrued interest receivable		3,404		3,404
Liabilities
Non-interest bearing deposits		181,670		181,670
Interest bearing deposits		571,859		569,138
Federal Home Loan Bank advances		65,000		65,230
Junior subordinated debentures		13,403		12,331
Accrued interest payable		606		606

	Notional		Cost to Cede
	Amount		or Assume
Off-balance sheet instruments, commitments to extend credit
and standby letters of credit	$	203,596	$	2,036

The following methods and assumptions were used by the Company in estimating fair values of financial instruments:

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.

 Heritage Oaks Bancorp | - 20 -

Notes to Consolidated Financial Statements

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.

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

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

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 commercial real estate and rental property mortgage loans and commercial and industrial loans) 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.

Bank Owned Life Insurance

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

Federal Home Loan Bank Advances

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

Junior Subordinated Debentures

The fair value disclosed for junior subordinated debentures is based on contractual cash flows at current market interest rates for similar instruments.

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.

 Heritage Oaks Bancorp | - 21 -

Notes to Consolidated Financial Statements

Note 9.  Preferred Stock

On February 27, 2009, the Company received shareholder approval for an amendment of its Articles of Incorporation to add a class of preferred stock, which ultimately allowed it to participate in the U.S Treasury’s Capital Purchase Program (“CPP”).

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

On March 20, 2009, the Company issued 21,000 shares of 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 will carry a coupon of 5% for five years and 9% thereafter.  Senior preferred issued to the U.S. Treasury will be 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 Company expects the warrant to be dilutive to earnings per common share.

The U.S. Treasury may not transfer a portion or portions of the warrant with respect to, and/or exercise the warrant for more than one-half of, the 611,650 common shares issuable upon exercise of the warrant, in the aggregate, until the earlier of (i) the date on which the Company has received aggregate gross proceeds of not less than $21.0 million from one or more Qualified Equity Offerings and (ii) December 31, 2009.  However, if the Company were to redeem all of the Senior Preferred Stock as permitted by and in accordance with the provisions set forth under the CPP, the U.S. Treasury will be permitted, subject to compliance with applicable securities laws, to transfer all or a portion of the warrant with respect to, and/or exercise the warrant for, all or a portion of the number of common shares issuable thereunder, at any time and without limitation.  In the event the Company completes one or more Qualified Equity Offerings on or prior to December 31, 2009, that result in the Company receiving aggregate gross proceeds of not less than $21.0 million, the number of the common shares underlying the portion of the warrant then held by the U.S. Treasury will be reduced by one-half of the common shares originally covered by the warrant.  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, 2009, 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 proceeds received from the U.S. Treasury were allocated to the Senior Preferred Stock and the warrant based on their relative fair values.  The fair value of the Senior Preferred Stock was determined through a discounted future cash flow model at a discount rate of 10%.  The fair value of the warrant was calculated using the Black-Scholes option pricing model, which includes assumptions regarding the Company’s dividend yield, stock price volatility, and the risk-free interest rate.  As a result the Company recorded the Senior Preferred Stock and the warrant at approximately $19.2 million and $1.8 million, respectively.  The Company will accrete the discount on the Senior Preferred Stock over a period of five years with corresponding charges to retained earnings.

It is also important to note that net income available to common shareholders will be impacted to the extent the Company charges retained earnings for the accretion of the discount on the Senior Preferred Stock and any dividends paid from retained earnings on the Senior Preferred Stock.  For the three and nine month periods ended September 30, 2009, dividends and accretion on the Senior Preferred Stock totaled approximately $352 thousand and $613 thousand, respectively.

Additionally, 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 Senior Preferred Stock cannot be redeemed for three years unless the Company obtains proceeds to replace the 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 of 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”).

 Heritage Oaks Bancorp | - 22 -

Notes to Consolidated Financial Statements

Note 10.  Subsequent Events

Late in October 2009, the Bank received approximately $0.8 million in proceeds from one customer related to interest the Bank previously accrued but that was reversed as a result of placing the loan on non-accrual status during the third quarter of 2009.  As a result of the customer’s payment, the Bank moved the loan back to performing status during the month of October and will recognize approximately $0.8 million in interest income in the fourth quarter of 2009 related to this loan.  The balance of the loan at September 30, 2009 was approximately $10.7 million.  The loan was originally placed on non-accrual as a result of an issue related to the treatment of an interest reserve.

The FDIC recently completed its regularly scheduled examination of the Bank.  Based on discussions with the FDIC following the examination, it is expected that the Bank will receive a formal agreement or enforcement order from the FDIC requiring the Bank to take certain steps to further strengthen the Bank, such as reducing the level of classified assets, increasing capital levels, and addressing other criticisms from the examination.  Management is already developing strategies and taking actions to address such issues.

The Bank is presently awaiting updated appraisals of real property securing a significant portion of classified loans, which we expect to receive in the fourth quarter of 2009.  The result of these appraisals either positive or negative may have an impact on the required level of the allowance for loan losses in the fourth quarter of 2009.  If the results of these appraisals indicate that the value of the properties securing these loans has declined since the date of the last appraisal, the Bank may be required to make additional provisions for loan losses in the fourth quarter of 2009.

Note 11.  Reclassifications

Certain amounts in the 2008 financial statements have been reclassified to conform to the 2009 presentation.

 Heritage Oaks Bancorp | - 23 -

Forward Looking Statements

Certain statements contained in this Quarterly Report on Form 10-Q (“Quarterly Report”), including, without limitation, statements containing the words “believes”, “anticipates”, “intends”, “expects”, and words of similar impact, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities and Exchange Act of 1934. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others, the following: the ongoing financial crisis in the United States, and the response of the federal and state government and our regulators thereto, general economic conditions, the recent fluctuations in U.S. markets resulting, in part, from problems related to sub-prime lending, the recent downturn in the California real estate market, general economic and business conditions in those areas in which the Company operates, demographic changes, competition, fluctuations in interest rates, changes in business strategy or development plans, changes in governmental regulation, credit quality, the availability of capital to fund the expansion of the Company’s business, as well as economic, political and global changes arising from the war on terrorism, increased profitability, continued growth, the Bank’s beliefs as to the adequacy of its existing and anticipated allowance for loan losses, beliefs and expectations regarding actions that may be taken by regulatory authorities having oversight of the Bank’s operations, financial policies of the United States government and continued weakness in the real estate markets within which we operate. (Refer to the Company’s December 31, 2008 10-K, ITEM 1A. Risk Factors). The Company disclaims any obligation to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements contained herein to reflect future events or developments.

Heritage Oaks Bancorp | - 24 - -

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

The following is an analysis of the results of operations and financial condition of the Company as of and for the three and nine month periods ending September 30, 2009 and 2008.  The analysis should be read in connection with the consolidated financial statements and notes thereto appearing elsewhere in this report.

The Company

Heritage Oaks Bancorp (the "Company") is a California corporation organized in 1994 to act as a holding company of Heritage Oaks Bank ("Bank"), a 15 branch bank serving San Luis Obispo and Santa Barbara Counties.  In 1994, the Company acquired all of the outstanding common stock of the Bank in a holding company formation transaction.

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

In September 2007, the Company formed Heritage Oaks Capital Trust III (“Trust III”). Trust III is a statutory business trust formed under the laws of the State of Delaware and is a wholly-owned, non-financial, non-consolidated subsidiary of the Company.

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

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

Where You Can Find More Information

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

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

 Heritage Oaks Bancorp | - 25 -

Management’s Discussion and Analysis

Executive Summary

For the three and nine month periods ended September 30, 2009, net losses available to common shareholders were approximately $5.6 million and $4.2 million, respectively.  In the same periods ended a year earlier, the Company reported net income available to common shareholders of approximately $0.5 million and $2.9 million, respectively.  Losses per diluted common share were ($0.73) and ($0.56) for the three and nine months ended September 30, 2009.  The Company reported earnings per diluted common share of $0.07 and $0.37 for the same three and nine month periods ended a year earlier.  Several significant factors that contributed substantially to the year over year decline in earnings were: elevated provisions for loan losses, losses incurred from the write-down and sale of certain OREO properties, increases in regulatory assessments costs, the one-time assessment imposed by the FDIC on all insured institutions, interest reversals related to loans placed on non-accrual status, as well as the absence of income in the amount of $0.3 million the Bank recognized related to the Visa, Inc. IPO during the second quarter of 2008.

Provisions for loan losses during the three and nine months ended September 30, 2009 were approximately $9.8 million and $14.6 million, respectively.  When compared to the $3.2 million and $6.2 million reported for the same periods ended a year earlier, this represents respective increases of approximately $6.6 million and $8.4 million.  Elevated provisions for loan losses during 2009 are the primary factor behind the year over year decline in earnings.  See also “Provision for Loan Losses” of this Discussion and Analysis for more information regarding factors impacting the level of provision for loan losses during 2009.

During the third quarter of 2009 the Bank wrote down the value of one foreclosed property in the amount of $1.3 million.  This property represents land for commercial development and is located within the Bank’s primary market area.  Additionally, the Bank sold five properties during the third quarter and recognized aggregate losses in connection with those sales of approximately $0.2 million.

Contributing further to the year over year decline in earnings were increased regulatory assessment costs, resulting from a one-time special assessment imposed by the FDIC on all insured institutions that totaled approximately $0.4 million for the Bank and was booked during the second quarter.  Year over year increases within this category can also be attributed to a one-time charge in the approximate amount of $0.5 million to correct for the cumulative effect of an error related to the accrual of FDIC assessments from 2007 through June 30, 2009.  Management determined that the amounts were not material to the Company’s financial condition and results of operations in each reporting period from 2007 through June 30, 2009, and as a result processed the correcting entry in the third quarter of 2009.

The following provides a summary of operating results for the three and nine month periods ended September 30, 2009 and 2008:

· For the three and nine months ended September 30, 2009 interest income totaled approximately $11.9 million and $36.0 million, respectively.  This when compared to the same three and nine month periods ended a year earlier, represents declines of approximately $0.7 million and $1.9 million, respectively.  Although, floors within the loan portfolio were instrumental in abating any substantial year over year decline in interest income, interest reversals related to loans placed on non-accrual during the first nine months of the year negatively impacted this line item.  Contributing significantly to the amount of interest reversed during the third quarter, was the reversal of approximately $0.8 million in interest income related to one loan placed on non-accrual, the result of an issue related to the treatment of an interest reserve.  As disclosed in Note 10. Subsequent Events of the consolidated financial statements, upon working with the borrower the Bank was able to recover the uncollected interest in  October 2009 and subsequently moved the loan back to performing status.  For the three and nine months ended September 30, 2009, interest reversals totaled approximately $1.1 million and $1.2 million, respectively.

· For the three and nine months ended September 30, 2009, interest expense totaled approximately $2.6 million and $7.4 million, respectively.  When compared to the same periods ended a year earlier, interest expense declined approximately $0.4 million and $2.3 million, respectively.  Although core deposit balances increased significantly when compared to that reported a year earlier, declines in the overnight Fed Funds rate during the later part of 2008 helped to bring down the cost of deposits and borrowings for the Bank, contributing substantially to the year over year decline in interest expense.  Additionally, throughout 2008 and early 2009, the Bank stayed relatively short with respect to maturities on various interest bearing liabilities, allowing the Bank the opportunity to more rapidly re-price those funds in a declining interest rate environment, further contributing to the decline in interest expense.

· Net interest income for the three and nine months ended September 30, 2009 totaled approximately $9.3 million and $28.7 million, respectively.  Net interest income declined approximately $0.3 million from that reported during the same three month period ended a year earlier and increased approximately $0.4 million when compared to same nine month period ended a year ago.  Year over year changes in net interest income can be attributed in large part to the items mentioned in the preceding paragraphs.

 Heritage Oaks Bancorp | - 26 -

Management’s Discussion and Analysis

· Non-interest income totaled approximately $1.6 million and $4.8 million for the three and nine month periods ended September 30, 2009, representing respective increases of approximately $80 thousand and $45 thousand when compared to the same periods ended a year earlier.  The modest year over year increases within this category can be attributed to increases in mortgage origination fee income of approximately $0.1 million and $0.5 million for the three and nine month periods ended September 30, 2009, respectively.  Additionally, gains on the sale of securities and SBA loans in the aggregate amounts of $0.3 million and $0.4 million for the three and nine months ended September 30, 2009, respectively contributed further to the increase within this category.  Offsetting these increases were year over year declines in service charge fee income of approximately $0.1 million and $0.3 million for the quarter and year to date periods ended September 30, 2009.  For more information related to non-interest income, please see “Non-Interest Income” of this Discussion and Analysis.

· Non-interest expense for the third quarter and the first nine months of 2009 totaled approximately $10.3 million and $25.7 million, respectively.  Non-interest expense increased approximately $3.1 million during the third quarter and $3.5 million for the first nine months of 2009, respectively when compared to the same periods ended a year earlier.  The primary factor behind the year over year increases within this category can be attributed to the write-down of one OREO property in the third quarter of 2009, totaling approximately $1.3 million.  For the third quarter and the first nine months of 2009, OREO write-downs totaled approximately $1.4 million and $1.5 million, respectively.  OREO write-downs accounted for approximately 44.0% and 42.3% of the increase in non-interest expenses for the three and nine month periods ended September 30, 2009.  Further contributing to the increase in non-interest expenses was an increase in regulatory assessment costs, the Special Assessment imposed by the FDIC on all insured institutions during the second quarter of 2009 and a one-time charge related to the cumulative effect of an error related to the accrual of FDIC assessments from 2007 through June 30, 2009, previously mentioned.  For more information related to non-interest expenses, please see “Non-Interest Expenses” of this Discussion and Analysis.

· For the three and nine months ended September 30, 2009, the Company’s efficiency ratio was 95.12% and 77.02%, respectively.  This compares to 64.40% and 67.55% reported for the same periods ended a year earlier.  The efficiency ratio was negatively impacted during the third quarter and the first nine months of 2009 by several one-time charges previously mentioned and that include: increased regulatory assessment costs, expenses and write-downs related to OREO properties, and a one-time charge related to the cumulative effect of an accounting error related to the accrual of FDIC assessment premiums.  Additionally, the reversal of approximately $1.1 million and $1.2 million in accrued interest related to loans the Bank placed on non-accrual during the three and nine months ended September 30, 2009 contributed to the rise in the efficiency ratio.  As previously mentioned, interest reversals include approximately $0.8 million related to one loan placed on non-accrual during the third quarter of 2009.  In October 2009, the Bank recovered all previously accrued interest on this loan and returned the loan to performing status.  Exclusive of one-time charges and the reversal of $0.8 million in interest income related to the loan previously mentioned, the efficiency ratio for the three and nine month periods ended September 30, 2009 was 68.44% and 66.28%, respectively.  Management remains focused on cost controls in an effort to mitigate the rise in non-interest expenses brought on by the one-time charges previously discussed.

The following provides a summary for significant year to date changes in balances as of September 30, 2009:

· At September 30, 2009, net loan balances were approximately $692.4 million or approximately $24.4 million and 3.6% higher than the $668.0 million reported at December 31, 2008.  See also “Loans” under “Financial Condition” of this Discussion and Analysis for additional information regarding the Bank’s loan portfolio.

· At September 30, 2009, total deposits were approximately $753.5 million or approximately $150.0 million and 24.9% higher than the $603.5 million reported at December 31, 2008.  Deposits, exclusive of brokered were approximately $736.5 million or $181.6 million higher than the $554.9 million reported at December 31, 2008.  See also “Deposits and Borrowed Funds” under “Financial Condition” of this Discussion and Analysis for information regarding the Bank’s deposit liabilities.

· At September 30, 2009, borrowings with the FHLB were $65.0 million or approximately $44.0 million lower than the $109.0 million reported at December 31, 2008.  Higher retail deposit balances during the first nine months of 2009 resulted in fewer borrowings with the FHLB.

 Heritage Oaks Bancorp | - 27 -

Management’s Discussion and Analysis

· Investment securities totaled approximately $102.9 million or approximately $52.1 million higher than the $50.8 million reported at December 31, 2008.  The year to date increase in the portfolio can be attributed to purchases the Bank made to take advantage of increased credit spreads available on investment securities and to invest excess liquidity in cash flow generating instruments in the absence of loan originations.  The lower volume of loan originations relative to historical periods can be attributed in part to lower demand for certain types of credit as well as the Bank becoming more selective with respect to the types of loans it chooses to originate.  For additional information on the Bank’s investment securities portfolio, please see “Investment Securities and Other Earning Assets” of this Discussion and Analysis.

· Federal Funds sold totaled approximately $45.7 million at September 30, 2009, representing an increase of approximately $39.1 million over that reported at December 31, 2008.  Increased balances within this category can be attributed to increased core deposit balances throughout 2009.  See also “Investment Securities and Other Earning Assets” of this Discussion and Analysis for additional information regarding Federal Funds sold.

The following provides an overview of asset quality as of September 30, 2009:

· At September 30, 2009, the balance of non-performing loans was approximately $39.8 million or $21.1 million higher than the $18.7 million reported at December 31, 2008.  As of September 30, 2009 the balance of non-performing loans as a percentage of total gross loans was 5.61% compared to 2.75% as of December 31, 2008.  During the third quarter of 2009, the Bank added approximately $34.2 million in loan balances to non-accruing status.  Contributing to the increase in non-accruing balances was the addition of one loan in the approximate amount of $10.7 million.  As mentioned, upon working with the borrower, Management was able to recover the interest reversed during the third quarter and move the loan back to performing status during the month of October 2009.   Please see “Non-Performing Assets” of this Discussion and Analysis for a more complete discussion of the loans the Bank has placed on non-accrual.

· As of September 30, 2009, the allowance for loan losses totaled approximately $15.9 million, representing 2.24% of total gross loans.  This compares to the $10.4 million or 1.53% of total gross loans reported at December 31, 2008.  Provisions for loan losses during the three and nine month periods ended September 30, 2009 totaled approximately $9.8 million and $14.6 million, respectively.  See also “Provision for Loan Losses” of this Discussion and Analysis for a more complete discussion regarding loan loss provisions.

· Charge-offs during the three and nine month periods ended September 30, 2009 were approximately $5.0 million and $9.1 million, respectively.  For the three and nine months ended September 30, 2009 net charge-offs to average gross loans were 0.70% and 1.29%, respectively.  When compared to the 0.15% and 0.31% reported for the same periods ended a year earlier, represents increases 55 and 98 basis points, respectively.

· During the first nine months of 2009, the Bank moved approximately $9.7 million in loan balances to foreclosed status of which approximately $9.6 million was classified as OREO.  During the third quarter of 2009 balances that moved to OREO totaled approximately $1.2 million.  As of September 30, 2009, the balance of OREO was $2.6 million compared to the $1.3 million reported at December 31, 2008.  In spite of the year to date increase in OREO balances, the Bank sold five properties during the third quarter, previously booked at $3.9 million.  Aggregate net losses the Bank incurred related to these sales totaled approximately $0.2 million.  For the first nine months of 2009, the Bank incurred aggregate net losses of approximately $0.3 million related to the sale of OREO properties.  See also “Non Performing Assets” under “Financial Condition” of this Discussion Analysis for additional information related asset quality.

Recent Developments

During the third and fourth quarters of 2008, the credit and equity markets came under significant duress as confidence by many in the U.S. financial system began to wane.  During the later part of 2007 and throughout 2008, many U.S. financial institutions were forced to significantly write-down the values of certain classes of assets in response to the weakened real estate market.  These losses lead to strained capital levels, impairing the confidence of many depositors and others providing funding to the nation’s banks, which in turn lead to a crisis of liquidity.  With liquidity levels of many financial institutions significantly weakened, borrowing costs began to rise considerably and the flow of credit to consumers and between banks all but came to a halt.  In response to this, the weakened economy and other factors, the U.S. Congress passes the Emergency Economic Stabilization Act of 2008 (the “EESA”) in October of 2008.  Under the EESA, the Department of the U.S. Treasury formed the Troubled Asset Relief Program (the “TARP”).  The TARP gives the U.S. Treasury the power to make purchases of certain troubled assets as well as the direct purchase of equity from U.S. financial institutions under the CPP.  Although the Company’s liquidity levels remained adequate and the Bank and Company were well capitalized throughout 2008, the Company applied to participate in the CPP to keep all capital raising options available.  On February 27, 2009, the Company received shareholder approval to add an authorized class of preferred stock to the Company’s Articles of Incorporation that allowed the Company to participate in the CPP and will also allow for more flexibility in capital raising efforts in general.  On March 20, 2009, the Company issued 21,000 shares of Senior Preferred Stock to the U.S. Treasury under the terms of the CPP for $21.0 million.  Additionally, the Company issued a warrant to the U.S. Treasury to purchase 611,650 shares of its common stock at a price of $5.15 per share, representing 15% of the preferred issuance or approximately $3.2 million.  For a more detailed discussion regarding the Company’s participation in the CPP, see Note 9. Preferred Stock, to the consolidated financial statements filed on this Form 10-Q.

 Heritage Oaks Bancorp | - 28 -

Management’s Discussion and Analysis

Dividends and Stock Repurchases

During the first nine month of 2009, the Company paid approximately $424 thousand in dividends on its Senior Preferred Stock issued to the U.S. Treasury under the CPP.  The Company paid dividends of approximately $263 thousand on its Senior Preferred Stock during the third quarter of 2009.  See also Note 9. Preferred Stock, to the consolidated financial statements filed on this form 10-Q for additional information about dividends on the Company’s Senior Preferred Stock.

On April 24, 2008, the Board of Directors declared a 5% stock divided to be paid on May 16, 2008 to shareholders of record on May 2, 2008.  This stock dividend represented a change in the form of dividend payment to the Company’s shareholders away from cash dividends in order to retain the Company’s capital for future growth.

On January 24, 2008, the Board of Directors declared a quarterly cash dividend of $0.08 per share to be paid on February 15, 2008 to shareholders of record on February 1, 2008.

The Company paid no dividends on or made repurchases of its common stock during the three and nine months ended September 30, 2009.

Selected Financial Data

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

	For the quarters ended,
(dollars in thousands except per share data)	09/30/09			06/30/09			03/31/09			12/31/08			09/30/08			06/30/08			03/31/08			12/31/07
Return on average assets		-2.30	%		0.23	%		0.54	%		-0.63	%		0.27	%		0.35	%		0.91	%		1.11	%
Return on average equity		-22.54	%		2.20	%		6.04	%		-6.93	%		2.94	%		3.84	%		9.55	%		11.65	%
Return on average common equity		-30.41	%		1.41	%		6.19	%		-6.93	%		2.94	%		3.84	%		9.55	%		11.65	%
Average equity to average assets		10.18	%		10.68	%		8.95	%		9.06	%		9.16	%		9.14	%		9.48	%		9.49	%
Average common equity to average assets		8.06	%		8.47	%		8.64	%		9.06	%		9.16	%		9.14	%		9.48	%		9.49	%
Net interest margin		4.34	%		4.91	%		5.03	%		5.04	%		5.18	%		5.28	%		5.33	%		5.33	%
Efficiency ratio*		95.12	%		70.02	%		66.71	%		66.43	%		64.40	%		66.31	%		72.17	%		67.26	%
Average loans to average deposits		98.20	%		103.58	%		112.39	%		109.95	%		111.54	%		109.26	%		103.64	%		96.40	%
Net (loss) / income	$	(5,242	)	$	507		$	1,102		$	(1,254	)	$	534		$	691		$	1,675		$	1,978
Net (loss) / income available to common shareholders	$	(5,594	)	$	257		$	1,091		$	(1,254	)	$	534		$	691		$	1,675		$	1,978
(Loss) / Earnings Per Common Share:
Basic	$	(0.73	)	$	0.03		$	0.14		$	(0.16	)	$	0.07		$	0.09		$	0.22		$	0.26
Diluted	$	(0.73	)	$	0.03		$	0.14		$	(0.16	)	$	0.07		$	0.09		$	0.21		$	0.25
Outstanding Shares:
Basic		7,699,377			7,696,027			7,689,317			7,660,342			7,709,600			7,705,174			7,694,546			7,682,730
Diluted		7,699,377			7,866,962			7,824,377			7,660,342			7,798,321			7,830,390			7,851,831			7,887,206

* 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 the sale of investment securities, sale of other real estate owned and sale of SBA loans.

 Heritage Oaks Bancorp | - 29 -

Management’s Discussion and Analysis

Local Economy

The economy in the Company’s service area is based primarily on agriculture, tourism, light industry, oil and retail trade. 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 262,000, 86,000, and 86,000 respectively, according to the most recent economic data provided by the U.S. Census Bureau. The moderate climate allows a year round growing season for numerous vegetables and fruits.  Vineyards and cattle ranches also contribute largely to the local economy.  The Central Coast’s leading agricultural industry is the production of wine grapes and production of premium quality wines. Vineyards in production have grown significantly over the past several years throughout the Company’s service area.  Access to numerous recreational activities including lakes, mountains and beaches, provide a relatively stable tourist industry from many areas including the Los Angeles/Orange County basin, the San Francisco Bay area and the San Joaquin Valley. While the economy in the Company’s primary markets of San Luis Obispo and Santa Barbara counties have not been immune to the negative impacts of both the national and state economies, the abundant tourism that has developed over the past decade in our market area, especially in the wine industry and coastal communities, has helped sustain our local economy in previous economic downturns.  According to a recent publication by Smith Travel Research in regard to hotel occupancy rates comparing May 2009 to May 2008, there was a decline in occupancy of 2.6%, 4.9% and 12.3% for Paso Robles/San Luis Obispo, Santa Barbara/Santa Maria and the State of California, respectively.

2009 is proving to be a challenging year not only on the national level, but within the state of California and more specifically our primary market area.  As the U.S. housing market continued to wane throughout 2009 and economic growth continued to slow, the ability of borrowers to satisfy their obligations to the financial sector has languished.  These among other factors placed severe stress on the U.S. financial system, leading to a crisis of confidence, further downturn in economic growth and unprecedented volatility in the U.S. equity and credit markets.  As mentioned, our primary market area has historically enjoyed a more stable level of economic activity; however we believe these more macro level concerns have started to become more evident within our market area.  Recent indications show the unemployment rate within California to be approximately 12.2%.  Within the Company’s primary market area, recent indications show the unemployment rate within San Luis Obispo and Santa Barbara major metropolitan areas to be approximately 9.4% and 8.5%, respectively.  Additionally, housing prices have fallen significantly in California and within the Bank’s market area from the highs seen during 2007.  Recent indications show that median home prices within California declined 7.3% from year ago levels and that prices within the Bank’s primary market of San Luis Obispo and Santa Barbara counties have actually increased by 3.9% and 17.2%, respectively from depressed levels seen in 2008.  Even though real estate prices remain well below levels seen in 2007, sales have been relatively strong within the State of California and the Company’s primary market area, climbing over 30% compared to 2008, the majority of which can be attributed to sales of distressed properties.  That said, the lack of oversupply in the Company’s market, desirable climate, close proximity to beaches, lakes and the wine industry, for both San Luis Obispo and Santa Barbara Counties have resulted in lower percentage declines in prices for the local real-estate market, relative to other areas of California and have in part resulted in slight year over year increases in median home prices.

Management acknowledges that as economic conditions continue to wane on state and national levels and as the level of unemployment continues to rise, conditions within our primary market may be negatively impacted above and beyond what the Bank has seen thus far.  Additional job losses and any prolonged decline in economic activity will no doubt impact the borrowers to whom the Bank has extended credit, which may further impact our operating results and financial condition.

Critical Accounting Policies

The Company’s significant accounting policies are set forth in the 2008 Annual Report, Note 1 of the consolidated financial statements, which was filed on Form 10-K.

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

Loans and Interest on Loans

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

 Heritage Oaks Bancorp | - 30 -

Management’s Discussion and Analysis

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

Loans on which the accrual of interest has been discontinued are designated as non-accrual loans.  The accrual of interest on loans is discontinued when principal or interest is past due 90 days based on contractual terms of the loan or when, in the opinion of Management, there is reasonable doubt as to collectibility.  When loans are placed on non-accrual status, all interest previously accrued but not collected is reversed against current period interest income.  Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote.  Interest payments received on such loans are applied as a reduction to the loan principal balance.  Interest accruals are resumed on such loans only when they are brought current with respect to interest and principal and when, in the judgment of Management, the loans are estimated to be fully collectible as to all principal and interest.

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

Allowance for Loan Losses

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

Loans are considered impaired if, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement.  The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate stipulated in the loan agreement, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral.  In measuring the fair value of the collateral, Management uses assumptions and methodologies consistent with those that would be utilized by unrelated third parties.  Allowances for impaired loans are generally determined based on collateral values or the present value of estimated future cash flows.

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

Other Real Estate Owned

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

 Heritage Oaks Bancorp | - 31 -

Management’s Discussion and Analysis

Securities Available for Sale

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

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

Goodwill and Other Intangible Assets

As discussed in the 2008 Annual Report, Note 1 of the consolidated financial statements, which was filed on Form 10-K, we assess goodwill and other intangible assets each year for impairment.  The Company’s assessment at December 31, 2008, pursuant to its Goodwill Impairment Testing Policy, was performed with the assistance of an independent third party and resulted in no impairment.

Deferred Tax Assets

Deferred income taxes reflect the tax effect of temporary and permanent differences between the financial statement carrying amount and the corresponding tax basis of assets and liabilities.  We use an estimate of future earnings to support our position that the benefit of our deferred tax assets will be realized.  If future income should prove non-existent or less than the amount of the deferred tax assets within the tax years to which they may be applied, the asset may not be realized and a valuation allowance may be established and our net income will be reduced.

Results of Operations

Significantly impacting the Company’s operating results for the three and nine month periods ended September 30, 2009 when compared to the same periods ended a year earlier were considerably higher provisions for loan losses.  Provisions for loan losses during the three and nine month periods ended September 30, 2009 totaled approximately $9.8 million and $14.6 million, respectively.  Increases in non-accruing loan balances, loan charge-offs, increases in the balance of loans the Bank classifies as substandard and continued weakness in economic conditions were drivers behind the increased loan loss provisions during 2009.  Please see “Provision for Loan Losses” of this Discussion and Analysis for additional information related to the year over year increases in provision expenses.

The Company’s earnings are highly influenced by changes in short term interest rates.  The nature of the Company’s balance sheet can be summarily described as of short duration and asset sensitive. The balance sheet is of short duration because a large percentage of its interest sensitive assets and liabilities re-price immediately with changes in Federal Funds and Prime interest rates.  This was evidenced during 2008, as the Federal Open Market Committee (“FOMC”) cut the overnight Fed Funds rate by over 400 basis points, placing pressure on the level of and growth in net interest income.

 Heritage Oaks Bancorp | - 32 -

Management’s Discussion and Analysis

Contributing significantly to an asset sensitive balance sheet is a relatively large volume of non-interest bearing demand deposit accounts which effectively never re-price.  Therefore, an upward movement in short term interest rates will generally result in higher net interest margin and conversely, a reduction in short term interest rates will result in reduced net interest margin.  However, as a result of promotions over the last two years designed to attract lower cost core deposits, the Bank was able to significantly increase the level of floating rate liabilities in the form of money market and short term certificate accounts, bringing the balance sheet to a more neutral position regarding interest rate sensitivity.  This was instrumental in mitigating substantial year over year declines in the net interest margin as a result of dramatic declines in the overnight Fed Funds and Prime rates during 2008.

For the three and nine months ended September 30, 2009, the net interest margin was 4.34% and 4.75%, respectively.  This compares to the 5.18% and 5.26% reported for the same periods ended in 2008.  The year over year declines in the net interest margin can be attributed to reductions in the overnight Fed Funds rate, higher average balances of Federal Funds sold resulting from substantial increases in core deposit balances and interest reversals related to the loans placed on non-accrual during 2009.  The resulting decrease in yield on earning assets overall was the driver in regard to margin compression during 2009.

Historically, the largest and most variable source of income for the Company is net interest income. The results of operations for the three and nine months ended September 30, 2009 and 2008 reflect the impact of dramatically lower interest rates throughout the majority of 2008 as the result of a significantly weakened economy.

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

 Heritage Oaks Bancorp | - 33 -

Management’s Discussion and Analysis

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 and nine month periods ended September 30, 2009 and 2008. The average balance of non-accruing loans has been included in loan totals:

	For the three months ending								For the three months ending
	September 30, 2009								September 30, 2008
				Yield/			Income/					Yield/			Income/
(dollars in thousands)	Balance			Rate (4)			Expense		Balance			Rate (4)			Expense
Interest Earning Assets:
Investments with other banks	$	119			3.33	%	$	1	$	128			3.11	%	$	1
Federal funds sold		33,895			0.25	%		21		3,342			2.14	%		18
Investment securities taxable		75,563			4.66	%		888		43,221			5.52	%		600
Investment securities non taxable		22,653			4.33	%		247		17,125			4.32	%		186
Loans (1) (2)		713,810			5.95	%		10,703		667,441			6.99	%		11,731
Total interest earning assets		846,040			5.56	%		11,860		731,257			6.82	%		12,536
Allowance for possible loan losses		(11,969	)							(8,664	)
Other assets		71,976								65,230
Total assets	$	906,047							$	787,823
Interest Bearing Liabilities:
Interest bearing demand	$	67,825			0.92	%	$	157	$	74,042			0.47	%	$	88
Savings		25,619			0.28	%		18		23,272			0.43	%		25
Money market		209,634			1.52	%		804		175,967			1.75	%		773
Time deposits		219,253			2.32	%		1,284		144,490			3.06	%		1,111
Brokered money market funds		2,826			0.70	%		5		-			0.00	%		-
Brokered time deposits		23,426			1.46	%		86		25,028			3.35	%		211
Total interest bearing deposits		548,583			1.70	%		2,354		442,799			1.98	%		2,208
Federal funds purchased		-			0.00	%		-		4,583			2.26	%		26
Securities sold under agreement to repurchase		-			0.00	%		-		2,327			1.88	%		11
Federal Home Loan Bank borrowing		65,000			0.63	%		103		89,408			2.59	%		582
Junior subordinated debentures		13,403			4.08	%		138		13,403			5.46	%		184
Total borrowed funds		78,403			1.22	%		241		109,721			2.91	%		803
Total interest bearing liabilities		626,986			1.64	%		2,595		552,520			2.17	%		3,011
Non interest bearing demand		178,293								155,582
Total funding		805,279			1.28	%		2,595		708,102			1.69	%		3,011
Other liabilities		8,490								7,585
Total liabilities	$	813,769							$	715,687
Stockholders' Equity:
Preferred stock	$	19,288							$	-
Common stock		48,695								48,456
Additional paid in capital		3,125								882
Retained earnings		23,171								23,401
Valuation allowance investments		(2,001	)							(603	)
Total stockholders' equity		92,278								72,136
Total liabilities and stockholders' equity	$	906,047							$	787,823
Net interest income							$	9,265							$	9,525
Net interest margin (3)					4.34	%							5.18	%

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

(2)  Loan fees of $229 and $285 for the three months ending September 30, 2009 and 2008, respectively have been included in interest income computation.

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

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

 Heritage Oaks Bancorp | - 34 -

Management’s Discussion and Analysis

	For the nine months ending								For the nine months ending
	September 30, 2009								September 30, 2008
				Yield/			Income/					Yield/			Income/
(dollars in thousands)	Balance			Rate (4)			Expense		Balance			Rate (4)			Expense
Interest Earning Assets:
Investments with other banks	$	119			3.37	%	$	3	$	246			3.80	%	$	7
Federal funds sold		22,596			0.22	%		38		6,855			2.53	%		130
Investment securities taxable		59,614			4.66	%		2,077		42,656			5.26	%		1,681
Investment securities non taxable		19,763			4.34	%		641		17,223			4.30	%		555
Loans (1) (2)		705,187			6.31	%		33,266		649,511			7.31	%		35,554
Total interest earning assets		807,279			5.97	%		36,025		716,491			7.07	%		37,927
Allowance for possible loan losses		(10,909	)							(7,120	)
Other assets		70,288								65,028
Total assets	$	866,658							$	774,399
Interest Bearing Liabilities:
Interest bearing demand	$	64,524			0.72	%	$	347	$	74,886			0.61	%	$	343
Savings		23,849			0.21	%		38		26,834			0.95	%		191
Money market		186,921			1.51	%		2,118		189,181			2.03	%		2,878
Time deposits		182,771			2.49	%		3,400		142,919			3.43	%		3,672
Brokered money market funds		25,387			0.72	%		137		-			0.00	%		-
Brokered time deposits		29,886			1.67	%		373		15,849			3.62	%		429
Total interest bearing deposits		513,338			1.67	%		6,413		449,669			2.23	%		7,513
Federal funds purchased		251			1.07	%		2		4,079			2.69	%		82
Securities sold under agreement to repurchase		870			0.15	%		1		2,163			2.35	%		38
Federal Home Loan Bank borrowing		80,982			0.81	%		492		74,637			2.64	%		1,473
Junior subordinated debentures		13,403			4.42	%		443		13,403			5.85	%		587
Total borrowed funds		95,506			1.31	%		938		94,282			3.09	%		2,180
Total interest bearing liabilities		608,844			1.61	%		7,351		543,951			2.38	%		9,693
Non interest bearing demand		162,830								150,890
Total funding		771,674			1.27	%		7,351		694,841			1.86	%		9,693
Other liabilities		8,650								7,894
Total liabilities	$	780,324							$	702,735
Stockholders' Equity:
Preferred stock	$	13,741							$	-
Common stock		48,673								46,269
Additional paid in capital		2,504								806
Retained earnings		23,166								24,739
Valuation allowance investments		(1,750	)							(150	)
Total stockholders' equity		86,334								71,664
Total liabilities and stockholders' equity	$	866,658							$	774,399
Net interest income							$	28,674							$	28,234
Net interest margin (3)					4.75	%							5.26	%

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

(2)  Loan fees of $711 and $1,008 for the nine months ending September 30, 2009 and 2008, respectively have been included in interest income computation.

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

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

 Heritage Oaks Bancorp | - 35 -

Management’s Discussion and Analysis

The table below sets forth changes in average interest earning assets and their respective yields for the three and nine month periods ending September 30, 2009 compared to the same period ended in 2008:

	Average Balance										Average Yield
	for the three months ending										for the three months ending
	September 30,				Variance						September 30,
(dollars in thousands)	2009		2008		dollar			percentage			2009			2008			Variance
Time deposits with other banks	$	119	$	128	$	(9	)		-7.03	%		3.33	%		3.11	%		0.22	%
Federal funds sold		33,895		3,342		30,553			914.21	%		0.25	%		2.14	%		-1.89	%
Investment securities taxable		75,563		43,221		32,342			74.83	%		4.66	%		5.52	%		-0.86	%
Investment securities non-taxable		22,653		17,125		5,528			32.28	%		4.33	%		4.32	%		0.01	%
Loans (1) (2)		713,810		667,441		46,369			6.95	%		5.95	%		6.99	%		-1.04	%
Total interest earning assets	$	846,040	$	731,257	$	114,783			15.70	%		5.56	%		6.82	%		-1.26	%

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

(2) Loan fees of $229 and $285 for the three months ending September 30, 2009 and 2008, respectively have been included in the interest income computation.

	Average Balance										Average Yield
	for the nine months ending										for the nine months ending
	September 30,				Variance						September 30,
(dollars in thousands)	2009		2008		dollar			percentage			2009			2008			Variance
Time deposits with other banks	$	119	$	246	$	(127	)		-51.63	%		3.37	%		3.80	%		-0.43	%
Federal funds sold		22,596		6,855		15,741			229.63	%		0.22	%		2.53	%		-2.31	%
Investment securities taxable		59,614		42,656		16,958			39.76	%		4.66	%		5.26	%		-0.60	%
Investment securities non-taxable		19,763		17,223		2,540			14.75	%		4.34	%		4.30	%		0.04	%
Loans (1) (2)		705,187		649,511		55,676			8.57	%		6.31	%		7.31	%		-1.00	%
Total interest earning assets	$	807,279	$	716,491	$	90,788			12.67	%		5.97	%		7.07	%		-1.10	%

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

(2) Loan fees of $711 and $1,008 for the nine months ending September 30, 2009 and 2008, respectively have been included in the interest income computation.

At September 30, 2009, average interest earning assets were approximately $114.8 million and $90.8 million higher than that reported over the same three and nine month periods ended a year earlier.  Organic loan growth as well as higher balances of Federal Funds sold and investment securities are the primary factors behind the increase.

For the three and nine month periods ended September 30, 2009, the average yield on loans was 5.95% and 6.31%, respectively.  This represents declines of 104 and 100 basis points from the 6.99% and 7.31% reported for the same periods ended a year earlier.  As economic conditions worsened throughout 2008, the FOMC moved to cut the overnight Fed Funds rate by over 400 basis points, which had a direct impact on yields in the loan portfolio.  Further impacting the year over year decline in the yield of the loan portfolio were interest reversals related to loans the Bank placed on non-accrual during 2009.  As previously mentioned, the Bank reversed approximately $0.8 million in interest income related to one loan, which was recovered in October 2009.  The payment received from the borrower of previously reversed interest allowed the Bank to move the loan back to performing status.  However, as a result of the interest reversal during the third quarter of 2009, the yield on earning assets was impacted by approximately 40 and 14 basis points for the three and nine months ended September 30, 2009, respectively.    The decline in the yield of the loan portfolio is the primary factor contributing to the year over year decline in the yield on earning assets.  Additionally, higher average balances of Federal Funds sold, resulting from substantial deposit growth during the first nine months of 2009, placed further pressure on earning asset yields.  During the first nine months of 2009, the Bank made selective purchases of mortgage related securities, in an effort to invest excess liquidity in higher yielding, cash flow generating instruments, in the absence of loan originations, to mitigate declines in the net interest margin.   For the three and nine month periods ended September 30, 2009, the yield on earning assets declined approximately 126 and 110 basis points when compared to the same periods ended a year ago.

 Heritage Oaks Bancorp | - 36 -

Management’s Discussion and Analysis

The tables below set forth changes in average interest bearing liabilities and their respective rates for the three and nine month periods ending September 30, 2009 compared to the same periods ended in 2008:

	Average Balance										Average Rate
	for the three months ending										for the three months ending
	September 30,				Variance						September 30,
(dollars in thousands)	2009		2008		dollar			percentage			2009			2008			Variance
Interest bearing demand	$	67,825	$	74,042	$	(6,217	)		-8.40	%		0.92	%		0.47	%		0.45	%
Savings		25,619		23,272		2,347			10.09	%		0.28	%		0.43	%		-0.15	%
Money market		209,634		175,967		33,667			19.13	%		1.52	%		1.75	%		-0.23	%
Time deposits		219,253		144,490		74,763			51.74	%		2.32	%		3.06	%		-0.74	%
Brokered money market funds		2,826		-		2,826			100.00	%		0.70	%		0.00	%		0.70	%
Brokered time deposits		23,426		25,028		(1,602	)		-6.40	%		1.46	%		3.35	%		-1.89	%
Federal funds purchased		-		4,583		(4,583	)		-100.00	%		0.00	%		2.26	%		-2.26	%
Securities sold under repurchase agreements		-		2,327		(2,327	)		-100.00	%		0.00	%		1.88	%		-1.88	%
Federal Home Loan Bank borrowing		65,000		89,408		(24,408	)		-27.30	%		0.63	%		2.59	%		-1.96	%
Junior subordinated debentures		13,403		13,403		-			0.00	%		4.08	%		5.46	%		-1.38	%
Total interest bearing liabilities	$	626,986	$	552,520	$	74,466			13.48	%		1.64	%		2.17	%		-0.53	%

	Average Balance										Average Rate
`	for the nine months ending										for the nine months ending
	September 30,				Variance						September 30,
(dollars in thousands)	2009		2008		dollar			percentage			2009			2008			Variance
Interest bearing demand	$	64,524	$	74,886	$	(10,362	)		-13.84	%		0.72	%		0.61	%		0.11	%
Savings		23,849		26,834		(2,985	)		-11.12	%		0.21	%		0.95	%		-0.74	%
Money market		186,921		189,181		(2,260	)		-1.19	%		1.51	%		2.03	%		-0.52	%
Time deposits		182,771		142,919		39,852			27.88	%		2.49	%		3.43	%		-0.94	%
Brokered money market funds		25,387		-		25,387			100.00	%		0.72	%		0.00	%		0.72	%
Brokered time deposits		29,886		15,849		14,037			88.57	%		1.67	%		3.62	%		-1.95	%
Federal funds purchased		251		4,079		(3,828	)		-93.85	%		1.07	%		2.69	%		-1.62	%
Securities sold under repurchase agreements		870		2,163		(1,293	)		-59.78	%		0.15	%		2.35	%		-2.20	%
Federal Home Loan Bank borrowing		80,982		74,637		6,345			8.50	%		0.81	%		2.64	%		-1.83	%
Junior subordinated debentures		13,403		13,403		-			0.00	%		4.42	%		5.85	%		-1.43	%
Total interest bearing liabilities	$	608,844	$	543,951	$	64,893			11.93	%		1.61	%		2.38	%		-0.77	%

At September 30, 2009, the balance of interest bearing liabilities was approximately $74.5 million and $64.9 million higher than that reported over the same three and nine month periods ended a year earlier.  Increases in the average balance of interest bearing liabilities for the three and nine months ended September 30, 2009 can be attributed in large part to higher money market and time deposit balances.  The Bank attributes strong year over year deposit growth to several factors including efforts in making its brand top of mind in the Bank’s primary markets.  Growth can also be attributed to the continued focus on providing excellent customer service as well as marketing and promotional activities designed to attract additional core deposits.  The Bank has also managed to attract deposits from some of the larger institutions in its market.

Increases in core deposits have allowed the Bank to pay down $44.0 million in FHLB borrowings and approximately $31.6 million in brokered funds during the first nine months of 2009.  The Bank’s focus on core deposit gathering has also led to a year over year increase in the average balance of non-interest bearing demand deposits, contributing to a decline in the Company’s cost of funds of 41 and 59 basis points for the three and nine month periods ended September 30, 2009, respectively, when compared to the same periods ended a year earlier.

The Bank stayed relatively short with respect to its interest bearing liabilities during 2008 and into the first quarter of 2009.  This proved to be beneficial with respect to the cost of its interest bearing liabilities as the Federal Reserve moved aggressively to lower the overnight Fed Funds rate by over 400 basis points during 2008.  The Bank’s ability to rapidly re-price a significant portion of its interest bearing liabilities in a declining interest rate environment helped to keep funding costs relatively low and reduce the impact of falling rates on the net interest margin.

Heritage Oaks Bancorp | - 37 -

Management’s Discussion and Analysis

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, 2009 over the same period ended in 2008, 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, 2009 over 2008									September 30, 2009 over 2008
(dollars in thousands)	Volume			Rate			Total			Volume			Rate			Total
Interest Income:
Investments with other banks	$	-		$	-		$	-		$	(4	)	$	-		$	(4	)
Federal funds sold		3			-			3			(152	)		60			(92	)
Investment securities taxable		363			(75	)		288			556			(160	)		396
Investment securities non-taxable (2)		92			-			92			123			8			131
Taxable equivalent adjustment (2)		(31	)		-			(31	)		(42	)		(3	)		(45	)
Loans (1)		898			(1,926	)		(1,028	)		3,810			(6,098	)		(2,288	)
Net increase (decrease)		1,325			(2,001	)		(676	)		4,291			(6,193	)		(1,902	)
Interest Expense:
Savings, NOW, money market		94			(1	)		93			(66	)		(843	)		(909	)
Time deposits		323			(150	)		173			(19,856	)		19,584			(272	)
Brokered funds		(13	)		(107	)		(120	)		(143	)		224			81
Other borrowings		(145	)		(371	)		(516	)		74			(1,172	)		(1,098	)
Long term debt		-			(46	)		(46	)		-			(144	)		(144	)
Net increase (decrease)		259			(675	)		(416	)		(19,991	)		17,649			(2,342	)
Total net increase (decrease)	$	1,066		$	(1,326	)	$	(260	)	$	24,282		$	(23,842	)	$	440

(1) Loan fees of $229 and $285 for the three months ending September 30, 2009 and 2008 and $711 and $1,008 for the nine months ending September 30, 2009 and 2008, respectively.

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

Non-Interest Income

The table below sets forth changes in non-interest income for the three and nine month periods ended September 30, 2009 compared to the same periods ended in 2008:

	For the three months ended
	September 30,					Variance
(dollars in thousands)	2009			2008		dollar			percentage
Service charges on deposit accounts	$	750		$	878	$	(128	)		-14.58	%
ATM/Debit and credit card transaction/interchange fees		253			232		21			9.05	%
Bancard		48			69		(21	)		-30.43	%
Mortgage origination fees		245			118		127			107.63	%
Earnings on bank owned life insurance		124			121		3			2.48	%
Other commissions and fees		92			95		(3	)		-3.16	%
Gain on sale of investment securities		211			-		211			100.00	%
Loss on sale of OREO		(200	)		-		(200	)		100.00	%
Gain on sale of SBA loans		70			-		70			100.00	%
Total non interest income	$	1,593		$	1,513	$	80			5.29	%

 Heritage Oaks Bancorp | - 38 -

Management’s Discussion and Analysis

	For the nine months ended
	September 30,					Variance
(dollars in thousands)	2009			2008		dollar			percentage
Service charges on deposit accounts	$	2,214		$	2,487	$	(273	)		-10.98	%
ATM/Debit and credit card transaction/interchange fees		723			671		52			7.75	%
Bancard		140			183		(43	)		-23.50	%
Mortgage origination fees		910			367		543			147.96	%
Earnings on bank owned life insurance		369			352		17			4.83	%
Other commissions and fees		325			611		(286	)		-46.81	%
Gain on sale of investment securities		333			37		296			800.00	%
Loss on sale of OREO		(331	)		-		(331	)		100.00	%
Gain on sale of SBA loans		70			-		70			100.00	%
Total non interest income	$	4,753		$	4,708	$	45			0.96	%

Non-interest income for the three and nine months ended September 30, 2009 increased approximately $80 thousand or 5.3% and $45 thousand or 1.0%, respectively when compared to the same periods ended in 2008.  Contributing substantially to the year over year increases were significantly higher mortgage origination fee income as well as gains the Bank recognized in connection with the sale of investment securities and SBA loans.  Offsetting these increases were declines in service charge fee income as well as losses the Bank incurred on the sale of OREO properties.  Additionally, the absence of income the Bank recognized in the approximate amount of $0.3 million during the second quarter of 2008 in connection with the Visa, Inc. IPO contributed to the year to date decline within the category of “other commissions and fees.”

During the third quarter of 2009, the Bank sold $11.3 million in investment securities and recognized an aggregate pre-tax gain of approximately $0.2 million.  During the first nine months of 2009, the Bank sold approximately $16.0 million in investment securities and recognized pre-tax gains of approximately $0.3 million.

Non-interest income for the three and nine month periods ended September 30, 2009 was negatively impacted by year over year declines in service charge fee income, primarily the result of a decline in NSF fee income.  Service charges on deposit accounts declined approximately $0.1 million and $0.3 million during the three and nine months ended September 30, 2009 when compared to the same periods ended a year earlier.

Contributing significantly to the year over year increases in non-interest income were significant increases in mortgage origination fees.  Income within this category increased approximately $0.1 million or 107.6% and $0.5 million or 148.0% during the three and nine month periods ended September 30, 2009, when compared to the same periods ended a year earlier.  The Bank witnessed a significant increase in the number of home loan re-financings during the first nine months of 2009 when compared to the same period ended a year earlier as a result of a significantly lower rate environment.

As the result of a significant reduction in the number of competitors in mortgage origination within the Bank’s market, the Bank recognized the opportunity to expand the mortgage origination department. More than a year ago, the Bank hired a well seasoned mortgage manager who has been able to expand the Bank’s penetration into the origination market both in San Luis Obispo and Santa Barbara counties.  This strategy has performed well at this point as is exhibited by the revenue generation of the department.

The table below illustrates the change in the number and total dollar volume of mortgage loans originated during the three and nine months ended September 30, 2009 when compared to the same period ended in 2008:

	For the three months ended September 30,
(dollars in thousands)	2009		2008		Variance
Dollar volume	$	38,993	$	14,710		165.1	%
Number of loans		99		35		182.9	%

	For the nine months ended September 30,
(dollars in thousands)	2009		2008		Variance
Dollar volume	$	127,680	$	44,087		189.6	%
Number of loans		377		118		219.5	%

 Heritage Oaks Bancorp | - 39 -

Management’s Discussion and Analysis

Non-Interest Expenses

The table below sets forth changes in non-interest expenses for the three and nine month periods ended September 30, 2009 compared to the same periods ended in 2008:

	For the three months ended
	September 30,				Variance
(dollars in thousands)	2009		2008		dollar			percentage
Salaries and employee benefits	$	3,969	$	3,651	$	318			8.71	%
Occupancy		843		741		102			13.77	%
Equipment		365		335		30			8.96	%
Promotional		191		199		(8	)		-4.02	%
Data processing		687		672		15			2.23	%
Stationery and supplies		111		99		12			12.12	%
Regulatory fees		851		116		735			633.62	%
Audit and tax costs		182		114		68			59.65	%
Amortization of core deposit intangible		262		215		47			21.86	%
Director fees		80		80		-			0.00	%
Communications		76		87		(11	)		-12.64	%
Other		2,634		799		1,835			229.66	%
Total non interest expense	$	10,251	$	7,108	$	3,143			44.22	%

	For the nine months ended
	September 30,				Variance
(dollars in thousands)	2009		2008		dollar			percentage
Salaries and employee benefits	$	11,517	$	11,897	$	(380	)		-3.19	%
Occupancy		2,521		2,291		230			10.04	%
Equipment		1,066		1,053		13			1.23	%
Promotional		517		681		(164	)		-24.08	%
Data processing		2,049		1,998		51			2.55	%
Stationery and supplies		314		323		(9	)		-2.79	%
Regulatory fees		1,531		340		1,191			350.29	%
Audit and tax costs		477		342		135			39.47	%
Amortization of core deposit intangible		787		646		141			21.83	%
Director fees		243		238		5			2.10	%
Communications		199		239		(40	)		-16.74	%
Other		4,469		2,178		2,291			105.19	%
Total non interest expense	$	25,690	$	22,226	$	3,464			15.59	%

Salary and Employee Benefits

Salaries and employee related expenses increased approximately $318 thousand during the three months ended September 30, 2009 when compared to that reported in the same period ended a year earlier.  Staff additions during the third quarter in response to the growth of the Bank contributed significantly to the rise within this category.

For the first nine months of 2009, the Bank saw expenses within this category decline approximately $380 thousand when compared to that reported during the same period ended a year ago.  Efficiencies the Bank gained with respect to staffing during the later part of 2008 and early in 2009 contributed to the majority of the year over year decline within this category.

Occupancy Expenses

Year over year increases within this category are primarily attributable to annual increases in rental expense.

Promotion Expenses

Year over year declines within this category are primarily attributable to cost cutting measures Management implemented during the first quarter of 2009.

Heritage Oaks Bancorp | - 40 -

Management’s Discussion and Analysis

Regulatory Fees

For the three and nine months ended September 30, 2009, regulatory fees were approximately $735 thousand and $1.2 million higher than that reported for the same periods ended a year earlier.  During the second quarter of 2009 the Bank took a one-time charge in the approximate amount of $0.4 million related to a special assessment imposed by the FDIC on all insured institutions with the intent to replenish the Deposit Insurance Fund.  The year over year increase within this category for both the three and nine months ended September 30, 2009 can also be attributed to a one-time charge in the approximate amount of $0.5 million to correct for the cumulative effect of an accounting error related to the accrual of FDIC assessments that covered ten reporting periods.  Management determined that the shortage in the accrual was not material to the Company’s financial statements in any one reporting period and as such, processed the correcting entry in the third quarter of 2009.

In addition to the items mentioned above regular quarterly assessment fees imposed by the FDIC have also increased from year ago levels and may increase further throughout the remainder of 2009.

Core Deposit Intangible (“CDI”) Amortization

Upon the acquisition of Business First the Company booked a CDI in the approximate amount of $3.8 million.  The balance of this intangible will be amortized over a six year period pursuant to a schedule provided in the initial valuation process.  For the three and nine months ended September 30, 2009 CDI amortization was approximately $47 thousand and $142 thousand higher than that reported for the same periods ended in 2008 of which substantially all can be attributed to the Business First acquisition.

Other Expenses

Expenses within this category increased approximately $1.8 million and $2.3 million during the three and nine months ended September 30, 2009 when compared to the same periods ended a year ago.  The majority of the increase within this category can be attributed to the write-down of a single OREO property during the third quarter of 2009 in the approximate amount of $1.3 million.  This property represents land for commercial development and is located in the Bank’s primary market area.  Total OREO write-downs for the three and nine months ended September 30, 2009 were approximately $1.4 million and $1.5 million, respectively.

The Bank also incurred other expenses related to OREO and other foreclosed collateral.  These expenses totaled approximately $0.3 million and $0.6 million for the three and nine months ended September 30, 2009, respectively.

Year over year increases within this category can also be attributed to increased loan department costs related to  expenses incurred for appraisals and collection efforts.  Loan department costs increased approximately $74 thousand and $179 thousand during the three and nine month periods ended September 30, 2009 when compared to the same periods ended a year ago.

Exclusive of one-time expenses mentioned in the preceding paragraphs as well as various expenses the Bank incurred related to OREO and foreclosed collateral, non-interest expense increased approximately $0.8 million or 11.9% and $0.4 million and 2.0% for the three and nine month periods ended September 30, 2009.

Provision for Income Taxes

For the three and nine month periods ended September 30, 2009 the Company recorded an income tax benefit of approximately $3.9 million and $3.2 million, respectively.  This compares to the $0.2 million and $1.6 million in income tax expense the Company recorded for the same periods ended in 2008.  The year over year declines within this category can be attributed in large part to substantial increases in provisions for loan losses throughout 2009 as well as other significant one-time expenses.  Income tax benefits for the three and nine month periods ended September 30, 2009 were 42.7% and 46.8% of the Company’s pre-tax loss for those periods.  The effective tax rate for the same periods ended a year earlier was 26.8% and 35.6%.  The primary reason behind the increase in the Company’s effective tax rate can be attributed in large part to the approximate $0.5 million and $1.2 million in non-taxable income related to holdings of municipal securities, bank owned life insurance, and interest income earned on loans with preferential tax treatment.  

 Heritage Oaks Bancorp | - 41 -

Management’s Discussion and Analysis

Provision for Loan Losses

An allowance for loan losses has been established by Management to provide for those loans that may not be repaid in their entirety for a variety of reasons.  The allowance is maintained at a level considered by Management to be adequate to provide for probable incurred losses.  The allowance for loan losses is comprised of three components: specific credit allocation, general portfolio allocation, and subjectively determined allocation.  The allowance is increased by provisions charged to earnings and is reduced by charge-offs, net of recoveries.  The provision for loan losses is based upon past loan loss experience and Management’s evaluation of the loan portfolio under current economic conditions.  Loans are charged to the allowance for loan losses when, and to the extent, they are deemed by Management to be un-collectible.

The Bank 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 Bank’s estimate of the allowance necessary to provide for probable incurred losses in the portfolio as of the balance sheet date.  In making this determination, the Bank analyzes the ultimate collectibility of the loans in the portfolio by incorporating feedback provided by internal loan staff, an independent loan review function, and information provided by examinations performed by regulatory agencies.  The Bank makes monthly evaluations as to the adequacy of the allowance for loan losses.

The Bank accounts for problem loans in accordance with accounting guidance provided under U.S. GAAP.  U.S. GAAP provides that when it is probable that a creditor will be unable to collect all amounts due in accordance with the terms of the loan that such loan is deemed impaired.  Impaired loans are accounted for differently in that the amount of the impairment is measured and reflected in the records of the creditor.  The allowance for credit losses related to loans that are identified for evaluation in accordance with accounting guidance under U.S. GAAP is based on discounted cash flows using the loan’s historical effective interest rate stipulated in the loan agreement or the fair value of the collateral for certain collateral dependent loans.  The general portfolio allocation of the allowance consists of assigned reserve percentages based on credit ratings of loans in the portfolio.  The subjective portion is determined based on loan history and the Bank’s evaluation of various factors including current economic conditions and trends in the portfolio including delinquencies and impairment, as well as changes in the composition of the portfolio.

The allowance for loan losses is based on estimates, and ultimate losses will vary from current estimates.  These estimates are reviewed monthly by the Bank’s Directors, Loan Committee and full Board of Directors, and as adjustments, either positive or negative, become necessary, a corresponding increase or decrease is made in the provision for loan losses.  The methodology used to determine the adequacy of the allowance for loan losses for the three and nine months ended September 30, 2009 is consistent with prior periods.

The Bank’s provision for loan losses was $9.8 million and $14.6 million for the three and nine month periods ended September 30, 2009 compared to provisions of $3.2 million and $6.2 million for the same periods ended a year earlier.  Provisions made to the allowance for loan losses during the third quarter and first nine months of 2009, were approximately $6.6 million and $8.4 million higher than that reported for the same periods ended a year earlier.  As economic conditions throughout the later part of 2008 and into 2009 worsened on national, state and local levels, the Bank moved to increase the allowance as required by monthly analyses it conducts in determining its adequacy to cover potential losses in the loan portfolio.  In addition, during the third quarter the Bank’s independent loan review firm completed its semi-annual loan portfolio examination to augment Management’s internal loan review.  As a result of feedback from this review, in connection with our own effort to identify and reserve for perceived credit risks in the portfolio and due to the continuation of worsening economic conditions, we moved approximately $34.2 million in loan balances to non-accruing status.  This increase in non-accrual loans contributed significantly to the increased provision in the third quarter.The Bank employs the use of a “watch list” and loan grading system to assist in monitoring the quality of certain credits in the loan portfolio.  As loans on the watch list and any other loan within the portfolio experience deterioration, the Bank typically moves to downgrade such loans, resulting in an increase in the required allowance to cover any potential losses.  During the third quarter of 2009, the Bank further expanded the list of credits it has placed on the watch list in an effort to add additional oversight and to more closely scrutinize certain groups of loans that have experienced deterioration as a result of, among other things, the continued weakened state of local, state and national economic environments.  Management believes the significant economic downturn witnessed during 2008 and that has continued into 2009 has had a considerable impact on the ability of certain borrowers to satisfy their obligations to the Bank, resulting in continued watch list expansion, loan downgrades and corresponding increases in loan loss provisions.  At September 30, 2009 the balance of loans the Bank has graded “substandard” totaled approximately $81.6 million, of which approximately $39.4 million were non-accruing. However, as disclosed in Note 10. Subsequent Events, of the consolidated financial statements, total non-accruing loans were reduced by $10.7 million during the month of October 2009.

The Bank also makes estimates as to the impact that certain economic factors will have on various credits within the portfolio.  Negative economic trends witnessed during 2008 have continued thus far into 2009 and contributed substantially to increases in the required allowance to cover potential losses in the loan portfolio, resulting in year over year increases in loan loss provisions.

 Heritage Oaks Bancorp | - 42 -

Management’s Discussion and Analysis

Charge-offs in the commercial and industrial, agriculture, construction and land segments of the loan portfolio during the first nine months of 2009 when compared to the same period ended a year earlier increased significantly, mainly attributable to several large write-downs.  These losses in conjunction with an increase in the number and total dollar volume of past due loans within these segments has further contributed to the additional provisions the Bank made to the allowance for loan losses when compared to the year ago periods.  Additionally, non-accruing balances when compared to that reported a year ago, and relative to historical periods remain elevated, also contributing to increased loan loss provisions.  Continued increases in the level of charge-offs, the number and dollar volume of past due, non-accruing and non-performing loans and any further significant downturn in economic conditions may result in further significant provisions to the allowance for loan losses.

Looking forward into the last quarter of 2009, Management anticipates there to be continued weakness in economic conditions on national, state and local levels.  Many economic forecasts suggest further increases in the national unemployment rate, which will undoubtedly place continued pressure on conditions within the Bank’s primary market area.  Continued economic pressures may negatively impact the financial condition of borrowers to whom the Bank has extended credit and as a result the Bank may be required to make further significant provisions to the allowance for loan losses during 2009.  That said, Management has been and will continue to be proactive in looking for signs of deterioration within the loan portfolio in an effort to manage credit quality and work with borrowers where possible to mitigate any further losses.

As of September 30, 2009, Management believes, based on all current and available information, the allowance for loan losses is adequate to absorb current estimable losses within the loan portfolio.

 Heritage Oaks Bancorp | - 43 -

Management’s Discussion and Analysis

Financial Condition

At September 30, 2009, total assets were $926.8 million.  This when compared to the $805.6 million reported at December 31, 2008, represents an increase of approximately $121.2 million or 15.1%.  Increases in investment securities, Federal Funds sold, and net loan balances were primary factors behind the year to date increase in total assets.  An increase of $39.1 million in the balance of Federal Funds sold is attributable to the dramatic increases the Bank saw in deposit balances during the first nine months of 2009.  Net increases in the investment portfolio of approximately $52.1 million are the result of purchases the Bank made during 2009 to take advantage of increased credit spreads on investment securities and to invest excess liquidity in higher yielding cash flow producing instruments in the absence of loan funding.  During the first nine months of 2009, net loan balances grew approximately $24.3 million, contributing to overall growth in total assets.

At September 30, 2009, total deposits were approximately $753.5 million or approximately $150.0 million higher than the $603.5 million reported at December 31, 2008.  Increases in non-interest bearing demand, money market and retail time deposits contributed to the year to date increase in deposits.  Deposit growth during the first nine months of 2009 allowed the Bank to pay down brokered funds as well as borrowings with the FHLB.  Net of the pay down in brokered funds, total deposits grew approximately $181.6 million from that reported at December 31, 2008.  During the first nine months of 2009, FHLB borrowings declined $44.0 million.  See also “Deposits and Borrowed Funds” of this Discussion and Analysis for additional information related to the changes in deposit balances and wholesale borrowings.

Loans

At September 30, 2009 total gross loan balances were $709.9 million.  This represents an increase of approximately $29.8 million or 4.4% from the $680.1 million reported at December 31, 2008.  Higher commercial real estate and commercial loan balances contributed to the majority of the year to date increase in the portfolio.  These loans were made to borrowers within the Bank’s primary market area and to borrowers within the industries of professional, commercial and hospitality.

The following table provides a summary of year to date variances in the loan portfolio as of September 30, 2009:

	September 30,		December 31,		Variance
(dollars in thousands)	2009		2008		dollar			percentage
Real Estate Secured
Multi-family residential	$	17,323	$	16,206	$	1,117			6.89	%
Residential 1 to 4 family		24,580		23,910		670			2.80	%
Home equity line of credit		29,189		26,409		2,780			10.52	%
Commercial		317,811		285,631		32,180			11.27	%
Farmland		9,842		10,723		(881	)		-8.22	%
Commercial
Commercial and industrial		166,618		157,674		8,944			5.67	%
Agriculture		14,819		13,744		1,075			7.83	%
Other		368		620		(252	)		-40.57	%
Construction
Single family residential		14,669		11,414		3,255			28.52	%
Single family residential - Spec.		5,757		15,395		(9,638	)		-62.60	%
Tract		2,215		2,431		(216	)		-8.88	%
Multi-family		5,575		5,808		(233	)		-4.02	%
Hospitality		14,252		18,630		(4,378	)		-23.50	%
Commercial		22,997		21,484		1,513			7.04	%
Land		54,619		61,681		(7,062	)		-11.45	%
Installment loans to individuals		8,863		7,851		1,012			12.89	%
All other loans (including overdrafts)		370		536		(166	)		-31.03	%
Total loans, gross		709,867		680,147		29,720			4.37	%
Deferred loan fees		1,635		1,701		(66	)		-3.87	%
Reserve for possible loan losses		15,873		10,412		5,461			52.45	%
Total loans, net	$	692,359	$	668,034	$	24,325			3.64	%
Loans held for sale	$	7,778	$	7,939	$	(161	)		-2.03	%

 Heritage Oaks Bancorp | - 44 -

Management’s Discussion and Analysis

Real Estate Secured

The following table provides a break-down of the real estate secured segment of the Bank’s loan portfolio as of September 30, 2009:

	September 30, 2009									Percent of					Single
			Undisbursed		Total Bank		Percent			Bank's Risk			Number		Largest
(dollars in thousands)	Balance		Commitment		Exposure		Composition			Based Capital			of Loans		Loan
Retail	$	44,831	$	3,041	$	47,872		11.2	%		55.0	%		62	$	5,000
Professional		81,786		328		82,114		19.3	%		94.3	%		104		9,000
Hospitality		71,562		115		71,677		16.8	%		82.3	%		40		10,981
Multi-family		17,323		-		17,323		4.1	%		19.9	%		20		4,066
Home equity lines of credit		29,189		20,146		49,335		11.6	%		56.7	%		317		1,680
Residential 1 to 4 family		24,580		569		25,149		5.9	%		28.9	%		70		3,000
Farmland		9,842		1,316		11,158		2.6	%		12.8	%		23		1,937
Healthcare / medical		15,963		-		15,963		3.7	%		18.3	%		31		2,155
Restaurants / food establishments		7,381		-		7,381		1.7	%		8.5	%		14		2,541
Commercial		79,230		1,742		80,972		19.0	%		93.0	%		114		4,714
Other		17,058		-		17,058		4.1	%		19.6	%		29		2,100
Total real estate secured	$	398,745	$	27,257	$	426,002		100.0	%		489.3	%		824	$	47,174

As of September 30, 2009, real estate secured balances represented approximately $398.7 million of total gross loans.  This when compared to the $362.9 million reported at December 31, 2008, represents an increase of approximately $35.8 million or 9.9%.  The primary factor behind the year to date increase can be attributed to higher commercial real estate balances.  Year to date increases within this category can be attributed to the completion of several large construction projects and their subsequent reclassification from construction to commercial real estate.  The aggregate balance of these large loans was approximately $14.9 million at September 30, 2009.  During the third quarter of 2009 the Bank funded one $9.0 million credit for the purpose of purchasing professional office space, occupied by three national tenants.  This credit was originated with a loan to value of 50% and a debt coverage ratio of 2.4 times. During the first nine months of the year the Bank also made several new loans in excess of $1.0 million.  The aggregate balance of these loans was approximately $22.6 million as of September 30, 2009.  These new loans were made to borrowers in the industries of professional, commercial and hospitality.  The Bank also had several large payoffs and pay downs in excess of $0.5 million during the first nine months of the year, totaling approximately $5.6 million.

Loans classified as multi-family residential also contributed to the year to date increase within the real estate secured portfolio.  Contributing substantially to the year to date increase was the funding of one loan in the aggregate amount of $2.3 million.  This loan was made for a government subsidized low income housing project  within the Bank’s primary market.  Notable pay downs within this category include the pay down of one loan in the aggregate amount of $1.5 million.

HELOC disbursements also contributed to the year to date increase within the real estate secured portfolio, rising approximately $2.8 million from the $26.4 million reported at December 31, 2008.

At September 30, 2009, real estate secured commitments represented approximately 489.3% of the Bank’s total risk based capital.  This when compared to the 510.7% reported at December 31, 2008, represents a decline of 21.4 percentage points.  The additional capital obtained under the U.S. Treasury’s CPP is the primary factor behind the year to date decline.  While the real estate secured portfolio in aggregate represents a concentration, no single category within this segment of the portfolio is considered a concentration as of September 30, 2009.

At September 30, 2009, approximately $162.4 million or 40.7% of the real estate secured segment of the loan portfolio was considered owner occupied.

Capitalization rates, the rate at which a stream of cash flows are discounted to find their present value, on commercial properties in our primary market area for the last three years were as follows: 5.0% to 6.5% in 2006, 6.0% to 7.0% in 2007, and 4.5% to 8.0% in 2008.  A recent uptick in capitalization rates would indicate that we are seeing some pressure on commercial real estate prices within our market, primarily resulting from weakened economic conditions.

In September 2004, the Bank issued an $11.7 million irrevocable standby letter of credit to guarantee the payment of taxable variable rate demand bonds that has since been reduced to $11.4 million.  The primary purpose of the bond issue was to refinance existing debt and provide funds for capital improvement and expansion of an assisted living facility.  The project is 100% complete and substantially leased.  The letter of credit was renewed in July 2009 and will expire in September 2010.

 Heritage Oaks Bancorp | - 45 -

Management’s Discussion and Analysis

Commercial

The following table provides a break-down of the commercial and industrial segment of the Bank’s commercial loan portfolio as of September 30, 2009:

	September 30, 2009									Percent of					Single
			Undisbursed		Total Bank		Percent			Bank's Risk			Number		Largest
(dollars in thousands)	Balance		Commitment		Exposure		Composition			Based Capital			of Loans		Loan
Agriculture	$	3,060	$	3,550	$	6,610		2.7	%		7.6	%		29	$	2,000
Oil / Gas and Utilities		2,110		1,091		3,201		1.3	%		3.7	%		10		1,200
Construction		19,425		15,278		34,703		13.9	%		39.9	%		171		2,750
Manufacturing		10,520		8,960		19,480		7.8	%		22.4	%		101		1,675
Wholesale and Retail		15,441		6,447		21,888		8.8	%		25.1	%		126		1,250
Transportation and Warehousing		2,710		716		3,426		1.4	%		3.9	%		34		596
Media & Information Services		10,153		1,724		11,877		4.8	%		13.6	%		28		8,000
Financial Services		18,626		2,825		21,451		8.6	%		24.6	%		50		6,000
Real-Estate / Rental and Leasing		16,237		9,369		25,606		10.3	%		29.4	%		89		3,500
Professional Services		18,990		8,510		27,500		11.0	%		31.6	%		150		1,994
Healthcare / Medical & Social Services		19,232		20,434		39,666		15.9	%		45.6	%		119		11,355
Restaurants and Hospitality		22,943		2,966		25,909		10.4	%		29.8	%		116		6,000
All Other		7,171		502		7,673		3.1	%		8.8	%		56		2,062
Commercial and industrial	$	166,618	$	82,372	$	248,990		100.0	%		286.0	%		1,079	$	48,382

At September 30, 2009, commercial and industrial loans represented approximately $166.6 million of total gross loan balances.  This when compared to the $157.7 million reported at December 31, 2008, represents an increase of approximately $8.9 million or 5.6%.  Increases in the commercial and industrial and agriculture categories were the primary factors behind the year to date increase.

During the first nine months of the year the Bank made several new loans as well as notable disbursements in amounts in excess of $1.0 million, totaling approximately $15.6 million.  These new loans and disbursements were made to borrowers in the following industries: healthcare / medical, wholesale and retail, real estate / rental and leasing, oil / gas and utilities, and restaurants and hospitality.

Although the commercial and industrial category as a whole does represent a concentration at 286.0% of the Bank’s total risk based capital, there was no one particular industry to which the Bank has extended credit within the commercial and industrial category that represented a concentration as of September 30, 2009. At September 30, 2009, commercial and industrial commitments as a percent of the Bank’s total risk based capital were approximately 286.0% or 38.0 percentage points lower than the 324.0% reported at December 31, 2008.  The additional capital obtained under the U.S. Treasury’s CPP is the primary factor behind the year to date decline.

At September 30, 2009 agriculture balances totaled approximately $14.8 million, which represents an approximate $1.1 million increase when compared to the $13.7 million reported at December 31, 2008.  The year to date increase within this category can be attributed to two new loans funded during the third quarter of 2009 totaling approximately $2.7 million.

 Heritage Oaks Bancorp | - 46 -

Management’s Discussion and Analysis

Construction

The following table provides a break-down of the construction segment of the Bank’s loan portfolio as of September 30, 2009:

	September 30, 2009									Percent of					Single
			Undisbursed		Total Bank		Percent			Bank's Risk			Number		Largest
(dollars in thousands)	Balance		Commitment		Exposure		Composition			Based Capital			of Loans		Loan
Single family residential	$	14,669	$	8,067	$	22,736		25.6	%		26.1	%		29	$	4,600
Single family residential - Spec.		5,757		545		6,302		7.1	%		7.2	%		9		2,346
Tract		2,215		-		2,215		2.5	%		2.5	%		10		532
Multi-family		5,575		1,909		7,484		8.4	%		8.6	%		4		3,584
Commercial		22,997		12,690		35,687		40.2	%		41.0	%		27		6,100
Hospitality		14,252		59		14,311		16.2	%		16.4	%		3		7,359
Total construction	$	65,465	$	23,270	$	88,735		100.0	%		101.8	%		82	$	24,521

At September 30, 2009, construction balances represented approximately $65.5 million or 9.2% of total gross loan balances.  This when compared to the $75.2 million reported at December 31, 2008, represents a decline of approximately $9.7 million or 12.9%.

As previously stated the primary factor behind the year to date decline can be attributed to construction loans moving into amortizing loans under the commercial real estate category as well as a general decline in demand for loans of this type in the current economic environment.

Year to date declines in the category of single family residential – spec can be attributed in large part to the charge off of several loans and their subsequent movement into OREO status.  For the first nine months of 2009 the Bank charged-off approximately $2.1 million in such balances and moved approximately $5.5 million to OREO status.

Declines in the category of hospitality is attributed in large part to balances moving to commercial real estate upon completion of underlying projects as well as pay downs.

At September 30, 2009 total construction commitments represented approximately 101.8% of the Bank’s total risk based capital.  This when compared to the 135.9% reported at December 31, 2008, represents a decline of approximately 34.1 percentage points.  The additional capital obtained under the Company’s participation in the U.S. Treasury’s CPP contributed substantially to the year to date decline.  Approximately $26.7 million or 40.9% of the Bank’s construction portfolio was considered owner occupied as of September 30, 2009.

Construction loans are typically granted for a one year period and then, with income properties, are amortized over a period not more than 30 years with 10 to 15 year maturities.

Land

The following table provides a break-down of the land segment of the Bank’s loan portfolio as of September 30, 2009:

	September 30, 2009									Percent of					Single
			Undisbursed		Total Bank		Percent			Bank's Risk			Number		Largest
(dollars in thousands)	Balance		Commitment		Exposure		Composition			Based Capital			of Loans		Loan
Single family residential	$	6,120	$	41	$	6,161		10.8	%		7.1	%		25	$	1,200
Single family residential - Spec.		2,054		-		2,054		3.6	%		2.4	%		8		618
Tract		30,538		1,096		31,634		55.7	%		36.3	%		12		12,208
Multi-family		1,512		-		1,512		2.7	%		1.7	%		3		675
Commercial		10,314		1,019		11,333		20.0	%		13.0	%		19		1,500
Hospitality		4,081		-		4,081		7.2	%		4.7	%		4		2,340
Total land	$	54,619	$	2,156	$	56,775		100.0	%		65.2	%		71	$	18,541

At September 30, 2009, land balances represented approximately $54.6 million or 7.7% of total gross loan balances.  When compared to the $61.7 million reported at December 31, 2008, land balances declined approximately $7.1 million.  The year to date decline can be attributed to the pay down / payoff of several loans in the aggregate amount of $4.6 million.  Additionally, during the first nine months of the year the Bank charged-off $2.8 million and  moved approximately $2.3 million in land balances to OREO, contributing to the year to date decline.

 Heritage Oaks Bancorp | - 47 -

Management’s Discussion and Analysis

New loans within this category include five loans to five borrowers in the aggregate amount of $1.7 million.  The majority of these loans are classified as land – commercial and land – single family residential as of September 30, 2009 and were made to borrowers within the Bank’s primary market area.

The single largest loan within this category is for a residential tract development and carries a balance of approximately $10.7 million at September 30, 2009.    This project, while located in Kern County of the California Central Valley is for a client within the Bank’s primary market area. The project was funded in the first quarter of 2008 and had an approximate loan to value of 50.0%, based on an appraisal conducted at the time.  During the ground grading process as the property was being developed, the client discovered that there was considerable value in the rock and as a result has begun to develop a rock quarry operation on part of the development site. The Bank is in the process of valuing both the development and quarry operations separately to create separate purpose financing.  During the third quarter of 2009, the Bank placed this loan on non-accrual status resulting from an issue related to the treatment of an interest reserve.  As a result, the Bank reversed approximately $0.8 million in interest income related to this loan in the third quarter.  Upon working with the borrower, Management was able to collect all the reversed interest and subsequently returned the loan to accruing status during the month of October 2009.  The Bank will recognize the $0.8 million interest payment in the fourth quarter of 2009.

At September 30, 2009 total land commitments represented 65.2% of the Bank’s total risk based capital.  When compared to the 85.2% reported at December 31, 2008, this represents a decline of approximately 20.0 percentage points.  The additional capital obtained under the Company’s participation in the U.S. Treasury’s CPP contributed substantially to the year to date decline.

At September 30, 2009 approximately $7.1 million or 13.1% of total land balances were considered owner occupied.

Installment

At September 30, 2009, the installment loan balances were approximately $8.9 million.  This, when compared to the $7.9 million reported at December 31, 2008, represents an increase of approximately $1.0 million.  Installment loans include revolving credit plans, consumer loans, as well as credit card balances obtained in the acquisition of Business First.

Loans Held for Sale

Loans held for sale consist of mortgage originations that have already been sold pursuant to correspondent mortgage loan agreements. There is no interest rate risk associated with these loans as the commitments are in place at the time the Bank funds them. Settlement from the correspondents is typically within 30 to 45 days.  At September 30, 2009 mortgage correspondent loans (loans held for sale) totaled approximately $7.8 million.  This when compared to the $7.9 million reported at December 31, 2008, represents an increase of approximately $0.1 million.  The dramatic year over year decline in interest rates has lead to significantly higher mortgage re-financing volumes, which combined with the Bank’s expansion of its mortgage origination department to further the Bank’s penetration its market, have contributed substantially to the year to date increase within this category.

Foreign Loans

At September 30, 2009 the Bank had no foreign loans outstanding.

Summary of Market Condition

Prices of single family homes have fallen significantly from market highs seen in 2007 in California as a whole.  Along with other segments in the real estate sector, commercial real estate prices in the Company’s market area experienced pressure during 2009 and the Company has begun to see increases in vacancy rates in certain retail, industrial and office segments.  The most recent data available to the Company shows vacancy rates within retail, industrial and office segments to be approximately 3.0%, 5.4% and 6.1%, respectively as of the third quarter of 2008.  When compared to levels in the year ago period, this represents respective increases of approximately 160, 310 and 260 basis points.  The Company realizes that any prolonged and significant downturn in the national and local economies may further impact the values of commercial real estate within its market footprint as well as the borrowers to whom the Bank has extended such credit and as such vacancy rates may increase in future periods.  As such, Management continues to closely monitor the credits within this segment of the loan portfolio for potential signs of deterioration.  Additionally, the Bank is aware that as economic conditions worsen and levels of unemployment continue to rise, borrowers to whom the Bank has extended commercial lines of credit may come under additional pressure to satisfy their outstanding obligations.  That said, the Bank continues to employ stringent lending standards and remains very selective with regard to any additional commercial real estate, real estate construction, land and commercial loans it chooses to originate in an effort to effectively manage risk in this difficult credit environment.

 Heritage Oaks Bancorp | -48 -

Management’s Discussion and Analysis

Although, the Company’s market footprint has historically enjoyed a more stable level of economic growth, we are not completely immune to the effects of a slowdown on a state or national level.  As previously mentioned, with the effects of a weakened economy placing more pressure on borrowers, the ability of consumers to satisfy outstanding obligations to the financial sector, as a whole, has begun to languish.  We believe that within certain areas of our local economy these more macro level concerns have started to become more evident.  This has had an impact on the level of and type of loans the Bank has placed on non-accrual and charged-off during 2008 and into 2009.  Additionally, the Company has devoted considerable resources to the monitoring of credits within the loan portfolio in order to take any appropriate steps when and if necessary to mitigate any material adverse impact the effects of weakened economic conditions may have on the Bank overall.

As of September 30, 2009, substantially all loans the Bank originated within the major categories of commercial real estate, construction, land, and commercial and industrial were made to borrowers within our current market footprint.

Allowance for Loan Losses

At September 30, 2009 the allowance for loan losses was approximately $15.9 million compared to the $10.4 million reported at December 31, 2008.  During the three and nine months ended September 30, 2009, the Bank made provisions to the allowance for loan losses in the amounts of $9.8 million and $14.6 million, respectively.  Loans charged-off during the three and nine months ended September 30, 2009 totaled approximately $5.0 million and $9.1 million, respectively.  For the three and nine months ended September 30, 2009, net charge-off to average loans was 0.70% and 1.29%, respectively.  At September 30, 2009 the allowance for loan losses represented 2.24% of total gross loans compared to the 1.53% reported at December 31, 2008.  Management believes that as of September 30, 2009, the allowance for loan losses was sufficient to cover current estimable losses in the Bank’s loan portfolio.

The Bank maintains an allowance for loan losses at a level considered by Management to be adequate to provide for probable incurred losses.  The allowance is comprised of three components: specific credit allocation, general portfolio allocation, and subjectively determined allocation.  The allowance is increased by provisions for loan losses charged to earnings and decreased by loan charge-offs, net of recovered balances.

The specific credit allocation of the allowance is determined through the measurement of impairment on certain loans that have been identified at each reporting period as impaired.  Once the amount of impairment on specific impaired loans has been determined, the Bank typically establishes a corresponding valuation allowance for such loans.  For purposes of determining the general portfolio allocation of the allowance, the loan portfolio is segmented into several pools of loans, exclusive of balances individually evaluated for impairment, similar to the stratification presented in Note 3. Loans and the Allowance for Loan Losses of the consolidated financial statements.  The loan portfolio is then further segmented by an internal loan grading system that classifies loans as: pass, special mention, substandard and doubtful.  Loss rates are then applied to each segment of the loan portfolio according to loan grade to determine the amount of the general portfolio allocation.  Loss rates applied are determined through an analysis of historical loss rates for each segment of the loan portfolio.  Finally, the subjectively determined allocation of the allowance is determined by estimates the Bank 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.  Certain of these factors include: local, state and national economic and business conditions, trends in the credit quality of the loan portfolio, existence and the effects of concentrations, the nature and volume of the loan portfolio, the quality of loan review as well as any other factor determined by Management to possibly have an impact on the credit quality of the loan portfolio.

Management periodically monitors loans in the portfolio to identify certain credits that may be impaired and/or experiencing deterioration and as such, makes appropriate changes in the level of the allowance when necessary.  Management employs the use of, among other things, a watch list, loan grading system, feedback provided by internal loan staff regarding specific credits, findings and analyses provided from the Bank’s semi-annual independent loan review function and information provided from examinations by regulatory agencies to manage credit risk and address any necessary changes in the required level of the allowance for loan losses in a timely manner.

 Heritage Oaks Bancorp | - 49 -

Management’s Discussion and Analysis

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.  In determining an appropriate level for the allowance, Management takes into consideration known relevant internal and external factors that may affect collectability of specific credits as well as certain pools of loans.  The nature of the process in which Management determines the appropriate level of the allowance involves the exercise of considerable judgment.  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 Bank’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, may 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.

Non-Performing Assets

The Bank’s Management is responsible for monitoring loan performance, which is done through various methods, including a review of loan delinquencies and personal knowledge of customers.  Additionally, the Bank maintains both a “watch” list of loans that, for a variety of reasons, Management believes require regular review as well as an internal loan classification process.  Semi-annually, the loan portfolio is also reviewed by an experienced, outside loan reviewer not affiliated with the Bank.  A list of delinquencies, the watch list, internal loan classifications and the outside loan review are reviewed regularly by the Bank’s Board of Directors.

The Bank has a non-accrual policy that requires a loan greater than 90 days past due and/or is specifically determined to be impaired to be placed on non-accrual status unless such loan is well-collateralized and in the process of collection.  When loans are placed on non-accrual status, all accrued but uncollected interest income is reversed from earnings.  Once on non-accrual status payments received on such loans are applied as a reduction of the loan principal balance.  Interest on a loan is only recognized on a cash basis and is generally not recognized on specific impaired loans unless the likelihood of further loss is remote.  Loans may be returned to accrual status if Management believes that all remaining principal and interest is fully collectible and there has been at least six months of sustained repayment performance since the loan was placed on non-accrual.

If a loan’s credit quality deteriorates to the point that collection of principal is believed by Management to be doubtful and the value of collateral securing the obligation is sufficient, the Bank generally takes steps to protect and liquidate the collateral.  Any loss resulting from the difference between the loan balance and the fair market value of the collateral is recognized by a charge to the allowance for loan losses.  When collateral is held for sale after foreclosure, it is subject to a periodic appraisal.  If the appraisal indicates that the collateral will sell for less than its recorded value, the Bank recognizes the loss by a charge to non-interest expense.

In regard to updated collateral valuations, once a loan is identified with sufficient weakness to merit a downgrade to substandard status, an appraisal of the underlying collateral is performed and if warranted, a valuation allowance for such loan is established. For loans on non-accrual, in addition to the action taken on downgraded credits noted in the previous sentence, an analysis of the value of the underlying collateral is performed at least quarterly.

Management acknowledges that due to continued stress and downturn in the economy and real estate markets, the internal watch list has expanded over the last twelve months.  While credit quality is consistently monitored, Management has implemented additional precautionary actions that include but are not limited to pro-actively identifying credit weaknesses earlier in the collection cycle, increasing the oversight frequency of watch list credits and devoting additional internal resources to monitor those credits.  Although the Bank believes these actions will serve to potentially minimize any future losses the Bank may incur related to problem loans, we cannot guarantee that the Bank will not experience an increase in non-performing loans.

As evidenced in the table below summarizing the Bank’s non-performing assets, the current economic downturn has had a significant impact in regard to loans related to land, construction and single family residential speculative construction. There also appears to be some increasing pressure on commercial real estate loans, however, the Bank has not experienced significant migration from performing to non-performing within this category as of this time.

 Heritage Oaks Bancorp | - 50 -

Management’s Discussion and Analysis

The following table provides a summary of non-accruing loans as of September 30, 2009 and December 31, 2008:

	September 30,			December 31,
(dollars in thousands)	2009			2008
Loans delinquent 90 days or more and still accruing	$	445		$	348
Non-Accruing Loans:
Commercial real estate		5,747			1,961
Residential 1-4 family		1,272			265
Home equity lines of credit		320			320
Commercial		5,958			7,060
Agriculture		3,214			-
Construction		3,838			5,990
Land		18,993			2,720
Installment		51			11
Total non-accruing loans	$	39,393		$	18,327
Other real estate owned	$	2,607		$	1,337
Total non-performing assets	$	42,445		$	20,012
Ratio of allowance for credit losses to total gross loans		2.24	%		1.53	%
Ratio of allowance for credit losses to total non-performing loans		39.84	%		55.75	%
Ratio of non-performing loans to total gross loans		5.61	%		2.75	%
Ratio of non-performing assets to total assets		4.58	%		2.48	%

At September 30, 2009 the balance of non-accruing loans was approximately $39.4 million or $21.1 million higher than the $18.3 million reported at December 31, 2008.  Notable changes in the balance of non-accruing loans occurred within the categories of commercial real estate, residential 1-4 family, commercial and industrial, construction and land.  The significant increase in non-accruing land balances can be attributed to the previously disclosed $10.7 million loan that was returned to accrual status during October 2009.  Increases within the non-accruing land category can also be attributed to five loans to three borrowers.

As indicated in the table below, the Bank received payments on non-accruing loans of approximately $2.0 million during the first nine months of 2009, which can be attributed in part to work-outs with borrowers as well as funds the Bank received from the sale collateral securing such loans.  Charge-offs during the first nine months of the year totaled approximately $9.1 million, the majority of which occurred in the categories of commercial and industrial, construction and land.   Balances moved to foreclosed collateral during the first nine months of 2009 totaled approximately $9.7 million, the majority of which occurred in the construction segment of the portfolio.  Partially offsetting the increase in non-accruing balances were two loans totaling approximately $1.3 million that the Bank returned to accruing status after working with the respective borrowers.

Non-performing assets totaled approximately $42.4 million at September 30, 2009, approximately $22.4 million higher than that reported at December 31, 2008.

 Heritage Oaks Bancorp | - 51 -

Management’s Discussion and Analysis

The following table reconciles the change in non accruing balances for the nine months ended September 30, 2009:

	Balance		Additions to											Transfers			Balance
	December 31,		Non-Accruing		Net						Returns to			to Foreclosed			September 30,
(dollars in thousands)	2008		Balances		Paydowns			Charge-offs			Accrual			Collateral			2009
Real Estate Secured
Multi-family residential	$	-	$	-	$	-		$	-		$	-		$	-		$	-
Residential 1 to 4 family		265		1,330		(19	)		(304	)		-			-			1,272
Home equity line of credit		320		-		-			-			-			-			320
Commercial		1,961		4,477		(615	)		(41	)		-			(35	)		5,747
Farmland		-		-		-			-			-			-			-
Commercial
Commercial and industrial		7,060		2,758		(376	)		(1,728	)		(14	)		(1,742	)		5,958
Agriculture		-		5,307		(184	)		(1,909	)		-			-			3,214
Other		-		-		-			-			-			-			-
Construction
Single family residential		-		1,465		(380	)		(145	)		-			-			940
Single family residential - Spec.		5,990		3,557		-			(2,073	)		(1,250	)		(5,541	)		683
Tract		-		2,215		-			-			-			-			2,215
Multi-family		-		-		-			-			-			-			-
Hospitality		-		-		-			-			-			-			-
Commercial		-		-		-			-			-			-			-
Land		2,720		21,715		(373	)		(2,792	)		-			(2,277	)		18,993
Installment loans to individuals		11		272		(6	)		(143	)		-			(83	)		51
All other loans		-		-		-			-			-			-			-
Totals	$	18,327	$	43,096	$	(1,953	)	$	(9,135	)	$	(1,264	)	$	(9,678	)	$	39,393

The following provides additional information regarding non-accruing loans and OREO balances as of September 30, 2009:

Real Estate Secured Commercial

Comprising a considerable portion of balances within this category are seven loans to four borrowers in the aggregate amount of $4.4 million.  These loans represented 76.9% of total non-accruing CRE balances and 11.2% of total non-accruing loans as of September 30, 2009.  These loans are well secured and the Bank is working with the respective borrowers where possible to liquidate the collateral.  During the first nine months of 2009, the Bank received proceeds in the amount of $0.5 million from the sale of collateral securing one loan as well as approximately $0.1 million in principal pay downs on several other credits.

Commercial and Industrial

The majority of C&I balances can be attributed to one loan with a current book balance of approximately $3.6 million, comprising 61.1% of total non-accruing C&I balances and 9.2% of total non-accruing balances as of September 30, 2009.  This loan is secured by property in the Bank’s primary market area that has a current appraisal received October 13, 2009 that supports the amount carried on the balance sheet.  Other significant balances within this category include two loans to two borrowers, totaling approximately $0.9 million, representing 15.7% of total C&I non-accruing balances.  The Bank also moved two loans to one borrower in the aggregate amount of $1.7 million to OREO status during the second quarter of 2009.  These loans are secured by land for commercial development within the Bank’s primary market.  During the third quarter of 2009, the Bank received an updated appraisal on this property and as a result wrote it down by approximately $1.3 million.  Of the $1.7 million in charge-offs occurring within this segment during 2009, approximately $1.0 million can be attributed to three loans, while $0.7 million can be attributed to several smaller loans added to non-accruing status during the first nine months of the year and subsequently charged-off.

Agriculture

The majority of non-accruing agriculture balances can be attributed to one loan in the approximate amount of $2.8 million.  During the third quarter of 2009, the Bank charged-off approximately $1.7 million related to this one loan.  This loan is collateralized by various inventory and business assets.  The Bank has begun the process to take possession of and liquidate the underlying collateral.  The loan was made to a borrower within the Bank’s primary market area.

 Heritage Oaks Bancorp | - 52 -

Management’s Discussion and Analysis

Construction

A significant portion of non-accruing balances within this segment of the loan portfolio can be attributed in large part to eight tract loans to one borrower totaling approximately $1.3 million or approximately 34.1% of total non-accruing construction balances.  All eight loans have approved purchase contracts in place and have been sold under a state assisted low income housing program and are expected to close in the fourth quarter of 2009.  Other significant non-accruing balances within this segment of the loan portfolio include three loans to one borrower, totaling approximately $1.5 million or 40.4% of total non-accruing construction balances.  These loans are secured by properties within the Bank’s primary market area.  The Bank is currently working with the borrower to liquidate the collateral.  During the first nine months of 2009, the Bank charged off approximately $2.2 million in construction balances, the majority of which can be attributed to balances the Bank subsequently moved to OREO status and later sold.

Land

The majority of balances within this category can be attributed to six loans to four borrowers totaling approximately $17.9 million.  These loans represented 94.4% of total non-accruing land balances and 45.5% of all non-accruing balances.  As previously mentioned, the majority of non-accruing balances within this category can be attributed to one loan to one borrower in the amount of $10.7 million that was placed on non-accrual in the third quarter, but was returned to accruing status following a payment the Bank received from the borrower of $0.8 million in October 2009.  This loan was placed on non-accrual during the third quarter related to the treatment of an interest reserve.

Contributing further to the year to date increase within this category were five additional loans the Bank placed on non-accruing status.  The majority of these loans can be attributed to two loans to one borrower totaling approximately $4.9 million.  Placing these loans on non-accrual status was the result of additional information obtained regarding the borrower’s financial condition and Management’s evaluation of the independent review performed on these credits.  During the third quarter of 2009, the Bank charged-off approximately $0.7 million related to this particular relationship.  Additionally, as the result of receiving new appraisals on property securing two other loans within this category, the Bank charged-off approximately $0.6 million related to one relationship during the third quarter of 2009.

Management is in the process of obtaining updated appraisal information for the collateral securing the remaining loans and is working with the borrowers to bring about resolution.  A significant portion of the charge-offs that occurred in the third quarter of 2009 within this segment of the loan portfolio can be attributed to the write-downs mentioned in the preceding paragraph.  Additionally, approximately $0.8 million in land charge-offs can be attributed to the write-down of one loan which the Bank subsequently moved to OREO and later sold late in the third quarter of 2009.

At September 30, 2009, all non-accruing balances were carried at their current fair values.

Other Real Estate Owned (“OREO”)

The following table provides a summary for the year to date change in the balance of OREO as of September 30, 2009:

	For the nine months ended
(dollars in thousands)	September 30, 2009
Balance December 31, 2008	$	1,337
Additions		9,595
Dispositions		(6,876	)
Write-downs		(1,449	)
Balance September 30, 2009	$	2,607

As of September 30, 2009, the balance of OREO was approximately $2.6 million, an increase of approximately $1.3 million from that reported at December 31, 2008 and down approximately $4.1 million from that reported at June 30, 2009.  During the first nine months of 2009, the Bank sold nine properties, resulting in a reduction in the balance of OREO of approximately $6.9 million, as represented in the table above.  During the third quarter of 2009, the Bank sold five properties, previously booked at approximately $3.9 million.  In connection with these sales, the Bank recognized aggregate losses of approximately $0.2 million.  For the first nine month of 2009 losses on the sale of OREO properties totaled approximately $0.3 million.

 Heritage Oaks Bancorp | - 53 -

Management’s Discussion and Analysis

Total Cash and Cash Equivalents

Total cash and cash equivalents were $63.9 million and $24.6 million at September 30, 2009 and December 31, 2008, respectively. This line item will vary depending on cash letters from the previous night and actual cash on hand in the branches.  Additionally, increased deposit balances are reflected in higher balances of Federal Funds sold.

Investment Securities and Other Earning Assets

Other earning assets are comprised of Federal Home Loan Bank stock, Federal Funds sold (funds the bank lends on a short-term basis to other banks), investments in securities and short-term interest bearing deposits at other financial institutions.  These assets are maintained for liquidity needs of the Bank, collateralization of public deposits, and diversification of the earning asset mix.

The table below summarizes the year to date change in the balances of other earning assets as of September 30, 2009:

	September 30,		December 31,		Variance
(dollars in thousands)	2009		2008		dollar		percentage
Federal Home Loan Bank stock	$	5,828	$	5,123	$	705		13.76	%
Available for sale securities		102,871		50,762		52,109		102.65	%
Federal funds sold		45,740		6,650		39,090		587.82	%
Interest bearing deposits other financial institutions		119		119		-		0.00	%
Total other earning assets	$	154,558	$	62,654	$	91,904		146.68	%

Federal Home Loan Bank (“FHLB”) Stock

As a member of the Federal Home Loan Bank of San Francisco, the Bank is required to hold a specified amount of FHLB capital stock based on the level of borrowings the Bank has obtained from the FHLB.  As such, the amount of FHLB stock the Bank carries can vary from one period to another based on among other things the current liquidity needs of the Bank.  At September 30, 2009, the Bank held approximately $5.8 million in FHLB stock, an increase of approximately $0.7 million from that reported at December 31, 2008.

Available for Sale Investment Securities

At September 30, 2009 the balance of available for sale investment securities was approximately $102.9 million, $52.1 million or 102.7% higher than that reported at December 31, 2008.  The change in the balance of the portfolio can be attributed in large part to purchases the Bank made during the first nine months of the year in the aggregate amount $76.6 million, sales, calls and maturities of securities in the aggregate amount of $17.2 million and principal pay downs totaling approximately $8.4 million.

The Company manages its securities portfolio to provide a source of both liquidity and earnings. The Bank has an Asset/Liability Committee that develops current investment policies based upon its operating needs and market circumstance. The Bank’s investment policy is formally reviewed and approved annually by the Board of Directors. The Asset/Liability Committee of the Bank is responsible for reporting and monitoring compliance with the investment policy. Reports are provided to the Bank’s Board of Directors on a regular basis.

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, 2009 the securities portfolio had a net unrealized loss of approximately $1.0 million and $0.6 million, net of tax.  This represents a decline in the net unrealized loss position of approximately $0.8 million and $0.5 million, net of tax, when compared to that reported at December 31, 2008.  The year to date increase in the fair value of the securities portfolio can be attributed to, among other things,more rational pricing of mortgage related securities as well as increases in the values of certain purchases the Bank made during the first and second quarters of 2009.

 Heritage Oaks Bancorp | - 54 -

Management’s Discussion and Analysis

At September 30, 2009, the Bank owned twelve Whole Loan Private Label Mortgage Backed Securities (“PMBS”) with a principal balance of approximately $23.4 million.   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. Due to the severe and prolonged downturn in the economy the PMBS bonds along with all asset classes have seen deterioration in price, credit quality, and liquidity.  Rating agencies have been reassessing all ratings associated with bonds starting with lower tranche or subordinate pieces (which have increased loss exposure) then moving on to senior and super senior bonds which is what the Bank owns with the exception of one Mezzanine bond (subordinate).  At September 30, 2009, six bonds in the approximate amount of $14.7 million, have been reassessed by one or more of the rating agencies (the Bank must use the most recent and lowest rating when there are discrepancies between the agencies) and subsequently downgraded below investment grade.  All six of these bonds are in Senior or Super Senior Tranche positions of their respective deals, meaning the Bank has priority in cash flows and has subordinate tranches below its position providing credit support. The more credit support or enhancement, the more protection is provided from possible losses on non-performing collateral and the credit enhancement has actually increased from the original amount through September 30, 2009 on all but one bond.  As the Bank receives cash flow on its senior position and principle is reduced quicker than default losses are applied to the subordinate positions, the credit enhancement percentage grows.

The Bank continues to perform extensive analyses on the PMBS bonds in the portfolio. These investment securities, including the six downgraded bonds mentioned above, continue to demonstrate cash flows as expected, based on pre-purchase analyses, and the credit support component of these tranches has actually increased from the origination date.  As of September 30, 2009, Management does not believe that there is other than temporary impairment and as such has made no entry for impairment.

During the third and fourth quarters of 2008, the credit markets came under significant duress 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 Bank’s portfolio was not completely immune to this.  Although the majority of  all of the Bank’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 have, among other things, been influential in placing pressure on the prices of these types of securities.

The majority of the Bank’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.

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 Bank 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 Funds Sold

The year to date increase in the balance of Federal Funds sold can be attributed in large part to higher deposit balances.  The amount of Federal Funds sold can vary widely on a daily basis depending on the cash position of the Bank which is affected by numerous variables such as cash letters, incoming and outgoing wire activity and loan funding needs.  Management continues to implement strategies for deployment of excess funds, including the origination of high quality loans and investments in securities, while ensuring the Bank continues to maintain appropriate levels of liquidity.

Heritage Oaks Bancorp | - 55 -

Management’s Discussion and Analysis

Deposits and Borrowed Funds

The following table provides a summary for the year to date change in various categories of deposit balances as of September 30, 2009:

											Variance Exclusive of
	September 30,		December 31,		Variance						Volatile Balances
(dollars in thousands)	2009		2008		dollar			percentage			dollar			percentage
Non-interest bearing demand	$	181,670	$	147,044	$	34,626			23.55	%	$	17,322			11.78	%
Interest bearing demand		70,092		72,952		(2,860	)		-3.92	%		15,712			21.54	%
Savings		26,088		21,835		4,253			19.48	%		4,253			19.48	%
Money market		231,005		173,199		57,806			33.38	%		71,363			41.20	%
Time deposits		227,670		139,872		87,798			62.77	%		87,798			62.77	%
Total retail deposits		736,525		554,902		181,623			32.73	%		196,448			35.40	%
Brokered time deposits		15,003		20,117		(5,114	)		-25.42	%		(5,114	)		-25.42	%
Brokered money market funds		2,001		28,502		(26,501	)		-92.98	%		(26,501	)		-92.98	%
Total brokered deposits		17,004		48,619		(31,615	)		-65.03	%		(31,615	)		-65.03	%
Total deposits	$	753,529	$	603,521	$	150,008			24.86	%	$	164,833			27.31	%

Deposits

During the first nine months of 2009, the Bank placed considerable emphasis on the acquisition of additional core deposits.  The focus on this initiative proved to be successful as the Bank 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 $126.4 million during the first nine months of 2009 from that reported at December 31, 2008, with significant increases in non-interest bearing demand, money market and time certificate of deposit accounts.

In an effort to rely less on FHLB borrowings and maintain an appropriate mix of secondary funding, the Bank purchased brokered deposits to assist in the funding of balance sheet growth and to provide an additional source of liquidity.  At September 30, 2009, brokered deposit balances totaled approximately $17.0 million, a decline of approximately $31.6 million from that reported at December 31, 2008 and a decline $21.5 million from that reported at June 30, 2009.  Declines in brokered funds can be attributed to the significant growth in core deposits.

Volatile Deposits

The Bank monitors the balance of various accounts that it considers to be volatile for a variety of reasons and provides this data to the Board of Directors on a regular basis.  Accounts may be added to or removed from the volatile liability dependency report when, based on Management’s judgment, it is determined that these funds are not suitable for any form of long term investment or that the risk associated with these funds leaving the Bank has become minimal.  Typically a material change in the balances of these accounts is reflected in the balance of Federal Funds sold.  At September 30, 2009, the aggregate balance of deposits the Bank considers to be volatile was approximately $46.5 million or $15.0 million lower than that reported at December 31, 2008.

The following table provides a summary of the deposit balances the Bank considers to be volatile as of September 30, 2009 and December 31, 2008:

			Percent of					Percent of
	September 30,		Total			December 31,		Total			Dollar
(dollars in thousands)	2009		Deposits			2008		Deposits			Variance
Non-interest bearing demand	$	28,497		3.8	%	$	11,193		1.9	%	$	17,304
Interest bearing demand		3,123		0.4	%		21,695		3.6	%		(18,572	)
Savings		-		0.0	%		196		0.0	%		(196	)
Money market deposits		14,925		2.0	%		28,482		4.7	%		(13,557	)
Total volatile deposits	$	46,545		6.2	%	$	61,566		10.2	%	$	(15,021	)

Heritage Oaks Bancorp | - 56 -

Management’s Discussion and Analysis

The year to date decline in balances the Bank considers to be volatile can be attributed in large part to declines in volatile interest bearing demand balances of approximately $18.6 million.  The year to date decline within this category is the result of two relationships leaving the Bank, the majority of which are considered public funds.  These declines were partially offset by a dramatic increase in volatile non-interest bearing demand balances.  The customers that hold these deposits engage in mortgage related activities.  As more and more home owners have moved to re-finance existing mortgages, given the current rate environment, deposit balances related to these customers have increased.  Management and the Board of Directors are aware that as conditions in the market change these relationships will be impacted.

Borrowed Funds

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

At September 30, 2009, borrowings obtained from the FHLB comprised the majority of borrowed funds.  The following table provides a summary of FHLB borrowings the Bank had outstanding as of September 30, 2009:

Amount		Interest				Maturity
Borrowed		Rate			Variable/Fixed	Date
$	55,000		0.10	%	Variable	Open
	10,000		2.89	%	Fixed	9/16/10
$	65,000		0.53	%

As evidenced in the table above, the balance of FHLB borrowing as of September 30, 2009 was $65.0 million.  This represents a decline of approximately $44.0 million from the balance reported at December 31, 2008.  The year to date decline can be attributed to higher deposit balances during the first nine months of 2009.

During the third quarter of 2009, the Company was advised that the ability to drawn on the  promissory note with Pacific Coast Bankers Bank (“PCBB”) for a revolving line of credit in the amount of $3.5 million was suspended. The Company was informed that PCBB was not suspending the Company’s line due to any action or circumstance surrounding the condition of the Company itself, but rather PCBB  was suspending all such similar lines of credit that they had issued to financial institutions due to overall uncertainty in the economic environment. The Company did not deem this to be of a material nature as the line was not used during 2008 nor was it used during the first nine months of 2009. Due to lack of use, the Company was not planning on renewing the loan at maturity in October 2009.

On September 17, 2004, the Bank 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 in regard to a senior care facility. The Letter of Credit was issued pursuant to a Letter of Credit Reimbursement Agreement between the Bank and the FHLB. It is collateralized by a blanket lien with the FHLB that includes all qualifying loans on the Bank’s balance sheet.  The letter of credit was renewed in July 2009 and will expire in September 2010.

Capital

At September 30, 2009, the balance of stockholders’ equity was approximately $87.8 million.  This, when compared to the $70.0 million at December 31, 2008, represents an increase of approximately $17.8 million. The year to date change in capital is due primarily to $21.0 million in Senior Preferred Stock the Company issued to the U.S. Treasury as part of its participation in the CPP.   Additionally, the year to date change is also attributed to net losses of $3.6 million, the impact of year-to-date share-based compensation expense in the amount of $0.3 million, dividends paid on Senior Preferred stock in the amount of $0.4 million, proceeds from the exercise of options in the amount of $46 thousand and a decline in the balance of accumulated other comprehensive loss in the amount of $0.5 million.

Heritage Oaks Bancorp | - 57 -

Management’s Discussion and Analysis

Senior Preferred Stock

On March 20, 2009, the Company issued $21.0 million in Senior Preferred Stock to the U.S. Treasury as part of its participation in the CPP.  Pursuant to the terms under the CPP, the Company is required to pay dividends on the Senior Preferred Stock in an amount equal to 5% per annum for five years and 9% per annum thereafter.  Dividends are cumulative and payable quarterly. Pursuant to an interim rule issued by the Federal Reserve Board, effective October 17, 2008, all $21.0 million of preferred stock the Company issued under the CPP qualifies as Tier I Capital.

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

For additional information regarding the Company’s Senior Preferred Stock and its participation in the CPP, see Note 9 of the consolidated financial statements filed on this Form 10-Q.

Dividends

The following table provides a summary of dividends the Company has paid on its common stock over the last two years:

	Dividend
	Amount			Declaration	Record	Payable
Dividend Type	Per Share			Date	Date	Date
Stock dividend		5	%	04/24/08	05/02/08	05/16/08
Cash dividend	$	0.08		01/24/08	02/01/08	02/15/08
Cash dividend	$	0.08		10/17/07	11/02/07	11/16/07
Cash dividend	$	0.08		07/18/07	08/03/07	08/17/07
Cash dividend	$	0.08		04/20/07	05/04/07	05/18/07

As evidenced in the table above, on April 24, 2008, the Board of Directors declared a stock dividend in the amount of 5% which was paid on May 16, 2008 to shareholders of record on May 2, 2008.  Shares and earnings per share for all prior periods have been adjusted to fully reflect the impact of the May 2008 stock dividend.  The Company paid no dividends on its common stock during the first six months of 2009 and as part of its participation in the U.S. Treasury’s CPP, must seek the approval of the Treasury before doing so.

Trust Preferred Securities

On October 27, 2006 the Company issued $8.2 million of Floating Rate Junior Subordinated Debt Securities to Heritage Oaks Capital Trust II (“Trust II”), a statutory trust created under the laws of the State of Delaware.  The debt securities issued to Trust II are subordinated to effectively all borrowings of the Company.  The Company used the proceeds from the issuance for general corporate purposes, which included, but not limited: capital contributions to the Bank, investments, payment of dividends, and repurchases of our common stock.

On April 23, 2007, the Company redeemed all of the Floating Rate Junior Subordinated Debt Securities it held associated with Heritage Oaks Capital Trust I, a wholly owned subsidiary of Heritage Oaks Bancorp.  The redemption price was 100% of the principal amount redeemed plus accrued and unpaid interest as of the redemption date.  The Company paid $0.4 million for the standard interest payment due April 22, 2007, plus a payment of $8.2 million for the principal amount to be redeemed on that date.  These amounts were funded from the Company’s general corporate reserves.  As a result of the redemption of the securities associated with Heritage Oaks Capital Trust I, the Trust was dissolved on June 1, 2007.

On September 20, 2007, the Company issued $5.2 million of Junior Subordinated Deferrable Interest Debentures to Heritage Oaks Capital Trust III (“Trust III”), a statutory trust created under the laws of the State of Delaware. The debt securities issued to Trust III are subordinated to effectively all borrowings of the Company. The Company used the proceeds from the issuance to assist in the acquisition of Business First, for general corporate purposes, and for capital contributions to the Bank for future growth.

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Management’s Discussion and Analysis

At September 30, 2009, the Company had at total of $13.4 million in Junior Subordinated Deferrable Interest Debentures issued and outstanding.  As mentioned in the preceding paragraphs, these securities have been issued to Trusts II and III.  The debt securities are subordinated to effectively all borrowings of the Company and can be redeemed at par if certain events occur that impact the tax treatment, regulatory treatment or the capital treatment of the issuance.  Upon the issuance of the debt securities, the Company purchased a 3.1% minority interest in both Trusts II and III, totaling $248 thousand and $155 thousand, respectively.  The balance of the equity of Trusts II and III is comprised of mandatory redeemable preferred securities and is included in other assets.  Interest associated with the securities issued to both Trusts II and III is payable quarterly at 3-month LIBOR plus 1.72% variable rate and 6.888% fixed, respectively.

The following table provides a summary of the securities the Company has issued to Trusts II and III as of September 30, 2009:

	Amount		Current			Issue	Scheduled	Call
(dollars in thousands)	Issued		Rate			Date	Maturity	Date	Rate Type
Heritage Oaks Capital Trust II	$	8,248		2.32	%	27-Oct-06	Aug-37	Nov-11	Variable 3-month LIBOR + 1.72%
Heritage Oaks Capital Trust III		5,155		6.89	%	20-Sep-07	Sep-37	Dec-12	5-year Fixed SWAP + 2.00%
Total Issued	$	13,403		4.08	%

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

Pursuant to U.S. GAAP, Under the Company is not allowed to consolidate Trusts II and III into the Company’s financial statements.  On February 28, 2005, the Federal Reserve Board issued a rule which provides that, notwithstanding the deconsolidation of such trusts, junior subordinated debentures, such as those issued by the Company, may continue to constitute up to 25% of a bank holding company's Tier I capital, subject to certain limitations which were to become effective on March 31, 2009.  However, on March 17, 2009, the Federal Reserve Board issued a ruling to delay the effective date of limitations on trust preferred securities until March 31, 2011.    At September 30, 2009, the Company included $13.0 million of the net junior subordinated debt in its Tier I Capital for regulatory capital purposes.

At September 30, 2009, the Company had sufficient cash to service the $13.4 million in junior subordinated debenture interest payments for approximately 9 years without dividends from subsidiaries. The Bank’s capacity to provide cash to the Company, while remaining “well-capitalized,” was approximately $8.8 million at September 30, 2009.

Regulatory Capital Requirements

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

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

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Management’s Discussion and Analysis

The following table provides a summary of Company and Bank regulatory capital ratios at September 30, 2009 and 2008:

	Regulatory Standard						September 30, 2009						September 30, 2008
	Adequately			Well			Heritage Oaks						Heritage Oaks
Ratio	Capitalized			Capitalized			Bancorp			Bank			Bancorp			Bank
Leverage ratio		4.00	%		5.00	%		9.30	%		8.76	%		9.01	%		8.78	%
Tier I capital to risk weighted assets		4.00	%		6.00	%		10.52	%		9.86	%		9.67	%		9.41	%
Total risk based capital to risk weighted assets		8.00	%		10.00	%		11.78	%		11.12	%		10.92	%		10.66	%

Regulatory capital ratios as of September 30, 2009 fully reflect the issuance of $21.0 million in Senior Preferred Stock issued to the U.S. Treasury under the terms of the CPP.  During the first six month of 2009, the holding company down-streamed $17.0 million in capital to the Bank.  As previously mentioned, pursuant to an interim rule issued by the Federal Reserve Board, effective October 17, 2008, all $21.0 million of preferred stock the Company issued qualifies as Tier I Capital, thus the Company’s and Bank’s capital ratios as of September 30, 2009 increased significantly from that reported a year earlier.

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 Bank’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 Bank’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 Bank’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, 2009, these credit lines totaled $35.0 million and the Bank had no borrowings against those lines.  As previously mentioned the Bank is a member of the FHLB and has collateralized borrowing capacities remaining of $117.7 million at September 30, 2009. This borrowing capacity is subject to increased discounts on specific collateral as the result of market valuations and as such, as of November 6, 2009, the available borrowing capacity was reduced to approximately $61.5 million.  Additionally, the Bank has established and tested a borrowing facility with the Federal Reserve. The amount of available credit is determined by the collateral provided by the Bank at the time of a transaction.

The Bank manages liquidity by maintaining a majority of the investment portfolio in Federal Funds sold and other liquid investments.  Most of these  investments include obligations of state and political subdivisions (municipal bonds) and mortgage related securities that provide a relatively steady stream of cash flows.  As of September 30, 2009, 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 19.65% at September 30, 2009 compared to 6.79% at December 31, 2008.   At September 30, 2009, the Bank was within its internal guideline for liquidity.  The ratio of net loans to deposits (“LTD”), another key liquidity ratio, was 91.9% at September 30, 2009 compared to 110.7% at December 31, 2008 both of which are and were within the Bank’s policy guidelines.

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Management’s Discussion and Analysis

Inflation

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

Off-Balance Sheet Arrangements

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

In the ordinary course of business, the Company has entered into off-balance sheet arrangements consisting of commitments to extend credit, commercial letters of credit, and standby letters of credit. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received.  For a more detailed discussion of these financial instruments, refer to Note 10 to the Company’s Consolidated Financial Statements under Item 8 of Part II of the Company’s December 31, 2008 Annual Report filed on Form 10-K.

In the ordinary course of business, the Bank is a party to various operating leases.  For a more detailed discussion of these financial instruments, refer to Note 10 to the Company’s Consolidated Financial Statements under Item 8 of Part II of the Company’s December 31, 2008 Annual Report filed on Form 10-K.

In connection with the $13.4 million in debt securities discussed under “Capital,” the Company issued the full and unconditional payment guarantee of certain accrued distributions.

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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 rates will ultimately impact both the level of interest income and interest expense recorded on a large portion of the Company’s assets and liabilities, and the market value of all interest earning assets and interest bearing liabilities, other than those which possess a short term to maturity. Virtually all of the Company’s interest earning assets and interest bearing liabilities are located at the banking subsidiary level. Thus, virtually all of the Company’s interest rate risk exposure lies at the banking subsidiary level other than $13.4 million in subordinated debentures issued by the Company’s subsidiary grantor trusts. As a result, all significant interest rate risk procedures are performed at the banking subsidiary level. The subsidiary Bank’s real estate loan portfolio, concentrated primarily within Santa Barbara and San Luis Obispo Counties, California, are subject to risks associated with the local economy.

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

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

Management employs the use of an Asset and Liability Management software that is used to measure the Bank’s exposure to future changes in interest rates. This model measures the expected cash flows and re-pricing of each financial asset/liability separately in measuring the Bank’s interest rate sensitivity.  Based on the results of this model, Management believes the Bank’s balance sheet is to a large extent “asset sensitive.”  This means the Company expects (all other things being equal) to expand its net interest income if rates rise and expects it conversely to contract if rates fall.  The level of potential or expected contraction indicated by the tables below is considered acceptable by Management and is compliant with the Bank’s ALCO policies.  Management will continue to perform this analysis each quarter to further validate the expected results against actual data.

The hypothetical impacts of sudden interest rate movements applied to the Company’s asset and liability balances are modeled monthly. The results of these models indicate how much of the Company’s net interest income is “at risk” from various rate changes over a one year horizon. This exercise is valuable in identifying risk exposures. Management believes the results for the Company’s September 30, 2009 balances indicate that the net interest income at risk over a one year time horizon for a 1% and 2% rate increase and decrease is acceptable and within policy guidelines at this time.

The results in the table below indicate the change in net interest income the Company would expect to see as of September 30, 2009, if interest rates were to change in the amounts set forth:

	Rate Shock Scenarios
(dollars in thousands)		-200bp			-100bp		Base				+100bp			+200bp
Net interest income (NII)	$	40,942		$	41,976		$	42,529		$	43,220		$	44,114
$ Change from base	$	(1,587	)	$	(553	)	$	-		$	691		$	1,585
% Change from base		-3.73	%		-1.30	%		0.00	%		1.62	%		3.73	%

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

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The following tables show Management’s estimates of how the loan portfolio is broken out between variable-daily, variable at various time lines, fixed rate loans and estimates of re-pricing opportunities for the entire loan portfolio at September 30, 2009: 

(dollars in thousands)
			Percent of
Rate Type	Balance		Total
Variable - daily	$	280,494		39.5	%
Variable other than daily		280,813		39.6	%
Fixed rate		148,560		20.9	%
Total gross loans	$	709,867		100.0	%

The table above identifies approximately 39.5% of the loan portfolio that will re-price immediately in a changing rate environment.  At September 30, 2009, approximately $561.3 million or 79.1% of the Bank’s loan portfolio is considered variable.

(dollars in thousands)
			Percent of
Re-Pricing	Balance		Total
< 1 Year	$	401,042		56.4	%
1-3 Years		174,367		24.6	%
3-5 Years		82,214		11.6	%
> 5 Years		52,244		7.4	%
Total gross loans	$	709,867		100.0	%

The following table provides a summary of the loans the Bank can expect to see come off their floors if the Prime rate were to increase by the amounts identified below as of September 30, 2009:

	Move in Prime Rate (bps)
(dollars in thousands)		+200		+250		+300		+350
Variable daily	$	660	$	17,488	$	51,095	$	120,055
Variable other than daily		2,605		5,433		50,218		121,007
Cumulative total variable at floor	$	3,265	$	22,921	$	101,313	$	241,062

Given the significant year over year decline in Prime rate, many loans in the portfolio possess floors significantly higher than the current Prime rate.  Therefore, the Bank will need to see rates increase significantly before the majority of loans in the portfolio start to come off their floors.

Item 4.  Controls and Procedures

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of its Management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rules 13a-15 and 15d-15. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective to provide reasonable assurances that information required to be disclosed in the reports the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

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Changes in Internal Control Over Financial Reporting

There was no change in the Company’s internal controls over financial reporting during the quarter ended September 30, 2009 that has materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting.

In designing and evaluating disclosure controls and procedures, the Company’s Management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable, not absolute, assurances of achieving the desired control objectives and Management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Part II.  Other Information

Item 1.  Legal Proceedings

The Bank is party to the following litigation:

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

Except as indicated above, neither the Company nor the Bank is involved in any legal proceedings other than routine legal proceedings occurring in the ordinary course of business.  Such routine legal proceedings, in the aggregate, are believed by Management to be immaterial to the financial condition, results of operations and cash flows of the Company as of September 30, 2009.

Item 1A.  Risk Factors

The following represents material changes in risk factors from that disclosed in the Company’s 2008 Annual Report filed on Form 10-K:

We Cannot Accurately Predict the Effect of the Current Economic Downturn on Our Future Results of Operations or Market Price of Our Stock

The national economy and the financial services sector in particular, are currently facing challenges of a scope unprecedented in recent history. We cannot accurately predict the severity or duration of the current economic downturn, which has adversely impacted the markets we serve. Any further deterioration in the economies of the nation as a whole or in our markets would have an adverse effect, which could be material, on our business, financial condition, results of operations and prospects, and could also cause the market price of our stock to decline.

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We Are Subject to Various Regulatory Requirements and Expect to Be Subject to Future Regulatory Restrictions and Enforcement Actions

In light of the current challenging operating environment, along with our elevated level of non-performing assets, delinquencies, and adversely classified assets, we are subject to increased regulatory scrutiny, and expect to become subject to potential enforcement actions. Such enforcement actions could place limitations on our business and adversely affect our ability to implement our business plans, including our growth strategy. Even though the Bank remains well-capitalized, the regulatory agencies have the authority to restrict our operations to those consistent with adequately capitalized institutions. For example, if the regulatory agencies were to impose such a restriction, we would likely have limitations on our lending activities. The regulatory agencies also have the power to limit the rates paid by the Bank to attract retail deposits in its local markets. We also may be required to reduce our levels of non-performing assets within specified time frames. These time frames might not necessarily result in maximizing the price that might otherwise be received for the underlying properties. In addition, if such restrictions were also imposed upon other institutions that operate in the Bank’s markets, multiple institutions disposing of properties at the same time could further diminish the potential proceeds received from the sale of these properties. If any of these or other additional restrictions are placed on us, it would limit the resources currently available to us as a well-capitalized institution.

In this regard, the FDIC recently completed its regularly scheduled examination of the Bank. Based on discussions with the FDIC following the examination, we presently expect to receive a formal agreement or enforcement order from the FDIC requiring us to take certain steps to further strengthen the Bank, such as reducing the level of classified assets, increasing capital levels, and addressing other criticisms from the examination. We already are developing strategies and taking actions to address such issues.

Our Level of Classified Assets Expose Us to Increased Lending Risk. Further, if Our Allowance for Loan Losses is Insufficient to Absorb Losses in Our Loan Portfolio, Our Earnings Could Decrease

At September 30, 2009, loans that we have categorized as doubtful, substandard or special mention totaled $101.3 million, representing 14.2% of total loans. If these loans do not perform according to their terms and the collateral is insufficient to pay any remaining loan balance, we may experience loan losses, which could have a material effect on our operating results. Like all financial institutions, we maintain an allowance for loan losses to provide for loans in our portfolio that may not be repaid in their entirety. At September 30, 2009, our allowance for loan losses totaled $15.9 million, which represented 2.24% of total loans and 39.84% of non-performing loans. We believe that our allowance for loan losses is maintained at a level adequate to absorb probable losses inherent in our loan portfolio as of the corresponding balance sheet date. However, our allowance for loan losses may not be sufficient to cover actual loan losses, and future provisions for loan losses could materially adversely affect our operating results. We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and their probability of making payment, as well as the value of real estate and other assets serving as collateral for the repayment of many of our loans. In determining the amount of the allowance for loan losses, significant factors we consider include loss experience in particular segments of the portfolio, trends and absolute levels of classified loans, trends and absolute levels in delinquent loans, trends in risk ratings, trends in industry charge-offs by particular segments and changes in existing general economic and business conditions affecting our lending areas and the national economy. If our assumptions are incorrect, our allowance for loan losses may be insufficient to cover losses inherent in our loan portfolio, resulting in additions to our allowance. Material additions to our allowance could materially decrease our net income. Our regulators, as an integral part of their examination process, periodically review our allowance for loan losses and may require us to increase our allowance for loan losses by recognizing additional provisions for loan losses charged to expense, or to decrease our allowance for loan losses by recognizing loan charge-offs, net of recoveries. Any such additional provisions for loan losses or charge-offs, as required by these regulatory agencies, could have a material adverse effect on our financial condition and results of operations.

The Unseasoned Nature Of A Large Portion Of Our Commercial Real Estate And Commercial And Industrial Loan Portfolios May Result In Changes In Estimating Collectability, Which May Lead To Additional Provisions Or Charge-Offs, Which Could Hurt Our Profits

Our commercial real estate and commercial and construction loan portfolios have increased $229.5 million or 58.5% from the end of 2006 through September 30, 2009. Accordingly, much of these loan portfolios are unseasoned. These loans also have not been subjected to continued declining and unfavorable economic conditions. As a result, it may be difficult to predict the future performance of this part of our loan portfolio. These loans may have delinquency or charge-off levels above our historical experience, which could adversely affect our future performance. Further, these types of loans generally have larger balances and involve a greater risk than one- to four-family residential mortgage loans. Accordingly, if we make any errors in judgment in the collectability of our commercial real estate and commercial and industrial loans, any resulting charge-offs may be larger on a per loan basis than those incurred historically with our residential mortgage loan or consumer loan portfolios.

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Liquidity Risk Could Impair Our Ability to Fund Operations and Jeopardize Our Financial Condition

Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a material adverse effect on our liquidity. Our access to funding sources in amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general. Factors that could detrimentally impact our access to liquidity sources include a decrease in the level of our business activity due to a market downturn or adverse regulatory action against us. Additionally, we regularly monitor certain larger deposit relationships that we determine are not suitable for any form of long-term investment or that possess a higher risk of leaving us. At September 30, 2009, these volatile deposits totaled $46.5 million or 6.2% of total deposits. Our ability to acquire deposits or borrow could also be impaired by factors that are not specific to us, such as a severe disruption of the financial markets or negative views and expectations about the prospects for the financial services industry in general.

We Depend On Cash Dividends From Our Subsidiary Bank To Meet Our Cash Obligations and a Failure to Receive them Could Impair Our Ability to Fulfill Our Obligations

As a holding company, dividends from our subsidiary bank provide a substantial portion of our cash flow used to service the interest payments on our trust preferred securities, our preferred stock and other obligations, including any cash dividends. Various statutory provisions restrict the amount of dividends our subsidiary bank can pay to us without regulatory approval.

Because of Our Participation in the Troubled Asset Relief Program (‘‘TARP’’), We Are Subject to Several Restrictions, Including Restrictions on Compensation Paid to Our Executives

Certain standards for executive compensation and corporate governance apply to us for the period during which the U.S. Treasury holds an equity position in us. These standards generally apply to our Chief Executive Officer, Chief Financial Officer and the three next most highly compensated senior executive officers. The standards include, among other things, (1) ensuring that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution; (2) required clawback of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate; (3) prohibition on making golden parachute payments to senior executives; and (4) agreement not to deduct for tax purposes, executive compensation in excess of $500,000 for each senior executive. In particular, the change to the deductibility limit on executive compensation may increase the overall cost of our compensation programs in future periods. Pursuant to the American Recovery and Reinvestment Act of 2009 (the ‘‘Stimulus Bill’’), more commonly known as the economic stimulus recovery package, further compensation restrictions, including significant limitations on incentive compensation, have been imposed on our senior executive officers and most highly compensated employees. Such restrictions and any future restrictions on executive compensation, which may be adopted, could adversely affect our ability to hire and retain senior executive officers.

Declines in Asset Values May Result in Impairment Charges and Adversely Affect the Value of Our Investments, Financial Performance and Capital

We maintain an investment portfolio that includes, but is not limited to, mortgage-backed securities. The market value of investments in our portfolio has become increasingly volatile over the past year. The market value of investments may be affected by factors other than the underlying performance of the servicer of the securities or the mortgages underlying the securities, such as ratings downgrades, adverse changes in the business climate and a lack of liquidity in the secondary market for certain investment securities. On a monthly basis, we evaluate investments and other assets for impairment indicators. We may be required to record impairment charges if our investments suffer a decline in value that is considered other-than-temporary. If we determine that a significant impairment has occurred, we would be required to charge against earnings the credit-related portion of the other-than-temporary impairment, which could have a material adverse effect on our results of operations in the periods in which the write-offs occur.

Heritage Oaks Bancorp | - 66 -

The Recession and Changes in Domestic and Foreign Financial Markets Have Adversely Affected Our Industry and May Have a Material Negative Impact on Our Results of Operations and Financial Condition

Economic indices have shown that since the fourth quarter of 2007, the United States economy has been in a recession. This has been reflected in significant business failures and job losses. Further, dramatic declines in the housing market, with decreasing home prices and increasing delinquencies and foreclosures, have negatively impacted the credit performance of mortgage and construction loans and resulted in significant write-downs of assets by many financial institutions. General downward economic trends, reduced availability of commercial credit and increased unemployment, have negatively impacted the performance of commercial and consumer credit resulting in additional write-downs. Concerns over the stability of the financial markets and the economy have resulted in decreased lending by financial institutions to their customers and to each other. This market turmoil and tightening of credit has led to increased commercial and consumer delinquencies, lack of customer confidence, increased market volatility and widespread reduction in general business activity. Financial institutions have experienced decreased access to deposits and borrowings. The resulting economic pressure on consumers and businesses and the lack of confidence in the financial markets may adversely affect our business, financial condition, results of operations and stock price. We do not expect that the difficult conditions in the financial markets are likely to improve in the near future. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial institutions industry. In particular, we may face the following risks in connection with these events:

• We potentially face increased regulation of our industry, compliance with which may increase our costs and limit our ability to pursue business opportunities.

• The process we use to estimate losses inherent in our credit exposure requires difficult, subjective and complex judgments, including forecasts of economic conditions and how these economic conditions might impair the ability of our borrowers to repay their loans. The level of uncertainty concerning economic conditions may adversely affect the accuracy of our estimates, which may, in turn, impact the reliability of the process.

• The value of the portfolio of investment securities that we hold may be aversely affected.

• We may be required to pay significantly higher FDIC premiums because market developments have significantly depleted the insurance fund of the FDIC and reduced the ratio of reserves to insured deposits.

If current levels of market disruption and volatility continue or worsen, there can be no assurance that we will not experience an adverse effect, which may be material, on our business, financial condition and results of operations.

The Terms of Our Outstanding Series A Preferred Stock Limit Our Ability to Pay Dividends on and Repurchase Our Common Stock

The Purchase Agreement between us and the U.S Treasury provides that before the earlier of (1) March 20, 2012 and (2) the date on which all of the shares of the preferred stock have been redeemed by us or transferred by the U.S. Treasury to third parties, we may not, without consent of the U.S. Treasury, (a) increase the quarterly cash dividend on our common stock above $0.08 per share, the amount of the last quarterly cash dividend per share declared prior to October 14, 2008 or (b) subject to limited exceptions, redeem, repurchase or otherwise acquire shares of our common stock or preferred stock other than the preferred stock. In addition, we are unable to pay any dividends on our common stock unless we are current in our dividend payments on the preferred stock. These restrictions, together with the potentially dilutive impact of the warrant issued to the U.S. Treasury, could have a negative effect on the value of our common stock.

Our Outstanding Preferred Stock Impacts Net Income Available to Our Common Stockholders and Earnings Per Common Share and the Warrant Issued to the U.S. Treasury As Well As Other Potential Issuances of Equity Securities May be Dilutive to Holders of Our Common Stock

The dividends declared and the accretion on our outstanding preferred stock will reduce the net income available to common stockholders and our earnings per common share. The preferred stock will also receive preferential treatment in the event of our liquidation, dissolution or winding-up. Additionally, the ownership interest of the existing holders of our common stock will be diluted to the extent the warrant issued to the U.S. Treasury is exercised. The shares of common stock underlying the warrant represent approximately 7.9% of the shares of our common stock outstanding as of September 30, 2009 (including the shares issuable upon exercise of the warrant in total shares outstanding). Although the U.S. Treasury has agreed not to vote any of the shares of common stock it receives upon exercise of the warrant, a transferee of any portion of the warrant or of any shares of common stock acquired upon exercise of the warrant is not bound by this restriction. In addition, to the extent options to purchase common stock under our employee and director stock option plans are exercised, holders of our common stock will incur additional dilution. Further, if we sell additional equity or convertible debt securities, such sales could result in increased dilution to our shareholders.

Heritage Oaks Bancorp | - 67 -

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

Unregistered Sale of Equity Securities

None.

Purchases of Equity Securities

None.

Item 3.  Defaults upon Senior Securities

None.

Item 4.  Submission of Matters to a Vote of Security Holders

None.

Item 5.  Other Information

Not applicable.

Item 6.  Exhibits

(a) Exhibits:

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

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

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

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

Heritage Oaks Bancorp | - 68 -

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 9, 2009

/s/ Lawrence P. Ward

Lawrence P. Ward

President

Chief Executive Officer

/s/ Margaret A. Torres

Margaret A. Torres

Executive Vice President

Chief Financial Officer

(Principal Financial and Accounting Officer)

Heritage Oaks Bancorp | - 69 -

EX-31.1

EXHIBIT 31.1

CERTIFICATIONS

I, Lawrence P. Ward, 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. The registrant’s other certifying officer and I are 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 we have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us 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 our 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 our 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. The registrant’s other certifying officer and I have disclosed, based on our 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 9, 2009
	/s/ Lawrence P. Ward
	Lawrence P. Ward
	Chief Executive Officer

EX-31.2

EXHIBIT 31.2

CERTIFICATIONS

I, Margaret A. Torres, 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. The registrant’s other certifying officer and I are 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 Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and we have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us 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 our 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 our 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. The registrant’s other certifying officer and I have disclosed, based on our 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 9, 2009
	/s/ Margaret A. Torres
	Margaret A. Torres
	Chief Financial Officer
	(Principal Financial and Accounting Officer)

EX-32.1

EXHIBIT 32.1

HERITAGE OAKS BANCORP

Quarterly report on Form 10Q

for the quarter ended September 30, 2009

CERTIFICATION

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

The undersigned, who is the 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 10Q for the quarter ended September 30, 2009, 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 9, 2009	/s/ Lawrence P. Ward
	Lawrence P. Ward,
	President and Chief 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.

EX-32.2

EXHIBIT 32.2

HERITAGE OAKS BANCORP

Quarterly report on Form 10Q

for the quarter ended September 30, 2009

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 10Q for the quarter ended September 30, 2009, 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 9, 2009	/s/ Margaret A. Torres
	Margaret A. Torres
	Executive Vice President
	Chief Financial Officer
	(Principal Financial and Accounting 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.