News Column

PACIFIC MERCANTILE BANCORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

August 8, 2014

Forward Looking Statements Statements contained in this Quarterly Report on Form 10-Q (this "Report") that are not historical facts or that discuss our expectations, beliefs or views regarding our future operations or future financial performance, or financial or other trends in our business or in the markets in which we operate, constitute "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include words such as "believe," "expect," "anticipate," "intend," "plan," "estimate," "project," "forecast," or words of similar meaning, or future or conditional verbs such as "will," "would," "should," "could," or "may." The information contained in such forward-looking statements is based on current information available to us and on assumptions that we make about future economic and market conditions and other events over which we do not have control. In addition, our business and the markets in which we operate are subject to a number of risks and uncertainties. Such risks and uncertainties, and the occurrence of events in the future or changes in circumstances that had not been anticipated, could cause our financial condition or actual operating results in the future to differ materially from our expected financial condition or operating results that are set forth in the forward-looking statements contained in this Report and could, therefore, also affect the price performance of our shares. In addition to the risk of incurring loan losses, which is an inherent risk of the banking business, these risks and uncertainties include, but are not limited to, the following: the risk that the economic recovery in the United States, which is still relatively fragile, will be adversely affected by domestic or international economic conditions, which could cause us to incur additional loan losses and adversely affect our results of operations in the future; uncertainties and risks with respect to the effects that our compliance with the written agreement (the "FRBSF Agreement") with the Federal Reserve Bank of San Francisco (the "FRBSF") will have on our business and results of operations because, among other things, the FRBSF Agreement imposes restrictions on our operations and our ability to grow our banking franchise, and the risk of potential future supervisory action against us or the Bank (as defined below) by the FRBSF if we are unable to meet the requirements of the FRBSF Agreement; the risk that our results of operations in the future will continue to be adversely affected by our exit from the wholesale and residential mortgage lending businesses and the risk that our commercial banking business will not generate the additional revenues needed to fully offset the decline in our mortgage banking revenues within the next two to three years; the risk that our interest margins and, therefore, our net interest income will be adversely affected by changes in prevailing interest rates; the risk that we will not succeed in further reducing our remaining nonperforming assets, in which event we would face the prospect of further loan charge-offs and write-downs of assets; the risk that we will not be able to manage our interest rate risks effectively, in which event our operating results could be harmed; the prospect that government regulation of banking and other financial services organizations will increase, causing our costs of doing business to increase and restricting our ability to take advantage of business and growth opportunities; the risk that our efforts to develop a robust commercial banking platform and a productive small business administration ("SBA") 32



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lending group may not succeed; and the risk that we may be unable to realize our expected level of increasing deposit inflows. Additional information regarding these and other risks and uncertainties to which our business is subject is contained in our Annual Report on Form 10-K for the year ended December 31, 2013 (the "2013 Form 10-K") that we filed with the Securities and Exchange Commission ("SEC") on March 14, 2014, and readers of this Report are urged to review the additional information contained in that report, and in any subsequent Quarterly Report on Form 10-Q that we file with the SEC. We urge you to read those risk factors in conjunction with your review of the following discussion and analysis of our results of operations for the three and six months ended, and our financial condition at, June 30, 2014. Due to the risks and uncertainties we face, readers are cautioned not to place undue reliance on the forward-looking statements contained in this Report, which speak only as of the date of this Report, or to make predictions about future performance based solely on historical financial performance. We also disclaim any obligation to update forward-looking statements contained in this Report as a result of new information, future events or otherwise, except as may otherwise be required by law.



Overview

The following discussion presents information about our consolidated results of operations, financial condition, liquidity and capital resources and should be read in conjunction with our consolidated financial statements and the notes thereto included in Item 1 above of this Report. Our principal operating subsidiary is Pacific Mercantile Bank (the "Bank"), which is a California state chartered bank. The Bank accounts for substantially all of our consolidated revenues, expenses and income and our consolidated assets and liabilities. Accordingly, the following discussion focuses primarily on the Bank's results of operations and financial condition. As of June 30, 2014, our total assets, net loans and total deposits were $1.0 billion, $794 million and $819 million, respectively. The Bank, which is headquartered in Orange County, California, approximately 40 miles south of Los Angeles, conducts a commercial banking business in Orange, Los Angeles, San Bernardino and San Diego counties in Southern California. The Bank is also a member of the Federal Reserve System and its deposits are insured, to the maximum extent permitted by law, by the Federal Deposit Insurance Corporation (the "FDIC"). For the six months ended June 30, 2014 and 2013, we operated as one reportable segment, Commercial Banking, and one non-reportable segment, Discontinued Operations. Unless the context otherwise requires, the "Company," "we," "our," "ours," and "us" refer to Pacific Mercantile Bancorp and its consolidated subsidiaries. Current Developments During the fourth quarter of 2013, we announced our decision to exit the mortgage banking business. We have made substantial progress in our efforts to wind down the mortgage division. During the first quarter of 2014, all of the loan applications that were in process at the time of the announcement to discontinue mortgage lending were funded, closed by the applicant, or denied. At June 30, 2014, the Bank only had 3 remaining employees in the mortgage division, down from 77 employees at December 31, 2013, and is no longer involved in the origination, selling and servicing of mortgage loans. In April 2014, the Bank also finalized arrangements to sell its portfolio of mortgage servicing rights in two separate transactions, which closed on April 30, 2014 and are described in more detail above in Item 1 of this Report under Note 11, Discontinued Operations. The remaining wind down of the mortgage banking business is expected to be complete during the third quarter of 2014. The Company has also furthered its efforts in laying the foundation for a full-fledged Asset Based Lending ("ABL") Group that was begun in 2013. The ABL Group will originate loans primarily secured by general corporate assets with a borrowing formula primarily based on accounts receivables. In the first half of 2014, the ABL Group developed a pipeline of potential relationships that included an ABL credit facility along with products and services to meet the customers' depository and cash management needs. The Bank commenced with some of these relationships during the second quarter of 2014 with the funding of the ABL facilities. The Company continued to expand its offerings through the SBA Programs and during the six months ended June 30, 2014 funded $19.7 million in loans through the 7(a) Program and sold $14.8 million of the guaranteed portion of those loans, which resulted in a $1.2 million gain during the six months ended June 30, 2014. The Company plans to continue its efforts to originate and sell SBA 7(a) loans. Results of Operations Discontinued Operations 33



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In connection with our exit from the mortgage banking business described above, the revenues and expenses of our mortgage banking division have been classified as discontinued operations for all periods presented. As a result, all comparisons below reflect results from continuing operations. Income from discontinued operations was $0.8 million and $2.0 million for the three and six months ended June 30, 2014, respectively, while our loss from discontinued operations was $0.5 million and $1.4 million for the three and six months ended June 30, 2013, respectively. During the six months ended June 30, 2014, we recorded a gain on the sale of the mortgage servicing rights that we sold in April 2014, which is included in income from discontinued operations in the consolidated statements of operations. This compares to a loss from the mortgage banking operations prior to the decision to discontinue the mortgage banking business. For additional information, see Note 11, Discontinued Operations, included in Item 1 of this Report. Operating Results for the Three and Six Months Ended June 30, 2014 and 2013 Our operating results for the three and six months ended June 30, 2014, compared to June 30, 2013, were as follows: Three Months Ended June 30, 2014 vs. 2013 Six Months Ended June 30, 2014 vs. 2013 2014 2013 % Change 2014 2013 % Change (Dollars in thousands) Interest income 9,134 8,728 4.7 % 18,421 17,478 5.4 % Interest expense 1,508 1,357 11.1 % 2,951 2,945 0.2 % Provision for loan and lease losses 600 - 100.0 % 1,050 1,150 (8.7 )% Non-interest income 1,209 (274 ) (541.2 )% 2,503 171 1,363.7 % Non-interest expense 9,003 9,721 (7.4 )% 18,424 19,999 (7.9 )% Income tax provision (benefit) - - - % - (1,490 ) (100.0 )% Net (loss) income from continuing operations (768 ) (2,624 ) (70.7 )%



(1,501 ) (4,955 ) (69.7 )% Net income (loss) from discontinued operations

772 (518 ) (249.0 )% 1,956 (1,356 ) (244.2 )% Net income (loss) 4 (3,142 ) (100.1 )% 455 (6,311 ) (107.2 )% Interest Income Three Months Ended June 30, 2014 and 2013 Total interest income increased 4.7% to $9.1 million for the three months ended June 30, 2014 from $8.7 million for the three months ended June 30, 2013, with an average yield on interest-earning assets of 3.70% for the three months ended June 30, 2014 compared to 3.82% for the three months ended June 30, 2013. This increase was primarily due to an increase in interest income on loans during the three months ended June 30, 2014 compared to the same prior year period due to an increase in average loan balances, partially offset by a decline in the average yield. During the three months ended June 30, 2014 and 2013, interest income on loans was $8.7 million and $8.3 million, respectively, yielding 4.40% and 4.65% on average loan balances of $787.9 million and $712.5 million, respectively. The increase in the average loan balances is attributable to an increase in loan demand. The decrease in average loan yield is primarily attributable to the actions of the Board of Governors of the Federal Reserve System ("Federal Reserve Board") to keep short-term interest rates low. During the three months ended June 30, 2014 and 2013, interest income from our securities available-for-sale and stock, was $403 thousand and $387 thousand, respectively, yielding 2.25% and 1.86% on average balances of $71.9 million and $83.4 million, respectively. The average securities balances decreased as a result of sales and maturities of, and payments on, securities which we did not fully replace due to liquidity needs. The investment yield increase is primarily due to lower premium amortization attributable to slower projected prepayment speeds on our securities available-for-sale, returning our prepayment speed to a more historically normal level as compared to the accelerated prepayment speed seen in the prior year. Interest income from our short-term investments, including our federal funds sold and interest-bearing deposits, was $79 thousand and $75 thousand for the three months ended June 30, 2014 and 2013, respectively, yielding 0.24% and 0.25% on average balances of $130.1 million and $120.0 million, respectively. The average balances of short-term investments increased as a result of an increase in our funds held at the FRBSF. As a result, total interest income on investments increased slightly for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013. Six Months Ended June 30, 2014 and 2013 Total interest income increased 5.4% to $18.4 million for the six months ended June 30, 2014 from $17.5 million for the six months ended June 30, 2013, with an average yield on interest-earning assets of 3.78% for the six months ended June 30, 2014 compared to 3.75% for the six months ended June 30, 2013. This increase was primarily due to an increase in interest income on loans during the six months ended June 30, 2014 compared to the same prior year period due to an increase in average loan balances, partially offset by a decline in the average yield. During the six months ended June 30, 2014 and 2013, interest income 34



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on loans was $17.4 million and $16.6 million, respectively, yielding 4.49% and 4.66% on average loan balances of $783.6 million and $716.7 million, respectively. The increase in the average loan balances is attributable to an increase in loan demand. The decrease in loan yield is primarily attributable to the actions of the Federal Reserve Board to keep short-term interest rates low. During the six months ended June 30, 2014 and 2013, interest income from our securities available-for-sale and stock, was $821 thousand and $757 thousand, respectively, yielding 2.27% and 1.75% on average balances of $72.8 million and $87.2 million, respectively. The average securities balances decreased as a result of sales and maturities of, and payments on, securities which we did not fully replace due to liquidity needs. The investment yield increase is primarily due to lower premium amortization attributable to slower projected prepayment speeds on our securities available-for-sale, returning our prepayment speed to a more historically normal level as compared to the accelerated prepayment speed seen in the prior year. Interest income from our short-term investments, including our federal funds sold and interest-bearing deposits, was $155 thousand and $170 thousand for the six months ended June 30, 2014 and 2013, respectively, yielding 0.25% and 0.25% on average balances of $126.3 million and $136.6 million, respectively. The decrease in interest income from our short-term investments was primarily attributable to a decrease in the average loan balances during the six months ended June 30, 2014 as compared to the six months ended June 30, 2013. As a result, total interest income on investments increased slightly for the six months ended June 30, 2014 and 2013. Interest Expense Three Months Ended June 30, 2014 and 2013 Total interest expense increased 11.1% to $1.5 million for the three months ended June 30, 2014 from $1.4 million for the three months ended June 30, 2013. The increase was primarily due to an increase in average interest-bearing liabilities of $713.5 million and $638.3 million at June 30, 2014 and 2013, respectively, yielding a cost of funds of 0.85% and 0.85%, respectively, which consisted of deposits, borrowings and junior subordinated debentures. Interest expense on our certificates of deposit for the three months ended June 30, 2014 and 2013, was $1.1 million and $1.0 million, respectively, yielding 0.95% and 1.02% on average balances of $454.0 million and $382.9 million, respectively. The increase in interest expense of $151 thousand, or 11.1%, was also due to an increase in the volume of certificates of deposit partially offset by a decrease in the rates of interest paid on certificates of deposit. Six Months Ended June 30, 2014 and 2013 Total interest expense increased 0.2% to $3.0 million for the six months ended June 30, 2014 from $2.9 million for the six months ended June 30, 2013. The increase was primarily due to an increase in average interest-bearing liabilities of $711.4 million and $667.7 million at June 30, 2014 and 2013, respectively, yielding a cost of funds of 0.84% and 0.89%, respectively, which consisted of deposits, borrowings and junior subordinated debentures. Interest expense on our certificates of deposit for the six months ended June 30, 2014 and 2013, was $2.1 million and $2.2 million, respectively, yielding 0.97% and 1.09% on average balances of $439.9 million and $405.2 million, respectively. The increase in interest expense was also due to an increase in the volume of certificates of deposit partially offset by a decrease in the rates of interest paid on certificates of deposit. Net Interest Margin One of the principal determinants of a bank's income is its net interest income, which is the difference between (i) the interest that a bank earns on loans, investment securities and other interest earning assets, on the one hand, and (ii) its interest expense, which consists primarily of the interest it must pay to attract and retain deposits and the interest that it pays on borrowings and other interest-bearing liabilities, on the other hand. As a general rule, all other things being equal, the greater the difference or "spread" between the amount of our interest income and the amount of our interest expense, the greater will be our net income; whereas, a decline in that difference or "spread" will generally result in a decline in our net income. A bank's interest income and interest expense are affected by a number of factors, some of which are outside of its control, including national and local economic conditions and the monetary policies of the Federal Reserve Board which affect interest rates, competition in the market place for loans and deposits, the demand for loans and the ability of borrowers to meet their loan payment obligations. Net interest income, when expressed as a percentage of total average interest earning assets, is a banking organization's "net interest margin." The following tables set forth information regarding our average balance sheet, yields on interest earning assets, interest expense on interest-bearing liabilities, the interest rate spread and the interest rate margin for the three and six months ended June 30, 2014 and 2013. Average balances are calculated based on average daily balances. 35



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Table of Contents Three Months Ended June 30, 2014 2013 Interest Average Interest Average Average Earned/ Yield/ Average Earned/ Yield/ Balance Paid Rate Balance Paid Rate (Dollars in thousands) Interest earning assets Short-term investments(1) $ 130,146$ 79 0.24 % $ 120,012$ 75 0.25 % Securities available for sale and stock(2) 71,928 403 2.25 % 83,375 387 1.86 % Loans(3) 787,882 8,652 4.40 % 712,525 8,266 4.65 % Total interest-earning assets 989,956 9,134 3.70 % 915,912 8,728 3.82 % Interest-bearing liabilities: Interest-bearing checking accounts $ 35,457$ 25 0.28 % $ 32,735$ 22 0.27 % Money market and savings accounts 154,591 119 0.31 % 160,124 151 0.38 % Certificates of deposit 454,041 1,081 0.95 % 382,935 975 1.02 % Other borrowings 51,911 129 1.00 % 45,011 71 0.63 % Junior subordinated debentures 17,527 154 3.52 % 17,527 138 3.16 % Total interest bearing liabilities 713,527 1,508 0.85 % 638,332 1,357 0.85 % Net interest income $ 7,626$ 7,371 Net interest income/spread 2.85 % 2.97 % Net interest margin 3.09 % 3.23 % Six Months Ended June 30, 2014 2013 Interest Average Interest Average Average Earned/ Yield/ Average Earned/ Yield/ Balance Paid Rate Balance Paid Rate (Dollars in thousands) Interest earning assets Short-term investments(1) $ 126,255$ 155 0.25 % $ 136,619$ 170 0.25 % Securities available for sale and stock(2) 72,827 821 2.27 % 87,150 757 1.75 % Loans(3) 783,559 17,445 4.49 % 716,723 16,551 4.66 % Total interest-earning assets 982,641 18,421 3.78 % 940,492 17,478 3.75 % Interest-bearing liabilities: Interest-bearing checking accounts $ 34,682$ 49 0.28 % $ 32,980$ 43 0.26 % Money market and savings accounts 158,789 250 0.32 % 164,218 349 0.43 % Certificates of deposit 439,855 2,111 0.97 % 405,188 2,181 1.09 % Other borrowings 60,565 282 0.94 % 47,713 103 0.44 % Junior subordinated debentures 17,527 259 2.98 % 17,604 269 3.08 % Total interest bearing liabilities 711,418 2,951 0.84 % 667,703 2,945 0.89 % Net interest income $ 15,470$ 14,533 Net interest income/spread 2.94 % 2.86 % Net interest margin 3.17 % 3.12 % (1) Short-term investments consist of federal funds sold and interest



bearing deposits that we maintain at other financial institutions.

(2) Stock consists of Federal Home Loan Bank of San Francisco ("FHLB")

stock and FRBSF stock.

(3) Loans include the average balance of nonaccrual loans.

The following table sets forth changes in interest income, including loan fees, and interest paid in each of the six months ended June 30, 2014 and 2013 and the extent to which those changes were attributable to changes in (i) the volumes of or in the rates of interest earned on interest-earning assets and (ii) the volumes of or in the rates of interest paid on our interest-bearing liabilities. 36



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Table of Contents Three Months Ended June 30, 2014 Compared to Six Months Ended June 30, 2014 Compared to Three Months Ended June 30, 2013 Increase (Decrease) due to Changes in Six Months Ended June 30, 2013 Increase (Decrease) due to Changes in Total Total Increase Increase Volume Rates (Decrease) Volume Rates (Decrease) (Dollars in thousands) Interest income Short-term investments(1) $ 6 $ (2 ) $ 4 $ (13 ) $ (2 ) $ (15 ) Securities available for sale and stock(2) (58 ) 74 16 (138 ) 202 64 Loans 843 (457 ) 386 1,503 (609 ) 894 Total earning assets 791 (385 ) 406 1,352 (409 ) 943 Interest expense Interest-bearing checking accounts 2 1 3 2 4 6 Money market and savings accounts (5 ) (27 ) (32 ) (11 ) (88 ) (99 ) Certificates of deposit 172 (66 ) 106 178 (248 ) (70 ) Borrowings 12 46 58 34 145 179 Junior subordinated debentures - 16 16 (1 ) (9 ) (10 ) Total interest-bearing liabilities 181 (30 ) 151 202 (196 ) 6 Net interest income $ 610 $ (355 ) $ 255 $ 1,150 $ (213 ) $ 937 (1) Short-term investments consist of federal funds sold and interest bearing deposits that we maintain at financial institutions.



(2) Stock consists of FHLB stock and FRBSF stock.

Provision for Loan and Lease Losses We maintain reserves to provide for loan losses that occur in the ordinary course of the banking business. When it is determined that the payment in full of a loan has become unlikely, the carrying value of the loan is reduced ("written down") to what management believes is its realizable value or, if it is determined that a loan no longer has any realizable value, the carrying value of the loan is written off in its entirety (a loan "charge-off"). Loan charge-offs and write-downs are charged against our allowance for loan and lease losses ("ALLL"). The amount of the ALLL is increased periodically to replenish the ALLL after it has been reduced due to loan write-downs or charge-offs. The ALLL also is increased or decreased periodically to reflect increases or decreases in the volume of outstanding loans and to take account of changes in the risk of potential loan losses due to a deterioration or improvement in the condition of borrowers or in the value of properties securing non-performing loans or adverse changes or improvements in economic conditions. Increases in the ALLL are made through a charge, recorded as an expense in the statement of operations, referred to as the "provision for loan and lease losses." Recoveries of loans previously charged-off are added back to and, therefore, to that extent increase the ALLL and reduce the amount of the provision for loan and lease losses that might otherwise have had to be made to replenish or increase the ALLL. We employ economic models that are based on bank regulatory guidelines, industry standards and our own historical loan loss experience, as well as a number of more subjective qualitative factors, to determine both the sufficiency of the ALLL and the amount of the provisions that we believe need to be made for potential loan losses to increase or replenish the ALLL. However, those determinations involve judgments and assumptions about trends in current economic conditions and other events that can affect the ability of borrowers to meet their loan obligations to us and a weighting among the quantitative and qualitative factors we consider in determining the amount of the ALLL. Moreover, the duration and anticipated effects of prevailing economic conditions or trends can be uncertain and can be affected by a number of risks and circumstances that are outside of our ability to control. If changes in economic or market conditions or unexpected subsequent events or changes in circumstances were to occur, or if changes were made to bank regulatory guidelines or industry standards that are used to assess the sufficiency of the ALLL, it could become necessary for us to record additional, and possibly significant, charges to increase the ALLL, which would have the effect of reducing our income or causing us to incur losses. In addition, the FRBSF and the California Department of Business Oversight ("CDBO"), as an integral part of their examination processes, periodically review the adequacy of our ALLL. These agencies may require us to make additional provisions for possible loan losses, over and above the provisions that we have already made, the effect of which would be to reduce our income or increase any losses we might incur. During the three and six months ended June 30, 2014, we recorded a provision for loan and lease losses of $600 thousand and $1.1 million, respectively, as compared to $0 and $1.2 million recorded during the three and six months ended June 30, 2013, 37



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respectively. The provision for loan and lease losses increased $600 thousand, or 100.0%, for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013, primarily as a result of an increase in loan balances by $28.0 million for the three months ended June 30, 2014 compared to $14.3 million for the three months ended June 30, 2013. The provision for loan and lease losses decreased $100 thousand, or 8.7%, for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013, primarily as a result of net recoveries of $172 thousand for the six months ended June 30, 2014, along with increased loan balances of $29.8 million in the first half of 2014 compared to net charge-offs of $908 thousand during the six months ended June 30, 2013 and a decrease in loan balances of $1.4 million for the same period. See "-Financial Condition-Nonperforming Assets and the Allowance for Loan and Lease Losses" below in this Item 2 for additional information regarding the ALLL. Noninterest Income The following table identifies the components of and the percentage changes in noninterest income during the three and six months ended June 30, 2014 and 2013: Three Months Ended June 30, Six Months Ended June 30, Percentage Percentage Amount Amount Change Amount Amount Change 2014 2013 2014 vs. 2013 2014 2013 2014 vs. 2013 (Dollars in thousands) Service fees on deposits and other banking services 218 196 11.2 % 426 392 8.7 % Net gains on sale of securities available for sale - - - % - 23 (100.0 )% Net gain on sale of small business administration loans 474 - 100.0 % 1,160 - 100.0 % Net loss on sale of other real estate owned - - - % - (9 ) (100.0 )% Income from other real estate owned 225 1 22,400.0 % 341 68 401.5 % Other noninterest income (loss) 292 (471 ) (162.0 )% 576 (303 ) (290.1 )% Total noninterest income $ 1,209$ (274 ) (541.2 )% $ 2,503$ 171 1,363.7 % Three Months Ended June 30, 2014 and 2013 Noninterest income increased by $1.5 million for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013 primarily as a result of: A net gain of $474 thousand on sales of commercial SBA loans for the three



months ended June 30, 2014 as compared to no sales of SBA loans during the

prior year period;

A $224 thousand increase in income from properties acquired by or in lieu of

loan foreclosures (commonly referred to as other real estate owned or

"OREO"); and

No sales of loans in the current period as compared to a net loss on the sale

of loans of $576 thousand for the three months ended June 30, 2013 included

within other noninterest income (loss).

Six Months Ended June 30, 2014 and 2013 Noninterest income increased $2.3 million for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013, primarily as a result of: A net gain of $1.2 million on sales of SBA loans for the six months ended



June 30, 2014 as compared to no sales of SBA loans during the prior year

period;

An increase of $273 thousand in income from OREO; and

No sales of loans in the current period as compared to a net loss on the sale

of loans of $485 thousand for the three months ended June 30, 2013 included

within other noninterest income (loss).

Noninterest Expense The following table sets forth the principal components and the amounts of, and the percentage changes in, noninterest expense during the three and six months ended June 30, 2014 and 2013. 38



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Table of Contents Three Months Ended June 30, Six Months Ended June 30, 2014 2013 2014 vs. 2013 2014 2013 2014 vs. 2013 Amount Amount Percent Change Amount Amount Percent Change (Dollars in thousands) Salaries and employee benefits $ 5,420$ 5,150 5.2 % $ 11,023$ 9,516 15.8 % Occupancy 610 597 2.2 % 1,198 1,086 10.3 % Equipment and depreciation 363 392 (7.4 )% 732 818 (10.5 )% Data processing 200 199 0.5 % 451 398 13.3 % FDIC expense 359 547 (34.4 )% 653 1,092 (40.2 )% Other real estate owned expense 538 1,245 (56.8 )% 1,398 3,362 (58.4 )% Professional fees 490 845 (42.0 )% 1,064 2,211 (51.9 )% (Recovery of) provision for contingencies 175 (279 ) (162.7 )% 175 (539 ) (132.5 )% Business development 169 327 (48.3 )% 338 534 (36.7 )% Loan related expense 129 80 61.3 % 216 220 (1.8 )% Insurance 141 147 (4.1 )% 278 294 (5.4 )% Other operating expenses (1) 409 471 (13.2 )% 898 1,007 (10.8 )% Total noninterest expense $ 9,003$ 9,721 (7.4 )% $ 18,424$ 19,999 (7.9 )% (1) Other operating expenses primarily consist of telephone, investor relations, promotional, regulatory expenses, and correspondent bank fees. Three Months Ended June 30, 2014 and 2013 During the three months ended June 30, 2014, noninterest expense decreased by $718 thousand, or 7.4%, to $9.0 million from $9.7 million for the three months ended June 30, 2013, primarily as a result of: A decrease of $707 thousand in OREO expenses related to the reduction of older OREO that incurred more expenses to maintain and resolve in the second quarter of 2013, partially offset by newer OREO taken in



collection of debts that have not incurred the same level of expense to

maintain and resolve during the second quarter of 2014;

A decrease of $355 thousand in professional fees related to decreased

legal expenses due to the settlement of certain lawsuits and other disputes and a decline in nonperforming loans; partially offset by An increase of $270 thousand in salaries and employee benefits related



to the hiring of a new CEO and other key employees in 2013, increases

in health care insurance costs, and increases in workers' compensation

premiums.

Six Months Ended June 30, 2014 and 2013 During the six months ended June 30, 2014, noninterest expense decreased by $1.6 million, or 7.9%, to $18.4 million from $20.0 million for the six months ended June 30, 2013, primarily as a result of: A decrease of $2.0 million in OREO expenses related to the reduction of



older OREO that incurred more expenses to maintain and resolve in the

first half of 2013, partially offset by newer OREO taken in collection

of debts that have not incurred the same level of expense to maintain

and resolve during the first half of 2014;

A decrease of $1.1 million in professional fees related to decreased

legal expenses due to the settlement of certain lawsuits and other disputes and a decline in nonperforming loans; partially offset by An increase of $1.5 million in salaries and employee benefits related



to the hiring of a new CEO and other key employees in 2013, increases

in health care insurance costs, and increases in workers' compensation

premiums.

Provision for (Benefit from ) Income Tax Three Months Ended June 30, 2014 and 2013 For the three months ended June 30, 2014 and 2013, we recorded no income tax provision. There was no income tax provision during the three months ended June 30, 2013 as a result of a net operating loss for the quarter. We generated net operating losses ("NOLs") for the year ended December 31, 2013 which may be utilized against taxable income. The 2013 NOLs were subject to a valuation allowance. As a result of taxable income generated and the utilization of the NOLs subject to a valuation allowance during the three months ended June 30, 2014, we had no income tax provision. Six Months Ended June 30, 2014 and 2013 39



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For the six months ended June 30, 2014, we recorded no income tax provision and we recorded an income tax benefit of $1.5 million for the six months ended June 30, 2013. The tax benefit during the six months ended June 30, 2013 was primarily related to the release of the remainder of a valuation allowance, which we had established against our deferred tax asset by means of non-cash charges to the provision for income taxes prior to 2013. We generated net operating losses ("NOLs") for the year ended December 31, 2013 which may be utilized against taxable income. The 2013 NOLs were subject to a valuation allowance. As a result of taxable income generated and the utilization of the NOLs subject to a valuation allowance during the six months ended June 30, 2014, we had no income tax provision. Financial Condition Assets Our total assets increased by $15 million to $1.0 billion at June 30, 2014 from $997 million at December 31, 2013. The following table sets forth the composition of our interest earning assets at: June 30, 2014



December 31, 2013

(Dollars in



thousands)

Interest-bearing deposits with financial institutions (1)

$ 90,441 $ 93,451 Interest-bearing time deposits with financial institutions 2,923 2,423 Federal Reserve Bank of San Francisco and Federal Home Loan Bank Stock, at cost 8,058 8,531 Securities available for sale, at fair value 62,728 65,989 Loans (net of allowances of $12,580 and $11,358, respectively) 793,820 765,426



(1) Includes interest-earning balances maintained at the FRBSF.

Investment Portfolio Securities Available for Sale. Securities that we intend to hold for an indefinite period of time, but which may be sold in response to changes in liquidity needs, in interest rates, or in prepayment risks or other similar factors, are classified as "securities available for sale". Such securities are recorded on our balance sheet at their respective fair values and increases or decreases in those values are recorded as unrealized gains or losses, respectively, and are reported as other comprehensive income (loss) on our accompanying consolidated statements of financial condition, rather than included in or deducted from our earnings. The following is a summary of the major components of securities available for sale and a comparison of the amortized cost, estimated fair values and the gross unrealized gains and losses attributable to those securities, as of June 30, 2014 and December 31, 2013: Gross Gross Estimated (Dollars in thousands) Amortized Cost Unrealized Gain Unrealized Loss Fair Value Securities available for sale at June 30, 2014: Mortgage backed securities issued by U.S. Agencies $ 56,915 $ 17 $ (1,329 )$ 55,603 Collateralized mortgage obligations issued by non agencies 899 - (10 ) 889 Asset backed security 2,101 - (598 ) 1,503 Mutual funds 4,733 - - 4,733 Total securities available for sale $ 64,648 $ 17 $ (1,937 )$ 62,728 Securities available for sale at December 31, 2013: U.S. Treasury securities $ 700 $ - $ - $ 700 Mortgage backed securities issued by U.S. Agencies 60,514 13 (2,719 ) 57,808 Collateralized mortgage obligations issued by non agencies 1,572 - (48 ) 1,524 Asset backed security 2,218 - (906 ) 1,312 Mutual funds 4,645 - - 4,645 Total securities available for sale $ 69,649 $ 13



$ (3,673 )$ 65,989

The amortized cost of securities available for sale at June 30, 2014 is shown in the table below by contractual maturities taking into consideration historical prepayments based on the prior twelve months of principal payments. Expected maturities will differ from contractual maturities and historical prepayments, particularly with respect to collateralized mortgage obligations, primarily because prepayment rates are affected by changes in conditions in the interest rate market and, therefore, future prepayment rates may differ from historical prepayment rates. 40



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Table of Contents June 30, 2014 Maturing in Over one year through five Over five years through One year or less years ten years Over ten years Total Weighted Weighted Weighted Weighted Weighted Average Average Average Average Average (Dollars in thousands) Amortized Cost Yield Amortized Cost Yield Amortized Cost Yield Amortized Cost Yield Amortized Cost Yield Securities available for sale: Mortgage-backed securities issued by U.S. Agencies $ 6,703 1.57 % $ 22,467 1.57 % $ 19,259 1.60 % $ 8,486 1.63 % $ 56,915 1.59 % Non-agency collateralized mortgage obligations - - 899 2.92 % - - - - 899 2.92 % Asset backed securities - - - - % - - 2,101 2.28 % 2,101 2.28 % Mutual funds - - 4,733 2.00 % - - - - 4,733 2.00 % Total Securities Available for sale $ 6,703 1.57 % $ 28,099 1.69 % $ 19,259 1.60 % $ 10,587 1.76 % $ 64,648 1.66 % Loans



The following table sets forth the composition, by loan category, of our loan portfolio at June 30, 2014 and December 31, 2013:

June 30, 2014 December 31, 2013 Amount Percent Amount Percent (Dollars in thousands) Commercial loans $ 253,442 31.4 % $ 226,450 29.2 % Commercial real estate loans - owner occupied 191,143 23.7 % 174,221 22.4 % Commercial real estate loans - all other 178,562 22.1 % 177,884 22.9 % Residential mortgage loans - multi-family 94,405 11.7 % 96,565 12.4 % Residential mortgage loans - single family 72,919 9.0 % 75,660 9.7 % Land development loans 9,966 1.2 % 18,458 2.4 % Consumer loans 6,210 0.8 % 7,599 1.0 % Gross loans 806,647 100.0 % 776,837 100.0 % Deferred fee costs (income), net (247 ) (53 ) Allowance for loan and lease losses (12,580 ) (11,358 ) Loans, net $ 793,820$ 765,426 Commercial loans are loans to businesses to finance capital purchases or improvements, or to provide cash flow for operations. Real estate and residential mortgage loans are loans secured by trust deeds on real properties, including commercial properties and single family and multi-family residences. Construction loans are interim loans to finance specific construction projects. Consumer loans include installment loans to consumers. The following table sets forth the maturity distribution of our loan portfolio (excluding single and multi-family residential mortgage loans and consumer loans) at June 30, 2014: June 30, 2014 Over One Year One Year Through Over Five or Less Five Years Years Total (Dollars in thousands) Real estate loans(1) Floating rate $ 43,713$ 44,984$ 121,883$ 210,580 Fixed rate 22,876 76,421 69,794 169,091 Commercial loans Floating rate 38,891 21,601 4,482 64,974 Fixed rate 132,108 51,222 5,138 188,468 Total $ 237,588$ 194,228$ 201,297$ 633,113 41



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(1) Does not include mortgage loans on single or multi-family residences or

consumer loans, which totaled $167.3 million and $6.2 million,

respectively, at June 30, 2014.

Nonperforming Assets and Allowance for Loan and Lease Losses Nonperforming Assets. Non-performing loans consist of (i) loans on non-accrual status which are loans on which the accrual of interest has been discontinued and include restructured loans when there has not been a history of past performance on debt service in accordance with the contractual terms of the restructured loans, and (ii) loans 90 days or more past due and still accruing interest. Non-performing assets are comprised of non-performing loans and OREO, which consists of real properties which we have acquired by or in lieu of foreclosure and which we intend to offer for sale. Loans are placed on non-accrual status when, in our opinion, the full timely collection of principal or interest is in doubt. Generally, the accrual of interest is discontinued when principal or interest payments become more than 90 days past due, unless we believe the loan is adequately collateralized and the loan is in the process of collection. However, in certain instances, we may place a particular loan on non-accrual status earlier, depending upon the individual circumstances involved in that loan's delinquency. When a loan is placed on non-accrual status, previously accrued but unpaid interest is reversed against current income. Subsequent collections of unpaid amounts on such a loan are applied to reduce principal when received, except when the ultimate collectability of principal is probable, in which case such payments are applied to interest and are credited to income. Non-accrual loans may be restored to accrual status if and when principal and interest become current and full repayment is expected. Interest income is recognized on the accrual basis for impaired loans which, based on our non-accrual policy, do not require non-accrual treatment. The following table sets forth information regarding our nonperforming assets, as well as information regarding restructured loans, at June 30, 2014 and December 31, 2013: At December 31, At June 30, 2014 2013 (Dollars in thousands) Nonaccrual loans: Commercial loans $ 5,044 $ 5,371 Commercial real estate 6,535 3,890 Residential real estate 66 1,874 Land development - 391 Total nonaccrual loans $ 11,645



$ 11,526 Loans past due 90 days and still accruing interest: Total loans past due 90 days and still accruing interest $

- $ - Other real estate owned (OREO): Commercial real estate $ 14,480 $ 9,569 Residential real estate 962 2,092 Construction and land development 630 630 Total other real estate owned $ 16,072 $ 12,291 Other nonperforming assets: Asset backed security - 1,312 Total other nonperforming assets $ - $ 1,312 Total nonperforming assets $ 27,717 $ 25,129 Restructured loans: Accruing loans $ 11,244 $ 12,634 Nonaccruing loans (included in nonaccrual loans above) 3,410 5,936 Total restructured loans $ 14,654 $ 18,570 As the above table indicates, total nonperforming assets increased by approximately $2.6 million, or 10.3%, to $27.7 million as of June 30, 2014 from $25.1 million as of December 31, 2013, primarily due to a $5.2 million commercial real estate property added to OREO from the foreclosure of a commercial loan, partially offset by $1.1 million of OREO sales from residential real estate and returning a $1.3 million asset backed security to accrual status from nonaccrual status. Information Regarding Impaired Loans. At June 30, 2014, loans deemed impaired totaled $22.9 million as compared to $24.2 million at December 31, 2013. We had an average investment in impaired loans of $26.1 million for the six months ended June 30, 2014 as compared to $35.7 million for the year ended December 31, 2013. The interest that would have been earned 42



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during the six months ended June 30, 2014 had the nonaccruing impaired loans remained current in accordance with their original terms was approximately $206 thousand. The following table sets forth the amount of impaired loans to which a portion of the ALLL has been specifically allocated, and the aggregate amount so allocated, in accordance with Accounting Standards Codification ("ASC") 310-10, and the amount of the ALLL and the amount of impaired loans for which no such allocations were made, in each case at June 30, 2014 and December 31, 2013: June 30, 2014 December 31, 2013 % of % of Reserves for Reserves to Reserves for Reserves to Loans Loan Losses Loans Loans Loan Losses Loans (Dollars in



thousands)

Impaired loans with specific reserves $ 2,949$ 1,820 61.7 % $ - $ - - % Impaired loans without specific reserves 19,940 - - 24,160 - - Total impaired loans $ 22,889$ 1,820 8.0 % $ 24,160 $ - - % The $1.3 million decrease in impaired loans to $22.9 million at June 30, 2014 from $24.2 million at December 31, 2013 was primarily attributable to the foreclosure and transfer to OREO on a $1.8 million nonaccrual loan. Accruing restructured loans were comprised of a number of loans performing in accordance with modified terms, which included lowering of interest rates, deferral of payments, or modifications to payment terms. Based on an internal analysis, using the current estimated fair values of the collateral or the discounted present values of the future estimated cash flows of the impaired loans, we concluded that, at June 30, 2014, $1.8 million of specific reserves were required on eight impaired loans and that all remaining impaired loans were well secured and adequately collateralized with no specific reserves required. Allowance for Loan and Lease Losses. The ALLL totaled $12.6 million, representing 1.56% of loans outstanding, at June 30, 2014, as compared to $11.4 million, or 1.46% of loans outstanding, at December 31, 2013. The adequacy of the ALLL is determined through periodic evaluations of the loan portfolio and other factors that can reasonably be expected to affect the ability of borrowers to meet their loan obligations. Those factors are inherently subjective as the process for determining the adequacy of the ALLL involves some significant estimates and assumptions about such matters such as (i) economic conditions and trends and the amounts and timing of expected future cash flows of borrowers which can affect their ability to meet their loan obligations to us, (ii) the fair value of the collateral securing non-performing loans, (iii) estimates of losses that we may incur on non-performing loans, which are determined on the basis of historical loss experience and industry loss factors and bank regulatory guidelines, which are subject to change, and (iv) various qualitative factors. Since those factors are subject to changes in economic and other conditions and changes in regulatory guidelines or other circumstances over which we have no control, the amount of the ALLL may prove to be insufficient to cover all of the loan losses we might incur in the future. In such an event, it may become necessary for us to increase the ALLL from time to time to maintain its adequacy. Such increases are effectuated by means of a charge to income, referred to as the "provision for loan and lease losses", in our statements of our operations. See "-Results of Operations- Provision for Loan and Lease Losses, above in this Item 2. The amount of the ALLL is first determined by assigning reserve ratios for all loans. All non-accrual loans and other loans classified as "Special Mention," "Substandard" or "Doubtful" ("classified loans" or "classification categories") and not fully collateralized are then assigned specific reserves within the ALLL, with greater reserve allocations made to loans deemed to be of a higher risk. These ratios are determined based on prior loss history and industry guidelines and loss factors, by type of loan, adjusted for current economic factors and current economic trends. Refer to Note 5, Loans and Allowance for Loan and Lease Losses for definitions related to our credit quality indicators stated above. On a quarterly basis, we utilize a classification migration model and individual loan review analytical tools as starting points for determining the adequacy of the ALLL. Our loss migration analysis tracks a certain number of quarters of loan loss history and industry loss factors to determine historical losses by classification category for each loan type, except certain loans (automobile, mortgage and credit cards), which are analyzed as homogeneous loan pools. These calculated loss factors are then applied to outstanding loan balances. We also conduct individual loan review analysis, as part of the ALLL allocation process, applying specific monitoring policies and procedures in analyzing the existing loan portfolio. In determining whether and the extent to which we will make adjustments to our loan loss migration model for purposes of determining the ALLL, we also consider a number of qualitative factors that can affect the performance and the collectability of the loans in our loan portfolio. Such qualitative factors include: The effects of changes that we may make in our loan policies or underwriting standards on the quality of the loans and the risks in our loan portfolios; 43



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Trends and changes in local, regional and national economic conditions, as well as changes in industry specific



conditions, and

any other reasonably foreseeable events that could affect the performance or the collectability of the loans in our loan portfolios; Material changes that may occur in the mix or in the volume of the loans in our loan portfolios that could alter, whether



positively or

negatively, the risk profile of those portfolios; Changes in management or loan personnel or other



circumstances that

could, either positively or negatively, impact the application



of

our loan underwriting standards, the monitoring of



nonperforming

loans or our loan collection efforts;



Changes in the concentration of risk in the loan portfolio; and

External factors that, in addition to economic conditions,



can

affect the ability of borrowers to meet their loan



obligations, such

as fires, earthquakes and terrorist attacks. Determining the effects that these qualitative factors may have on the performance of each category of loans in our loan portfolio requires numerous judgments, assumptions and estimates about conditions, trends and events which may subsequently prove to have been incorrect due to circumstances outside of our control. Moreover, the effects of qualitative factors such as these on the performance of our loan portfolios are often difficult to quantify. As a result, we may sustain loan losses in any particular period that are sizable in relation to the ALLL or that may even exceed the ALLL. In response to the economic recession, which resulted in increased and relatively persistent high rates of unemployment, and the credit crisis that has led to a severe tightening in the availability of credit, preventing borrowers from refinancing their loans, we (i) implemented more stringent loan underwriting standards, (ii) strengthened loan underwriting and approval processes, and (iii) added personnel with experience in addressing problem assets. Set forth below is information regarding loan balances and the related ALLL, by portfolio type, for the six months ended June 30, 2014 and 2013 (excluding mortgage loans held for sale). Consumer and Land Single Family (Dollars in thousands) Commercial Real Estate Development Mortgages Total ALLL for the six months ended June 30, 2014: Balance at beginning of year $ 5,812$ 4,517$ 165 $ 864 $ 11,358 Charge offs (276 ) - - (102 ) (378 ) Recoveries 452 19 - 79 550 Provision 489 861 (80 ) (220 ) 1,050 Balance at end of year $ 6,477$ 5,397 $ 85 $ 621 $ 12,580 Ratio of net charge-offs to average loans outstanding (annualized) (0.04 )% ALLL for the six months ended June 30, 2013: Balance at beginning of year $ 6,340$ 3,487$ 248 $ 806 $ 10,881 Charge offs (2,603 ) (308 ) (5 ) (2 ) (2,918 ) Recoveries 1,932 2 54 22 2,010 Provision 1,284 (327 ) - 193 1,150 Balance at end of year $ 6,953$ 2,854$ 297$ 1,019$ 11,123 Ratio of net charge-offs to average loans outstanding (annualized) 0.25 % The ALLL increased $1.2 million from December 31, 2013 to June 30, 2014 as a result of net loan growth of $29.8 million in the first half of 2014 and an increase in specific reserves of $1.8 million on our impaired loans. The decrease in the provision for loan and lease losses from June 30, 2013 to June 30, 2014 was primarily the result of net recoveries of $172 thousand for the six months ended June 30, 2014 compared to net charge-offs of $908 thousand during the six months ended June 30, 2013. We classify our loan portfolios using internal credit quality ratings. The credit quality table in Note 5, Loans and Allowance for Loan and Lease Losses above in Item 1, provides a summary of loans by portfolio type and our internal credit quality ratings as of June 30, 2014 and December 31, 2013. Loans totaled approximately $806.6 million at June 30, 2014, an increase of $29.8 million from $776.8 million at December 31, 2013. The disaggregation of the loan portfolio by risk rating in the credit quality table located in Note 5 reflects the following changes that occurred between June 30, 2014 and December 31, 2013: 44



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Loans rated "Pass" totaled $751.6 million, an increase of $25.9 million from $725.7 million at December 31, 2013. The increase was primarily attributable to new loan growth in commercial loans of $27.0 million and commercial real estate loans - owner occupied of $16.9 million, partially offset by the downgrade to "Special Mention" of $15.4 million in loans and "Substandard" of $3.6 million in loans. Loans rated "Special Mention" totaled $15.4 million, an increase of $10.1 million from $5.2 million at December 31, 2013. The increase was primarily the result of $15.4 million



downgraded from

"Pass", which included a $12.9 million commercial loan relationship, partially offset by the downgrade to "Substandard" of a $5.1 million residential mortgage loan - multi family relationship in current status. Loans rated "Substandard" totaled $39.7 million, a decrease of $6.1 million from $45.9 million at December 31, 2013. This decrease was primarily the result of principal payments of $12.1 million and the foreclosure and transfer to OREO of a $1.8 million commercial loan, partially offset by approximately $8.8 million in loans downgraded to "Substandard". We use a rolling twelve quarter loss migration analysis to determine the loss factors we will apply to each of the above-described loan classification categories. We previously used an eight quarter loss migration analysis through December 2013. The economic cycle has improved based on delinquency balances due to the drop in impaired loan balances over the past few years. Management decided an eight quarter loss migration cycle may overweight the benefits of an improving economic cycle and revisited the general reserve factors as part of its normal review of the ALLL, resulting in an increased look-back period. As a result, for purposes of determining applicable loss factors at June 30, 2014, our migration analysis covered the period from June 30, 2011 to June 30, 2014. That migration analysis resulted in modest increases to the loss factors of our June 30, 2014 ALLL analysis, which we believe was consistent with and reasonably reflects current economic conditions and the risks that were inherent in our loan portfolio at June 30, 2014. The table below sets forth loan delinquencies, by quarter, from June 30, 2014 to June 30, 2013. September 30, June 30, 2014 March 31, 2014 December 31, 2013 2013 June 30, 2013 Loans Delinquent: (Dollars in thousands) 90 days or more: Commercial loans $ 1,647 $ 266 $ 2,192 $ 1,402 $ 756 Commercial real estate 2,117 2,117 2,117 2,117 2,117 3,764 2,383 4,309 3,519 2,873 30-89 days: Commercial loans 4,251 1,416 - 4,977 4,592 Commercial real estate 485 - - - 4,792 Residential mortgages 264 137 748 - - Land development loans 368 - - - - Consumer loans - - 450 - - 5,368 1,553 1,198 4,977 9,384 Total Past Due(1): $ 9,132 $ 3,936 $ 5,507 $ 8,496$ 12,257



(1) Past due balances include nonaccrual loans.

As the above table indicates, total past due loans increased by $3.6 million, to $9.1 million at June 30, 2014 from $5.5 million at December 31, 2013. Loans past due 90 days or more decreased by $0.5 million, to $3.8 million at June 30, 2014, from $4.3 million at December 31, 2013. Loans 30-89 days past due increased by $4.2 million to $5.4 million at June 30, 2014 from $1.2 million at December 31, 2013, primarily due to a matured commercial loan relationship of $3.1 million, which is well secured and due to be paid off. Deposits Average Balances of and Average Interest Rates Paid on Deposits Set forth below are the average amounts of, and the average rates paid on, deposits for the six months ended June 30, 2014 and year ended December 31, 2013: 45



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Table of Contents Six Months Ended June 30, 2014 Year Ended December 31, 2013 Average Average Average Average Balance Rate Balance Rate (Dollars in thousands) Noninterest bearing demand deposits $ 188,862 - $ 188,696 - Interest-bearing checking accounts 34,682 0.28 % 33,447 0.28 % Money market and savings deposits 158,789 0.32 % 155,352 0.36 % Time deposits(1) 439,855 0.97 % 354,720 1.06 % Total deposits $ 822,188 0.59 % $ 732,215 0.60 %



(1) Comprised of time certificates of deposit in denominations of less than

and more than $100,000.

Deposit Totals Deposits totaled $819.3 million at June 30, 2014 as compared to $780.2 million at December 31, 2013. The following table provides information regarding the mix of our deposits at June 30, 2014 and December 31, 2013: At June 30, 2014 At December 31, 2013 % of Total % of Total Amounts Deposits Amounts Deposits (Dollars in thousands)



Core deposits Noninterest bearing demand deposits $ 193,499 23.6 % $ 203,942

26.1 % Savings and other interest-bearing transaction deposits 175,944 21.5 % 197,614 25.3 % Time deposits 449,851 54.9 % 378,669 48.5 % Total deposits $ 819,294 100.0 % $ 780,225 100.0 % At June 30, 2014, noninterest-bearing deposits totaled $193.5 million, or 23.6% of total deposits, as compared to $203.9 million, or 26.1% of total deposits at December 31, 2013. Certificates of deposit in denominations of $100,000 or more, on which we pay higher rates of interest than on other deposits, aggregated $397.2 million, or 48.5%, of total deposits at June 30, 2014, as compared to $327.6 million, or 42.0%, of total deposits at December 31, 2013. Set forth below is a maturity schedule of domestic time certificates of deposit outstanding at June 30, 2014 and December 31, 2013: June 30, 2014 December 31, 2013 Certificates of Certificates of Certificates of Certificates of Deposit Under Deposit $100,000 Deposit Under Deposit $100,000 Maturities $ 100,000 or more $100,000 or more (Dollars in thousands) Three months or less $ 10,209 $ 51,966 $ 19,581 $ 90,694 Over three and through six months 10,648 117,524 7,359 36,946 Over six and through twelve months 22,366 139,426 17,735 149,919 Over twelve months 9,429 88,283 6,354 50,081 Total $ 52,652 $ 397,199 $ 51,029 $ 327,640 Liquidity We actively manage our liquidity needs to ensure that sufficient funds are available to meet our needs for cash, including to fund new loans to and deposit withdrawals by our customers. We project the future sources and uses of funds and maintain liquid funds for unanticipated events. Our primary sources of cash include cash we have on deposit at other financial institutions, payments from borrowers on their loans, proceeds from sales or maturities of securities held for sale, sales of residential mortgage loans, increases in deposits and increases in borrowings principally from the FHLB. The primary uses of cash include funding new loans and making advances on existing lines of credit, purchasing investments, including securities available for sale, funding new residential mortgage loans, funding deposit withdrawals and paying operating expenses. We maintain funds in overnight federal funds and other short-term investments to provide for short-term liquidity needs. We also have obtained credit lines from 46



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the FHLB and other financial institutions to meet any additional liquidity requirements we might have. See "-Contractual Obligations-Borrowings" below for additional information related to our borrowings from the FHLB. Our liquid assets, which included cash and due from banks, federal funds sold, interest earning deposits that we maintain with financial institutions and unpledged securities available for sale (excluding FRBSF and FHLB stock) totaled $147.7 million, which represented 15% of total assets, at June 30, 2014. We believe that our cash and cash equivalent resources, together with available borrowings under our credit facilities, will be sufficient to meet normal operating requirements for at least the next twelve months, including to enable us to meet any increase in deposit withdrawals that might occur in the foreseeable future. Cash Flow Provided by (Used in) Operating Activities. During the six months ended June 30, 2014, operating activities provided net cash of $10.1 million, comprised primarily of $9.2 million provided by our discontinued operations and our net income of $0.5 million. During the six months ended June 30, 2013, operating activities provided net cash of $33.5 million, comprised primarily of $45.1 million provided by our discontinued operations, partially offset by our net loss of $6.3 million. Cash Flow (Used in) Provided by Investing Activities. During the six months ended June 30, 2014, investing activities used net cash of $29.2 million, primarily attributable to $35.0 million used to fund an increase in loans, partially offset by $4.9 million and $0.5 million of cash from maturities of and principal payments on securities available for sale and FRBSF and FHLB stock, respectively, and $1.1 million of proceeds from sales of OREO. During the six months ended June 30, 2013, investing activities provided net cash of $19.1 million, primarily comprised of $6.2 million from sales of securities available for sale, $14.4 million of cash from maturities and principal payments on securities available for sale, partially offset by $1.1 million used to fund an increase in loans. Cash Flow Used in Financing Activities. During the six months ended June 30, 2014, financing activities provided net cash of $16.9 million, consisting primarily of a $49.5 million net increase in interest bearing deposits, which resulted primarily from a decision to increase the rates of interest we pay on our certificates of deposit in order to decrease our loan-to-deposit ratio and increase our liquidity, partially offset by a $22.5 million decrease in borrowings, and a decrease in noninterest bearing deposits of $10.4 million. During the six months ended June 30, 2013, financing activities used net cash of $91.4 million, consisting primarily of a $96.4 million net decrease in deposits as a result of a decision to decrease the rates paid on certificates of deposit in order to decrease our cost of funds, and a $10.0 million decrease in borrowings, partially offset by net proceeds of $15.0 million from a private placement of shares of our common stock in March 2013. Ratio of Loans to Deposits. The relationship between gross loans and total deposits can provide a useful measure of a bank's liquidity. Since repayment of loans tends to be less predictable than the maturity of investments and other liquid resources, the higher the loan-to-deposit ratio the less liquid are our assets. On the other hand, since we realize greater yields on loans than we do on investments, a lower loan-to-deposit ratio can adversely affect interest income and earnings. As a result, our goal is to achieve a loan-to-deposit ratio that appropriately balances the requirements of liquidity and the need to generate a fair return on our assets. At June 30, 2014 and December 31, 2013, the loan-to-deposit ratio was 98% and 100%, respectively. Capital Resources Regulatory Capital Requirements Applicable to Banking Institutions Under federal banking regulations that apply to all United States based bank holding companies and federally insured banks, the Company (on a consolidated basis) and the Bank (on a stand-alone basis) must meet specific capital adequacy requirements that, for the most part, involve quantitative measures, primarily in terms of the ratios of their capital to their assets, liabilities, and certain off-balance sheet items, calculated under regulatory accounting practices. Under those regulations, each bank holding company must meet a minimum capital ratio and each federally insured bank is determined by its primary federal bank regulatory agency to come within one of the following capital adequacy categories on the basis of its capital ratios: well capitalized adequately capitalized undercapitalized



significantly undercapitalized; or

critically undercapitalized

Certain qualitative assessments also are made by a banking institution's primary federal regulatory agency that could lead the agency to determine that the banking institution should be assigned to a lower capital category than the one indicated by the quantitative measures used to assess the institution's capital adequacy. At each successive lower capital category, a banking institution is subject to greater operating restrictions and increased regulatory supervision by its federal bank regulatory agency. The following table sets forth the capital and capital ratios of the Company (on a consolidated basis) and the Bank (on a stand-alone basis) at June 30, 2014, as compared to the respective regulatory requirements applicable to them. 47



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Table of Contents Applicable Federal Regulatory Requirement For Capital To be Categorized As Adequacy Purposes Well Capital Amount Ratio Amount Ratio Amount Ratio (Dollars in thousands) Total Capital to Risk Weighted Assets: Company $ 139,842 17.1 % $ 65,579 At least 8.0 N/A N/A Bank 119,796 14.9 % 64,529 At least 8.0 $ 80,661 At least 10.0 Tier 1 Capital to Risk Weighted Assets: Company $ 129,559 15.8 % $ 32,789 At least 4.0 N/A N/A Bank 109,675 13.6 % 32,264 At least 4.0 $ 48,397 At least 6.0 Tier 1 Capital to Average Assets: Company $ 129,559 12.6 % $ 41,062 At least 4.0 N/A N/A Bank 109,675 10.8 % 40,661 At least 4.0 $ 50,826 At least 5.0 At June 30, 2014 the Bank (on a stand-alone basis) continued to qualify as a well-capitalized institution, and the Company continued to exceed the minimum required capital ratios applicable to it, under the capital adequacy guidelines described above. The consolidated total capital and Tier 1 capital of the Company at June 30, 2014 includes an aggregate of $17.0 million principal amount of the $17.5 million of junior subordinated debentures that we issued in 2002 and 2004. See "-Contractual Obligations-Junior Subordinated Debentures" below for additional information. We contributed the net proceeds from the sales of the junior subordinated debentures to the Bank over the nine year period ended June 30, 2014, thereby providing it with additional cash to fund the growth of its banking operations and, at the same time, to increase its total capital and Tier 1 capital. Capital and Other Requirements under FRBSF Agreement and CDBO Order On August 31, 2010, the Company and the Bank entered into the FRBSF Agreement with FRBSF. On the same date, the Bank consented to the issuance of a regulatory order by the CDBO (the "CDBO Order"). On October 31, 2013, the CDBO terminated the CDBO Order after concluding that the Bank had substantially complied with its terms. The principal purposes of the FRBSF Agreement, which constitutes formal supervisory action by the FRBSF, were to require us to adopt and implement formal plans and take certain actions, as well as to continue to implement other measures that we previously adopted, to address the adverse consequences that the economic recession has had on the performance of our loan portfolio and our operating results, to improve our operating results, and to increase our capital to strengthen our ability to weather any further adverse economic conditions that might arise in the future. The FRBSF Agreement requires the Boards of Directors of the Company and the Bank to prepare and submit written plans to the FRBSF to address the following matters: (i) strengthening board oversight of the management operations of the Bank; (ii) strengthening credit risk management practices; (iii) improving credit administration policies and procedures; (iv) improving the Bank's position with respect to problem assets; (v) maintaining adequate reserves for loan losses in accordance with applicable supervisory guidelines; (vi) improving the capital position of the Bank and of the Company; (vii) improving the Bank's earnings through the formulation, adoption and implementation of a new strategic plan, and (viii) submitting a satisfactory funding contingency plan for the Bank that would identify available sources of liquidity and a plan for dealing with adverse economic and market conditions. The Company may not declare or pay cash dividends, repurchase any of its shares, make payments on its trust preferred securities or incur or guarantee any debt, without the prior approval of the FRBSF. As a result of these prohibitions, the Company has not made interest payments on the junior subordinated debentures issued in 2002 and 2004. See "-Contractual Obligations-Junior Subordinated Debentures" below for additional information. The Company and the Bank have made substantial progress with respect to several of the requirements imposed by the FRBSF Agreement, including a requirement, achieved in August 2011, that the Bank raise additional capital to increase its ratio of adjusted tangible shareholders' equity-to-tangible assets to 9.00%. The Company is committed to achieving all of the requirements on a timely basis. Formal termination of the FRBSF Agreement requires an express determination by the FRBSF to the effect that substantial compliance with all of the provisions have been achieved. A failure by the Company or the Bank to meet any of those remaining requirements could be deemed by the FRBSF to be conducting business in an unsafe manner which could subject the Company or the Bank to further regulatory enforcement action. See "Risks and uncertainties posed by the FRBSF Agreement to which we and the Bank are subject" under Item 1A "Risk Factors" in Part I of our 2013 Form 10-K. 48



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Dividend Policy and Share Repurchase Programs. It is, and since the beginning of 2009 it has been, the policy of the Boards of Directors of the Company and the Bank to preserve cash to enhance our capital positions and the Bank's liquidity. Moreover, since mid-2009, bank regulatory restrictions, including those under the FRBSF Agreement, have precluded the Company and the Bank from paying cash dividends, and we have been precluded from repurchasing our shares, without the prior approval of the FRBSF. Accordingly, we do not expect to pay dividends or make share repurchases for the foreseeable future. The principal source of cash available to a bank holding company consists of cash dividends from its bank subsidiaries. There are currently several restrictions on the Bank's ability to pay us cash dividends in addition to the FRBSF Agreement discussed above. Government regulations, including the laws of the State of California, as they pertain to the payment of cash dividends by California state chartered banks, also limit the amount of funds that the Bank is permitted to dividend to us. Further, Section 23(a) of the Federal Reserve Act limits the amounts that a bank may loan to its bank holding company to an aggregate of no more than 10% of the bank subsidiary's capital surplus and retained earnings and requires that such loans be secured by specified assets of the bank holding company. See Note 15, Shareholders' Equity in the notes to our consolidated financial statements in Part II of our 2013 Form 10-K for more detail regarding the restrictions on dividends and inter-company transactions. While restrictions on the payment of dividends from the Bank to us exist, there are no restrictions on the dividends that may be paid to us by PM Asset Resolution, Inc. ("PMAR"), a wholly owned subsidiary we organized during the first quarter of 2013 for the purpose of purchasing certain non-performing loans and other real estate from the Bank and thereafter collecting or disposing of those assets. PMAR has approximately $16.2 million in assets which are in the process of being liquidated and could provide us with additional cash if required. In addition, we currently have sufficient cash on hand to meet our cash obligations. As a result, we do not expect that these restrictions will impact our ability to meet our cash obligations. Off Balance Sheet Arrangements Loan Commitments and Standby Letters of Credit. To meet the financing needs of our customers in the normal course of business, we are a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. At June 30, 2014 and December 31, 2013, we were committed to fund certain loans including letters of credit amounting to approximately $130 million and $138 million, respectively. Commitments to extend credit and standby letters of credit generally have fixed expiration dates or other termination clauses and the customer may be required to pay a fee and meet other conditions in order to draw on those commitments or standby letters of credit. We expect, based on historical experience, that many of the commitments will expire without being drawn upon and, therefore, the total commitment amounts do not necessarily represent future cash requirements. To varying degrees, commitments to extend credit involve elements of credit and interest rate risk for us that are in excess of the amounts recognized in our balance sheets. Our maximum exposure to credit loss in the event of nonperformance by the customers to whom such commitments are made could potentially be equal to the amount of those commitments. As a result, before making such a commitment to a customer, we evaluate the customer's creditworthiness using the same underwriting standards that we would apply if we were approving loans to the customer. In addition, we often require the customer to secure its payment obligations for amounts drawn on such commitments with collateral such as accounts receivable, inventory, property, plant and equipment, income-producing commercial properties, residential properties and properties under construction. As a consequence, our exposure to credit and interest rate risk on such commitments is not different in character or amount than risks inherent in the outstanding loans in our loan portfolio. Standby letters of credit are conditional commitments issued by the Bank to guarantee a payment obligation of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers. Contractual Obligations Borrowings. As of June 30, 2014, we had $17.5 million of outstanding short-term borrowings and $30.0 million of outstanding long-term borrowings that we had obtained from the FHLB. The table below sets forth the amounts of, the interest rates we pay on and the maturity dates of these FHLB borrowings. These borrowings had a weighted-average annualized interest rate of 0.70% for the year ended June 30, 2014. 49



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Table of Contents Principal Interest Principal Interest Amounts Rate Maturity Dates Amounts Rate Maturity Dates (Dollars in thousands) $ 3,000 0.64 % September 26, 2014 $ 5,000 0.61 % September 18, 2015 5,000 0.35 % October 9, 2014 5,000 0.57 % September 30, 2015 4,500 0.78 % March 26, 2015 5,000 1.08 % September 19, 2016 5,000 0.76 % March 30, 2015 5,000 0.96 % September 30, 2016 10,000 0.61 % August 31, 2015 At June 30, 2014, $441.9 million of residential mortgage and other real estate secured loans were pledged to secure these FHLB borrowings. The highest amount of borrowings outstanding at any month-end during the six months ended June 30, 2014 was $70 million, which consisted of borrowings from the FHLB. By comparison, the highest amount of borrowings outstanding at any month end in 2013 consisted of $85 million of borrowings from the FHLB. Junior Subordinated Debentures. Pursuant to rulings of the Federal Reserve Board, bank holding companies were permitted to issue long term subordinated debt instruments that, subject to certain conditions, would qualify as and, therefore, augment capital for regulatory purposes. At June 30, 2014, we had outstanding approximately $17.5 million principal amount of 30-year junior subordinated floating rate debentures (the "Debentures"), of which $17.0 million qualified as Tier 1 capital for regulatory purposes as of June 30, 2014. Set forth below is certain information regarding the Debentures: Original Issue Dates Principal Amount Interest Rates Maturity Dates September 2002 $ 7,217 LIBOR plus 3.40% September 2032 October 2004 10,310 LIBOR plus 2.00% October 2034 Total $ 17,527



(1) Subject to the receipt of prior regulatory approval, we may redeem the

Debentures, in whole or in part, without premium or penalty, at any time prior to maturity. As previously reported, since July 2009 we have been required to obtain the prior approval of the FRBSF to make interest payments on the Debentures. During the years ended June 30, 2014 and 2013, we were unable to obtain regulatory approvals to pay, and it became necessary for us to defer, quarterly interest payments on the Debentures. We cannot predict when the FRBSF will approve our resumption of such interest payments and until such approval can be obtained it will be necessary for us to continue deferring interest payments on the Debentures. Since we have the right, under the terms of the Debentures, to defer interest payments for up to twenty (20) consecutive quarters, the deferrals of interest payments to date have not constituted, and any future deferrals of interest payments through January 2015 will not constitute, a default under or with respect to the Debentures. However, if by that date we have not been able to obtain regulatory approval to pay all of the deferred interest payments, we would then be in default under the Debentures, in which case the entire $17.5 million principal amount of, and accrued but unpaid interest on, the Debentures could be declared immediately due and payable. For additional information regarding the restrictions on the payment by us of interest on the Debentures, as well as other regulatory restrictions that apply to us and the Bank under a regulatory agreement entered into with the FRBSF, see "Capital Resources" above in this section of this Report and "Supervision and Regulation" in Item 1 and "Risk Factors" in Item 1A in Part I of our 2013 Form 10-K. Critical Accounting Policies Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States ("GAAP") and general practices in the banking industry. Certain of those accounting policies are considered critical accounting policies, because they require us to make assumptions and judgments regarding circumstances or trends that could affect the carrying value of our material assets, such as, for example, assumptions regarding economic conditions or trends that could impact our ability to fully collect our loans or ultimately realize the carrying value of certain of our other assets, such as securities available for sale and our deferred tax asset. Those assumptions and judgments are based on current information available to us regarding those economic conditions or trends or other circumstances. If adverse changes were to occur in the conditions, trends or other events on which our assumptions or judgments had been based, then under GAAP it could become necessary for us to reduce the carrying values of any affected assets on our balance sheet. In addition, because reductions in the carrying value of assets are sometimes effectuated by or require charges to income, such reductions also may have the effect of reducing our income. 50



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There have been no significant changes during the six months ended June 30, 2014 to the items that we disclosed as our critical accounting policies and estimates in Critical Accounting Policies within Management's Discussion and Analysis of Financial Condition and Results of Operations included in our 2013 Form 10-K.


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