Edgar Filing: PACIFIC MERCANTILE BANCORP

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller reporting company

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended March 31, 2013

¨	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 0-30777

PACIFIC MERCANTILE BANCORP

(Exact name of Registrant as specified in its charter)


California		33-0898238
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

949 South Coast Drive, Suite 300, Costa Mesa, California		92626
(Address of principal executive offices)		(Zip Code)

(714) 438-2500

(Registrant’s telephone number, including area code)

Not Applicable

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports); and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every interactive data file required to be submitted and posted pursuant to Rule 405 of Regulation S-T (section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

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

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

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

18,905,741 shares of Common Stock as of May 2, 2013

QUARTERLY REPORT ON FORM 10Q

FOR

THE QUARTER ENDED MARCH 31, 2013

TABLE OF CONTENTS


		Page
Part I. Financial Information

Item 1.	Financial Statements (unaudited)

	Consolidated Statements of Financial Condition at March 31, 2013 and December 31, 2012		1

	Consolidated Statements of Operations for the Three Months ended March 31, 2013 and 2012		2

	Consolidated Statements of Comprehensive (Loss) Income for the Three Months ended March 31, 2013 and 2012		3

	Consolidated Statements of Cash Flows for the Three Months ended March 31, 2013 and 2012		4

	Consolidated Statement of Shareholders’ Equity for the Three Months ended March 31, 2013		5

	Notes to Consolidated Financial Statements		6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		34

Item 4T.	Controls and Procedures		60

Part II. Other Information

Item 1A.	Risk Factors		61

Item 6.	Exhibits		61

Signatures			S-1

Exhibit Index			E-1

Exhibit 31.1 Certification of Chief Executive Officer under Section 302 of the Sarbanes – Oxley Act of 2002

Exhibit 31.2 Certification of Chief Financial Officer under Section 302 of the Sarbanes – Oxley Act of 2002

Exhibit 32.1 Certification of Chief Executive Officer under Section 906 of the Sarbanes – Oxley Act of 2002

Exhibit 32.2 Certification of Chief Financial Officer under Section 906 of the Sarbanes – Oxley Act of 2002

Exhibit 101.INS XBRL Instance Document

Exhibit 101.SCH XBRL Taxonomy Extension Schema Document

Exhibit 101.CAL XBRL Taxonomy Extension Calculation Linkbase Document

Exhibit 101.DEF XBRL Taxonomy Extension Definition Linkbase Document

Exhibit 101.LAB XBRL Taxonomy Extension Labels Linkbase Document

Exhibit 101.PRE XBRL Taxonomy Extension Presentation Linkbase Document

(i)

PART I.—FINANCIAL INFORMATION

ITEM 1.

FINANCIAL STATEMENTS

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands, except per share data)

(Unaudited)


	March 31, 2013			December 31, 2012
ASSETS
Cash and due from banks	$	15,513		$	12,256
Interest bearing deposits with financial institutions		141,926			115,952

Cash and cash equivalents		157,439			128,208
Interest-bearing time deposits with financial institutions		2,423			2,423
Federal Reserve Bank and Federal Home Loan Bank Stock, at cost		9,604			10,284
Securities available for sale, at fair value		75,522			86,378
Loans held for sale at fair value		21,232			55,809
Loans (net of allowances of $11,018 and $10,881, respectively)		703,573			719,257
Other real estate owned		17,618			17,710
Accrued interest receivable		2,271			2,242
Premises and equipment, net		1,396			1,362
Other assets		32,702			30,268

Total assets	$	1,023,780		$	1,053,941

LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Noninterest-bearing	$	183,185		$	170,259
Interest-bearing		632,408			675,136

Total deposits		815,593			845,395
Borrowings		45,000			55,000
Accrued interest payable		1,965			1,832
Other liabilities		9,420			11,311
Junior subordinated debentures		17,527			17,527

Total liabilities		889,505			931,065

Commitments and contingencies (Note 2)
Shareholders’ equity:
Preferred stock, no par value, 2,000,000 shares authorized:
Series A Convertible 10% Cumulative Preferred Stock, 155,000 shares authorized; no shares issued and outstanding at March 31, 2013 and December 31, 2012, respectively		—			—
Series B Convertible 8.4% Noncumulative Preferred Stock, 300,000 shares authorized; 112,000 issued and outstanding at March 31, 2013 and December 31, 2012; liquidation preference $100 per share, plus accumulated but undeclared dividends at March 31, 2013 and December 31, 2012		8,747			8,747
Series C Convertible 8.4% Noncumulative Preferred Stock, 300,000 shares authorized; 12,803 issued and outstanding at March 31, 2013 and December 31, 2012; liquidation preference $100 per share plus accumulated but undeclared dividends at March 31, 2013 and December 31, 2012		1,280			1,280
Common stock, no par value, 85,000,000 shares authorized; 18,905,741 and 16,677,419 shares issued and outstanding at March 31, 2013 and December 31, 2012, respectively		127,969			112,792
Retained (deficit) earnings		(2,547	)		622
Accumulated other comprehensive loss		(1,174	)		(565	)

Total shareholders’ equity		134,275			122,876

Total liabilities and shareholders’ equity	$	1,023,780		$	1,053,941

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

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except for shares and per share data)

(Unaudited)


	Three Months Ended March 31,
	2013			2012
Interest income
Loans, including fees	$	8,519		$	9,378
Securities available for sale and stock		370			877
Interest-bearing deposits with financial institutions		95			55

Total interest income		8,984			10,310
Interest expense
Deposits		1,403			2,052
Borrowings		223			243

Total interest expense		1,626			2,295

Net interest income		7,358			8,015
Provision for (recovery of) loan losses		1,150			(400	)

Net interest income after provision for loan losses		6,208			8,415
Noninterest income
Total other-than-temporary impairment of securities		—			(25	)
Less: Portion of other-than-temporary impairment losses recognized in other comprehensive loss		—			52

Net impairment loss recognized in earnings		—			(77	)
Service fees on deposits and other banking services		196			233
Mortgage banking (including net gains on sales of loans held for sale)		1,589			4,531
Net gains on sale of securities available for sale		23			1,186
Net (loss) gain on sale of other real estate owned		—			(19	)
Other		225			173

Total noninterest income		2,033			6,027
Noninterest expense
Salaries and employee benefits		6,117			5,617
Occupancy		666			652
Equipment and depreciation		629			398
Data processing		198			195
FDIC expense		546			614
Other real estate owned expense		2,117			1,824
Professional fees		1,666			1,226
Mortgage related loan expense		427			318
Provision for (recovery of) contingencies		(260	)		339
Other operating expense		1,233			1,054

Total noninterest expense		13,339			12,237

(Loss) income before income taxes		(5,098	)		2,205
Income tax (benefit) provision		(1,929	)		823

Net (loss) income		(3,169	)		1,382
Accumulated undeclared dividends on preferred stock		(296	)		(234	)

Net (loss) income allocable to common shareholders	$	(3,465	)	$	1,148

(Loss) income per common share
Basic	$	(0.21	)	$	0.09
Diluted	$	(0.21	)	$	0.09
Weighted average number of common shares outstanding
Basic		16,732,774			12,396,367
Diluted		16,732,774			12,428,949

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

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (LOSS)

(Dollars in thousands)

(Unaudited)


	Three Months Ended March 31,
	2013			2012
Net (loss) income	$	(3,169	)	$	1,382
Other comprehensive (loss) income net of tax:
Change in unrealized gain (loss) on securities available for sale		(629	)		(352	)
Change in net unrealized gain (loss) and prior service benefit on supplemental executive retirement plan		20			9

Total comprehensive (loss) income	$	(3,778	)	$	1,039

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

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)


	Three Months Ended March 31,
	2013			2012
Cash Flows From Operating Activities:
Net (loss) income	$	(3,169	)	$	1,382
Adjustments to reconcile net (loss) income to net cash provided by (used in) operating activities:
Depreciation and amortization		144			129
Provision for (recovery of) loan losses		1,150			(400	)
Amortization of premium on securities		149			143
Net gains on sales of securities available for sale		(23	)		(1,186	)
Other than temporary impairment on securities available for sale		—			77
Net gains on sales of mortgage loans held for sale		(3,315	)		(4,704	)
Net mark-to-market on mortgage loans held for sale		1,582			(1,506	)
Proceeds from sales and principal reductions of mortgage loans held for sale		88,265			134,177
Originations and purchases of mortgage loans held for sale		(57,480	)		(144,236	)
Net amortization of deferred fees and unearned income on loans		(87	)		(136	)
Net loss on sales of other real estate owned		—			19
Write down of other real estate owned		1,645			1,724
Stock-based compensation expense		155			77
Net mark-to-market loss on derivatives		40			(1,205	)
Net mark to market gain on mortgage servicing rights		(595	)		—
Changes in operating assets and liabilities:
Net (increase) decrease in accrued interest receivable		(29	)		130
Net increase in other assets		(1,434	)		(3,381	)
Net increase (decrease) in deferred taxes		1,761			(602	)
Net (increase) decrease in income taxes receivable		(3,472	)		53
Net increase in accrued interest payable		133			22
Net increase (decrease) in other liabilities		(1,871	)		1,119

Net cash provided by operating activities		23,549			(18,304	)
Cash Flows From Investing Activities:
Net increase in interest-bearing time deposits with financial institutions		—			(130	)
Maturities of and principal payments received on securities available for sale and other stock		5,328			4,129
Purchase of securities available for sale and other stock		—			(34,894	)
Proceeds from sale of securities available for sale and other stock		6,164			135,619
Proceeds from sale of other real estate owned					1,192
Capitalized cost of other real estate owned		—			(337	)
Net (increase) decrease in loans		13,068			(28,253	)
Net decrease in loans held for sale		6,080			6,168
Purchases of premises and equipment		(178	)		(161	)

Net cash provided by investing activities		30,462			83,333
Cash Flows From Financing Activities:
Proceeds from sale of common stock		15,000			—
Net (decrease) increase in deposits		(29,802	)		6,015
Net (decrease) increase in borrowings		(10,000	)		5,000
Proceeds from exercise of common stock options		22			—

Net cash provided by (used in) financing activities		(24,780	)		11,015
Net increase in cash and cash equivalents		29,231			76,044
Cash and Cash Equivalents, beginning of period		128,208			96,467

Cash and Cash Equivalents, end of period	$	157,439		$	172,511

Supplementary Cash Flow Information:
Cash paid for interest on deposits and other borrowings	$	1,493		$	2,273

Cash paid for income taxes		—			204

Non-Cash Investing Activities:
Transfer of loans into other real estate owned	$	1,554		$	2,047

Transfer of loans held for sale to loans held for investment	$	—		$	6,788

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

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(Shares and dollars in thousands)

(Unaudited)

For The Three Months Ended March 31, 2013


	Series B and C Preferred Stock				Common Stock				Retained Earnings (Deficit)			Accumulated Other Comprehensive Loss			Total
	Number of Shares		Amount		Number of Shares		Amount		Retained Earnings (Deficit)			Accumulated Other Comprehensive Loss			Total
Balance at January 1, 2013		125	$	10,027		16,677	$	112,792	$	622		$	(565	)	$	122,876
Issuance of common stock		—		—		2,222		15,000		—			—			15,000
Common stock based compensation expense		—		—		—		155		—			—			155
Common stock options exercised		—		—		6		22		—			—			22
Net loss		—		—		—		—		(3,169	)		—			(3,169	)
Change in accumulated other comprehensive loss		—		—		—		—		—			(609	)		(609	)

Balance at March 31, 2013		125	$	10,027		18,905	$	127,969	$	(2,547	)	$	(1,174	)	$	134,275

The accompanying notes are an integral part of this consolidated financial statement.

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Interim Consolidated Financial Statements

(Unaudited)

1.	Nature of Business

Pacific Mercantile Bancorp (“PMBC”) is a bank holding company which, through its wholly owned subsidiary, Pacific Mercantile Bank (the “Bank”) is engaged in commercial banking and conducts a mortgage banking business in Southern California. PMBC is registered as a one bank holding company under the United States Bank Holding Company Act of 1956, as amended. The Bank is chartered by the California Department of Financial Institutions (the “DFI”) and is a member of the Federal Reserve Bank of San Francisco (“FRB”). In addition, the deposit accounts of the Bank’s customers are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to the maximum amount allowed by law. During the first quarter of 2013, PMBC organized a new wholly-owned subsidiary, PM Asset Resolution, Inc. (PMAR”) for the purpose of purchasing and collecting or disposing of certain non-performing assets comprised of non-performing loans and other real estate owned by the Bank. PMBC, the Bank and PMAR are sometimes referred to, together, in this report as the “Company” or as “we”, “us” or “our”.

Substantially all of our operations are conducted and substantially all our assets are owned by the Bank, which accounts for substantially all of our consolidated revenues and expenses, and our earnings. The Bank provides a full range of banking services to small and medium-size businesses, professionals and the general public in Orange, Los Angeles, San Bernardino and San Diego Counties of California and is subject to competition from other banks and financial institutions and from financial services organizations conducting operations in those same markets.

2.	Significant Accounting Policies, Recent Accounting Pronouncements, Commitments and Contingencies

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and, therefore, do not include all footnotes that would be required for a full presentation of our financial position, results of operations, changes in cash flows and comprehensive income (loss) in accordance with generally accepted accounting principles in the United States (“GAAP”). However, these interim financial statements reflect all adjustments (consisting of normal recurring adjustments and accruals) which, in the opinion of management, are necessary for a fair presentation of our consolidated financial position and results of operations for the interim periods presented. The Company has evaluated subsequent events through the date these interim unaudited consolidated financial statements are filed with the Securities and Exchange Commission, for transactions as events which may require adjustment to and/or disclosure.

These unaudited consolidated financial statements have been prepared on a basis consistent with prior periods and should be read in conjunction with our audited consolidated financial statements as of and for the year ended December 31, 2012, and the notes thereto, included in our Annual Report on Form 10-K for the year ended December 31, 2012 (our “2012 10-K”), as filed with the Securities and Exchange Commission (“SEC”) under the Securities Exchange Act of 1934. The Company evaluates subsequent events through the date of the filing with the SEC.

Our consolidated financial position at March 31, 2013, and the consolidated results of operations for the three months then ended, are not necessarily indicative of what our financial position will be at December 31, 2013, or of the results of our operations that may be expected for any other interim period or for the full year ending December 31, 2013.

2.	Significant Accounting Policies, Recent Accounting Pronouncements, Commitments and Contingencies (Cont,-)

Use of Estimates

The preparation of the financial statements in conformity with generally accepted accounting principles requires us to make certain estimates and assumptions that could affect the reported amounts of certain of our assets, liabilities, and contingencies at the date of the financial statements and the reported amounts of our revenues and expenses during the reporting periods. For the fiscal periods covered by this Report, those estimates related primarily to our determinations of the allowance for loan losses, the fair values of securities available for sale and mortgage loans held for sale, repurchase reserves on mortgage loans held for sale, and the determination of reserves pertaining to deferred tax assets. If circumstances or financial trends on which those estimates were based were to change in the future or there were to occur any currently unanticipated events affecting the amounts of those estimates, our future financial position or results of operations could differ, possibly materially, from those expected at the current time.

Recent Accounting Pronouncements

In February 2013, the FASB issued ASU 2013-02, “Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income”, which requires an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective lines in net income if the amount being reclassified is required under GAAP to be reclassified in its entirety to net income. The ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2012. The adoption of ASU No. 2013-02 did not have a material impact on the Company’s financial condition or results of operations but may impact the presentation of operations in future periods.

Commitments and Contingencies

Commitments

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. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated financial statements. At March 31, 2013, loan commitments and letters of credit totaled $119 million and $2 million, respectively. The contractual amount of a credit-related financial instrument such as a commitment to extend credit, a credit-card arrangement or a letter of credit represents the amounts of potential accounting loss should the commitment be fully drawn upon, the customer were to default, and the value of any existing collateral securing the customer’s payment obligation becomes worthless.

As a result, we use the same credit policies in making commitments to extend credit and conditional obligations as we do for on-balance sheet instruments. Commitments generally have fixed expiration dates; however, since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis, using the same credit underwriting standards that are employed in making commercial loans. The amount of collateral obtained, if any, upon an extension of credit is based on our evaluation of the credit worthiness of the customer. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, real estate and income-producing commercial properties.

During the first quarter of 2012, we began selling a portion of our mortgage loan production directly to secondary market investors on a “mandatory commitment” basis, agreeing to sell a specified dollar amount of mortgage loans at an agreed-upon price within a specified timeframe in order to avail ourselves of more favorable pricing on mortgage loan sales to investors. In order to mitigate interest rate risk on loans subject to such mandatory commitments, when we locked the interest rate for the borrowers on those loans prior to funding, we locked the price to sell the loans to investors in a mandatory commitment and entered into a mortgage backed to-be-announced (“TBA”) security. The mandatory commitment and the TBA

2.	Significant Accounting Policies, Recent Accounting Pronouncements, Commitments and Contingencies (Cont,-)

security act as a hedge against market interest rate movements between the time the interest rate is locked and the loan is funded and sold in the secondary market. TBA securities are deemed to be derivatives and involve off-balance sheet financial risk. The contractual or notional amounts of the TBA securities are tied to the Bank’s loan origination volume and we bear a financial risk from such securities. The unrealized fair value losses from the interest rate contracts and TBA security hedges were $191,000 as of March 31, 2013. These gains or losses depend upon the value of the underlying financial instruments and are affected by market changes in interest rates.

TBA securities pose credit risk for us if and to the extent that the institutional counterparties are unable to meet the terms of the agreements. We control counterparty credit risk by using multiple counterparties and limiting them to major financial institutions with investment grade credit ratings. In addition, we regularly monitor the potential risk of loss with any one party resulting from this type of credit risk.

Legal Proceedings

Mark Zigner vs. Pacific Mercantile Bank, et al., filed in January, 2010, in the California Superior Court for the County of Orange (Case No.0337433). This lawsuit was filed by plaintiff asserting that a set-off by the Bank of funds in plaintiff’s deposit accounts in the Bank’s efforts to recover borrowings owed to it by plaintiff was wrongful. The Plaintiff also asserted certain related claims, including an alleged breach by the Bank of the covenant of good faith and fair dealing.

The case was tried before a jury in August, 2011. However, before the case went to the jury for a decision, the trial judge ruled that the Bank had wrongfully exercised its set off rights and, based on that finding, the jury awarded plaintiff $100,000 of compensatory damages against for Bank and the jury later found that the Bank’s exercise of its set-off rights also constituted a wrongful conversion of plaintiff’s funds and awarded the plaintiff $150,000 in compensatory damages and $950,000 in punitive damages against the Bank. In addition, the trial court entered an award to plaintiff of his attorney’s fees and costs, in the amount of $762,000.

Following the entry of the final judgment by the trial court in February 2012, the Bank filed an appeal of the trial court’s rulings and the jury verdict, asserting that those rulings and the jury’s verdict were erroneous and that plaintiff is not entitled, as a matter of law, to an award of either compensatory or punitive damages. Although we believe that the judgment entered by the court against the Bank should be overturned on appeal, it is too early in the appellate process for us to predict, with any certainty, how the appellate courts will ultimately rule on our appeal.

Other Claims. We also are subject to legal actions that arise from time to time in the ordinary course of our business. Currently there are no such pending legal proceedings that we believe their resolution will be material to our financial condition or results of operations.

2.	Significant Accounting Policies, Recent Accounting Pronouncements, Commitments and Contingencies (Cont,-)

Regulatory Matters

On August 31, 2010, the Company and the Bank entered into a Written Agreement (the “FRB Agreement”) with FRB. On the same date, the Bank consented to the issuance of a regulatory order by the California Department of Financial Institutions (the “DFI Order”). The principal purposes of the FRB Written Agreement and DFI Order, which constitute formal supervisory actions by the FRB and the DFI, 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 FRB Agreement and DFI Order contain substantially similar provisions. They required the Boards of Directors of the Company and the Bank to prepare and submit written plans to the FRB and the DFI 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, in the case of the FRB Agreement, the capital position 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 possible future adverse economic and market conditions. The Bank is also prohibited from paying dividends to the Company without the prior approval of the DFI, and 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 FRB.

The Company and the Bank already have made substantial progress with respect to several of these requirements, including a requirement, achieved in August 2011, that the Bank raise additional capital to increase its ratio of adjusted tangible shareholders’ equity to its tangible assets to 9.0%. Additionally, both the Board and management are committed to achieving all of the requirements on a timely basis. However, a failure by the Company or the Bank to meet any of those remaining requirements could be deemed, by the FRB or the DFI, to be conducting business in an unsafe manner which could subject the Company or the Bank to further regulatory enforcement action.

3.	Fair Value Measurements

The following tables shows the recorded amounts of assets and liabilities measured at fair value on a recurring basis at March 31, 2013 and December 31, 2012:


	At March 31, 2013
(Dollars in thousands)	Total			Level 1		Level 2			Level 3
Investment securities available for sale
Mortgage backed securities issued by U.S. agencies	$	67,780		$	—	$	67,780		$	—
Collateralized mortgage obligations issued by non-agency		2,509			—		2,509			—
Asset backed securities		857			—		—			857
Mutual funds		4,376			4,376		—			—

Total securities available for sale at fair value		75,522			4,376		70,289			857
Loans held for sale		21,232			—		21,232			—
Other assets – Mortgage servicing rights		3,397			—		—			3,397
Derivative assets – IRLC’s		319			—		—			319

Total assets measured at fair value on a recurring basis	$	100,470		$	4,376	$	91,521		$	4,573

Derivative liabilities – TBA securities	$	(87	)	$	—	$	(87	)	$	—

Total liabilities measured at fair value on a recurring basis	$	(87	)	$	—	$	(87	)	$	—


	At December 31, 2012
(Dollars in thousands)	Total			Level 1		Level 2			Level 3
Investment securities available for sale
Mortgage backed securities issued by U.S. agencies	$	78,446		$	—	$	78,446		$	—
Collateralized mortgage obligations issued by non agency		2,625			—		1,963			662
Asset back securities		900			—		—			900
Mutual funds		4,407			4,407		—			—

Total securities available for sale at fair value		86,378			4,407		80,409			1,562
Loans held for sale		55,809			—		55,809			—
Other assets – Mortgage servicing rights		2,801			—		—			2,801
Derivative assets – IRLC’s		580			—		—			580

Total assets measured at fair value on a recurring basis	$	145,568		$	4,407	$	136,218		$	4,943

Derivative liabilities – TBA securities	$	(158	)	$	—	$	(158	)	$	—

Total liabilities measured at fair value on a recurring basis	$	(158	)	$	—	$	(158	)	$	—

3.	Fair Value Measurements (Cont,-)

The changes in Level 3 assets measured at fair value on a recurring basis are summarized in the following table:


(Dollars in thousands)	Investment Securities Available for Sale
Balance of recurring Level 3 instruments at January 1, 2013	$	4,943
Total gains or losses (realized/unrealized):
Included in earnings-realized		—
Included in earnings-unrealized⁽¹⁾		—
Included in other comprehensive income		(1,308	)
Purchases		—
Sales		—
Issuances		—
Settlements		938
Transfers in and/or out of Level 3		—

Balance of Level 3 assets at March 31, 2013	$	4,573

⁽¹⁾	Amount reported as other than temporary impairment loss in the noninterest income portion of the accompanying consolidated statement of operations.

The following is a description of valuation methodologies used for assets and liabilities recorded at fair value on a recurring basis.

Investment Securities Available for Sale. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 investments securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the- counter markets and money market funds. Level 2 investment securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.

Loans Held for Sale (LHFS). Effective December 1, 2011, the Company elected to measure new LHFS at fair value. The remaining LHFS are carried at the lower of cost or market. Fair value is based on quoted market prices, if available, prices for other traded mortgage loans with similar characteristics, purchase commitments and bid information received from market participants. We classify those loans subject to recurring fair value adjustments as Level 2, given the meaningful level of secondary market activity for conforming mortgage loans.

Mortgage Servicing Rights. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques that would incorporate assumptions that market participants would use in estimating the fair value of servicing. These assumptions might include estimates of prepayment speeds, discount rate, costs to service, escrow account earnings, contractual servicing fee income, prepayment and late fees, among other considerations. Mortgage servicing rights are considered a Level 3 measurement at March 31, 2013 and are included in other assets in the accompanying consolidated balance sheets.

Derivative Assets and Liabilities. The Company’s derivative assets and liabilities are carried at fair value as required by GAAP and are accounted for as free standing derivatives. The derivative assets are interest rate lock commitments (“IRLCs”) with prospective residential mortgage borrowers whereby the interest rate on the loan is determined prior to funding and the borrowers have locked in that interest rate. These commitments are determined to be derivative instruments in accordance with GAAP. The derivative liabilities are hedging instruments (typically TBA securities) used to hedge the risk of fair value changes associated with changes in interest rates relating to its mortgage loan origination operations. The Company hedges the period from the interest rate lock (assuming a fall-out factor) to the date of the loan sale. The estimated fair value is based on current market prices for similar assets plus a fall-out factor estimated by management and accordingly, the Company classifies its derivative assets and liabilities as Level 3 measurement at March 31, 2013 and such assets are included in other assets in the accompanying consolidated statement of financial condition.

3.	Fair Value Measurements (Cont,-)

The following descriptions present qualitative information about the valuation techniques and unobservable inputs applied to Level 3 fair value measurements for financial instruments measured at fair value on a recurring and non recurring basis at March 31, 2013.

Investment Securities Available for Sale. The valuation technique used for Level 3 investment securities is a discounted cash flow. Inputs considered in determining Level 3 pricing include, the securities anticipated prepayment rates, default rates, and the loss severity given a future default. Significant increases or decreases in any of those inputs in isolation would result in significantly lower or higher fair value measurement. In general, a change in the assumption regarding the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity in an event of default. Prepayment rates are subject to change based on market conditions. For the asset backed security, the security was priced using an option adjusted discounted cash flow model. This discount margin of 6.5% was based on sector spreads and trading in related credit markets. A 2% constant default rate was presumed based on historical analysis and forward projection. A loss severity of 90% was based on low recovery expectations in this sector.

Mortgage Servicing Rights. The valuation technique used for Level 3 mortgage servicing rights is based upon market prices for similar instruments and an internal discounted cash flow model. The valuation model incorporates assumptions that market participants would use in estimating the fair value of servicing, the most significant of which include estimates of prepayment speeds of between 10% and 15%, and a discount rate of 12%. For mortgage servicing rights, a significant increase in discount rates would result in a significantly lower estimated fair value. The impact of changes in prepayment speeds would have differing impacts depending on the seniority or other characteristics of the instrument.

Derivative assets – IRLC’s. The valuation technique used for Level 3 IRLC’s is based on pricing of related loan instruments (which includes the value of servicing), which are Level 2 inputs, however also includes an estimate for a fall-out factor, otherwise known as the “pull-through” rate. A significant increase or decrease in pull-through rate assumptions would result in a significant increase or decrease in the fair value of IRLCs. The Company believes that the imprecision of an estimate could be significant.

Assets Recorded at Fair Value on a Nonrecurring Basis

The Company may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with GAAP. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Impaired Loans. Loans measured for impairment are measured at an observable market price (if available), or the fair value of the loan’s collateral (if the loan is collateral dependent). The fair value of an impaired loan may be estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance for loan losses represent loans for which the fair value of the expected repayments or collateral exceeds the recorded investments in such loans. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the impaired loan at Level 2. When an appraised value is not available or we determine that the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the impaired loan at Level 3.

Foreclosed Assets. Foreclosed assets are adjusted to fair value, less estimated costs to sell, at the time the loans are transferred to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value less estimated costs to sell. Fair value is determined based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the foreclosed asset at Level 2. When an appraised value is not available or we determine that the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the foreclosed asset at Level 3.

3.	Fair Value Measurements (Cont,-)

Loans Held for Sale. Mortgage loans held for sale and funded prior to December 1, 2011 are carried at the lower of cost or market value. The fair value of these loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics. As such, the Company classifies loans subjected to nonrecurring fair value adjustments as Level 2.

Information regarding assets measured at fair value on a nonrecurring basis is set forth in the table below.


	At March 31, 2013
(Dollars in thousands)	Total		Level 1		Level 2		Level 3
Assets at Fair Value:
Impaired loans	$	36,813	$	—	$	10,601	$	26,212
Loans held for sale not held at fair value		21,232		—		21,232		—
Other assets⁽¹⁾		17,618		—		17,618		—

Total	$	75,663	$	—	$	49,451	$	26,212

⁽¹⁾	Includes foreclosed assets.

There were no transfers in or out of Level 3 measurements for nonrecurring items during the three months ended March 31, 2013.

Fair value estimates are made at a discrete point in time based on relevant market information and other information about the financial instruments. Because no active market exists for a significant portion of our financial instruments, fair value estimates are based in large part on judgments we make primarily regarding current economic conditions, risk characteristics of various financial instruments, prepayment rates, and future expected loss experience. These estimates are subjective in nature and invariably involve some inherent uncertainties. Additionally unexpected changes in events or circumstances can occur that could require us to make changes to our assumptions and which, in turn, could significantly affect and require us to make changes to our previous estimates of fair value.

In addition, the fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of existing and anticipated future customer relationships and the value of assets and liabilities that are not considered financial instruments, such as premises and equipment and other real estate owned.

The following methods and assumptions were used to estimate the fair value of financial instruments not previously discussed.

Cash and Cash Equivalents. The fair value of cash and cash equivalents approximates its carrying value.

Interest-Bearing Deposits with Financial Institutions. The fair values of interest-bearing deposits maturing within ninety days approximate their carrying values.

Federal Home Loan Bank and Federal Reserve Bank Stock. The Bank is a member of the Federal Home Loan Bank (the “FHLB”) and the Federal Reserve Bank of San Francisco (the “FRB”). As members, we are required to own stock of the FHLB and the FRB, the amount of which is based primarily on the level of our borrowings from those institutions. We also have the right to acquire additional shares of stock in either or both of the FHLB and the FRB; however, to date, we have not done so. The fair values of that stock are equal to their respective carrying amounts, are classified as restricted securities and are periodically evaluated for impairment based on our assessment of the ultimate recoverability of our investments in that stock. Any cash or stock dividends paid to us on such stock are reported as income.

3.	Fair Value Measurements (Cont,-)

Deposits. The fair value of demand deposits, savings deposits, and money market deposits is defined as the amounts payable on demand at quarter-end. The fair value of fixed maturity certificates of deposit is estimated based on the discounted value of the future cash flows expected to be paid on the deposits.

Borrowings. The fair value of borrowings is the carrying amount for those borrowings that mature on a daily basis. The fair value of term borrowings is derived by calculating the discounted value of future cash flows expected to be paid out by the Company.

Junior Subordinated Debentures. The fair value of the junior subordinated debentures is based on quoted market prices of the underlying securities. These securities are variable rate in nature and reprice quarterly.

Commitments to Extend Credit and Standby Letters of Credit. The fair value of commitments to extend credit and standby letters of credit, are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. These fees were not material in amount either at March 31, 2013, or December 31, 2012.

The estimated fair values and related carrying amounts of all of the Company’s financial instruments are as follows:


	At March 31, 2013
(Dollars in thousands)	Total			Level 1			Level 2			Level 3
Cash and cash equivalents	$	157,439		$	157,439		$	—		$	—
Interest-bearing deposits with financial institutions		2,423			2,423			—			—
Federal Reserve Bank and Federal Home Loan Bank Stock		9,604			9,604			—			—
Investment securities available for sale
Mortgage backed securities issued by U.S. agencies		67,780			—			67,780			—
Collateralized mortgage obligations issued by non-agency		2,509			—			2,509			—
Asset backed securities		857			—			—			857
Mutual funds		4,376			4,376			—			—

Total securities available for sale at fair value		75,522			4,376			70,289			857
Loans held for sale		21,232			—			21,232			—
Loans, net		703,573			—			703,573			—
Other assets – Mortgage servicing rights		3,397			—			—			3,397
Derivative assets – IRLC’s		319			—			—			319

Total assets measured at fair value on a recurring basis	$	973,509		$	173,842		$	795,094		$	4,573

Noninterest bearing deposits	$	(183,185	)	$	(183,185	)	$	—		$	—
Interest-bearing deposits		(632,408	)		(632,408	)		—			—
Borrowings		(45,000	)		(45,000	)		—			—
Junior subordinated debentures		(17,527	)		(17,527	)		—			—
Derivative liabilities – TBA securities		(87	)		—			(87	)		—

Total liabilities measured at fair value on a recurring basis	$	(878,207	)	$	(878,120	)	$	(87	)	$	—

	At December 31, 2012
(Dollars in thousands)	Total			Level 1			Level 2			Level 3
Cash and cash equivalents	$	128,208		$	128,208		$	—		$	—
Interest-bearing deposits with financial institutions		2,423			2,423			—			—
Federal Reserve Bank and Federal Home Loan Bank Stock		10,284			10,284			—			—
Investment securities available for sale
Mortgage backed securities issued by U.S. agencies		78,446			—			78,446			—
Collateralized mortgage obligations issued by non agency		2,625			—			1,963			662
Asset back securities		900			—			—			900
Mutual funds		4,407			4,407			—			—

Total securities available for sale at fair value		86,378			4,407			80,409			1,562
Loans held for sale		55,809			—			55,809			—
Loans, net		719,257			—			719,257			—
Other assets – Mortgage servicing rights		2,801			—			—			2,801
Derivative assets – IRLC’s		580			—			—			580

Total assets measured at fair value on a recurring basis	$	1,005,740		$	145,322		$	855,475		$	4,943

Noninterest bearing deposits	$	(170,259	)	$	(170,259	)	$	—		$	—
Interest-bearing deposits		(675,136	)		(675,136	)		—			—
Borrowings		(45,000	)		(45,000	)		—			—
Junior subordinated debentures		(17,527	)		(17,527	)		—			—
Derivative liabilities – TBA securities		(158	)		—			(158	)		—

Total liabilities measured at fair value on a recurring basis	$	(908,080	)	$	(907,922	)	$	(158	)	$	—

Fair Value Option. The following table reflects the differences between the fair value carrying amount of LHFS measured at fair value under ASU 825 and the aggregate unpaid principal amount we are contractually entitled to receive at maturity.

3.	Fair Value Measurements (Cont,-)

The assets accounted for under the fair value option are initially measured at fair value. Gains and losses from initial measurement and subsequent changes in fair value are recognized in earnings. The changes in fair value related to initial measurement and subsequent changes in fair value included in earnings for these assets measured at fair value are shown, by income statement line item, below.


Loans Held for Sale at Fair Value	Three Months Ended March 31,
(Dollars in thousands)	2013		2012
Changes in fair value included in net income:
Mortgage banking noninterest income	$	1,582	$	1,451


	March 31, 2013
(Dollars in thousands)	Fair Value Carrying Amount		Aggregate Unpaid Principal		Fair Value Carrying Amount Less Aggregate Unpaid Principal
Loans held for sale reported at fair value:
Total loans	$	21,232	$	20,131	$	686
Nonaccrual loans		—		—		—
Loans 90 days or more past due and still accruing		—		—		—

Derivatives. The following table includes information for the derivative assets and liabilities for the periods presented:


			Total Gains (Losses)
	Notional Balance		For the Three Months Ended March 31, 2013⁽¹⁾
(Dollars in thousands)	March 31, 2013		For the Three Months Ended March 31, 2013⁽¹⁾
Derivative assets - IRLC’s	$	10,347	$	(262	)
Derivative liabilities - TBAs	$	18,495	$	70

⁽¹⁾	Amounts included in noninterest income – mortgage banking, within the accompanying consolidated statements of operations.

4.	Investment Securities Available For Sale

The following table sets forth the major components of securities available for sale and compares the amortized costs and estimated fair market values of, and the gross unrealized gains and losses on, these securities at March 31, 2013 and December 31, 2012:


(Dollars in thousands)	Amortized Cost		Gross Unrealized Gain		Gross Unrealized Loss			Estimated Fair Value
Securities available for sale at March 31, 2013:
Mortgage backed securities issued by U.S. agencies⁽¹⁾	$	68,028	$	246	$	(494	)	$	67,780
Collateralized mortgage obligations issued by non-agency⁽¹⁾		2,462		98		(51	)		2,509
Asset backed securities⁽²⁾		2,247		—		(1,390	)		857
Mutual funds⁽³⁾		4,376		—		—			4,376

Total securities available for sale	$	77,113	$	344	$	(1,935	)	$	75,522

Securities available for sale at December 31, 2012:
Mortgage-backed securities issued by U.S. agencies⁽¹⁾	$	78,053	$	553	$	(160	)	$	78,446
Collateralized mortgage obligations issued by non-agency⁽¹⁾		2,599		87		(61	)		2,625
Asset backed securities⁽²⁾		2,247		—		(1,347	)		900
Mutual funds⁽³⁾		4,407		—		—			4,407

Total securities available for sale	$	87,306	$	640	$	(1,568	)	$	86,378

⁽¹⁾	Secured by closed-end first lien 1-4 family residential mortgages.

⁽²⁾	Comprised of a security that represents an interest in a pool of trust preferred securities issued by U.S.-based banks and insurance companies.

⁽³⁾	Consists primarily of mutual fund investments in closed-end first lien 1-4 family residential mortgages.

4.	Investment Securities Available For Sale (Cont,-)

At March 31, 2013 and December 31, 2012, U.S. agency mortgage backed securities and collateralized mortgage obligations with an aggregate fair market value of $14 million and $10 million, respectively, were pledged to secure Federal Home Loan Bank borrowings, repurchase agreements, local agency deposits and Treasury, tax and loan accounts.

The amortized cost and estimated fair values of securities available for sale at March 31, 2013 and December 31, 2012, are shown in the table below by contractual maturities and 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.


	At March 31, 2013 Maturing in
(Dollars in thousands)	One year or less			Over one year through five years			Over five years through ten years			Over ten Years			Total
Securities available for sale, amortized cost	$	10,893		$	32,850		$	19,829		$	13,541		$	77,113
Securities available for sale, estimated fair value		10,909			32,817			19,691			12,105			75,522
Weighted average yield		1.46	%		1.58	%		1.49	%		1.40	%		1.51	%

	At December 31, 2012 Maturing in
(Dollars in thousands)	One year or less			Over one year through five years			Over five years through ten years			Over ten Years			Total
Securities available for sale, amortized cost	$	11,679		$	35,038		$	24,738		$	15,851		$	87,306
Securities available for sale, estimated fair value		11,788			35,264			24,747			14,579			86,378
Weighted average yield		1.59	%		1.62	%		1.62	%		1.43	%		1.58	%

The Company recognized net gains on sales of securities available for sale of $14,000, net of $9,000 of taxes, on sale proceeds of $6.2 million during the three months ended March 31, 2013 and $698,000, net of $488,000 of taxes, on sale proceeds of $136 million during the three months ended March 31, 2012.

The table below indicates, as of March 31, 2013, the gross unrealized losses and fair values of our investments, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position.


	Securities with Unrealized Loss at March 31, 2013
	Less than 12 months					12 months or more					Total
Dollars in thousands	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
Mortgage backed securities issued by U.S. agencies		34,896		(494	)		39		—			34,935		(494	)
Municipal securities		—		—			—		—			—		—
Collateralized mortgage obligations issued by non-agency		—		—			1,143		(51	)		1,143		(51	)
Asset backed securities		—		—			858		(1,390	)		858		(1,390	)

Total temporarily impaired securities	$	34,896	$	(494	)	$	2,040	$	(1,441	)	$	36,936	$	(1,935	)

We regularly monitor investments for significant declines in fair value. We have determined that declines in the fair values of these investments below their respective amortized costs, as set forth in the table above, are temporary because (i) those declines were due to interest rate changes and not to a deterioration in the creditworthiness of the issuers of those investment securities, and (ii) we have the ability to hold those securities until there is a recovery in their values or until their maturity.

We recognize other-than-temporary impairments (“OTTI”) for our available-for-sale debt securities in accordance with ASC 320-10. When there are credit losses associated with an impaired debt security, but we have no intention to sell, and it is more likely, than not, that we will not have to sell the security before recovery of its cost basis, we will separate the amount of impairment, or OTTI, between the amount that is credit related and the amount that is related to non-credit factors. Credit-related impairments are recognized in our consolidated statements of operations. Any non-credit-related impairments are recognized and reflected in other comprehensive income (loss).

Through the impairment assessment process, we determined that the available-for-sale securities discussed below were other-than-temporarily impaired at March 31, 2013. We recorded no impairments of credit losses on available-for-sale securities in our consolidated statement of operations for the three months ended March 31, 2013. The OTTI related to factors other than credit losses, in the aggregate amount of $1.4 million, was recognized as other comprehensive loss in our balance sheet at March 31, 2013.

4.	Investment Securities Available For Sale (Cont,-)

The table below presents a roll-forward of OTTI where a portion attributable to non-credit related factors was recognized in other comprehensive loss for the three months ended March 31, 2013:


(Dollars in thousands)	Gross Other- Than- Temporary Impairments			Other-Than- Temporary Impairments Included in Other Comprehensive Loss			Net Other-Than Temporary Impairments Included in Retained Earnings (Deficit)
Balance – December 31, 2012	$	(1,995	)	$	(1,264	)	$	(731	)
Additions for credit losses on securities for which an OTTI was not previously recognized		(44	)		(44	)		—

Balance – March 31, 2013	$	(2,039	)	$	(1,308	)	$	(731	)

In determining the component of OTTI related to credit losses, we compare the amortized cost basis of each OTTI security to the present value of its expected cash flows, discounted using the effective interest rate implicit in the security at the date of acquisition.

As a part of our OTTI assessment process with respect to securities held for sale with unrealized losses, we consider available information about (i) the performance of the collateral underlying each such security, including credit enhancements, (ii) historical prepayment speeds, (iii) delinquency and default rates, (iv) loss severities, (v) the age or “vintage” of the security, and (vi) rating agency reports on the security. Significant judgments are required with respect to these and other factors when making a determination of the future cash flows that can be expected to be generated by the security.

Based on our OTTI assessment process, we determined that there is one asset-backed security in our portfolio of securities held for sale that was impaired as of December 31, 2012. This security is a multi-class, cash flow collateralized bond obligation backed by a pool of trust preferred securities issued by a diversified pool of 56 issuers consisting of 45 U.S. depository institutions and 11 insurance companies at the time of the security’s issuance in November 2007. We purchased $3.0 million face amount of this security in November 2007 at a price of 95.21% for a total purchase price of $2.9 million, out of a total of $363 million of this security sold at the time of issuance. The security that we own (CUSIP 74042CAE8) is the mezzanine class B piece security with a variable interest rate of 3 month LIBOR +60 basis points, which had a rating of Aa2/AA by Moody’s and Fitch at the time of issuance in 2007.

As of March 31, 2013 the amortized cost of this security was $2.25 million with a fair value of $857,000, for an unrealized loss of approximately $1.4 million. As of March 31, 2013, the security had a Ca rating from Moody’s and CC rating from Fitch and had experienced $47.5 million in defaults (13.7% of total current collateral) and $43.5 million in deferring securities (12.6% of total current collateral) from issuance to March 31, 2013. The security did not pay its scheduled first quarter interest payment. We are not currently accruing interest on this security. We estimate that the security could experience another $73.5 million in defaults before the issuer would not receive all of the contractual cash flows under this security. This analysis is based on the following assumptions: future default rates of 2.4%, prepayment rates of 1% until maturity, and 15% recovery of future defaults. With respect to this security, we did not recognize any impairment losses to earnings during the first quarter of 2013; whereas we recognized $77,000 of impairment losses to earnings for the same period in 2012. Set forth below is additional information regarding impairment losses that we recognized in earnings for the three months ended March 31, 2013 and 2012:


Impairment Losses on OTTI Securities	For the Three Months Ended March 31,
(Dollars in thousands)	2013		2012
Asset Backed Security	$	—	$	77

Total impairment loss recognized in earnings	$	—	$	77

We have made a determination that the remainder of our securities with respect to which there were unrealized losses as of March 31, 2013 were not other-than-temporarily impaired, because we concluded that we had the ability to continue to hold those securities until their respective fair market values increase above their respective amortized costs or, if necessary, until their respective maturities. In reaching that conclusion we considered a number of factors and other information, which included: (i) the significance of each such security, (ii) the amount of the unrealized losses attributable to each such security, (iii) our liquidity position, (iv) the impact that retention of those securities could have on our capital position, and (v) our evaluation of the expected future performance of these securities (based on the criteria discussed above).

5.	Mortgage Banking

Mortgage Loans Held for Sale (LHFS), at fair value

A summary of the unpaid principal balances of mortgage loans held-for-sale (“LHFS”) for which the fair value option has been elected, by type, is presented below:


(Dollars in thousands)	At March 31, 2013		At December 31, 2012
Government	$	7,306	$	16,902
Conventional		4,491		10,805
Jumbo		7,936		20,514
Fair value adjustment		687		2,269

Total mortgage loans held-for-sale at fair value	$	20,420	$	50,490

We did not have any delinquent or nonaccrual LHFS as of December 31, 2012.

Gains on LHFS for the three months ended March 31, 2013 and 2012 are as follows:


(Dollars in thousands)	At March 31, 2013			At March 31, 2012
Gain on sale of mortgage loans	$	3,910		$	4,705
Premium from servicing retained loan sales		198			4
Unrealized gains (losses) from derivative financial statements		(191	)		1,052
Realized gains (losses) derivative financial instruments		152			(36	)
Mark-to-market (loss) gain on LHFS		(1,582	)		1,326
Direct origination (expenses) fees, net		(979	)		(2,883	)
Provision for repurchases		(51	)		(27	)

Total gain on LHFS	$	1,457		$	4,141

Repurchase Reserves

We maintain reserves for possible repurchases that we may be required to make of certain of the mortgage loans which we sell due to deficiencies or defects that may be found to exist in such loans. The following table sets forth information, at March 31, 2013 and December 31, 2012, with respect to such reserves:


(Dollars in thousands)	At March 31, 2013		At December 31, 2012
Beginning balance	$	906	$	115
Provision for repurchases		51		791
Settlements		—		—

Total repurchases reserve	$	957	$	906

The Company’s repurchase reserve for the mortgage banking division was established to cover returns of any premiums earned and administrative fees pertaining to the repurchase of mortgage loans that did not meet investor guidelines. We did not repurchase any loans in the three months ended March 31, 2013 or three months ended March 31, 2012. We review the repurchase reserves throughout the year for adequacy.

5.	Mortgage Banking (Cont,-)

Mortgage Servicing Rights

We sometimes retain mortgage servicing rights on mortgage loans that we sell. Such rights represent the net positive cash flows generated from the servicing of such mortgage loans and we recognize such rights as assets on our statements of financial condition based on their estimated fair values. We receive servicing fees, less any subservicing costs, on the unpaid principal balances of such mortgage loans. Those fees are collected from the monthly payments made by the mortgagors or from the proceeds of the sale or foreclosure and liquidation of the underlying real property collateralizing the loans. We also generally receive various mortgagor-contracted fees, such as late charges, collateral reconveyance charges and nonsufficient fund fees. In addition, we generally are entitled to retain interest earned on funds held pending remittance (or float) related to its collection of principal, interest, taxes and insurance payments on the mortgage loans which we service. At March 31, 2013 and December 31, 2012, mortgage servicing rights totaled $3.3 million and $2.8 million, respectively, and are included in other assets in the accompanying consolidated statement of financial condition.

At March 31, 2013 and December 31, 2012, we were servicing approximately $492 million, and $456 million, respectively, in principal amount of mortgage loans with the following characteristics:


	Unpaid Principal Balance
(Dollars in thousands)	At March 31, 2013		At December 31, 2012
Government	$	415,124	$	396,951
Conventional		76,505		58,867

Total loans serviced	$	491,629	$	455,818

6.	Loans and Allowance for Loan Losses

The composition of the Company’s loan portfolio as of March 31, 2013 and December 31, 2012 was as follows:


	March 31, 2013						December 31, 2012
(Dollars in thousands)	Amount			Percent			Amount			Percent
Commercial loans	$	166,054			23.2	%	$	170,792			23.4	%
Commercial real estate loans – owner occupied		158,156			22.1	%		165,922			22.7	%
Commercial real estate loans – all other		162,958			22.8	%		150,189			20.6	%
Residential mortgage loans – multi-family		100,703			14.1	%		105,119			14.4	%
Residential mortgage loans – single family		81,553			11.4	%		87,263			11.9	%
Land development loans		19,371			2.7	%		24,018			3.3	%
Consumer loans		26,122			3.7	%		27,296			3.7	%

Gross loans		714,917			100.0	%		730,599			100.0	%

Deferred fee (income) costs, net		(326	)					(461	)
Allowance for loan losses		(11,018	)					(10,881	)

Loans, net	$	703,573					$	719,257

At March 31, 2013 and December 31, 2012, real estate loans of approximately $156 million and $162 million, respectively, were pledged to secure borrowings obtained from the Federal Home Loan Bank.

6.	Loans and Allowance for Loan Losses (Cont,-)

Allowance for Loan Losses

The allowance for loan losses (“ALL”) represents our estimate of credit losses inherent in the loan portfolio at the balance sheet date. 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 ALL and the amount of the provisions that are required to be made for potential loan losses.

The ALL is first determined by (i) analyzing all classified loans (graded as “Substandard” or “Doubtful” under our internal credit quality grading parameters—see below) on non-accrual status for loss exposure and (ii) establishing specific reserves as needed. ASC 310-10 defines loan impairment as the existence of uncertainty concerning collection of all principal and interest in accordance with the contractual terms of a loan. For collateral dependent loans, impairment is typically measured by comparing the loan amount to the fair value of collateral, less estimated costs to sell, with a specific reserve established for any “shortfall” amount. Other methods can be used in estimating impairment, including market price and the present value of expected future cash flows discounted at the loan’s original interest rate.

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 ALL for homogenous pools of loans that are not subject to specific reserve allocations. 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 consumer loans. We then apply these calculated loss factors, together with a qualitative factors based on external economic conditions and trends and internal assessments, to the outstanding loan balances in each homogenous group of loans, and then, using our internal credit quality grading parameters, we grade the loans as “Pass,” “Special Mention,” “Substandard” or “Doubtful”. We also conduct individual loan review analysis, as part of the allowance for loan losses allocation process, applying specific monitoring policies and procedures in analyzing the existing loan portfolios. Set forth below is a summary of the activity in the ALL during the following periods:


	Three Months Ended March 31, 2013			Three Months Ended March 31, 2012			Year Ended December 31, 2012
(Dollars in thousands)
Balance, beginning of period	$	10,881			15,627		$	15,627
Charged off loans		(1,485	)		(1,670	)		(8,574	)
Recoveries on loans previously charged off		472			77			1,878
Provision for loan losses		1,150			(400	)		1,950

Balance, end of period	$	11,018			13,634		$	10,881

6.	Loans and Allowance for Loan Losses (Cont,-)

Set forth below is information regarding loan balances and the related allowance for loan losses, by portfolio type, for the three months ended March 31, 2013, March 31, 2012, and the year ended December 31, 2012.


(Dollars in thousands)	Commercial			Real Estate⁽¹⁾			Land Development			Consumer and Single Family Mortgages			Total
ALL for the three months ended March 31, 2013:
Balance at beginning of period	$	6,340		$	3,487		$	248		$	806		$	10,881
Charge offs		(1,170	)		(308	)		(5	)		(2	)		(1,485	)
Recoveries		400			1			54			17			472
Provision		1,280			(127	)		(81	)		78			1,150

Balance at end of period	$	6,850		$	3,053		$	216		$	899		$	11,018

ALL balance at March 31, 2013 related to:
Loans individually evaluated for impairment	$	2,400		$	—		$	—		$	—		$	2,400

Loans collectively evaluated for impairment	$	4,450		$	3,053		$	216		$	899		$	8,618

Loans balance at March 31, 2013:
Loans individually evaluated for impairment	$	14,347		$	21,637		$	—		$	829		$	36,813
Loans collectively evaluated for impairment		151,707			400,180			19,371			106,846			678,104

Ending Balance	$	166,054		$	421,817		$	19,371		$	107,675		$	714,917

ALL for the three months ended March 31, 2012:
Balance at beginning of quarter	$	8,908		$	5,777		$	316		$	626		$	15,627
Charge offs		(720	)		(655	)		(51	)		(244	)		(1,670	)
Recoveries		73			1			0			3			77
Provision		(2,038	)		1,240			0			398			(400	)

Balance at end of quarter	$	6,223		$	6,363		$	265		$	783		$	13,634

ALL balance at March 31, 2012 related to:
Loans individually evaluated for impairment	$	1,481		$	260		$	—		$	—		$	1,741

Loans collectively evaluated for impairment	$	4,742		$	6,103		$	265		$	783		$	11,893

Loans balance at March 31, 2012:
Loans individually evaluated for impairment	$	8,056		$	10,827		$	539		$	1,231		$	20,653
Loans collectively evaluated for impairment		180,707			360,301			28,646			99,594			669,248

Ending Balance	$	188,763		$	371,128		$	29,185		$	100,825		$	689,901

ALL for the year ended December 31, 2012:
Balance at beginning of year	$	8,908		$	5,777		$	316		$	626		$	15,627
Charge offs		(6,664	)		(1,184	)		(158	)		(568	)		(8,574	)
Recoveries		1,657			198			—			23			1,878
Provision		2,439			(1,304	)		90			725			1,950

Balance at end of year	$	6,340		$	3,487		$	248		$	806		$	10,881

ALL balance at end of year related to:
Loans individually evaluated for impairment	$	2,428		$	—		$	—		$	—		$	2,428

Loans collectively evaluated for impairment	$	3,912		$	3,487		$	248		$	806		$	8,453

Loans balance at end of year:
Loans individually evaluated for impairment	$	16,180		$	21,918		$	314		$	839		$	39,251
Loans collectively evaluated for impairment		154,612			399,312			23,704			113,720			691,348

Ending Balance	$	170,792		$	421,230		$	24,018		$	114,559		$	730,599

⁽¹⁾	Excludes mortgage loans held for sale.

6.	Loans and Allowance for Loan Losses (Cont,-)

Credit Quality

The quality of the loans in the Company’s loan portfolio is assessed as a function of net credit losses and the amounts of nonperforming assets and delinquencies that occur within our loan portfolio. These factors are an important part of our overall credit risk management process and our evaluation of the adequacy of the ALL.

The following table provides a summary of the delinquency status of loans by portfolio type at March 31, 2013 and December 31, 2012:


(Dollars in thousands)	30-59 Days Past Due		60-89 Days Past Due		90 Days and Greater		Total Past Due		Current		Total Loans Outstanding		Loans >90 Days still Accruing Interest
March 31, 2013
Commercial loans	$	4,637	$	618	$	2,935	$	8,190	$	157,864	$	166,054	$	—
Commercial real estate loans – owner-occupied		606		—		2,926		3,532		154,624		158,156		—
Commercial real estate loans – all other		5,497		—		2,117		7,614		155,344		162,958		—
Residential mortgage loans – multi-family		—		—		—		—		100,703		100,703		—
Residential mortgage loans – single family		—		—		735		735		80,818		81,553		—
Land development loans		—		—		—		—		19,371		19,371		—
Consumer loans		—		—		—		—		26,122		26,122		—

Total	$	10,740	$	618	$	8,713	$	20,071	$	694,846	$	714,917	$	—

December 31, 2012
Commercial loans	$	1,321	$	778	$	4,295	$	6,394	$	164,398	$	170,792	$	—
Commercial real estate loans – owner occupied		—		—		3,232		3,232		162,690		165,922		—
Commercial real estate loans – all other		—		—		2,599		2,599		147,590		150,189		—
Residential mortgage loans – multi-family		—		—		—		—		105,119		105,119		—
Residential mortgage loans – single family		259		378		359		996		86,267		87,263		—
Land development loans		—		—		314		314		23,704		24,018		—
Consumer loans		—		—		—		—		27,296		27,296		—

Total	$	1,580	$	1,156	$	10,799	$	13,535	$	717,064	$	730,599	$	—

As the above table indicates, total past due loans increased by $6.5 million, to $20.1 million at March 31, 2013, from $13.5 million at December 31, 2012. Loans past due 90 days or more decreased by $2.1 million, to $8.7 million at March 31, 2013, from $10.8 million at December 31, 2012 primarily due to $1.6 million of real estate properties foreclosed during the quarter, resulting in the transfer of three loans to other real estate owned.

Between December 31, 2012 and March 31, 2013, loans 30-89 days past due increased by $8.6 million, primarily due to a $5.4 million commercial real estate loan relationship which is the subject of a payment dispute and a commercial loan relationship of $4.4 million of which a $1.0 million loan is under bankruptcy proceedings and risk graded “doubtful”.

6.	Loans and Allowance for Loan Losses (Cont,-)

Generally, the accrual of interest on a loan is discontinued when principal or interest payments become more than 90 days past due, unless management believes the loan is adequately collateralized and it is in the process of collection. There were no loans 90 days or more past due and still accruing interest at March 31, 2013 or December 31, 2012. In certain instances, when a loan is placed on non-accrual status, previously accrued but unpaid interest is reversed against current income. Subsequent collections of cash are applied as principal reductions when received, except when the ultimate collectability of principal is probable, in which case such payments are applied to accrued and unpaid interest, which is credited to income. Non-accrual loans may be restored to accrual status when principal and interest become current and full repayment is expected.

The following table provides information, as of March 31, 2013 and December 31, 2012, with respect to loans on nonaccrual status, by portfolio type:


	March 31, 2013		December 31, 2012
	(Dollars in thousands)
Nonaccrual loans:
Commercial loans	$	6,060	$	6,846
Commercial real estate loans – owner occupied		2,926		3,232
Commercial real estate loans – all other		3,947		6,424
Residential mortgage loans – single family		829		839
Land development loans		—		314

Total	$	13,762	$	17,655

At March 31, 2013 nonaccrual loans totaled to $13.8 million, down from $17.7 million at December 31, 2012, primarily due to (i) the restoration to accrual status of a $1.9 million commercial real estate-all other loan as a result of the resumption by the borrower of its loan payment obligations to us and (ii) the foreclosure of $1.6 million of commercial real estate-all other loans, in the first quarter of 2013.

6.	Loans and Allowance for Loan Losses (Cont,-)

The Company classifies its loan portfolio using internal credit quality ratings. The following table provides a summary of loans by portfolio type and the Company’s internal credit quality ratings as of March 31, 2013 and December 31, 2012, respectively.


(Dollars in thousands)	March 31, 2013		December 31, 2012		Increase (Decrease)
Pass:
Commercial loans	$	142,364	$	146,952	$	(4,588	)
Commercial real estate loans – owner occupied		155,229		162,689		(7,460	)
Commercial real estate loans – all other		145,039		135,274		9,765
Residential mortgage loans – multi family		100,703		104,747		(4,044	)
Residential mortgage loans – single family		78,543		84,237		(5,694	)
Land development loans		11,212		12,461		(1,249	)
Consumer loans		23,550		27,296		(3,746	)

Total pass loans	$	656,640	$	673,656	$	(17,016	)

Special Mention:
Commercial loans	$	2,263	$	2,381	$	(118	)
Commercial real estate loans – owner occupied		—		—		—
Commercial real estate loans – all other		7,612		3,859		3,753
Residential mortgage loans – multi family		—		373		(373	)
Residential mortgage loans – single family		988		990		(2	)
Land development loans		8,160		8,201		(41	)
Consumer loans		2,572		—		2,572

Total special mention loans	$	21,595	$	15,804	$	5,791

Substandard:
Commercial loans	$	20,353	$	21,347	$	(994	)
Commercial real estate loans – owner occupied		2,926		3,232		(306	)
Commercial real estate loans – all other		10,307		11,057		(750	)
Residential mortgage loans – multi family		—		—		—
Residential mortgage loans – single family		2,022		2,036		(14	)
Land development loans		—		3,355		(3,355	)
Consumer loans		—		—		—

Total substandard loans	$	35,608	$	41,027	$	(5,419	)

Doubtful:
Commercial loans	$	1,074	$	112	$	962
Commercial real estate loans – owner occupied		—		—		—
Commercial real estate loans – all other		—		—		—
Residential mortgage loans – multi family		—		—		—
Residential mortgage loans – single family		—		—		—
Land development loans		—		—		—
Consumer loans		—		—		—

Total doubtful loans	$	1,074	$	112	$	962

Total Outstanding Loans, gross:	$	714,917	$	730,599	$	(15,682	)

6.	Loans and Allowance for Loan Losses (Cont,-)

As the above table indicates, the Company’s total loans approximated $715 million at March 31, 2013, a decrease of $16 million from $731 million at December 31, 2012. The disaggregation of the portfolio by risk rating in the table above reflects the following changes between December 31, 2012 and March 31, 2013:

•

Loans rated “pass” decreased $17.0 million to $656.6 million at March 31, 2013, from $673.6 million at December 31, 2012, due primarily to a $16 million decrease in total loans outstanding primarily as a result of principal paydowns/payoffs during the quarter ended March 31, 2013.

•

The loans rated “special mention” increased $5.8 million to $21.6 million at March 31, 2013 from $15.8 million at year-end 2012. The increase was primarily the result of downgrades of a $3.8 million commercial real estate loan and a $2.0 million consumer loan relationship.

•

Loans classified “substandard” decreased $5.4 million to $35.6 million at March 31, 2013, from $41.0 million at December 31, 2012, due primarily to a $2.0 million upgrade to “pass” of a commercial real estate loan which has performed according to terms over an extended period of time, a downgrade of a $1.0 million commercial loan to “doubtful” and the foreclosure and transfer to REO of $1.6 million of loans that had been classified as “substandard” at December 31, 2012.

•

Loans classified as “doubtful” increased by $1 million due to a downgrade from “substandard” of a commercial loan, due to a bankruptcy filing by the borrower.

At March 31, 2013, the ALL totaled approximately $11.0 million, or 1.54% of the loans then outstanding and loans outstanding stood at $715 million, a decrease of $16 million from $731 million at December 31, 2012. This decrease was primarily attributable to principal pay downs of loans classified “pass”. Despite the improvement in the overall risk categories, reserves are based on historical loss factors within the loss migration model, and those factors were slightly higher than in the fourth quarter ended December 31, 2012. Based on our assessment of asset quality and applicable bank regulatory guidelines, we believe the ALL was adequate to cover losses inherent in the loan portfolio as of March 31, 2013.

Impaired Loans

A loan is generally classified as impaired and placed on nonaccrual status when, in management’s judgment, principal or interest is not likely to be collected in accordance with the contractual terms of the loan agreement. We measure for impairment on a loan-by-loan basis, using either the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if the loan is collateral dependent.

The following table sets forth information regarding impaired loans, at March 31, 2013 and December 31, 2012:


(Dollars in thousands)	March 31, 2013		December 31, 2012
Impaired loans:
Nonaccruing loans	$	7,908	$	12,018
Nonaccruing restructured loans		5,854		5,637
Accruing restructured loans ⁽¹⁾		23,051		21,596
Accruing impaired loans		—		—

Total impaired loans	$	36,813	$	39,251

Impaired loans less than 90 days delinquent and included in total impaired loans	$	28,099	$	28,452

⁽¹⁾	See “Trouble Debt Restructings” below for a description of accruing restructured loans at March 31, 2013 and December 31, 2012.

The $2.4 million decrease in impaired loans to $36.8 million at March 31, 2013, from $39.3 million at December 31, 2012, was primarily attributable to $1.6 million in nonaccrual loans foreclosed by the Bank. Accruing restructured loans were comprised of a number of loans performing in accordance with modified terms, including lower interest rates, deferred payments, or modified payment terms. Based on an internal analysis, using the current fair value of the collateral or the discounted present value of the future cash flows of the impaired loans, we concluded that $2.4 million of specific reserves were required on a $4.4 million troubled debt restructured (“TDR”) loan relationship and that the other impaired loans were well secured and adequately collateralized as of March 31, 2013.

6.	Loans and Allowance for Loan Losses (Cont,-)

The following tables contain additional information with respect to impaired loans, by portfolio type, at March 31, 2013 and December 31, 2012:


(Dollars in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance ⁽¹⁾		Average Recorded Investment		Interest Income Recognized
2013 Loans with no specific reserves established:
Commercial loans	$	9,949	$	11,737	$	—	$	8,830	$	54
Commercial real estate loans – owner occupied		4,329		4,640		—		5,294		14
Commercial real estate loans – all other		17,308		17,444		—		15,038		153
Residential mortgage loans – multi-family		—		—		—		—		—
Residential mortgage loans – single family		829		1,031		—		865		—
Land development loans		—		—		—		289		—
Consumer loans		—		—		—		—		—
2013 Loans with specific reserves established:
Commercial loans	$	4,398	$	4,398	$	2,400	$	7,118	$	42
Commercial real estate loans – owner occupied		—		—		—		—		—
Commercial real estate loans – all other		—		—		—		1,018		—
Residential mortgage loans – multi-family		—		—		—		—		—
Residential mortgage loans – single family		—		—		—		—		—
Land development loans		—		—		—		—		—
Consumer loans		—		—		—		—		—
2013 Total:
Commercial loans	$	14,347	$	16,135	$	2,400	$	15,948	$	96
Commercial real estate loans – owner occupied		4,329		4,640		—		5,294		14
Commercial real estate loans – all other		17,308		17,444		—		16,056		153
Residential mortgage loans – multi-family		—		—		—		—		—
Residential mortgage loans – single family		829		1,031		—		865		—
Land development loans		—		—		—		289		—
Consumer loans		—		—		—		—		—
2012 Loans with no specific reserves established:
Commercial loans	$	11,782	$	12,770	$	—	$	7,733	$	377
Commercial real estate loans – owner occupied		4,644		4,649		—		5,584		92
Commercial real estate loans – all other		17,274		17,317		—		10,893		703
Residential mortgage loans – multi-family		—		—		—		45		—
Residential mortgage loans – single family		839		1,033		—		1,050		41
Land development loans		314		318		—		424		33
Consumer loans		—		—		—		—		—
2012 Loans with specific reserves established:
Commercial loans	$	4,398	$	4,398	$	2,428	$	6,976	$	221
Commercial real estate loans – owner occupied		—		—		—		—		—
Commercial real estate loans – all other		—		—		—		2,053		—
Residential mortgage loans – multi-family		—		—		—		—		—
Residential mortgage loans – single family		—		—		—		—		—
Land development loans		—		—		—		—		—
Consumer loans		—		—		—		—		—
2012 Total:
Commercial loans	$	16,180	$	17,168	$	2,428	$	14,709	$	598
Commercial real estate loans – owner occupied		4,644		4,649		—		5,584		92
Commercial real estate loans – all other		17,274		17,317		—		12,946		703
Residential mortgage loans – multi-family		—		—		—		45		—
Residential mortgage loans – single family		839		1,033		—		1,050		41
Land development loans		314		318		—		424		33
Consumer loans		—		—		—		—		—

⁽¹⁾

When the discounted cash flows, collateral value or market price equals or exceeds the recorded investment in the loan, then the loan does not require reserves to be set aside within the ALL. This typically occurs when the impaired loans have been previously partially charged-off and/or there have been interest payments received and applied to the principal loan balance.

6.	Loans and Allowance for Loan Losses (Cont,-)

At March 31, 2013 and December 31, 2012 there were impaired loans of $32.4 million and $34.9 million, respectively, to which no specific reserves had been allocated because these loans, in our judgment, were sufficiently collateralized. Of the impaired loans at March 31, 2013 for which no specific reserves were allocated, $31.4 million had been deemed impaired in prior quarters and the deficiencies were charged off during the periods in which the loans were determined to have become impaired.

We had average investments in impaired loans of $38.5 million and $34.8 million for the period ended March 31, 2013 and December 31, 2012, respectively. The interest that would have been earned, in the first quarter of 2013, had the impaired loans remained current in accordance with their original terms was approximately $270,000.

Troubled Debt Restructurings

Pursuant to the FASB’s Accounting Standard Update No. 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring (“ASU No. 2011-02”), the Bank’s TDR totaled $28.2 million as of March 31, 2013, as compared to $27.2 million as of December 31, 2012. TDRs consist of loans to which modifications have been made for the purpose of alleviating temporary impairments of the borrowers’ financial condition. Those modifications have come in the forms of changes in amortization terms, reductions in interest rates, interest only payments and, in limited cases, concessions to outstanding loan balances. The modifications are made as part of workout plans we enter into with the borrowers that are designed to provide a bridge for the borrowers’ cash flow shortfalls in the near term. If a borrower works through the near term issues, then in most cases, the original contractual terms of the borrower’s loan will be reinstated.

As of March 31, 2013, of the $28.9 million of TDRs, $23.1 million were performing in accordance with their terms and accruing interest; whereas $5.8 million were not performing in accordance with their terms. The performing TDR’s increased by $1.5 million to $23.1 million at March 31, 2013 compared to $21.6 million at December 31, 2012, primarily due to interest rate modifications made with respect to two performing commercial real estate loans. We carried $2.4 million of specific reserves for $1.0 million in nonperforming TDR’s and $3.4 million in performing TDR’s as of March 31, 2013. By comparison nonperforming TDR’s totaled $5.6 million, at December 31, 2012.


	March 31, 2013
(Dollars in thousands)	Number of Loans		Pre- Modification Outstanding Recorded Investment		Post Modification Outstanding Recorded Investment		End of Period Balance
Performing
Commercial loans		2	$	8,310	$	8,310	$	8,287
Commercial real estate – all other		6		16,451		16,451		13,361
Land development loans		1		1,429		1,429		1,403

		9		26,190		26,190		23,051
Nonperforming
Commercial loans		7		5,789		4,670		3,967
Commercial real estate – all other		1		1,872		1,867		1,830
Residential mortgage loans – single family		1		171		64		57

		9		7,832		6,601		5,854

Total TDR loans		18	$	34,022	$	32,791	$	28,905

6.	Loans and Allowance for Loan Losses (Cont,-)


	December 31, 2012
(Dollars in thousands)	Number of Loans		Pre- Modification Outstanding Recorded Investment		Post- Modification Outstanding Recorded Investment		End of Period Balance
Performing
Commercial loans		4	$	9,754	$	9,754	$	9,334
Commercial real estate – all other		4		10,897		10,897		10,849
Land development loans		1		1,429		1,429		1,412

		9		22,080		22,080		21,595
Nonperforming
Commercial loans		3		1,943		1,855		1,753
Commercial real estate – all other		2		6,814		6,685		3,825
Residential mortgage loans – single family		1		171		64		59

		6		8,928		8,604		5,637

Total Troubled Debt Restructurings		15	$	31,008	$	30,684	$	27,232

7.	Income Taxes

7.	Income Taxes (Cont,-)

For the three months ended March 31, 2013, we recorded income tax benefit of $1.9 million, which represents an effective tax rate of 37%. The effective rate differed from our statutory federal rate of 34% as a result of state taxes (net of federal benefit), less a permanent tax difference associated with an addition to our deferred tax valuation allowance of approximately $0.1 million.

We record as a deferred tax asset on our balance sheet an amount equal to the tax credit and tax loss carryforwards and tax deductions (“tax benefits”) that we believe will be available to us to offset or reduce the amounts of our income taxes in future periods. Under applicable federal and state income tax laws and regulations, such tax benefits will expire if not used within specified periods of time. Accordingly, the ability to fully use our deferred tax asset depends on the amount of taxable income that we generate during those time periods. At least once each year, or more frequently, if warranted, we make estimates of future taxable income that we believe we are likely to generate during those future periods. If we conclude, on the basis of those estimates and the amount of the tax benefits available to us, that it is more likely than not that we will be able to fully utilize those tax benefits prior to their expiration, we recognize the deferred tax asset in full on our balance sheet. On the other hand, if we conclude on the basis of those estimates and the amount of the tax benefits available to us that it has become more likely than not that we will be unable to utilize those tax benefits in full prior to their expiration, then, we would establish (or increase any existing) valuation allowance to reduce the deferred tax asset on our balance sheet to the amount which we believe we are more likely than not to be able to utilize. Such a reduction is implemented by recognizing a non-cash charge that would have the effect of increasing the provision, or reducing any credit, for income taxes that we would otherwise have recorded in our statements of operations. The determination of whether and the extent to which we will be able to utilize our deferred tax asset involves significant management judgments and assumptions that are subject to period to period changes as a result of changes in tax laws, changes in market or economic conditions that could affect our operating results or variances between our actual operating results and our projected operating results, as wells as other factors.

At March 31, 2013, we have a net deferred tax asset of $13.6 million, as compared with $11.7 million at December 31, 2012. The increase in our deferred tax asset was directly attributable to the losses we incurred in the first quarter. We recorded a valuation allowance of $0.1 million on our net deferred tax asset because we concluded that we could utilize tax benefits totaling only $13.6 million, as the full benefit of our first quarter loss would have increased our net deferred tax asset to $13.7 million. Further adjustments to our deferred tax valuation allowance could be required in the future if we were to conclude, on the basis of our assessment of the realizability of the deferred tax asset, that the amount of that asset which is more likely, than not, to be available to offset or reduce future taxes has decreased. Any such decrease could result in an increase in our provision for income taxes or reductions to our income tax benefits.

We file income tax returns with the U.S. federal government and the state of California. As of March 31, 2013, we were subject to examination by the Internal Revenue Service with respect to our U.S. federal income tax return for the 2008 to 2012 tax year and Franchise Tax Board for California state income tax returns for the 2008 to 2012 tax years. We do not believe there will be any material adverse changes in our unrecognized tax benefits over the next 12 months. Net operating losses (“NOLs”) on our U.S. federal and California state income tax returns may be carried forward twenty years. Beginning in 2012, California taxpayers may carryback losses for two years and carryforward for twenty years, which conforms to the U.S. tax law. We expect (although no assurance can be given) that we will generate taxable income in future years to offset the California NOL generated in prior years.

Our policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of tax expense. We did not have any accrued interest or penalties associated with any unrecognized tax benefits, and no interest expense was recognized during the quarter ended March 31, 2013 and 20112.

8.	Shareholder’s Equity

Effective as of March 30, 2013, we sold and issued a total of 2,222,222 shares of our common stock to Carpenter Community Bancfund L.P. and Carpenter Community Bancfund-A, L.P. (the “Carpenter Funds”), at a price of $6.75 per share in cash, generating gross proceeds to us of $15 million. The purchase price of $6.75 per share of common stock is equal to the Company’s tangible book value per share of common stock as of December 31, 2012.

The proceeds from the sale of those shares were contributed by the Company to capitalize a new wholly-owned asset management subsidiary, which has used those proceeds to fund the purchase of $10 million of nonperforming loans and foreclosed real properties from the Bank.

As a result of this sale of shares, the Carpenter Funds, which are the Company’s largest shareholder, owns approximately 34% of our outstanding voting shares, as compared to the 28% which they had owned prior to this sale of shares.

9.	Stock-Based and Other Employee Compensation

The fair values of the options that were outstanding at March 31, 2013 were estimated as of their respective dates of grant using the Black-Scholes option-pricing model. For additional information regarding the Company’s stock based compensation plans, see Note 14—“Stock-Based Employee Compensation Plans” in the Notes to Consolidated Financial Statement included in the Company’s 2012 10-K. The table below summarizes the weighted average assumptions used to determine the fair values of the options granted during the following periods:


	Three Months Ended March 31,
Assumptions with respect to:	2013⁽¹⁾			2012
Expected volatility		—	%	39% to 42%
Risk-free interest rate		—	%	1.39%
Expected dividend yields		—	%	0.26%
Expected term (years)		—	%	6.6% to 8.2%
Weighted average fair value of options granted during period	$	—		$1.61

⁽¹⁾	The Company did not grant any options during the first quarter of 2013.

9.	Stock-Based and Other Employee Compensation (Cont,-)

The following tables summarize the stock option activity under the Plans during the three months ended March 31, 2013 and 2012, respectively.


	Number of Shares			Weighted- Average Exercise Price Per Share		Number of Shares			Weighted- Average Exercise Price Per Share
	2013					2012
Outstanding – January 1,		1,565,965		$	6.90		1,153,741		$	7.35
Granted		—			—		119,500			3.74
Exercised		(6,100	)		3.49		(128	)		3.40
Forfeited/Canceled		(45,100	)		5.98		(38,948	)		7.54

Outstanding – March 31,		1,514,765			6.94		1,234,165			7.03

Options Exercisable – March 31,		975,444		$	7.86		804,006		$	8.84

Options to purchase 6,100 shares and 128 shares of our common stock were exercised during the three months ended March 31, 2013 and 2012, respectively. The fair values of options vested during the three months ended March 31, 2013 and 2012 were $117,843 and $56,800, respectively.

The following table provides additional information regarding the vested and unvested options that were outstanding at March 31, 2013.


	Options Outstanding as of March 31, 2013								Options Exercisable as of March 31, 2013⁽¹⁾
	Vested		Unvested		Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (Years)		Shares		Weighted Average Exercise Price
$ 2.97 – $5.99		512,401		378,921	$	4.15		7.93		512,401	$	3.76
$ 6.00 – $9.99		13,600		160,400		6.74		9.00		13,600		7.27
$ 10.00 – $12.99		310,100		—		11.23		0.88		310,100		11.23
$ 13.00 – $17.99		119,843		—		15.10		2.37		119,843		15.10
$ 18.00 – $18.84		19,500		—		18.06		2.84		19,500		18.06

		975,444		539,321	$	6.93		6.11		975,444	$	7.86

⁽¹⁾	The weighted average remaining contractual life of the options that were exercisable as of March 31, 2013 was 4.59 years.

The aggregate intrinsic values of options that were outstanding and exercisable under the Plans at March 31, 2013 and 2012 were $1.1 million and $610,505, respectively.

A summary of the status of the unvested options as of December 31, 2012, and changes in the number of shares subject to and in the weighted average grant date fair values of the unvested options during the three months ended March 31, 2013, are set forth in the following table.


	Number of Shares Subject to Options			Weighted Average Grant Date Fair Value
Unvested at December 31, 2012		635,706		$	2.30
Granted		—			—
Vested		(50,285	)		1.51
Forfeited/Cancelled		(46,100	)		2.58

Unvested at March 31, 2013		539,321		$	2.35

The aggregate amounts of stock based compensation expense recognized in our consolidated statements of operations for the three months ended March 31, 2013 and 2012, were $155,000 and $47,000, respectively, in each case net of taxes. At March 31, 2013, the weighted average period over which unvested options were expected to be recognized was 1.22 years.

9.	Stock-Based and Other Employee Compensation (Cont,-)

The following table sets forth the compensation expense which was expected to be recognized during the periods presented below in respect of unvested stock options outstanding at March 31, 2013:


	Estimated Stock Based Compensation Expense
(Dollars in thousands)
For the period and years ending December 31,
Remainder 2013	$	424
2014		465
2015		206
2016		21
2017		4

	$	1,120

In 1999, we established a Supplemental Retirement Plan (“SERP”) for our Chief Executive Officer, who retired from that position in April 2013. The components of net periodic benefit cost for the SERP are set forth in the table below:


	Three Months Ended March 31,
(Dollars in thousands)	2013		2012
Service cost	$	18	$	51
Interest cost		45		39
Expected return on plan assets		—		—
Amortization of prior service cost (benefits)		1		4
Amortization of net actuarial loss (gain)		29		(12	)

Net periodic SERP cost	$	93	$	82

10.

Earnings Per Share (“EPS”)

Basic EPS is computed by dividing net income or loss allocable to our common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS gives effect to the potential dilution that could occur if stock options, convertible preferred stock or other contracts to issue common stock were either exercised or converted into common stock that would then share in our earnings. For the three months ended March 31, 2013 and 2012, 1,520,265 and 882,543 shares, respectively, of our common stock that were purchasable on exercise of outstanding stock options and 2,345,919 shares of our common stock into which our outstanding shares of Series B Preferred Stock were convertible, were excluded from the computation of diluted earnings per common share, because they were anti-dilutive. An additional 761,278 shares of our common stock subject to outstanding stock purchase warrants were also excluded from the computation of diluted earnings per common share for the three months ended March 31, 2013 and 2012, because the exercisability of those warrants is conditioned on future events which may not occur.

The following table shows how we computed basic and diluted EPS for the three month periods ended March 31, 2013 and 2012.


	Three Months Ended March 31,
(In thousands, except earnings per share data)	2013			2012
Net (loss) income	$	(3,169	)	$	1,382
Accumulated undeclared dividends on preferred stock		(296	)		(234	)

Net (loss) income allocable to common shareholders ^(A)	$	(3,465	)	$	1,148

Weighted average outstanding shares of common stock ^(B)		16,733			12,396
Dilutive effect of convertible preferred stock, employee stock options and warrants		—			33

Common stock and common stock equivalents ^(C)		16,733			12,429

(Loss) income per common share:
Basic (A/B)	$	(0.21	)	$	0.09
Diluted (A/C)	$	(0.21	)	$	0.09

11.

Business Segment Information

We have two reportable business segments, commercial banking and mortgage banking. Our commercial banking segment provides small and medium-size businesses, professional firms and individuals with a diversified range of products and services, such as various types of deposit accounts, various types of commercial and consumer loans, cash management services, and online banking services. Our mortgage banking segment originates mortgage loans that, for the most part, are resold within 30 days to long-term investors in the secondary residential mortgage market.

Since these operating segments derive all of their revenues from interest and noninterest income and interest expense constitutes their most significant expense, these two segments are reported below using net interest income (interest income less interest expense) and noninterest income (primarily net gains on sales of loans held for sale and fee income). We do not allocate general and administrative expenses or income taxes to our operating segments.

The following table sets forth information regarding the interest income and noninterest income of our commercial banking and mortgage banking segments, respectively, for the three months ended March, 2013 and 2012.


(Dollars in thousands)	Commercial		Mortgage		Other			Total
Net interest income for the period ended: March 31,
2013	$	6,962	$	497	$	(101	)	$	7,358
2012	$	7,486	$	656	$	(127	)	$	8,015
Noninterest income for the period ended: March 31,
2013	$	348	$	1,685	$	—		$	2,033
2012	$	1,496	$	4,531	$	—		$	6,027
Segment Assets at:
March 31, 2013	$	926,890	$	68,646	$	28,244		$	1,023,780
December 31, 2012	$	940,748	$	99,829	$	13,364		$	1,053,941

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Introduction

Pacific Mercantile Bancorp is a bank holding company (the “Company”) which owns all of the stock of Pacific Mercantile Bank (the “Bank”), which is a commercial bank that provides a full range of banking services to small and medium-size businesses and to professionals and the general public in Orange, Los Angeles, San Bernardino and San Diego counties, in Southern California. The Bank also operates a mortgage banking business, originating and funding residential mortgage loans and selling those loans, generally within the succeeding 30 days, into the secondary mortgage market. Substantially all of our operations are conducted and substantially all of our assets are owned by the Bank, which accounts for substantially all of our consolidated revenues, expenses and operating income. For ease of reference we will sometimes refer to the Company and the Bank, together as “we”, “us” or “our”.

The following discussion presents information about (i) our consolidated results of operations for the three months ended March 31, 2013 and comparisons of those results with the results of operations for the corresponding three month period of 2012, and (ii) our consolidated financial condition, liquidity and capital resources at March 31, 2013. The information in the following discussion should be read in conjunction with our interim consolidated financial statements and the notes thereto included elsewhere in this Report.

Forward-Looking Information

Statements contained in 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 and on assumptions that we make about future 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 significantly 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.

Many of those risks and uncertainties are discussed in Item 1A Part I, entitled “Risk Factors,” in our Annual Report on Form 10-K for the year ended December 31, 2012 (the “2012 10-K”) that we filed with the SEC on March 20, 2013. 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 months ended, and our financial condition at, March 31, 2013.

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, except as may otherwise be required by law or NASDAQ rules.

Overview of Operating Results in the Three Months Ended March 31, 2013

The following table provides comparative information with respect to our results of operations for the three month periods ended March 31, 2013 and 2012, respectively.


	Three Months Ended March 31,
	2013			2012			2013 vs. 2012
	Amount			Amount			% Change
Interest income	$	8,984		$	10,310			(12.9	)%
Interest expense		1,626			2,295			(29.2	)%

Net interest income		7,358			8,015			(8.2	)%
Provision for loan losses		1,150			(400	)		387.5	%

Net interest income after provision for loan losses		6,208			8,415			(26.2	)%
Noninterest income		2,033			6,027			(66.3	)%
Noninterest expense		13,339			12,237			9.0	%

Income before income taxes		(5,098	)		2,205			(331.2	)%
Income tax (benefit) expense		(1,929	)		823			334.4	%

Net (loss) income		(3,169	)		1,382			(329.3	)%
Accumulated undeclared dividends on preferred stock		(296	)		(234	)		26.5	%

Net income allocable to common shareholders	$	(3,465	)	$	1,148			(401.8	)%

Net income (loss) per common share
Basic	$	(0.21	)	$	0.09			(333.3	)%
Diluted	$	(0.21	)	$	0.09			(333.3	)%
Weighted average number of shares outstanding
Basic		16,732,774			12,396,367			(35.0	)%
Diluted		16,732,774			12,428,949			(34.6	)%

Results of Operations in the Three Months Ended.

As the above table indicates, we incurred a net loss of $3.2 million, or $0.21 per diluted share, in the first three months of 2013, as compared to net income of $1.4 million, or $0.09 per diluted share, in the same three months of 2012. That loss was primarily attributable to a number of factors, including (i) a $1.3 million, or 12.9%, decline in interest income, due primarily to continuing declines in interest rates as a result of Federal Reserve Board actions to keep interest rates low; (ii) a $1.55 million increase in the provision for loan losses due primarily to offset a $1.0 million of write-downs in the carrying values of certain nonperforming loans which were charged against the allowance for loan losses; (iii) a $4.0 million, or 66.3%, decline in noninterest income that was primarily due to a $2.9 million, or 64.9%, decrease in mortgage banking revenues that resulted from our exit from the wholesale residential mortgage loan business in late August 2012, and a $1.2 million decline in net gains from sales of securities available for sale due to a decrease in sales of such securities, and (iv) a $1.1 million, or 9%, increase in noninterest expense. Partially offsetting the decline in interest income was a $669,000, or 29.2%, reduction in interest expense in this year’s first quarter as compared to the first quarter of 2012, that was primarily attributable to reductions in the volume of higher-priced time deposits, partially offset by an increase in demand and other core deposits, and decreases in rates of interest paid on deposits.

Actions to Improve the Quality and Performance of the Bank’s Loan Portfolio and Strengthen its Financial Condition. In March 2013, we sold $15 million of shares of our common stock, at a price of $6.75 per share in cash, to Carpenter Community Bancfund, L.P. and Carpenter Community Bancfund-A, L.P. (the “Carpenter Funds”) which, together, constitute our largest shareholder. We used the proceeds from that sale of shares to capitalize a new wholly-owned asset management subsidiary, which will use those proceeds to fund the purchase of nonperforming loans and foreclosed real properties (“OREO”) from the Bank and thereafter manage and dispose of those loans and OREO. The purpose of these transactions is to significantly reduce the Bank’s nonperforming assets in order to improve the Bank’s financial condition and reduce the costs it has been incurring in managing and disposing of those assets in order to improve

the Bank’s results of operation. If these initiatives prove to be successful, we believe that such success will move the Bank closer to a relaxation of some of the regulatory restrictions under which it has been operating since August 2010 and which, therefore, could enable us to focus more resources on growing our banking franchise.

The sale of the shares of common stock to the Carpenter Funds also strengthen the Company’s financial condition by increasing its capital and capital ratios. However, the Bank’s sale of non-performing assets to the Company’s new asset management subsidiary will not result in changes in or improvements to the Company’s consolidated financial condition or operating results, because those non-performing assets will remain on the Company’s consolidated balance sheet and the costs of managing and disposing of those assets, and any losses that may be recognized on their sale, will continue to be reflected in the Company’s consolidated operating results and cash flows until the sales or other dispositions of those assets have been completed.

Outlook for 2013

Expected Decline in Mortgage Banking Revenues. As previously reported, effective August 31, 2012 we exited the wholesale residential mortgage loan business. As a result, our mortgage banking division is currently engaged in the direct-to-consumer retail mortgage business in which we originate mortgage loans directly from consumers seeking to refinance existing mortgage loans or finance the purchase of residential real estate. The decision to exit the wholesale mortgage business was made to enable us (i) to redeploy some of our capital resources, which had been committed to the wholesale mortgage business, to our core commercial lending business, (ii) to reduce and control our staffing costs and operating expenses, which had grown significantly to a large extent as a result of the growth of the wholesale mortgage business, and (iii) to manage and limit interest rate and other risks inherent in a wholesale mortgage business. As discussed above, our exit from the wholesale residential mortgage loan business contributed to the loss we incurred in this year’s first quarter and is expected to adversely affect our results of operations during the remainder of 2013.

Financial Ratios. The following table sets forth our net interest margin for the three months ended March 31, 2013 and 2012, and the return on average assets and average shareholders’ equity for the same respective periods:


	Three Months Ended March 31,
	2013			2012
Net interest margin⁽¹⁾⁽²⁾		3.01	%		3.34	%
Return on average assets⁽¹⁾		(1.23	)%		0.54	%
Return on average shareholders’ equity⁽¹⁾		(10.48	)%		6.28	%

⁽¹⁾	Annualized.

⁽²⁾	Net interest income expressed as a percentage of total average interest earning assets.

Critical Accounting Policies

Introduction. 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 values 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 values of certain of our other assets, such as securities available for sale and our deferred tax assets. Those assumptions and judgments are necessarily based on current information available to us regarding those economic conditions or trends or other circumstances. If adverse changes were to occur in the events, trends or other circumstances on which our assumptions or judgments had been based, or other unanticipated events were to happen that might affect our operating results, under GAAP it could become necessary for us to reduce the carrying values of the affected assets on our balance sheet. In addition, because reductions in the carrying value of assets are sometime effectuated by or require charges to income, such reductions also may have the effect of reducing our income.

Our critical accounting policies consist of the accounting policies and practices we follow in determining (i) the sufficiency of the allowance we establish for loan losses; (ii) the fair values of our investment securities that we hold for sale and financial instruments related to our mortgage banking assets and liabilities, and (iii) the amount of our deferred tax asset, consisting primarily of tax loss carryforwards and tax credits that we believe will be able to use to offset income taxes in future periods. There were no significant changes in the Company’s critical accounting policies or their application during the three months ended March 31, 2013, as compared to our critical accounting policies in effect as of December 31, 2012. Information regarding our critical accounting policies in effect as of December 31, 2012 is contained in the sections captioned “Critical Accounting Policies” and “Allowance for Loan Losses” in Item 7, entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained in our 2012 10-K, which we filed with the SEC on March 20, 2013, and readers of this report are urged to read those sections of that 10-K.

Results of Operations

Net Interest Income

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, in turn, 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, and 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 table sets forth our interest income, interest expense and net interest income (in thousands of dollars) and our net interest margin for the three months ended March 31, 2013 and 2012, respectively:


	Three Months Ended March 31,
	Amount			Amount			Amount
	2013			2012			2013 vs. 2012
Interest income	$	8,984		$	10,310			(12.9	)%
Interest expense		1,626			2,295			(29.2	)%

Net interest income	$	7,358		$	8,015			(8.2	)%

Net interest margin		3.01	%		3.34	%

In the three months ended March 31, 2013, net interest income decreased by $657,000, or 8.2%, due to a $1.3 million, or 12.9%, decrease in interest income, which was only partially offset by a $669,000, or 29.2%, decrease in interest expense, in each case as compared to the same three months of 2012. The decrease in interest income was primarily attributable to a decrease in the average interest rate on loans outstanding, to 4.62% for the first three months of 2013, from 5.19% in the respective period of 2012, which more than offset increases in the volume of our interest earning assets, including loans. The decrease in average interest rates paid on loans was primarily attributable to actions taken by the Federal Reserve Board designed to keep interest rates low as a means of stimulating economic growth. The decrease in interest expense was primarily attributable to reductions in the rates of interest we were paying on, and in the volume of, time certificates of deposit, in the three months ended March 31, 2013 as compared to the same three months of 2012.

Average Balances

Information Regarding Average Assets and Average Liabilities

The following table sets 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 months ended March 31, 2013 and 2012.


	Three Months Ended March 31,
	2013							2012
(Dollars in thousands)	Average Balance		Interest Earned/ Paid		Average Yield/ Rate			Average Balance		Interest Earned/ Paid		Average Yield/ Rate
Interest earning assets:
Short-term investments⁽¹⁾	$	153,409	$	95		0.25	%	$	87,474	$	55		0.25	%
Securities available for sale and stock⁽²⁾		90,967		370		1.65	%		151,612		877		2.32	%
Loans⁽³⁾		748,388		8,519		4.62	%		724,621		9,378		5.19	%

Total earning assets		992,764		8,984		3.67	%		963,707		10,310		4.31	%
Noninterest earning assets		54,861							59,035

Total Assets	$	1,047,625						$	1,022,742

Interest-bearing liabilities:
Interest-bearing checking accounts	$	33,228		21		0.26	%	$	29,005		21		0.29	%
Money market and savings accounts		168,355		198		0.48	%		177,357		386		0.87	%
Certificates of deposit		457,608		1,184		1.05	%		496,768		1,644		1.33	%
Other borrowings		50,444		92		0.74	%		43,346		107		0.99	%
Junior subordinated debentures		17,682		131		3.00	%		17,682		137		3.11	%

Total interest-bearing liabilities		727,317		1,626		0.91	%		764,158		2,295		1.20	%

Noninterest-bearing liabilities		197,722							170,052

Total Liabilities		925,039							934,210
Shareholders’ equity		122,586							88,532

Total Liabilities and Shareholders’ Equity	$	1,047,625						$	1,022,742

Net interest income			$	7,358						$	8,015

Interest rate spread						2.76	%						3.11	%

Net interest margin						3.01	%						3.34	%

⁽¹⁾	Short-term investments consist of federal funds sold and interest bearing deposits with financial institutions that we maintain at other financial institutions.

⁽²⁾	Stock consists of Federal Home Loan Bank Stock and Federal Reserve Bank Stock.

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

The following table sets forth, in thousands of dollars, the changes in our interest income, including loan fees, and interest expense in the three months ended March 31, 2013, as compared to the same period of 2012, and the extent to which those changes were attributable to changes in (i) the volume of, or in the rates of interest earned on interest-earning assets and (ii) the volume of, or the rates of interest paid on our interest-bearing liabilities.


	Three Months Ended March 31, 2013 vs. 2012
	Increase (Decrease) due to:
	Volume			Rate			Total
Interest income:
Short term investments⁽¹⁾	$	40		$	—		$	40
Securities available for sale and stock⁽²⁾		(294	)		(213	)		(507	)
Loans		273			(1,132	)		(859	)

Total earning assets		19			(1,345	)		(1,326	)
Interest expense
Interest bearing checking accounts		3			(3	)		—
Money market and savings accounts		(19	)		(169	)		(188	)
Certificates of deposit		(126	)		(335	)		(461	)
Borrowings		15			(30	)		(15	)
Junior subordinated debentures		—			(5	)		(5	)

Total interest bearing liabilities		(127	)		(542	)		(669	)

Net interest income	$	146		$	(803	)	$	(657	)

(1)	Short-term investments consist of federal funds sold and interest bearing deposits with financial institutions.

(2)	Stock consists of Federal Home Loan Bank Stock and Federal Reserve Bank Stock.

Provision for Loan Losses

Like virtually all banks and other financial institutions, we follow the practice of maintaining 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 losses (the “Allowance for Loan Losses” or the “ALL”) which, at March 31, 2013, totaled $11.0 million. The amount of the ALL is increased periodically to replenish the ALL after it has been reduced due to loan write-downs or charge-offs. The ALL 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 ALL are made through a charge, recorded as an expense in the statement of operations, referred to as the “provision for loan losses.” Recoveries of loans previously charged-off are added back to and, therefore, to that extent increase the ALL and reduce the amount of the provision for loan losses that might otherwise have had to be made to replenish or increase the ALL. See “—Financial Condition—Nonperforming Loans and the Allowance for Loan Losses” below in this Item 2 for additional information regarding the ALL.

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 ALL and the amount of the provisions that need to be made for potential loan losses. 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 ALL. Moreover, the duration and anticipated effects of prevailing economic conditions or trends can be uncertain and can be affected by number of risks and circumstances that are outside of our ability to control. See the discussion below in this Item 2 under the caption “Financial Condition—Nonperforming Loans and the Allowance for Loan Losses”. 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 ALL, it could become necessary for us to record additional, and possibly significant, charges to increase the allowance for loan losses, which would have the effect of reducing our income or causing us to incur losses.

In addition, the FRB and the DFI, as an integral part of their examination processes, periodically review the adequacy of our ALL. 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.

At March 31, 2013, the ALL totaled $11.0 million, which was approximately $100,000, or 1%, higher than at December 31, 2012. The ALL activity for the first three months of 2013 included net charge-offs of $1.0 million offset by a $1.15 million provision that we made for loan losses. The ratio of the ALL to total loans outstanding as of March 31, 2013 was 1.54% compared to 1.49% as of December 31, 2012. On the basis of the methodologies we use to assess asset quality, bank regulatory guidelines and our historical loan loss history, we believe that the ALL was adequate at March 31, 2013 to cover inherent losses in the loan portfolio.

Noninterest Income

The following table identifies the components of and the percentage changes in noninterest income in the three months ended March 31, 2013, as compared to the same period of 2012:


	Three Months Ended March 31,
	Amounts					Percent Change
(Dollars in thousands)	2013		2012			2013 vs. 2012
Total other-than-temporary impairment of securities	$	—	$	(25	)		N/M
Portion of (losses) gains recognized in other comprehensive loss		—		52			N/M

Net impairment loss recognized in earnings		—		(77	)		N/M
Service fees on deposits and other banking services		196		233			(15.9	)%
Mortgage banking (including net gains on sales of loans held for sale)		1,589		4,531			(64.9	)%
Net gains on sale of securities available for sale		23		1,186			(98.1	)%
Net gain (loss) on sale of other real estate owned		—		(19	)		N/M
Other		225		173			30.1	%

Total noninterest income	$	2,033	$	6,027			(66.3	)%

As the table above indicates, the decrease in noninterest income in the three months ended March 31, 2013, as compared to the same period in 2012, was attributable to a $2.9 million, or 64.9%, decrease in revenue generated by our mortgage banking division and a decrease of $1.2 million, or 98.1%, in net gains on sales of securities available for sale.

The decrease in mortgage banking revenue for the first three months of 2013, as compared to the same three months of 2012, is primarily attributable to the Bank’s exit from the wholesale residential mortgage business in August 2012, which, as we had previously reported, was expected to result in a significant decrease in our mortgage banking revenues during 2013. The nearly $1.2 million decline in net gains on sales of securities in the first three months of 2013 was due primarily to a decrease to $6 million in volume of sales of such securities in the three months ended March 31, 2013, from approximately $135 million of sales of such securities in the three months ended March 31, 2012. Sales of securities available for sale can vary, sometimes materially, from period to period primarily in response to changes in market rates of interest.

Noninterest Expense

The following table compares the amounts of the principal components of noninterest expense in the three months ended March 31, 2013 and 2012.


	Three Months Ended March 31,
	Amounts					Percentage Change
(Dollars in thousands)	2013			2012		2013 vs. 2012
Salaries and employee benefits	$	6,117		$	5,617		8.9	%
Occupancy		666			652		2.1	%
Equipment and depreciation		629			398		58.0	%
Data processing		198			195		1.5	%
FDIC expense		546			614		(11.1	)%
Other real estate owned expense		2,117			1,824		16.1	%
Professional fees		1,666			1,226		35.9	%
Mortgage related loan expense⁽¹⁾		427			318		34.3	%
Provision for contingencies		(260	)		339		(176.7	)%
Other operating expense⁽²⁾		1,233			1,054		17.0	%

Total noninterest expense	$	13,339		$	12,237		9.0	%

⁽¹⁾	Mortgage related loan expense consist primarily of repurchase provision expense, appraisal, underwriting and document expense.

⁽²⁾	Other operating expenses consist of telephone, advertising, and investor relations, charges for promotional, business development, and regulatory expenses, insurance premiums and correspondent bank fees.

As the above table indicates, noninterest expense increased by $1.1 million, or 9%, in the first three months of 2013, as compared to the same period of 2012. That increase was primarily attributable to (i) a $500,000 increase in compensation expense that was due primarily to staffing increases in our commercial banking division, (ii) a $440,000 increase in professional fees, (iii) a $293,000 increase in other real estate expense that was primarily due to $1.6 million of write-downs in the carrying values of OREO to their respective fair values, and (iv) a $240,000 increase in equipment and depreciation expenses incurred primarily in connection with software and infrastructure upgrades. Those increases were partially offset by a nearly $600,000 reduction in contingency reserves made possible by favorable rulings in pending lawsuits.

A measure of our ability to control noninterest expense is our efficiency ratio, which is the ratio of noninterest expense to net revenue (net interest income plus noninterest income). As a general rule, a lower efficiency ratio indicates an ability to generate increased revenue without a commensurate increase in the staffing and equipment and third party services and, therefore, would be indicative of greater operational efficiencies. Due to the large decrease in noninterest income, primarily attributable to the exit of our mortgage division from the wholesale residential mortgage business, our efficiency ratio increased to 142% in the three months ended March 31, 2013 from 87.1% in the corresponding three month period of 2012.

Provision for (Benefit from) Income Tax

Our effective tax rate in both the three month periods ended March 31, 2013 and 2012 was 37%. The income tax benefit recorded in the three months ended March 31, 2013 was primarily attributable to the pre-tax loss for that period.

Asset/Liability Management

The primary objective of asset/liability management is to reduce our exposure to interest rate fluctuations, which can affect our net interest margins and, therefore, our net interest income and net earnings. We seek to achieve this objective by matching interest rate sensitive assets and liabilities, and maintaining the maturities of and repricing these assets and liabilities in response to the changes in the interest rate environment. Generally, if rate sensitive assets exceed rate sensitive liabilities, net interest income will be positively impacted during a rising interest rate environment and negatively impacted during a declining interest rate environment. When rate sensitive liabilities exceed rate sensitive assets, net interest income generally will be positively impacted during a declining interest rate environment and negatively impacted during a rising interest rate environment. However, interest rates for different asset and liability products offered by depository institutions respond differently to changes in the interest rate environment. As a result, the relationship or “gap” between interest sensitive assets and interest sensitive liabilities is only a general indicator of interest rate sensitivity and how our net interest income might be affected by changing rates of interest.

For example, rates on certain assets or liabilities typically lag behind changes in market rates of interest. Additionally, prepayments of loans and securities available for sale, and early withdrawals of certificates of deposit, can cause the interest sensitivities to vary.

The table below sets forth information concerning our rate sensitive assets and liabilities at March 31, 2013. The assets and liabilities are classified by the earlier of maturity or repricing dates in accordance with their contractual terms. As described above, certain shortcomings are inherent in the method of analysis presented in this table.


(Dollars in thousands)	Three Months or Less			Over Three Through Twelve Months			Over One Year Through Five Years			Over Five Years			Non- Interest- Bearing			Total
Assets
Interest-bearing time deposits in other financial institutions	$	1,174		$	1,249		$	—		$	—		$	—		$	2,423
Investment in unconsolidated trust subsidiaries		—			—			—			682			—			682
Securities available for sale		10,797			11,324			36,122			17,279			—			75,522
Federal Reserve Bank and Federal Home Loan Bank stock		9,604			—			—			—			—			9,604
Interest bearing deposits with financial institutions		141,926			—			—			—			—			141,926
Loans held for sale, at fair value		21,232			—			—			—			—			21,232
Loans, gross		291,459			79,424			254,154			89,554			—			714,591
Noninterest earning assets, net		—			—			—			—			57,800			57,800

Total assets	$	476,192		$	91,997		$	290,276		$	107,515		$	57,800		$	1,023,780

Liabilities and Shareholders’ Equity
Noninterest-bearing deposits	$	—		$	—		$	—		$	—		$	183,185		$	183,185
Interest-bearing deposits⁽¹⁾⁽²⁾		280,855			281,706			69,847			—			—			632,408
Borrowings		—			22,500			22,500			—			—			45,000
Junior subordinated debentures		17,527			—			—			—			—			17,527
Other liabilities		—			—			—			—			11,385			11,385
Shareholders’ equity		—			—			—			—			134,275			134,275

Total liabilities and shareholders’ equity	$	298,382		$	304,206		$	92,347		$	—		$	329,045		$	1,023,780

Interest rate sensitivity gap	$	177,810		$	(212,209	)	$	197,929		$	107,515		$	(271,045	)

Cumulative interest rate sensitivity gap	$	177,810		$	(34,399	)	$	163,530		$	271,045		$	—

Cumulative % of rate sensitive assets in maturity period		47	%		55	%		84	%		94	%		100	%

Rate sensitive assets to rate sensitive liabilities and shareholders’ equity		160	%		30	%		314	%		NA			18	%

Cumulative ratio		160	%		94	%		124	%		139	%		100	%

⁽¹⁾	Excludes savings accounts that we maintain at the Bank totaling $16.3 million.

⁽²⁾	Excludes a $250,000 certificate of deposit issued to us by the Bank, which matures January 2014.

At March 31, 2013, our rate sensitive balance sheet was shown to be in a negative twelve-month gap position. This would imply that our net interest margin would decrease in the short-term if interest rates were to rise and would increase in the short-term if interest rates were to fall. However, as noted above, the extent to which our net interest margin will be impacted by changes in prevailing interest rates will depend on a number of factors, including how quickly rate sensitive assets and liabilities react to interest rate changes, the mix of our interest earning assets (loans versus other lower yielding interest earning assets, such as securities or federal funds sold) and the mix of our interest bearing deposits (between, for example, lower interest core deposits and higher cost time certificates of deposit) and our other interest-bearing liabilities.

Financial Condition

Assets

Our consolidated assets totaled $1.024 billion at March 31, 2013, which represents a $30 million, or 2.8%, decrease from our total consolidated assets of $1.054 billion at December 31, 2012. The decrease in assets is primarily due to a $34.6 million decrease in loans available for sale, to $21.3 million, at March 31, 2013 from $55.8 million at December 31, 2012.

The following table sets forth the composition of our interest-earning assets (in thousands of dollars) at:


	March 31, 2013		December 31, 2012
Interest-bearing deposits with financial institutions⁽¹⁾	$	141,926	$	115,952
Interest-bearing time deposits with financial institutions		2,423		2,423
Federal Reserve Bank and Federal Home Loan Bank Stock, at cost		9,604		10,284
Securities available for sale, at fair value		75,522		86,378
Loans held for sale, (including $21,232 and $55,809, respectively, of loans held for sale at value at March 31, 2013 and December 31, 2012)		21,232		55,809
Loans (net of allowances of $11,018 and $10,881 at March 31, 2013 and December 31, 2012, respectively)		703,572		719,257

⁽¹⁾	Includes interest-earning balances maintained at the Federal Reserve Bank of San Francisco.

Loans Held for Sale

We commenced a mortgage banking business during the second quarter of 2009 to originate, primarily in Southern California, and fund residential real estate mortgage loans that qualify for sale into the secondary mortgage market. Our mortgage originations have been primarily for the financing of purchases of residential property and, to a lesser extent, refinancing of existing residential mortgage loans. In addition to conventional mortgage loans, we offer loan programs for low to moderate income families that qualify for mortgage assistance, such as the FHLB’s Wish Program, Homepath-financing on Fannie Mae repossessed homes, and Southern California Home Financing Authority and various mortgage assistance programs in counties and cities within our branch network. As a general rule, most of the residential mortgage loans that we originate are sold in the secondary mortgage market within a period of less than 30 days following their origination. The following table reflects the activity, in thousands of dollars, of our mortgage loan operations.


	Three Months Ended March 31, 2013		Year Ended December 31, 2012
Single family mortgage loans funded	$	57,480	$	933,214
Single family mortgage loans sold		88,265		937,201
Loans held for sale (LHFS)		21,232		55,809

Loans held for sale (“LHFS”) that were originated prior to December 1, 2011 are carried at the lower of aggregate cost or market. Effective December 1, 2011 we adopted ASU 825, The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115 (ASU 825) and, therefore, we elected to measure LHFS originated on or after December 1, 2011 at fair value. Fair values of LHFS are based on quoted market prices. Gains and losses on LHFS at fair value are, respectively, added to or charged against mortgage banking revenues. Loan origination costs related to LHFS for which we elect the fair value option are recognized in noninterest expense when incurred.

Net unrealized losses, if any, on loans carried at the lower of aggregate cost or market would be recognized through a valuation allowance established by a charge to income. Loan origination costs for LHFS carried at the lower of cost or market are capitalized as part of the carrying amount of the loans and recognized as a reduction of mortgage banking revenues upon the sale of such loans.

During the first quarter of 2012, we began selling a portion of the mortgage loans we originate directly to secondary market investors on a “mandatory commitment” basis, agreeing to sell a specified dollar amount of mortgage loans at an agreed-upon price within a specified timeframe in order to avail ourselves of more favorable pricing on loan sales to investors. In order to mitigate interest rate risk on loans subject to such mandatory commitments, when we lock the interest rate for the borrowers on those loans prior to funding, we also lock the price at which we will sell the loans to the investors and enter into a mortgaged backed to-be-announced (“TBA”) security. The mandatory commitment and the TBA security act as a hedge against market interest rate movements between the time the interest rate is locked and the loan is funded and sold

into the secondary market. TBA securities are deemed to be derivatives and involve off-balance sheet financial risk. The contractual or notional amounts of the TBA securities are tied to the Bank’s loan origination volume and we bear a financial risk from such securities. As of March 31, 2013, $10.3 million of loans held for sale were subject to investor commitments providing a hedge to interest rates and $11.8 million were subject to expired interest rate locks. The unrealized fair value losses from the interest rate contracts and TBA security hedges were $191,000 as of March 31, 2013, and were recorded in the accompanying consolidated statements of financial condition. Unrealized gains or losses on these hedges depend upon the value of the underlying financial instruments and are affected by changes in market rates of interest.

Loans

The following table sets forth the composition, by loan category, of our loan portfolio at March 31, 2013 and December 31, 2012, respectively:


	March 31, 2013						December 31, 2012
(Dollars in thousands)	Amount			Percent			Amount			Percent
Commercial loans	$	166,054			23.2	%	$	170,792			23.4	%
Commercial real estate loans – owner occupied		158,156			22.1	%		165,922			22.7	%
Commercial real estate loans – all other		162,958			22.8	%		150,189			20.6	%
Residential mortgage loans – multi-family		100,703			14.1	%		105,119			14.4	%
Residential mortgage loans – single-family		81,553			11.4	%		87,263			11.9	%
Land development loans		19,371			2.7	%		24,018			3.3	%
Consumer loans		26,122			3.7	%		27,296			3.7	%

Gross loans		714,917			100.0	%		730,599			100.0	%

Deferred fee (income) costs, net		(326	)					(461	)
Allowance for loan losses		(11,018	)					(10,881	)

Loans, net	$	703,573					$	719,257

Commercial loans are loans to businesses to finance capital purchases or improvements, or to provide cash flow for operations. Commercial real estate and residential mortgage loans are loans secured by trust deeds on real property, including commercial property and single family and multi-family residences. Land development loans are interim loans to finance specific construction projects. Consumer loans consist primarily of installment loans to consumers.

The following table sets forth the maturity distribution of our loan portfolio (excluding consumer and residential mortgage loans) at March 31, 2013:


	March 31, 2013
(Dollars in thousands)	One Year or Less		Over One Year through Five Years		Over Five Years		Total
Real estate and land development loans⁽¹⁾
Floating rate	$	72,229	$	55,788	$	10,690	$	138,707
Fixed rate		34,435		84,249		83,094		201,778
Commercial loans
Floating rate		55,300		—		—		55,300
Fixed rate		86,238		15,502		9,014		110,754

Total	$	248,202	$	155,539	$	102,798	$	506,539

⁽¹⁾	Does not include mortgage loans on single and multi-family residences and consumer loans, which totaled $182.3 million and $26.1 million, respectively, at March 31, 2013.

Nonperforming Loans and Allowance for Loan Losses

Nonperforming Loans. 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 other real estate owned, or 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 or 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 restructured loans, at March 31, 2013 and December 31, 2012:


(Dollars in thousands)	At March 31, 2013		At December 31, 2012
Nonaccrual loans:
Commercial loans	$	6,060	$	6,846
Commercial real estate		6,873		9,656
Residential real estate		829		839
Land development		—		314

Total nonaccrual loans	$	13,762	$	17,655

Loans past due 90 days and still accruing:
Total loans past due 90 days and still accruing	$	—	$	—

Other real estate owned (OREO):
Commercial real estate	$	12,943	$	12,944
Residential real estate		—		—
Construction and land development		4,675		4,766

Total other real estate owned	$	17,618	$	17,710

Other nonperforming assets:
Asset backed security		858		900

Total other nonperforming assets	$	858	$	900

Total nonperforming assets	$	32,238	$	36,265

Restructured loans:
Accruing loans	$	23,051	$	21,595
Nonaccruing loans (included in nonaccrual loans above)		5,854		5,637

Total restructured loans	$	28,905	$	27,232

As the above table indicates, during the three months ended March 31, 2013, non-performing loans decreased by approximately $3.9 million, or 22%, primarily due to a $2.0 million upgrade of a commercial real estate loan and the foreclosure and resulting transfer to OREO of $1.6 million of non-performing loans. Nonperforming assets dropped by $4.1 million to $32.2 million from $36.3 million at December 31, 2012.

We have allocated specific reserves within the ALL to provide for losses we may incur on nonaccrual loans, and we have established specific reserves on OREO.

Information Regarding Impaired Loans. At March 31, 2013 and December 31, 2012, loans deemed impaired totaled $36.8 million and $39.3 million, respectively. At March 31, 2013 we had an average investment in impaired loans of $38.5 million as compared to an average investment in impaired loans of $34.8 million at December 31, 2012. The interest that would have been earned during the three months ended March 31, 2013 had the nonaccruing impaired loans remained current in accordance with their original terms was approximately $270,000.

The following table sets forth the amount of impaired loans to which a portion of the ALL has been specifically allocated, and the aggregate amount so allocated, in accordance with ASC 310-10, and the amount of the ALL and the amount of impaired loans for which no such allocations were made, in each case at March 31, 2013 and December 31, 2012, respectively:


	March 31, 2013							December 31, 2012
Impaired Loans	Loans		Reserves for Loan Losses		% of Reserves to Loans			Loans		Reserves for Loan Losses		% of Reserves to Loans
(Dollars in thousands)
Impaired loans with specific reserves	$	4,370	$	2,400		54.9	%	$	4,398	$	2,448		55.7	%
Impaired loans without specific reserves		32,443		—		—			34,853		—		—

Total impaired loans	$	36,813	$	2,400		6.5	%	$	39,251	$	2,448		6.2	%

Allowance for Loan Losses. The ALL was $11.0 million, and 1.54% of loans outstanding, at March 31, 2013, as compared to $10.9 million, and 1.49%, of loans outstanding at December 31, 2012.

The adequacy of the ALL 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 ALL involves some significant estimates and assumptions about such matters as (i) the amounts and timing of expected future cash flows of borrowers, (ii) the fair value of the collateral securing non-performing loans, (iii) estimates of losses that the we may incur on non-performing loans, which are determined on the basis of historical loss experience, industry loss factors and bank regulatory guidelines, and (iv) various qualitative factors. Those factors are subject to changes in economic and other conditions and changes in regulatory guidelines or circumstances over which we have no control. As a result, the amount of the ALL may prove to be insufficient to cover all of the loan losses we might incur in the future and, therefore, it may become necessary for us to increase the ALL from time to time to maintain its adequacy by recording additional provisions for loan losses in our statements of operations.

The amount of the ALL is first determined by assigning reserve ratios to non-accrual loans and other loans classified as “special mention,” “substandard” or “doubtful” (“classified loans” or “classification categories”). These ratios are determined based on prior loss history and industry guidelines and loss factors, by type of loan, adjusted for current economic factors, with greater reserve ratios or percentages applied to loans deemed to pose a higher collection risk.

On a quarterly basis, we utilize a classification migration model and individual loan review analysis tools as starting points for determining the adequacy of the ALL. 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 ALL allocation process, applying specific monitoring policies and procedures in analyzing the existing loan portfolios.

In determining whether and the extent to which we will make adjustments to our loan loss migration model for purposes of determining the ALL, 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;

•

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 our loan portfolios 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 ALL or that may even exceed the ALL.

In response to the economic recession and continued weakness in the economy, which has 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 have (i) implemented more stringent loan underwriting standards, (ii) strengthened loan underwriting and approval processes and (iii) added personnel with experience in addressing problem assets.

The following table compares the total amount of loans outstanding, and the allowance for loan losses, by loan category, in each case, in thousands of dollars, and certain related ratios, as of March 31, 2013 and December 31, 2012.


	March 31, 2013			December 31, 2012			Increase (Decrease)
	March 31, 2013			December 31, 2012			March 31, 2013 to December 31, 2012
(Dollars in thousands)
Commercial loans	$	166,054		$	170,792		$	(4,738	)
Loans impaired⁽¹⁾		14,347			16,180			(1,833	)
Loans 90 days past due		2,935			4,295			(1,360	)
Loans 30 days past due		5,255			2,099			3,156
Allowance for loan losses
General component	$	4,450		$	3,912		$	538
Specific component⁽¹⁾		2,400			2,428			(28	)

Total allowance	$	6,850		$	6,340		$	510
Ratio of allowance to loan category		4.13	%		3.71	%		0.42	%
Real estate loans:	$	421,817		$	421,230		$	(587	)
Loans impaired⁽¹⁾		21,637			21,918			(281	)
Loans 90 days past due		5,043			5,831			(788	)
Loans 30 days past due		6,103			—			6,103
Allowance for loan losses
General component		3,053			3,487			(434	)
Specific component⁽¹⁾		—			—			—

Total allowance	$	3,053		$	3,487		$	(434	)
Ratio of allowance to loan category		0.72	%		0.83	%		(0.11	)%
Land development	$	19,371		$	24,018		$	(4,647	)
Loans impaired⁽¹⁾		—			314			(314	)
Loans 90 days past due		—			314			(314	)
Loans 30 days past due		—			—			—
Allowance for loan losses
General component	$	216		$	248		$	(32	)
Specific component⁽¹⁾		—			—			—

Total allowance	$	216		$	248		$	(32	)
Ratio of allowance to loan category		1.12	%		1.03	%		0.09	%
Consumer loans and single family mortgages	$	107,675		$	114,559		$	(6,884	)
Loans impaired⁽¹⁾		829			839			(10	)
Loans 90 days past due		735			359			376
Loans 30 days past due		—			637			(637	)
Allowance for loan losses
General component	$	899		$	806		$	93
Specific component⁽¹⁾		—			—			—

Total allowance	$	899		$	806		$	93
Ratio of allowance to loan category		0.83	%		0.70	%		0.13	%
Total loans outstanding	$	714,917		$	730,599		$	(15,682	)
Loans impaired⁽¹⁾		36,813			39,251			(2,438	)
Loans 90 days past due		8,713			10,799			(2,086	)
Loans 30 days past due		11,358			2,736			8,622
Allowance for loan losses
General component	$	8,618		$	8,453		$	165
Specific component⁽¹⁾		2,400			2,428			(28	)

Total allowance	$	11,018		$	10,881		$	137
Ratio of allowance to total loans outstanding		1.54	%		1.49	%		0.05	%

⁽¹⁾	Amounts in impaired loans and in specific components include nonperforming delinquent loans.

We classify our loan portfolios using internal credit quality ratings. The following table provides a summary of loans by portfolio type and the Company’s internal credit quality ratings as of March 31, 2013 and December 31, 2012.


(Dollars in thousands)	March 31, 2013		December 31, 2012		Increase (Decrease)
Pass:
Commercial loans	$	142,364	$	146,952	$	(4,588	)
Commercial real estate loans – owner occupied		155,229		162,689		(7,460	)
Commercial real estate loans – all other		145,039		135,274		9,765
Residential mortgage loans – multi family		100,703		104,747		(4,044	)
Residential mortgage loans – single family		78,543		84,237		(5,694	)
Land development loans		11,212		12,461		(1,249	)
Consumer loans		23,550		27,296		(3,746	)

Total pass loans	$	656,640	$	673,656	$	(17,016	)

Special Mention:
Commercial loans	$	2,263	$	2,381	$	(118	)
Commercial real estate loans – owner occupied		—		—		0
Commercial real estate loans – all other		7,612		3,859		3,753
Residential mortgage loans – multi family		—		373		(373	)
Residential mortgage loans – single family		988		990		(2	)
Land development loans		8,160		8,201		(41	)
Consumer loans		2,572		—		2,572

Total special mention loans	$	21,595	$	15,804	$	5,791

Substandard:
Commercial loans	$	20,353	$	21,347	$	(994	)
Commercial real estate loans – owner occupied		2,926		3,232		(306	)
Commercial real estate loans – all other		10,307		11,057		(750	)
Residential mortgage loans – multi family		—		—		—
Residential mortgage loans – single family		2,022		2,036		(14	)
Land development loans		—		3,355		(3,355	)
Consumer loans		—		—		—

Total substandard loans	$	35,608	$	41,027	$	(5,419	)

Doubtful:
Commercial loans	$	1,074	$	112	$	962
Commercial real estate loans – owner occupied		—		—		—
Commercial real estate loans – all other		—		—		—
Residential mortgage loans – multi family		—		—		—
Residential mortgage loans – single family		—		—		—
Land development loans		—		—		—
Consumer loans		—		—		—

Total doubtful loans	$	1,074	$	112	$	962

Total Outstanding Loans, gross:	$	714,917	$	730,599	$	(15,682	)

The disaggregation of the loan portfolio by risk rating in the table above reflects the following changes that occurred between December 31, 2012 and March 31, 2013:

•

Loans rated “pass” decreased by $17 million to $657 million at March 31, 2013, from $674 million at December 31, 2012, due primarily to the $16 million decrease in total loans outstanding.

•

Loans rated “special mention” increased by $5.8 million to $21.6 million at March 31, 2013, from $15.8 million at year end 2012, primarily as a result of downgrades of a $3.8 million commercial real estate loan and a $2.0 million consumer loan.

•

Loans classified “substandard” decreased by $5.4 million to $35.6 million at March 31, 2013, from $41.0 million at December 31, 2012, due primarily to an upgrade to “pass” of a $2 milllion commercial real estate loan which has performed according to terms over an extended period of time, a downgrade to “doubtful” of a $1.0 million commercial loan and the foreclosure and transfer to OREO of $1.6 million of loans that had been classified as “substandard”.

•

Loans classified as “doubtful” increased by $1 million due to a downgrade from “substandard” of a commercial loan as a result of a bankruptcy filing by the borrower.

We use a rolling eight quarter loss migration analysis to determine the loss factors we will apply to each of the classification categories. As a result, for purposes of determining applicable loss factors at the March 31, 2013, our migration analysis covered the period from March 31, 2011 to March 31, 2013. That migration analysis resulted in a modest reduction in the loss factors in the quantitative component of our March 31, 2013 ALL analysis, which we believe was consistent with and reasonably reflects current economic conditions and the risks that were inherent in our loan portfolio at March 31, 2013.

The table below sets forth loan delinquencies, by quarter, from March 31, 2013 to March 31, 2012.


	2013		2012
(Dollars in thousands)	At March 31		At December 31		At September 30		At June 30		At March 31
Loans Delinquent:
90 days or more:
Commercial loans	$	2,935	$	4,295	$	4,727	$	4,775	$	3,231
Commercial real estate		5,043		5,831		3,863		5,491		2,253
Residential mortgages		735		359		348		—		1,677
Land development loans		—		314		—		528		539
Consumer loans		—		—		—		—		—

		8,713		10,799		8,938		10,794		7,700

30-89 days:
Commercial loans		5,255		2,099		609		12,239		4,961
Commercial real estate		6,103		—		428		—		3,334
Residential mortgages		—		637		1,237		347		758
Land development loans		—		—		664		320		—
Consumer loans		—		—		5		2		—

		11,358		2,736		2,943		12,908		9,053

Total Past Due⁽¹⁾ :	$	20,071	$	13,535	$	11,881	$	23,702		16,753

⁽¹⁾	Past due balances include nonaccrual loans.

As the above table indicates, total past due loans increased by $6.5 million, to $20.1 million at March 31, 2013, from $13.5 million at December 31, 2012. Loans past due 90 days or more decreased by $2.1 million, to $8.7 million at March 31, 2013, from $10.8 million at December 31, 2012, primarily due to the foreclosure and transfers to OREO of $1.6 million of real estate loan during the three months ended March 31, 2013.

Loans 30-89 days past due increased by $8.6 million to $11.3 million at March 31, 2013, from $2.7 million at December 31, 2012, primarily due to a dispute with respect to a $5.4 million commercial loan relationship and the bankruptcy of a borrower with an outstanding $1.0 million commercial loan.

Set forth below is a summary of the transactions in the ALL in the three months ended March 31, 2013 and the year ended December 31, 2012:


(Dollars in thousands)	Three Months Ended March 31, 2013			Year Ended December 31, 2012
Balance, beginning of period	$	10,881		$	15,627
Charged off loans		(1,485	)		(8,574	)
Recoveries on loans previously charged off		472			1,878
Provision for loan losses		1,150			1,950

Balance, end of period	$	11,018		$	10,881

As the above table indicates, at March 31, 2013 the ALL totaled $11.0 million, or 1.54% of the loans then outstanding. The net charge-offs for the quarter totaled $1.0 million, offset by $1.15 million of provisions made for loan losses in the three months ended March 31, 2013. The loan charge-offs were primarily attributable to a $1.0 million write-down to a commercial loan relationship. On the basis of the methodologies we use to assess asset quality, bank regulatory guidelines and our historical loan loss history, we believe that the ALL was adequate to cover potential losses in the loan portfolio at March 31, 2013.

Deposits

Average Balances of and Average Interest Rates Paid on Deposits

Set forth below are the average amounts (in thousands of dollars) of, and the average rates paid on, deposits in the three months ended March 31, 2013:


	Three Months Ended March 31, 2013
	Average Balance		Average Rate
Noninterest-bearing demand deposits	$	184,159		—
Interest-bearing checking accounts		33,228		0.26	%
Money market and savings deposits		168,355		0.48	%
Time deposits		457,608		1.05	%

Average total deposits	$	843,350		0.68	%

Deposit Totals. Deposits totaled $816 million at March 31, 2013 as compared to $845 million at December 31, 2012 and $868 million at March 31, 2012. The following table compares the mix of our deposits, as between lower cost core deposits and higher cost time deposits, at March 31, 2013, December 31, 2012 and March 31, 2012, respectively:


	At March 31, 2013					At December 31, 2012					At March 31, 2012
(Dollars in thousands)	Amounts		Percent of Total Deposits			Amounts		Percent of Total Deposits			Amounts		Percent of Total Deposits
Core deposits
Noninterest bearing demand deposits	$	183,185		22.5	%	$	170,259		20.1	%	$	166,102		19.2	%
Savings and other interest-bearing transaction deposits		202,021		24.8	%		194,215		23.0	%		207,887		23.9	%
Time deposits		430,387		52.7	%		480,921		56.9	%		494,073		56.9	%

Total deposits	$	815,593		100.0	%	$	845,395		100.0	%	$	868,062		100.0	%

As indicated in the above table, noninterest bearing demand deposits and savings and other interest-bearing deposits increased to 22.5% and 24.8%, respectively, of total deposits at March 31, 2013, from 20.1% and 23.0%, respectively, of total deposits at December 31, 2012. The mix of deposits changed as a result of a decrease in higher-priced time deposits to 52.7% of total deposits at March 31, 2013 from 56.9% of total deposits at March 31, 2012. That change in the mix of deposits contributed to the reduction in interest expense in this year’s third quarter, as compared to the same quarter of 2012. See “—Results of Operations—Net Interest Income” above in this Section of this Report.

Set forth below, in thousands of dollars, is a maturity schedule of domestic time certificates of deposit outstanding at March 31, 2013:


	At March 31, 2013
	Certificates of Deposit under $100,000		Certificates of Deposit of $100,000 or More
Maturities
Three months or less	$	13,110	$	63,926
Over three and through nine months		13,799		60,032
Over nine and through twelve months		29,730		176,711
Over twelve months		8,172		64,907

Total certificates of deposit	$	64,811	$	365,576

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 on loans, proceeds from the sale or maturity of securities, and from sales of residential mortgage loans, increases in deposits and increases in borrowings principally from the Federal Home Loan Bank. 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 the Federal Home Loan Bank and other financial institutions to meet any additional liquidity requirements.

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 Federal Reserve Bank and Federal Home Loan Bank stock) totaled $208 million, which represented 20% of total assets at March 31, 2013.

Cash Flow Provided by Operating Activities. In the three months ended March 31, 2013, operating activities provided net cash of $24 million, comprised primarily of $88 million from sales of mortgages loans available for sale, partially offset by the use of $57 million to fund new mortgage loan originations. By contrast, operating activities used $12 million of cash in the three months ended March 31, 2012 as mortgage loan originations, totaling $144 million, exceeded proceeds from sales of mortgage loans, which totaled $134 million, by approximately $10.1 million. The decrease in mortgage loan originations in the three months ended March 31, 2013 was due primarily to our exit from the wholesale residential mortgage business in August 2012.

Cash Flow Provided by Investing Activities. In the three months ended March 31, 2013, investing activities provided net cash of $30 million, comprised primarily of $8 million from sales of OREO, $6 million from sales of securities available for sale and a $13 million net decrease in outstanding loans. In the three months ended March 31, 2012, financing activities provided net cash of $77 million consisting primarily of $136 million of proceeds from sales of securities available for sale, $4 million from the maturities of or payments of principal on securities available for sale and $1 million from sales of OREO, which more than offset the use of $35 million to purchase securities available for sale and $28 million to fund new loans.

Cash Flow Used in Financing Activities. In the three months ended March 31, 2013, we used $25 million in financing activities, comprised primarily of a $30 million decrease in deposits and a $10 million decrease in borrowings, partially offset by $15 million of proceeds from the sale of 2,222,222 shares of our common stock, at a price of $6.75 per share, to the Carpenter Funds in March 2013. In the three months ended March 31, 2012, financing activities provided cash of $11 million, comprised of increases of $6 million in deposits and $5 million in borrowings.

Ratio of Loans to Deposits. The relationship between gross loans and total deposits can provide a useful measure of a bank’s liquidity. Since repayments of loans tend to be less predictable than the maturity of investments and other liquid resources, the higher the loan-to-deposit ratio the less liquid are a bank’s 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 our 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 March 31, 2013 and December 31, 2012, the loan-to-deposit ratios were 88% and 86%, respectively.

Off Balance Sheet Arrangements

Loan Commitments and Standby Letters of Credit. In order to meet the financing needs of our customers, in the normal course of business we make commitments to extend credit and issue standby commercial letters of credit to or for our customers. At March 31, 2013 and December 31, 2012, we were committed to fund certain loans, including letters of credit, amounting to approximately $221 million and $118 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.

We believe that our cash and cash equivalent resources, together with available borrowings under our credit facilities, will be sufficient to enable us to meet any increases in demand for loans or in the utilization of outstanding loan commitments or standby letters of credit and any increase in deposit withdrawals that might occur in the foreseeable future.

Borrowings and Contractual Obligations

Borrowings. As of March 31, 2013, we had $22.5 million of outstanding short-term borrowings and $22.5 million of outstanding long-term borrowings that we had obtained from the Federal Home Loan Bank. The following table sets forth the principal amounts of, the interest rates we paid on, and the maturity dates of these Federal Home Loan Bank borrowings. These borrowings, along with the securities sold under agreements to repurchase, had a weighted-average annualized interest rate of 0.74% during the first quarter of 2013.


Principal Amounts		Interest Rate			Maturity Dates	Principal Amounts		Interest Rate			Maturity Dates
(Dollars in thousands)
	$5,000		1.06	%	August 9, 2013	$	5,000		0.48	%	May 6, 2014
	5,000		0.41	%	November 5, 2013		3,000		0.64	%	September 26, 2014
	7,500		0.49	%	March 3, 2014		4,500		0.78	%	March 26, 2015
	5,000		0.56	%	March 26, 2014		5,000		0.76	%	March 30, 2015
	5,000		0.48	%	April 14, 2014

At March 31, 2013, U.S. Agency and mortgage backed securities, U.S. Government agency securities and collateralized mortgage obligations with an aggregate fair market value of $2 million and $149 million of residential mortgage and other real estate secured loans were pledged to secure these Federal Home Loan Bank borrowings, repurchase agreements, local agency deposits and treasury, tax and loan accounts.

The highest amount of borrowings outstanding at any month end in the quarter ended March 31, 2013 consisted of $55 million of borrowings from the Federal Home Loan Bank. By

comparison, the highest amount of borrowings outstanding at any month end in 2012 consisted of $69 million of borrowings from the Federal Home Loan Bank.

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 March 31, 2013, we had outstanding approximately $17.5 million principal amount of 30-year junior subordinated floating rate debentures (the “Debentures”), of which $16.8 million qualified as Tier 1 capital for regulatory purposes as of March 31, 2013. See discussion below under the subcaption “—Capital Resources-Regulatory Capital Requirements.”

Set forth below is certain information regarding the Debentures:

(Dollars in thousands)

Principal Amount

Interest Rate

Maturity Dates⁽¹⁾

September 2002

7,217

90 day Libor plus 3.40

September 2032

October 2004

10,310

90 day 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.

Interest on the Debentures is payable quarterly. However, subject to certain conditions, we are entitled by the express terms of the Debentures to defer those interest payments for up to 20 quarters.

As previously reported, since July 2009 we have been required to obtain the prior approval of the Federal Reserve Bank of San Francisco (the “FRBSF”) to make interest payments on the Debentures. Since September 2010, we have been unable to obtain FRBSF approvals needed to permit us to make interest payments on the Debentures. As a result, as of March 31, 2013, we had deferred 10 quarterly interest payments, totaling $756,000, on the $7.2 million of Debentures due in September, 2032, and 11 quarterly interest payments, totaling $813,000, on the $10.3 million of Debentures due in October, 2034. 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) quarters, the deferrals of interest payments to date have not, and any deferral of future interest payments through January, 2015, will not constitute a default under or with respect to the Debentures. However, if we are not able to obtain regulatory approval to pay all of the deferred interest payments by January, 2015, we would then be in default under the Debentures. 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 and a regulatory order issued by the California Department of Financial Institutions, see “Capital Resources-Capital and Other Requirements under FRB Agreement and DFI Order” below in this section of this report and “Supervision and Regulation-Regulatory Action by the FRB and DFI” in Item 1 and “RISK FACTORS” in Item 1A in Part I of our 2012 10-K.

Investment Policy and Securities Available for Sale

Our investment policy is designed to provide for our liquidity needs and to generate a favorable return on investments without undue interest rate risk, credit risk or asset concentrations.

Our investment policy:

•

authorizes us to invest in obligations issued or fully guaranteed by the United States Government, certain federal agency obligations, time deposits issued by federally insured depository institutions, municipal securities and in federal funds sold;

•

provides that the aggregate weighted average life of U.S. Government obligations and federal agency securities exclusive of variable rate securities cannot, without approval by the Board of Directors, exceed 10 years and municipal obligations cannot exceed 25 years;

•

provides that time deposits must be placed with federally insured financial institutions, cannot exceed the current federally insured amount in any one institution and may not have a maturity exceeding 60 months, unless that time deposit is matched to a liability instrument issued by the Bank; and

•

prohibits engaging in securities trading activities.

Securities available for sale are those that we intend to hold for an indefinite period of time, but which we may sell in response to changes in liquidity needs, changes in interest rates, changes in prepayment risks or other similar factors. Such securities are recorded at fair value. Any unrealized gains and losses are reported as “Other Comprehensive Income (Loss)” rather than included in or deducted from 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 gross unrealized gains and losses, in each case, in thousands of dollars, as of March 31, 2013 and December 31, 2012:


(Dollars in thousands)	Amortized Cost		Gross Unrealized Gain		Gross Unrealized Loss			Estimated Fair Value
Securities available for sale at March 31, 2013:
Mortgage backed securities issued by U.S. Agencies⁽¹⁾	$	68,028	$	246	$	(494	)	$	67,780
Collateralized non-agency mortgage obligations⁽¹⁾		2,462		98		(51	)		2,509
Asset backed securities⁽²⁾		2,247		—		(1,390	)		857
Mutual funds⁽³⁾		4,376		—		—			4,376

Total securities available for sale	$	77,113	$	344	$	(1,935	)	$	75,522

Securities available for sale at December 31, 2012:
Mortgage-backed securities issued by U.S. agencies⁽¹⁾	$	78,053	$	553	$	(160	)	$	78,446
Collateralized non-agency mortgage obligations⁽¹⁾		2,599		87		(61	)		2,625
Asset backed securities⁽²⁾		2,247		—		(1,347	)		900
Mutual funds⁽³⁾		4,407		—		—			4,407

Total securities available for sale	$	87,306	$	640	$	(1,568	)	$	86,378

⁽¹⁾	Secured by closed-end first lien 1-4 family residential mortgages.

⁽²⁾	Comprised of a security that represents an interest in a pool of trust preferred securities issued by U.S.-based banks and insurance companies

⁽³⁾	Consists primarily of mutual fund investments in closed-end first lien 1-4 family residential mortgages.

At March 31, 2013, U.S. agencies and mortgage backed securities, U.S. government agency securities, collateralized mortgage obligations and time deposits with an aggregate fair market value of $14 million were pledged to secure FHLB borrowings, repurchase agreements, local agency deposits, to secure lines of credit at our correspondent banks and treasury, and tax and loan accounts.

The amortized costs, at March 31, 2013, of securities available for sale are shown in the following table, by contractual maturities and historical prepayments based on the prior three months of principal payments. Expected maturities will differ from contractual maturities and historical prepayments, particularly with respect to collateralized mortgage obligations, because borrowers may react to interest rate market conditions differently than the historical prepayment rates.


	March 31, 2013 Maturing in
	One year or less					Over one year through five years					Over five years through ten years					Over ten years					Total
(Dollars in thousands)	Book Value		Weighted Average Yield			Book Value		Weighted Average Yield			Book Value		Weighted Average Yield			Book Value		Weighted Average Yield			Book Value		Weighted Average Yield
Securities available for sale:
Mortgage-backed securities issued by U.S. Agencies	$	10,169		1.41	%	$	27,279		1.45	%	$	19,829		1.49	%	$	10,751		1.55	%	$	68,028		1.47	%
Collateralized non-agency mortgage obligations		724		2.24	%		1,195		3.36	%		—		—			543		4.07	%		2,462		3.18	%
Asset backed securities		—		—			—		—			—		—		$	2,247		0	%	$	2,247		0	%
Mutual funds		—		—			4,376		1.90	%		—		—			—		—			4,376		1.90	%

Total securities available for sale	$	10,893		1.46	%	$	32,850		1.58	%	$	19,829		1.49	%	$	13,541		1.40	%	$	77,113		1.51	%

The table below shows, as of March 31, 2013, the gross unrealized losses and fair values of our investments, aggregated by investment category, and the length of time that the individual securities have been in a continuous unrealized loss position.


	Securities with Unrealized Loss at March 31, 2013
	Less than 12 months					12 months or more					Total
Dollars in thousands	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
Mortgage backed securities issued by U.S. agencies		34,896		(494	)		39		0			34,935		(494	)
Collateralized non-agency mortgage obligations		—		—			1,143		(51	)		1,143		(51	)
Asset backed securities		—		—			858		(1,390	)		858		(1,390	)

Total temporarily impaired securities	$	34,896	$	(494	)	$	2,040	$	(1,441	)	$	36,936	$	(1,935	)

Impairment exists when the fair value of the security has declined below its cost. We perform quarterly assessments of the securities that have an unrealized loss to determine whether the decline in fair value of those securities below their cost is other-than-temporary.

We adopted ASC 321-10 effective April 1, 2009 and, accordingly, we recognize other-than-temporary impairments (“OTTI”) to our available-for-sale debt securities. In accordance with ASC 321-10, when there are credit losses associated with an impaired debt security and (i) we do not have the intent to sell the security and (ii) it is more likely than not that we will not have to sell the security before recovery of its cost basis, then, we will separate the amount of an impairment that is credit-related from the amount thereof related to non-credit factors. The credit-related impairment is recognized in our consolidated statements of income. The non-credit-related impairment is recognized and reflected in Other Comprehensive Income.

Capital Resources

Capital Regulatory 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, which are based primarily on those quantitative measures, 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 March 31, 2013, as compared to the respective regulatory requirements applicable to them.


	Actual					Applicable Federal Regulatory Requirement
	Actual					To be Categorized as Adequately Capitalized					To be Categorized as Well Capitalized
(Dollars in thousands)	Amount		Ratio			Amount		Ratio			Amount		Ratio
Total Capital to Risk Weighted Assets:
Company	$	151,376		18.6	%	$	65,168		At least 8	%		N/A		N/A
Bank		129,327		16.1	%		64,277		At least 8	%	$	80,346		At least 10	%
Tier 1 Capital to Risk Weighted Assets:
Company	$	141,181		17.3	%	$	32,584		At least 4	%		N/A		N/A
Bank		119,269		14.8	%		32,138		At least 4	%	$	48,207		At least 6	%
Tier 1 Capital to Average Assets:
Company	$	141,181		13.6	%	$	41,452		At least 4	%		N/A		N/A
Bank		119,269		11.5	%		41,406		At least 4	%	$	51,758		At least 5	%

At March 31, 2013, 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, under the capital adequacy guidelines described above.

The Company’s consolidated total capital and Tier 1 capital, at March 31, 2013, includes an aggregate of $16.8 million principal amount of the $17.5 million of Junior Subordinated Debentures that we issued in 2002 and 2004. We contributed that amount to the Bank over the three year period ended December 31, 2009, 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.

Basel III Capital Requirements.

The current risk-based capital guidelines are based upon the 1988 capital accord of the International Basel Committee on Banking Supervision (the “BCBS”), which is a committee of central banks and bank supervisors/regulators from the major industrialized countries that develops broad policy guidelines for use by each country’s banking regulators in determining the banking supervisory policies they apply. In December 2010, the BCBS issued a new set of international guidelines for determining regulatory capital, known as “Basel III.” These guidelines were revised in June 2011. As revised, the Basel III capital guidelines would increase minimum capital requirements, and when fully implemented, would require banks to maintain a minimum ratio of Tier 1 common equity-to-risk-weighted assets of at least 4.5 percent plus a 2.5 percent capital conservation buffer.

In June 2012, the Federal Reserve Board issued three notices of proposed rulemaking (the “Basel III NPRs”) that would revise the regulatory risk-based capital and leverage requirements for banks in the United States consistent with the Basel III guidelines. The proposed revisions include the implementation of a more conservative definition of capital, a new common equity Tier 1 minimum capital requirement, a higher minimum Tier 1 capital requirement, and a supplementary leverage ratio. In addition, the Federal Reserve

Board and other federal bank regulatory agencies have proposed to revise the calculation of risk-weighted assets under the general risk-based capital rule that would be applicable to all banks, including the Bank.

The Federal Reserve Board has delayed the finalization of its Basel III NPRs, but has not, as yet, provided any guidance as to when the final rules will be adopted or as to the duration of the transition period over which banks will be permitted to implement these new requirements.

Capital and Other Requirements under FRB Agreement and DFI Order.

On August 31, 2010, the Company and the Bank entered into a regulatory agreement with the FRBSF (the “FRB Agreement”) and the Bank consented to the issuance, by California Department of Financial Institutions (the “DFI”), of a regulatory order (the “DFI Order”).

The principal purposes of the FRB Agreement and the DFI Order, which constitute formal supervisory actions by the FRB and the DFI, were to require the Company and the Bank to adopt and implement formal plans and take certain actions, as well as to continue implementing measures that we previously adopted, to address the adverse consequences that the

economic recession and weakened state of the economy have had on the performance of our loan portfolio and 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 FRB Agreement and DFI Order contain substantially similar provisions. They required the Boards of Directors of the Company and the Bank to prepare and submit written plans to the FRBSF and the DFI that address a number of matters, including improving the Bank’s position with respect to problem assets, maintaining adequate reserves for loan and lease losses in accordance with applicable supervisory guidelines, and improving the capital position of the Bank and, in the case of the FRB Agreement, the capital position of the Company. The Bank is also prohibited from paying dividends to the Company without the prior approval of the DFI, and the Company may not declare or pay cash dividends, repurchase any of its shares, make interest or principal payments on its Junior Subordinated Debentures or incur or guarantee any debt without the prior approval of FRBSF.

The DFI Order also states that if we were to violate or fail to comply with the Order the Bank could be deemed to be conducting business in an unsafe manner which could subject the Bank to further regulatory enforcement action.

The FRB Agreement also required us to submit a capital plan to the FRBSF that would meet with its approval and then to implement that plan. Under the DFI Order, the Bank was required to achieve a ratio of adjusted tangible shareholders’ equity to its tangible assets of 9% by January 31, 2011, by raising additional capital, generating earnings or reducing the Bank’s tangible assets (subject to a 15% limitation on such a reduction) or a combination thereof and, upon achieving that ratio, to maintain at least a 9% ratio during the remaining term of the Order.

The Company and the Bank have made substantial progress with respect to the requirements of the FRB Agreement and the DFI Order and both the Board and management are committed to achieving all of those requirements.

Among other things, on August 26, 2011, we sold to three institutional investors (the “Investors”) a total of 112,000 shares of a newly created Series B Convertible 8.4% Noncumulative Preferred Stock (the “Series B Shares”), at a price of $100.00 per share in cash, generating aggregate gross proceeds to the Company of $11.2 million. The Investors were SBAV LP, an affiliate of the Clinton Group, which purchased 75,000 Series B Shares, and the Carpenter Funds which, together, purchased a total of 37,000 Series B Shares. We contributed the net proceeds from the sale of those Series B Shares to the Bank, which enabled it to increase the ratio of its adjusted tangible shareholders’ equity to its tangible assets above 9% and thereby meet the capital requirements under the DFI Order.

As previously reported, on April 20, 2012 we sold to the Carpenter Funds a total of 4,201,278 shares of our common stock at a price of $6.26 per share in cash, generating aggregate gross proceeds to the Company of $26.3 million, which has further increased the amount of our Tier 1 capital. We then used $15.0 million of those proceeds to make a capital contribution to the Bank.

Effective as of March 30, 2013, we sold a total of 2,222,222 shares of our common stock to Carpenter Community Bancfund L.P. and Carpenter Community Bancfund-A, L.P. (the “Carpenter Funds”), at a price of $6.75 per share in cash, generating gross proceeds to us of $15 million. The purchase price of $6.75 per share of common stock is equal to the Company’s tangible book value per share of common stock as of December 31, 2012. The proceeds from the sale of those shares were contributed by the Company to capitalize a new wholly-owned asset management subsidiary, which has used those proceeds to fund the purchase of $10 million of nonperforming loans and foreclosed real properties from the Bank. As a result of these capital contributions and the income generated by the Bank since 2011 the ratio of the Bank’s adjusted tangible shareholders’ equity to its tangible assets had increased to 12.4% at March 31, 2013.

Additional information regarding the FRB Agreement and the DFI Order is set forth in our 2012 10-K in the subsection of Item 1 thereof entitled “Supervision and Regulation—Regulatory Action by the FRB and DFI” and in Item 1A thereof entitled “RISK FACTORS”.

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 their capital positions and the Bank’s liquidity. Moreover, since mid-2009, bank regulatory restrictions, including those under the FRB Agreement and DFI Order, 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 at least for the foreseeable future.

ITEM 4T.

CONTROLS AND PROCEDURES

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, our management recognized that any system of controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, as ours are designed to do, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by Rules 13a-15 and 15d-15 under the Exchange Act, in connection with the filing of this Quarterly Report on Form 10-Q, an evaluation was performed under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of March 31, 2013. Based on that evaluation, our CEO and CFO have concluded that, as of March 31, 2013, the Company’s disclosure controls and procedures were effective to provide reasonable assurance that information required to disclose in our reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules of the Securities and Exchange Commission and that such information is accumulated and communicated to management, including our Chief Executive and Chief Financial Officers, to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting during the three months ended March 31, 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II

ITEM 1A.

RISK FACTORS

There have been no material changes in our assessment of our risk factors from those set forth in our 2012 10-K.

ITEM 6.

EXHIBITS

The following documents are filed as Exhibits to this Quarterly Report on Form 10-Q:


Exhibit No.		Description of Exhibit

Exhibit 31.1		Certification of Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 31.2		Certification of Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 32.1		Certification of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit 32.2		Certification of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit 101.INS		XBRL Instance Document

Exhibit 101.SCH		XBRL Taxonomy Extension Schema Document

Exhibit 101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document

Exhibit 101.DEF		XBRL Taxonomy Extension Definition Linkbase Document

Exhibit 101.LAB		XBRL Taxonomy Extension Labels Linkbase Document

Exhibit 101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document

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.

S-1

EXHIBIT INDEX


Exhibit No.		Description of Exhibit

Exhibit 31.1		Certification of Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 31.2		Certification of Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 32.1		Certification of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit 32.2		Certification of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit 101.INS		XBRL Instance Document

Exhibit 101.SCH		XBRL Taxonomy Extension Schema Document

Exhibit 101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document

Exhibit 101.DEF		XBRL Taxonomy Extension Definition Linkbase Document

Exhibit 101.LAB		XBRL Taxonomy Extension Labels Linkbase Document

Exhibit 101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document

E-1