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UNITED SECURITY BANCSHARES - Quarter Report: 2007 June (Form 10-Q)

Unassociated Document
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q

x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2007.

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

Commission file number: 000-32987
 
UNITED SECURITY BANCSHARES
(Exact name of registrant as specified in its charter)

CALIFORNIA
 
91-2112732
(State or other jurisdiction of
 
(I.R.S. Employer
incorporation or organization)
 
Identification No.)
     
1525 East Shaw Ave., Fresno, California
 
93710
(Address of principal executive offices)
 
(Zip Code)
 
Registrants telephone number, including area code (559) 248-4943

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 for the past 90 days.
Yes No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
Large accelerated filer o Accelerated filer x Non-accelerated filer o

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

Aggregate market value of the Common Stock held by non-affiliates as of the last business day of the registrant's most recently completed second fiscal quarter - June 30, 2007: $176,229,651

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

Common Stock, no par value
(Title of Class)

Shares outstanding as of July 31, 2007: 11,932,000  


 
TABLE OF CONTENTS

Facing Page

Table of Contents
 
PART I. Financial Information
2
       
 
Item 1.
Financial Statements
 
       
   
Consolidated Balance Sheets
2
   
Consolidated Statements of Income and Comprehensive Income
 3
   
Consolidated Statements of Changes in Shareholders' Equity
 4
   
Consolidated Statements of Cash Flows
 5
   
Notes to Consolidated Financial Statements
 6
       
 
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
 17
       
   
Overview
 17
   
Results of Operations
 19
   
Financial Condition
 23
   
Liquidity and Asset/Liability Management
 30
   
Regulatory Matters
 31
       
 
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
 31
       
   
Interest Rate Sensitivity and Market Risk
 31
       
 
Item 4.
Controls and Procedures
 33
       
PART II. Other Information
 34
       
 
Item 1.
Legal Proceedings
 34
 
Item 1A.
Risk Factors
 34
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceed
 34
 
Item 3.
Defaults Upon Senior Securities
 35
 
Item 4.
Submission of Matters to a Vote of Security Holders
 35
 
Item 5.
Other Information
 35
 
Item 6.
Exhibits
 35
       
Signatures
 36
 
1

 
PART I. Financial Information
 
United Security Bancshares and Subsidiaries
   
Consolidated Balance Sheets - (unaudited)
   
June 30, 2007 and December 31, 2006
   
 
   
June 30,
 
December 31,
 
(in thousands except shares)
 
2007
 
2006
 
Assets
         
Cash and due from banks
 
$
24,190
 
$
28,771
 
Federal funds sold
   
2,376
   
14,297
 
Cash and cash equivalents
   
26,566
   
43,068
 
Interest-bearing deposits in other banks
   
7,910
   
7,893
 
Investment securities available for sale at fair value
   
91,636
   
83,366
 
Loans and leases
   
590,264
   
500,568
 
Unearned fees
   
(1,234
)
 
(999
)
Allowance for credit losses
   
(9,905
)
 
(8,365
)
Net loans
   
579,125
   
491,204
 
Accrued interest receivable
   
4,477
   
4,237
 
Premises and equipment - net
   
15,970
   
15,302
 
Other real estate owned
   
1,919
   
1,919
 
Intangible assets
   
4,803
   
2,264
 
Goodwill
   
8,835
   
750
 
Cash surrender value of life insurance
   
13,769
   
13,668
 
Investment in limited partnership
   
3,347
   
3,564
 
Deferred income taxes
   
8,006
   
5,307
 
Other assets
   
5,949
   
5,772
 
Total assets
 
$
772,312
 
$
678,314
 
               
Liabilities & Shareholders' Equity
             
Liabilities
             
Deposits
             
Noninterest bearing
 
$
137,563
 
$
159,002
 
Interest bearing
   
503,624
   
428,125
 
Total deposits
   
641,187
   
587,127
 
Federal funds purchased
   
13,060
   
0
 
Other borrowings
   
10,000
   
0
 
Accrued interest payable
   
1,831
   
2,477
 
Accounts payable and other liabilities
   
7,867
   
7,204
 
Junior subordinated debentures (at fair value 6/30/07)
   
16,998
   
15,464
 
Total liabilities
   
690,943
   
612,272
 
               
Shareholders' Equity
             
Common stock, no par value 
20,000,000 shares authorized, 11,943,363 and 11,301,113
issued and outstanding, in 2007 and 2006, respectively
   
33,966
   
20,448
 
Retained earnings
   
48,618
   
46,884
 
Accumulated other comprehensive loss
   
(1,215
)
 
(1,290
)
Total shareholders' equity
   
81,369
   
66,042
 
Total liabilities and shareholders' equity
 
$
772,312
 
$
678,314
 
 
See notes to consolidated financial statements 

2

 
United Security Bancshares and Subsidiaries
Consolidated Statements of Income and Comprehensive Income (unaudited)
 
   
Quarter Ended June 30,
 
Six Months Ended June 30,
 
(In thousands except shares and EPS)
 
2007
 
2006
 
2007
 
2006
 
Interest Income:
                 
Loans, including fees
 
$
12,809
 
$
10,421
 
$
25,909
 
$
19,675
 
Investment securities AFS – taxable
   
1,000
   
803
   
1,933
   
1,642
 
Investment securities – AFS – nontaxable
   
27
   
27
   
54
   
54
 
Federal funds sold
   
49
   
79
   
145
   
429
 
Interest on deposits in other banks
   
77
   
80
   
157
   
161
 
Total interest income
   
13,962
   
11,410
   
28,198
   
21,961
 
Interest Expense:
                         
Interest on deposits
   
4,531
   
2,880
   
8,588
   
5,326
 
Interest on other borrowings
   
595
   
431
   
1,041
   
724
 
Total interest expense
   
5,126
   
3,311
   
9,629
   
6,050
 
Net Interest Income Before
                         
Provision for Credit Losses
   
8,836
   
8,099
   
18,569
   
15,911
 
Provision for Credit Losses
   
208
   
123
   
410
   
363
 
Net Interest Income
   
8,628
   
7,976
   
18,159
   
15,548
 
Noninterest Income:
                         
Customer service fees
   
1,176
   
964
   
2,312
   
2,000
 
Gain on sale of other real estate owned
   
11
   
12
   
23
   
27
 
Gain on proceeds from bank-owned life insurance
   
219
   
477
   
219
   
477
 
Gain (loss) on swap ineffectiveness
   
33
   
(147
)
 
32
   
(147
)
Gain on fair value option of financial liabilities
   
113
   
0
   
113
   
0
 
Gain on sale of investment in correspondent bank stock
   
0
   
0
   
0
   
1,877
 
Shared appreciation income
   
18
   
0
   
24
   
0
 
Other
   
384
   
288
   
812
   
567
 
Total noninterest income
   
1,954
   
1,594
   
3,535
   
4,801
 
Noninterest Expense:
                         
Salaries and employee benefits
   
2,795
   
2,374
   
5,482
   
4,810
 
Occupancy expense
   
917
   
614
   
1,740
   
1,203
 
Data processing
   
99
   
145
   
236
   
277
 
Professional fees
   
333
   
207
   
766
   
420
 
Director fees
   
72
   
56
   
128
   
110
 
Amortization of intangibles
   
278
   
135
   
462
   
269
 
Correspondent bank service charges
   
129
   
51
   
205
   
100
 
Loss on California tax credit partnership
   
116
   
110
   
217
   
220
 
OREO expense
   
33
   
680
   
75
   
934
 
Other
   
745
   
664
   
1,406
   
1,241
 
Total noninterest expense
   
5,517
   
5,036
   
10,717
   
9,584
 
Income Before Taxes on Income
   
5,065
   
4,534
   
10,977
   
10,765
 
Provision for Taxes on Income
   
1,757
   
1,472
   
4,066
   
3,839
 
Net Income
 
$
3,308
 
$
3,062
 
$
6,911
 
$
6,926
 
Other comprehensive income, net of tax:
                         
Unrealized gain (loss) on available for sale securities, interest rate swap, and past service costs of employee benefit plans - net income tax (benefit) of $(156), $125, $50 and $41
   
(262
)
 
188
   
75
   
62
 
Comprehensive Income
 
$
3,046
 
$
3,250
 
$
6,986
 
$
6,988
 
Net Income per common share
                         
Basic
 
$
0.27
 
$
0.27
 
$
0.58
 
$
0.61
 
Diluted
 
$
0.27
 
$
0.27
 
$
0.57
 
$
0.60
 
Shares on which net income per common shares were based
                         
Basic
   
12,078,030
   
11,367,629
   
12,012,675
   
11,368,679
 
Diluted
   
12,135,006
   
11,502,106
   
12,068,897
   
11,496,469
 
 
See notes to consolidated financial statements
 
3

 
United Security Bancshares and Subsidiaries
Consolidated Statements of Changes in Shareholders' Equity
Periods Ended June 30, 2007 

   
Common 
stock
 
Common 
stock
 
Retained 
Earnings
 
Accumulated 
Other 
Comprehensive 
Income (Loss)
 
Total
 
(In thousands except shares)
 
Number 
of Shares
 
Amount
 
Balance January 1, 2006
   
11,361,118
 
$
22,084
 
$
38,682
 
$
(1,752
)
$
59,014
 
Director/Employee stock options exercised
   
14,000
   
123
               
123
 
Tax benefit of stock options exercised
         
7
               
7
 
Net changes in unrealized loss  on available for sale securities  (net of income tax benefit of $247)
                     
(371
)
 
(371
)
Net changes in unrealized loss  on interest rate swaps  (net of income tax of $288)
                     
432
   
432
 
Dividends on common stock ($0.22 per share)
               
(2,501
)
       
(2,501
)
Repurchase and cancellation of common shares
   
(13,205
)
 
(305
)
           
(305
)
Stock-based compensation expense
         
110
               
110
 
Net Income
               
6,926
         
6,926
 
Balance June 30, 2006 (Unaudited)
   
11,361,913
   
22,019
   
43,107
   
(1,691
)
 
63,435
 
                                 
Director/Employee stock options exercised
   
34,000
   
212
               
212
 
Tax benefit of stock options exercised
         
211
               
211
 
Net changes in unrealized loss  on available for sale securities  (net of income tax of $489)
                     
734
   
734
 
Net changes in unrealized loss  on interest rate swaps  (net of income tax benefit of $149)
                     
(164
)
 
(164
)
Net changes in unrecognized past service Cost on employee benefit plans (net of income tax benefit of $112)
                     
(169
)
 
(169
)
Dividends on common stock ($0.225 per share)
               
(2,656
)
       
(2,656
)
Repurchase and cancellation of common shares
   
(94,800
)
 
(2,131
)
           
(2,131
)
Stock-based compensation expense
         
137
               
137
 
Net Income
               
6,433
         
6,433
 
Balance December 31, 2006
   
11,301,113
   
20,448
   
46,884
   
(1,290
)
 
66,042
 
                                 
Director/Employee stock options exercised
   
90,000
   
510
               
510
 
Net changes in unrealized loss  on available for sale securities  (net of income tax benefit of $39)
                     
(58
)
 
(58
)
Net changes in unrealized loss  on interest rate swaps  (net of income tax of $61)
                     
91
   
91
 
Net changes in unrecognized past service Cost on employee benefit plans (net of income tax of $28)
                     
42
   
42
 
Dividends on common stock ($0.25 per share)
               
(3,034
)
       
(3,034
)
Repurchase and cancellation of common shares
   
(424,161
)
 
(8,622
)
           
(8,622
)
Issuance of shares for business combination
   
976,411
   
21,537
               
21,537
 
Stock-based compensation expense
         
93
               
93
 
Cumulative effect of adoption of SFAS No. 159 (net income tax benefit of $613)
               
(845
)
       
(845
)
Cumulative effect of adoption of FIN48
               
(1,298
)
       
(1,298
)
Net Income
               
6,911
         
6,911
 
Balance June 30, 2007 (Unaudited)
   
11,943,363
 
$
33,966
 
$
48,618
 
$
(1,215
)
$
81,369
 
 
See notes to consolidated financial statements
 
4

 

United Security Bancshares and Subsidiaries
Consolidated Statements of Cash Flows (unaudited)

   
Six Months Ended June 30,
 
(In thousands)
 
2007
 
2006
 
Cash Flows From Operating Activities:
         
Net income
 
$
6,911
 
$
6,926
 
Adjustments to reconcile net earnings to cash provided by operating activities:
             
Provision for credit losses
   
410
   
363
 
Depreciation and amortization
   
1,266
   
802
 
Amortization of investment securities
   
(62
)
 
(20
)
Decrease (increase) in accrued interest receivable
   
111
   
(733
)
Decrease in accrued interest payable
   
(67
)
 
(199
)
Increase in unearned fees
   
3
   
390
 
Increase (decrease) in income taxes payable
   
342
   
(322
)
Excess tax benefits from stock-based payment arrangements
   
0
   
(1
)
Stock-based compensation expense
   
93
   
110
 
Decrease in accounts payable and accrued liabilities
   
(1,217
)
 
(156
)
Gain on sale of correspondent bank stock
   
0
   
(1,877
)
Gain on sale of other real estate owned
   
(23
)
 
(27
)
(Gain) loss on swap ineffectiveness
   
(32
)
 
147
 
Income from life insurance proceeds
   
(219
)
 
(477
)
(Increase) decrease in surrender value of life insurance
   
(101
)
 
342
 
Gain on fair value option of financial liabilities
   
(113
)
 
0
 
Loss on limited partnership interest
   
217
   
220
 
Net decrease in other assets
   
537
   
202
 
Net cash provided by operating activities
   
8,056
   
5,690
 
               
Cash Flows From Investing Activities:
             
Net increase in interest-bearing deposits with banks
   
(17
)
 
(116
)
Purchases of available-for-sale securities
   
(19,178
)
 
0
 
Maturities and calls of available-for-sale securities
   
18,287
   
3,402
 
Net redemption of correspondent bank stock
   
255
   
51
 
Net increase in loans
   
(26,030
)
 
(65,655
)
Cash and equivalents received in bank acquisition
   
6,373
   
0
 
Proceeds from sale of correspondent bank stock
   
0
   
2,607
 
Proceeds from sales of foreclosed assets
   
14
   
187
 
Proceeds from sales of other real estate owned
   
23
   
20
 
Capital expenditures for premises and equipment
   
(745
)
 
(1,961
)
Net cash used in investing activities
   
(21,018
)
 
(61,465
)
               
Cash Flows From Financing Activities:
             
Net (decrease) increase in demand deposit and savings accounts
   
(57,132
)
 
5,278
 
Net increase in certificates of deposit
   
41,592
   
9,369
 
Net increase in federal funds purchased
   
13,060
   
17,100
 
Net increase in FHLB borrowings
   
10,000
   
0
 
Director/Employee stock options exercised
   
510
   
123
 
Excess tax benefits from stock-based payment arrangements
   
0
   
1
 
Repurchase and retirement of common stock
   
(8,622
)
 
(305
)
Payment of dividends on common stock
   
(2,948
)
 
(2,388
)
Net cash (used in) provided by financing activities
   
(3,540
)
 
29,178
 
               
Net decrease in cash and cash equivalents
   
(16,502
)
 
(26,597
)
Cash and cash equivalents at beginning of period
   
43,068
   
63,030
 
Cash and cash equivalents at end of period
 
$
26,566
 
$
36,433
 
 

5



United Security Bancshares and Subsidiaries - Notes to Consolidated Financial Statements - (Unaudited)

1. Organization and Summary of Significant Accounting and Reporting Policies

The consolidated financial statements include the accounts of United Security Bancshares, and its wholly owned subsidiary United Security Bank (the “Bank”) and two bank subsidiaries, USB Investment Trust (the “REIT”) and United Security Emerging Capital Fund (the “Fund”). United Security Bancshares Capital Trust I (the “Trust”) was deconsolidated effective March 2004 pursuant to FIN46, (collectively the “Company” or “USB”). Intercompany accounts and transactions have been eliminated in consolidation.

On February 16, 2007, the Company completed its merger with Legacy Bank, N.A., located in Campbell, California, with the acquisition of 100 percent of Legacy’s outstanding common shares. At merger, Legacy Bank’s one branch was merged with and into United Security Bank, a wholly owned subsidiary of the Company. The total value of the merger transaction was $21.5 million, and the shareholders of Legacy Bank received merger consideration consisting of 976,411 shares of common stock of the Company. The merger transaction was accounted for as a purchase transaction, and resulted in the purchase price being allocated to the assets acquired and liabilities assumed from Legacy Bank based on the fair value of those assets and liabilities. The net of assets acquired and liabilities assumed totaled approximately $8.6 million at the date of the merger. Fair value of Legacy assets and liabilities acquired, and resultant goodwill, has been preliminarily determined, and may be subject to minor adjustments during the third quarter of 2007. (See Note 14 to the Company’s consolidated financial statements contained herein for details of the merger).

These unaudited financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information on a basis consistent with the accounting policies reflected in the audited financial statements of the Company included in its Annual Report on Form 10-K for the year ended December 31, 2006. These interim financial statements do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of a normal recurring nature) considered necessary for a fair presentation have been included. Operating results for the interim periods presented are not necessarily indicative of the results that may be expected for any other interim period or for the year as a whole. Certain reclassifications have been made to the 2006 financial statements to conform to the classifications used in 2007. None of these reclassifications were material.

2. Investment Securities Available for Sale

Following is a comparison of the amortized cost and approximate fair value of securities available for sale as of June 30, 2007 and December 31, 2006:

(In thousands)
 
Amortized Cost
 
Gross 
Unrealized 
Gains
 
Gross
Unrealized 
Losses
 
Fair Value
(Carrying 
Amount)
 
June 30, 2007: 
                 
U.S. Government agencies
 
$
77,438
 
$
76
   
($1,258
)
$
76,256
 
U.S. Government agency collateralized mortgage obligations
   
14
   
0
   
(1
)
 
13
 
Obligations of state and political subdivisions
   
2,227
   
43
   
(4
)
 
2,266
 
Other investment securities
   
13,677
   
0
   
(576
)
 
13,101
 
   
$
93,356
 
$
119
   
($1,839
)
$
91,636
 
December 31, 2006:
                         
U.S. Government agencies
 
$
69,746
 
$
51
   
($1,293
)
$
68,504
 
U.S. Government agency collateralized mortgage obligations
   
17
   
0
   
(1
)
 
16
 
Obligations of state and political subdivisions
   
2,226
   
65
   
(1
)
 
2,290
 
Other investment securities
   
13,000
   
0
   
(444
)
 
12,556
 
   
$
84,989
 
$
116
   
($1,739
)
$
83,366
 

Included in other investment securities at June 30, 2007, is a short-term government securities mutual fund totaling $7.7 million, a CRA-qualified mortgage fund totaling $4.8 million, and a money-market mutual fund totaling $677,000. Included in other investment securities at December 31, 2006, is a short-term government securities mutual fund totaling $7.7 million, and a CRA-qualified mortgage fund totaling $4.8 million. The short-term government securities mutual fund invests in debt securities issued or guaranteed by the U.S. Government, its agencies or instrumentalities, with a maximum duration equal to that of a 3-year U.S. Treasury Note.
 
6


There were no realized gains or losses on sales or calls of available-for-sale securities during the six months ended June 30, 2007 or June 30, 2006.

Securities that have been temporarily impaired less than 12 months at June 30, 2007 are comprised of nine U.S. government agency securities, four municipal agency securities, and one collateralized mortgage obligation, with a total weighted average life of 7.2 years. As of June 30, 2007, there were twelve U.S. government agency securities and two other investment securities with a total weighted average life of 0.9 years that have been temporarily impaired for twelve months or more.

The following summarizes temporarily impaired investment securities at June 30, 2007:

   
Less than 12 Months
 
12 Months or More
 
Total
 
(In thousands)
 
Fair Value 
(Carrying 
Amount)
 
Unrealized 
Losses
 
Fair Value 
(Carrying 
Amount)
 
Unrealized 
Losses
 
Fair Value 
(Carrying 
Amount)
 
Unrealized 
Losses
 
Securities available for sale:
                         
U.S. Government agencies
 
$
22,645
 
$
(336
)
$
43,506
 
$
(922
)
$
66,151
 
$
(1,258
)
U.S. Government agency collateralized mortgage obligations
   
10
   
(1
)
 
0
   
0
   
10
   
(1
)
Obligations of state and political subdivisions
   
369
   
(4
)
 
0
   
0
   
369
   
(4
)
Other investment securities
   
0
   
0
   
12,423
   
(576
)
 
12,423
   
(576
)
Total impaired securities
 
$
23,024
 
$
(341
)
$
55,929
 
$
(1,498
)
$
78,953
 
$
(1,839
)

Because the decline in market value is attributable to changes in market rates of interest rather than credit quality, and because the Company has the ability and intent to hold these investments until a recovery of fair value, which may be at maturity, the Company considers these investments to be temporarily impaired at June 30, 2007.

At June 30, 2007 and December 31, 2007, available-for-sale securities with an amortized cost of approximately $72.5 million and $70.9 million (fair value of $71.4 million and $69.7 million) were pledged as collateral for public funds, treasury tax and loan balances, and repurchase agreements.

3. Loans and Leases

     Loans include the following:     

(In thousands)
 
June 30,
2007
 
% of
Loans
 
December 31,
2006
 
% of
Loans
 
Commercial and industrial
 
$
183,397
   
31.1
%
$
155,811
   
31.1
%
Real estate – mortgage
   
145,719
   
24.7
%
 
113,613
   
22.7
%
Real estate – construction
   
181,467
   
30.7
%
 
168,378
   
33.7
%
Agricultural
   
49,854
   
8.4
%
 
35,102
   
7.0
%
Installment/other
   
19,420
   
3.3
%
 
16,712
   
3.3
%
Lease financing
   
10,407
   
1.8
%
 
10,952
   
2.2
%
Total Gross Loans
 
$
590,264
   
100.0
%
$
500,568
   
100.0
%

There were no loans over 90 days past due and still accruing interest at June 30, 2007 or December 31, 2006. Nonaccrual loans totaled $17.8 million and $8.1 million at June 30, 2007 and December 31, 2006, respectively.
 
7

 
An analysis of changes in the allowance for credit losses is as follows:


(In thousands)
 
June 30,
2007
 
December 31,
2006
 
June 30,
2006
 
Balance, beginning of year
 
$
8,365
 
$
7,748
 
$
7,748
 
Provision charged to operations
   
410
   
880
   
363
 
Losses charged to allowance
   
(168
)
 
(502
)
 
(168
)
Recoveries on loans previously charged off
   
30
   
239
   
63
 
Reserve acquired in merger
   
1,268
   
   
 
 
Reclassification of off-balance sheet reserve
   
0
   
0
   
33
 
Balance at end-of-period
 
$
9,905
 
$
8,365
 
$
8,039
 

The allowance for credit losses represents management's estimate of the risk inherent in the loan portfolio based on the current economic conditions, collateral values and economic prospects of the borrowers. The formula allowance for unfunded loan commitments totaling $593,000 at June 30, 2007 is carried in other liabilities. Significant changes in these estimates might be required in the event of a downturn in the economy and/or the real estate markets in the San Joaquin Valley, and the greater Oakhurst and East Madera County areas.

The following table summarizes the Company’s investment in loans for which impairment has been recognized for the periods presented:

 
(in thousands)
 
June 30,
2007
 
December 31,
2006
 
June 30,
2006
 
Total impaired loans at period-end
 
$
17,921
 
$
8,893
 
$
7,359
 
Impaired loans which have specific allowance
   
14,314
   
5,638
   
5,930
 
Total specific allowance on impaired loans
   
5,056
   
4,117
   
4,084
 
Total impaired loans which as a result of write-downs or the fair value of the collateral, did not have a specific allowance
   
3,607
   
3,255
   
1,429
 
                     
(in thousands)
   
YTD - 6/30/07
   
YTD - 12/31/06
   
YTD - 6/30/06
 
Average recorded investment in impaired loans during period
 
$
11,973
 
$
10,088
 
$
10,896
 
Income recognized on impaired loans during period
   
0
   
65
   
35
 
 
4. Deposits

Deposits include the following:
 
   
June 30,
 
December 31,
 
(In thousands)
 
2007
 
2006
 
Noninterest-bearing deposits
 
$
137,563
 
$
159,002
 
Interest-bearing deposits:
             
NOW and money market accounts
   
187,528
   
184,384
 
Savings accounts
   
50,359
   
31,933
 
Time deposits:
             
Under $100,000
   
47,582
   
42,428
 
$100,000 and over
   
218,155
   
169,380
 
Total interest-bearing deposits
   
503,624
   
428,125
 
Total deposits
 
$
641,187
 
$
587,127
 
 
5. Short-term Borrowings/Other Borrowings

At June 30, 2007, the Company had collateralized and uncollateralized lines of credit with the Federal Reserve Bank of San Francisco and other correspondent banks aggregating $345.9 million, as well as Federal Home Loan Bank (“FHLB”) lines of credit totaling $22.2 million. At June 30, 2007, the Company had an outstanding balance of $10.0 million drawn against its FHLB line of credit. The $10.0 million FHLB advance is for a term of two years, at a fixed rate of 4.92%, and a maturity date of March 30, 2009.
 
8


The Company had collateralized and uncollateralized lines of credit with the Federal Reserve Bank of San Francisco and other correspondent banks aggregating $308.3 million, as well as Federal Home Loan Bank (“FHLB”) lines of credit totaling $28.0 million at December 31, 2006. At December 31, 2006, the Company had no advances on its lines of credit.

These lines of credit generally have interest rates tied to the Federal Funds rate or are indexed to short-term U.S. Treasury rates or LIBOR. FHLB advances are collateralized by all of the Company’s stock in the FHLB and certain qualifying mortgage loans. All lines of credit are on an “as available” basis and can be revoked by the grantor at any time.

6. Supplemental Cash Flow Disclosures
 
   
Six Months Ended June 30,
 
(In thousands)
 
2007
 
2006
 
Cash paid during the period for:
         
Interest
 
$
10,274
 
$
6,249
 
Income Taxes
   
3,724
   
4,201
 
Noncash investing activities:
             
Dividends declared not paid
 
$
1,499
   
1,250
 
Supplemental disclosures related to acquisitions:
             
Deposits
 
$
69,600
       
Other liabilities
   
286
       
Securities available for sale
   
(7,414
)
     
Loans, net of allowance for loan losses
   
(62,426
)
     
Premises and equipment
   
(728
)
     
Intangibles
   
(11,085
)
     
Accrued interest and other assets
   
(3,396
)
     
Stock issued
   
21,536
       
Net cash and equivalents acquired
 
$
6,373
       

7. Net Income per Common Share

The following table provides a reconciliation of the numerator and the denominator of the basic EPS computation with the numerator and the denominator of the diluted EPS computation:

   
Quarter Ended June 30,
 
Six Months Ended June 30,
 
(In thousands except earnings per share data)
 
2007
 
2006
 
2007
 
2006
 
Net income available to common shareholders
 
$
3,308
 
$
3,062
 
$
6,911
 
$
6,926
 
                           
Weighted average shares issued
   
12,078
   
11,368
   
12,013
   
11,369
 
Add: dilutive effect of stock options
   
57
   
134
   
56
   
127
 
Weighted average shares outstanding adjusted for potential dilution
   
12,135
   
11,502
   
12,069
   
11,496
 
                           
Basic earnings per share
 
$
0.27
 
$
0.27
 
$
0.58
 
$
0.61
 
Diluted earnings per share
 
$
0.27
 
$
0.27
 
$
0.57
 
$
0.60
 

8. Derivative Financial Instruments and Hedging Activities

As part of its overall risk management, the Company pursues various asset and liability management strategies, which may include obtaining derivative financial instruments to mitigate the impact of interest fluctuations on the Company’s net interest margin. During the second quarter of 2003, the Company entered into an interest rate swap agreement for the purpose of minimizing interest rate fluctuations on its interest rate margin and equity.
 
9


Under the interest rate swap agreement, the Company receives a fixed rate and pays a variable rate based on the Prime Rate (“Prime”). The swap qualifies as a cash flow hedge under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, as amended, and is designated as a hedge of the variability of cash flows the Company receives from certain variable-rate loans indexed to Prime. In accordance with SFAS No. 133, the swap agreement is measured at fair value and reported as an asset or liability on the consolidated balance sheet. The portion of the change in the fair value of the swap that is deemed effective in hedging the cash flows of the designated assets is recorded in accumulated other comprehensive income and reclassified into interest income when such cash flow occurs in the future. Any ineffectiveness resulting from the hedge is recorded as a gain or loss in the consolidated statement of income as part of noninterest income.

The amortizing hedge has a remaining notional value of $8.3 million at June 30, 2007, matures in September 2008, and has a duration of approximately 4 months. As of June 30, 2007, the maximum length of time over which the Company is hedging its exposure to the variability of future cash flows is approximately 1.25 years. As of June 30, 2007, the loss amounts in accumulated other comprehensive income associated with these cash flows totaled $91,000 (net of tax benefit of $61,000). During the six months ended June 30, 2007, $200,000 was reclassified from other accumulated comprehensive income into expense, and is reflected as a reduction in interest income.

The Company performed a quarterly analysis of the effectiveness of the interest rate swap agreement at June 30, 2007. As a result of a correlation analysis, the Company has determined that the swap remains highly effective in achieving offsetting cash flows attributable to the hedged risk during the term of the hedge and, therefore, continues to qualify for hedge accounting under the guidelines of SFAS No. 133. However, during the second quarter of 2006, the Company determined that the underlying loans being hedged were paying off faster than the notional value of the hedge instrument was amortizing. This difference between the notional value of the hedge and the underlying hedged assets is considered an “overhedge” pursuant to SFAS No. 133 guidelines and may constitute ineffectiveness if the difference is other than temporary. The Company determined during 2006 that the difference was other than temporary and, as a result, reclassified a net total of $75,000 of the pretax hedge loss reported in other comprehensive income into earnings during 2006. As of June 30, 2007, the notional value of the hedge was still in excess of the value of the underlying loans being hedged by approximately $2.6 million, but had improved from the $3.3 million difference existing at December 31, 2006. As a result, the Company recorded a pretax hedge gain related to swap ineffectiveness of approximately $32,000 during the first six months of 2007. Amounts recognized as hedge ineffectiveness gains or losses are reflected in noninterest income.

9. Common Stock Repurchase Plan

During August 2001, the Company’s Board of Directors approved a plan to repurchase, as conditions warrant, up to 280,000 shares (effectively 580,000 shares adjusted for 2-for-1 stock split in May 2006) of the Company’s common stock on the open market or in privately negotiated transactions. The duration of the program is open-ended and the timing of the purchases will depend on market conditions.

On February 25, 2004, the Company announced another stock repurchase plan under which the Board of Directors approved a plan to repurchase, as conditions warrant, up to 276,500 shares (effectively 553,000 shares adjusted for 2-for-1 stock split in May 2006) of the Company's common stock on the open market or in privately negotiated transactions. As with the first plan, the duration of the new program is open-ended and the timing of purchases will depend on market conditions. Concurrent with the approval of the new repurchase plan, the Board terminated the 2001 repurchase plan. During the year ended December 31, 2005, 13,081 shares (26,162 shares effected for 2006 2-for-1 stock split) were repurchased at a total cost of $377,000 and an average price per share of $28.92 ($14.46 effected for 2006 2-for-1 stock split). During the year ended December 31, 2006, 108,005 shares were repurchased at a total cost of $2.4 million and an average price per share of $22.55.
 
On May 16, 2007, the Company announced a third stock repurchase plan to repurchase, as conditions warrant, up to 610,000 shares of the Company's common stock on the open market or in privately negotiated transactions. The repurchase plan represents approximately 5.00% of the Company's currently outstanding common stock. The duration of the program is open-ended and the timing of purchases will depend on market conditions. Concurrent with the approval of the new repurchase plan, the Company canceled the remaining 75,733 shares available under the 2004 repurchase plan.
 
During the six months ended June 30, 2007, 424,161 shares were repurchased at a total cost of $8.6 million and an average per share price of $20.33. Of the shares repurchased during 2007, 166,660 shares were repurchased under the 2004 plan at an average cost of $20.46 per shares, and 257,501 shares were repurchased under the 2007 plan at an average cost of $20.24 per shares.
 
10


10. Stock Based Compensation
 
On January 1, 2006 the Company adopted the disclosure provisions of Financial Accounting Standards Board (FASB) Statement No. 123 R, “Accounting for Share-Based Payments”. SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on the grant-date fair value of the award. The fair value is amortized over the requisite service period (generally the vesting period). The Company previously accounted for stock-based awards to employees under the intrinsic value provisions of APB 25 in which no compensation cost was required to be recognized for options granted that had an exercise price equal to the market value of the underlying common stock on the date of the grant.
 
Included in salaries and employee benefits for the six months ending June 30, 2007 and 2006 is $93,000 and $110,000 of share-based compensation, respectively. The related tax benefit on share-based compensation recorded in the provision for income taxes was not material to either quarter.
 
A summary of the Company’s options as of January 1, 2007 and changes during the six months ended June 30, 2007 is presented below.

   
2005
Plan
 
Weighted
Average
Exercise
Price
 
1995
Plan
 
Weighted
Average
Exercise
Price
 
Options outstanding January 1, 2007
   
171,500
 
$
17.05
   
126,000
 
$
7.25
 
Granted during the period
   
5,000
   
20.24
   
   
 
Exercised during the period
   
0
   
   
(90,000
)
 
5.67
 
Options outstanding June 30, 2007
   
176,500
 
$
17.14
   
36,000
 
$
11.21
 
                           
Options exercisable at June 30, 2007
   
49,900
 
$
17.18
   
24,000
 
$
10.74
 
 
As of June 30, 2007 and 2006, there was $317,000 and $495,000, respectively, of total unrecognized compensation expense related to nonvested stock options. This cost is expected to be recognized over a weighted average period of approximately 1.5 years and 1.75 years, respectively. The Company received $510,000 and $123,000 in cash proceeds on options exercised during the six months ended June 30, 2007 and 2006, respectively. No tax benefits were realized on stock options exercised during the six months ended June 30, 2007. Tax benefits realized on options exercised during the six months ended June 30, 2006 totaled $7,000.

   
Period Ended
June 30,
2007
 
Period Ended
June 30,
2006
 
Weighted average grant-date fair value of stock options granted
 
$
4.51
 
$
4.01
 
Total fair value of stock options vested
 
$
103,346
 
$
29,170
 
Total intrinsic value of stock options exercised
 
$
1,517,000
 
$
147,190
 
 
The Company determines fair value at grant date using the Black-Scholes-Merton pricing model that takes into account the stock price at the grant date, the exercise price, the expected life of the option, the volatility of the underlying stock and the expected dividend yield and the risk-free interest rate over the expected life of the option.
 
The weighted average assumptions used in the pricing model are noted in the table below. The expected term of options granted is derived using the simplified method, which is based upon the average period between vesting term and expiration term of the options. The risk free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of the grant. Expected volatility is based on the historical volatility of the Bank's stock over a period commensurate with the expected term of the options. The Company believes that historical volatility is indicative of expectations about its future volatility over the expected term of the options.
 
For options vested as of January 1, 2006 or granted after January 1, 2006, and valued in accordance with FAS 123R, the Company expenses the fair value of the option on a straight-line basis over the vesting period for each separately vesting portion of the award. The Company estimates forfeitures and only recognizes expense for those shares expected to vest. Based upon historical evidence, the Company has determined that because options are granted to a limited number of key employees rather than a broad segment of the employee base, expected forfeitures, if any, are not material.
 
11


   
Six Months Ended
   
June 30, 2007
 
June 30, 2006
Risk Free Interest Rate
 
4.53%
 
4.58%
Expected Dividend Yield
 
2.47%
 
2.69%
Expected Life in Years
 
6.50 Years
 
6.50 Years
Expected Price Volatility
 
20.63%
 
18.38%
 
The Black-Scholes-Merton option valuation model requires the input of highly subjective assumptions, including the expected life of the stock based award and stock price volatility. The assumptions listed about represent management's best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if other assumptions had been used, the Company's recorded stock-based compensation expense could have been materially different from that previously reported by the Company. In addition, the Company is required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. If the Company's actual forfeiture rate is materially different from the estimate, the share-based compensation expense could be materially different.

11. Taxes – Adoption of FIN48

The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN48), on January 1, 2007. FIN 48 clarifies SFAS No. 109, “Accounting for Income Taxes”, to indicate a criterion that an individual tax position would have to meet for some or all of the income tax benefit to be recognized in a taxable entity’s financial statements. Under the guidelines of FIN48, an entity should recognize the financial statement benefit of a tax position if it determines that it is more likely than not that the position will be sustained on examination. The term, “more likely than not”, means a likelihood of more than 50 percent.” In assessing whether the more-likely-than-not criterion is met, the entity should assume that the tax position will be reviewed by the applicable taxing authority and all available information is known to the taxing authority.

The Company and a subsidiary file income tax returns in the U.S federal jurisdiction, and several states within the U.S. There are no filings in foreign jurisdictions. The Company is not currently aware of any tax jurisdictions where the Company or any subsidiary is subject examination by federal, state, or local taxing authorities before 2001. The Internal Revenue Service (IRS) has not examined the Company’s or any subsidiaries federal tax returns since before 2001, and the Company currently is not aware of any examination planned or contemplated by the IRS. The California Franchise Tax Board (FTB) is currently examining the Company’s 2004 state tax return, and it is anticipated that the examination will be completed during the third quarter of 2007.

During the second quarter of 2006, the FTB issued the Company a letter of proposed adjustments to, and assessments for, (as a result of examination of the tax years 2001 and 2002) certain tax benefits taken by the REIT during 2002. The Company continues to review the information available from the FTB and its financial advisors and believes that the Company's position has merit. The Company will pursue its tax claims and defend its use of these entities and transactions. The Company will continue to assert its administrative protest and appeal rights pending the outcome of litigation by another taxpayer presently in process on the REIT issue in the Los Angeles Superior Court (City National v. Franchise Tax Board).

The Company has reviewed its REIT tax position as of January 1, 2007 (adoption date) and again at March 31, 2007 and June 30, 2007 in light of the adoption of FIN48. The Bank, with guidance from advisors believes that the case has merit with regard to points of law, and that the tax law at the time allowed for the deduction of the consent dividend. However, the Bank, with the concurrence of advisors, cannot conclude that it is “more than likely” (as defined in FIN48) that the Bank will prevail in its case with the FTB. As a result of the implementation of FIN48, the Company recognized approximately a $1.3 million increase in the liability for unrecognized tax benefits (included in other liabilities), which was accounted for as a reduction to the January 1, 2007 balance of retained earnings. The adjustment provided at adoption included penalties proposed by the FTB of $181,000 and interest totaling $210,000. During the six months ended June 30, 2007, the Company recorded an additional $43,000 in interest liability pursuant to the provisions of FIN48. The Company had approximately $434,000 accrued for the payment of interest and penalties at June 30, 2007. Subsequent to the initial adoption of FIN48, it is the Company’s policy to recognize interest expense related to unrecognized tax benefits, and penalties, as a component tax expense. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (in 000’s):
 
12

 
Balance at January 1, 2007
 
$
1,298
 
Additions for tax provisions of prior years
   
43
 
Balance at June 30, 2007
 
$
1,341
 
 
12. Fair Market Value – Adoption of SFAS No. 159
 
Effective January 1, 2007, the Company elected early adoption of SFAS No.159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115”. The Company also adopted the provisions of SFAS No. 157, “Fair Value Measurements”, effective January 1, 2007, in conjunction with the adoption of SFAS No. 159. SFAS No. 159 generally permits the measurement of selected eligible financial instruments at fair value at specified election dates. Upon adoption of SFAS No. 159, the Company elected the fair value measurement option for all the Company’s pre-existing junior subordinated debentures with a carrying cost of $15.5 million, prior to the adoption of SFAS No. 159.
 
The Company believes its adoption of SFAS No. 159 will have a positive impact on its ability to better manage the balance sheet and interest rate risks associated with this liability while potentially benefiting the net interest margin, net interest income, net income and earnings per common share in future periods. Specifically, the Company believes the election of fair value accounting for the junior subordinated debentures better reflects the true economic value of the debt instrument on the balance sheet. The Company’s junior subordinated debentures were issued in 2001 when the Trust Preferred Securities market was new and less liquid than today. As a result, subordinated debentures are available in the market at narrower spreads and lower issuing costs. With a higher-than-market spread to LIBOR, and remaining capitalized issuance costs of more than $400,000 on the balance sheet, the Company’s cost-basis of the subordinated debentures recorded on the balance sheet does not properly reflect the true opportunity costs to the Company.
 
The initial fair value measurement at adoption resulted in a $1,053,000 cumulative-effect adjustment to the opening balance of retained earnings at January 1, 2007. The adjustment resulted in an increase of $1,053,000 in the reported balance of the junior subordinated debentures, an increase in deferred tax assets of $443,000 and the corresponding reduction in retained earnings of $610,000. Under SFAS No. 159, this one-time charge to shareholders’ equity was not recognized in earnings. In addition to the fair value adjustment of the junior subordinated debentures recorded effective January 1, 2007, the Company also removed the remaining $405,000 in unamortized issuance costs of the debt instrument. The remaining issuance costs were removed in accordance with SFAS 159 effective January 1, 2007, with corresponding charges of $170,000 to deferred taxes and $235,000 to retained earnings.
 
As a requirement of electing early adoption of SFAS 159, the Company also adopted SFAS 157, “Fair Value Measurement” effective January 1, 2007. The Company utilized the guidelines of SFAS No. 157 to perform the fair value analysis on the junior subordinated debentures. In its analysis, the Company used a net-present-value approach based upon observable market rates of interest, over a term that considers the most advantageous market for the liability, and the most reasonable behavior of market participants.
 
The Company utilized discount rates in the present value analysis that were observable in the marketplace for borrowers with similar credit risk as the Company. At January 1, 2007 and March 31, 2007, junior subordinated debentures were offered at 3-month LIBOR rates plus 1.65% and 1.55% respectively. At June 30, 2007, junior subordinated debentures were being offered at an average rate of 3-month LIBOR rates plus 1.40%. The periods used for measurement end on July 25, 2007, the date the Company intends to redeem the debentures. Contractually, the Company may prepay the principal on July 25, 2007 along with a prepayment penalty of 6.15% of the principal, or $922,500. The cash flows used for the net-present-value analysis included periodic interest payments, as well as the payment of principal and the $922,500 pre-payment premium at the redemption date of July 25, 2007, all discounted at a market rate of interest, taking into account credit risk factors for the Company. The Company did, in fact, redeem the subordinated debentures on July 25, 2007 (see Note 15 to the Company’s consolidated financial statements).
 
13

 
The following table summarizes the effects of the adoption of SFAS No. 159 at both adoption date and June 30, 2007 (in 000’s) on the Company’s junior subordinated debentures. Changes in fair value (FV) for periods subsequent to adoption are recorded in current earnings. Pretax changes in fair value for the six months ended June 30, 2007 totaled $113,000 and included as a gain in other noninterest income.
 
Balance of junior subordinated debentures at December 31, 2006
 
$
15,464
 
Adjustments upon adoption:
     
Combine accrued interest 1/1/07
   
613
 
Total carrying value 1/1/07
   
16,077
 
FV adjustment upon adoption of SFAS No. 159
   
1,053
 
Total FV of junior subordinated debentures at adoption - January 1, 2007
 
$
17,130
 
 
     
Total FV of junior subordinated debentures at June 30, 2007
 
$
16,998
 
 
13. Fair Value Measurements– Adoption of SFAS No. 157

Effective January 1, 2007, the Company adopted SFAS 157, “Fair Value Measurements”, concurrent with its early adoption of SFAS No. 159. SFAS No. 157 clarifies the definition of fair value, describes methods used to appropriately measure fair value in accordance with generally accepted accounting principles and expands fair value disclosure requirements. This statement applies whenever other accounting pronouncements require or permit fair value measurements.

The fair value hierarchy under SFAS No. 157 prioritizes the inputs to valuation techniques used to measure fair value into three broad levels (Level 1, Level 2, and Level 3). Level 1 inputs are unadjusted quoted prices in active markets (as defined) for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability, and reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability (including assumptions about risk).

The Company performs fair value measurements on certain assets and liabilities as the result of the application of accounting guidelines and pronouncements that were relevant prior to the adoption of SFAS No. 157. Some fair value measurements, such as for available-for-sale securities and interest rate swaps are performed on a recurring basis, while others, such as impairment of goodwill and other intangibles, are performed on a nonrecurring basis.

The following tables summarize the Company’s assets and liabilities that were measured at fair value on a recurring basis during the period (in 000’s):
 
Description of Assets
 
June 30, 2007
 

Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)
 

Significant Other
Observable Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
AFS Securities
 
$
91,636
 
$
91,636
             
Interest Rate Swap
   
(136
)
       
($136
)
     
Impaired Loans
   
12,865
         
11,462
 
$
1,403
 
Total
 
$
104,365
 
$
91,636
 
$
11,326
 
$
1,403
 

Description of Liabilities
 
June 30, 2007
 

Quoted Prices in 
Active Markets 
for Identical 
Assets
(Level 1)
 

Significant Other 
Observable Inputs
(Level 2)
 

Significant 
Unobservable 
Inputs
(Level 3)
 
Junior subordinated debt
 
$
16,998
       
$
16,998
       
Total
 
$
16,998
 
$
0
 
$
16,998
 
$
0
 
 
Available for sale securities are valued based upon open-market quotes obtained from reputable third-party brokers. Market pricing is based upon specific CUSIP identification for each individual security. Changes in fair market value are recorded in other comprehensive income as the securities are available for sale.

14

 
The fair value of interest rate swap contracts is based on the discounted net present value of the swap using third party dealer quotes. Changes in fair market value are recorded in other comprehensive income, and changes resulting from ineffectiveness are recorded in current earnings.

Fair value measurements for impaired loans are performed pursuant to SFAS No. 114, and are based upon either collateral values supported by appraisals, or observed market prices. The Company has a portfolio of impaired leases for which it uses a discounted cash flow valuation, based upon management’s estimation of the probability of collection and the potential amount that may ultimately be collected. The change in fair value of impaired assets that were valued based upon level three inputs was approximately $118,000 for the six months ended June 30, 2007. This loss is not recorded directly as an adjustment to current earnings or comprehensive income, but rather as an adjustment component in determining the overall adequacy of the loan loss reserve. Such adjustments to the estimated fair value of impaired loans may result in increases or decreases to the provision for credit losses recorded in current earnings.

Upon adoption of SFAS No. 159 on January 1, 2007, the Company elected the fair value measurement option for all the Company’s pre-existing junior subordinated debentures. The fair value of the debentures was determined based upon discounted cash flows utilizing observable market rates and credit characteristics for similar instruments. In its analysis, the Company used characteristics that distinguish market participants generally use, and considered factors specific to (a) the liability, (b) the principal (or most advantageous) market for the liability, and (c) market participants with whom the reporting entity would transact in that market. The adjustment for fair value at adoption was recorded as a cumulative-effect adjustment to the opening balance of retained earnings at January 1, 2007. Fair value adjustments subsequent to adoption are recorded in current earnings (see Note 12 to the financial statements included herein in the Company’s 10-Q for June 30, 2007).

The following tables summarize the Company’s assets and liabilities that were measured at fair value on a nonrecurring basis during the period (in 000’s):

Description of Assets
 

(in 000’s)
June 30, 2007
 

Quoted Prices 
in Active 
Markets for 
Identical Assets
(Level 1)
 

Significant 
Other 
Observable 
Inputs
(Level 2)
 

Significant 
Unobservable 
Inputs
(Level 3)
 
Business combination:
                         
Securities - AFS
 
$
7,414
 
$
7,414
             
Loans, net allowance for losses
   
62,426
             
$
62,426
 
Premises and Equipment
   
729
             
729
 
Goodwill
   
8,085
               
8,085
 
Other assets
   
7,633
               
7,633
 
Total assets
 
$
86,287
 
$
7,414
 
$
0
 
$
78,873
 


   
(in 000's)
 
Quoted Prices in Active Markets for Identical Assets
 
Significant
Other
Observable
 Inputs
 
Significant Unobservable Inputs
 
Description of Liabilities
 
June 30, 2007
 
(Level 1)
 
(Level 2)
 
(Level 3)
 
Business combination:
                         
Deposits (net CDI)
 
$
66,600
             
$
66,600
 
Other liabilities
   
286
               
286
 
Total liabilities
 
$
66,886
 
$
0
 
$
0
 
$
66,886
 

The Company completed its merger with Legacy Bank in February 2007 (see Note 14 to the financial statements included herein in the Company’s 10-Q for June 30, 2007). The merger transaction was accounted for using the purchase accounting method, and resulted in the purchase price being allocated to the assets acquired and liabilities assumed from Legacy Bank based on the fair value of those assets and liabilities. The allocations of purchase price based upon the fair market value of assets acquired and liabilities assumed is preliminary, but management does not believe that adjustments, if any, will be material. The fair value measurements for Legacy’s loan portfolio included certain market rate assumptions on segmented portions of the loan portfolio with similar credit characteristics, and credit risk assumptions specific to the individual loans within that portfolio. Available-for sale securities were valued based upon open-market quotes obtained from reputable third-party brokers. Legacy’s deposits were valued based upon anticipated net present cash flows related to Legacy’s deposit base, and resulted in a core deposit intangible (CDI) adjustment of $3.0 million carried as an asset on the Company’s balance sheet. Assumptions used to determine the CDI included anticipated costs of, and revenues generated by, those deposits, as well as the estimated life of the deposit base. Other assets and liabilities generally consist of short-term items including cash, overnight investments, and accrued interest receivable or payable, and as such, it was determined that carrying value approximated fair value.

The following tables provide a reconciliation of assets and liabilities at fair value using significant unobservable inputs (Level 3) on both a recurring (impaired loans) and nonrecurring (business combination) basis during the period (in 000’s):

 
Impaired
Loans
 
Reconciliation of Assets:
     
Beginning balance
 
$
1,521
 
Total gains or (losses) included in earnings (or changes in net assets)
   
(203
)
Transfers in and/or out of Level 3
   
85
 
Ending balance
 
$
1,403
 
       
The amount of total gains or (losses) for the period included in earnings (or changes in net assets) attributable to the change in unrealized gains or losses relating to assets still held at the reporting date
   
($203
)
 
14. Business Combination
 
On February 16, 2007, the Company acquired 100 percent of the outstanding common shares of Legacy Bank, N.A., located in Campbell, California. At merger, Legacy Bank’s one branch was merged with and into United Security Bank, a wholly owned subsidiary of the Company. The purchase of Legacy Bank provided the Company with an opportunity to expand its market area into Santa Clara County and to serve a loyal and growing small business niche and individual client base build by Legacy.
 
The aggregate purchase price for Legacy was $21.7 million, which included $171,000 in direct acquisition costs related to the merger. At the date of merger, Legacy Bank had 1,674,373 shares of common stock outstanding. Based upon an exchange rate of approximately .58 shares of the Company’s stock for each share of Legacy stock, Legacy shareholders received 976,411 shares of the Company’s common stock, amounting to consideration of approximately $12.86 per Legacy common share.
 
Legacy’s results of the operations have been included in the Company’s results beginning February 17, 2007.
 
During the second quarter of 2007, the Company re-evaluated the preliminary estimate of the core deposit intangible related to savings accounts acquired from Legacy and determined that the initial run-off of those deposits was faster than originally anticipated. As a result, the Company reduced the core deposits intangible by approximately $215,000 from the amount reported at March 31, 2007. Correspondingly, resultant goodwill was increased by that same $215,000.
 
The following summarizes the purchase and the resultant allocation to fair-market-value adjustments and goodwill:
 
Purchase Price:
       
Total value of the Company's common stock exchanged
 
$
21,536
 
Direct acquisition costs
   
177
 
Total purchase price
   
21,713
 
Allocation of Purchase Price:
       
Legacy's shareholder equity
   
8,588
 
Estimated adjustments to reflect assets acquired and liabilities assumed at fair value:
Investments
   
23
 
Loans
   
(118
)
Deferred tax asset (NOL)
   
2,135
 
Core Deposit Intangible
   
3,000
 
Estimated fair value of net assets acquired
   
13,628
 
Goodwill resulting from acquisition
 
$
8,085
 
 
The following condensed balance sheet summarizes the amount assigned for each major asset and liability category of Legacy at the merger date:
 
Assets:
       
Cash
 
$
3,173
 
Federal Funds Purchased
   
3,200
 
Securities available for sale
   
7,414
 
Loans, net of allowance for loan losses
   
62,426
 
Premises and equipment
   
729
 
Deferred tax assets (NOL)
   
2,135
 
Core deposit intangibles
   
3,000
 
Goodwill
   
8,085
 
Accrued interest and other assets
   
1,260
 
Total Assets
 
$
91,422
 
Liabilities:
       
Deposits:
       
Non-interest bearing
 
$
17,262
 
Interest-bearing
   
52,338
 
Total deposits
 
$
69,600
 
Accrued interest payable and other liabilities
   
286
 
Total liabilities
 
$
69,886
 
Net assets
 
$
21,536
 
 
The merger transaction was accounted for using the purchase accounting method, and resulted in the purchase price being allocated to the assets acquired and liabilities assumed from Legacy Bank based on the fair value of those assets and liabilities. The allocations of purchase price based upon the fair market value of assets acquired and liabilities assumed is preliminary, but management does not believe that adjustments, if any, will be material. While management believes the Company will be able to fully utilize the net operating loss carry-forward (NOL) obtained in the Legacy merger, the 2007 portion of Legacy’s NOL has not been finalized, which may result in minor adjustments to the deferred tax asset carried on the Company’s balance sheet. The Company has utilized a fair value approach for Legacy’s loan portfolio which includes certain market rate assumptions on segmented portions of the loan portfolio with similar credit characteristics, and credit risk assumptions specific to the individual loans within that portfolio. Any changes in the fair-market-value assumptions used for purchase allocation purposes will be reflected as an adjustment to goodwill.
 
15

 
Core deposit intangibles totaling $3.0 million will be amortized for book purposes over an estimated life of approximately 7 years using the yield method. Core deposit intangibles will be reviewed for impairment on an annual basis.
 
Goodwill totaling $8.1 million will not be amortized for book purposes under current accounting guidelines. Because the merger was a purchase of assets, goodwill is tax deductible over a statutory term of 15 years. Goodwill be reviewed for impairment on an annual basis.

15. Employee Benefit Plans - Application of SFAS No. 158

In the Company's Form 10-K for the fiscal year ended December 31, 2006, a transition adjustment in the amount of $169,000 net of tax benefit of $112,000, was recognized as a component of the ending balance of Accumulated Other Comprehensive Income/(Loss) on the Company’s balance sheet as the result of the adoption of SFAS No. 158, “Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans”.

This adjustment was misapplied as a component of Comprehensive Income on the Company’s consolidated statement of income and comprehensive income for the year ended December 31, 2006. The table below reflects the effects of the misapplication of this adjustment at December 31, 2006.

(in 000’s)
 
As Reported
 
Misapplied
 
As Revised
 
 
Other comprehensive loss, net of tax
 
$
462
 
$
(169
)
$
631
 
 
Comprehensive income
 
$
13,822
 
$
(169
)
$
13,991
 

The Company will correct the Other Comprehensive Income presentations in the Form 1O-K for the fiscal year ending December 31, 2007 to reflect the revised amounts shown above.

16. Subsequent Event - Redemption of Trust Preferred Securities and formation of USB Capital Trust II

At June 30, 2007, the Company held junior subordinated debentures issued to capital trusts commonly known as "Trust Preferred securities.” The debt instrument was issued by the Company’s wholly-owned special purpose trust entity, USB Capital Trust I on July 25, 2001 in the amount of $15,000,000 with a thirty-year maturity, interest benchmarked at the 6-month-LIBOR rate (re-priced in January and July each year) plus 3.75%. The Company has the ability to redeem the debentures at its option. The prepayment provisions of the instrument allow repayment after five years (July 25, 2006) with a prepayment penalty of 7.69%. Subsequent year prepayment penalties are as follows; 6.15% in 2007, 4.61% in 2008, 3.08% in 2009, 1.54% in 2010 and no penalty after July 25, 2011. The debt instrument carries a higher interest rate than similar debt instruments issued in the current market. Recently, typical interest rates range from 3-month-LIBOR plus 0.75%, to 3-month-LIBOR plus 2.0%, depending on the credit risk of the borrower. At the current time, companies with credit risk similar to the Company may expect a rate of 3-month-LIBOR plus 1.40%. On July 25, 2007, the Company redeemed the $15.0 million in subordinated debentures plus accrued interest of $690,000 and a 6.15% prepayment penalty totaling $922,500. Concurrently, the Trust Preferred securities issued by Capital Trust I were redeemed.
 
During July 2007, the Company formed USB Capital Trust II, a wholly-owned special purpose entity, for the purpose of issuing Trust Preferred Securities. Like USB Capital Trust I formed in July 2001, USB Capital Trust II is a Variable Interest Entity (VIE) and will be considered a deconsolidated entity pursuant to FIN 46. On July 23, 2007 USB Capital Trust II issued $15 million in Trust Preferred securities. The securities have a thirty-year maturity and bear a floating rate of interest (repricing quarterly) of 1.29% over the three-month LIBOR rate (initial coupon rate of 6.65%). Interest will be paid quarterly. Concurrent with the issuance of the Trust Preferred securities, USB Capital Trust II used the proceeds of the Trust Preferred securities offering to purchase a like amount of junior subordinated debentures of the Company. The Company will pay interest on the junior subordinated debentures to USB Capital Trust II, which represents the sole source of dividend distributions to the holders of the Trust Preferred securities. The Company may redeem the Trust Preferred securities at anytime before October 2008 at a redemption price of 103.3, and thereafter each October as follows: 2008 at 102.64, 2009 at 101.98, 2010 at 101.32, 2011 at 100.66, and at par anytime after October 2012.
 
16


Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview

Certain matters discussed or incorporated by reference in this Quarterly Report of Form 10-Q are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Such risks and uncertainties include, but are not limited to, those described in Management’s Discussion and Analysis of Financial Condition and Results of Operations. Such risks and uncertainties include, but are not limited to, the following factors: i) competitive pressures in the banking industry and changes in the regulatory environment; ii) exposure to changes in the interest rate environment and the resulting impact on the Company’s interest rate sensitive assets and liabilities; iii) decline in the health of the economy nationally or regionally which could reduce the demand for loans or reduce the value of real estate collateral securing most of the Company’s loans; iv) credit quality deterioration that could cause an increase in the provision for loan losses; v) Asset/Liability matching risks and liquidity risks; volatility and devaluation in the securities markets, and vi) expected cost savings from recent acquisitions are not realized. Therefore, the information set forth therein should be carefully considered when evaluating the business prospects of the Company. For additional information concerning risks and uncertainties related to the Company and its operations, please refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

 
On February 16, 2007, the Company completed its merger of Legacy Bank, N.A. with and into United Security Bank, a wholly owned subsidiary of the Company. Legacy Bank which began operations in 2003 operated one banking office in Campbell, California serving small business and retail banking clients. With its small business and retail banking focus, Legacy Bank provides a unique opportunity for United Security Bank to serve a loyal and growing small business niche and individual client base in the San Jose area. Upon completion of the merger, Legacy Bank's branch office began operating as a branch office of United Security Bank. As of February 16, 2007 Legacy Bank had net assets of approximately of $8.6 million, including net loans of approximately $63 million and deposits of approximately $70 million.
 
In the merger, the Company issued 976,411 shares of its stock in a tax free exchange for all of the Legacy Bank common shares. The total value of the transaction was approximately $21.7 million. The merger transaction was accounted for using the purchase accounting method, and resulted in the purchase price being allocated to the assets acquired and liabilities assumed from Legacy based on the fair value of those assets and liabilities. Fair-market-value adjustments and intangible assets totaled approximately $12.9 million, including $8.1 million in goodwill. The allocations of purchase price based upon the fair market value of assets acquired and liabilities assumed is preliminary, but management does not believe that adjustments, if any, will be material.

The Company currently has eleven banking branches, which provide financial services in Fresno, Madera, Kern, and Santa Clara counties.

Trends Affecting Results of Operations and Financial Position

The following table summarizes the six-month and year-to-date averages of the components of interest-bearing assets as a percentage of total interest-bearing assets, and the components of interest-bearing liabilities as a percentage of total interest-bearing liabilities:

   
YTD Average
 
YTD Average
 
YTD Average
 
   
6/30/07
 
12/31/06
 
6/30/06
 
Loans and Leases
   
83.77
%
 
80.26
%
 
78.49
%
Investment securities available for sale
   
14.23
%
 
15.65
%
 
16.67
%
Interest-bearing deposits in other banks
   
1.20
%
 
1.33
%
 
1.37
%
Federal funds sold
   
0.80
%
 
2.76
%
 
3.47
%
Total earning assets
   
100.00
%
 
100.00
%
 
100.00
%
                     
NOW accounts
   
9.34
%
 
11.21
%
 
11.96
%
Money market accounts
   
27.95
%
 
31.56
%
 
31.00
%
Savings accounts
   
9.45
%
 
8.02
%
 
8.41
%
Time deposits
   
47.41
%
 
44.72
%
 
44.12
%
Other borrowings
   
2.57
%
 
0.96
%
 
0.83
%
Subordinated debentures
   
3.28
%
 
3.53
%
 
3.68
%
Total interest-bearing liabilities
   
100.00
%
 
100.00
%
 
100.00
%

17

 
The Company’s overall operations are impacted by a number of factors, including not only interest rates and margin spreads, which impact results of operations, but also the composition of the Company’s balance sheet. One of the primary strategic goals of the Company is to maintain a mix of assets that will generate a reasonable rate of return without undue risk, and to finance those assets with a low-cost and stable source of funds. Liquidity and capital resources must also be considered in the planning process to mitigate risk and allow for growth.

The Company continues its business development and expansion efforts throughout a dynamic and growing market area, and as a result, realized substantial increases in both loan and deposit volumes during the six months ended June 30, 2007. Resulting primarily from the Legacy Bank merger completed during February 2007, the Company experienced increases of $89.7 million in loans, while other interest earning assets, including investment securities and federal funds sold, declined during the period, as loan growth exceeded deposit growth during the period. The Company experienced growth in all loan categories except lease financing, with growth being strongest in commercial and industrial loans, commercial real estate loans real estate, and construction loans. Deposit growth totaled $54.1 million during the six months ended June 30, 2007, and as with loan growth, deposit increases were primarily the result of the merger with Legacy Bank. Deposit growth occurred in all categories except noninterest-bearing deposits, which actually declined $21.4 million during the six months ended June 30, 2007. Depositors continue to be attracted to money market accounts and time deposits over $100,000, as they seek higher yields.

With increases in market rates of interest slowing during early 2006, and remaining level since mid-2006, the Company has realized moderate increases in net interest margins throughout 2006, which have begun to stabilize during 2007. The Company anticipates stable interest rates in the near future. The Company’s net interest margin was 5.68% for the six months ended June 30, 2007, as compared to 5.67% for the year ended December 31, 2006, and 5.68% for the six months ended June 30, 2006. With approximately 61% of the loan portfolio in floating rate instruments at June 30, 2007, the effects of market rates continue to be realized almost immediately on loan yields. Loans yielded 9.45% during the six months ended June 30, 2007, as compared to 9.13% for the year ended December 31, 2006, and 8.97% for the six months ended June 30, 2006. Loan yield was enhanced during the first six months of 2007, as a nonperforming loan was paid off during the quarter, providing an additional $1.1 million in previously unrecognized interest income, and an enhancement to loan yield of approximately 41 basis points. The Company continues to experience pricing pressures on deposits, especially money market accounts and time deposits, as increased competition for deposits continues throughout the Company’s market area. The Company’s average cost of funds was 3.86% for the six months ended June 30, 2007 as compared to 3.24% for the year ended December 31, 2006, and 2.90% for the six months ended June 30, 2006.

Noninterest income continues to be driven by customer service fees, which totaled $2.3 million for the six months ended June 30, 2007, representing on increase of $312,000 or 15.60% over the $2.0 million in customer service fees reported for the six months ended June 30, 2006. Total noninterest income actually declined by $1.3 million between the six-month periods ended June 30, 2006 and June 30, 2007, primarily as the result of a nonrecurring $1.9 million gain on the sale of an investment in correspondent bank stock recognized during the first quarter of 2006. Other noninterest income increased approximately $245,000 as the result of a number of items including increases in rental and OREO income experienced during the first six months of 2007.

Noninterest expense increased approximately $1.1 million or 11.8% between the six-month periods ended June 30, 2006 and June 30, 2007. Increases were experienced in salaries and employee benefits, occupancy expense, professional fees, and other general business expenses, as the Company continues to grow and seek qualified staff as part of its strategic plan. As part of noninterest expense, OREO expense actually declined by $859,000 or 92.0% between the six-month periods ended June 30, 2006 and June 30, 2007 as costs associated with an OREO property the Company was in the process of liquidating during 2006, were not again incurred during 2007.

The Company has maintained a strong balance sheet, with sustained loan growth and sound deposit growth. With the Legacy merger completed during February 2007, total assets have grown more than $94.0 million between December 31, 2006 and June 30, 2007, while net loans have grown $87.9 million, and deposits have grown $54.1 million during the six months ended June 30, 2007. With increased loan growth, average loans comprised approximately 84% of overall average earning assets during the six months ended June 30, 2007. In total, average core deposits, including NOW accounts, money market accounts, and savings accounts, continue to comprise a high percentage of total interest-bearing liabilities for the six months ended June 30, 2007, although time deposits as a percentage of average deposits for the period have increased as the Company has sought brokered deposits to fund continued loan demand. To further fund loan demand, the Company utilized its FHLB credit line during the first quarter of 2007, borrowing $10.0 million for a term of two years at a fixed rate of 4.92%.

18

 
During July 2007, the Company formed USB Capital Trust II, a wholly-owned special purpose entity, for the purpose of issuing Trust Preferred securities. At the same time, the Company redeemed the $15 million in junior subordinated debt issued to USB Capital Trust I which in turn had issued Trust Preferred securities to investors. The Trust Preferred securities issued by USB Capital Trust I during 2001 carried a floating interest rate of six-month LIBOR plus 3.75% and had a maturity term of thirty years. During July, USB Capital Trust II issued $15 million in Trust Preferred securities at a floating rate of three-month LIBOR plus 1.29% and had a maturity term of thirty years. Concurrent with the issuance of the Trust Preferred securities, USB Capital Trust II used the proceeds of the Trust Preferred securities offering to purchase a like amount of junior subordinated debentures of the Company with substantially like terms to the Trust Preferred securities issued by the Trust. The new subordinated debentures will reduce the cost of the Company’s $15 million debt by 246 basis points, and should result in pre-tax interest cost savings of approximately $30,000 per month. Effective January 1, 2007, the Company had elected the fair value option for the Company’s junior subordinated debt pursuant to SFAS No. 159. The Company will also elect the fair value option for the subordinated debentures issued to USB Capital Trust II during July 2007.

The Company continues to emphasize relationship banking and core deposit growth, and has focused greater attention on its market area of Fresno, Madera, and Kern Counties, as well as its new market area of Campbell, in Santa Clara County. The San Joaquin Valley and other California markets continue to benefit from construction lending and commercial loan demand from small and medium size businesses, although commercial and residential real estate markets began to soften somewhat during the later part of 2006. On average, loans have increased nearly $110.4 million between the six-month periods ended June 30, 2006 and June 30, 2007, and end-of-period loans have increased more than $107.2 million between June 30, 2006 and June 30, 2007. Growth continues primarily in commercial and industrial loans, commercial real estate loans, and construction loans. In the future, the Company will continue to maintain an emphasis on its core lending strengths of commercial real estate and construction lending, as well as small business financing, while expanding opportunities in agricultural, installment, and other loan categories when possible.

The Company continually evaluates its strategic business plan as economic and market factors change in its market area. Growth and increasing market share will be of primary importance during the remainder of 2007 and beyond. The Company is excited about its recent merger with Legacy Bank located in Campbell, California. This new acquisition brings additional opportunities in a dynamic new market, and will enable the Company to expand its ability to serve Legacy’s current clients and increase lending capabilities in the market area of Santa Clara County. The Company will continue to develop new business in its Convention Center Branch opened in Downtown Fresno during April 2004, as well in the two Kern County branches acquired during April 2004 as the result of the merger with Taft National Bank. During the third quarter of 2005, the Company relocated its East Shaw branch, as well as the Construction and Consumer Loan Departments, located in Fresno, to a new location in north Fresno, which has enhanced its business presence in that rapidly growing area. During the fourth quarter of 2006, the Company relocated its administrative headquarters to downtown Fresno, thus increasing its presence there. Market rates of interest will continue be an important factor in the Company’s ongoing strategic planning process, as it is predicted that we are near the end of an interest rate cycle.

Results of Operations

For the six months ended June 30, 2007, the Company reported net income of $6.9 million or $0.58 per share ($0.57 diluted) as compared to $6.9 million or $0.61 per share ($0.60 diluted) for the six months ended June 30, 2006. The Company’s return on average assets was 1.89% for the six-month-period ended June 30, 2007 as compared to 2.20% for the six-month-period ended June 30, 2006. The Bank’s return on average equity was 17.42% for the six months ended June 30, 2007 as compared to 22.34% for the same -month period of 2006.

Net Interest Income

Net interest income before provision for credit losses totaled $18.6 million for the six months ended June 30, 2007, representing an increase of $2.7 million or 16.7% when compared to the $15.9 million reported for the same six months of the previous year. The increase in net interest income between 2006 and 2007 is primarily the result of increased volumes in, and yields on, interest-earning assets, which more than offset increases in the Company’s cost of interest-bearing liabilities.

The Bank's net interest margin, as shown in Table 1, decreased to 5.68% at June 30, 2007 from 5.69% at June 30, 2006, a decrease of only 1 basis point (100 basis points = 1%) between the two periods. Average market rates of interest increased between the six-month periods ended June 30, 2006 and 2007. The prime rate averaged 8.25% for the six months ended June 30, 2007 as compared to 7.66% for the comparative six months of 2006. While yields on earning assets increased between the two periods presented, costs of interest-bearing liabilities increased more, increasing 96 basis points between the two six-month periods.

19

 
Table 1. Distribution of Average Assets, Liabilities and Shareholders’ Equity:
Interest rates and Interest Differentials
Six Months Ended June 30, 2007 and 2006

   
 2007
 
 2006
 
(dollars in thousands)
 
Average
     
Yield/
 
Average
     
Yield/
 
   
Balance
 
Interest
 
Rate
 
Balance
 
Interest
 
Rate
 
Assets:
                                     
Interest-earning assets:
                                     
Loans and leases (1)
 
$
552,701
 
$
25,909
   
9.45
%
$
442,271
 
$
19,675
   
8.97
%
Investment Securities - taxable
   
91,665
   
1,933
   
4.25
%
 
91,695
   
1,642
   
3.61
%
Investment Securities - nontaxable (2)
   
2,227
   
54
   
4.89
%
 
2,226
   
54
   
4.89
%
Interest-bearing deposits in other banks
   
7,912
   
157
   
4.00
%
 
7,710
   
161
   
4.21
%
Federal funds sold and reverse repos
   
5,308
   
145
   
5.51
%
 
19,553
   
429
   
4.42
%
Total interest-earning assets
   
659,813
 
$
28,198
   
8.62
%
 
563,455
 
$
21,961
   
7.86
%
Allowance for credit losses
   
(9,461
)
             
(7,960
)
           
Noninterest-bearing assets:
                                     
Cash and due from banks
   
24,395
               
26,913
             
Premises and equipment, net
   
15,956
               
11,470
             
Accrued interest receivable
   
4,146
               
3,383
             
Other real estate owned
   
1,919
               
4,355
             
Other assets
   
41,562
               
34,290
             
Total average assets
 
$
738,330
             
$
635,906
             
Liabilities and Shareholders' Equity:
                                     
Interest-bearing liabilities:
                                     
NOW accounts
 
$
47,021
 
$
151
   
0.65
%
$
50,322
 
$
148
   
0.59
%
Money market accounts
   
140,674
   
2,143
   
3.07
%
 
130,394
   
1,520
   
2.35
%
Savings accounts
   
47,566
   
456
   
1.93
%
 
35,364
   
94
   
0.54
%
Time deposits
   
238,653
   
5,838
   
4.93
%
 
185,631
   
3,564
   
3.87
%
Other borrowings
   
12,933
   
347
   
5.41
%
 
3,491
   
91
   
5.26
%
Junior subordinated debentures
   
16,490
   
694
   
8.49
%
 
15,464
   
633
   
8.25
%
Total interest-bearing liabilities
   
503,337
 
$
9,629
   
3.86
%
 
420,666
 
$
6,050
   
2.90
%
Noninterest-bearing liabilities:
                                     
Noninterest-bearing checking
   
145,668
               
145,044
             
Accrued interest payable
   
2,264
               
1,861
             
Other liabilities
   
7,065
               
5,803
             
Total Liabilities
   
658,334
               
573,374
             
Total shareholders' equity
   
79,996
               
62,532
             
Total average liabilities and shareholders' equity
 
$
738,330
             
$
635,906
             
Interest income as a percentage of average earning assets
               
8.62
%
             
7.86
%
Interest expense as a percentage of average earning assets
               
2.94
%
             
2.17
%
Net interest margin
               
5.68
%
             
5.69
%

(1)
Loan amounts include nonaccrual loans, but the related interest income has been included only if collected for the period prior to the loan being placed on a nonaccrual basis. Loan interest income includes loan fees of approximately $1,557,000 and $1,674,000 for the six months ended June 30, 2007 and 2006, respectively.

(2)
Applicable nontaxable securities yields have not been calculated on a tax-equivalent basis because they are not material to the Company’s results of operations.

20

 
Both the Company's net interest income and net interest margin are affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as "volume change." Both are also affected by changes in yields on interest-earning assets and rates paid on interest-bearing liabilities, referred to as "rate change". The following table sets forth the changes in interest income and interest expense for each major category of interest-earning asset and interest-bearing liability, and the amount of change attributable to volume and rate changes for the periods indicated.

Table 2. Rate and Volume Analysis  

   
Increase (decrease) in the six months ended
 
   
June 30, 2007 compared to June 30, 2006
 
(In thousands)
 
Total
 
Rate
 
Volume
 
Increase (decrease) in interest income:
                   
Loans and leases
 
$
6,234
 
$
1,104
 
$
5,130
 
Investment securities available for sale
   
291
   
292
   
(1
)
Interest-bearing deposits in other banks
   
(4
)
 
(8
)
 
4
 
Federal funds sold and securities purchased under agreements to resell
   
(284
)
 
86
   
(370
)
Total interest income
   
6,237
   
1,474
   
4,763
 
Increase (decrease) in interest expense:
                   
Interest-bearing demand accounts
   
626
   
559
   
67
 
Savings accounts
   
362
   
320
   
42
 
Time deposits
   
2,274
   
1,114
   
1,160
 
Other borrowings
   
256
   
3
   
253
 
Subordinated debentures
   
61
   
18
   
43
 
Total interest expense
   
3,579
   
2,014
   
1,565
 
Increase (decrease) in net interest income
 
$
2,658
 
$
(540
)
$
3,198
 
 
For the six months ended June 30, 2007, total interest income increased approximately $6.2 million or 28.4% as compared to the six-month period ended June 30, 2006. Earning asset volumes increased almost exclusively in loans, while volumes decreased moderately in investment securities and federal funds sold.

For the six months ended June 30, 2007, total interest expense increased approximately $3.6 million or 59.2% as compared to the six-month period ended June 30, 2006. Between those two periods, average interest-bearing liabilities increased by $82.7 million, while the average rates paid on those liabilities increased by 96 basis points.

Provisions for credit losses are determined on the basis of management's periodic credit review of the loan portfolio, consideration of past loan loss experience, current and future economic conditions, and other pertinent factors. Such factors consider the allowance for credit losses to be adequate when it covers estimated losses inherent in the loan portfolio. Based on the condition of the loan portfolio, management believes the allowance is sufficient to cover risk elements in the loan portfolio. For the six months ending June 30, 2007, the provision to the allowance for credit losses amounted to $410,000 as compared to $363,000 for the six months ended June 30, 2006. The amount provided to the allowance for credit losses during the first six months brought the allowance to 1.68% of net outstanding loan balances at June 30, 2007, as compared to 1.67% of net outstanding loan balances at December 31, 2006, and 1.63% at June 30, 2006.

Noninterest Income

Table 3. Changes in Noninterest Income

The following table sets forth the amount and percentage changes in the categories presented for the six months ended June 30, 2007 as compared to the six months ended June 30, 2006:

 
(In thousands)
 
 
2007
 
 
2006
 
Amount of
Change
 
Percent
Change
 
Customer service fees
 
$
2,312
 
$
2,000
 
$
312
   
15.60
%
Gain on sale of OREO
   
23
   
27
   
(4
)
 
-14.81
%
Gain on proceeds from life insurance
   
219
   
477
   
(258
)
 
-54.09
%
Gain (loss) on swap ineffectiveness
   
32
   
(147
)
 
179
   
121.77
%
Gain on fair value option of financial assets
   
113
   
0
   
113
   
--
 
Gain on sale of investment
   
0
   
1,877
   
(1,877
)
 
-100.00
%
Shared appreciation income
   
24
   
0
   
24
   
--
 
Other
   
812
   
567
   
245
   
43.29
%
Total noninterest income
 
$
3,535
 
$
4,801
 
$
(1,266
)
 
-26.37
%

21

 
Noninterest income for the six months ended June 30, 2007 decreased $1.3 million or 26.4% when compared to the same period of 2006. Decreases in total noninterest income experienced during 2007 were the result of a $1.8 million gain on the sale of an investment in correspondent bank during the first quarter of 2006, which was not again experienced during 2007. Customer service fees increased $312,000 or 15.6% between the two six-month periods presented, which is attributable in large part to increases in ATM income, but is also attributable to increases in DDA analysis fees and NSF fees. Increases in other noninterest income of $245,000 or 43.3% between the six-month periods ended June 2006 and 2007, were the result of a number of items including increases in rental and OREO income experienced during the first six months of 2007.

Noninterest Expense

The following table sets forth the amount and percentage changes in the categories presented for the six months ended June 30, 2007 as compared to the six months ended June 30, 2006:

Table 4. Changes in Noninterest Expense

 
(In thousands)
 
 
2007
 
 
2006
 
Amount of
Change
 
Percent
Change
 
Salaries and employee benefits
 
$
5,482
 
$
4,810
 
$
672
   
13.97
%
Occupancy expense
   
1,740
   
1,203
   
537
   
44.64
%
Data processing
   
236
   
277
   
(41
)
 
-14.80
%
Professional fees
   
766
   
420
   
346
   
82.38
%
Directors fees
   
128
   
110
   
18
   
16.36
%
Amortization of intangibles
   
462
   
269
   
193
   
71.75
%
Correspondent bank service charges
   
205
   
100
   
105
   
105.00
%
Loss on California tax credit partnership
   
217
   
220
   
(3
)
 
-1.36
%
OREO expense
   
75
   
934
   
(859
)
 
-91.97
%
Other
   
1,406
   
1,241
   
165
   
13.30
%
Total expense
 
$
10,717
 
$
9,584
 
$
1,133
   
11.82
%

Increases in noninterest expense between the six months ended June 30, 2006 and 2007 are associated primarily with normal continued growth of the Company, including additional staffing costs, and costs associated with the new branch operations in Campbell, California, resulting from the merger with Legacy Bank. Decreases in OREO expense were the result of additional expenses, including disposal and clean-up costs, incurred during 2006 on a single OREO property, which was in the process of liquidation. 

Pursuant to the adoption of SFAS No. 123R during the first quarter of 2006, the Company recognized stock-based compensation expense of $93,000 and $110,000 for the six months ended June 30, 2007 and 2006, respectively. This expense is included in noninterest expense under salaries and employee benefits. The Company expects stock-based compensation expense to be about $48,000 per quarter during the remainder of 2007. Under the current pool of stock options, stock-based compensation expense will decline to approximately $30,000 per quarter during 2008, then to $17,000 per quarter for 2009, and decline after that through 2011. If new stock options are issued, or existing options fail to vest, for example, due to forfeiture, actual stock-based compensation expense in future periods will change.

Income Taxes 

On December 31, 2003 the California Franchise Tax Board (FTB) announced certain tax transactions related to real estate investment trusts (REITs) and regulated investment companies (RICs) will be disallowed pursuant to Senate Bill 614 and Assembly Bill 1601, which were signed into law in the 4th quarter of 2003. As a result, the Company reversed related net state tax benefits recorded in the first three quarters of 2003 and has taken no related tax benefits since that time. The Company continues to review the information available from the FTB and its financial advisors and believes that the Company's position has merit. The Company will pursue its tax claims and defend its use of these entities and transactions. At this time, the Company cannot predict the ultimate outcome.

22

 
During the first quarter of 2005, the FTB notified the Company of its intent to audit the REIT for the tax years ended December 2001 and 2002. The Company has retained legal counsel to represent it in the tax audit, and counsel has provided the FTB with documentation supporting the Company's position. The FTB concluded its audit during January 2006. During April 2006, the FTB issued a Notice of Proposed Assessment to the Company, which included proposed tax and penalty assessments related to the tax benefits taken for the REIT during 2002. The Company still believes the case has merit based upon the fact that the FTB is ignoring certain facts of law in the case. The issuance of the Notice of Proposed Assessment by the FTB will not end the administrative processing of the REIT issue because the Company has asserted its administrative protest and appeal rights pending the outcome of litigation by another taxpayer presently in process on the REIT issue in the Los Angeles Superior Court (City National v. Franchise Tax Board). The case is ongoing and may take several years to complete.
 
On January 1, 2007 the Company adopted Financial Accounting Standards Board (FASB) Interpretation 48 (FIN 48), Accounting for Uncertainty in Income Taxes: an interpretation of FASB Statement No. 109”. FIN 48 clarifies SFAS No. 109, Accounting for Income Taxes”, to indicate a criterion that an individual tax position would have to meet for some or all of the income tax benefit to be recognized in a taxable entity’s financial statements. Under the guidelines of FIN48, an entity should recognize the financial statement benefit of a tax position if it determines that it is more likely than not that the position will be sustained on examination. The term “more likely than not” means a likelihood of more than 50 percent.” In assessing whether the more-likely-than-not criterion is met, the entity should assume that the tax position will be reviewed by the applicable taxing authority.
 
The Company has reviewed its REIT tax position as of January 1, 2007 (adoption date), and then again at March 31st and June 30th, 2007 in light of the adoption of FIN48. The Bank, with guidance from advisors believes that the case has merit with regard to points of law, and that the tax law at the time allowed for the deduction of the consent dividend. However, the Bank, with the concurrence of experts, cannot conclude that it is “more than likely” (as defined in FIN48) that the Bank will prevail in its case with the FTB. As a result of this determination, effective January 1, 2007 the Company recorded an adjustment of $1,299,000 to beginning retained earnings upon adoption of FIN48 to recognize the potential tax liability under the guidelines of the interpretation. The adjustment includes amounts for assessed taxes, penalties, and interest. During the six months ended June 30, 2007, the Company increased the unrecognized tax liability by an additional $43,000 in interest for the period, bringing the total recorded tax liability under FIN48 to $1,341,000 at June 30, 2007. It is the Company’s policy to recognize interest and penalties under FIN48 as a component of income tax expense.

Financial Condition

Total assets increased $94.0 million or 13.86% to a balance of $772.3 million at June 30, 2007, from the balance of $678.3 million at December 31, 2006, and increased $108.0 million or 16.3% from the balance of $664.3 million at June 30, 2006. Total deposits of $641.2 million at June 30, 2007 increased $54.1 million or 9.21% from the balance reported at December 31, 2006, and increased $80.1 million from the balance of $561.1 million reported at June 30, 2006. Between December 31, 2006 and June 30, 2007, loan growth totaled $89.7 million, while securities increased by $8.3 million or 9.92%, and other short-term investments decreased $11.9 million as these funds were utilized to fund loan growth.

Earning assets averaged approximately $659.8 million during the six months ended June 30, 2007, as compared to $563.5 million for the same six-month period of 2006. Average interest-bearing liabilities increased to $503.3 million for the six months ended June 30, 2007, as compared to $420.7 million for the comparative six-month period of 2006.

Loans and Leases

The Company's primary business is that of acquiring deposits and making loans, with the loan portfolio representing the largest and most important component of its earning assets. Loans totaled $590.3 million at June 30, 2007, an increase of $89.7 million or 17.9% when compared to the balance of $500.6 million at December 31, 2006, and an increase of $107.2 million or 20.2% when compared to the balance of $483.0 million reported at June 30, 2006. Loans on average increased 25.0% between the six-month periods ended June 30, 2006 and June 30, 2007, with loans averaging $552.7 million for the six months ended June 30, 2007, as compared to $442.3 million for the same six-month period of 2006.

23

 
During the first six months of 2007, increases were experienced in all loan categories except lease financing, with the strongest growth in the Company’s core lending categories of commercial and industrial loans, commercial real estate, and construction loans. The following table sets forth the amounts of loans outstanding by category at June 30, 2007 and December 31, 2006, the category percentages as of those dates, and the net change between the two periods presented.

Table 5. Loans
 
   
June 30, 2007
 
December 31, 2006
         
   
Dollar
 
% of
 
Dollar
 
% of
 
Net%
     
(In thousands)
 
Amount
 
Loans
 
Amount
 
Loans
 
Change
 
Change
 
Commercial and industrial
 
$
183,397
   
31.1
%
$
155,811
   
31.1
%
$
27,586
   
17.71
%
Real estate - mortgage
   
145,719
   
24.7
%
 
113,613
   
22.7
%
 
32,106
   
28.26
%
Real estate - construction
   
181,467
   
30.7
%
 
168,378
   
33.7
%
 
13,089
   
7.77
%
Agricultural
   
49,854
   
8.4
%
 
35,102
   
7.0
%
 
14,752
   
42.03
%
Installment/other
   
19,420
   
3.3
%
 
16,712
   
3.3
%
 
2,708
   
16.20
%
Lease financing
   
10,407
   
1.8
%
 
10,952
   
2.2
%
 
(545
)
 
-4.98
%
Total Gross Loans
 
$
590,264
   
100.0
%
$
500,568
   
100.0
%
$
89,696
   
17.92
%

The overall average yield on the loan portfolio was 9.45% for the six months ended June 30, 2007 as compared to 8.97% for the six months ended June 30, 2006, and increased between the two periods primarily as the result of an increase in market rates of interest which positively impacted loan yields. The loan yield realized during the first six months of 2007 was enhanced to some degree as the result of a nonperforming loan that was paid off during the quarter, providing an additional $1.1 million in previously unrecognized interest income, and an increase in loan yield for 2007 of approximately 0.41%. At June 30, 2007, 61.3% of the Company's loan portfolio consisted of floating rate instruments, as compared to 59.5% of the portfolio at December 31, 2006, with the majority of those tied to the prime rate.

Loans acquired in the acquisition of Legacy Bank totaled approximately $63.9 million at the date of merger (February 16, 2007). Exclusive of the loans acquired from Legacy Bank during the first quarter, loan balances attributable to the Company’s previously existing loan portfolio increased approximately $25.8 million during the six months ended June 30, 2007. The following table shows the net change experienced during the six months ended June 30, 2007, removing the effect of the loans acquired in the Legacy Bank merger.

           
June 30, 2007
 
Net Change
 
   
Total Loans
 
Legacy Loans
 
Loans without
 
Six Months Ended
 
   
June 30, 2007
 
at merger
 
Legacy Loans
 
June 30, 2007 (1)
 
Commercial and industrial
 
$
183,397
 
$
31,735
 
$
151,662
   
($4,149
)
Real estate - mortgage
   
145,719
   
14,417
   
131,302
   
17,689
 
Real estate - construction
   
181,467
   
12,817
   
168,650
   
272
 
Agricultural
   
49,854
   
0
   
49,854
   
14,752
 
Installment/other
   
19,420
   
4,957
   
14,463
   
(2,249
)
Lease financing
   
10,407
   
0
   
10,407
   
(545
)
Total Loans
 
$
590,264
 
$
63,926
 
$
526,338
 
$
25,770
 

 (1) Net change in loans between December 31, 2006 and June 30, 2007, excluding balance of loans acquired from Legacy Bank at merger date (2/16/07).

Deposits

Total deposits increased during the period to a balance of $641.2 million at June 30, 2007 representing an increase of $54.1 million or 9.21% from the balance of $587.1 million reported at December 31, 2006, and an increase of $80.1 million or 14.27% from the balance reported at June 30, 2006. During the first six months of 2007, increases were experienced in all deposit categories except noninterest-bearing checking accounts.

24

 
The following table sets forth the amounts of deposits outstanding by category at June 30, 2007 and December 31, 2006, and the net change between the two periods presented.
 
Table 6. Deposits
 
   
June 30,
 
December 31,
 
Net
 
Percentage
 
 (In thousands)
 
2007
 
2006
 
Change
 
Change
 
Noninterest bearing deposits
 
$
137,563
 
$
159,002
   
($21,439
)
 
-13.48
%
Interest bearing deposits:
                         
NOW and money market accounts
   
187,528
   
184,384
   
3,144
   
1.71
%
Savings accounts
   
50,359
   
31,933
   
18,426
   
57.70
%
Time deposits:
                         
Under $100,000
   
47,582
   
42,428
   
5,154
   
12.15
%
$100,000 and over
   
218,155
   
169,380
   
48,775
   
28.80
%
Total interest bearing deposits
   
503,624
   
428,125
   
75,499
   
17.63
%
Total deposits
 
$
641,187
 
$
587,127
 
$
54,060
   
9.21
%

The Company's deposit base consists of two major components represented by noninterest-bearing (demand) deposits and interest-bearing deposits. Interest-bearing deposits consist of time certificates, NOW and money market accounts and savings deposits. Total interest-bearing deposits increased $75.5 million or 17.63% between December 31, 2006 and June 30, 2007, while noninterest-bearing deposits decreased $21.4 million or 13.48% between the same two periods presented. Core deposits, consisting of all deposits other than time deposits of $100,000 or more, and brokered deposits, continue to provide the foundation for the Company's principal sources of funding and liquidity. These core deposits amounted to 65.5% and 70.9% of the total deposit portfolio at June 30, 2007 and December 31, 2006, respectively.

On a year-to-date average (refer to Table 1), the Company experienced an increase of $72.8 million or 13.32% in total deposits between the six-month periods ended June 30, 2006 and June 30, 2007. Between these two periods, average interest-bearing deposits increased $72.2 million or 17.97%, while total noninterest-bearing checking increased $624,000 or 0.43% on a year-to-date average basis.

Deposit balances acquired in the acquisition of Legacy Bank totaled approximately $69.6 million at the date of merger (February 16, 2007). Exclusive of the deposits acquired from Legacy Bank during the first quarter, deposit balances attributable to the Company’s previously existing deposit base declined approximately $15.5 million during the six months ended June 30, 2007. The following table shows the net change experienced during the six months ended June 30, 2007, removing the effect of the deposit balances acquired in the Legacy Bank merger.

       
Legacy
 
June 30, 2007
 
Net Change
 
   
Total Deposits
 
Deposits
 
Deposits
 
Six Months
 
   
June 30, 2007
 
at merger
 
without Legacy
 
Ended 6/30/07 (1)
 
Noninterest bearing deposits
 
$
137,563
 
$
17,970
 
$
119,593
   
($39,409
)
                           
Interest bearing deposits:
                         
NOW and money market accounts
   
187,528
   
10,541
   
176,987
   
(7,397
)
Savings accounts
   
50,359
   
28,752
   
21,607
   
(10,326
)
Time deposits:
                         
Under $100,000
   
47,582
   
2,860
   
44,722
   
2,294
 
$100,000 and over
   
218,155
   
9,477
   
208,678
   
39,298
 
Total interest bearing deposits
   
503,624
   
51,630
   
451,994
   
23,869
 
                           
Total deposits
 
$
641,187
 
$
69,600
 
$
571,587
   
($15,540
)

(1) Net change between December 31, 2006 and June 30, 2007 in deposit balances, excluding deposits acquired from Legacy Bank at merger date (2/16/07).
 
25

 
Short-Term Borrowings

The Company had collateralized and uncollateralized lines of credit aggregating $345.9 million, as well as FHLB lines of credit totaling $22.2 million at June 30, 2007. These lines of credit generally have interest rates tied to the Federal Funds rate or are indexed to short-term U.S. Treasury rates or LIBOR. All lines of credit are on an “as available” basis and can be revoked by the grantor at any time. At June 30, 2007, the Company had $10 million borrowed against its FHLB line of credit. The $10 million in FHLB borrowings is for a term of two years at a fixed rate of 4.92% and a maturity date of March 30, 2009. The Company had collateralized and uncollateralized lines of credit aggregating $308.3 million, as well as FHLB lines of credit totaling $28.0 million at December 31, 2006.

Asset Quality and Allowance for Credit Losses

Lending money is the Company's principal business activity, and ensuring appropriate evaluation, diversification, and control of credit risks is a primary management responsibility. Implicit in lending activities is the fact that losses will be experienced and that the amount of such losses will vary from time to time, depending on the risk characteristics of the loan portfolio as affected by local economic conditions and the financial experience of borrowers.

The allowance for credit losses is maintained at a level deemed appropriate by management to provide for known and inherent risks in existing loans and commitments to extend credit. The adequacy of the allowance for credit losses is based upon management's continuing assessment of various factors affecting the collectibility of loans and commitments to extend credit; including current economic conditions, past credit experience, collateral, and concentrations of credit. There is no precise method of predicting specific losses or amounts which may ultimately be charged off on particular segments of the loan portfolio. The conclusion that a loan may become uncollectible, either in part or in whole is judgmental and subject to economic, environmental, and other conditions which cannot be predicted with certainty. When determining the adequacy of the allowance for credit losses, the Company follows, in accordance with GAAP, the guidelines set forth in the Revised Interagency Policy Statement on the Allowance for Loan and Lease Losses (“Statement”) issued by banking regulators during December 2006. The Statement is a revision of the previous guidance released in July 2001, and outlines characteristics that should be used in segmentation of the loan portfolio for purposes of the analysis including risk classification, past due status, type of loan, industry or collateral. It also outlines factors to consider when adjusting the loss factors for various segments of the loan portfolio, and updates previous guidance that describes the responsibilities of the board of directors, management, and bank examiners regarding the allowance for credit losses. Securities and Exchange Commission Staff Accounting Bulletin No. 102 was released during July 2001, and represents the SEC staff’s view relating to methodologies and supporting documentation for the Allowance for Loan and Lease Losses that should be observed by all public companies in complying with the federal securities laws and the Commission’s interpretations. It is also generally consistent with the guidance published by the banking regulators. The Company segments the loan and lease portfolio into eleven (11) segments, primarily by loan class and type, that have homogeneity and commonality of purpose and terms for analysis under SFAS No. 5. Those loans, which are determined to be impaired under SFAS No. 114, are not subject to the general reserve analysis under SFAS No. 5, and evaluated individually for specific impairment.

The Company’s methodology for assessing the adequacy of the allowance for credit losses consists of several key elements, which include:

- the formula allowance,
- specific allowances for problem graded loans (“classified loans”)
- and the unallocated allowance

In addition, the allowance analysis also incorporates the results of measuring impaired loans as provided in:

- Statement of Financial Accounting Standards (“SFAS”) No. 114, “Accounting by Creditors for Impairment of a Loan” and
- SFAS 118, “Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures.”

The formula allowance is calculated by applying loss factors to outstanding loans and certain unfunded loan commitments. Loss factors are based on the Company’s historical loss experience and on the internal risk grade of those loans and, may be adjusted for significant factors that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date. Management determines the loss factors for problem graded loans (substandard, doubtful, and loss), special mention loans, and pass graded loans, based on a loss migration model. The migration analysis incorporates loan losses over the past twelve quarters (three years) and loss factors are adjusted to recognize and quantify the loss exposure from changes in market conditions and trends in the Company’s loan portfolio. For purposes of this analysis, loans are grouped by internal risk classifications, which are “pass”, “special mention”, “substandard”, “doubtful”, and “loss”. Certain loans are homogenous in nature and are therefore pooled by risk grade. These homogenous loans include consumer installment and home equity loans. Special mention loans are currently performing but are potentially weak, as the borrower has begun to exhibit deteriorating trends, which if not corrected, could jeopardize repayment of the loan and result in further downgrade. Substandard loans have well-defined weaknesses which, if not corrected, could jeopardize the full satisfaction of the debt. A loan classified as “doubtful” has critical weaknesses that make full collection of the obligation improbable. Classified loans, as defined by the Company, include loans categorized as substandard, doubtful, and loss.
 
26

 
Specific allowances are established based on management’s periodic evaluation of loss exposure inherent in classified loans, impaired loans, and other loans in which management believes there is a probability that a loss has been incurred in excess of the amount determined by the application of the formula allowance.

The unallocated portion of the allowance is based upon management’s evaluation of various conditions that are not directly measured in the determination of the formula and specific allowances. The conditions may include, but are not limited to, general economic and business conditions affecting the key lending areas of the Company, credit quality trends, collateral values, loan volumes and concentrations, and other business conditions.

The Company’s methodology includes features that are intended to reduce the difference between estimated and actual losses. The specific allowance portion of the analysis is designed to be self-correcting by taking into account the current loan loss experience based on that portion of the portfolio. By analyzing the probable estimated losses inherent in the loan portfolio on a quarterly basis, management is able to adjust specific and inherent loss estimates using the most recent information available. In performing the periodic migration analysis, management believes that historical loss factors used in the computation of the formula allowance need to be adjusted to reflect current changes in market conditions and trends in the Company’s loan portfolio. There are a number of other factors which are reviewed when determining adjustments in the historical loss factors. They include 1) trends in delinquent and nonaccrual loans, 2) trends in loan volume and terms, 3) effects of changes in lending policies, 4) concentrations of credit, 5) competition, 6) national and local economic trends and conditions, 7) experience of lending staff, 8) loan review and Board of Directors oversight, 9) high balance loan concentrations, and 10) other business conditions. During the first six months of 2007, there were no changes in estimation methods or assumptions that affected the methodology for assessing the adequacy of the allowance for credit losses.

Management and the Company’s lending officers evaluate the loss exposure of classified and impaired loans on a weekly/monthly basis and through discussions and officer meetings as conditions change. The Company’s Loan Committee meets weekly and serves as a forum to discuss specific problem assets that pose significant concerns to the Company, and to keep the Board of Directors informed through committee minutes. All special mention and classified loans are reported quarterly on Criticized Asset Reports which are reviewed by senior management. With this information, the migration analysis and the impaired loan analysis are performed on a quarterly basis and adjustments are made to the allowance as deemed necessary.

Impaired loans are calculated under SFAS No. 114, and are measured based on the present value of the 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 amount of impaired loans is not directly comparable to the amount of nonperforming loans disclosed later in this section. The primary differences between impaired loans and nonperforming loans are: i) all loan categories are considered in determining nonperforming loans while impaired loan recognition is limited to commercial and industrial loans, commercial and residential real estate loans, construction loans, and agricultural loans, and ii) impaired loan recognition considers not only loans 90 days or more past due, restructured loans and nonaccrual loans but also may include problem loans other than delinquent loans.

The Company considers a loan to be impaired when, based upon current information and events, it believes it is probable the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans include nonaccrual loans, restructured debt, and performing loans in which full payment of principal or interest is not expected. Management bases the measurement of these impaired loans on the fair value of the loan's collateral or the expected cash flows on the loans discounted at the loan's stated interest rates. Cash receipts on impaired loans not performing to contractual terms and that are on nonaccrual status are used to reduce principal balances. Impairment losses are included in the allowance for credit losses through a charge to the provision, if applicable.

At June 30, 2007 and 2006, the Company's recorded investment in loans for which impairment has been recognized totaled $17.9 million and $7.4 million, respectively. Included in total impaired loans at June 30, 2007, are $14.3 million of impaired loans for which the related specific allowance is $5.1 million, as well as $3.6 million of impaired loans that as a result of write-downs or the fair value of the collateral, did not have a specific allowance. Total impaired loans at June 30, 2006 included $5.9 million of impaired loans for which the related specific allowance is $4.1 million, as well as $1.5 million of impaired loans that, as a result of write-downs or the fair value of the collateral, did not have a specific allowance. The average recorded investment in impaired loans was $12.1 million during the first six months of 2007 and $10.9 million during the six months of 2006. In most cases, the Bank uses the cash basis method of income recognition for impaired loans. In the case of certain troubled debt restructuring, for which the loan is performing under the current contractual terms, income is recognized under the accrual method. For the six months ended June 30, 2007, the Company recognized no income on such loans. For the year ended December 31, 2006 and the six months ended June 30, 2006, the Company recognized $65,000 and $35,000, respectively, in income on such loans.
 
27

 
The Company focuses on competition and other economic conditions within its market area, which may ultimately affect the risk assessment of the portfolio. The Company continues to experience increased competition from major banks, local independents and non-bank institutions creating pressure on loan pricing. With interest rates remaining level during the second half of 2006, indications are that rates will remain level throughout the remainder of 2007. Both business and consumer spending have improved during the past several years, with GDP currently ranging between 3.5% and 4.0%. It is difficult to determine what direction the Federal Reserve will take with interest rates in its efforts to influence the economy, however with the 125 basis point increase in the prime rate during the second half of 2004, an additional 200 basis point increase during 2005, and then four 25 basis point increases during 2006, it is predicted that we are near the end of an interest rate cycle. It is likely that the business environment in California will continue to be influenced by these domestic as well as global events. The local market has improved economically during the past several years while the rest of the state and the nation have experienced slowed economic growth. The local area residential housing markets continue to perform, which should bode well for sustained growth in the Company’s market areas of Fresno and Madera, Kern, and Santa Clara Counties, although there is some indication of slowing commercial and residential real estate markets in at least some of these areas. Local unemployment rates in the San Joaquin Valley remain high primarily as a result of the areas’ agricultural dynamics, however unemployment rates have improved during the past several years. It is difficult to predict what impact this will have on the local economy. The Company believes that the Central San Joaquin Valley will continue to grow and diversify as property and housing costs remain reasonable relative to other areas of the state, although this growth may begin to slow as higher interest rates dampen economic expansion. Management recognizes increased risk of loss due to the Company's exposure from local and worldwide economic conditions, as well as potentially volatile real estate markets, and takes these factors into consideration when analyzing the adequacy of the allowance for credit losses.

The following table provides a summary of the Company's allowance for possible credit losses, provisions made to that allowance, and charge-off and recovery activity affecting the allowance for the periods indicated.

Table 7. Allowance for Credit Losses - Summary of Activity (unaudited)
 
(In thousands)
 
June 30,
2007
 
June 30,
2006
 
Total loans outstanding at end of period before deducting allowances for credit losses
 
$
589,030
 
$
481,896
 
Average net loans outstanding during period
   
552,701
   
442,271
 
Balance of allowance at beginning of period
   
8,365
   
7,748
 
Loans charged off:
             
Real estate
   
0
   
0
 
Commercial and industrial
   
(70
)
 
(2
)
Lease financing
   
(3
)
 
(149
)
Installment and other
   
(95
)
 
(17
)
Total loans charged off
   
(168
)
 
(168
)
Recoveries of loans previously charged off:
             
Real estate
   
0
   
0
 
Commercial and industrial
   
17
   
42
 
Lease financing
   
0
   
1
 
Installment and other
   
13
   
20
 
Total loan recoveries
   
30
   
63
 
Net loans charged off
   
(138
)
 
(105
)
               
Provision charged to operating expense
   
410
   
363
 
Reclassification of off-balance sheet reserve
   
0
   
33
 
Reserve acquired in business combination
   
1,268
   
0
 
Balance of allowance for credit losses at end of period
 
$
9,905
 
$
8,039
 
               
Net loan charge-offs to total average loans (annualized)
   
0.05
%
 
0.05
%
Net loan charge-offs to loans at end of period (annualized)
   
0.05
%
 
0.04
%
Allowance for credit losses to total loans at end of period
   
1.68
%
 
1.67
%
Net loan charge-offs to allowance for credit losses (annualized)
   
2.81
%
 
2.63
%
Net loan charge-offs to provision for credit losses (annualized)
   
33.66
%
 
28.93
%

28

 
At June 30, 2007 and 2006, $593,000 and $509,000, respectively, of the formula allowance is allocated to unfunded loan commitments and is, therefore, carried separately in other liabilities. Management believes that the 1.68% credit loss allowance at June 30, 2007 is adequate to absorb known and inherent risks in the loan portfolio. No assurance can be given, however, that the economic conditions which may adversely affect the Company's service areas or other circumstances will not be reflected in increased losses in the loan portfolio.

It is the Company's policy to discontinue the accrual of interest income on loans for which reasonable doubt exists with respect to the timely collectibility of interest or principal due to the ability of the borrower to comply with the terms of the loan agreement. Such loans are placed on nonaccrual status whenever the payment of principal or interest is 90 days past due or earlier when the conditions warrant, and interest collected is thereafter credited to principal to the extent necessary to eliminate doubt as to the collectibility of the net carrying amount of the loan. Management may grant exceptions to this policy if the loans are well secured and in the process of collection.

Table 8. Nonperforming Assets 
 
(In thousands)
 
June 30,
2007
 
December 31,
2006
 
Nonaccrual Loans
 
$
17,798
 
$
8,138
 
Restructured Loans
   
75
   
4,906
 
Total nonperforming loans
   
17,873
   
13,044
 
Other real estate owned
   
1,919
   
1,919
 
Total nonperforming assets
 
$
19,792
 
$
14,963
 
               
Loans past due 90 days or more, still accruing
 
$
0
 
$
0
 
Nonperforming loans to total gross loans
   
3.03
%
 
2.61
%
Nonperforming assets to total gross loans
   
3.35
%
 
2.99
%
 
Nonaccrual loans have increased between December 31, 2006 and June 30, 2007 as the result of the transfer of two lending relationships to nonaccrual status during the first six months of 2007, one of those relationships totaling more than $7.6 million. Of that $7.6 million relationship, $6.0 million is a land development loan which is a shared appreciation credit, and as such, the Company has agreed to receive interest on the loan as lots are sold rather than monthly, and the borrower has agreed to share in the profits of the project. Interest is accrued and recognized in income on an ongoing basis. Shared appreciation profit is currently established at $22,000 per lot. Upon moving the credit to nonaccrual status during the first quarter of 2007, the Company did not reverse the accrued interest amount of $865,000 from income, based upon the current appraised value of the property and the additional values estimated of the 177 completed lots (see “Asset Quality and Allowance for Credit Losses” section of Management's Discussion and Analysis of Financial Condition and Results of Operations included in the Company’s December 31, 2006 10-K). At this time, the Company believes that based upon such values, it will collect all principal and interest due on the loan.

A $4.9 million loan classified as restructured at December 31, 2006, paid off during the first quarter of 2007, resulting in the recognition of approximately $1.1 million in previously unrecognized interest income during the six months ended June 30, 2007.

The Company purchased a schedule of payments collateralized by Surety Bonds and lease payments in September 2001 that have a current balance owing of $5.4 million plus interest. The leases have been nonperforming since June 2002 (see “Asset Quality and Allowance for Credit Losses” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in the Company’s 2006 Annual Report on Form 10-K). The impaired lease portfolio is on non-accrual status and has a specific allowance allocation of $4.2 million and $4.0 million allocated at June 30, 2007 and December 31, 2006, and a net carrying value of $1.2 million and $1.4 million at June 30, 2007 and December 31, 2006, respectively. The specific allowance was determined based on an estimate of expected future cash flows.
 
29

 
The Company believes that under generally accepted accounting principles a total loss of principal is not probable, and the specific allowance of $4.2 million calculated for the impaired lease portfolio at June 30, 2007 under SFAS No. 114 is in accordance with generally accepted accounting principles.

Loans past due more than 30 days are receiving increased management attention and are monitored for increased risk. The Company continues to move past due loans to nonaccrual status in its ongoing effort to recognize loan problems at an earlier point in time when they may be dealt with more effectively. As impaired loans, nonaccrual and restructured loans are reviewed for specific reserve allocations and the allowance for credit losses is adjusted accordingly. 

Except for the loans included in the above table, or those otherwise included in the impaired loan totals, there were no loans at June 30, 2007 where the known credit problems of a borrower caused the Company to have serious doubts as to the ability of such borrower to comply with the present loan repayment terms and which would result in such loan being included as a nonaccrual, past due or restructured loan at some future date.

Liquidity and Asset/Liability Management

The primary function of asset/liability management is to provide adequate liquidity and maintain an appropriate balance between interest-sensitive assets and interest-sensitive liabilities.

Liquidity management may be described as the ability to maintain sufficient cash flows to fulfill financial obligations, including loan funding commitments and customer deposit withdrawals, without straining the Company’s equity structure. To maintain an adequate liquidity position, the Company relies on, in addition to cash and cash equivalents, cash inflows from deposits and short-term borrowings, repayments of principal on loans and investments, and interest income received. The Company's principal cash outflows are for loan origination, purchases of investment securities, depositor withdrawals and payment of operating expenses.

The Company continues to emphasize liability management as part of its overall asset/liability strategy. Through the discretionary acquisition of short term borrowings, the Company has been able to provide liquidity to fund asset growth while, at the same time, better utilizing its capital resources, and better controlling interest rate risk. The borrowings are generally short-term and more closely match the repricing characteristics of floating rate loans, which comprise approximately 61.3% of the Company’s loan portfolio at June 30, 2007. This does not preclude the Company from selling assets such as investment securities to fund liquidity needs but, with favorable borrowing rates, the Company has maintained a positive yield spread between borrowed liabilities and the assets which those liabilities fund. If, at some time, rate spreads become unfavorable, the Company has the ability to utilize an asset management approach and, either control asset growth or, fund further growth with maturities or sales of investment securities.

The Company's liquid asset base which generally consists of cash and due from banks, federal funds sold, securities purchased under agreements to resell (“reverse repos”) and investment securities, is maintained at a level deemed sufficient to provide the cash outlay necessary to fund loan growth as well as any customer deposit runoff that may occur. Within this framework is the objective of maximizing the yield on earning assets. This is generally achieved by maintaining a high percentage of earning assets in loans, which historically have represented the Company's highest yielding asset. At June 30, 2007, the Bank had 75.0% of total assets in the loan portfolio and a loan to deposit ratio of 91.9%. Liquid assets at June 30, 2007 include cash and cash equivalents totaling $26.6 million as compared to $43.1 million at December 31, 2006. Other sources of liquidity include collateralized and uncollateralized lines of credit from other banks, the Federal Home Loan Bank, and from the Federal Reserve Bank totaling $368.1 million at June 30, 2007.

The liquidity of the parent company, United Security Bancshares, is primarily dependent on the payment of cash dividends by its subsidiary, United Security Bank, subject to limitations imposed by the Financial Code of the State of California. During the six months ended June 30, 2007, dividends paid by the Bank to the parent company totaled $13.3 million dollars.
 
30

 
Regulatory Matters

Capital Adequacy

The Board of Governors of the Federal Reserve System (“Board of Governors”) has adopted regulations requiring insured institutions to maintain a minimum leverage ratio of Tier 1 capital (the sum of common stockholders' equity, noncumulative perpetual preferred stock and minority interests in consolidated subsidiaries, minus intangible assets, identified losses and investments in certain subsidiaries, plus unrealized losses or minus unrealized gains on available for sale securities) to total assets. Institutions which have received the highest composite regulatory rating and which are not experiencing or anticipating significant growth are required to maintain a minimum leverage capital ratio of 3% Tier 1 capital to total assets. All other institutions are required to maintain a minimum leverage capital ratio of at least 100 to 200 basis points above the 3% minimum requirement.

The Board of Governors has also adopted a statement of policy, supplementing its leverage capital ratio requirements, which provides definitions of qualifying total capital (consisting of Tier 1 capital and Tier 2 supplementary capital, including the allowance for loan losses up to a maximum of 1.25% of risk-weighted assets) and sets forth minimum risk-based capital ratios of capital to risk-weighted assets. Insured institutions are required to maintain a ratio of qualifying total capital to risk weighted assets of 8%, at least one-half (4%) of which must be in the form of Tier 1 capital.

The following table sets forth the Company’s and the Bank's actual capital positions at June 30, 2007 and the minimum capital requirements for both under the regulatory guidelines discussed above:

Table 9. Capital Ratios 
 
   
Company
 
Bank
     
   
Actual
Capital Ratios
 
Actual
Capital Ratios
 
Minimum
Capital Ratios
 
Total risk-based capital ratio
   
12.61
%
 
12.05
%
 
10.00
%
Tier 1 capital to risk-weighted assets
   
11.44
%
 
10.88
%
 
6.00
%
Leverage ratio
   
11.16
%
 
10.62
%
 
5.00
%

As is indicated by the above table, the Company and the Bank exceeded all applicable regulatory capital guidelines at June 30, 2007. Management believes that, under the current regulations, both will continue to meet their minimum capital requirements in the foreseeable future.

Dividends

The primary source of funds with which dividends will be paid to shareholders is from cash dividends received by the Company from the Bank. During the first six months of 2007, the Company has received $13.3 million in cash dividends from the Bank, from which the Company paid $2.9 million in dividends to shareholders.

Reserve Balances

The Bank is required to maintain average reserve balances with the Federal Reserve Bank. At June 30, 2007 the Bank's qualifying balance with the Federal Reserve was approximately $25,000 consisting of balances held with the Federal Reserve.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Sensitivity and Market Risk

There have been no material changes in the Company’s quantitative and qualitative disclosures about market risk as of June 30, 2007 from those presented in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

As part of its overall risk management, the Company pursues various asset and liability management strategies, which may include obtaining derivative financial instruments to mitigate the impact of interest fluctuations on the Company’s net interest margin. During the second quarter of 2003, the Company entered into an interest rate swap agreement with the purpose of minimizing interest rate fluctuations on its interest rate margin and equity.
 
31

 
Under the interest rate swap agreement, the Company receives a fixed rate and pays a variable rate based on a spread from the Prime Rate (“Prime”). The swap qualifies as a cash flow hedge under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, as amended, and is designated as a hedge of the variability of cash flows the Company receives from certain variable-rate loans indexed to Prime. In accordance with SFAS No. 133, the swap agreement is measured at fair value and reported as an asset or liability on the consolidated balance sheet. The portion of the change in the fair value of the swap that is deemed effective in hedging the cash flows of the designated assets are recorded in accumulated other comprehensive income and reclassified into interest income when such cash flow occurs in the future. Any ineffectiveness resulting from the hedge is recorded as a gain or loss in the consolidated statement of income as part of noninterest income. The amortizing hedge has a remaining notional value of $8.3 million at June 30, 2007, matures in September 2008, and has a duration of approximately 4 months. As of June 30, 2007, the maximum length of time over which the Company is hedging its exposure to the variability of future cash flows is approximately 1.25 years. As of June 30, 2007, the loss amounts in accumulated other comprehensive income associated with these cash flows totaled $91,000 (net of tax benefit of $61,000). During the six months ended June 30, 2007, $200,000 was reclassified from other accumulated other comprehensive income into expense, and is reflected as a reduction in interest income.

The Company performs a quarterly analysis of the interest rate swap agreement. At June 30, 2007, the Company determined that the swap remains highly effective in achieving offsetting cash flows attributable to the hedged risk during the term of the hedge, and therefore continues to qualify for hedge accounting under the guidelines of SFAS No. 133. However, during the second quarter of 2006, the Company determined that the underlying loans being hedged were paying off faster than the notional value of the hedge instrument was amortizing. This difference between the notional value of the hedge and the underlying hedged assets is considered an “overhedge” pursuant to SFAS No. 133 guidelines and may constitute ineffectiveness if the difference is other than temporary. The Company determined during 2006 that the difference was other than temporary and, as a result, reclassified a net total of $75,000 of the pretax hedge loss reported in other comprehensive income into earnings during 2006. As of June 30, 2007, the notional value of the hedge is still in excess of the value of the underlying loans by approximately $2.6 million, but has improved from the $3.3 million difference reflected at December 31, 2006. As a result, the Company recorded a pretax hedge gain related to swap ineffectiveness of approximately $32,000 during the first six months of 2006. Amounts recognized as hedge ineffectiveness gains or losses are reflected in noninterest income.

The Board of Directors has adopted an interest rate risk policy which establishes maximum decreases in net interest income of 12% and 15% in the event of a 100 BP and 200 BP increase or decrease in market interest rates over a twelve month period. Based on the information and assumptions utilized in the simulation model at June 30, 2007, the resultant projected impact on net interest income falls within policy limits set by the Board of Directors for all rate scenarios run.

The Company's interest rate risk policy establishes maximum decreases in the Company's market value of equity of 12% and 15% in the event of an immediate and sustained 100 BP and 200 BP increase or decrease in market interest rates. As shown in the table below, the percentage changes in the net market value of the Company's equity are within policy limits for both rising and falling rate scenarios.

The following sets forth the analysis of the Company's market value risk inherent in its interest-sensitive financial instruments as they relate to the entire balance sheet at June 30, 2007 and December 31, 2006 ($ in thousands). Fair value estimates are subjective in nature and involve uncertainties and significant judgment and, therefore, cannot be determined with absolute precision. Assumptions have been made as to the appropriate discount rates, prepayment speeds, expected cash flows and other variables. Changes in these assumptions significantly affect the estimates and as such, the obtained fair value may not be indicative of the value negotiated in the actual sale or liquidation of such financial instruments, nor comparable to that reported by other financial institutions. In addition, fair value estimates are based on existing financial instruments without attempting to estimate future business.
 
   
June 30, 2007
 
December 31, 2006
 
Change in
Rates
 
Estimated
MV
of Equity
 
Change in
MV
of Equity $
 
Change in
MV
of Equity $
 
Estimated
MV
Of Equity
 
Change in
MV
of Equity $
 
Change in
MV
of Equity %
 
+ 200 BP
 
$
113,138
 
$
4,020
   
3.68
%
$
90,317
 
$
912
   
1.02
%
+ 100 BP
   
112,126
   
3,009
   
2.76
%
 
90,524
   
1,118
   
1.25
%
  0 BP
   
109,118
   
0
   
0.00
%
 
89,406
   
0
   
0.00
%
- 100 BP
   
104,796
   
(4,322
)
 
-3.96
%
 
87,291
   
(2,115
)
 
-2.37
%
- 200 BP
   
99,087
   
(10,031
)
 
-9.19
%
 
84,278
   
(5,128
)
 
-5.74
%
 
32

 
Item 4. Controls and Procedures
 
a) As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as defined in the Securities and Exchange Act Rule 13(a)-15(e). Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective on a timely manner to alert them to material information relating to the Company which is required to be included in the Company’s periodic Securities and Exchange Commission filings.

(b) Changes in Internal Controls over Financial Reporting: During the quarter ended June 30, 2007, the Company did not make any significant changes in, nor take any corrective actions regarding, its internal controls over financial reporting or other factors that could significantly affect these controls.

The Company does not expect that its disclosure controls and procedures and internal control over financial reporting will prevent all error and fraud.  A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met.  Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.  These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns in controls or procedures can occur because of simple error or mistake.  Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control.  The design of any control procedure is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.  Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.
 
33


PART II. Other Information

Item 1. Not applicable
Item 1A. There have been no material changes in the Company’s risk factors during the second quarter of 2007.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
 
Purchases of Equity Securities by Affiliates and Associated Purchasers

Period
 
Total Number
Of Shares
Purchased
 
Weighted
Average
Price Paid
Per Share
 
Total Number of
Shares Purchased
as Part of Publicly
Announced Plan
or Program
 
Maximum Number
of Shares That May
Yet be Purchased
Under the Plans
or Programs (1)
 
04/01/07 to 04/30/07
   
14,390
 
$
19.49
   
14,390
   
110,600
 
05/01/07 to 05/31/07
   
128,234
 
$
18.32
   
128,234
   
387,633
 
06/01/07 to 06/30/07
   
164,134
 
$
21.14
   
164,134
   
352,499
 
                           
Total second quarter 2007
   
306,758
 
$
19.89
   
306,758
       
 
(1)
Number of shares yet to be purchased at April 30, 2007 is for the 2004 repurchase plan. Number of shares yet to be purchased at May 31, 2007 and June 30, 2007 are for the 2007 repurchase plan.
 
On August 30, 2001 the Company announced that its Board of Directors approved a plan to repurchase, as conditions warrant, up to 280,000 shares (560,000 shares adjusted for May 2006 stock split) of the Company's common stock on the open market or in privately negotiated transactions. The duration of the program was open-ended and the timing of purchases was dependent on market conditions. A total of 215,423 shares (430,846 shares adjusted for May 2006 stock split) had been repurchased under that plan as of December 31, 2003, at a total cost of $3.7 million.
 
On February 25, 2004 the Company announced a second stock repurchase plan under which the Board of Directors approved a plan to repurchase, as conditions warrant, up to 276,500 shares (553,000 shares adjusted for May 2006 stock split) of the Company's common stock on the open market or in privately negotiated transactions. As with the first plan, the duration of the new program is open-ended and the timing of purchases will depend on market conditions. Concurrent with the approval of the new repurchase plan, the Board terminated the 2001 repurchase plan and canceled the remaining 64,577 shares (129,154 shares adjusted for May 2006 stock split) yet to be purchased under the earlier plan.
 
On May 16, 2007, the Company announced another stock repurchase plan to repurchase, as conditions warrant, up to 610,000 shares of the Company's common stock on the open market or in privately negotiated transactions. The repurchase plan represents approximately 5.00% of the Company's currently outstanding common stock. The duration of the program is open-ended and the timing of purchases will depend on market conditions. Concurrent with the approval of the new repurchase plan, the Company canceled the remaining 75,733 shares available under the 2004 repurchase plan.
 
During the six months ended June 30, 2007, 424,161 shares were repurchased at a total cost of $8.6 million and an average per share price of $20.33. Of the shares repurchased during 2007, 166,660 shares were repurchased under the 2004 plan at an average cost of $20.46 per shares, and 257,501 shares were repurchased under the 2007 plan at an average cost of $20.24 per shares.
 
34


Item 3. Not applicable
 
Item 4. Submission of Matters to a Vote of Security Holders

The Company’s Annual Shareholder’s Meeting was held on Wednesday May 16, 2007 in Fresno, California. Shareholders were asked to vote on the following matter:

1) The shareholders were asked to vote on the election of eleven nominees to serve on the Company’s Board of Directors. Such Directors nominate for election will serve on the Board until the 2008 annual meeting of shareholders and until their successors are elected and have been qualified. Votes regarding the election of Directors were as follows:
 
Director Nominee
Votes For
Votes Withheld
Robert G. Bitter, Pharm. D.
8,281,822
32,782
Stanley J. Cavalla
8,297,682
16,922
Tom Ellithorpe
8,085,848
228,756
R. Todd Henry
8,232,322
82,282
Gary Luke Hong
8,297,682
16,922
Robert M. Mochizuki
8,294,682
19,922
Ronnie D. Miller
8,296,682
17,922
Walter Reinhard
8,292,652
21,952
John Terzian
8,227,084
87,520
Dennis R. Woods
8,288,922
25,682
Michael T. Woolf, D.D.S.
8,293,682
20,922
 
Item 5. Not applicable
 
Item 6. Exhibits:

 
(a)
Exhibits:

 
Computation of Earnings per Share*
 
31.1
Certification of the Chief Executive Officer of United Security Bancshares pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
31.2
Certification of the Chief Financial Officer of United Security Bancshares pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
Certification of the Chief Executive Officer of United Security Bancshares pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
32.2
Certification of the Chief Financial Officer of United Security Bancshares pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
* Data required by Statement of Financial Accounting Standards No. 128, Earnings per Share, is provided in note 6 to the consolidated financial statements in this report.
 
35


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.
 
   
 United Security Bancshares
 
 
 
 
 
 
Date: August 9, 2007  
/S/ Dennis R. Woods
 

Dennis R. Woods
 
President and
Chief Executive Officer
     
 
 
 
 
 
 
   
/S/ Kenneth L. Donahue
 

Kenneth L. Donahue
 
Senior Vice President and
Chief Financial Officer
 
36