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EX-32 - EXHIBIT 32 - FNB BANCORP/CA/ex_32.htm
EX-31.1 - EXHIBIT 31.1 - FNB BANCORP/CA/ex31_1.htm
EX-23 - EXHIBIT 23 - FNB BANCORP/CA/ex23_1.htm
EX-31.2 - EXHIBIT 31.2 - FNB BANCORP/CA/ex31_2.htm
EX-10.49 - EXHIBIT 10.49 - FNB BANCORP/CA/ex10_49.htm
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-K
 
x
Annual report pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934
   
  for the fiscal year ended December 31, 2009
   
 
or
   
o
Transition report pursuant to Section 13 or 15 (d) of Securities Exchange Act of 1934
 
Commission File No. 000-49693
 
FNB BANCORP
(Exact name of registrant as specified in its charter)

California
 
92-2115369
(State or other jurisdiction of
 
(IRS Employer ID Number)
incorporation or organization)
   
     
975 El Camino Real, South San Francisco, California
 
94080
(Address of principal executive offices)
 
(Zip code)
     
(650) 588-6800
(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:
 
None
Securities registered pursuant to Section 12(g) of the Act:
   
Title of Class:
 
Common Stock, no par value

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes o No x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes o No x
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes o No o
 
Indicate by check mark if disclosure of delinquent filers pursuant to item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this 10-K o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company “ in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer o
Accelerated filer o
Non-accelerated filer x
     
Smaller reporting company 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 voting and non-voting common equity held by non-affiliates of the registrant, computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter: $28,299,997
 
Page 1 of 106 pages
 
Number of shares outstanding of each of the registrant’s classes of common stock, as of March 1, 2010
 
No par value Common Stock – 3,181,714 shares outstanding.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
The following documents are incorporated by reference into this Form 10-K: Part III, Items 10 through 14 from Registrant’s definitive proxy statement for the 2010 annual meeting of shareholders.

 
 

 
 
TABLE OF CONTENTS

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Exhibit 31 – Rule 13a-14(a)/15d-14(a) Certifications
   
 
Exhibit 32 – Section 1350 Certifications
   
 
 
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Forward-Looking Statements: Certain matters discussed or incorporated by reference in this Annual Report on Form 10-K including, but not limited to, matters described in “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations,” are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended. Such forward-looking statements may contain words related to future projections including, but not limited to, words such as “believe,” “expect,” “anticipate,” “intend,” “may,” “will,” “should,” “could,” “would,” and variations of those words and similar words that are subject to risks, uncertainties and other factors that could cause actual results to differ materially from those projected. Factors that could cause or contribute to such differences include, but are not limited to, the following: (1) variances in the actual versus projected growth in assets; (2) return on assets; (3) loan and lease losses; (4) expenses; (5) changes in the interest rate environment including interest rates charged on loans, earned on securities investments and paid on deposits; (6) competition effects; (7) fee and other noninterest income earned; (8) general economic conditions nationally, regionally, and in the operating market areas of the Company and its subsidiary, including State and local issues being addressed in California; (9) changes in the regulatory environment; (10) changes in business conditions and inflation; (11) changes in securities markets; (12) data processing problems; (13) a further decline in real estate values in the Company’s operating market areas; (14) the effects of terrorism, the threat of terrorism or the impact of the current military conflicts in Iraq and Afghanistan, and the conduct of the war on terrorism by the United States and its allies, as well as other factors. The factors set forth under “Item 1A – Risk Factors” in this report and other cautionary statements and information set forth in this report should be read carefully, considered and understood as being applicable to all related forward-looking statements contained in this report when evaluating the business prospects of the Company and its subsidiary.
 
Forward-looking statements are not guarantees of performance. By their nature, they involve risks, uncertainties and assumptions. Actual results and shareholder values in the future may differ significantly from those expressed in forward-looking statements. You are cautioned not to put undue reliance on any forward-looking statement. Any such statement speaks only as of the date of the report, and in the case of any documents that may be incorporated by reference, as of the date of those documents. We do not undertake any obligation to update or release any revisions to any forward-looking statements, or to report any new information, future event or other circumstances after the date of this report or to reflect the occurrence of unanticipated events, except as required by law. However, your attention is directed to any further disclosures made on related subjects in our subsequent reports filed with the Securities and Exchange Commission on Forms 10-K, 10-Q and 8-K.
 
General
 
FNB Bancorp (the “Company”) is a bank holding company registered under the Bank Holding Company Act of 1956, as amended. The Company was incorporated under the laws of the State of California on February 28, 2001.
 
 
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As a bank holding company, the Company is authorized to engage in the activities permitted under the Bank Holding Company Act of 1956, as amended, and regulations thereunder. Its principal office is located at 975 El Camino Real, South San Francisco, California 94080, and its telephone number is (650) 588-6800.
 
The Company owns all of the issued and outstanding shares of common stock of First National Bank of Northern California, a national banking association (the “Bank”). The Company has no other subsidiary.
 
The Bank was organized in 1963 as “First National Bank of Daly City.” In 1995, the shareholders approved a change in the name to “First National Bank of Northern California.” The administrative headquarters of the Bank is located at 975 El Camino Real, South San Francisco, California. The Bank is locally owned and presently operates thirteen full service banking offices in the cities of Colma, Daly City, South San Francisco, Millbrae, Pacifica, Half Moon Bay, San Mateo, Redwood City, Pescadero, as well as its Financial District and Portola offices in San Francisco. The Bank’s primary business is servicing the business or commercial banking needs of individuals and small to mid-sized businesses within San Mateo and San Francisco Counties.
 
The Bank is chartered under the laws of the United States and is governed by the National Bank Act, and is a member of the Federal Reserve System. The Federal Deposit Insurance Corporation insures the deposits of the Bank up to the applicable legal limits. The Bank is also participating in the FDIC Transaction Account Guarantee Program (“TAGP”). Under that program, through June 30, 2010, all noninterest-bearing transaction accounts are fully guaranteed by the FDIC for the entire amount in the account. Coverage under the TAGP is in addition to and separate from the coverage available under the FDIC’s general deposit insurance rules. The Bank is subject to regulation, supervision and regular examination by the Office of the Comptroller of the Currency. The regulations of the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve System, and the Office of the Comptroller of the Currency govern many aspects of the Bank’s business and activities, including investments, loans, borrowings, branching, mergers and acquisitions, reporting and numerous other areas. The Bank is also subject to applicable provisions of California law to the extent those provisions are not in conflict with or preempted by federal banking law. See “Supervision and Regulation” below.
 
The Bank offers a broad range of services to individuals and businesses in its primary service area, including a full line of business financial products with specialized services such as courier, appointment banking, and business Internet banking. The Bank offers personal and business checking and savings accounts, including individual interest-bearing negotiable orders of withdrawal (“NOW”), money market accounts and/or accounts combining checking and savings accounts with automatic transfer capabilities, IRA accounts, time certificates of deposit, direct deposit services and computer cash management with access through the Internet. First National Bank also makes available commercial loans and standby letters of credit and construction, accounts receivable, inventory, automobile, home improvement, residential real estate, commercial real estate, Home Equity Lines, Small Business Administration, office equipment, leasehold improvement and consumer loans as well as overdraft protection lines of credit. In addition, the Bank sells travelers checks and cashiers checks, offers automated teller machine (ATM) services tied in with major statewide and national networks and offers other customary commercial banking services.
 
 
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Most of the Bank’s deposits are obtained from commercial and non-profit businesses, professionals and individuals. As of December 31, 2009, First National Bank had a total of 24,398 deposit accounts. On occasion, the Bank has obtained deposits through deposit brokers for which it pays a broker fee. As of December 31, 2009, First National Bank had no such deposits. There is no concentration of deposits or any customer with 5% or more of First National Bank’s deposits.
 
At December 31, 2009, the Company had total assets of $708,309,000, net loans of $494,349,000, deposits of $598,964,000 and shareholders’ equity of $78,865,000. The Company competes with approximately 33 other banking or savings institutions in its service areas. The Company’s market share of Federal Deposit Insurance Corporation insured deposits in the service area of San Mateo County is approximately 2.29% (based upon the most recent information available by the Federal Deposit Insurance Corporation through June 30, 2009). See “Competitive Data” below.
 
Employees
 
At December 31, 2009, The Company employed 185 persons on a full-time equivalent basis. The Company believes its employee relations are good. The Company is not a party to any collective bargaining agreement.
 
Available Information
 
The Company and the Bank maintain an Internet website at http://www.FNBNORCAL.com. The Company’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports, filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, are made available free of charge on or through such website as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission. Also made available on or through such website are the Section 16 reports of ownership and changes in ownership of the Company’s common stock which are filed with the Securities and Exchange Commission by the directors and executive officers of the Company and by any persons who own more than 10 percent of the outstanding shares of such stock. Information on such website is not incorporated by reference into this report.
 
SUPERVISION AND REGULATION
 
General
 
FNB Bancorp. The common stock of the Company is subject to the registration requirements of the Securities Act of 1933, as amended, and the qualification requirements of the California Corporate Securities Law of 1968, as amended. FNB Bancorp has registered its common stock under Section 12 (g) of the Securities Exchange Act of 1934, as amended. The Company is also subject to the periodic reporting requirements of Section 13 of the Securities Exchange Act of 1934, as amended, which include, but are not limited to, annual, quarterly and other current reports required to be filed with the Securities and Exchange Commission.
 
 
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The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the “Bank Holding Company Act”), and is registered as such with, and subject to the supervision of, the Board of Governors of the Federal Reserve System (the “Board of Governors”). The Company is required to obtain the approval of the Board of Governors before it may acquire all or substantially all of the assets of any bank, or ownership or control of the voting shares of any bank if, after giving effect to such acquisition of shares, FNB Bancorp would own or control more than 5% of the voting shares of such bank. The Bank Holding Company Act prohibits the Company from acquiring any voting shares of, or interest in, all or substantially all of the assets of a bank located outside the State of California unless such an acquisition is specifically authorized by the laws of the state in which such bank is located. Any such interstate acquisition is also subject to the provisions of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994.
 
The Company, and any subsidiary which it may acquire or organize, are deemed to be “affiliates” of the Bank within the meaning of that term as defined in the Federal Reserve Act. This means, for example, that there are limitations (a) on loans by First National Bank to its affiliates, and (b) on investments by the Bank in affiliates’ stock as collateral for loans to any borrower. The Company and the Bank are also subject to certain restrictions with respect to engaging in the underwriting, public sale and distribution of securities.
 
In addition, regulations of the Board of Governors under the Federal Reserve Act require that reserves be maintained by the Bank in conjunction with any liability of the Company under any obligation (promissory note, acknowledgment of advance, banker’s acceptance or similar obligation) with a weighted average maturity of less than seven (7) years to the extent that the proceeds of such obligations are used for the purpose of supplying funds to the Bank for use in its banking business, or to maintain the availability of such funds.
 
First National Bank of Northern California. As a national banking association licensed under the national banking laws of the United States, the Bank is regularly examined by the Office of the Comptroller of the Currency and is subject to supervision and regulation by the Federal Deposit Insurance Corporation, and the Board of Governors of the Federal Reserve System.
 
This supervision and regulation includes comprehensive reviews of all major aspects of the Bank’s business and condition, including its capital ratios, allowance for possible loan losses and other factors. However, no inference should be drawn that such authorities have approved any such factors. The Bank is required to file reports with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation. The Bank’s deposits are insured by the Federal Deposit Insurance Corporation up to the applicable legal limits.
 
Capital Standards.
 
The Board of Governors, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency have adopted risk-based guidelines for evaluating the capital adequacy of bank holding companies and banks. The guidelines are designed to make capital requirements sensitive to differences in risk profiles among banking organizations, to take into account off-balance sheet exposures and to aid in making the definition of bank capital uniform internationally.
 
 
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Under the risk-based capital guidelines, assets reported on an institution’s balance sheet and certain off-balance sheet items are assigned to risk categories, each of which has an assigned risk weight. Capital ratios are calculated by dividing the institution’s qualifying capital by its period-end risk-weighted assets. The guidelines establish two categories of qualifying capital: Tier 1 capital (defined to include common shareholders’ equity and noncumulative perpetual preferred stock) and Tier 2 capital which includes, among other items, limited life (and in the case of banks, cumulative) preferred stock, mandatory convertible securities, subordinated debt and a limited amount of reserve for credit losses. Tier 2 capital may also include up to 45% of the pretax unrealized gains on certain available-for-sale equity securities having readily determinable fair values (i.e. the excess, if any, of fair market value over the book value or historical cost of the investment security). The federal regulatory agencies reserve the right to exclude all or a portion of the unrealized gains upon a determination that the equity securities are not prudently valued. Unrealized gains and losses on other types of assets, such as bank premises and available-for-sale debt securities, are not included in Tier 2 capital, but may be taken into account in the evaluation of overall capital adequacy. Net unrealized losses on available-for-sale equity securities will continue to be deducted from Tier 1 capital as a cushion against risk.
 
A leverage capital standard was adopted as a supplement to the risk-weighted capital guidelines. Under the leverage capital standard, an institution is required to maintain a minimum ratio of Tier 1 capital to the sum of its quarterly average total assets and quarterly average reserve for loan losses, less intangibles not included in Tier 1 capital. Period-end assets may be used in place of quarterly average total assets on a case-by-case basis. The Board of Governors and the Federal Deposit Insurance Corporation have also adopted a minimum leverage ratio for bank holding companies as a supplement to the risk-weighted capital guidelines. The leverage ratio establishes a minimum Tier 1 ratio of 3% (Tier 1 capital to total assets) for the highest rated bank holding companies or those that have implemented the risk-based capital market risk measure. All other bank holding companies must maintain a minimum Tier 1 leverage ratio of 4% with higher leverage capital ratios required for bank holding companies that have significant financial and/or operational weakness, a high risk profile, or are undergoing or anticipating rapid growth.
 
At December 31, 2009, the Company was in compliance with the risk-weighted capital and leverage ratios. See “Capital” under Item 7 below.
 
Prompt Corrective Action
 
The Board of Governors, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency have adopted regulations implementing a system of prompt corrective action pursuant to Section 38 of the Federal Deposit Insurance Act and Section 131 of the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”). The regulations establish five capital categories with the following characteristics:
 
(1) “Well capitalized” – consisting of institutions with a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 6% or greater and a leverage ratio of 5% or greater, and the institution is not subject to an order, written agreement, capital directive or prompt corrective action directive;
 
 
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(2) “Adequately capitalized” – consisting of institutions with a total risk-based capital ratio of 8% or greater, a Tier 1 risk-based capital ratio of 4% or greater and a leverage ratio of 4% or greater, and the institution does not meet the definition of a “well capitalized” institution;
 
(3) “Undercapitalized” - consisting of institutions with a total risk-based capital ratio less than 8%, a Tier 1 risk-based capital ratio of less than 4%, or a leverage ratio of less than 4%;
 
(4) “Significantly undercapitalized” – consisting of institutions with a total risk-based capital ratio of less than 6%, a Tier 1 risk-based capital ratio of less than 3%, or a leverage ratio of less than 3%;
 
(5) “Critically undercapitalized” – consisting of an institution with a ratio of tangible equity to total assets that is equal to or less than 2%.
 
The regulations established procedures for classification of financial institutions within the capital categories, filing and reviewing capital restoration plans required under the regulations and procedures for issuance of directives by the appropriate regulatory agency, among other matters. The regulations impose restrictions upon all institutions to refrain from certain actions which would cause an institution to be classified within any one of the three “undercapitalized” categories, such as declaration of dividends or other capital distributions or payment of management fees, if following the distribution or payment the institution would be classified within one of the “undercapitalized” categories. In addition, institutions that are classified in one of the three “undercapitalized” categories are subject to certain mandatory and discretionary supervisory actions. Mandatory supervisory actions include:
 
(1) increased monitoring and review by the appropriate federal banking agency;
 
(2) implementation of a capital restoration plan;
 
(3) total asset growth restrictions; and
 
(4) limitation upon acquisitions, branch expansion, and new business activities without prior approval of the appropriate federal banking agency. Discretionary supervisory actions may include:
 
(a) requirements to augment capital;
 
(b) restrictions upon affiliate transactions;
 
(c) restrictions upon deposit gathering activities and interest rates paid;
 
(d) replacement of senior executive officers and directors;
 
(e) restrictions upon activities of the institution and its affiliates;
 
(f) requiring divestiture or sale of the institution; and
 
 
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(g) any other supervisory action that the appropriate federal banking agency determines is necessary to further the purposes of the regulations. Further, the federal banking agencies may not accept a capital restoration plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. In addition, for a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with such capital restoration plan.
 
The aggregate liability of the parent holding company under the guaranty is limited to the lesser of (i) an amount equal to 5 percent of the depository institution’s total assets at the time it became undercapitalized, and (ii) the amount that is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it were “significantly undercapitalized”. FDICIA also restricts the solicitation and acceptance of and interest rates payable on brokered deposits by insured depository institutions that are not “well capitalized.”
 
An “undercapitalized” institution is not allowed to solicit deposits by offering rates of interest that are significantly higher than the prevailing rates of interest on insured deposits in the particular institution’s normal market areas or in the market areas in which such deposits would otherwise be accepted.
 
Any financial institution which is classified as “critically undercapitalized” must be placed in conservatorship or receivership within 90 days of such determination unless it is also determined that some other course of action would better serve the purposes of the regulations. Critically undercapitalized institutions are also prohibited from making (but not accruing) any payment of principal or interest on subordinated debt without prior regulatory approval and regulators must prohibit a critically undercapitalized institution from taking certain other actions without prior approval, including (1) entering into any material transaction other than in the usual course of business, including investment expansion, acquisition, sale of assets or other similar actions; (2) extending credit for any highly leveraged transaction; (3) amending articles or bylaws unless required to do so to comply with any law, regulation or order; (4) making any material change in accounting methods; (5) engaging in certain affiliate transactions; (6) paying excessive compensation or bonuses; and (7) paying interest on new or renewed liabilities at rates which would increase the weighted average costs of funds beyond prevailing rates in the institution’s normal market areas.
 
Additional Regulations
 
Under FDICIA, the federal financial institution agencies have adopted regulations which require institutions to establish and maintain comprehensive written real estate policies which address certain lending considerations, including loan-to-value limits, loan administrative policies, portfolio diversification standards, and documentation, approval and reporting requirements. FDICIA further generally prohibits an insured bank from engaging as a principal in any activity that is impermissible for a national bank, absent Federal Deposit Insurance Corporation determination that the activity would not pose a significant risk to the Bank Insurance Fund, and that such bank is, and will continue to be, within applicable capital standards.
 
 
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The Federal Financial Institutions Examination Council (“FFIEC”) utilizes the Uniform Financial Institutions Rating System (“UFIRS”), commonly referred to as “CAMELS,” to classify and evaluate the soundness of financial institutions. Bank examiners use the CAMELS measurements to evaluate capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk. Effective January 1, 2005, bank holding companies such as the Company, became subject to evaluation and examination under a revised bank holding company rating system. This so-called BOPEC (Bank, Other subsidiaries, Parent, Earnings, Capital) rating system, implemented in 1979, has been focused primarily on financial condition, consolidated capital and consolidated earnings. The new rating system reflects a change toward analysis of risk management (as reflected in bank examination under the CAMELS measurements), in addition to financial factors and the potential impact of nondepository subsidiaries upon depository institution subsidiaries.
 
The federal financial institution agencies have established bases for analysis and standards for assessing financial institution’s capital adequacy in conjunction with the risk-based capital guidelines including analysis of interest rate risk, concentrations of credit risk, risk posed by non-traditional activities, and factors affecting overall safety and soundness. The safety and soundness standards for insured financial institutions include analysis of (1) internal controls, information systems and internal audit systems; (2) loan documentation; (3) credit underwriting; (4) interest rate exposure; (5) asset growth; (6) compensation, fees and benefits; and (7) excessive compensation for executive officers, directors or principal shareholders which could lead to material financial loss. If an agency determines that an institution fails to meet any standard, the agency may require the financial institution to submit to the agency an acceptable plan to achieve compliance with the standard. If the agency requires submission of a compliance plan and the institution fails to timely submit an acceptable plan or to implement an accepted plan, the agency must require the institution to correct the deficiency. The agencies may elect to initiate enforcement action in certain cases rather than rely on an existing plan particularly where failure to meet one or more of the standards could threaten the safe and sound operation of the institution.
 
Community Reinvestment Act (“CRA”) regulations evaluate banks’ lending to low and moderate income individuals and businesses across a four-point scale from “outstanding” to “substantial noncompliance,” and are a factor in regulatory review of applications to merge, establish new branches or form bank holding companies. In addition, any bank rated in “substantial noncompliance” with the CRA regulations may be subject to enforcement proceedings. First National Bank has a current rating of “satisfactory” for CRA compliance.
 
FDIC Insurance
 
On February 8, 2006, the Federal Deposit Insurance Reform Act of 2005 (the “Reform Act”), was enacted. The Reform Act had the effect of merging the Bank Insurance Fund and the Savings Association Insurance Fund into a new Deposit Insurance Fund (“DIF”). The FDIC released final regulations under the Reform Act on November 2, 2006 that established a revised risk-based deposit insurance assessment rate system for members of the DIF to insure, among other matters, that there will be sufficient assessment income for repayment of DIF obligations and to further refine the differentiation of risk profiles among institutions as a basis for assessments. The Reform Act established a Designated Reserve Ratio (“DRR”) that included a target range for the DRR of 1.15% to 1.50%.
 
The revised assessment rate system consolidates the nine categories of the prior assessment system into four categories (Risk Categories I, II, III and IV) and three Supervisory Groups (A, B and C) based upon institution’s capital levels and supervisory ratings. Risk Category I includes all well capitalized institutions with the highest supervisory ratings. Risk Category II includes adequately capitalized institutions that are assigned to Supervisory Groups A and B. Risk Category III includes all undercapitalized institutions that are assigned to Supervisory Groups A and B and institutions assigned to Supervisory Group C that are not undercapitalized but have a low supervisory rating. Risk Category IV includes all undercapitalized institutions that are assigned to Supervisory Group C.
 
 
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On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (the “EESA”) was signed into law. The EESA temporarily raised the limit on federal deposit insurance coverage provided by the FDIC from $100,000 to $250,000 per depositor, and on May 20, 2009, this increase was extended to December 31, 2013.
 
On October 14, 2008, the FDIC implemented the Temporary Liquidity Guarantee Program (the “TLGP”) to strengthen confidence and encourage liquidity in the financial system. The TLGP includes the Transaction Account Guarantee Program (the “TAGP”). The TAGP offers full guarantee for noninterest-bearing transaction accounts held at FDIC-insured depository institutions. The unlimited deposit coverage was voluntary for eligible institutions and was in addition to the $250,000 FDIC deposit insurance per account that was included as part of the EESA. The insured deposit limits are currently scheduled to return to $100,000 on December 31, 2013. The TAGP coverage became effective on October 14, 2008 and is scheduled to continue for participating institutions until June 30, 2010. In addition to the existing risk-based deposit insurance premium assessed on such deposits, TAGP participants will be assessed, on a quarterly basis, an annualized fee, based on the participant’s insurance risk rating up to 25 basis points, on balances in noninterest-bearing transaction accounts that exceed the existing deposit insurance limit of $250,000. The Bank has elected to participate in the TAGP.
 
On December 16, 2008, the FDIC approved an earlier proposed seven basis point rate increase for the first quarter 2009 assessment period effective January 1, 2009 as part of the DIF (Deposit Insurance Fund) restoration plan to achieve a minimum DRR (Designated Reserve Ratio) of 1.15% within five years.
 
On February 28, 2009, the FDIC established increased assessment rates effective as of April 1, 2009 and included adjustments to improve differentiation of risk profiles among institutions. The FDIC concurrently adopted an interim rule that imposed a 20 basis point emergency special assessment effective June 30, 2009, to be collected from all insured depository institutions on September 30, 2009, in addition to the imposition of an emergency special assessment of up to 10 basis points at the end of any calendar quarter after June 30, 2009 if the FDIC determines that the DRR will fall to a level that would adversely affect public confidence, among other factors. The changes to differentiate risk profiles will require riskier institutions to pay higher assessment rates based on classification into one of four risk categories. Within each category, the FDIC will be able to assess higher rates to institutions with a significant reliance on secured liabilities, which generally raises the FDIC’s loss in the event of failure without providing additional assessment revenue. Higher rates will be assessed for institutions with a significant reliance on brokered deposits but, for well-managed and well-capitalized institutions, only when accompanied by rapid asset growth. The changes also provide incentives in the form of a reduction in assessment rates for institutions to hold long-term unsecured debt and, for smaller institutions, high levels of Tier 1 capital. Together, the changes would improve the way the system differentiates risk among insured institutions and help ensure that a minimum DRR of at least 1.15% is achieved by the end of 2013.
 
 
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On November 17, 2009, the FDIC amended its regulations and required all insured financial institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011 and 2012. The prepaid assessment was collected on December 30, 2009 The FDIC also approved a three basis point increase in the assessment rate applied to insured financial institutions beginning in 2011. The amount of the Company’s prepaid assessment was $3,011,000.
 
Based upon the current assessment rate system, the Bank’s capital ratios and levels of deposits, the Bank anticipates a significant increase in operating expenses due to the FDIC insurance assessment rate expected to be applicable to the Bank during 2010 compared to the rate applicable to the Bank in 2009.
 
Limitation on Dividends
 
FNB Bancorp. The Company’s ability to pay cash dividends is subject to restrictions set forth in the California General Corporation Law. Also, the Company is required to make dividend payments to the U. S. Treasury on the shares of Preferred Stock that were issued on February 27, 2009, before the Company can pay dividends on its Common Stock.
 
Funds for payment of any cash dividends by the Company would be obtained from its investments as well as dividends and/or management fees from the Bank. The Bank’s ability to pay cash dividends is subject to restrictions imposed under the National Bank Act and regulations promulgated by the Office of the Comptroller of the Currency.
 
The Company has paid quarterly dividends for each quarter commencing with the second quarter of 2002. Future dividends will continue to be determined after consideration of the Company’s earnings, financial condition, future capital funds, regulatory requirements and other factors such as the Board of Directors may deem relevant. It is the intention of the Company to continue to pay cash dividends, subject to legal restrictions on the payment of cash dividends and depending upon the level of earnings, management’s assessment of future capital needs and other factors to be considered by the Board of Directors.
 
The California General Corporation Law provides that a corporation may make a distribution to its shareholders if the corporation’s retained earnings equal at least the amount of the proposed distribution. The California General Corporation Law further provides that, in the event sufficient retained earnings are not available for the proposed distribution, a corporation may nevertheless make a distribution to its shareholders if, after giving effect to the distribution, it meets two conditions, which generally stated are as follows: (i) the corporation’s assets must equal at least 125% of its liabilities; and (ii) the corporation’s current assets must equal at least its current liabilities or, if the average of the corporation’s earnings before taxes on income and before interest expense for the two preceding fiscal years was less than the average of the corporation’s interest expense for those fiscal years, then the corporation’s current assets must equal at least 125% of its current liabilities.
 
The Board of Governors of the Federal Reserve System generally prohibits a bank holding company from declaring or paying a cash dividend which would impose undue pressure on the capital of subsidiary banks or would be funded only through borrowing or other arrangements that might adversely affect a bank holding company’s financial position. The Federal Reserve Board policy is that a bank holding company should not continue its existing rate of cash dividends on its common stock unless its net income is sufficient to fully fund each dividend and its prospective rate of earnings retention appears consistent with its capital needs, asset quality and overall financial condition.
 
 
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First National Bank of Northern California. As the Bank’s sole shareholder, the Company is entitled to receive dividends when and as declared by its Board of Directors, out of funds legally available therefore, subject to the restrictions set forth in the National Bank Act.
 
The payment of cash dividends by the Bank may be subject to the approval of the Office of the Comptroller of the Currency, as well as restrictions established by federal banking law and the Federal Deposit Insurance Corporation. Approval of the Office of the Comptroller of the Currency is required if the total of all dividends declared by the Bank’s board of directors in any calendar year will exceed the Bank’s net profits for that year combined with its retained net profits for the preceding two years, less any required transfers to surplus or to a fund for the retirement of preferred stock.
 
Additionally, the Federal Deposit Insurance Corporation and/or the Office of the Comptroller of the Currency, might, under some circumstances, place restrictions on the ability of a bank to pay dividends based upon peer group averages and the performance and maturity of that bank.
 
COMPETITION
 
Competitive Data
 
In its market area, the Bank competes for deposit and loan customers with other banks (including those with much greater resources), thrifts and, to a lesser extent, credit unions, finance companies and other financial service providers.
 
Larger banks may have a competitive advantage because of higher lending limits and major advertising and marketing campaigns, along with significant investment banking, trust and insurance operations, and international banking, services which the Bank is not authorized nor prepared to offer currently. The Bank has made arrangements with its correspondent banks and with others to provide some of these services for its customers. For borrowers requiring loans in excess of the Bank’s legal lending limits, the Bank has offered, and intends to offer in the future, such loans on a participating basis with its correspondent banks and with other independent banks, retaining the portion of such loans which is within its lending limits. As of December 31, 2009, the Bank’s aggregate legal lending limits to a single borrower and such borrower’s related parties were $12,438,000 on an unsecured basis and $20,729,000 on a fully secured basis, based on regulatory capital of $82,917,000. The Bank’s business is concentrated in its service area, which primarily encompasses San Mateo County, but also includes portions of the City and County of San Francisco. The economy of the Bank’s service area is dependent upon government, manufacturing, tourism, retail sales, population growth and smaller service oriented businesses.
 
Based upon the most recent information made available by the Federal Deposit Insurance Corporation Summary of Deposits at June 30, 2009, there were 33 commercial and savings banking institutions in San Mateo County with a total of $20,528,467,000 in deposits at June 30, 2009. The Bank had a total of 11 offices with total deposits of $470,650,000 at the same date, or 2.29% of the San Mateo County totals.
 
 
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General Competitive Factors
 
In order to compete with the financial institutions in their primary service areas, community banks use, to the fullest extent possible, the flexibility which is accorded by their independent status. This includes an emphasis on specialized services, local promotional activity, and personal contacts by their respective officers, directors and employees. The Bank’s management and employees develop a thorough knowledge of local businesses and markets.
 
They also seek to provide special services and programs for individuals in their primary service area who are employed in the agricultural, professional and business fields, such as loans for equipment, furniture and tools of the trade or expansion of practices or businesses. In the event there are customers whose loan demands exceed their respective lending limits, they seek to arrange for such loans on a participation basis with other financial institutions. They also assist those customers requiring services not offered by either bank to obtain such services from correspondent banks.
 
Banking is a business that depends on interest rate differentials. In general, the difference between the interest rate paid by a bank to obtain their deposits and other borrowings and the interest rate received by a bank on loans extended to customers and on securities held in a bank’s portfolio comprise the major portion of a bank’s earnings. The Bank competes with savings and loan associations, credit unions, other financial institutions and other entities for funds. For instance, yields on corporate and government debt securities and other commercial paper affect the ability of commercial banks to attract and hold deposits. The Bank also competes for loans with savings and loan associations, credit unions, consumer finance companies, banking and other financial institutions, mortgage companies and other lending institutions.
 
The interest rate differentials of a bank, and therefore its earnings, are affected not only by general economic conditions, both domestic and foreign, but also by statutes and as implemented by federal agencies, particularly the Federal Reserve Board. The Federal Reserve Board can and does implement national monetary policy, such as seeking to curb inflation and combat recession, by its open market operations in United States government securities, adjustments in the amount of interest free reserves that banks and other financial institutions are required to maintain, and adjustments to the discount rates applicable to borrowing by banks from the Federal Reserve Board. These activities influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and timing of any future changes in monetary policies and their impact on the Bank are not predictable.
 
Legislative and Regulatory Impact
 
Since 1996, California law implementing certain provisions of prior federal law has (1) permitted interstate merger transactions; (2) prohibited interstate branching through the acquisition of a branch business unit located in California without acquisition of the whole business unit of the California bank; and (3) prohibited interstate branching through de novo establishment of California branch offices. Initial entry into California by an out-of-state institution must be accomplished by acquisition or merger with an existing whole bank, which has been in existence for at least five years.
 
 
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The federal financial institution agencies, especially the Office of the Comptroller of the Currency and the Board of Governors of the Federal Reserve System, have taken steps to increase the types of activities in which national banks and bank holding companies can engage, and to make it easier to engage in such activities. The Office of the Comptroller of the Currency has issued regulations permitting national banks to engage in a wider range of activities through subsidiaries.
 
“Eligible institutions” (those national banks that are well capitalized, have a high overall rating and a satisfactory CRA rating, and are not subject to an enforcement order) may engage in activities related to banking through operating subsidiaries subject to an expedited application process. In addition, a national bank may apply to the Office of the Comptroller of the Currency to engage in an activity through a subsidiary in which the Bank itself may not engage.
 
The Gramm-Leach-Bliley Act (the “Act”), eliminated most of the remaining depression-era “firewalls” between banks, securities firms and insurance companies which was established by the Banking Act of 1933, also known as the Glass-Steagall Act (“Glass-Steagall”). Glass-Steagall sought to insulate banks as depository institutions from the perceived risks of securities dealing and underwriting, and related activities. The Act repealed Section 20 of Glass-Steagall, which prohibited banks from affiliating with securities firms. Bank holding companies that can qualify as “financial holding companies” can now, among other matters, acquire securities firms or create them as subsidiaries, and securities firms can now acquire banks or start banking activities through a financial holding company. The Act includes provisions which permit national banks to conduct financial activities through a subsidiary that are permissible for a national bank to engage in directly, as well as certain activities authorized by statute, or that are financial in nature or incidental to financial activities to the same extent as permitted to a “financial holding company” or its affiliates. This liberalization of United States banking and financial services regulation applies both to domestic institutions and foreign institutions conducting business in the United States. Consequently, the common ownership of banks, securities firms and insurance is now possible, as is the conduct of commercial banking, merchant banking, investment management, securities underwriting and insurance within a single financial institution using a structure authorized by the Act.
 
Prior to the Act, significant restrictions existed on the affiliation of banks with securities firms and related securities activities. Banks were also (with minor exceptions) prohibited from engaging in insurance activities or affiliating with insurers. The Act removed these restrictions and substantially eliminated the prohibitions under the Bank Holding Company Act on affiliations between banks and insurance companies. Bank holding companies which qualify as financial holding companies can now, among other matters, insure, guarantee, or indemnify against loss, harm, damage, illness, disability, or death; issue annuities; and act as a principal, agent, or broker regarding such insurance services.
 
In order for a commercial bank to affiliate with a securities firm or an insurance company pursuant to the Act, its bank holding company must qualify as a financial holding company. A bank holding company will qualify if (i) its banking subsidiaries are “well capitalized” and “well managed” and (ii) it files with the Board of Governors a certification to such an effect and a declaration that it elects to become a financial holding company. The amendment of the Bank Holding Company Act now permits financial holding companies to engage in activities, and acquire companies engaged in activities, that are financial in nature or incidental to such financial activities. Financial holding companies are also permitted to engage in activities that are complementary to financial activities if the Board of Governors determines that the activity does not pose a substantial risk to the safety or soundness of depository institutions or the financial system in general. These standards expand upon the list of activities “closely related to banking” which to date have defined the permissible activities of bank holding companies under the Bank Holding Company Act.
 
 
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One further effect of the Act was to require that federal financial institution and securities regulatory agencies prescribe regulation to implement the policy that financial institutions must respect the privacy of their customers and protect the security and confidentiality of customers’ non-public personal information. These regulations require, in general, that financial institutions (1) may not disclose non-public information of customers to non-affiliated third parties without notice to their customers, who must have an opportunity to direct that such information not be disclosed; (2) may not disclose customer account numbers except to consumer reporting agencies; and (3) must give prior disclosure of their privacy policies before establishing new customer relationships.
 
Neither the Company nor the Bank has determined whether or when it may seek to acquire and exercise new powers or activities under the Act, and the extent to which competition will change among financial institutions affected by the Act has not yet become clear.
 
OTHER LEGISLATION
 
The Patriot Act
 
On October 26, 2001, President Bush signed the USA Patriot Act (the “Patriot Act”), which includes provisions pertaining to domestic security, surveillance procedures, border protection, and terrorism laws to be administered by the Secretary of the Treasury. Title III of the Patriot Act entitled, “International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001” includes amendments to the Bank Secrecy Act which expand the responsibilities of financial institutions in regard to anti-money laundering activities with particular emphasis upon international money laundering and terrorism financing activities through designated correspondent and private banking accounts.
 
Effective December 25, 2001, Section 313(a) of the Patriot Act prohibits any insured financial institution such as First National Bank, from providing correspondent accounts to foreign banks which do not have a physical presence in any country (designated as “shell banks”), subject to certain exceptions for regulated affiliates of foreign banks. Section 313(a) also requires financial institutions to take reasonable steps to ensure that foreign bank correspondent accounts are not being used to indirectly provide banking services to foreign shell banks, and Section 319(b) requires financial institutions to maintain records of the owners and agent for service of process of any such foreign banks with whom correspondent accounts have been established.
 
Effective July 23, 2002, Section 312 of the Patriot Act created a requirement for special due diligence for correspondent accounts and private banking accounts. Under Section 312, each financial institution that establishes, maintains, administers, or manages a private banking account or a correspondent account in the United States for a non-United States person, including a foreign individual visiting the United States, or a representative of a non-United States person shall establish appropriate, specific, and, where necessary, enhanced, due diligence policies, procedures, and controls that are reasonably designed to detect and record instances of money laundering through those accounts.
 
 
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The Patriot Act contains various provisions in addition to Sections 313(a) and 312 that affect the operations of financial institutions by encouraging cooperation among financial institutions, regulatory authorities and law enforcement authorities with respect to individuals, entities and organizations engaged in, or reasonably suspected of engaging in, terrorist acts or money laundering activities. The Company and the Bank are not currently aware of any account relationships between the Bank and any foreign bank or other person or entity as described above under Sections 313(a) or 312 of the Patriot Act.
 
Certain surveillance provisions of the Patriot Act were scheduled to expire on December 31, 2005, and actions to restrict the use of the Patriot Act surveillance provisions were filed by the ACLU and other organizations. On March 9, 2006, after temporary extensions of the Patriot Act, President Bush signed the “USA Patriot Improvement and Reauthorization Act of 2005” and the “USA Patriot Act Additional Reauthorizing Amendments Act of 2006,” which reauthorized all expiring provisions of the Act and extended certain provisions related to surveillance and production of business records until December 31, 2009. The extended deadline for those provisions was subsequently further extended to February 28, 2010. On February 24 and 25, 2010, the Senate and the House of Representatives, respectively, voted to further extend the deadline until December 31, 2010 and President Obama has signed the legislation.
 
The effects which the Patriot Act and any amendments to the Patriot Act or any additional legislation enacted by Congress may have upon financial institutions is uncertain; however, such legislation could increase compliance costs and thereby potentially may have an adverse effect upon the Company’s results of operations.
 
Sarbanes-Oxley Act of 2002
 
On July 30, 2002, President George W. Bush signed into law the Sarbanes-Oxley Act of 2002 (the “Act”), legislation designed to address certain issues of corporate governance and accountability. The key provisions of the Act and the rules promulgated by the SEC pursuant to the Act include the following:
 
 
Expanded oversight of the accounting profession by creating a new independent public company oversight board to be monitored by the SEC.
     
 
Revised rules on auditor independence to restrict the nature of non-audit services provided to audit clients and to require such services to be pre-approved by the audit committee.
     
 
Improved corporate responsibility through mandatory listing standards relating to audit committees, certifications of periodic reports by the CEO and CFO and making issuer interference with an audit a crime.
     
 
Enhanced financial disclosures, including periodic reviews for largest issuers and real time disclosure of material company information.
     
 
Enhanced criminal penalties for a broad array of white collar crimes and increases in the statute of limitations for securities fraud lawsuits.
 
 
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Disclosure of whether a company has adopted a code of ethics that applies to the company’s principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, and disclosure of any amendments or waivers to such code of ethics.
     
 
Disclosure of whether a company’s audit committee of its board of directors has a member of the audit committee who qualifies as an “audit committee financial expert.”
     
 
A prohibition on insider trading during pension plan black-out periods.
     
 
Disclosure of off-balance sheet transactions.
     
 
A prohibition on personal loans to directors and officers.
     
 
Conditions on the use of non-GAAP (generally accepted accounting principles) financial measures.
     
 
Standards of professional conduct for attorneys, requiring attorneys having an attorney-client relationship with a company, among other matters, to report “up the ladder” to the audit committee, to another board committee or to the entire board of directors regarding certain material violations.
     
 
Expedited filing requirements for Form 4 reports of changes in beneficial ownership of securities, reducing the filing deadline to within 2 business days of the date on which an obligation to report is triggered.
     
 
Accelerated filing requirements for reports on Forms 10-K and 10-Q by public companies which qualify as “accelerated filers,” with a phased-in reduction of the filing deadline for Form 10-K and Form 10-Q.
     
 
Disclosure concerning website access to reports on Forms 10-K, 10-Q and 8-K, and any amendments to those reports, by “accelerated filers” as soon as reasonably practicable after such reports and material are filed with or furnished to the SEC.
     
 
Rules requiring national securities exchanges and national securities associations to prohibit the listing of any security whose issuer does not meet audit committee standards established pursuant to the Act.
 
The Company’s securities are not currently listed on any exchange. In the event of such a listing in the future, in addition to the rules promulgated by the SEC pursuant to the Act, the Company would be required to comply with the listing standards applicable to all exchange listed companies.
 
The Company has incurred and it is anticipated that it will continue to incur costs to comply with the Act and the rules and regulations promulgated pursuant to the Act by the Securities and Exchange Commission of approximately $200,000 annually.
 
 
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California Corporate Disclosure Act
 
Effective January 1, 2003, the California Corporate Disclosure Act (the “CCD Act”) required publicly traded corporations incorporated or qualified to do business in California to disclose information about their past history, auditors, directors and officers. Effective September 28, 2004, the CCD Act, as currently in effect and codified at California Corporations Code Section 1502.1, requires the Company to file with the California Secretary of State and disclose within 150 days after the end of its fiscal year certain information including the following:
 
 
The name of the company’s independent auditor and a description of services, if any, performed for a company during the previous two fiscal years and the period from the end of the most recent fiscal year to the date of filing;
     
 
The annual compensation paid to each director and the five most highly compensated non-director executive officers (including the CEO) during the most recent fiscal year, including all plan and non-plan compensation for all services rendered to a company as specified in Item 402 of Regulation S-K such as grants, awards or issuance of stock, stock options and similar equity-based compensation;
     
 
A description of any loans made to a director or executive officer at a “preferential” loan rate during the company’s two most recent fiscal years, including the amount and terms of the loans;
     
 
Whether any bankruptcy was filed by a company or any of its directors or executive officers within the previous 10 years;
     
 
Whether any director or executive officer of a company has been convicted of fraud during the previous 10 years; and
     
 
A description of any material pending legal proceedings other than ordinary routine litigation as specified in Item 103 of Regulation S-K and a description of such litigation where the company was found legally liable by a final judgment or order.
 
The Company does not currently anticipate that compliance with the CCD Act will have a material adverse effect upon its financial position or results of its operations or its cash flows.
 
Emergency Economic Stabilization Act of 2008
 
On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (the “EESA”) was signed into law. Pursuant to the EESA, the United States Department of the Treasury (the “U.S. Treasury”) was granted the authority to take a range of actions for the purpose of stabilizing and providing liquidity to the U.S. financial markets and has implemented several programs, including the purchase by the U.S. Treasury of certain troubled assets from financial institutions under the Troubled Asset Relief Program” (the “TARP”) and the direct purchase by the U.S. Treasury of equity securities of financial institutions under the Capital Purchase Program (the “CPP”). A summary of the CPP appears below under “Recent Regulatory Developments.” The EESA also temporarily raised the limit on federal deposit insurance coverage provided by the FDIC from $100,000 to $250,000 per depositor. Please refer to the discussion of liquidity sources, following Table 14 in Item 7 below.
 
 
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On February 27, 2009, as part of the CPP, the Company entered into a Letter Agreement and Securities Purchase Agreement – Standard Terms (collectively, the “Purchase Agreement”) with the U.S. Treasury. Pursuant to the Purchase Agreement, the Company (i) sold to the U.S. Treasury 12,000 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “Series A Preferred Stock”), having a liquidation preference amount of $1,000 per share, for a purchase price of $12,000,000 in cash, and (ii) issued to the U.S. Treasury a warrant (the “Warrant”) to purchase 600 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series B (the “Series B Preferred Stock”), at an exercise price of $0.01 per share. Immediately after the issuance of the Warrant, the U.S. Treasury exercised the Warrant in a cashless exercise resulting in the net issuance of 600 shares of the Series B Preferred Stock, having a liquidation preference amount of $1,000 per share, to the U.S. Treasury. The Series A Preferred Stock entitles its holder(s) to cumulative dividends on the liquidation preference amount on a quarterly basis at a rate of 5% per annum for the first five years, and 9% per annum thereafter. The Series B Preferred Stock entitles its holder(s) to cumulative dividends on the liquidation preference amount on a quarterly basis at a rate of 9% per annum from the date of issuance. Subject to certain conditions, the Series A and Series B Preferred Stock are redeemable at the option of the Company in whole or in part at a redemption price of 100% of the liquidation preference amount plus any accrued and unpaid dividends. So long as the Series A and Series B Preferred Stock remain outstanding, the Company will be subject to certain executive compensation and corporate governance requirements set forth in the EESA and regulations adopted pursuant to the EESA.
 
American Recovery and Reinvestment Act of 2009
 
On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (the “ARRA”) was signed into law. Section 7001 of the ARRA amended Section 111 of the EESA in its entirety. While the U.S. Treasury must promulgate regulations to implement the restrictions and standards set forth in Section 7001, the ARRA, among other things, significantly expands the executive compensation restrictions previously imposed by the EESA. Such restrictions apply to any entity that has received or will receive financial assistance under the TARP, and shall generally continue to apply for as long as any obligation arising from financial assistance provided under the TARP, including preferred stock issued under the CPP, remains outstanding. These ARRA restrictions do not apply to any TARP recipient during such time when the federal government (i) only holds any warrants to purchase common stock of such recipient or (ii) holds no preferred stock or warrants to purchase common stock of such recipient. Since the Company participates in the CPP, the restrictions and standards set forth in Section 7001 of the ARRA are applicable to the Company.
 
Recent Regulatory Developments
 
In response to global credit and liquidity issues involving a number of financial institutions, the United States government, particularly the U.S. Treasury and the Federal financial institution regulatory agencies, have taken a variety of extraordinary measures designed to restore confidence in the financial markets and to strengthen financial institutions, including capital injections, guarantees of bank liabilities and the acquisition of illiquid assets from banks.
 
 
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Capital Purchase Program. On October 24, 2008, the U.S. Treasury announced plans to direct $700 billion of the TARP funding into the CPP to acquire preferred stock investments in bank holding companies and banks. Requirements for bank holding companies and banks eligible to participate as a Qualifying Financial Institution (“QFI”) in the CPP include:
 
 
Submission of an application prior to November 14, 2008 to the QFI’s Federal banking regulator to obtain preliminary approval to participate in the CPP;
     
 
If the QFI receives preliminary approval, it will have 30 days within which to submit final documentation and fulfill any outstanding requirements;
     
 
The minimum amount of capital eligible for purchase by the U.S. Treasury under the CPP is 1 percent of the Total Risk-Weighted Assets of the QFI and the maximum is the lesser of (i) an amount equal to 3 percent of the Total Risk-Weighted Assets of the QFI or (ii) $25 billion;
     
 
Capital acquired by a QFI under the CPP will be accorded Tier 1 capital treatment;
     
 
The preferred stock issued to the U.S. Treasury will be non-voting (except in the case of class votes), senior perpetual preferred stock that ranks senior to common stock and pari passu with existing preferred stock (except junior preferred stock);
     
 
In addition to the preferred stock, the U.S. Treasury will be issued warrants to acquire shares of the QFI’s common stock equal in value to 15 percent of the amount of capital purchased by the QFI;
     
 
Dividends are payable to the U.S. Treasury at the rate of 5% per annum for the first 5 years and 9% per annum thereafter;
     
 
Subject to certain exceptions and other requirements, no redemption of the preferred stock is permitted during the first 3 years;
     
 
Certain restrictions on the payment of dividends to shareholders of the QFI shall remain in effect while the preferred stock purchased by the U.S. Treasury is outstanding;
     
 
Repurchase of the QFI’s stock requires consent of the U.S. Treasury, subject to certain exceptions;
     
 
The preferred shares are not subject to any contractual restrictions on transfer by the U.S. Treasury; and
     
 
The QFI must agree to be bound by certain executive compensation and corporate governance requirements and senior executive officers must agree to certain compensation restrictions.
     
     On February 27, 2009, as part of the CPP, the Company issued and sold shares of its Series A and Series B Preferred Stock to the U.S. Treasury See discussion above under “Emergency Economic Stabilization Act of 2008.”
 
Temporary Liquidity Guarantee Program. Among other programs and actions taken by the U.S. Treasury and other regulatory agencies, the FDIC implemented the Temporary Liquidity Guarantee Program (the “TLGP”) to strengthen confidence and encourage liquidity in the financial system. The TLGP is comprised of the Debt Guarantee Program (the “DGP”) and the Transaction Account Guarantee Program (the “TAGP”). The Bank did not participate in the DGP Program. The DGP guarantees all newly issued senior unsecured debt (e.g., promissory notes, unsubordinated unsecured notes and commercial paper) up to prescribed limits issued by participating entities beginning on October 14, 2008 and continuing through April 30, 2010. For eligible debt issued by that date, the FDIC will provide the guarantee coverage until the earlier of the maturity date of the debt or December 31, 2012. The TAGP offers full guarantee for noninterest-bearing transaction accounts held at FDIC-insured depository institutions. The unlimited deposit coverage was voluntary for eligible institutions and was in addition to the $250,000 FDIC deposit insurance per account that was included as part of the EESA. The TAGP coverage became effective on October 14, 2008 and is currently scheduled to continue for participating institutions until June 30, 2010. The Bank has elected to participate in the TAGP.
 
 
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Financial Stability Plan. On February 10, 2009, the U.S. Treasury announced a Financial Stability Plan (the “FSP”) as a comprehensive approach to strengthening the financial system and credit crisis.
 
The Plan includes a Capital Assistance Program (the “CAP”) that is intended to serve as a bridge to raising private capital and to ensure sufficient capital to preserve or increase lending in a worse-than-expected economic deterioration. Eligibility to participate in the CAP will be consistent with the criteria for QFI’s under the CPP. Eligible institutions with consolidated assets in excess of $100 billion will be able to obtain capital under the CAP, subject to a supervisory review process and comprehensive stress test assessment of the losses that could occur over a two year period in the future across a range of economic scenarios, including conditions more severe than anticipated or as typically used in capital planning processes.
 
Eligible institutions with consolidated assets below $100 billion will be able to obtain capital under the CAP after a supervisory review. As announced, the CAP includes issuance of a convertible preferred security to the U.S. Treasury at a discount to the participating institution’s stock price as of February 9, 2009, subject to a dividend to be determined. The security instrument will be designed to incentivize institutions to replace the CAP capital with private capital or redeem it. Institutions participating in the CPP under TARP may also be permitted to exchange their CPP preferred stock for the convertible preferred CAP security.
 
Term Asset-Backed Securities Loan Facility. On March 3, 2009, the U.S. Treasury and the Board of Governors announced the Term Asset-Backed Securities Loan Facility (the “TALF”). The TALF is one of the programs under the Financial Stability Plan announced by the U.S. Treasury on February 10, 2009. The TALF is intended to help stimulate the economy by facilitating securitization activities which allow lenders to increase the availability of credit to consumers and businesses.
 
Under the TALF, the Federal Reserve Bank of New York (“FRBNY”) will lend up to $200 billion to provide financing to investors as support for purchases of certain AAA-rated asset-backed securities (“ABS”) initially for newly and recently originated auto loans, credit card loans, student loans, SBA-guaranteed small business loans, and rental, commercial, and government vehicle fleet leases, small ticket equipment, heavy equipment, and agricultural equipment loans and leases.
 
ABS fundings are held monthly. The FRBNY presently intends to cease making new loans on June 30, 2010, but loans collateralized by certain types of ABS will cease on March 31, 2010, unless the Board of Governors extends the facility. The loan asset classes may be expanded in the future to include commercial mortgages, non-Agency residential mortgages, and/or other asset classes. Credit extensions under the TALF will be non-recourse loans to eligible borrowers secured by eligible collateral for a three-year term with interest paid monthly. Any U.S. company that owns eligible collateral may borrow from the TALF, provided the company maintains an account with a primary dealer who will act as agent for the borrower and deliver eligible collateral to the FRBNY custodian in connection with the loan funding. The FRBNY will create a special purpose vehicle (“SPV”) to purchase and manage any assets received by the FRBNY in connection with the TALF loans.
 
 
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The U.S. Treasury will provide $20 billion of credit protection to the FRBNY in connection with the TALF through the Troubled Assets Relief Program (the “TARP”) by purchasing subordinated debt issued by the SPV to finance the first $20 billion of asset purchases. If more than $20 billion in assets are purchased by the SPV, the FRBNY will lend additional funds to the SPV to finance such additional purchases. The FRBNY’s loan to the SPV will be senior to the TARP subordinated loan and secured by all of the assets of the SPV.
 
Future Legislation and Regulations
 
Certain legislative and regulatory proposals that could affect the Company, the Bank, and the banking business in general are periodically introduced before the United States Congress, the California State Legislature and Federal and state government agencies. It is not known to what extent, if any, legislative proposals will be enacted and what effect such legislation would have on the structure, regulation and competitive relationships of financial institutions. It is likely, however, that such legislation could subject the Company and the Bank to increased regulation, disclosure and reporting requirements, competition, and costs of doing business.
 
In addition to legislative changes, the various Federal and state financial institution regulatory agencies frequently propose rules and regulations to implement and enforce already existing legislation. It cannot be predicted whether or in what form any such rules or regulations will be enacted or the effect that such regulations may have on the Company and the Bank.
 
 
In addition to the risks associated with the business of banking generally, as described above under Item 1 (Description of Business), the Company’s business, financial condition, operating results, future prospects and stock price can be adversely impacted by certain risk factors, as set forth below, any of which could cause the Company’s actual results to vary materially from recent results or from the Company’s anticipated future results.
 
Extensive Regulation of Banking. The Company’s operations are subject to extensive regulation by Federal, state and local governmental authorities and are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of its operations. The Company believes that it is in substantial compliance in all material respects with laws, rules and regulations applicable to the conduct of its business. Because the Company’s business is highly regulated, the laws, rules and regulations applicable to it are subject to regular modification and change. There can be no assurance that these laws, rules and regulations, or any other laws, rules or regulations, will not be adopted in the future, which could make compliance much more difficult or expensive, restrict the Company’s ability to originate, broker or sell loans, further limit or restrict the amount of commissions, interest or other charges earned on loans originated or sold by the Company, or otherwise adversely affect the Company’s results of operations, financial condition, or future prospects.
 
 
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Governmental Fiscal and Monetary Policies. The business of banking is affected significantly by the fiscal and monetary policies of the federal government and its agencies. Such policies are beyond the control of the Company. The Company is particularly affected by the policies established by the Board of Governors in relation to the supply of money and credit in the United States, and the target federal funds rate. The instruments of monetary policy available to the Board of Governors can be used in varying degrees and combinations to directly affect the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits, and this can and does have a material effect on the Company’s business, results of operations and financial condition. Federal monetary policy may also affect the longer-term inflation rate which directly affects the national and local economy.
 
The Effects of Legislation in Response to Current Credit Conditions. Legislation passed at the federal level and/or by the State of California in response to current conditions affecting credit markets could cause the Company to experience higher credit losses if such legislation reduces the amount that borrowers are otherwise contractually required to pay under existing loan contracts with the Bank. Such legislation could also result in the imposition of limitations upon the Bank’s ability to foreclose on property or other collateral or make foreclosure less economically feasible. Such events could result in increased loan losses and require a material increase in the allowance for loan losses and thereby adversely affect the Company’s results of operations, financial condition, future prospects, profitability and stock price.
 
Geographic Concentration. All of the banking offices of the Company are located in the Northern California Counties of San Mateo and San Francisco. The Company and the Bank conduct business primarily in the San Francisco Bay area. As a result, our financial condition, results of operations and cash flows are subject to changes in the economic conditions in this area. Our success depends upon the business activity, population, income levels, deposits and real estate activity in these markets, and adverse economic conditions could reduce our growth rate, or affect the ability of our customers to repay their loans, and generally impact our financial condition and results of operations. Economic conditions in the State of California are subject to various uncertainties at this time, including the budgetary and fiscal difficulties facing the State Government. The Company can provide no assurance that conditions in the California economy will not deteriorate further or that such deterioration will not adversely affect the Company.
 
Competition. Increased competition in the market of the Bank may result in reduced loans and deposits. Ultimately, the Bank may not be able to compete successfully against current and future bank and non bank competitors. Many competitors offer the banking services that are offered by the Bank in its service area. These competitors include national and super-regional banks, finance companies, investment banking and brokerage firms, credit unions, government-assisted farm credit programs, other community banks and technology-oriented financial institutions offering online services. In particular, the Bank’s competitors include several major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous banking locations and mount extensive promotional and advertising campaigns. Additionally, banks and other financial institutions with larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the credit needs of larger customers. Areas of competition include interest rates for loans and deposits, efforts to obtain deposits, and range and quality of products and services provided, including new technology-driven products and services. Technological innovation continues to contribute to greater competition in domestic and international financial services markets as technological advances, such as Internet-based banking services that cross traditional geographic bounds, enable more companies to provide financial services. If the Bank is unable to attract and retain banking customers, it may be unable to continue its loan growth and level of deposits, which may adversely affect its and the Company’s results of operations, financial condition and future prospects.
 
 
24

 
 
The Effects of Changes to FDIC Insurance Coverage Limits and Assessments. These changes are uncertain and increased premiums may adversely affect the Company. The FDIC charges insured financial institutions premiums to maintain the Deposit Insurance Fund. Current economic conditions have increased expectations for bank failures. In such event, the FDIC would take control of failed banks and guarantee payment of deposits up to applicable insured limits from the Deposit Insurance Fund. Insurance premium assessments to insured financial institutions may increase as necessary to maintain adequate funding of the Deposit Insurance Fund.
 
The Emergency Economic Stabilization Act of 2008 included a provision for an increase in the amount of deposits insured by the FDIC to $250,000. On October 24, 2008, the FDIC announced the Temporary Liquidity Guarantee Program that provides unlimited deposit insurance on funds in noninterest-bearing transaction deposit accounts not otherwise covered by the existing deposit insurance limit of $250,000. All eligible institutions will be covered under the program for the first 30 days without incurring any costs. After the initial period, participating institutions will be assessed a 10 basis point surcharge on the additional insured deposits through the scheduled end of the program, currently June 30, 2010. Increased premiums will negatively impact the Company’s earnings.
 
It is not clear how depositors may respond regarding the increase in insurance coverage. Despite the increase, some depositors may reduce the amount of deposits held at the Bank if concerns regarding bank failures persist, which could affect the level and composition of the Bank’s deposit portfolio and thereby directly impact the Bank’s funding costs and net interest margin. The Bank’s funding costs may also be adversely affected in the event that activities of the Federal Reserve Board and the U.S. Treasury to provide liquidity for the banking system and improvement in capital markets are curtailed or are unsuccessful. Such events could reduce liquidity in the markets, thereby increasing funding costs to the Bank or reducing the availability of funds to the Bank to finance its existing operations and thereby adversely affect the Company’s results of operations, financial condition, future prospects, profitability and stock price.
 
Dependence on Key Officers and Employees. We are dependent on the successful recruitment and retention of highly qualified personnel. Our ability to implement our business strategies is closely tied to the strengths of our executive officers who have extensive experience in the banking industry but who are not easily replaced. In addition, business banking, one of the Company’s principal lines of business, is dependent on relationship banking, in which the Bank personnel develop professional relationships with small business owners and officers of larger business customers who are responsible for the financial management of the companies they represent. If these employees were to leave the Bank and become employed by a local competing bank, we could potentially lose business customers. In addition, we rely on our customer service staff to effectively serve the needs of our consumer customers. We actively recruit for all open positions and management believes that its relations with employees are good.
 
 
25

 
 
Growth strategy. We have pursued and continue to pursue a growth strategy which depends primarily on generating an increasing level of loans and deposits at acceptable risk levels. We may not be able to sustain this growth strategy without establishing new branches or new products. We may attempt to expand in our current market by opening or acquiring branch offices or other financial institutions or branch offices or through a purchase, in whole or in part, of other financial institutions. This expansion may require significant investments in equipment, technology, personnel and site locations. We cannot assure you of our success in implementing our growth strategy either through expansion of our existing branch system or through mergers and acquisitions, and there may be significant increases in our noninterest expenses, without any corresponding balance sheet growth.
 
Commercial loans. As of December 31, 2009, approximately 13.5% of our loan portfolio consisted of commercial business loans, which could have a higher degree of risk than other types of loans. Commercial lending is dependent on borrowers making payments on their loans and lines of credit in accordance with the terms of their notes. Our current economic recession has made it difficult for many commercial borrowers to make their required loan payments. This credit risk is increased when there is a concentration of principal in a limited number of loans and borrowers, the mobility of collateral, the effect of general economic conditions and the increased difficulty of evaluating and monitoring these types of loans. The availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself and the general economic environment. If the cash flow from business operations is reduced, the borrower’s ability to repay the loan may be impaired. In addition, unlike residential mortgage loans, which generally are made on the basis of the borrower’s ability to make repayment from his or her employment and other income and which are secured by real property whose value tends to be more easily ascertainable, commercial business loans typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business. If the Bank is required to repossess equipment or pursue collection efforts under personal guarantees, there could be a substantial decrease in value of collateral, if any, increased legal costs, and an increased risk of loss on the amount outstanding.
 
Real Estate Values. A large portion of the loan portfolio of the Company is dependent on the performance of our real estate portfolio. At December 31, 2009, real estate (including construction loans) served as the principal source of collateral with respect to approximately 86.0% of the Company’s loan portfolio. The current substantial decline in the economy in general, coupled with a continued decline in real estate values in the Company’s primary operating market areas could have an adverse effect on the demand for new loans, the ability of borrowers to repay outstanding loans, and the value of real estate and other collateral securing loans. Real estate values have declined, due in part to reduced construction lending, tighter underwriting requirements, and reduced borrower ability to make payments. Real estate loans may pose collection problems, resulting in increased collection expenses, and delays in the ultimate collection of these loans.
 
In addition, acts of nature, including fires, earthquakes and floods, which may cause uninsured damage and other loss of value to real estate that secures these loans, may also negatively impact the Company’s financial condition.
 
 
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Allowance for Loan and Lease Losses. The Company maintains an allowance for loan losses to provide for loan defaults and non-performance, but its allowance for loan losses may not be adequate to cover actual loan and lease losses. In addition, future provisions for loan and lease losses could materially and adversely affect the Company and therefore the Company’s operating results. The Company’s allowance for loan and lease losses is based on prior experience, as well as an evaluation of the risks in the current portfolio. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates that may be beyond the Company’s control, and these losses may exceed current estimates. Federal regulatory agencies, as an integral part of their examination process, review the Company’s loans and the allowance for loan and lease losses. Although we believe that the Company’s allowance for loan and lease losses is adequate to cover current losses, we cannot assure you that it will not further increase the allowance for loan and lease losses or that the regulators will not require it to increase this allowance. Either of these occurrences could materially and adversely affect the Company’s earnings.
 
Environmental Liabilities. In the course of our business, we may foreclose and take title to real estate, and could become subject to environmental liabilities with respect to these properties. We may be held liable to a governmental entity or third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property. The costs associated with investigations or remediation activities could be substantial. In addition, as the owner or former owner of a contaminated site, we could become subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. If we ever become subject to significant environmental liabilities, our business prospects, financial condition, liquidity, results of operations and stock price could be materially and adversely affected.
 
Dilution of Common Stock. Shares of the Company’s common stock eligible for future sale could have a dilutive effect on the market for common stock and could adversely affect the market price.
 
The Articles of Incorporation of the Company authorize the issuance of 10,000,000 shares of common stock, of which approximately 3,182,000 were outstanding at December 31, 2009. Pursuant to its 1997, 2002 and 2008 Stock Option Plans, at December 31, 2009, the Company had outstanding options to purchase a total of 430,034 shares of common stock. As of December 31, 2009, 269,460 shares of common stock remained available for grants under the 2008 Stock Option Plan as well as an additional 39,020 shares under the 2002 Stock Option Plan. The issuance of substantial amounts of the Company’s newly issued common stock in the public market could adversely affect the market price of the Company’s common stock. The market for the Company’s common stock is limited. The ability to raise funds in the future through a stock offering could be difficult.
 
Operating Losses. The Company is subject to certain operations risks, including, but not limited to, data processing system failures and errors and customer or employee fraud.
 
The Company maintains a system of internal controls to mitigate against such occurrences and maintains insurance coverage for such risks, but should such an event occur that is not prevented or detected by the Company’s internal controls, uninsured or in excess of applicable insurance limits, it could have a significant adverse impact on the Company’s business, financial condition or results of operations. Additionally, the Company is dependent on network and computer systems. If these systems and their back-up systems were to fail or were breached, the Company could be adversely affected.
 
 
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Business Confidence Uncertainty. Terrorist activities in the future and the actions taken by the United States and its allies in combating terrorism on a worldwide basis could adversely impact the Company and the extent of such impact is uncertain. Even more so, the problems in the mortgage and credit markets, the government conservatorship of Fannie Mae and Freddie Mac, the failure of investment firms such as Bear Stearns and Lehman Brothers, and the bailout of AIG Inc., the insurance giant, as well as large write-offs at some major financial institutions have had a ripple effect on the entire financial services industry, and may continue to do so for some time. Such events have had and may continue to have an adverse effect on the economy in the Company’s market areas. Such continued economic deterioration could adversely affect the Company’s future results of operations by, among other matters, reducing the demand for loans and the amounts required to be reserved for loan losses, reducing the value of collateral held as security for the Company’s loans, and causing a decline in the Company’s stock price.
 
Restrictions in Purchase Agreement with U.S. Treasury. The Purchase Agreement between the Company and the U.S. Treasury dated February 27, 2009, pursuant to which the Company sold $12 million of the Company’s Series A Preferred Stock and issued 600 shares of the Company’s Series B Preferred Stock (upon exercise of the Warrant issued to the U.S. Treasury), provides that prior to the earlier of (1) February 27, 2012 and (2) the date on which all of the shares of the U.S. Treasury Preferred Stock have been redeemed by the Company or transferred by the U.S. Treasury to third parties, the Company may not, without the consent of the Treasury, (a) declare or pay any dividend or make any distribution on capital stock or other equity securities of any kind of the Company other than (i) regular quarterly cash dividends of not more than the amount of the last quarterly cash dividend per share declared, or (ii) dividends payable solely in shares of common stock, or (b) subject to limited exceptions, redeem, repurchase or otherwise acquire shares of the Company’s common stock or preferred stock other than the U.S. Treasury Preferred Stock. In addition, the Company is unable to pay any dividends on the Company’s common stock unless the Company is current in the Company’s dividend payments on the U.S. Treasury Preferred Stock. These restrictions could have a negative effect on the value of the Company’s common stock. Dividends paid by the Company on the shares of U.S. Treasury Preferred Stock will reduce the net income available to the holders of Company common stock and the Company’s earnings per common share. The holders of the Company’s common stock are entitled to receive dividends only when, as and if declared by the Company’s Board of Directors. Although the Company has historically paid stock and cash dividends on the Company’s common stock, the Company is not required to do so and the Company’s Board of Directors could reduce or eliminate these common stock dividends in the future, depending on the circumstances.
 
The U.S. Treasury Preferred Stock will also receive preferential treatment in the event of liquidation, dissolution or winding up of the Company.
 
Restrictions on Executive Compensation. Pursuant to the terms of the Purchase Agreement, the Company adopted certain standards for executive compensation and corporate governance. These standards generally apply to the Company’s Chief Executive Officer, the Chief Financial Officer and the three next most highly compensated senior executive officers. The standards (1) ensure that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution; (2) require “clawback” of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate; (3) prohibit making golden parachute payments to senior executives; and (4) confirm agreement not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive. Pursuant to the American Recovery and Reinvestment Act of 2009, further compensation restrictions, including significant limitations on incentive compensation and “golden parachute” payments, have been imposed on the Company’s most highly compensated employees, which could, in the future, make it more difficult for the Company to retain and recruit qualified personnel.
 
 
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Federal Home Loan Bank Risk. The failure of the Federal Home Loan Bank (“FHLB”) of San Francisco or the national Federal Home Loan Bank System may have a material negative impact on our earnings and liquidity.
 
Even though the FHLB of San Francisco has announced it does not anticipate that additional capital is immediately necessary, nor does it believe that its capital level is inadequate to support realized losses in the future, the FHLB of San Francisco could require its members, including the Bank, to contribute additional capital in order to return the FHLB of San Francisco to compliance with capital guidelines.
 
At December 31, 2009, we held $4.4 million of common stock in the FHLB of San Francisco. Should the FHLB of San Francisco fail, we anticipate that our investment in the FHLB’s common stock would be “other than temporarily” impaired and may have no value.
 
At December 31, 2009, we maintained a line of credit with the FHLB of San Francisco equal to approximately 30% of total assets to the extent the Bank provides qualifying collateral and holds sufficient FHLB stock. At December 31, 2009, we were in compliance with collateral requirements. The Company also maintained a Line of Credit available with the Federal Reserve Bank of San Francisco (“FRB”) of $34,124,000 as of December 31, 2009 that was secured by commercial and construction loans. In addition, we have an unsecured Federal Funds line of up to $25,000,000 At year end. We are highly dependent on the FHLB of San Francisco to provide the primary source of wholesale funding for immediate liquidity and borrowing needs. The failure of the FHLB of San Francisco or the FHLB system in general, may materially impair our ability to meet our growth plans or to meet short and long term liquidity demands.
 
 
None.
 
 
The Company does not own any real property. Since its incorporation on February 28, 2001, the Company has conducted its operations at the administrative offices of the Bank, located at 975 El Camino Real, South San Francisco, California 94080.
 
The Bank owns the land and building at 975 El Camino Real, South San Francisco, California 94080. The premises consist of a modern, three-story building of approximately 15,000 square feet and off-street parking for employees and customers of approximately 45 vehicles.
 
 
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The Buri Buri Branch Office of the Bank is located on the ground floor of this three-story building and administrative offices, including the offices of senior management, occupy the second and third floors.
 
The Bank owns the land and two-story building occupied by the Daly City Branch Office (6600 Mission Street, Daly City, CA 94014); the land and two-story building occupied by the Colma Branch Office (1300 El Camino Real, Colma, CA 94014); the land and two-story building occupied by the South San Francisco Branch Office (211 Airport Boulevard, South San Francisco, CA 94080); the land and two-story building occupied by the Redwood City Branch Office (700 El Camino Real, Redwood City, CA 94063); the land and two-story building occupied by the Millbrae Branch Office (1551 El Camino Real, Millbrae, CA 94030); the land and single-story building occupied by the Half Moon Bay Branch Office (756 Main Street, Half Moon Bay, CA 94019); and the land and two-story building occupied by the Pescadero Branch Office (239 Stage Road, Pescadero, CA 94060). All properties include adequate vehicle parking for customers and employees.
 
The Bank leases premises at 1450 Linda Mar Shopping Center, Pacifica, California 94044, for its Linda Mar Branch Office. This ground floor space of approximately 4,100 square feet is leased from Fifty Associates and Demartini/Linda Mar, LLC. The original lease term was 10 years and expired on September 1, 2009. The lease has been renewed for a further ten years and will expire on August 31, 2019.
 
The Bank leases premises at 210 Eureka Square, Pacifica, California 94044, for its Eureka Square Branch Office. This ground floor space of approximately 3,000 square feet is leased from Joseph A. Sorci and Eldiva Sorci. The lease term is for 5 years, commencing January 1, 1995, with two 5-year options to extend the lease term, the second of which has been exercised and expired on December 31, 2009. The premises are currently on a month-to-month basis.
 
The Bank leases premises at 65 Post Street, San Francisco, CA 94104, for its Financial District Office. The current lease term expires April 30, 2013, with one 5-year option to extend the lease remaining. The location consists of approximately 2,826 square feet of street level, 1,322 square feet of basement, and 1,077 square feet of mezzanine space.
 
The Bank leases premises at 6599 Portola Drive, San Francisco, CA 94127, for its Portola Office. The current lease expires June 30, 2012, and has a remaining 2-year option to extend the lease to June 30, 2014. The location consists of approximately 1,325 square feet of street level space.
 
The Bank leases premises at 150 East Third Avenue, San Mateo, CA 94401, for its San Mateo Branch Office. The current lease term, expires July 31, 2013. It has one remaining five-year option to extend the lease. The location consists of approximately 4,000 square feet of ground floor usable commercial space.
 
The Bank leases a warehouse facility at 450 Cabot Road, South San Francisco, CA 94080. The lease term is for 5 years and one half month, and will expire February 28, 2011. The facility consists of approximately 7,600 square feet of office/warehouse space.
 
 
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The foregoing summary descriptions of leased premises are qualified in their entirety by reference to the full text of the lease agreements listed as exhibits to this report.
 
ITEM 3. LEGAL PROCEEDINGS
 
There are no material legal proceedings adverse to the Company or the Bank to which any director, officer, affiliate of the Company, or 5% shareholder of the Company, or any associate of any such director, officer, affiliate or 5% shareholder of the Company are a party, and none of the foregoing persons has a material interest adverse to the Company or the Bank.
 
From time to time, the Company and/or the Bank are a party to claims and legal proceedings arising in the ordinary course of business. The Company’s management is not aware of any material pending legal proceedings to which either it or the Bank may be a party or has recently been a party, which will have a material adverse effect on the financial condition or results of operations of the Company and the Bank, taken as a whole.
 
ITEM 4. (REMOVED AND RESERVED)
 
 
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
 
Since March 18, 2002, the common stock of the Company has been quoted on the OTC Bulletin Board under the trading symbol, “FNBG.” There has been limited trading in the shares of common stock of the Company. On February 28, 2010, the Company had approximately 700 shareholders of common stock of record.
 
The following table summarizes sales of the Common Stock of the Company during the periods indicated of which management has knowledge, including the approximate high and low bid prices during such periods and the per share cash dividends declared for the periods indicated. All information has been adjusted to reflect 5% stock dividends effected on December 15, 2008 and on December 15, 2009. The prices indicated below reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.

   
Bid Price of FNB Bancorp
   
Cash
 
   
Common Stock
   
Dividends
 
 
 
High
   
Low
   
Declared (1)
 
2008                        
First Quarter
  $ 24.4650     $ 21.5250     $ 0.15  
Second Quarter
    23.1000       16.2750       0.15  
Third Quarter
    16.9050       11.5500       0.15  
Fourth Quarter
    13.0000       10.1500       0.15  
                         
2009
                       
First Quarter
  $ 12.2850     $ 10.5105     $ 0.15  
Second Quarter
  $ 12.1800     $ 10.6575       0.15  
Third Quarter
  $ 10.4475     $ 7.1925       0.05  
Fourth Quarter
    10.2500       7.0500       0.05  

See Item 1, “Limitations on Dividends,” above, for a description of the limitations applicable to the payment of dividends by the Company.
 
 
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STOCK PERFORMANCE GRAPH
 
Set forth below is a line graph comparing the annual percentage change in the cumulative total return on the Company’s Common Stock with the cumulative total return of the SNL Securities Index of Pink Banks (asset size of over $500 million) and the Russell 2000 Index as of the end of each of the last five fiscal years.
 
The graph assumes that $100.00 was invested on December 31, 2004 in the Company’s Common Stock and each index, and that all dividends were reinvested. Returns have been adjusted for any stock dividends and stock splits declared by the Company. Shareholder returns over the indicated period should not be considered indicative of future shareholder returns.
 
FNB Bancorp
 
(STOCK PERFORMANCE GRAPH)
      Period Ending
Index
 
12/31/04
 
12/31/05
 
12/31/06
 
12/31/07
 
12/31/08
 
12/31/09
FNB Bancorp
  100.00     105.10     107.30     80.75     44.05     32.85  
Russell 2000
  100.00     104.55     123.76     121.82     80.66     102.58  
SNL Bank Pink > $500M
  100.00     106.42     116.77     107.59     78.07     66.75  
 
ISSUER PURCHASES OF EQUITY SECURITIES
 
On August 24, 2007, the Board of Directors of the Company authorized a stock repurchase program which calls for the repurchase of up to five percent (5%) of the Company’s then outstanding 2,863,635 shares of Common Stock, or 143,182 shares. There were no repurchases during the quarter ended December 31, 2009. There were 10,457 shares remaining that may be purchased under this Plan as of December 31, 2009. Effective February 27, 2009, based on the Purchase Agreement with the U. S. Treasury, the Company may not repurchase Company common stock so long as the Treasury’s Preferred Stock investment is outstanding.
 
 
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The following table presents a summary of selected financial information that should be read in conjunction with the Company’s consolidated financial statements and notes thereto included under Item 8 - “FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.”

Dollar amounts in thousands, except
   At and for the years ended December 31,  
per share amounts and ratios
 
2009
   
2008
   
2007
   
2006
   
2005
 
                               
STATEMENT OF INCOME DATA
                             
Total interest income
  $ 35,817     $ 39,427     $ 42,290     $ 37,196     $ 30,732  
Total interest expense
    9,011       11,507       13,657       9,821       5,533  
Net interest income
    26,806       27,920       28,633       27,375       25,199  
Provision for loan losses
    4,596       3,045       690       683       628  
Net interest income after provision for loan losses
    22,210       24,875       27,943       26,692       24,571  
Total noninterest income
    5,387       5,045       4,300       6,259       3,841  
Total noninterest expenses
    27,585       25,346       23,182       21,760       20,255  
Earnings before provision for income taxes
    12       4,574       9,061       11,191       8,157  
Provision for income taxes
    (581 )     611       2,382       3,609       2,429  
Net earnings
    593       3,963       6,679       7,582       5,728  
Dividends and discount accretion on preferred stock
    632    
   
   
   
 
Net (loss) earnings available to common shareholders
  $ (39 )   $ 3,963     $ 6,679     $ 7,582     $ 5,728  
                                         
PER SHARE DATA - see note (1)
                                       
Net earnings per share:
                                       
Basic
  $ (0.01 )   $ 1.23     $ 2.03     $ 2.37     $ 1.80  
Diluted
  $ (0.01 )   $ 1.22     $ 2.00     $ 2.25     $ 1.71  
Cash dividends per share
  $ 0.30     $ 0.60     $ 0.60     $ 0.60     $ 0.60  
Weighted average shares outstanding:
                                       
Basic
    3,182,000       3,231,000       3,296,000       3,203,000       3,181,000  
Diluted
    3,203,000       3,254,000       3,332,000       3,363,000       3,340,000  
Shares outstanding at period end
    3,182,000       3,030,000       2,965,000       2,853,000       2,700,000  
Book value per share
  $ 24.78     $ 22.49     $ 22.44     $ 21.75     $ 20.46  
                                         
BALANCE SHEET DATA
                                       
Investment securities
    97,188       99,221       94,432       94,945       113,463  
Net loans
    494,349       497,984       489,574       419,437       380,224  
Allowance for loan losses
    9,829       7,075       5,638       5,002       4,374  
Total assets
    708,309       660,957       644,465       581,270       569,314  
Total deposits
    598,964       500,910       499,255       481,567       507,544  
Shareholders’ equity
    78,865       68,149       66,545       62,063       55,243  
                                         
SELECTED PERFORMANCE DATA
                                       
Return on average assets
    (0.01 %)     0.60 %     1.07 %     1.32 %     1.08 %
Return on average equity
    (0.05 %)     5.87 %     10.39 %     12.86 %     10.75 %
Net interest margin
    4.47 %     4.75 %     5.05 %     5.26 %     5.27 %
Average loans as a percentage of average deposits
    91.32 %     97.93 %     91.74 %     78.92 %     77.80 %
Average total stockholders’ equity as a percentage of average total assets
    11.31 %     10.25 %     10.31 %     10.25 %     10.06 %
Common dividend payout ratio
    n/a       44.71 %     25.69 %     21.43 %     26.92 %
SELECTED ASSET QUALITY RATIOS
                                       
Net loan charge-offs to average loans
    0.37 %     0.32 %     0.01 %     0.01 %     0.02 %
Allowance for loan losses/Total Loans
    1.95 %     1.40 %     1.14 %     1.18 %     1.14 %
CAPITAL RATIOS
                                       
Total risk-based capital
    14.29 %     11.86 %     11.47 %     12.00 %     11.59 %
Tier 1 risk-based capital
    13.04 %     10.67 %     10.52 %     11.05 %     10.67 %
Tier 1 leverage capital
    10.77 %     9.70 %     9.89 %     10.08 %     9.50 %

(1) per share data has been adjusted for stock dividends.
 
 
33

 
 
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF FNB BANCORP AND SUBSIDIARY
 
Critical Accounting Policies And Estimates
 
Management’s discussion and analysis of its financial condition and results of operations are based upon the Company’s financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates, including those related to its loans and allowance for loan losses. The Company bases its estimates on current market conditions, historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. All adjustments that, in the opinion of management, are necessary for a fair presentation for the periods presented have been reflected as required by Regulation S-X, Rule 10-01. The Company believes the following critical accounting policy requires significant judgments and estimates used in the preparation of the consolidated financial statements.
 
Allowance for Loan Losses
 
The allowance for loan losses is periodically evaluated for adequacy by management. Factors considered include the Company’s loan loss experience, known and inherent risks in the portfolio, current economic conditions, known adverse situations that may affect the borrower’s ability to repay, regulatory policies, and the estimated value of underlying collateral. The evaluation of the adequacy of the allowance is based on the above factors along with prevailing and anticipated economic conditions that may impact borrowers’ ability to repay loans. Determination of the allowance is part objective and part a subjective judgment by management given the information it currently has in its possession. Adverse changes in any of these factors or the discovery of new adverse information could result in higher charge-offs and loan loss provisions.
 
Goodwill
 
Goodwill arises when the Company’s purchase price exceeds the fair value of net assets of an acquired business. Goodwill represents the value attributable to intangible elements acquired. The value of goodwill is supported ultimately by profit from the acquired business. A decline in earnings could lead to impairment, which would be recorded as a write-down in the Company’s consolidated statements of income. Events that may indicate goodwill impairment include significant or adverse changes in results of operations of the acquired business or asset, economic or political climate; an adverse action or assessment by a regulator; unanticipated competition; and a more-likely-than-not expectation that a reporting unit will be sold or disposed of at a loss.
 
 
34

 
 
Other Than Temporary Impairment
 
The decline in the fair value of any security in the Company’s investment portfolio that is considered other than temporarily impaired is written down with a charge to noninterest income in the period in which the impairment occurs in an amount that equals the book value less the fair value of the security. There are many factors that are considered before an other than temporary impairment is recorded. These factors include the length of time and the extent to which market value has been less than cost, reasons for decline in market price – whether an industry issue or issuer specific, changes in the general market condition of the area or issuer’s industry, the Company’s intent to sell the investment security, the possibility the Company may be required to sell the investment security, the issuer’s financial condition, capital strength, ability to make timely future payments and any changes in agencies ratings that drop the security’s rating below investment grade and any potential legal actions.
 
Provision for Income Taxes
 
The Company is subject to income tax laws of the United States, its states, and municipalities in which it operates. The Company considers its income tax provision methodology to be critical, as the determination of current and deferred taxes based on complex analyses of many factors including interpretation of federal and state laws, the difference between tax and financial reporting bases of assets and liabilities (temporary differences), estimates of amounts due or owed, the timing of reversals of temporary differences and current financial standards. Actual results could differ significantly from the estimates due to tax law interpretations used in determining the current and deferred income tax liabilities. Additionally, there can be no assurances that estimates and interpretations used in determining income tax liabilities may not be challenged by federal and state taxing authorities.
 
Recent Accounting Pronouncements
 
The Company has adopted guidance as codified by the Financial Accounting Standards Board (“FASB”) which refers to “Interim Disclosures about Fair Value of Financial Instruments” which was issued in April 2009. This guidance amends earlier guidance on the same subject as well as guidance regarding “Interim Financial Reporting” by requiring disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements and requiring disclosures in summarized financial information at interim reporting periods. This guidance is effective for interim reporting periods ending after June 15, 2009; early adoption is permitted for periods ending after March 15, 2009. This guidance did not have a material impact on the Company’s financial statements.
 
The Company has adopted guidance as codified by the FASB issued in April 2009, which amends the other-than-temporary impairment guidance in U. S. GAAP for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities in the financial statements. This guidance does not amend an existing recognition and measurement guidance related to other-than-temporary impairments of equity securities.
 
The Company has adopted guidance as codified by the FASB issued in April 2009, which was adopted to provide additional guidance for estimating fair value in accordance with guidance regarding “Fair Value Measurements”, when the volume and level of activity for the asset or liability have significantly decreased. This guidance also includes guidance on identifying circumstances that indicate a transaction is not orderly.
 
 
35

 
 
The Company has adopted guidance as codified by the FASB which was issued in June, 2009, “Accounting for Transfers of Financial Assets.” This is a revision to guidance on “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” and will require more information about transfers of financial assets, including securitization transactions, and where companies have continuing exposure to the risks related to transferred financial assets. It eliminates the concept of a “qualifying special-purpose entity,” changes the requirements for derecognizing financial assets, and requires additional disclosures. This guidance becomes effective at the start of a company’s fiscal year after November 15, 2009. This guidance did not have a material impact on the Company’s financial statements.
 
The Company has adopted guidance as codified by the FASB issued in June, 2009, “Amendments to Previous Guidance Regarding Consolidation of Variable Interest Entities,” and changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance. This guidance becomes effective at the start of a company’s fiscal year after November 15, 2009. The Company does not expect this guidance to have a material impact on the Company’s financial statements.
 
The Company has adopted guidance as codified by the FASB issued in June 2009 regarding “The FASB Accounting Standards Codification” and the “Hierarchy of Generally Accepted Accounting Principles” - a replacement of an earlier guidance on the same subject. The FASB Accounting Standards Codification (“Codification”) will become the source of authoritative U.S. generally accepted accounting principles (“GAAP”) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. On the effective date of this Statement, the Codification will supersede all then-existing non-SEC accounting and reporting standards. All other nongrandfathered non-SEC accounting literature not included in the Codification will become nonauthoritative. This guidance is effective for financial statements issued for interim and annual periods ending after September 15, 2009.
 
Following this guidance, the Board will not issue new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts. Instead, it will issue Accounting Standards Updates. The Board will not consider Accounting Standards Updates as authoritative in their own right. Accounting Standards Updates will serve only to update the Codification, provide background information about the guidance, and provide the bases for conclusions on the change(s) in the Codification.
 
 
36

 
 
Earnings Analysis
 
Net earnings in 2009 were $593,000, a $3,370,000 or an 85.0% decrease from 2008 earnings of $3,963,000. Net earnings for the year 2008 decreased $2,716,000 or 40.7% from year 2007 earnings of $6,679,000. The principal source of income is interest income on loans. The level of interest income can be affected by changes in interest rate, volume of loans outstanding, and the quality of the Bank’s loan portfolio. Loans that are 90 days or more past due are placed on non-accrual status and interest is recorded on these loans only as payments are made to the Bank. All other loans accrue interest at the stated contract rate.
 
Basic (loss) earnings per share were ($0.01) in 2009, $1.23 in 2008, and $2.03 in 2007. Diluted (loss) earnings per share were ($0.01) in 2009, $1.22 in 2008 and $2.00 in 2007.
 
Net interest income for 2009 was $26,806,000, a decrease of $1,114,000 or 4.0% from 2008. In 2008 it was $27,920,000, a decrease of $713,000 or 2.5% from 2007. Interest income was $35,817,000 in 2009, a decrease of $3,610,000 or 9.2% from 2008. Interest income was $39,427,000 in 2008, a decrease of $2,863,000 or 6.8% from 2007. The decrease in net interest income was caused primarily by a decrease in the interest rate on earning assets which exceeded the decrease in the interest rate on interest bearing liabilities, reflecting the actions of the Federal Open Market Committee,which has lowered short term interest rates significantly throughout 2008 and ending in January 2009 with a federal funds target rate range of 0% to 0.25%. Most of the interest earning assets are tied to the prime lending rate, which adjusts immediately, whereas most of the interest-bearing liabilities adjust on a lagged basis, particularly in the case of time deposits, which change only at maturity. An increase in the volume of loans in nonaccrual status of $11,490,000 during 2009 also contributed to the decline. Total nonaccrual loans were $25,592,000 and $14,102,000 as of December 31, 2009 and 2008, respectively. Loans on nonaccrual status, where principal is believed to be fully collectible, are credited to interest income when they are received. Average interest earning assets totaled $608,322,000 in 2009, an increase of $9,923,000 or 1.7% over 2008. Average interest earning assets in 2008 were $598,399,000, an increase of $31,154,000 or 5.5% over 2007. The yield on interest earning assets decreased 72 basis points in 2009 compared to 2008. The yield on interest earning assets decreased 89 basis points in 2008 compared to 2007. The principal earning assets were loans, and average loans outstanding increased $4,707,000 in 2009 versus 2008, and increased $30,100,000 in 2008 versus 2007. Their yield decreased 63 basis points in 2009 versus 2008, and decreased 100 basis points in 2008 versus 2007.
 
 
37

 
 
Interest expense for 2009 was $9,011,000 compared to $11,507,000 for 2008, a decrease of $2,496,000, or 21.7% Interest expense was $11,507,000 in 2008, compared to $13,657,000 for 2007, a decrease of $2,150,000 or 15.7%. The decrease in interest expense during 2009, 2008 and 2007 was caused by rate decreases on deposits, as rates followed the declines in prevailing short term market interest rates. The Federal Open Market Committee intended federal funds rate was 4.25% on December 31, 2007. By December 31, 2008, that rate had been reduced to a target of 0% to 0.25%. This rate continued throughout 2009. A new consumer product, the Money Market Maximizer, was created, and reached $107,950,000 at year end. Average interest bearing liabilities were $482,900,000 in 2009, $463,546,000 in 2008 and $426,354,000 in 2007. This represented an increase of $19,354,000 in 2009 over 2008, and an increase of $37,192,000 in 2008 over 2007. The cost of these liabilities decreased 61 points in 2009 compared to 2008, and decreased 72 basis points in 2008 compared to 2007. Time deposit costs decreased 130 basis points in 2009 compared to 2008, and decreased 113 basis points in 2008 compared to 2007. Short term deposit rates are expected to remain low so long as the FOMC continues to push down short term interest rates to 25 basis points or less.
 
Net Interest Income
 
Net interest income is the difference between interest yield generated by earning assets and the interest expense associated with the funding of those assets. Net interest income is affected by the interest rate earned or paid and by volume changes in loans, investment securities, deposits and borrowed funds.

TABLE 1
    Net Interest Income and Average Balances
                                                       
       Year ended December 31
      2009     2008     2007
(Dollar amounts in thousands)
       
Interest
   
Average
       
Interest
   
Average
       
Interest
   
Average
   
Average
   
Income
   
Yield
 
Average
   
Income
   
Yield
 
Average
   
Income
   
Yield
   
Balance
   
(Expense)
   
(Cost)
 
Balance
   
(Expense)
   
(Cost)
 
Balance
   
(Expense)
   
(Cost)
INTEREST EARNING ASSETS
                                                     
Loans, gross (1) (2)
  $ 502,239     $ 32,718     6.51 %   $ 497,532     $ 35,515     7.14 %   $ 467,432     $ 38,035     8.14 %
Taxable securities (3)
    58,248       1,779     3.05 %     53,328       2,248     4.22 %     34,323       1,733     5.05 %
Nontaxable securities (3)
    34,406       1,634     4.75 %     42,809       2,044     4.77 %     56,080       2,643     4.71 %
Federal funds sold
    13,429       78     0.58 %     4,730       106     2.24 %     9,410       487     5.18 %
Total interest earning assets
  $ 608,322     $ 36,209     5.95 %   $ 598,399     $ 39,913     6.67 %   $ 567,245     $ 42,898     7.56 %
                                                                   
NONINTEREST EARNING ASSETS:
                                                                 
Cash and due from banks
  $ 33,933                   $ 17,155                     17,487                
Premises and equipment
    12,417                     13,648                     13,735                
Other assets
    29,157                     28,906                     24,924                
Total noninterest earning assets
  $ 75,507                   $ 59,709                   $ 56,146                
TOTAL ASSETS
  $ 683,829                   $ 658,108                   $ 623,391                
                                                                   
INTEREST BEARING LIABILITIES:
                                                                 
Deposits:
                                                                 
Demand, interest bearing
  $ 57,886     $ 307     0.53 %   $ 59,472     $ 329     0.55 %   $ 59,491     $ 416     0.70 %
Money market
    198,236       4,007     2.02 %     140,177       3,259     2.32 %     136,672       4,656     3.41 %
Savings
    43,531       123     0.28 %     46,695       127     0.27 %     48,633       247     0.51 %
Time deposits
    133,388       2,637     1.98 %     142,895       4,689     3.28 %     140,934       6,210     4.41 %
Fed Home Loan Bank advances
    49,859       1,937     3.88 %     73,777       3,084     4.18 %     39,482       2,070     5.24 %
Fed funds purchased
 
   
    n/a       530       19     3.58 %     1,142       58     5.08 %
Total interest bearing liabilities
  $ 482,900     $ 9,011     1.87 %   $ 463,546     $ 11,507     2.48 %   $ 426,354     $ 13,657     3.20 %
                                                                   
NONINTEREST BEARING LIABILITIES:
                                                                 
Demand deposits
    116,946                     118,784                     123,766                
Other liabilities
    6,616                     8,290                     8,977                
Total noninterest bearing liabilities
  $ 123,562                   $ 127,074                   $ 132,743                
Total liabilities
  $ 606,462                   $ 590,620                   $ 559,097                
Stockholders’ equity
  $ 77,367                   $ 67,488                   $ 64,294                
                                                                   
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
  $ 683,829                   $ 658,108                   $ 623,391                
                                                                   
NET INTEREST INCOME AND MARGIN ON TOTAL EARNING ASSETS (4)
          $ 27,198     4.47 %           $ 28,406     4.75 %           $ 29,241     5.15 %
 
(1)
Interest on non-accrual loans is recognized into income on a cash received basis.
(2)
Amounts of interest earned included loan fees of $1,249,000 $1,425,000 and $1,593,000 for the years ended December 31, 2009, 2008 and 2007, respectively.
(3)
Tax equivalent adjustments recorded at the statutory rate of 34% that are included in the nontaxable securities portfolio are $392,000, $481,000, and $608,000 for the years ended December 31, 2009, 2008 and 2007, respectively, and were derived from nontaxable municipal interest income. Tax equivalent adjustments recorded at the statutory rate of 34% that are included in taxable securities portfolio were created by a dividends received deduction of $0, $5,000 and $0 in the years ended December 31, 2009, 2008 and 2007, respectively.
(4)
Net interest margin is computed by dividing net interest income by total average interest earning assets.
 
 
38

 
 
The following table analyzes the dollar amount of change in interest income and expense and the changes in dollar amounts attributable to (a) changes in volume (changes in volume at the current year rate), (b) changes in rate (changes in rate times the prior year’s volume) and (c) changes in rate/volume (changes in rate times changes in volume). In this table, the dollar change in rate/volume is prorated to volume and rate proportionately.
 
TABLE 2
 
Rate/Volume Variance Analysis
 
                                     
(Dollar amounts in thousands)  
Year Ended December 31
 
    2009 compared to 2008    
2008 compared to 2007
 
   
Increase (decrease)
   
Increase (decrease)
 
   
Interest
               
Interest
             
   
Income/
   
Variance
   
Income/
   
Variance
 
   
Expense
   
Attributable To
   
Expense
   
Attributable To
 
   
Variance
   
Rate
   
Volume
   
Variance
   
Rate
   
Volume
 
INTEREST EARNING ASSETS:
 
 
                               
Loans
  $ (2,797 )   $ (3,104 )   $ 307     $ (2,520 )   $ (4,669 )   $ 2149  
Taxable securities
    (469 )     (676 )     207       515       (444 )     959  
Nontaxable securities
    (410 )     (9 )     (401 )     (599 )     27       (626 )
Federal funds sold
    (28 )     (78 )     50       (381 )     (276 )     (105 )
Total
  $ (3,704 )   $ (3,867 )   $ 163     $ (2,985 )   $ (5,362 )     2,377  
                                                 
INTEREST BEARING LIABILITIES:
 
 
                                         
Demand deposits
  $ (22 )   $ (13 )   $ (9 )   $ (87 )   $ (87 )   $
 
Money market
    748       (426 )     1,174       (1,397 )     (1,478 )     81  
Savings deposits
    (4 )     5       (9 )     (120 )     (115 )     (5 )
Time deposits
    (2,052 )     (1,740 )     (312 )     (1,521 )     (1,607 )     86  
Federal Home Loan Bank advances
    (1,147 )     (218 )     (929 )     1,014       (420 )     1,434  
Federal funds purchased
    (19 )     (19 )    
      (39 )     (17 )     (22 )
Total
  $ (2,496 )   $ (2,411 )   $ (85 )   $ (2,150 )   $ (3,724 )   $ 1,574  
NET INTEREST INCOME
  $ (1,208 )   $ (1,456 )   $ 248     $ (835 )   $ (1,638 )   $ 803  

The net interest margin on average earning assets was 4.47% in 2009 compared to 4.75% in 2008 and 5.15% in 2007. The average rate earned on interest earning assets was 5.95% in 2009, 6.67% in 2008 and 7.56% in 2007. The average cost for interest-bearing liabilities was 1.87% in 2009 compared to 2.48% in 2008 and 3.20% in 2007. The decline in net interest margin in 2009 and 2008 is related to an overall market rate decline and the fact that the Bank is slightly asset sensitive to interest rates which means in a downward rate environment assets reprice at a faster pace than liabilities.
 
 
39

 
 
As mentioned above under the heading “Earnings Analysis”, there were decreases in the prime lending rate from 8.25% at the beginning of 2007 to 7.25% at the end of 2007, and 3.25% at the end of 2008 and which has continued at this rate for all of 2009. Action taken by the Federal Open Market Committee of the Federal Reserve, which affect the Prime Rate is indirectly affected by asset/liability pricing decisions, including their decisions regarding the appropriate Prime Rate level.
 
Yield on average loans was 6.51% in 2009, 7.14% in 2008 and 8.14% in 2007. Interest on average taxable securities was 3.05% in 2009, 4.22% in 2008, and 5.05% in 2007. Interest on average nontaxable securities was 4.75% in 2009, 4.77% in 2008, and 4.71% in 2007. Interest on average federal funds sold was 0.58% in 2009, 2.24% in 2008, and 5.18% in 2007. Interest on average total interest earning assets was 5.95% in 2009, 6.67% in 2008, and 7.56% in 2007. On the expense side, interest on average interest bearing demand deposits was 0.53% in 2009, 0.55% in 2008, and 0.70% in 2007. Interest on average money market accounts was 2.02% in 2009, 2.32% in 2008, and 3.41% in 2007. Interest on average savings accounts was 0.28% in 2009, 0.27% in 2008 and 0.51% in 2007. Interest on average time deposits was 1.98% in 2009, 3.28% in 2008 and 4.41% in 2007. Interest on average Federal Home Loan Bank advances was 3.88% in 2009, 4.18% in 2008 and 5.24% in 2007. Interest on federal funds purchased was 3.58% in 2008 and 5.08% in 2007. There were no federal funds purchased in 2009. Interest on average total interest bearing liabilities was 1.87% in 2009, 2.48% in 2008 and 3.20% in 2007.
 
Allowance For Loan Losses
 
The Bank has the responsibility of assessing the overall risks in its loan portfolio, assessing the specific loss expectancy, and determining the adequacy of the loan loss reserve. The level of reserves is determined by internally generated credit quality ratings, a review of the local economic conditions in the Bank’s market area, and consideration of the Bank’s historical loan loss experience. The Bank is committed to maintaining adequate reserves, identifying credit weaknesses through frequent loan reviews, and updating loan risk ratings and changing those risk ratings in a timely manner as circumstances change.
 
Real estate loans outstanding increased by $33,519,000 in 2009 compared to 2008, and increased by $961,000 in 2008 compared to 2007. Real estate loans increased in 2009 compared to 2008, while remaining nearly the same in 2008 compared to 2007.
 
During 2009 and 2008, we priced our loans competitively, but did not discount our loans in order to attract new business. The reserve allocated to our loans was increased in 2008 and again in 2009, to reflect the credit risk involved in the our loan portfolio. We experienced increased loan charge-offs and non accrual loans during 2008 and 2009. The credit quality of our underlying collateral also deteriorated during 2008, and 2009, necessitating an increased provision for loan losses.
 
 
40

 
 
The allowance for loan losses totaled $9,829,000, $7,075,000 and $5,638,000 at December 31, 2009, 2008 and 2007, respectively. This represented 1.95%, 1.40% and 1.14% of total loans outstanding on those dates. These balances reflect amounts that, in management’s judgment, are adequate to provide for probable loan losses based on the considerations listed above. During 2009, the provision for loan losses was $4,596,000, and the charge-offs were $1,921,000. During 2008, the provision for loan losses was $3,045,000, and the charge-offs were $1,788,000. During 2007, the provision for loan losses was $690,000, and the charge-offs were $80,000. Management also performs stress testing of our loan portfolio to gain a better understanding of the portfolio effects of additional declines in Real Estate values and lease rates.

TABLE 3
 
Allocation of the Allowance for Loan Losses
 
   
(Dollar amounts in thousands)
 
                                                             
         
2009
         
2008
         
2007
         
2006
         
2005
 
         
Percent
         
Percent
         
Percent
         
Percent
         
Percent
 
         
of loans
         
of loans
         
of loans
         
of loans
         
of loans
 
         
in each
         
in each
         
in each
         
in each
         
in each
 
         
category
         
category
         
category
         
category
         
category
 
         
to total
         
to total
         
to total
         
to total
         
to total
 
   
Amount
   
Loans
   
Amount
   
Loans
   
Amount
   
Loans
   
Amount
   
Loans
   
Amount
   
Loans
 
                                                             
Real Estate
  $ 5,881       76.6 %   $ 4,712       69.9 %   $ 3,669       69.7 %   $ 3,864       74.9 %   $ 3,373       78.5 %
Construction
    3,110       9.4 %     1,388       13.0 %     1,576       11.4 %     539       8.7 %     365       6.8 %
Commercial
    809       13.5 %     932       16.5 %     370       16.3 %     582       15.6 %     611       13.8 %
Consumer
    29       0.5 %     43       0.6 %     23       0.7 %     17       0.8 %     25       0.9 %
Total
  $ 9,829       100.0 %   $ 7,075       100.0 %   $ 5,638       98.0 %   $ 5,002       100.0 %   $ 4,374       100.0 %
 
 
41

 
 
Table 4 summarizes transactions in the allowance for loan losses and details the charge-offs, recoveries and net loan losses by loan category for each of the last five fiscal years ended December 31, 2009. The amount added to the provision and charged to operating expenses for each period is based on the risk profile of the loan portfolio.

TABLE 4
  Allowance for Loan Losses  
     Historical Analysis  
                               
(Dollar amounts in thousands)
  For the year ended December 31,  
   
2009
   
2008
   
2007
   
2006
   
2005
 
Balance at Beginning of Period
  $ 7,075     $ 5,638     $ 5,002     $ 4,374     $ 3,133  
Provision for Loan Losses
    4,596       3,045       690       683       628  
                                         
Charge-offs:
                                       
Real Estate
    (1,471 )     (493 )     (48 )     0       (70 )
Commercial
    (390 )     (1,284 )     (19 )     (49 )     (34 )
Consumer
    (60 )     (11 )     (13 )     (10 )     (6 )
Total
    (1,921 )     (1,788 )     (80 )     (59 )     (110 )
                                         
Recoveries:
                                       
Real Estate
    61       36       15    
   
 
Commercial
    18       144       10       3       22  
Consumer
   
     
     
1
     
1
      1  
Total
    79       180       26       4       23  
Net Charge-offs
    (1,842 )     (1,608 )     (54 )     (55 )     (87 )
                                         
Allowance acquired in business combination
   
     
     
     
      700  
Balance at End of Period
  $ 9,829     $ 7,075     $ 5,638     $ 5,002     $ 4,374  
                                         
Percentages
                                       
Allowance for loan losses/total loans
    1.95 %     1.40 %     1.14 %     1.18 %     1.14 %
Net charge-offs/real estate loans
    0.38 %     0.14 %     0.01 %     0.00 %     0.02 %
Net charge-offs/commercial loans
    0.55 %     1.37 %     0.01 %     0.07 %     0.06 %
Net charge-offs/consumer loans
    2.25 %     0.35 %     0.33 %     0.27 %     0.15 %
Net charge-offs/total loans
    0.37 %     0.32 %     0.01 %     0.01 %     0.02 %
Allowance for loan losses/non-performing loans
    38.41 %     50.17 %     49.18 %     190.33 %     25729.41 %

The increase in charge-offs during 2009 and 2008 is primarily attributable to problems that were identified with specific borrowers rather than problems with a particular segment of the loan portfolio. In particular, borrowers who had exposure to real estate projects outside of San Mateo and San Francisco counties were identified as having a relatively higher risk profile than those operating solely within these two counties. Additionally, there was a high default rate related to purchased single family loans that were serviced by outside third parties. These loan purchase programs have been terminated and the servicing of these loans is now performed by the Bank. If real estate values or lease rates continue to decline in the future, an increase in our allowance for loan losses may be warranted.
 
Non-performing Assets.
 
Non-performing assets consist of nonaccrual loans, foreclosed assets, and loans that are 90 days or more past due but are still accruing interest. The accrual of interest on non-accrual loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due. For the years ended December 31, 2009, 2008 and 2007, had non-accrual loans performed as agreed, approximately $759,000, $692,000 and $547,000, respectively, would have been recognized in additional interest income.
 
 
42

 
 
Table 5 provides a summary of contractually past due loans for the most recent five years. Nonperforming loans were 5.1% of total loans at December 31, 2009 compared to 2.8% of total loans at December 31, 2008. Nonperforming loans were 2.8% of total loans at December 31, 2008 and 2.3% of total loans at December 31, 2007. Management believes the current list of past due loans are collectible and does not anticipate significant losses. Nonperforming loans at December 31, 2009 include fifteen real estate secured loans compared to five at December 31, 2008.

TABLE 5
   Analysis of Nonperforming Assets  
                               
(Dollar amounts in thousands)
   Year ended December 31  
   
2009
   
2008
   
2007
   
2006
   
2005
 
Accruing loans 90 days or more
  $
    $
    $
    $
    $
 
Nonaccrual loans
    25,592       14,102       11,465       2,628       17  
Other real estate owned
    7,320       3,557       440