United States Securities and Exchange Commission

FORM 10-Q

Commission File Number: 000-25597

Umpqua Holdings Corporation

(Exact Name of Registrant as Specified in Its Charter)

One SW Columbia Street, Suite 1200
Portland, Oregon 97258
(Address of Principal Executive Offices)(Zip Code)

(971) 544-1085
(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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.

þ Yes o No

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

þ Yes o No

Indicate the number of shares outstanding for each of the issuer’s classes of common stock, as of the latest practical date:

Common stock, no par value: 44,450,754 shares outstanding as of April 30, 2005

UMPQUA HOLDINGS CORPORATION
FORM 10-Q
QUARTERLY REPORT
Table of Contents

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (unaudited)

UMPQUA HOLDINGS CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)

See accompanying notes to condensed consolidated financial statements

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UMPQUA HOLDINGS CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)

See accompanying notes to condensed consolidated financial statements

4

UMPQUA HOLDINGS CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(UNAUDITED)

See accompanying notes to condensed consolidated financial statements

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UMPQUA HOLDINGS CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

See accompanying notes to consolidated financial statements

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Note 1 – Summary of Significant Accounting Policies

The accounting and financial reporting policies of Umpqua Holdings Corporation (referred to in this report as “we”, “our” or “the Company”) conform with accounting principles generally accepted in the United States of America. The accompanying interim consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Umpqua Bank (“Bank”), and Strand, Atkinson, Williams & York, Inc. (“Strand”). All material inter-company balances and transactions have been eliminated. The consolidated financial statements have not been audited. A more detailed description of our accounting policies is included in the 2004 Annual Report filed on Form 10-K. There have been no significant changes to these policies.

In management’s opinion, all accounting adjustments necessary to accurately reflect the financial position and results of operations on the accompanying financial statements have been made. These adjustments are normal and recurring accruals considered necessary for a fair and accurate presentation. The results for interim periods are not necessarily indicative of results for the full year or any other interim period. Certain reclassifications of prior year amounts have been made to conform to current classifications.

Note 2 – Stock-Based Compensation

At March 31, 2005 the Company had a total of 2.1 million stock options issued under various plans (some assumed in connection with mergers) that were accounted for under the intrinsic value method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees. Under the intrinsic value method, compensation expense is recognized only to the extent an option’s exercise price is less than the market value of the underlying stock on the date of grant. For all options originally granted by the Company, no compensation cost has been recognized in the accompanying statement of income. Compensation cost has been recognized for certain options that were assumed in connection with prior acquisitions that were unvested as of the date the acquisitions were completed.

The following table presents the effect on net income and earnings per share if the fair value based method prescribed by Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, as amended, had been applied to all outstanding and unvested awards in each period:

Stock-Based Compensation Disclosure

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The Company’s stock compensation plan provides for granting of restricted stock awards. The restricted stock awards generally vest ratably over 5 years and are recognized as expense over that same period of time. For the three months ended March 31, 2005 and 2004, compensation expense of $68,000 and $55,000, respectively, was recognized in connection with restricted stock grants.

Note 3 – Discontinued Operations

During the fourth quarter of 2004, the Bank sold its merchant bankcard portfolio to an unrelated third party for $5.9 million in cash. The gain on sale, after selling costs and other expenses, was $5.6 million. Except for standard representations and warranties, the Bank assumed no liability subsequent to completion of the sale.

The following table presents the contribution components from the Bank’s merchant bankcard operations for the three months ended March 31, 2005 and 2004:

Contribution from Merchant Bankcard

At March 31, 2005, the remaining liability recorded in connection with professional fees and contract termination costs related to the sale of the merchant bankcard portfolio was $184,000. This liability is expected to be relieved through cash payments by December 31, 2005.

In accordance with SFAS No. 144, Impairment of Long-Lived Assets, the financial results related to the merchant bankcard operation (exclusive of the gain on sale) have been reclassified as income from discontinued operations, net of tax in the statements of income.

Note 4 – Business Combinations

On July 9, 2004, the Company acquired all of the outstanding common stock of Humboldt Bancorp (“Humboldt”) of Roseville, California, the parent company of Humboldt Bank, in an acquisition accounted for under the purchase method of accounting. The results of Humboldt’s operations have been included in the consolidated financial statements since that date. This merger was consistent with the Company’s community banking expansion strategy and provides the opportunity to enter growth markets in Northern California with an established franchise of 27 stores.

The aggregate purchase price was $328 million and included common stock valued at $310 million, stock options valued at $17 million and direct merger costs of $1 million. The value of the 15.5 million common shares issued was determined based on the $19.98 average closing market price of the Company’s common stock for the two trading days before and after announcement of the merger agreement on March 15, 2004. Outstanding Humboldt stock options were converted (using the same 1:1 exchange ratio applied to the share conversion) into approximately 1.1 million Umpqua Holdings Corporation stock options, at a weighted average fair value of $15.58 per option.

The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of acquisition:

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Fair Value of Humboldt Assets Acquired and Liabilities Assumed

Subsequent to the acquisition, certain of these assets were adjusted as part of the allocation of the purchase price. Additional adjustments may be made to the purchase price allocation, specifically related to other assets, taxes and compensation adjustments. At March 31, 2005, the goodwill asset recorded in connection with the Humboldt acquisition was approximately $237 million.

The following table presents unaudited pro forma results of operations for the three months ended March 31, 2004 as if the acquisition of Humboldt had occurred on January 1, 2004. The Company expects to realize significant revenue enhancements and cost savings as a result of the Humboldt merger that are not reflected in the pro forma consolidated condensed statements of income. No assurance can be given with respect to the ultimate level of such revenue enhancements or cost savings. The pro forma results do not necessarily indicate the results that would have been obtained had the acquisitions actually occurred on January 1, 2004:

Pro Forma Financial Information – Unaudited

The Company expects to incur less than $500,000 of additional merger-related expenses in connection with the Humboldt merger,

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principally during the second quarter of 2005. No additional merger-related expenses are expected in connection with any other previous acquisitions.

Note 5 – Per Share Information

Basic earnings per share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed in a similar manner, except that the denominator is increased to include the number of additional common shares that would have been outstanding if potentially dilutive common shares were issued using the treasury stock method. For all periods presented, stock options and restricted stocks are the only potentially dilutive instruments issued by the Company. During 2004, the Company entered into a transaction that resulted in certain financial results being reported as a discontinued operation. Accordingly, basic and diluted earnings per share from continuing operations and discontinued operations (net of tax) are presented.

The following is a computation of basic and diluted earnings per share and basic and diluted earnings per share from continuing operations for the three months ended March 31, 2005 and 2004:

Earnings Per Share

Note 6 – Segment Information

The Company operates three primary segments: Community Banking, Mortgage Banking and Retail Brokerage. The Community Banking segment consists of all non-mortgage related operations of Umpqua Bank (“the Bank”), which operates 93 stores located throughout Oregon, Northern California and Washington. The Community Banking segment’s principal business focus is the offering of loan and deposit products to its business and retail customers in its primary market areas.

The Mortgage Banking segment, which operates as a division of the Bank, originates, sells and services residential mortgage loans. During the third quarter of 2004, the Company completed a strategic review of the Mortgage Banking segment and decided to terminate wholesale channel origination. Although this decision resulted in a reduction in mortgage loan origination volumes, revenue and expense, the segment net income was not adversely impacted in a material manner.

The Retail Brokerage segment consists of the operations of the Company’s brokerage subsidiary, Strand, which offers a full range of retail brokerage services and products to its clients who consist primarily of individual investors. The Company accounts for intercompany fees and services between Strand and the Bank at an estimated fair value according to regulatory requirements for services provided. Intercompany items relate primarily to management services and interest on intercompany borrowings.

Summarized financial information concerning the Company’s reportable segments and the reconciliation to the consolidated financial results is shown in the following tables:

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Segment Information

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Note 7 – Recently Issued Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R, Share Based Payment, a revision to the previously issued guidance on accounting for stock options and other forms of equity-based compensation. SFAS No. 123R requires companies to recognize in the income statement the grant-date fair value of stock options and other equity-based forms of compensation issued to employees. For the Company, this standard will become effective on January 1, 2006. The Company does not expect the impact of adoption of SFAS No. 123R on earnings per share will be materially different from the current fair value pro forma disclosure.

Companies may elect one of two methods for adoption of SFAS No. 123R. Under the modified prospective method, any awards that are granted or modified after the date of adoption will be measured and accounted for under the provisions of SFAS No. 123R. The unvested portion of previously granted awards will continue to be accounted for under SFAS No. 123, Accounting for Stock-Based Compensation, except that the compensation expense associated with the unvested portions will be recognized in the statement of income. Under the modified retrospective method, all amounts previously reported are restated to reflect the amounts in the SFAS No. 123 pro forma disclosure. The Company expects to make a decision with respect to the method of adoption during the fourth quarter of 2005.

In March 2005, the SEC issued Staff Accounting Bulletin (“SAB”) No. 107 which expressed the views of the SEC regarding the interaction between SFAS No. 123R and certain SEC rules and regulations. SAB No. 107 provides guidance related to the valuation of share-based payment arrangements for public companies, including assumptions such as expected volatility and expected term. The Company is assessing the impact SAB No. 107 will have on its consolidated financial statements.

In March 2004, the Securities and Exchange Commission issued SAB No. 105, Application of Accounting Principles to Loan Commitments. SAB No. 105 provides guidance on the accounting for loan commitments accounted for as derivative instruments. The Company adopted SAB No. 105 in March 2004. The adoption did not have a material impact on our financial condition or results of operations.

In March 2004, the FASB ratified the consensus reached by the Emerging Issues Task Force regarding issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (“EITF 03-01”). The consensus provided guidance for determining when an investment is other-than-temporarily-impaired and established disclosure requirements for investments with unrealized losses. The guidance was effective for periods beginning after June 15, 2004. On September 30, 2004, the FASB deferred the implementation of the recognition criteria of EITF 03-01 pending a review of the guidance in light of comments received. We will evaluate the potential impact this guidance may have on our financial condition and results of operations when it is released in final form.

In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), Consolidation of Variable Interest Entities (revised December 2003). In December 2003, the FASB made revisions and delayed implementation of certain provisions of FIN 46 with the issuance of FIN 46R. FIN 46R provides guidance on how to identify the primary beneficiary of a variable interest entity and determine when the variable interest entity should be consolidated by the primary beneficiary. The recognition and measurement provisions of FIN 46, were adopted for our Trust subsidiaries for the quarter ended September 30, 2003, and for other variable interest entities under FIN 46R for the quarter ended March 31, 2004. The adoption did not have a material impact on our financial condition or results of operations.

Note 8 – Allowance for Loan Losses

As of September 30, 2004, we refined the model used for determining certain components of the allowance for loan losses. The model refinement was done principally in connection with the Humboldt acquisition, and did not have a material impact on the recorded allowance for loan losses. Additionally, as of September 30, 2004, we reclassified the reserve for unfunded lending commitments from

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the allowance for loan losses to other liabilities. The amount reclassified as of September 30, 2004 was approximately $1.2 million, or 3 basis points of total gross loans. The reclassifications had no effect on the provision for credit losses as reported.

Note 9 — Junior Subordinated Debentures

As of March 31, 2005, the Company had ten wholly-owned trusts (“Trusts”) that were formed to issue trust preferred securities and related common securities of the Trusts. Five Trusts, representing aggregate total obligations of approximately $58.9 million (fair value of approximately $69 million as of the merger date), were assumed in connection with the Humboldt merger. Following is information about the Trusts:

Junior Subordinated Debentures

As a result of the adoption of FIN 46, the Trusts have been deconsolidated. The $166.1 million of junior subordinated debentures issued to the Trusts as of March 31, 2005 ($166.3 million as of December 31, 2004) are reflected as junior subordinated debentures in the consolidated balance sheets. The common stock issued by the Trusts is recorded in other assets in the consolidated balance sheets, and totaled $4.7 million at March 31, 2005 and December 31, 2004.

All of the debentures issued to the Trusts, less the common stock of the Trusts, qualified as Tier 1 capital as of March 31, 2005, under guidance issued by the Board of Governors of the Federal Reserve System (“Federal Reserve Board”). In May 2004, the Federal Reserve Board proposed a rule that would continue to allow the inclusion of trust preferred securities in Tier 1 capital, but with stricter quantitative limits. Under the proposal, after a three-year transition period, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25% of Tier 1 capital elements, net of goodwill. The amount of trust preferred securities and certain other elements in excess of the limit could be included in Tier 2 capital, subject to restrictions. Based on the proposed rule, the Company expects to include all currently issued trust preferred securities in Tier 1 capital. However, the provisions of the final rule could significantly differ from those proposed and there can be no assurance that the Federal Reserve Board will not further limit the amount of trust preferred securities permitted to be included in Tier 1 capital for regulatory capital purposes.

Note 10 – Commitments and Contingencies

Lease Commitments — The Company leases 65 sites under non-cancelable operating leases. The leases contain various provisions for increases in rental rates, based either on changes in the published Consumer Price Index or a predetermined escalation schedule. Substantially all of the leases provide the Company with the option to extend the lease term one or more times upon expiration. Rent expense, net of rental income, for premises and equipment rentals for the three months ended March 31, 2005 was $1.4 million compared to $832,000 in the comparable period in 2004.

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Financial Instruments with Off-Balance Sheet Risk — The Company’s financial statements do not reflect various commitments and contingent liabilities that arise in the normal course of the Bank’s business and involve elements of credit, liquidity and interest rate risk. These commitments and contingent liabilities include commitments to extend credit, commitments to sell residential mortgage loans and standby letters of credit. The following table presents a summary of the Bank’s commitments and contingent liabilities as of March 31, 2005:

Contractual Amounts

The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit and financial guarantees. Those instruments involve elements of credit and interest-rate risk similar to the amounts recognized in the consolidated balance sheets. The contract or notional amounts of those instruments reflect the extent of the Bank’s involvement in particular classes of financial instruments.

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit, and financial guarantees written, is represented by the contractual notional amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. While most commercial letters of credit are not utilized, a significant portion of such utilization is on an immediate payment basis. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if it is deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the counterparty. Collateral varies but may include cash, accounts receivable, inventory, premises and equipment and income-producing commercial properties.

Standby letters of credit and financial guarantees written are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. These guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank holds cash, marketable securities, or real estate as collateral supporting those commitments for which collateral is deemed necessary. The Bank has not been required to perform on any financial guarantees and did not incur any losses in connection with standby letters of credit during the three months ended March 31, 2005.

The Bank established a loss reserve for unfunded commitments, including loan commitments and letters of credit, during 2004 by reclassifying $1.2 million of the allowance for loan losses. At March 31, 2005, the reserve for unfunded commitments, which is included in other liabilities on the consolidated balance sheet, was approximately $1.4 million. The adequacy of the reserve for unfunded commitments is reviewed on a quarterly basis, based upon changes in the amounts of commitments, loss experience and economic conditions.

The Bank enters into forward delivery contracts to sell residential mortgage loans or mortgage-backed securities to broker/ dealers at specific prices and dates in order to hedge the interest rate risk in its portfolio of mortgage loans held for sale and its residential mortgage loan commitments. Credit risk associated with forward contracts is limited to the replacement cost of those forward contracts in a gain position. There were no counterparty default losses on forward contracts in the three months ended March 31, 2005. Market risk with respect to forward contracts arises principally from changes in the value of contractual positions due to changes in interest rates. The Bank limits its exposure to market risk by monitoring differences between commitments to customers and forward contracts with broker/ dealers. In the event the Company has forward delivery contract commitments in excess of available mortgage loans, the Company completes the transaction by either paying or receiving a fee to or from the broker/dealer equal to the increase or decrease in the market value of the forward contract. At March 31, 2005, the Bank had forward contracts outstanding totaling $10.5 million, with a fair value of approximately $85,000.

Mortgage loans sold to investors are generally sold with servicing rights retained, with only the standard legal representations and warranties regarding recourse to the Bank. Management believes that any liabilities that may result from such recourse provisions are not significant.

Legal Proceedings—In the ordinary course of business, various claims and lawsuits are brought by and against the Company, the Bank and Strand. In the opinion of management, there is no pending or threatened proceeding in which an adverse decision could result in a material adverse change in the Company’s consolidated financial condition or results of operations.

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

Forward-Looking Statements

This Report contains certain forward-looking statements, which are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Statements that expressly or implicitly predict future results, performance or events are forward-looking. In addition, the words “expect,” believe,” “anticipate” and other similar expressions identify forward-looking statements. Forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those expected. Factors that could cause or contribute to such differences include, but are not limited to, the risk factors discussed in this and other reports filed with the SEC, including exhibit 99.1 attached hereto, and the following:

	•	The ability to attract new deposits and loans
	•	Competitive market pricing factors
	•	Deterioration in economic conditions that could result in increased loan losses
	•	Market interest rate volatility
	•	Changes in legal or regulatory requirements
	•	The ability to recruit and retain certain key management and staff
	•	Risks associated with merger integration

Readers of this report should not place undue reliance on forward-looking statements contained herein, which speak only as of the date of this report. Umpqua Holdings Corporation undertakes no obligation to revise any forward-looking statements to reflect subsequent events or circumstances.

Summary of Critical Accounting Policies

Our significant accounting policies are described in Note 1 in the Notes to Consolidated Financial Statements for the year ended December 31, 2004 as filed on Form 10-K. Not all of these accounting policies require management to make difficult, subjective or complex judgments or estimates. Management believes that the following policies could be considered critical under the SEC’s definition.

Allowance for Loan Losses and Reserve for Unfunded Commitments

The allowance for loan losses (“ALL”) is maintained at a level that is adequate to absorb probable incurred losses inherent in the loan portfolio. The reserve for unfunded commitments (“RUC”) is maintained at a level that is adequate to absorb probable losses associated with our commitment to lend funds, such as with a letter or line of credit. The adequacy of the ALL and RUC are monitored on a regular basis and are based on management’s evaluation of numerous factors. These factors include the quality of the current loan portfolio; the trend in the loan portfolio’s risk ratings; current economic conditions; loan concentrations; loan growth rates; past-due and non-performing trends; evaluation of specific loss estimates for all significant problem loans; historical charge-off and recovery experience; and other pertinent information. Approximately 76% of our loan portfolio is secured by real estate, and a significant decline in real estate market values may require an increase in the allowance for loan losses.

Mortgage Servicing Rights

Mortgage servicing rights (“MSR”) retained are measured by allocating the carrying value of the loans between the assets sold and the interest retained, based on their relative fair values at the date of the sale. The subsequent measurements are determined based on evaluations provided by third parties. MSR assets are amortized over the expected life of the loan and are evaluated periodically for impairment. The expected life of the loan can vary from management’s estimates due to prepayments by borrowers, especially when rates fall. Prepayments in excess of management’s estimates would negatively impact the recorded value of the MSR. The value of the MSR is also dependent upon the discount rate used in the model. Management reviews this rate on an ongoing basis based on current market rates. A significant increase in the discount rate would reduce the value of MSR.

Goodwill and Other Intangibles

At March 31, 2005, we had approximately $408 million in goodwill and other intangible assets as a result of business combinations. Intangible assets with definite useful lives are amortized to their estimated residual values over their respective estimated useful lives, and also reviewed for impairment. Goodwill and other intangibles with indefinite lives are not amortized but instead are periodically tested for impairment. Management performs this impairment analysis on a quarterly basis, or more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount of the asset exceeds its fair value. No impairment loss was recognized during the quarter ended March 31, 2005.

Results of Operations—Overview

For the three months ended March 31, 2005, net income was $15.0 million, or $0.33 per diluted share, an increase of 14% on a per diluted share basis as compared to $8.4 million, or $0.29 per diluted share for the first quarter of 2004. Income from continuing operations for the three months ended March 31, 2005, which excludes the after-tax operating results from our merchant bankcard portfolio, was $15.0 million, or $0.33 per diluted share, as compared to $8.2 million, or $0.29 per diluted share for the first quarter of 2004. Additional information on discontinued operations is provided under the heading Discontinued Operations below. The

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improvement in diluted earnings per share from continuing operations for the three months ended March 31, 2005 is principally attributable to improved net interest income, offset by a decrease in mortgage banking revenue and increased operating expenses. We completed the acquisition of Humboldt on July 9, 2004, and the results of the acquired operations are included in our financial results starting on July 10, 2004.

We incur significant expenses related to the completion and integration of mergers. Accordingly, we believe that our operating results are best measured on a comparative basis excluding the impact of merger-related expenses, net of tax. We define operating income as income before merger related expenses, net of tax, and we calculate operating income per diluted share by dividing operating earnings by the same diluted share total used in determining diluted earnings per share (see Note 5 of the Notes to Condensed Consolidated Financial Statements). Operating income and operating income per diluted share are considered “non-GAAP” financial measures. Although we believe the presentation of non-GAAP financial measures provides a better indication of our operating performance, readers of this report are urged to review the GAAP results as presented in the Condensed Consolidated Financial Statements.

The following table presents a reconciliation of operating income and operating income per share to net income and net income per share for the three months ended March 31, 2005 and 2004:

Reconciliation of Operating Income to Net Income

The following table presents the returns on average assets, average shareholders’ equity and average tangible shareholders’ equity for the three months ended March 31, 2005 and 2004. It includes the calculated ratios based on reported net income and income from continuing operations, and operating income as shown in the Table above. To the extent return on average shareholders’ equity is used to compare our performance with other financial institutions that do not have merger-related intangible assets, we believe it beneficial to also consider the return on average tangible shareholders’ equity. The return on average tangible shareholders’ equity is calculated by dividing net income by average shareholders’ equity less average intangible assets. The return on average tangible shareholders’ equity is considered a non-GAAP financial measure and should be viewed in conjunction with the return on average shareholders’ equity.

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Returns on Average Assets, Shareholders’ Equity and Tangible Shareholders’ Equity

Discontinued Operations

During the fourth quarter of 2004, we completed a strategic review of our merchant bankcard portfolio. We concluded that shareholder value would be maximized, on a risk-adjusted basis, through a sale of the portfolio to a third party. In December 2004, the Bank sold its merchant bankcard portfolio to a third party for $5.9 million in cash, resulting in a gain on sale (after selling costs and related expenses) of $5.6 million, or $3.4 million after-tax. The operating results related to the merchant bankcard portfolio (including the gain on sale) have been reclassified as income from discontinued operations, net of tax for all periods presented. We retained no ongoing liability related to the portfolio subsequent to the sale and entered into an agreement whereby we will refer all merchant applications exclusively to the buyer for a period of seven years. In consideration for the referrals, we will receive remuneration for each accepted application and an on-going royalty based on a percentage of net revenue generated by the account as defined in the agreement. We do not expect the referral revenue will have a material impact on our non-interest income.

For the three months ended March 31, 2005, we recognized no income related to the merchant bankcard portfolio. In the first quarter of 2004, we recognized $151,000, net of tax. As a result of the sale, we will no longer have the benefit of this revenue stream. Since, for the year ended December 31, 2004, merchant bankcard revenue comprised only about 2% of total non-interest income, we do not expect the loss of revenue will have a material impact on our results of operations in 2005.

Additional information on discontinued operations is provided in Note 3 of the Notes to Condensed Consolidated Financial Statements.

Net Interest Income

Net interest income is the largest source of our operating income. Net interest income was $49.9 million for the three-month period ended March 31, 2005, an increase of $20.3 million, or 69% over the comparable period in 2004. This increase is attributable to growth in outstanding average interest earning assets and interest-bearing liabilities over the comparable prior year period, primarily due to the Humboldt merger, which was completed on July 9, 2004. The fair value of earning assets acquired on that date totaled $1.3 billion, and interest-bearing liabilities totaled $836 million.

For the three-month period ended March 31, 2005, the net interest margin (net interest income as a percentage of average interest earning assets) on a fully tax-equivalent basis was 4.83%, an increase of 20 basis points as compared to the same period in 2004. This increase is principally attributable to both the higher historical margin of Humboldt and accretion resulting from purchase accounting adjustments. The first quarter 2005 margin expanded by 9 basis points over the fourth quarter 2004 principally due to recent increases in short-term market interest rates.

The following table presents the condensed average balance sheet information, together with interest income and yields on average interest bearing assets, and interest expense and rates paid on average interest-bearing liabilities for the three-month periods ended March 31, 2005 and 2004:

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Average Rates and Balances

The following table sets forth a summary of the changes in net interest income due to changes in average asset and liability balances (volume) and changes in average rates (rate) for the three month period ended March 31, 2005 as compared to the same period in 2004. Changes in interest income and expense, which are not attributable specifically to either volume or rate, are allocated proportionately between both variances.

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Rate/ Volume Analysis

Provision for Loan Losses

The provision for loan losses was $1.0 million for the three months ended March 31, 2005, compared with $1.1 million for the same period in 2004. As a percentage of average outstanding loans, the provision for loan losses recorded for the three months ended March 31, 2005 was 0.12%, a decrease of nine basis points from the same period in 2004. The decrease in the provision for loan losses in the three months ended March 31, 2005 is principally attributable to net recoveries during the period and improved asset quality trends.

The provision for loan losses is based on management’s evaluation of inherent risks in the loan portfolio and a corresponding analysis of the allowance for loan losses. Additional discussion on loan quality and the allowance for loan losses is provided under the heading Asset Quality and Non-Performing Assets below.

Non-Interest Income

Non-interest income for the quarter ended March 31, 2005 was $10.6 million, an increase of $2.4 million, or 29%, over the same period in 2004. The following table presents the key components of non-interest income for the three months ended March 31, 2005 and 2004:

Non-Interest Income

Deposit service charges increases are principally attributable to the Humboldt acquisition. Total brokerage fees for the three months

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ended March 31, 2005 increased $238,000 or 8% as compared to the same period in 2004. The increase is primarily due to additional brokerage staff and enhanced sales and marketing efforts. Increases in other non-interest income result primarily from increased revenue related to the Humboldt acquisition.

Non-Interest Expense

Non-interest expense for the quarter ended March 31, 2005 was $35.4 million, an increase of $11.5 million or 48% over the same period of 2004. The following table presents the key elements of non-interest expense for the three months ended March 31, 2005 and 2004.

Non-Interest Expense