Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF COMMUNITY VALLEY BANCORP

The following is Community Valley Bancorp’s (the “Company”) management’s discussion and analysis of the significant changes in balance sheet accounts for March 31, 2005 and December 31, 2004 and income and expense accounts for the three-month period ended March 31, 2005 and 2004. The discussion is designed to provide a better understanding of significant trends related to the Company’s financial condition, results of operations, liquidity, capital resources and interest rate sensitivity.

In addition to the historical information contained herein, this report on Form 10-Q contains certain forward-looking statements.  The reader of this report should understand that all such forward-looking statements are subject to various uncertainties and risks that could affect their outcome.   The Company’s actual results could differ materially from those suggested by such forward-looking statements.  Factors that could cause or contribute to such differences include, but are not limited to, variances in the actual versus projected growth in assets, return on assets, loan losses, expenses, rates charged on loans and earned on securities investments, rates paid on deposits, competition effects, fee and other noninterest income earned, general economic conditions, nationally, regionally and in the operating market areas of the Company and its s ubsidiaries, changes in the regulatory environment, changes in business conditions and inflation, changes in securities markets, data processing problems, a decline in real estate values in the Company’s market area,  the effects of terrorism, including the events of September 11, 2001 and thereafter, and the conduct of the war on terrorism by the United States and its allies, as well as other factors. This entire report should be read putting such forward-looking statements in context.

General Development of Business

The Company is a financial holding company (FHC”) registered and authorized to engage in the activities permitted under the Bank Holding Company Act of 1956, as amended. The Company was incorporated under the laws of the State of California in 2002 and elected to change to a FHC in 2004.  As a financial holding company, the Company is subject to the Federal Holding Company Act and to supervision by the board of Governors of the Federal Reserve System (“FRB”).  Its principal office is located at 2041 Forest Avenue, Chico, California 95928 and its telephone number is (530) 899-2344.

The Company owns 100% of the issued and outstanding common shares of Butte Community Bank.  Butte Community Bank was incorporated and commenced business in Paradise and Oroville, California in 1990.  Butte Community Bank operates twelve full service offices within its service areas of Butte, Sutter, Yuba, Tehama, and Colusa Counties.  The Bank also maintains Loan Production Offices in Citrus Heights and Redding. Butte Community Bank’s primary business is serving the commercial banking needs of small to mid-sized businesses and consumers within those counties.  Butte Community Bank accepts checking and savings deposits, offers money market deposit accounts and certificates of deposit, makes secured and unsecured commercial, secured real estate, and other installment and term loans and offers other customary banking services.

On December 19, 2002, the Company formed a wholly-owned unconsolidated subsidiary, Community Valley Bancorp Trust I (the “Trust”), a Delaware statutory business trust, for the purpose of issuing trust preferred securities.

On December 1, 2004, the Company formed a wholly-owned subsidiary, CVB Insurance Agency LLC for the purpose of providing insurance related services.

Critical Accounting Policies

General

The Company’s significant accounting principles are described in Note 1 of the consolidated financial statements in the Company’s 2004 Annual Report to Shareholders on Form 10-K and are essential to understanding

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Management’s Discussion and Analysis of Results of Operations and Financial Condition. Community Valley Bancorp’s annual consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. Some of the Company’s accounting principles require significant judgment to estimate values of assets or liabilities. In addition, certain accounting principles require significant judgment in applying the complex accounting principles to transactions to determine the most appropriate treatment. The following is a summary of the more judgmental and complex accounting estimates and principles.

Allowance for Loan Losses (ALL)

The allowance for loan losses is management’s best estimate of the probable losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting:  (1) SFAS No.5 which requires that losses be accrued when they are probable of occurring and estimable and (2) SFAS No. 114, which requires that losses be accrued on impaired loans based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. The Company performs periodic and systematic detailed evaluations of its lending portfolio to identify and estimate the inherent risks and assess the overall collectibility. These evaluations include general conditions such as the portfolio composition, size and maturities of various segmented portions of the portfolio such as secured, unsecured, construction, and Small Business Administration (“SBA”).

Additional factors include concentrations of borrowers, industries, geographical sectors, loan product, loan classes and collateral types, volume and trends of loan delinquencies and non-accrual, criticized and classified assets and trends in the aggregate in significant credits identified as watch list items. There are several components to the determination of the adequacy of the ALL. Each of these components is determined based upon estimates that can and do change when the actual events occur. The Company estimates the SFAS No. 5 portion of the ALL based on the segmentation of its portfolio. For those segments that require an ALL, the Company estimates loan losses on a monthly basis based upon its ongoing loan review process and analysis of loan performance. The Company follows a systematic and consistently applied approach to select the most appropriate loss measurement methods and support its conclusions and rationale with written documentation. One method of estimating loan losses for groups of loans is through the application of loss rates to the groups’ aggregate loan balances. Such rates typically reflect historical loss experience for each group of loans, adjusted for relevant economic factors over a defined period of time. The Company evaluates and modifies its loss estimation model as needed to ensure that the resulting loss estimate is consistent with GAAP.

For individually impaired loans, SFAS No. 114 provides guidance on the acceptable methods to measure impairment. Specifically, SFAS No. 114 states that when a loan is impaired, the Company should measure impairment based on the present value of expected future principal and interest cash flows discounted at the loan’s effective interest rate, except that as a practical expedient, a creditor may measure impairment based on a loan’s observable market price or the fair value of collateral, if the loan is collateral dependent. When developing the estimate of future cash flows for a loan, the Company considers all available information reflecting past events and current conditions, including the effect of existing environmental factors.

Loan Sales and Servicing

The Company originates government guaranteed loans and mortgage loans that may be sold in the secondary market.  The amounts of gains recorded on sales of loans and the initial recording of servicing assets and interest only (I/O) strips is based on the estimated fair values of the respective components.  In recording the initial value of the servicing assets and the fair value of the I/O strips receivable, the Company uses estimates which are based on management’s expectations of future prepayments and discount rates.  Servicing assets are amortized

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over the estimated life of the related loan.  I/O strips are not significant at March 31, 2005.  These prepayment and discount rates were based on current market conditions and historical performance of the various pools of serviced loans.  If actual prepayments with respect to sold loans occur more quickly than projected the carrying value of the servicing assets may have to be adjusted through a charge to earnings.

Stock-Based Compensation

The Company uses the intrinsic value based method for measuring compensation cost related to stock options. Under the intrinsic value based method, compensation cost is the excess, if any, of the quoted market price of the stock at grant date over the amount an employee must pay to acquire the stock. This cost is amortized on a straight-line basis over the vesting period of the options granted. The Company applies Accounting Principles Board Opinion (“APB”) No. 25 Accounting for Stock Issued to Employees and related interpretations in accounting for stock options.  No compensation cost has been recorded in the accompanying financial statements because all options have been granted at an exercise price of no less than the fair market value at date of grant.

Revenue recognition

The Company’s primary source of revenue is interest income, which is the difference between the interest income it receives on interest-earning assets and the interest expense it pays on interest-bearing liabilities, and (ii) fee income, which includes fees earned on deposit services, income from SBA lending, electronic-based cash management services, mortgage brokerage fee income and merchant credit card processing services. Interest income is recorded on an accrual basis. Note 1 to the Consolidated Financial Statements in the Company’s 2004 Annual Report to Shareholders on Form 10-K offers an explanation of the process for determining when the accrual of interest income is discontinued on an impaired loan.

Income Taxes

The Company accounts for income taxes under the asset and liability method. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using currently enacted tax rates applied to such taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. If future income should prove non-existent or less than the amount of deferred tax assets within the tax years to which they may be applied, the asset may not be realized and our net income will be reduced.

Stock Split

On April 13, 2005, the Board of Directors of the Company declared a two-for-one stock split effective May 16, 2005 for shareholders of record on May 2, 2005. Share and per share information has not been retroactively adjusted to reflect the stock split except for the pro forma basic and diluted earnings per share included in the condensed consolidated statement of income.

Overview

The Company recorded net income of $1,454,000 for the quarter ended March 31, 2005, which was a 34% increase from the $1,088,000 reported for the same period of 2004.  Diluted earnings per share for the first quarter of 2005 were $0.38, compared to the $0.29 recorded in the first quarter of 2004.  The annualized return on average equity (ROAE) and the annualized return on average assets (ROA) for the first quarter of 2005 were 16.61% and 1.31%, respectively, as compared to 14.13% and 1.12%, respectively, for the same period in 2004.  The primary reason for the increase in income was due to significant growth in earning assets. Total assets of the Company increased by $9,038,000 or (2.0%) from December 31, 2004 to $458,700,000 at March 31, 2005.  ; Net loans totaled $347,801,000, up $7,137,000 (2.1%) from the ending balances on December 31, 2004.  Deposit balances at March 31, 2005 totaled $406,840,000 up $7,781,000 (1.9%) from December 31, 2004.

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Table One below provides a summary of the components of net income for the periods indicated:

Table One:  Components of Net Income

Results of Operations

Net Interest Income and Net Interest Margin

Net interest income represents the excess of interest and fees earned on interest earning assets (loans, securities, federal funds sold and investments in time deposits) over the interest paid on deposits and borrowed funds.  Net interest margin is net interest income expressed as a percentage of average earning assets.

The Company’s net interest margin was 5.94% for the three months ended March 31, 2005 and 5.40% for the three months ended March 31, 2004.  Net interest income increased $1,318,000 (28.8%) for the first quarter of 2005 compared to the same period in 2004.  The primary reason for this increase was the increase in average loans of $69,146,000 (24.8%) higher in the first quarter of 2005 versus the same period in 2004 resulting in increased interest income and fees associated with that growth.

Interest expense was $159,000 (16%) higher in the first quarter versus the same period in 2004. The average balances of interest bearing liabilities were $40,691,000 (14.2%) higher in the first quarter of 2005 versus the same quarter in 2004.  Even though interest bearing balances increased, rates paid on these liabilities only increased by 4 basis points on a quarter over quarter basis.

Table Two, Analysis of Net Interest Margin on Earning Assets, and Table Three, Analysis of Volume and Rate Changes on Net Interest Income and Expenses, are provided to enable the reader to understand the components and past trends of the Company’s interest income and expense.  Table Two provides an analysis of net interest margin on earning assets setting forth average assets, liabilities and shareholders’ equity; interest income earned and interest expense paid and average rates earned and paid; and the net interest margin.

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Table Two:  Analysis of Net Interest Margin on Earning Assets

Three Months Ended March 31,

(1)   Loan interest includes loan fees of $616,000 and $532,000 during the three months ended March 31, 2005 and March 31, 2004, respectively.

(2)   Does not include taxable-equivalent adjustments that primarily relate to income on certain securities that is exempt from federal income taxes.

(3)   Net interest margin is computed by dividing net interest income by total average earning assets.

(4)   Average yield is calculated based on actual days in quarter (90 for March 31, 2005 and 91 for March 31, 2004) and annualized to actual days in year (365 for 2005 and 366 for 2004).

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Table Three sets forth a summary of the changes in interest income and interest expense from changes in average asset and liability balances (volume) and changes in average interest rates.  On a quarter over quarter basis for the period ending March 31, 2005 net interest income has increased $1,318,000 over the same time period in 2004.  Interest income from earning assets has increased by $1,147,000. Changes in the volume of earning assets, primarily loans, have resulted in an increase in interest income of $1,332,000 while interest income from changes in rates has decreased by $1,000.  Changes in the volume of interest bearing liabilities, primarily the increase in balances of demand deposits and time deposits, has resulted in a net increase of interest expense of $159,000.

Table Three:  Analysis of Volume and Rate Changes on Net Interest Income and Expenses

(In thousands) Three Months Ended March 31, 2005 over 2004

Increase (decrease) due to change in:

(1)   The average balance of non-accruing loans is not significant as a percentage of total loans and is included in net loans.

(2)   Does not include taxable-equivalent adjustments that primarily relate to income on certain securities that is exempt from federal income taxes.

(3)   The rate/volume variance has been included in the rate variance.

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Non-interest Income

Table Four below provides a summary of the components of noninterest income for the periods indicated (dollars in thousands):

Table Four:  Components of Noninterest Income

Three Months Ended March 31,

Non-interest income was up $407,000 (33.1%) to $1,636,000 for the three months ended March 31, 2005 as compared to $1,229,000 for the three months ended March 31, 2004.  Increases in non-interest income were realized in fees from service charges (up 19%), loan servicing fees (up 6.5%), fees from alternative investment sales (up 16%), gains on the sale of loans (up 92.3%) and other income (up 33.1%).  Merchant fee income declined by (7.7%) for the three months ended March 31, 2005 as compared to March 31, 2004.  The increase in service charge income was the result of additional deposit accounts opened during the first quarter and the establishment of the four new branches opened during 2004 and early 2005 in Red Bluff, Marysville, Colusa and Corning.  Loan servicing fees increased as more loans were sold in the secondary market for which the Company retains servicing rights.  The Alternative Investment Department, which sells third-party mutual funds and annuities, experienced an increase in fees due to an increase in sales during the first quarter.  Gains on sales of loans increased as our Government Lending and Mortgage Lending Divisions sold a greater number of loans in the secondary market.

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Non-interest Expense

Non-interest expense increased $1,087,000 (28.7%) to $4,874,000 in the first quarter of 2005 versus $3,787,000 in the first quarter of 2004.  On a quarter over quarter basis, full time equivalent employees increased by 38 to 219 (21.0%).  Salary and employee benefits increased $757,000 (33.2%) resulting from normal cost of living raises, commissions paid to Butte Community Bank’s Real Estate Loan agents and staffing additions made during the year as the Company continues to grow.  Benefit costs and employer taxes increased commensurate with the salaries.  On a quarter over quarter basis, occupancy expenses were higher by $41,000 (17%).  This increase in costs is associated with the opening of the Red Bluff, Marysville and Colusa offices in 2004 and the opening of the Corning office in March of 2005, and is related to building leases, utilities, janitorial services and property taxes.   Fixed asset expense was $391,000 in the first quarter of 2005 compared to $373,000 in the same period of 2004, representing a 4.8% increase.   This increase relates to the furniture fixtures and equipment needed to open the four offices mentioned above. Other expenses increased $268,000 (29.9%) in the first quarter of 2005 versus the first quarter of 2004.   This increase was attributed to higher telephone, postage and insurance costs as well as increased advertising and promotion costs associated with the new offices.

Provision for Loan Losses

The Company provided $225,000 for loan losses for the both the first quarter of 2005 and 2004.  Net loan charge-offs for the three months ended March 31, 2005 were $1,000 as compared to $10,000 in net recoveries for the three months ended March 31, 2004.  Management assesses its loan quality on a monthly basis to maintain an adequate allowance for loan losses.  The Company’s loan portfolio composition, non-performing assets and allowance for loan losses are further discussed under the Balance Sheet Analysis section below.

Provision for Income Taxes

The effective tax rate for the first quarter of 2005 was 40.5%, up slightly from the 39.7% for the same period in 2004.

Balance Sheet Analysis

The Company’s total assets were $458,713,000 at March 31, 2005 as compared to $449,675,000 at December 31, 2004, representing an increase of 2.0%.  The average balance of total assets for the three months ended March 31, 2005 was $449,807,000, which represents an increase of $59,698,000 (15.3%) over the $390,109,000 during the three-month period ended March 31, 2004.

Loans

The Company concentrates its lending activities in the following principal areas: 1) commercial; 2) real estate mortgage; 3) residential real estate and real estate construction (both commercial and residential); 4) agriculture; and 5) consumer loans.  Commercial and residential real estate loans are generally secured by improved property, with original maturities of 3-10 years.  At March 31, 2005, these principal areas accounted for approximately 17%, 44%, 25%, 6% and 8%, respectively, of the Company’s loan portfolio.    The mix at December 31, 2004 was 17%, 43%, 26%, 6% and 8%.  Continuing strong economic activity in the Company’s market area, new borrowers developed through the Company’s marketing efforts and credit extensions expanded to existing borrowers, offset by normal loan pay-downs and payoffs, resulted in net increases in loan balances for commercial loans ($1,212,000 or 2.1%), consumer loans ($1,836,000 or 7.0%), commercial and residential real estate loans ($5,354,000 or 3.6%) and decreases in real estate construction loans ($2,187,000 or 2.5%) and agricultural loans ($1,023,000 or 7.0%).  Table Five below summarizes the composition of the loan portfolio as of March 31, 2005 and December 31, 2004.  Real estate construction loans and agricultural loans totals are typically lower in the first quarter because of weather conditions.

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Table Five: Loan Portfolio Composition