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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10–Q

(Mark One)

For the quarterly period ended March 31, 2004

OR

For the transition period from                      to                     

Commission file number 0–30777

PACIFIC MERCANTILE BANCORP

(Exact name of Registrant as specified in its charter)

(714) 438–2500

(Registrant’s telephone number, including area code)

Not Applicable

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports); and (2) has been subject to such filing requirements for the past 90 days.

Yes x    No ¨

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

Yes ¨    No x

APPLICABLE ONLY TO CORPORATE ISSUERS:

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

10,081,248 shares of Common Stock as of May 10, 2004

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PACIFIC MERCANTILE BANCORP

QUARTERLY REPORT ON FORM 10Q

FOR

THE QUARTER ENDED March 31, 2004

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PART I. – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands)

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

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Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in thousands, except for per share data)

(Unaudited)

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

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Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Dollars in thousands)

(Unaudited)

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

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Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(unaudited)

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

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Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Unaudited)

The consolidated financial statements include the accounts of Pacific Mercantile Bancorp (“PMBC”) and its wholly owned subsidiaries, which are Pacific Mercantile Bank (the “Bank”) and PMB Securities Corp. (which, together with PMBC, shall be referred to as the “Company”). The Bank is chartered by the California Department of Financial Institutions (the “DFI”) and is a member of the Federal Reserve Bank of San Francisco (“FRB”). In addition, deposit accounts of the Bank’s customers are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to the maximum amount allowed by law.

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

In June 2002, PMB Securities Corp., a wholly owned subsidiary of the Company, commenced operations as an SEC registered securities broker–dealer that is engaged in the retail securities brokerage business and is a member firm of the National Association of Securities Dealers.

In June 2002, Pacific Mercantile Capital Trust I, a Delaware trust, was organized by the Company to facilitate its sale of an issue of $5,000,000 trust preferred securities to an institutional investor in a private placement.

In August 2002, PMB Capital Trust I, a Delaware trust, was organized by the Company to facilitate its sale of an issue of $5,000,000 of trust preferred securities to an institutional investor in a private placement.

In September 2002, PMB Statutory Trust III, a Connecticut trust, was organized by the Company to facilitate the sale of an issue of $7,000,000 of trust preferred securities to an institutional investor in a private placement.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions to Form 10–Q and, therefore, do not include all footnotes as would be necessary for a fair presentation of financial position, results of operations, changes in cash flows and comprehensive income (loss) in accordance with accounting principles generally accepted in the United States of America (“US GAAP”). However, these interim financial statements reflect all adjustments (consisting of normal recurring adjustments and accruals) which, in the opinion of the management, are necessary for a fair presentation of the results for the interim periods presented. These unaudited condensed consolidated financial statements have been prepared in accordance with US GAAP on a basis consistent with prior periods, and should be read in conjunction with the Company’s audited financial statements as of and for the year ended December 31, 2003 and the notes thereto included in the Company’s Annual Report on Form 10–K for the fiscal year ended December 31, 2003 filed with the Securities and Exchange Commission under the Securities Exchange Act of 1934.

The Company’s consolidated financial position at March 31, 2004, and the results of its operations for the three month period ended March 31, 2004, are not necessarily indicative of the results of operations that may be expected for any other interim period during or for the full year ending December 31, 2004.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

Use of Estimates

The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make certain estimates and assumptions that affect the reported amounts of assets, liabilities, and contingencies at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries Pacific Mercantile Bank and PMB Securities Corp. All significant intercompany accounts and transactions have been eliminated in consolidation. In accordance with Financial Interpretation Number (FIN) 46, the wholly owned subsidiaries, Pacific Mercantile Capital Trust I, PMB Capital Trust I, and PMB Statutory Trust III, are not included in the consolidated financial statements. See “ – Recent Accounting Pronouncements” in this section.

Nonperforming Loans

At March 31, 2004, the Company had $1.5 million in nonaccrual loans and impaired loans, no restructured or delinquent loans 90 days or more with principal that were still accruing interest.

Income Per Share

Basic income per share is computed by dividing net income available to shareholders by the weighted average number of common shares outstanding during the period. Fully diluted income per share reflects the potential dilution that could occur if convertible securities or options, or contracts to issue common stock, were exercised or converted into common stock or resulted in the issuance of common stock that then shared in net income available to shareholders.

Stock Option Plan

The Company accounts for stock-based employee compensation as prescribed by APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and has adopted the disclosure provisions of Statements of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock Based Compensation.” SFAS No. 123 requires pro-forma disclosures of the Company’s net income and net income per share as if the fair value based method of accounting for stock based awards had been applied. Under the fair value based method, compensation cost is recorded based on the value of the award at the grant date and is recognized over the service period. In December 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure”, which amended the disclosure requirements of FASB No. 123 to require certain disclosures about stock-based employee compensation plans in an entity’s accounting policy note. The disclosure requirements for interim financial information are effective for interim periods beginning after December 15, 2002 and in the case of calendar year-end entities, such as the Company, the new interim period disclosures were required to be included in their interim financial statements beginning with the first quarter of 2003. The Company has adopted the disclosure provisions of SFAS No. 148 in the accompanying footnotes to the consolidated financial statements.

Effective March 2, 1999, the Board of Directors adopted a stock option plan (the “Option Plan”), which was subsequently approved by the Company’s shareholders. The Option Plan authorizes the granting of options to directors, officers and other key employees, that entitle them to purchase shares of common stock of the Company at a price per share equal to or above the fair market value of the Company’s shares on the date the option is granted. Options may vest immediately or over various periods of up to five years, determined at the time the options are granted and expire 10 years after the grant date, or following termination of service, if sooner. A total of 1,248,230 shares were authorized for issuance under the Option Plan (which number has been adjusted for stock splits effectuated subsequent to the Plan’s adoption).

The Company continues to account for stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” under which no compensation cost for stock options is recognized for stock option awards granted at or above fair market value. Had compensation expense for the Company’s Option Plan been determined based upon the fair value at the grant date for awards under the Plan in accordance with

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

Stock Option Plan (Cont.-)

SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company’s net income and income per share would have been reduced to the pro forma amounts indicated below:

The fair value of these options was estimated at the date of grant using the Black-Scholes option-pricing model with the following assumptions for the three months ended March 31, 2004 and 2003, respectively: dividend yield of 1.22% and 2.43%, expected volatility of 57% and 38%, risk-free interest rate of 3.02% and 3.17%, and, in each case, an expected option life of 5 years.

Comprehensive Income

Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on securities available for sale, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income.

Recent Accounting Pronouncements

In December 2002, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities”—an interpretation of Accounting Research Bulletin (“ARB”) No. 51. This Interpretation defines a variable interest entity and provides that if a business enterprise has a controlling financial interest in a variable interest entity, the assets, liabilities and results of the activities of the variable interest entity should be included in consolidated financial statements with those of the business enterprise. Furthermore, the FASB indicates that the voting interest approach of ARB No. 51 is not effective in identifying controlling financial interests in entities that are not controllable through voting interest or in which the equity investors do not bear the residual economic risk. This Interpretation applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. The Interpretation applies to public enterprises as of the beginning of the applicable interim or annual period. In January 2004, subsequent to the issuance of FIN 46, the FASB issued a revised interpretation, the provisions of which must be applied to certain variable interest entities by March 31, 2004. The Company has determined that the provisions of FIN 46, as revised, require deconsolidation of the subsidiary trusts which issued trust preferred securities. The Company deconsolidated the trusts as of March 31, 2004, as required by FIN 46, as revised. The adoption of FIN 46 and its revisions did not have a material impact on the Company’s financial statements.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

Reclassification

Certain amounts in the accompanying 2003 consolidated financial statements have been reclassified to conform to 2004 presentation.

Commitments and Contingencies

To meet the financing needs of its customers in the normal course of business, the Company is party to financial instruments with off–balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated financial statements. At March 31, 2004, the Company was committed to fund loans totaling approximately $143 million (inclusive of mortgages held for sale). The contractual amounts of credit-related financial instruments such as commitments to extend credit, credit-card arrangements, and letters of credit represent the amounts of potential accounting loss should the contract be fully drawn upon, the customer default, and the value of any existing collateral become worthless.

The Company uses the same credit policies in making commitments to extend credit and conditional obligations as it does for on–balance sheet instruments. Commitments generally have fixed expiration dates; however, since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s credit worthiness on a case–by–case basis. The amount of collateral obtained, if deemed necessary by the Company upon an extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, residential real estate and income–producing commercial properties.

In the ordinary course of business, the Company is subject to legal actions normally associated with financial institutions. At March 31, 2004, the Company was not a party to any pending legal actions that is expected to be material to its consolidated financial condition or results of operations.

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OVERVIEW

Pacific Mercantile Bancorp is a bank holding company that owns all of the stock of Pacific Mercantile Bank (the “Bank”), which is a commercial bank that provides a full range of banking services to small and medium-size businesses, professionals and the general public in Orange, Los Angeles and San Diego counties, in Southern California. Substantially all of our operations are conducted by the Bank, which accounts for substantially all of our consolidated revenues and operating costs.

The following discussion presents information about our consolidated results of operations for the quarters ended March 31, 2004 and 2003 and our consolidated financial condition, liquidity and capital resources at March 31, 2004 and December 31, 2003 and should be read in conjunction with our consolidated financial statements and the notes thereto included elsewhere in this Report.

Forward–Looking Information

Statements contained in this Report that are not historical facts or that discuss our expectations or beliefs regarding our future operations or future financial performance, or financial or other trends in our business, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include the words “believe,” “expect,” “anticipate,” “intend,” “plan,” “estimate,” “project,” or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could,” or “may.” Such forward-looking statements are based on current information and assumptions about future events over which we do not have control and our business is subject to a number of risks and uncertainties that could cause our financial condition or operating results in the future to differ significantly from those expected at the current time. Those risks and uncertainties are described below in the Section of this Report entitled “Forward Looking Information and Uncertainties Regarding Our Future Financial Performance” and readers of this Report are urged to read that Section in its entirety.

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“US GAAP”) and general practices in the banking industry. The accounting policies we follow in determining the sufficiency of our allowance for loan losses and the fair value of derivative financial instruments involve judgments and assumptions which can have a material impact on the carrying value of our loans and those financial instruments, respectively, and, as a result, we consider these accounting policies to be critical accounting policies.

Allowance for Loan Losses. In determining the adequacy of the allowance for loan losses, we use historical loss factors, adjusted for current economic market conditions and other economic indicators, to determine the losses inherent in our loan portfolio. Actual loan losses could be greater than that predicted by those loss factors and our current assessments of current conditions and economic trends if unanticipated changes were to occur in those conditions. In such an event, we would be required to increase the allowance for loan losses by means of a charge to income referred to in our financial statements as the “provision for loan losses.” Such an increase would reduce the carrying value of our loans on our balance sheet, and the additional provision for loan losses taken to increase that allowance would reduce our income, in the period when it is determined that an increase in the allowance for loan losses is necessary. See “—Provision for Loan Losses” and “—Allowance for Loan Losses” below.

Derivative Financial Instruments. The derivative financial instruments that we enter into consist primarily of interest rate lock commitments that are designed to hedge mortgage loans held for sale. At March 31, 2004, approximately $25 million of mortgage loans held for sale were hedged. We estimate the fair value of mortgage loans held for sale based on period end market interest rates obtained from various mortgage investors. If the fair values of the mortgage loans held for sale were to decline below those estimated values, we would be required to reduce the carrying values of the mortgage loans held for sale on our statement of financial condition and, correspondingly, reduce our noninterest income. We also enter into non-designated derivative instruments relating to mortgage loan interest rate lock commitments with borrowers and investors in order to reduce our exposure to adverse fluctuations in interest rates. At March 31, 2004 we had $19 million of mortgage loan commitments identified as non-designated derivative instruments. We estimate the fair value of these mortgage loan commitments based on market interest rates at period end. If the fair value of these non-designated derivative instruments were to decline below the expected values, we would be required to recognize a reduction in our noninterest income.

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Overview of Operating Results in the First Quarter ended March 31, 2004

The following table sets forth information regarding the interest income that we generated, the interest expense that we incurred, our net interest income, noninterest income, noninterest expense, and our net income and net income per share for the three months ended March 31, 2004 and 2003.

Key Factors Affecting Operating Results in the First Quarter of 2004

Set forth below are certain key financial performance ratios and other financial data for the periods indicated:

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Results of Operations

Net Interest Income

One of the principal determinants of a bank’s income is net interest income, which is the difference between (i) the interest that a bank earns on loans, investment securities and other interest earning assets, on the one hand, and (ii) its interest expense, which consists primarily of the interest it must pay to attract and retain deposits and the interest that it pays on other interest-bearing liabilities, on the other hand. A bank’s interest income and interest expense are, in turn, affected by a number of factors, some of which are outside of its control, including national and local economic conditions and the monetary policies of the Board of Governors of the Federal Reserve (the “Federal Reserve Board” or the “FRB”), which affect interest rates, the demand for loans, and the ability of borrowers to meet their loan payment obligations. Net interest income, when expressed as a percentage of total average interest earning assets, is a banking organization’s “net interest margin.”

First quarter ended March 31, 2004, compared to first quarter ended March 31, 2003. As the table above indicates, the $1.7 million, or 48% increase in the net interest income in the first quarter ended March 31, 2004, was entirely attributable to a $1.7 million, or 27% increase in our interest income during that quarter. Our interest expense remained essentially unchanged in the quarter ended March 31, 2004, despite a $74 million increase in average advances from the Federal Home Loan Bank during that quarter, as compared to the same quarter last year.

The increase in interest income was primarily attributable to an increase in the volume of interest earning assets during the first quarter of 2004, including a $104 million increase in the average of outstanding loans (including mortgages held for sale) and a $64 million increase in the average securities available for sale during the first quarter of fiscal 2004 over the corresponding period of fiscal 2003. Those increases in average interest earning assets, which enabled us to offset, to a significant extent, the impact of declining interest rates on our interest income, were funded primarily by the increase in deposits and in borrowings we obtained from the Federal Home Loan Bank and a shift of funds out of lower yielding federal funds sold during fiscal 2004.

The fact that interest expense remained substantially unchanged in the first quarter of 2004, as compared to the same quarter last year, was attributable to the decline in market rates of interest, which almost entirely offset the effects on interest expense of the volume related increases in interest bearing deposits and other interest bearing liabilities.

The improvement in our net interest margin for the first quarter ended March 31, 2004 to 2.99% from 2.56% in the first quarter ended March 31, 2003, was primarily due to a decline in the yield on our interest bearing liabilities to 2.19% for the first quarter of 2004 from 2.54% in the first quarter of the prior year, primarily reflective of a decline in the prime rate of interest by approximately 25 basis points shortly after the first quarter 2003. By contrast, despite that decline in the prime interest rate, the yield on our interest earning assets remained relatively unchanged at 4.58% and 4.56% for the three months ended March 31, 2004 and 2003, respectively, primarily as a result of interest rate floors established on loans.

The following table sets forth changes in interest income, including loan fees, and interest paid in the three months ended March 31, 2004, as compared to the same period in 2003 and the extent to which those changes were attributable to changes in the volume and rates of interest earning assets and in the volume and rates of interest-bearing liabilities.

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Changes in interest earned and interest paid due to the mix of earning assets and interest bearing liabilities have been allocated to the change due to volume and the change due to rate in proportion to the relationship of the absolute dollar amounts of the changes in each.

The above table indicates that the $1.7 million increase in our net interest income in the three months ended March 31, 2004 as compared to the like period in 2003 was the result of a $2.8 million increase in the volume variance offset by a $1.1 million decrease in the rate variance.

Provision for Loan Losses

Like virtually all banks and other financial institutions, we follow the practice of maintaining a reserve or allowance (the “Allowance”) for possible losses on loans that occur from time to time as an incidental part of the banking business. When it is determined that the payment in full of a loan has become unlikely, the carrying value of the loan is reduced to what management believes is its realizable value. This reduction, which is referred to as a loan “charge-off,” or “write-down” is charged against that Allowance. The amount of the Allowance for Loan Losses is increased periodically (i) to replenish the Allowance after it has been reduced due to loan charge-offs, (ii) to reflect changes in the volume of outstanding loans, and (iii) to take account of changes in the risk of potential losses due to a deterioration in the condition of borrowers or in the value of property securing non–performing loans or changes in economic conditions. See “—Financial Condition—Allowance for Loan Losses and Nonperforming Loans” below in this Section of this Report. Increases in the Allowance for Loan Losses are made through a charge, recorded as an expense in the statement of income referred to as the “provision for loan losses.” Recoveries of loans previously charged-off are added back to and, therefore, have the effect of increasing, the Allowance for Loan Losses.

Although we employ economic models that are based on bank regulatory guidelines and industry standards to evaluate and determine the sufficiency of the Allowance for Loan Losses and, thereby, the amount of the provisions required to be made for potential loan losses, those determinations involve judgments or trends in current economic conditions and other events that can affect the ability of borrowers to meet their loan obligations. Future economic conditions are subject to a number of uncertainties, some of which are outside of our ability to control. See the discussion below in this Section under the caption “Risks and Uncertainties that could Affect our Future Financial Performance—We could incur losses on the loans we make.” In the event of unexpected subsequent events or changes in circumstances, it could become necessary in the future to incur additional charges to increase the Allowance for Loan Losses, which would have the effect of reducing our income or which might cause us to incur losses.

In addition, the Federal Reserve Board and the California Department of Financial Institutions, as an integral part of their examination processes, periodically review the Bank’s Allowance for Loan Losses. These agencies may require the Bank to make additional provisions, over and above those made by management.

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Noninterest Income

Noninterest income consists primarily of mortgage banking income (which includes loan origination and processing fees and service released premiums) and net gains on sales of loans held for sale, which are generated by our mortgage loan division. That division, which we established during fiscal 2001, originates conforming and non-conforming, agency quality, residential first lien and home equity mortgage loans.

The volume of residential mortgage refinancings is subject to significant fluctuations as interest rates change. Therefore, changes in interest rates can impact our loan origination and processing fees and yield spread premiums. For example, the decline in mortgage rates which occurred in 2002 and the first six months of 2003 increased demand for mortgage loan refinancings. Conversely, an increasing interest rate environment, which occurred over the last nine months, would generally cause a decline in loan refinancings and, therefore, corresponding declines in the volume of mortgage loan originations and in the income that the mortgage banking division would be able to generate. We seek to manage the impact of changes in interest rates by seeking to originate mortgages for home purchases which are not as interest rate sensitive as mortgage loan refinancings. Mortgage loans for home purchases accounted for approximately 27% of our mortgage loan fundings in the quarter ended March 31, 2004 and approximately 11% of our mortgage loan fundings in the quarter ended March 31, 2003.

The following table identifies the components of and the percentage changes in noninterest income in the first quarter of 2004, as compared to the same period in 2003.

The decrease in noninterest income in the three months ended March 31, 2004, over the same period in 2003 was primarily attributable to substantial decreases in mortgage loan refinancings prompted by rising market rates of interest and the decrease of $108,000 in net gains on securities available for sale. The increase in service charges and fees was attributable to the growth in the volume of our deposits subsequent to the first quarter of 2003.

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Noninterest Expense

The following table sets forth the principal components of noninterest expense and the amounts thereof, incurred in the three months ended March 31, 2004 and 2003, respectively.

As indicated in the table above, total noninterest expense for the three months ended March 31, 2004 increased by 3.7% to $4.5 million from $4.3 million for the corresponding period of 2003. That increase was primarily attributable to expansion costs incurred during the period subsequent to March 31, 2003, offset somewhat by a reduction in mortgage lending salaries, commissions and other loan related expenses due to the decline in the volume of mortgage refinancing.

Our ability to control noninterest expense in relation to the level of net revenue (net interest income plus noninterest income) can be measured in terms of noninterest expenses as a percentage of net revenue. This is known as the efficiency ratio and indicates the percentage of revenue that is used to cover expenses. In the three months ended March 31, 2004, our efficiency ratio improved to 70% from 74% for the three months ended March 31, 2003. These decreases, which indicate that a proportionately smaller amount of net revenue was needed to cover noninterest expenses arising from our day-to-day operations, was primarily attributable to the fact that in 2003 we were in the midst of implementing an expansion program that began in 2002, but which was substantially completed by the end of 2003. However, in April 2004 we received the regulatory approvals needed to open our seventh full service financial center, which will be located in Long Beach, California, approximately 25 miles south Los Angeles and 20 miles north of our headquarters offices in Costa Mesa, California. We also will be seeking to open at least two additional financial centers in Southern California. As a result, we expect noninterest expense to increase during the balance of 2004.

Asset/Liability Management

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

For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees and at different times to changes in market interest rates. Rates on some assets and liabilities change in advance of changes in market rates of interest, while rates on other assets or liabilities may lag behind changes in market rates of interest. Additionally, loan and securities available for sale prepayments, and early withdrawals of certificates of deposit, could cause the interest sensitivities to vary.

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The table below sets forth information concerning our rate sensitive assets and liabilities at March 31, 2004. The assets and liabilities are classified by the earlier of maturity or repricing dates in accordance with their contractual terms. Certain shortcomings are inherent in the method of analysis presented in the following table.

At March 31, 2004, our rate sensitive balance sheet was shown to be in a negative twelve-month gap position. This implies that our net interest margin would decrease in the short–term if interest rates rise and would increase in the short-term if interest rates were to fall. However, as noted above, the extent to which our net interest margin will be impacted by changes in prevailing interests rates will depend on a number of factors, including how quickly rate sensitive assets and liabilities react to interest rate changes, the mix of our interest earning assets (loans versus other interest earning assets, such as securities) and the mix of our interest bearing deposits (between for example, lower interest core deposits and higher cost time certificates of deposit) and our other interest bearing liabilities.

Derivative Financial Instruments

The Bank uses derivative instruments to reduce its exposure to adverse fluctuations in interest rates in accordance with its risk management policy. Generally, if interest rates increase, the value of the Bank’s mortgage loan commitments to borrowers and mortgage loans held for sale are adversely impacted. The Bank attempts to economically hedge 100% of the risk of the overall change in the fair value of loan commitments to borrowers and mortgage loans held for sale by entering into rate lock commitments with investors in mortgage loans at the date loan commitments are made to the individual borrowers. These rate lock commitments are entered into at the same terms as those extended to borrowers to be delivered to the investors at a future date.

Mortgage loan commitments to borrowers and rate lock commitments with investors in mortgage loans are non-designated derivative instruments and are included in mortgage loans held for sale, gains and losses resulting from these derivative instruments are included in gains on sales of loans in the Company’s consolidated statements of income.

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Financial Condition

Assets

Our total consolidated assets increased by $35 million, or 5%, to $759 million at March 31, 2004 from $724 million at December 31, 2003. That increase was funded by increases in deposits and borrowings which were used primarily to fund loans and purchases of investment securities and to sell federal funds to other banks.

The following table sets forth the interest earning assets:

Loans Held for Sale

Loans held for sale in the secondary market, which consist primarily of mortgage loans, totaled $25 million at March 31, 2004, an increase of $6 million from $19 million at December 31, 2003. Loans held for sale are carried at the lower of cost or estimated fair value in the aggregate except for those that are designated as fair value hedges, which are carried at fair value. There were $25 million of loans held for sale designated as fair value hedges at March 31, 2004, and there were no ineffective hedges. Net unrealized losses on loans held for sale, if any, are recognized through a valuation allowance by charges to income. As of March 31, 2004, we had recognized approximately $97,000 in net unrealized gains related to these loans held for sale and unfunded commitments to make such loans.

Loans

The following table sets forth the composition, by loan category, of our loan portfolio, excluding mortgage loans held for sale, at March 31, 2004 and December 31, 2003:

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

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The following tables set forth the maturity distribution of our loan portfolio (excluding consumer loans and mortgage loans held for sale) at March 31, 2004: