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EX-14 - EXHIBIT 14 - CODE OF ETHICS - MISSION COMMUNITY BANCORPexh14.htm
EX-21 - EXHIBIT 21 - SUBSIDIARIES - MISSION COMMUNITY BANCORPexh21.htm
EX-31.1 - EXHIBIT 31.1 - SEC. 302 CEO CERTIFICATION - MISSION COMMUNITY BANCORPexh31-1.htm
EX-32.2 - EXHIBIT 32.2 - SEC. 906 CFO CERTIFICATION - MISSION COMMUNITY BANCORPexh32-2.htm
EX-32.1 - EXHIBIT 32.1 - SEC. 906 CEO CERTIFICATION - MISSION COMMUNITY BANCORPexh32-1.htm
EX-23.1 - EXHIBIT 23.1 - ACCOUNTANT'S CONSENT - PERRY-SMITH LLP - MISSION COMMUNITY BANCORPexh23-1.htm
EX-31.2 - EXHIBIT 31.2 - SEC. 302 CFO CERTIFICATION - MISSION COMMUNITY BANCORPexh31-2.htm
EX-23.2 - EXHIBIT 23.2 - ACCOUNTANT'S CONSENT - VAVRINEK, TRINE DAY & CO. - MISSION COMMUNITY BANCORPexh23-2.htm


SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K

 
þ
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year ended December 31, 2010
OR
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number 333-12892

MISSION COMMUNITY BANCORP
(Exact name of registrant as specified in its charter)

California                                                                               77-0559736
State or other jurisdiction of incorporation or organizationI.R.S. Employer Identification No.

 3380 S. Higuera St., San Luis Obispo, California  93401                                                                                                                                (805) 782-5000
(Address of principal executive offices)                                                                                        Issuer’s telephone number

Securities registered pursuant to Section 12(b) of the Exchange Act: None
Securities registered pursuant to Section 12(g) of the Exchange Act:  None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. oYes. þNo

Check whether the issuer is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act.   o

Indicate by check mark whether the issuer (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.   Yes þ No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o Noo  (This requirement is not yet applicable to registrant)

Check if disclosure of delinquent filers pursuant to Item 405 of Regulation S-B is not contained in this form, and no disclosure will be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K þ.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer o
Accelerated filer  o
Non-accelerated filer o (Do not check if a smaller reporting company)
 
Smaller reporting company þ
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No þ

The aggregate market value of the voting and non-voting common equity held by non-affiliates, computed by reference to the price at which the common equity was last sold, or the average bid and asked prices of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter, was $4,366,100.

As of March 25, 2011, the Registrant had 7,094,274 shares of Common Stock outstanding.
[Missing Graphic Reference]

 
 

 

Documents Incorporated by Reference:  Portions of the definitive proxy statement for the 2011 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission pursuant to SEC regulation 14A are incorporated by reference in Part III, Items 10-14.

 
Forward Looking Statements
 
This Annual Report on Form 10-K includes forward-looking information, which is subject to the “safe harbor” created by Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act and the Private Securities Litigation Reform Act of 1995.  When the Company uses or incorporates by reference in this Annual Report on Form 10-K the words “anticipate,” “estimate,” “expect,” “project,” “intend,” “commit,” “believe” and similar expressions, the Company intends to identify forward-looking statements.  Such statements are subject to certain risks, uncertainties and assumptions, including those described in this Annual Report on Form 10-K.  Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, estimated, expected, projected, intended, committed or believed.  Such risks and uncertainties include, but are not limited to, the following factors: (i) general economic conditions, whether national or regional, that could affect the demand for loans and other banking services or lead to increased loan losses; (ii) competitive factors, including increased competition with community, regional and national financial institutions that may lead to pricing pressures on rates the Bank charges on loans and pays on deposits or reduce the value of real estate collateral securing the Bank's loans; (iii) loss of customers of greatest value to the Bank or other losses; (iv) increasing or decreasing interest rate environments that could lead to decreased net interest margin and increased volatility of rate sensitive loans and deposits; (v) changing business conditions in the banking industry; (vi) changes in the regulatory environment or new legislation; (vii) changes in technology or required investments in technology; (viii) credit quality deterioration which could cause an increase in the provision for loan losses; (ix) dividend restrictions; (x) continued tensions in Iraq and elsewhere in the Middle East; and (xi) increased regulation of the securities markets, whether pursuant to the Sarbanes-Oxley Act of 2002 or otherwise.

Investors and other readers are cautioned not to place undue reliance on forward-looking statements, which reflect management’s analysis only as of the date of the statement.

The Company undertakes no obligation to revise any forward-looking statement to reflect later events or circumstances.



 
Table of Contents
 

Mission Community Bancorp
Form 10-K
December 31, 2010



Part I

 
 
 
 
 
Item 4.
Reserved



Part II

 
 
 
 
 
 
 



Part III

 
 
 
 
 
 
 



 
PART I
 

 
Item 1.  Description of Business
 
Business Development

The Company

Mission Community Bancorp (“Bancorp”) is a California corporation registered as a bank holding company under the Bank Holding Company Act of 1956, as amended, and is headquartered in San Luis Obispo, California.  It was incorporated on September 22, 2000 and acquired all the outstanding shares of Mission Community Bank in a one bank holding company organization effective December 15, 2000.
 
Bancorp’s principal activity is the ownership of all of the outstanding common stock of Mission Community Bank and any other subsidiaries we may acquire or establish.  Bancorp formed a wholly-owned subsidiary, Mission Community Capital Trust I, in 2003 solely to facilitate the issuance of trust preferred securities.  In May 2010, Bancorp formed its only other direct subsidiary, Mission Asset Management, Inc., in order to purchase certain of the non-performing assets of Mission Community Bank, which assets were purchased in June 2010.
 
As of December 31, 2010 Bancorp and its consolidated subsidiaries (“the Company”) had approximately $218 million in total assets and $39 million in shareholders’ equity.
 
The Company’s address is 3380 South Higuera Street, San Luis Obispo, California 9340, and its telephone number is (805) 782-5000.
 
Bancorp’s principal source of income is dividends from Mission Community Bank although supplemental sources of income may be explored in the future.  Its expenditures, including (but not limited to) the payment of dividends to shareholders, if and when declared by the Board of Directors, the cost of servicing debt, legal fees, audit fees and shareholders costs will generally be paid from dividends paid to us by Mission Community Bank.  Due to recent losses by Mission Community Bank, it is not currently anticipated that Mission Community Bank will be able to pay dividends to Mission Community Bancorp in the near future.  See “Part II--Item 5—Market for Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities—Dividends.”
 
At the present time, we have no plans to engage in any activities other than acting as a bank holding company for Mission Community Bank and Mission Asset Management, Inc., although in the future, we may consider engaging in other activities which are permissible for a bank holding company, including the acquisition of other banks, provided that engaging in such activities is deemed by the Board of Directors to be in the best interest of Mission Community Bancorp and its shareholders.
 
Mission Community Bancorp neither owns nor leases any material property, but instead uses the premises, equipment and furniture of Mission Community Bank.
 
Each of Mission Community Bancorp, and our subsidiary, Mission Community Bank, has been certified by the U.S. Department of the Treasury as a Community Development Financial Institution with a commitment to providing financial services to low and moderate-income communities.  Although we intend to continue our commitment to providing financial services to low and moderate-income communities, we anticipate that each of Mission Community Bancorp and Mission Community Bank will soon lose their status as CDFI’s due to a change in control in the second quarter of 2010 pursuant to which the ownership by our principal shareholder in the Bancorp’s common stock increased from 24.7% of our common stock to more than 75% of our common stock.  Because our principal shareholder is not itself a CDFI, each of Mission Community Bancorp and Mission Community Bank no longer meet the regulatory criteria to retain their respective CDFI status since in order to maintain such status, any bank holding company which owns more than 25% of the voting shares or otherwise controls through a majority of directors of a company a bank with CDFI status must itself be a CDFI.  Accordingly, we believe that each of Mission Community Bancorp and Mission Community Bank will lose their respective CDFI status in the near future, and, in any event, we do not believe we will any longer be able to take advantage of the benefits of being a CDFI, such as applying for grants and awards under applicable CDFI programs.
 


Further, pursuant to the terms of our Series A and Series C common stock, which shares were issued to the Community Development Financial Institutions Fund of the U.S. Department of the Treasury in conjunction with funding relating to our CDFI status, the Community Development Financial Institutions Fund has the right to cause us to redeem all of the Series A and Series C common stock in the event we lose our CDFI status.  If upon the loss of our CDFI status, the Community Development Financial Institutions Fund should exercise its right to cause us to redeem our Series A and Series C preferred stock, we would be required to redeem this stock for an aggregate of approximately $1.0 million.
 
Mission Community Bank
 
The Bank, a wholly-owned subsidiary of Bancorp, is a California state-chartered bank headquartered in San Luis Obispo, California.  It is also a member of the Federal Reserve System.  Its deposits are insured by the FDIC up to the applicable limits of the law.  Mission Community Bank opened for business on December 18, 1997, and currently operates four full service locations in the cities of San Luis Obispo, Paso Robles and Arroyo Grande in San Luis Obispo County and in Santa Maria in northern Santa Barbara County in the Central Coast of California.  We also operate a Business Banking Center in San Luis Obispo which is primarily engaged in originating and servicing SBA-guaranteed loans.  Our administrative offices are also located in San Luis Obispo.
 
We opened our branch in the city of Paso Robles in 1998, our branch in Arroyo Grande in 2002, and our branch in Santa Maria in December 2008.  The Business Banking Center opened in 2006.
 
The Bank is a community bank engaged in the general commercial banking business in the Central Coast of California.  It offers a variety of deposit and loan products to individuals and small businesses and a specialization in community development financial services and SBA loans.  Through its community development activities, the Bank seeks to provide financial support and services by promoting community development and economic vitality.
 
At December 31, 2010, the Bank, on a stand-alone basis, had approximately $199.4 million in assets, $105.1 million in loans, $178.0 million in deposits, and $19.5 million in stockholders’ equity.
 
Our primary market area is San Luis Obispo County and northern Santa Barbara County.  Secondary market areas include cities and unincorporated areas in the neighboring counties of Kern, Kings and Fresno.  We service these secondary market areas through direct contact by calling officers who travel into the neighboring counties.  Any physical expansion into this secondary market area would most likely come from acquisitions or through the establishment of loan production offices although we have no immediate plans for acquisitions or the establishment of loan production offices.
 
The Bank is also certified by the State of California Department of Insurance to accept deposits or investments under the California Organized Investment Network (the “COIN”).  The COIN program provides California tax credits and/or CRA credit to individuals, corporations, or partnerships that invest at below market rates for specified terms.  In addition, the Bank has obtained preferred lender status with the Small Business Administration which generally allows it to approve and fund SBA loans without the necessity of having the loan approved in advance by the SBA.
 
Mission Community Development Corporation (“MCDC”)
 
Mission Community Development Corporation, a community development corporation which was incorporated in August 1997, is a wholly-owned subsidiary of the Bank.  MCDC is a “for-profit” Community Development Corporation (“CDC”), which provides financing for small businesses and low- to moderate-income area development and/or affordable housing projects.  Its purpose is to benefit small business and low- to moderate-income areas/residents.  The board of directors of MCDC consists of the members of the Board of Directors of the Bank.
 
At December 31, 2010, MCDC had no loans and $156,000 in shareholder’s equity.  MCDC provides loan accounting services for a very small pool of community development micro loans which have been funded by a group of banks through the Economic Vitality Corporation, as well as management of an emergency assistance loan pool created after the San Simeon earthquake of December 2003.  MCDC also manages a loan pool for the San Luis Obispo County Housing Trust Fund to assist in providing affordable housing within the county.  Loans serviced by MCDC as of December 31, 2010, totaled approximately $3,452,000.
 


Mission Asset Management, Inc. (“MAM”)
 
Mission Asset Management, Inc., a wholly-owned subsidiary of Bancorp, was established in June 2010 to facilitate the orderly sale or resolution of the Bank’s foreclosed real estate and certain lower-quality loans.  To that end, in 2010 the Bank reclassified $22.4 million of lower-quality loans (including $10.3 million of nonaccrual loans) to “held for sale,” writing down the value of those loans to $16.9 million through charge-offs to the allowance for loan and lease losses.  Those loans, along with $1.0 million of other real estate, were sold from the Bank to MAM at the aggregate purchase price of $17.9 million.
 
Mission Community Services Corporation (“MCSC”)
 
Bancorp and the Bank have an affiliate relationship with, but no ownership of, MCSC, which was incorporated in August 1997 and which was established in September 2003 as a “not-for-profit” public charitable corporation under Internal Revenue Code Section 501(c)(3).  The accounts of MCSC are not included in the Company’s consolidated financial statements or elsewhere in this Form 10-K.  MCSC’s primary focus is to provide technical assistance and training services to the community, including small business, minority and low-income entrepreneurs.  The Board of Directors of MCSC includes representatives from the Company, together with members representing the low-income and business community.  Over the five-year period ended December 31, 2010, Bancorp has provided $205 thousand in cash contributions and $90 thousand in in-kind (non-cash) contributions to MCSC.
 
In 2006, MCSC was awarded a five-year, $750,000 grant from the U.S. Small Business Administration to fund one of 99 Women’s Business Centers nationwide.  MCSC is also “COIN”-certified as a CDFI.  See also Note M to the Consolidated Financial Statements for additional information regarding MCSC.
 
The “Mission” Group
 
Bancorp, the Bank and its subsidiary MCDC, MAM and MCSC form an organizational structure intended to provide traditional community bank financial services and to foster economic revitalization and community development to its target market.
 

 
Business of Issuer
 
Principal Products, Services, and Markets
Other than holding the shares of the Bank, Bancorp conducts no significant activities. Bancorp is authorized with the prior approval of the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”), its principal regulator, to engage in a variety of activities which are deemed closely related to the business of banking.
 
The Bank offers checking and savings accounts, money market accounts and time certificates of deposits; offers commercial, agribusiness, government guaranteed, real estate, automobile and other installment and term loans and leases; issues drafts, sells travelers’ checks and provides other customary banking services. Although the Bank does not operate a trust department or provide international services, it makes trust services or international services available through correspondent institutions.
 
The areas in which the Company has directed virtually all of its lending activities are commercial loans (including government-guaranteed, agricultural and municipal loans), real estate loans, construction loans, consumer loans and lease financing  As of December 31, 2010, these five categories accounted for approximately 18.2%, 72.3%, 7.4%, 1.2%, and 0.9% respectively, of the Company’s gross loan portfolio.  As of that date, $95.9 million, or 79.8%, of the Company’s loans consisted of real estate loans, for single family residences or for commercial development, and interim construction loans.  This represents a $13.6 million decrease in real estate and construction loans from the prior year’s combined total of $109.5 million.  In percentage terms, real estate and construction loans decreased from 80.3% to 79.8% of the loan portfolio.  Under the regulatory definition of commercial real estate—which excludes owner-occupied properties—the Company’s commercial real estate concentration is reduced to $44.9 million, or 37.4% of gross loans.  See Loan Concentrations in Management’s Discussion and Analysis under Item 7 of Part II of this report.
 


As of December 31, 2010, the Bank had 4,629 deposit accounts, including 2,940 demand accounts (both non-interest-bearing and interest-bearing, including NOW and money market deposit accounts) totaling $69.9 million; 987 savings accounts with balances totaling $22.1 million; and 702 time certificates of deposit totaling $80.3 million.
 
The principal sources of the Bank’s revenues are interest and fees on loans, interest on investments including federal funds sold and deposits in other banks, gain on loan sales, service charges on deposit accounts and, occasionally, gain on securities sales and grants and awards.  For the year ended December 31, 2010, these sources comprised 71.2%, 12.6%, 4.1%, 3.3%, 4.7%, and 5.7%, respectively, of the Bank’s total operating income.
 
Distribution Methods of the Products and Services
 
The Bank’s primary service area consists of San Luis Obispo county and northern Santa Barbara county, which lie centrally within the State of California along the Pacific Ocean.  Secondary market areas include cities and unincorporated areas in the neighboring counties, including Monterey, Kern, Kings, and Fresno, with expansion in 2011 into Ventura and south Santa Barbara Counties.
 
The Bank operates out of four full service offices (in the cities of San Luis Obispo, Paso Robles, Arroyo Grande and Santa Maria) plus an administrative and loan production facility, which is located in the city of San Luis Obispo, with a fifth full-service office in the Company’s headquarters building is currently scheduled to open in April 2011.  In the first quarter of 2011, the Bank opened a loan production office for food and agribusiness lending in Oxnard, California.  The Bank provides some financial services through direct contact by calling officers who travel into the neighboring counties.
 
The Bank’s operating policy since its inception has emphasized community development through small business, commercial and retail banking.  Most of the Bank’s customers are retail customers, farmers and small to medium-sized businesses and their owners.  The Bank also emphasizes loans and financial services to low- to moderate-income communities within its target market area.  Most of the Bank’s deposits are attracted by relationship banking, local activities, and advertising.
 
The business plan of the Bank emphasizes providing highly specialized financial services in a professional and personalized manner to individuals and businesses in its service area.  Its key strengths are customer service and an experienced management team familiar with the community through the Bank’s involvement in various community lending and development projects.
 
Since 2007, the Bank has extended its use of Internet technology as a distribution tool to improve its customer service by making available a “remote capture” deposit product, as well as enhanced Internet Banking, electronic Bill-Pay and ACH origination.  Today the Bank continues to expand its technology-based products, with “virtual lockbox,” “positive pay” and online image statements for both consumer and business customers expected to be made available in 2011.
 
During 2006 the Bank began to capitalize on its status as one of only four banks in its primary service area participating in the Certificate of Deposit Account Registry Service (“CDARS”) program.  This program permits the Bank’s customers to place all of their certificates of deposit at the Bank and have those deposits fully-insured by the FDIC.  The CDARS program acts as a clearinghouse, matching deposits from one institution in the CDARS network of more than 3,000 banks with other network banks (in increments of less than the $250 thousand FDIC insurance limit), so funds that a customer places with the Bank essentially remain on the Bank’s balance sheet.  While the Bank continues to focus its extension of CDARS to client relationships in its local market area who are seeking additional FDIC insurance coverage, its participation in the CDARS program also permits it to bid on additional certificates of deposit through banks across the country to meet additional funding needs.  These “One-Way Buy” CDARS deposits would be considered to be brokered deposits.  When the Bank has excess funds, the CDARS program enables the Bank to place those funds in CD’s with CDARS network banks (known as the “One-Way Sell” program), which generally results in a higher yield than if those funds were invested in Federal Funds.
 
Status of and Publicly Announced New Products or Services
 
In an effort to reach out to the community to share sound money management practices and habits to the target market of low-income and under-banked individuals, the Bank has formed a Financial Education team of bank employees.  A series of training workshops covering the fundamentals of banking and financial services have been developed in English and Spanish.  The Bank expects to increase its focus on profitable financial services for the un-banked and under-banked customers in its market area, but does not expect these services will be a material percentage of its deposit activities.
 


In 2010 the Bank received a $600 thousand BEA award, based on lending activity in 2009.  This grant was recognized in non-interest income.  Previous grants and awards that have been included in non-interest income are as follows:
 
2001                                           $   537,750
2002                                                182,936
2003                                                180,900
2004                                             1,332,756
2006                                                100,188
2007                                                359,480
2009                                                  80,948
2010                                                600,000
Total 2001 through 2010        $3,374,958
 
Competition
 
The banking and financial services business in the Bank’s market area is highly competitive.  The increasingly competitive environment is a result primarily of changes in regulation, and changes in technology and product delivery systems.  The Bank emphasizes to its customers the advantages of dealing with a locally owned and community development oriented institution. Larger banks may have a competitive advantage because of higher lending limits and major advertising and marketing campaigns in addition to expanded products like trust services, international banking, discount brokerage and insurance services that the Bank does not offer.  As a service to its customers, the Bank has made arrangements with other financial service providers to extend such services to its customers where possible.  For borrowers requiring loans in excess of the Bank’s legal lending limits, the Bank makes use of loan participations with its correspondent banks and with other independent banks, retaining the portion of such loans that is within its legal lending limits.  Commercial banks compete with savings and loan associations, credit unions, other financial institutions, securities brokerage firms, and other entities for funds.  For instance, yields on corporate and government debt securities and other commercial paper affect the ability of commercial banks to attract and hold deposits.
 
The Bank utilizes technology to improve its competitive advantages by use of ATMs, Internet Banking, ACH origination, electronic bill pay, email, remote deposit capture and credit card and merchant card relationships.
 
In addition, in order to compete effectively, the Bank has created a sales and service culture that combines the experience of its senior officers with the commitment to service and a focus on the individual needs of its customers that is found at the best community banks.  The Bank also relies on local advertising programs, direct personal contact by its officers, directors, employees and shareholders and specialized services such as courier pick-up and remote deposit capture.  The Bank believes it provides a level of service and decision-making responsiveness not generally offered by larger institutions.
 
The Bank’s primary service area consists of the county of San Luis Obispo and parts of Santa Barbara County and now Ventura County.    As in most major U.S. cities, large banks compete in our service area.  However, rather than these large financial institutions, community banks are more prominent in our market.  As such, we believe our primary competitors for individuals and small and medium-sized business customers are the community banks, which can provide the service and responsiveness attractive to this customer base.
 
Within San Luis Obispo county and northern Santa Barbara county, and based on data from the FDIC as of June 30, 2010, there were 19 banks with 105 branches with aggregate deposits of $6.7 billion.  The Bank’s deposits represent a 2.4% share of this market.  Of the 19 banks, nine were community banks (banks with less than $1 billion in assets), with seven of these banks headquartered in San Luis Obispo county and three headquartered in Santa Barbara county.  There were also six credit unions operating in San Luis Obispo and northern Santa Barbara Counties.  Three of those credit unions are headquartered in the Bank’s target market area.
 
Dependence on One or a Few Major Customers
 
The Bank is limited, due to legal lending limits, in the size of loans it can make to any one individual borrower (in the aggregate).  It has in its portfolio approximately 500 loans to approximately 385 loan customers.  As of December 31, 2010, the Bank’s legal lending limit to a single borrower, and such borrower’s related parties, was approximately $5.7
 


million on a secured basis, and was $3.4 million for unsecured loans, based on regulatory capital plus reserves of approximately $22.7 million.
 
The Bank has a higher than average dependence (as measured by peer group analysis) on larger deposit balances (deposits of $100,000 or more) with a total of 429 deposit accounts holding $122.2 million in deposits as of December 31, 2010.  Included in those totals are 11 customers with deposits of $1 million or more totaling $52.8 million, with one local customer relationship representing approximately 20% of the Bank’s total deposits as of December 31, 2010.  Management works with large depositors to “ladder out” certificate of deposit maturities in order to both minimize liquidity risk for the Bank and provide a better return for the customer on their deposited funds.  These large deposit balances have been reasonably stable during the past several years and are consistent with the Bank’s deposit/funding strategy.  Also included in the totals above are 18 non-interest-bearing transaction accounts, of which $15.7 million exceeds the normal FDIC insurance limit, but which have been subject to unlimited FDIC insurance coverage under the Transaction Account Guarantee Program (“TAGP”) through December 31, 2010. On July 21, 2010, President Barack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which, in part, extends full deposit insurance coverage for noninterest bearing deposit transaction accounts beginning December 31, 2010 for an additional two year period.  The Bank has a contingency funding plan in place to address any potential loss of these large deposits.
 
The Bank’s business does not appear to be seasonal.
 
Recent Developments
 
Enacted as part of the Small Business Jobs Act of 2010, the Treasury Department recently announced the creation of a Small Business Lending Fund (“SBLF”), which is intended to encourage lending to small businesses by providing Tier 1 capital—up to 5% of risk-weighted assets—to qualified community banks with less than $10 billion in assets.  Eligible community banks that have issued preferred stock to the Treasury Department through the TARP CPP, such as the Company, may refinance their TARP preferred stock with a new issuance through SBLF.  Dividends on SBLF preferred stock may be either lower or higher than the rate currently paid on TARP preferred, depending on whether certain lending targets are, or aren’t, met.   The Company has submitted an application with the Treasury Department for the issuance of preferred stock under the SBLF program.  It is not yet known whether the Company’s application will be accepted by the Treasury and the Company’s primary regulators.
 
Effect of Government Policies and Regulations
 
Banking is a business that depends on rate differentials.  In general, the difference between the interest rate paid by the Bank on its deposits and its other borrowings and the interest rate received by the Bank on loans extended to its customers and securities held in the Bank’s portfolio comprise the major portion of the Bank’s earnings.  These rates are highly sensitive to many factors that are beyond the control of the Bank. Accordingly, the earnings and growth of the Bank are subject to the influence of domestic and foreign economic conditions, including inflation, recession and unemployment.
 
The commercial banking business is not only affected by general economic conditions but is also influenced by the monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Federal Reserve Board.  The Federal Reserve Board implements national monetary policies (with objectives such as curbing inflation and combating recession) by its open-market operations in U.S. Government securities, by adjusting the required level of reserves for financial institutions subject to its reserve requirements and by varying the discount rates applicable to borrowings by depository institutions. The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits.  The nature and impact of any future changes in monetary policies cannot be predicted.
 
From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial institutions.  Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial institutions are frequently made in Congress, in the California legislature and before various bank regulatory and other professional agencies.  For example, the Bank’s ability to originate and sell SBA loans would be severely impacted if federal appropriations for the SBA lending program were curtailed or eliminated.
 


Supervision and Regulation
 
Both federal and state laws extensively regulate banks and bank holding companies.  This regulation is intended primarily for the protection of depositors and the deposit insurance fund and not for the benefit of shareholders of the Company.  The following is a summary of particular statutes and regulations affecting the Company and the Bank.  This summary is qualified in its entirety by the statutes and regulations.  No assurance can be given that such statutes or regulations will not change in the future.
 
Regulation of Mission Community Bancorp—General
 
Mission Community Bancorp is a registered bank holding company under the Bank Holding Company Act of 1956, as amended, and is regulated by the Federal Reserve Board.  The Company is required to file periodic reports with the Federal Reserve Board and such additional information as the Federal Reserve Board may require pursuant to the Bank Holding Company Act.  The Federal Reserve Board may conduct examinations of the Company and its subsidiaries, which includes the Bank.
 
The Bank Holding Company Act requires every bank holding company to obtain the prior approval of the Federal Reserve Board before acquiring substantially all the assets of any bank or bank holding company or ownership or control of any voting shares of any bank or bank holding company, if, after the acquisition, it would own or control, directly or indirectly, more than 5% of the voting shares of the bank or bank holding company.  The principal exceptions to these prohibitions involve non-bank activities identified by statute, by Federal Reserve regulation, or by Federal Reserve order as activities so closely related to the business of banking or of managing or controlling banks as to be a proper incident thereto, including securities brokerage services, investment advisory services, fiduciary services, and management advisory and data processing services, among others. A bank holding company that also qualifies as and elects to become a “financial holding company” may engage in a broader range of activities that are financial in nature (and complementary to such activities), specifically non-bank activities identified by the Gramm-Leach-Bliley Act of 1999 or by Federal Reserve and Treasury regulation as financial in nature or incidental to a financial activity. Activities that are defined as financial in nature include securities underwriting, dealing, and market making, sponsoring mutual funds and investment companies, engaging in insurance underwriting and agency activities, and making merchant banking investments in non-financial companies. To become and remain a financial holding company, a bank holding company and its subsidiary banks must be well capitalized, well managed, and, except in limited circumstances, have at least a satisfactory rating under the Community Reinvestment Act.  The Company has no current intention of becoming a financial holding company, but may do so at some point in the future if deemed appropriate in view of opportunities or circumstances at the time.
 
The Company and the Bank are deemed to be affiliates of each other within the meaning set forth in the Federal Reserve Act and are subject to Sections 23A and 23B of the Federal Reserve Act. The Federal Reserve Board has also issued Regulation W, which codifies prior regulations under Sections 23A and 23B of the Federal Reserve Act and interpretative guidance with respect to affiliate transactions.  This means, for example, that there are limitations on loans by the Bank to affiliates, and that all affiliate transactions must satisfy certain limitations and otherwise be on terms and conditions at least as favorable to the Bank as would be available for non-affiliates. In addition, we must comply with the Federal Reserve Act and Regulation O issued by the Federal Reserve Board, which require that loans and extensions of credit to our executive officers, directors and principal shareholders, or any company controlled by any such persons, shall, among other conditions, be made on substantially the same terms and follow credit-underwriting procedures no less stringent than those prevailing at the time for comparable transactions with non-insiders.
 
Regulations and policies of the Federal Reserve Board require a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks.  It is the Federal Reserve Board’s policy that a bank holding company should stand ready to use available resources to provide adequate capital funds to a subsidiary bank during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting a subsidiary bank.  Under certain conditions, the Federal Reserve Board may conclude that certain actions of a bank holding company, such as a payment of a cash dividend, would constitute an unsafe and unsound banking practice.
 
The Federal Reserve Board also has the authority to regulate bank holding companies’ debt, including the authority to impose interest rate ceilings and reserve requirements on such debt. Under certain circumstances, the Federal Reserve Board may require a bank holding company to file written notice and obtain its approval prior to purchasing or redeeming its equity securities, unless certain conditions are met.
 


The securities of the Company are also subject to the requirements of the Securities Act, and matters related thereto are regulated by the Securities and Exchange Commission.  Certain issuances may also be subject to the California’s corporate securities law as administered by the California Commissioner of Corporations.  The Company is subject to the public reporting requirements of the Securities and Exchange Act of 1934, as amended, generally applicable to publicly held companies, under Section 15(d) of the Exchange Act.  Companies which file a registration statement under the Securities Act are required under Section 15(d) of the Exchange Act for at least a 12-month period after the effectiveness of such registration statement to file periodic quarterly and annual reports under the Securities Act.  If and when the Company has more than 500 shareholders of record, it will be required to register its securities with the Securities and Exchange Commission under Section 12(g) of the Exchange Act at which time its filing of periodic reports, as well as certain other reporting obligations, will become mandatory.
 
Regulation of Mission Community Bank—General
 
As a California state-chartered bank, the Bank is subject to regulation, supervision and examination by the California Department of Financial Institutions.  It is also a member of the Federal Reserve System and, as such, is subject to applicable provisions of the Federal Reserve Act and the related regulations promulgated by the Board of Governors of the Federal Reserve System.  In addition, the deposits of the Bank are currently insured by the Federal Deposit Insurance Corporation (“FDIC”) to a maximum of $250,000 per depositor, and potentially higher limits with respect to certain retirement accounts.  Beginning December 5, 2008, the Bank elected to participate in the FDIC’s Transaction Account Guarantee Program (“TAGP”), which provides, through December 31, 2012, an unlimited guarantee of funds in noninterest-bearing transaction accounts (including NOW accounts restricted during the guarantee period to interest rates of 0.25% or less).  For deposit insurance protection, the Bank pays a quarterly assessment, and occasional mandated special assessments, to the FDIC and is subject to the rules and regulations of the FDIC pertaining to deposit insurance and other matters.  The regulations of those agencies will govern most aspects of the Bank’s business, including the making of periodic reports by the Bank, and the Bank’s activities relating to dividends, investments, loans, borrowings, capital requirements, certain check-clearing activities, branching, mergers and acquisitions, reserves against deposits, the issuance of securities and numerous other areas.
 
The earnings and growth of the Bank is largely dependent on its ability to maintain a favorable differential or “spread” between the yield on its interest-earning assets and the rate paid on its deposits and other interest-bearing liabilities.  As a result, the Bank’s performance is influenced by general economic condi­tions, both domestic and foreign, the monetary and fiscal policies of the federal government, and the policies of the regulatory agencies, particularly the Federal Reserve Board.  The Federal Reserve Board implements national monetary policies (such as seeking to curb inflation and combat recession) by its open-market operations in United States Government securities, by adjusting the required level of reserves for financial institutions subject to its reserve requirements and by varying the discount rate applicable to borrowings by banks which are members of the Federal Reserve System.  The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged and paid on loans and deposits.  The nature and impact of any future changes in monetary policies cannot be predicted.
 
Capital Adequacy Requirements
 
The Company and the Bank are subject to the regulations of the Federal Reserve Board governing capital adequacy.  Those regulations incorporate both risk-based and leverage capital requirements.  Under existing regulations, the capital requirements for a bank holding company whose consolidated assets are less than $500 million, like the Company, are deemed to be the same as that of its subsidiary bank.  The Federal Reserve Board has established risk-based and leverage capital guidelines for the banks it regulates, which set total capital requirements and define capital in terms of “core capital elements,” or Tier 1 capital, and “supplemental capital elements,” or Tier 2 capital.  Tier 1 capital is generally defined as the sum of the core capital elements less goodwill and certain intangibles.  The following items are defined as core capital elements: (i) common stockholders’ equity; (ii) qualifying non-cumulative perpetual preferred stock and related surplus; and (iii) minority interests in the equity accounts of consolidated subsidiaries.  Supplementary capital elements include: (i) allowance for loan and lease losses (but not more than 1.25% of an institution’s risk-weighted assets); (ii) perpetual preferred stock and related surplus not qualifying as core capital; (iii) hybrid capital instruments, perpetual debt and mandatory convertible debt instruments; and (iv) term subordinated debt and intermediate-term preferred stock and related surplus.  The maximum amount of supplemental capital elements which qualifies as Tier 2 capital is limited to 100% of Tier 1 capital, net of goodwill.
 
In March 2005, the Federal Reserve Board adopted a final rule allowing bank holding companies to continue to include trust preferred securities in their Tier 1 capital. The amount that can be included is limited to 25 percent of core
 


capital elements, net of goodwill less any associated deferred tax liability.  In addition, since the Company had less than $15 billion in assets at December 31, 2009, under the Dodd-Frank Act, the Company will be able to continue to include its existing trust preferred securities in Tier 1 capital to the extent permitted by FRB guidelines.  See “Dodd-Frank Wall Street Reform and Consumer Protection Act” below.
 
The Bank is required to maintain a minimum ratio of qualifying total capital to total risk-weighted assets of 8.0% (“Total Risk-Based Capital Ratio”), at least one-half of which must be in the form of Tier 1 capital (“Tier 1 Risk-Based Capital Ratio”).  Risk-based capital ratios are calculated to provide a measure of capital that reflects the degree of risk associated with a banking organization’s operations for both transactions reported on the balance sheet as assets, and transactions, such as letters of credit and recourse arrangements, which are recorded as off-balance sheet items.  Under the risk-based capital guidelines, the nominal dollar amounts of assets and credit-equivalent amounts of off-balance-sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with very low credit risk, such as certain U. S. Treasury securities, to 100% for assets with relatively high credit risk, such as business loans.  As of December 31, 2010 and December 31, 2009, the Bank’s Total Risk-Based Capital Ratio was 17.2% and 14.2%, respectively, and its Tier 1 Risk-Based Capital Ratio was 15.9% and 12.9%, respectively.
 
The risk-based capital standards also take into account concentrations of credit and the risks of “non-traditional” activities (those that have not customarily been part of the banking business). The regulations require institutions with high or inordinate levels of risk to operate with higher minimum capital standards, and authorize the regulators to review an institution’s management of such risks in assessing an institution’s capital adequacy.
 
Additionally, the regulatory statements of policy on risk-based capital include exposure to interest rate risk as a factor that the regulators will consider in evaluating a bank’s capital adequacy, although interest rate risk does not impact the calculation of a bank’s risk-based capital ratios.  Interest rate risk is the exposure of a bank’s current and future earnings and equity capital arising from adverse movements in interest rates.  While interest risk is inherent in a bank’s role as financial intermediary, it introduces volatility to bank earnings and to the economic value of the bank or bank holding company.
 
Banks are also required to maintain a leverage capital ratio designed to supplement the risk-based capital guidelines.  Banks that have received the highest rating of the five categories used by regulators to rate banks and are not anticipating or experiencing any significant growth must maintain a ratio of Tier 1 capital (net of all intangibles) to adjusted total assets (“Leverage Capital Ratio”) of at least 3%.  All other institutions are required to maintain a leverage ratio of at least 100 to 200 basis points above the 3% minimum, for a minimum of 4% to 5%.  Pursuant to federal regulations, banks must maintain capital levels commensurate with the level of risk to which they are exposed, including the volume and severity of problem loans, and federal regulators may set higher capital requirements when a bank’s particular circumstances warrant.   The Bank’s Leverage Capital Ratio was 10.2% as of December 31, 2010 and 9.6% at December 31, 2009.  See also Note P to the Consolidated Financial Statements for additional information regarding regulatory capital.
 
Prompt Corrective Action Provisions
 
Federal law requires each federal banking agency to take prompt corrective action to resolve the problems of insured financial institutions, including but not limited to those that fall below one or more prescribed minimum capital ratios.  The federal banking agencies have by regulation defined the following five capital categories: “well capitalized” (Total Risk-Based Capital Ratio of 10%; Tier 1 Risk-Based Capital Ratio of 6%; and Leverage Capital Ratio of 5%); “adequately capitalized” (Total Risk-Based Capital Ratio of 8%; Tier 1 Risk-Based Capital Ratio of 4%; and Leverage Capital Ratio of 4%) (or 3% if the institution receives the highest rating from its primary regulator); “undercapitalized” (Total Risk-Based Capital Ratio of less than 8%; Tier 1 Risk-Based Capital Ratio of less than 4%; or Leverage Capital Ratio of less than 4%) (or 3% if the institution receives the highest rating from its primary regulator); “significantly undercapitalized” (Total Risk-Based Capital Ratio of less than 6%; Tier 1 Risk-Based Capital Ratio of less than 3%; or Leverage Capital Ratio less than 3%); and “critically undercapitalized” (tangible equity to total assets less than 2%).  A bank may be treated as though it were in the next lower capital category if, after notice and the opportunity for a hearing, the appropriate federal agency finds an unsafe or unsound condition or practice so warrants, but no bank may be treated as “critically undercapitalized” unless its actual capital ratio warrants such treatment.
 
At each successively lower capital category, an insured bank is subject to increased restrictions on its operations.  For example, a bank is generally prohibited from paying management fees to any controlling persons or from making capital distributions if to do so would make the bank “undercapitalized.”  Asset growth and branching restrictions apply to undercapitalized banks, which are required to submit written capital restoration plans meeting specified requirements
 


(including a guarantee by the parent holding company, if any).  “Significantly undercapitalized” banks are subject to broad regulatory authority, including among other things, capital directives, forced mergers, restrictions on the rates of interest they may pay on deposits, restrictions on asset growth and activities, and prohibitions on paying bonuses or increasing compensation to senior executive officers without regulatory approval.  Even more severe restrictions apply to critically undercapitalized banks.  Most importantly, except under limited circumstances, not later than 90 days after an insured bank becomes critically undercapitalized, the appropriate federal banking agency is required to appoint a conservator or receiver for the bank.
 
In addition to measures taken under the prompt corrective action provisions, insured banks may be subject to potential actions by the federal regulators for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency.  Enforcement actions may include the issuance of cease and desist orders, termination of insurance of deposits (in the case of a bank), the imposition of civil money penalties, the issuance of directives to increase capital, formal and informal agreements, or removal and prohibition orders against “institution-affiliated” parties.
 
Safety and Soundness Standards
 
The federal banking agencies have also adopted guidelines establishing safety and soundness standards for all insured depository institutions.  Those guidelines relate to internal controls, information systems, internal audit systems, loan underwriting and documentation, compensation and interest rate exposure.  In general, the standards are designed to assist the federal banking agencies in identifying and addressing problems at insured depository institutions before capital becomes impaired.  If an institution fails to meet these standards, the appropriate federal banking agency may require the institution to submit a compliance plan and institute enforcement proceedings if an acceptable compliance plan is not submitted.
 
The Dodd-Frank Wall Street Reform and Consumer Protection Act
 
On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), a landmark financial reform bill that significantly changes the current bank regulatory structure and affects the lending, investment, trading and operating activities of financial institutions and their holding companies. Among other things, the Dodd-Frank Act dramatically impacts the rules governing the provision of consumer financial products and services. The new law includes, among other things, the following:
 
 
·
The Dodd-Frank Act establishes a new Financial Stability Oversight Counsel to monitor systemic financial risks.  The Board of Governors of the Federal Reserve are given extensive new authorities to impose strict controls on large bank holding companies with total consolidated assets equal to or in excess of $50 billion and systemically significant non-bank financial companies to limit the risk they might pose for the economy and to other large interconnected companies.  The Dodd-Frank Act also grants to the Treasury Department, FDIC and the FRB broad new powers to seize, close and wind-down “too big to fail” financial institutions (including non-bank institutions) in an orderly fashion.
 
·
The Dodd-Frank Act also establishes a new independent Federal regulatory body for consumer protection within the Federal Reserve System known as the Bureau of Consumer Financial Protection (the “Bureau”), which will assume responsibility for most consumer protection laws. It will also be in charge of setting appropriate consumer banking fees and caps.  The Bureau has examination and enforcement authority over all banks and savings institutions with more than $10 billion in assets.  Banks and savings institutions with $10 billion or less in assets, like the Bank, will continue to be examined by their applicable bank regulators.
 
·
The Dodd-Frank Act restricts the amount of trust preferred securities (“TPS”) that may be considered Tier 1 Capital.  For depository institution holding companies below $15 billion in total assets, TPS issued before May 19, 2010 will be grandfathered, so their status as Tier 1 capital does not change. However going forward, TPS will be disallowed as Tier 1 capital. Since the Company had less than $15 billion in assets, under the Dodd-Frank Act, the Company will be able to continue to include its existing TPS in Tier 1 capital to the extent permitted by FRB guidelines.
 
·
The Dodd-Frank Act effects changes in the FDIC assessment base with stricter oversight. A new council of regulators led by the U.S. Treasury will set higher requirements for the amount of cash banks must keep on hand. The minimum reserve ratio is to be increased from 1.15 percent to 1.35 percent; however, financial institutions with assets of less than $10 billion like the Bank are to be exempt from the cost of the increase. FDIC insurance coverage is made permanent at the $250,000 level retroactive to January 1, 2008 and unlimited FDIC insurance is provided for non-interest-bearing demand deposits, which coverage will continue until December 31, 2012.


 
·
Under the Dodd-Frank Act, the Comptroller of the Currency’s ability to preempt state consumer protection laws was made more difficult by raising the applicable preemption standards and state attorneys general are granted greater authority to enforce state consumer protection laws against national banks and their operating subsidiaries.
 
·
The Dodd-Frank Act adopts the so-called “Volcker rule,” which, subject to certain exceptions, prohibits any banking entity from engaging in proprietary trading, or sponsoring or investing in a hedge fund or private equity fund.
The Company is currently evaluating the potential impact the Dodd-Frank Act will have on its business, financial condition, results of operations and prospects and expects that some provisions of the Dodd-Frank Act may have adverse effects on the Company, such as the cost of complying with the numerous new regulations and reporting requirements mandated by the Dodd-Frank Act. Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on the Company and the financial services industry more generally. Provisions in the legislation that affect deposit insurance assessments, and payment of interest on demand deposits could increase the costs associated with deposits.
 
The Emergency Economic Stabilization Act of 2008 and the Troubled Asset Relief Program
 
In response to unprecedented market turmoil and the financial crises affecting the overall banking system and financial markets in the United States, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted on October 3, 2008.  On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (the “Stimulus Bill”) was enacted, which among other things augmented certain provisions of the EESA.  Under the EESA, the Treasury Department was given the authority, among other authorizations, to purchase up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions in the Troubled Asset Relief Program (the “TARP”).  The purpose of the TARP was to restore confidence and stability to the U.S. banking system and to encourage financial institutions to increase their lending to customers and to each other.  
 
Pursuant to the EESA, the Treasury Department allocated $250 billion to the TARP Capital Purchase Program (see description below).
 
The TARP Capital Purchase Program (“CPP) was developed to purchase $250 billion in senior preferred stock from qualifying financial institutions, and was designed to strengthen the capital and liquidity positions of viable institutions and to encourage banks and thrifts to increase lending to creditworthy borrowers.  The amount of the Treasury Department’s preferred stock a particular qualifying financial institution could be approved to issue would be not less than 1% of risk-weighted assets and not more than the lesser of $25 billion or 3% of risk-weighted assets.
 
The general terms of the TARP CPP include:
 
 
·
Dividends on the Treasury Department’s preferred stock at a rate of five percent for the first five years and nine percent thereafter;
 
·
Common stock dividends cannot be increased for three years while the Treasury Department is an investor unless preferred stock is redeemed or consent from the Treasury is received;
 
·
The Treasury Department must consent to any buyback of other stock (common or other preferred);
 
·
The Treasury Department’s preferred stock will have the right to elect two directors if dividends have not been paid for six periods;
 
·
The Treasury Department receives warrants equal to 15 percent of the Treasury Department’s total investment in the participating institution (provided, however, that the Company was not required to issue any warrants due to its status as a Community Development Financial Institution); and
 
·
The participating institution’s executives must agree to certain compensation restrictions, and restrictions on the amount of executive compensation that is tax deductible.
 
The Company elected to participate in the TARP CPP and in January 2009 issued $5.1 million worth of preferred stock to the Treasury Department pursuant to this program.
 
The EESA also established a Temporary Liquidity Guarantee Program (“TLGP”) that gave the FDIC the ability to provide a guarantee for newly-issued senior unsecured debt and non-interest bearing transaction deposit accounts at eligible insured institutions. The Company is currently participating in the transaction account guarantee program. This program was initially scheduled to continue through December 31, 2010, but the Dodd-Frank Act has extended full deposit insurance coverage for non-interest bearing transaction accounts through December 31, 2012, and all financial institutions
 


are required to participate in this extended guarantee program. For non-interest bearing transaction deposit accounts, a 10 basis point annual FDIC insurance premium surcharge was applied to deposit amounts in excess of $250,000 through December 31, 2009, and a risk-based surcharge of between 15 and 25 basis points was applied beginning January 1, 2010.
 
Deposit Insurance
 
 The Bank’s deposits are insured under the Federal Deposit Insurance Act, up to the maximum applicable limits by the Deposit Insurance Fund (“DIF”) of the FDIC and are subject to deposit insurance assessments to maintain the DIF. In October 2010, the FDIC adopted a revised restoration plan to ensure that the DIF’s designated reserve ratio (“DRR”) reaches 1.35% of insured deposits by September 30, 2020, the deadline mandated by the Dodd-Frank Act.  However, financial institutions like the Bank with assets of less than $10 billion are required to be exempt from the cost of this increase, and the FDIC plans further rulemaking in 2011 regarding the method that will be used to reach the requisite 1.35% minimum reserve ratio while offsetting the effect of required increases on such smaller institutions.  In addition, because of lower expected losses over the next five years and the additional time provided by Dodd-Frank to meet the minimum DRR, the FDIC eliminated the uniform 3 basis point increase in assessment rates that was previously scheduled to go into effect on January 1, 2011.  Furthermore, the restoration plan proposed an increase in the DRR to 2% of estimated insured deposits as a long-term goal for the fund.  The FDIC also proposed future assessment rate reductions in lieu of dividends, when the DRR reaches 1.5% or greater.
 
Furthermore, the FDIC redefined its deposit insurance premium from an institution’s total domestic deposits to an institution’s total assets less tangible equity, effective in the second quarter of 2011.  The changes to the assessment base necessitated changes to assessment rates, which will become effective April 1, 2011.  While revised assessment rates will be lower than current rates, the assessment base will be larger, and the expectation is that approximately the same amount of assessment revenue will be collected by the FDIC as under the current structure.
 
To help address liquidity issues created by potential timing differences between the collection of premiums and charges against the DIF, in November 2009 the FDIC adopted a final rule to require insured institutions to prepay, on December 31, 2009, their estimated quarterly risk-based deposit insurance assessments for the fourth quarter of 2009, and for all of 2010, 2011 and 2012.
 
In addition to DIF assessments, banks must pay quarterly assessments in an amount which fluctuates but is currently 1.02 basis points of insured deposits, towards the retirement of the Financing Corporation bonds issued in the 1980’s to assist in the recovery of the savings and loan industry. These assessments will continue until the Financing Corporation bonds mature in 2019.
 
The enactment of the EESA (discussed above) temporarily raised the basic limit on federal deposit insurance coverage from $100,000 to $250,000 per depositor. The temporary increase in deposit insurance coverage became effective on October 3, 2008. The Dodd-Frank Act made permanent the increase to $250,000 in the deposit insurance limit.  As of December 31, 2010, the Bank had approximately $15.7 million in non-interest bearing accounts exceeding $250,000.
 
Community Reinvestment Act
 
The Bank is subject to certain requirements and reporting obligations involving Community Reinvestment Act activities.  The Community Reinvestment Act generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of its local communities, including low and moderate income neighborhoods. The Community Reinvestment Act further requires the agencies to take a financial institution’s record of meeting its community credit needs into account when evaluating applications for, among other things, domestic branches, consummating mergers or acquisitions, or holding company formations.  In measuring a bank’s compliance with its Community Reinvestment Act obligations, the regulators utilize a performance-based evaluation system which bases Community Reinvestment Act ratings on the bank’s actual lending service and investment performance, rather than on the extent to which the institution conducts needs assessments, documents community outreach activities or complies with other procedural requirements.  In connection with its assessment of Community Reinvestment Act performance, the agencies assign a rating of “outstanding,” “satisfactory,” “needs to improve” or “substantial noncompliance.”  The Bank received an “outstanding” rating in its last completed Community Reinvestment Act examination in 2010.
 


Privacy and Data Security
 
The Gramm-Leach-Bliley Act, also known as the “Financial Modernization Act”, which became effective in 2000, imposed new requirements on financial institutions with respect to consumer privacy.  The statute generally prohibits disclosure of consumer information to non-affiliated third parties unless the consumer has been given the opportunity to object and has not objected to such disclosure.  Financial institutions are further required to disclose their privacy policies to consumers annually.  Financial institutions, however, are required to comply with state law if it is more protective of consumer privacy than the Gramm-Leach-Bliley Act.  The statute also directed federal regulators, including the Federal Reserve and the FDIC, to prescribe standards for the security of consumer information.  Bancorp and the Bank are subject to such standards, as well as standards for notifying consumers in the event of a security breach.
 
Other Consumer Protection Laws and Regulations
 
Activities of all insured banks are subject to a variety of statutes and regulations designed to protect consumers, such as the Fair Credit Reporting Act, Equal Credit Opportunity Act, and Truth-in-Lending Act.  Interest and other charges collected or contracted for by the Bank are also subject to state usury laws and certain other federal laws concerning interest rates. The Bank’s loan operations are also subject to federal laws and regulations applicable to credit transactions.  Together, these laws and regulations include provisions that:
 
 
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govern disclosures of credit terms to consumer borrowers;
 
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require financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;
 
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prohibit discrimination on the basis of race, creed, or other prohibited factors in extending credit;
 
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govern the use and provision of information to credit reporting agencies; and
 
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govern the manner in which consumer debts may be collected by collection agencies.
 
 
The Bank’s deposit operations are also subject to laws and regulations that:
 
 
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impose a duty to maintain the confidentiality of consumer financial records and prescribe procedures for complying with administrative subpoenas of financial records; and
 
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govern automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services.
 
In November 2009, the Board of Governors of the Federal Reserve System promulgated a rule entitled “Electronic Fund Transfers”, with an effective date of January 19, 2010 and a mandatory compliance date of July 1, 2010.  The rule, which applies to all FDIC-regulated institutions, prohibits financial institutions from assessing an overdraft fee for paying automated teller machine (ATM) and one-time point-of-sale debit card transactions, unless the customer affirmatively opts in to the overdraft service for those types of transactions.  The opt-in provision establishes requirements for clear disclosure of fees and terms of overdraft services for ATM and one-time debit card transactions.  The rule does not apply to other types of transactions, such as check, automated clearinghouse (ACH) and recurring debit card transactions.  Since none of the Company’s service charges on deposits are in the form of overdraft fees on ATM or point-of-sale transactions, compliance with this rule did not have an adverse impact on our non-interest income.
 
Interstate Banking and Branching
 
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 regulates the interstate activities of banks and bank holding companies and establishes a framework for nationwide interstate banking and branching.  Since 1995, adequately capitalized and managed bank holding companies have been permitted to acquire banks located in any state, subject to two exceptions: first, any state may still prohibit bank holding companies from acquiring a bank which is less than five years old; and second, no interstate acquisition can be consummated by a bank holding company if the acquirer would control more then 10% of the deposits held by insured depository institutions nationwide or 30% percent or more of the deposits held by insured depository institutions in any state in which the target bank has branches.
 
In 1995 California enacted legislation to implement important provisions of the Riegle-Neal Act discussed above and to repeal California’s previous interstate banking laws, which were largely preempted by the Riegle-Neal Act.
 


A bank may establish and operate de novo branches in any state in which the bank does not maintain a branch if that state has enacted legislation to expressly permit all out-of-state banks to establish branches in that state.  However, California law expressly prohibits an out-of-state bank which does not already have a California branch office from (i) purchasing a branch office of a California bank (as opposed to purchasing the entire bank) and thereby establishing a California branch office or (ii) establishing a de novo branch in California.
 
The changes effected by the Riegle-Neal Act and California laws have increased competition in the environment in which the Bank operates to the extent that out-of-state financial institutions may directly or indirectly enter the Bank’s market areas.  It appears that the Riegle-Neal Act has contributed to the accelerated consolidation of the banking industry, with many large out-of-state banks having entered the California market as a result of this legislation.
 
Financial Modernization Act
 
Effective March 11, 2000, the Gramm-Leach-Bliley Financial Modernization Act enabled full affiliations to occur between banks and securities firms, insurance companies and other financial service providers.  This legislation permits bank holding companies to become “financial holding companies” and thereby acquire securities firms and insurance companies and engage in other activities that are financial in nature.  A bank holding company may become a financial holding company if each of its subsidiary banks is “well capitalized” and “well managed” under applicable definitions, and has at least a satisfactory rating under the CRA by filing a declaration that the bank holding company wishes to become a financial holding company.
 
The Financial Modernization Act defines “financial in nature” to include securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency; merchant banking activities; and activities that the Federal Reserve Board has determined to be closely related to banking.  A national bank also may engage, subject to limitations on investment, in activities that are financial in nature, other than insurance underwriting, insurance company portfolio investment, real estate development and real estate investment, through a financial subsidiary of the bank, if the bank is well capitalized, well managed and has at least a satisfactory CRA rating.  Subsidiary banks of a financial holding company or national banks with financial subsidiaries must continue to be well capitalized and well managed in order to continue to engage in activities that are financial in nature without regulatory actions or restrictions, which could include divestiture of financial subsidiaries.  In addition, a financial holding company or a bank may not acquire a company that is engaged in activities that are financial in nature unless each of the subsidiary banks of the financial holding company or the bank has a CRA rating of satisfactory or better.
 
USA Patriot Act of 2001
 
The impact of the USA Patriot Act of 2001 (the “Patriot Act”) on financial institutions of all kinds has been significant and wide ranging.  The Patriot Act substantially enhanced existing anti-money laundering and financial transparency laws, and required appropriate regulatory authorities to adopt rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.  Under the Patriot Act, financial institutions are subject to prohibitions regarding specified financial transactions and account relationships, as well as enhanced due diligence and “know your customer” standards in their dealings with foreign financial institutions and foreign customers.

The Patriot Act also requires all financial institutions to establish anti-money-laundering programs.  To fulfill the anti-money laundering requirements of the Patriot Act, the Bank intensified its due diligence procedures concerning the opening of new accounts and implemented new systems and procedures (including a risk management process) to identify suspicious activity.  Any such suspicious activity is reported to the Financial Crimes Enforcement Network.

Sarbanes-Oxley Act of 2002
 
As a public company, the Company is subject to the Sarbanes-Oxley Act of 2002, which implements a broad range of corporate governance and accounting measures for public companies designed to promote honesty and transparency in corporate America and better protect investors from corporate wrongdoing.  The Sarbanes-Oxley Act’s principal legislation and the derivative regulation and rule making promulgated by the Securities and Exchange Commission includes:

 
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the creation of an independent accounting oversight board;
 
·
auditor independence provisions that restrict non-audit services that accountants may provide to their audit clients;


 
·
additional corporate governance and responsibility measures, including the requirement that the chief executive officer and chief financial officer certify financial statements;
 
·
a requirement that companies establish and maintain a system of internal control over financial reporting and that a company’s management provide an annual report regarding its assessment of the effectiveness of such internal control over financial reporting to the company’s independent accountants;
 
·
a requirement that the company’s independent accountants provide an attestation report with respect to management’s assessment of the effectiveness of the company’s internal control over financial reporting (the recently enacted Dodd-Frank Act exempts smaller reporting companies like Mission Community Bancorp from this requirement);
 
·
the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer’s securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement;
 
·
an increase in the oversight of, and enhancement of certain requirements relating to audit committees of public companies and how they interact with the company’s independent auditors;
 
·
the requirement that audit committee members must be independent and are absolutely barred from accepting consulting, advisory or other compensatory fees from the issuer;
 
·
the requirement that companies disclose whether at least one member of the committee is a “financial expert” (as such term is defined by the SEC) and if not, why not;
 
·
expanded disclosure requirements for corporate insiders, including accelerated reporting of stock transactions by insiders and a prohibition on insider trading during pension blackout periods;
 
·
a prohibition on personal loans to directors and officers, except certain loans made by insured financial institutions;
 
·
disclosure of a code of ethics and the requirement of filing of a Form 8-K for a change or waiver of such code;
 
·
mandatory disclosure by analysts of potential conflicts of interest; and
 
·
a range of enhanced penalties for fraud and other violations.

Commercial Real Estate Lending and Concentrations
 
In December 2006, the federal bank regulatory agencies released Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices (“the Guidance”).  The Guidance, which was issued in response to the agencies’ concern that rising CRE concentrations might expose institutions to unanticipated earnings and capital volatility in the event of adverse changes in the commercial real estate market, reinforces existing regulations and guidelines for real estate lending and loan portfolio management.
 
Highlights of the Guidance include the following:
 
 
·
The agencies have observed that CRE concentrations have been rising over the past several years with small to mid-size institutions showing the most significant increase in CRE concentrations over the last decade.  However, some institutions’ risk management practices are not evolving with their increasing CRE concentrations, and therefore, the Guidance reminds institutions that strong risk management practices and appropriate levels of capital are important elements of a sound CRE lending program.
 
·
The Guidance applies to national banks and state chartered banks and is also broadly applicable to bank holding companies.  For purposes of the Guidance, CRE loans include loans for land development and construction, other land loans and loans secured by multifamily and nonfarm nonresidential properties.  The definition also extends to loans to real estate investment trusts and unsecured loans to developers if their performance is closely linked to the performance of the general CRE market.
 
·
The agencies recognize that banks serve a vital role in their communities by supplying credit for business and real estate development.  Therefore, the Guidance is not intended to limit banks’ CRE lending.  Instead, the Guidance encourages institutions to identify and monitor credit concentrations, establish internal concentration limits, and report all concentrations to management and the board of directors on a periodic basis.
 
·
The agencies recognized that different types of CRE lending present different levels of risk, and therefore, institutions are encouraged to segment their CRE portfolios to acknowledge these distinctions.  However, the CRE portfolio should not be divided into multiple sections simply to avoid the appearance of risk concentration.
 
·
Institutions should address the following key elements in establishing a risk management framework for identifying, monitoring, and controlling CRE risk: (1) board of directors and management oversight; (2) portfolio management; (3) management information systems; (4) market analysis; (5) credit underwriting standards; (6) portfolio stress testing and sensitivity analysis; and (7) credit review function.


 
·
As part of the ongoing supervisory monitoring processes, the agencies will use certain criteria to identify institutions that are potentially exposed to significant CRE concentration risk.  An institution that has experienced rapid growth in CRE lending, has notable exposure to a specific type of CRE, or is approaching or exceeds specified supervisory criteria may be identified for further supervisory analysis.

The Company believes that the Guidance is applicable to it, as it has a concentration in CRE loans, although that concentration has been reduced in recent years.  The Company and its board of directors have discussed the Guidance and believe that Mission Community Bank’s underwriting policy, management information systems, independent credit administration process and monthly monitoring of real estate loan concentrations adequately address the Guidance. See Loan Concentrations in Management’s Discussion and Analysis of Financial Condition and Results of Operations under Item 6 of Part II of this report.
 
Allowance for Loan and Lease Losses
 
In December 2006, the federal bank regulatory agencies released Interagency Policy Statement on the Allowance for Loan and Lease Losses (“ALLL”), which revised and replaced the banking agencies’ 1993 policy statement on the ALLL.  The revised statement was issued to ensure consistency with generally accepted accounting principles (GAAP) and more recent supervisory guidance.  The revised statement also extended the applicability of the policy to credit unions.  Additionally, the agencies issued 16 FAQs to assist institutions in complying with both GAAP and ALLL supervisory guidance.
 
Highlights of the revised statement include the following:
 
 
·
The revised statement emphasizes that the ALLL represents one of the most significant estimates in an institution’s financial statements and regulatory reports and that an assessment of the appropriateness of the ALLL is critical to an institution’s safety and soundness.
 
·
Each institution has a responsibility to develop, maintain, and document a comprehensive, systematic, and consistently applied process for determining the amounts of the ALLL.  An institution must maintain an ALLL that is sufficient to cover estimated credit losses on individual impaired loans as well as estimated credit losses inherent in the remainder of the portfolio.
 
·
The revised statement updated the previous guidance on the following issues regarding ALLL: (1) responsibilities of the board of directors, management, and bank examiners; (2) factors to be considered in the estimation of ALLL; and (3) objectives and elements of an effective loan review system.

The Company believes that its ALLL methodology is comprehensive, systematic, and that it is consistently applied across the Company.  The Company also believes its management information systems, independent credit administration process, policies and procedures adequately address the supervisory guidance.
 

Transactions Between Affiliates
 
Transactions between a bank and its “affiliates” are quantitatively and qualitatively restricted under the Federal Reserve Act.  The FRB has also issued Regulation W, which codifies prior regulations under Sections 23A and 23B of the Federal Reserve Act and interpretative guidance with respect to affiliate transactions.  Regulation W incorporates the exemption from the affiliate transaction rules but expands the exemption to cover the purchase of any type of loan or extension of credit from an affiliate.  Affiliates of a bank include, among other entities, companies that are under common control with the bank.  In general, subject to certain specified exemptions, a bank or its subsidiaries are limited in their ability to engage in “covered transactions” with affiliates:
 
 
·
to an amount equal to 10% of the bank’s capital and surplus, in the case of covered transactions with any one affiliate; and
 
·
to an amount equal to 20% of the bank’s capital and surplus, in the case of covered transactions with all affiliates.

In addition, a bank and its subsidiaries may engage in covered transactions and other specified transactions only on terms and under circumstances that are substantially the same, or at least as favorable to the bank or its subsidiary, as those prevailing at the time for comparable transactions with nonaffiliated companies. A “covered transaction” includes:
 
 
·
a loan or extension of credit to an affiliate;


 
·
a purchase of, or an investment in, securities issued by an affiliate;
 
·
a purchase of assets from an affiliate, with some exceptions;
 
·
the acceptance of securities issued by an affiliate as collateral for a loan or extension of credit to any party; and
 
·
the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate.
 
In addition, under Regulation W:
 
 
·
a bank and its subsidiaries may not purchase a low-quality asset from an affiliate;
 
·
covered transactions and other specified transactions between a bank or its subsidiaries and an affiliate must be on terms and conditions that are consistent with safe and sound banking practices; and
 
·
with some exceptions, each loan or extension of credit by a bank to an affiliate must be secured by collateral with a market value ranging from 100% to 130%, depending on the type of collateral, of the amount of the loan or extension of credit.

Regulation W generally excludes all non-bank and non-savings association subsidiaries of banks from treatment as affiliates, except to the extent that the FRB decides to treat these subsidiaries as affiliates. The Bank, under inter-company arrangements, charges Bancorp and MAM for management, staff, and/or services.  For 2010, the Bank charged Bancorp a total of $180,000 for services performed on its behalf by Bank employees.
 

Employees
 
As of December 31, 2010 the Company had a total of 64 employees (63 full-time equivalent employees).  Two of those employees are employed by Bancorp, two by MAM and 60 by the Bank.  MCDC has no salaried employees.
 

 
Reports to Security Holders.
 
Annual Report
 
An annual report to security holders including audited financial statements is sent each year by the Company.
 
Certain reports are filed by the Company with the Securities Exchange Commission pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.   The SEC maintains an Internet site (www.sec.gov/edgar.shtml) that contains reports and other information statements that the Company files electronically via the SEC’s EDGAR system, and which may be viewed on the site.  The public may also request public documents by calling the SEC at 202-551-8090.
 
Reports filed with the SEC by the Company may also be viewed via the Company’s Internet site (www.missioncommunitybank.com) on the “About Us / Investor Information” page.
 

 
Item 1A.  Risk Factors
 
In addition to other information contained in this Report, the following risks may affect the Company.  If any of these risks occur, the Company’s business, financial condition and operations results could be adversely affected
 
The Company’s business has been and may continue to be adversely affected by volatile conditions in the financial markets and deteriorating economic conditions generally.
 
From December 2007 through June 2009, the U.S. economy was in recession. Business activity across a wide range of industries and regions in the U. S. was greatly reduced.   The financial markets and the financial services industry in particular suffered unprecedented disruption, causing a number of institutions to fail or to require government intervention to avoid failure.
 


As a result of these financial and economic crises, many lending institutions, including the Company, have experienced declines in the performance of their loans.  Total nonperforming loans, including troubled debt restructurings, increased to $12.0 million as of December 31, 2010, from $6.7 million as of December 31, 2009, and $4.5 million as of December 31, 2008.  This represents 10.32%, 4.93%, and 2.93%, respectively, of total loans.  Total nonperforming loans, net of SBA guarantees, were $10.2 million as of December 31, 2010, as compared with $5.6 million as of December 31, 2009, and $3.1 million as of December 31, 2008.
 
Although economic conditions have begun to improve in California and nationally, certain sectors, such as real estate, remain weak and unemployment remains high.  The state government, most local governments, and many businesses are still in serious difficulty due to lower consumer spending and the lack of liquidity in the credit markets.  In addition, the values of the real estate collateral supporting many commercial loans and home mortgages have declined and may continue to decline.  Continued negative market developments also may continue to adversely affect consumer confidence levels and payment patterns, which could cause delinquencies and default rates to continue at high levels.
 
If business and economic conditions do not improve generally or in the principal markets in which we do business, the prolonged economic weakness could have one or more of the following adverse effects on our business:
 
 
·
a decrease in the demand for loans or other products and services we offer;
 
·
a decrease in the value of our loans or other assets secured by residential or commercial real estate;
 
·
a decrease in deposit balances due to overall reductions in the accounts of customers;
 
·
an impairment of our investment securities; and
 
·
an increase in the number of borrowers who become delinquent, file for protection under bankruptcy laws or default on their loans or other obligations to us, which in turn could result in a higher level of nonperforming assets, net charge-offs and provision for loan and lease losses, which would reduce our earnings.

Significant reliance on loans secured by real estate may increase the Bank’s vulnerability to the current downturn in the California real estate market and other variables impacting the value of real estate
 
A substantial portion of the Bank’s assets consist of real estate-secured loans (including construction loans) which are generally secured by real estate in the Central Coast of California.  At December 31, 2010, approximately $96 million or 80% of the Bank’s loans were real estate and construction loans, as compared to December 31, 2009, when approximately $109 million or 80% of its loans were real estate and construction loans. A prolonged and deepening of the current real estate contraction in the Central Coast of California could increase the level of non-performing assets and adversely affect results of operations. From 2008 through 2010, the real estate market in the Central Coast of California deteriorated significantly, as evidenced by declining prices, reduced transaction volume, decreased rents and increased foreclosure rates, and this deterioration resulted in an increase in the level of the Company’s nonperforming loans, particularly commercial real estate loans.  The Company had nonperforming commercial real estate and construction loans of $8.1 million and $2.6 million, respectively, as of December 31 2010, compared to $2.7 million and $2.0 million respectively, as of December 31, 2009.  If this real estate trend in the Company’s market areas continues to decline, the result could be reduced income, increased expenses, and less cash available for lending and other activities, which could have a material impact on the Company’s financial condition and results of operations.
 
In addition, banking regulators are now giving commercial real estate loans greater scrutiny, due to risks relating to the cyclical nature of the real estate market and related risks for lenders with high concentrations of such loans.  The regulators have required banks with higher levels of commercial real estate loans to implement enhanced underwriting, internal controls, risk management policies and portfolio stress testing, which has resulted in higher allowances for possible loan losses.  Expectations for higher capital levels have also materialized.
 
Our provision for loan losses and net loan charge-offs have increased significantly and we may be required to make further increases in our provisions for loan losses and to charge off additional loans in the future, which could adversely affect our results of operations
 
For the year ended December 31, 2010, we recorded a provision for loan losses of $5.8 million after net loan charge-offs of $8.1 million, compared to $5.1 million and $3.5 million, respectively, for the same periods in 2009.  We have experienced elevated levels of loan delinquencies and credit losses.  At December 31, 2010, our total non-performing assets, including foreclosed real estate, had increased to $15.1 million compared to $8.4 million at December 31, 2009.   Although the large provisions for loan losses in the year ended December 31, 2010 were made for the purpose of restoring our allowance for loan and lease losses to an appropriate level following a write-down of certain loans classified as “held
 


for-sale” to their fair values; the levels of loan delinquencies and credit losses were also contributing factors.  If current weak economic conditions continue, particularly in the construction and real estate markets, we expect that we would continue to experience higher than normal delinquencies and credit losses, and if the recession is prolonged, we could experience significantly higher delinquencies and credit losses.  As a result, we may be required to make further increases in our provision for loan losses and to charge off additional loans in the future, which could materially adversely affect our financial condition and results of operations.
 
Our allowance for loan and lease losses may not be adequate to cover actual losses.
 
A significant source of risk arises from the possibility that losses could be sustained because borrowers, guarantors, and related parties may fail to perform in accordance with the terms of their loans.  The underwriting and credit monitoring policies and procedures that we have adopted to address this risk may not prevent unexpected losses that could have a material adverse effect on our business, financial condition, results of operations and cash flows.  Unexpected losses may arise from a wide variety or specific or systematic factors, many of which are beyond our ability to predict, influence, or control.
 
Like all financial institutions, we maintain an allowance for loan and lease losses to provide for loan defaults and non-performance.  The allowance is funded from a provision for loan losses which is a charge to our statement of operations.  Our allowance for loan and lease losses may not be adequate to cover actual loan losses, and future provisions for loan losses could materially and adversely affect our business, financial condition, results of operations and cash flows.  The allowance for loan and lease losses reflects our estimate of the probable losses in our loan portfolio at the relevant balance sheet date.  Our allowance for loan and lease losses is based on historical experience, as well as an evaluation of known risks in the current portfolio, composition and growth of the loan portfolio and economic factors.  The determination of an appropriate level of loan loss allowance is an inherently difficult process and is based on numerous assumptions.  The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates, that may be beyond our control and these losses may exceed current estimates.
 
The process we use to estimate losses inherent in our credit exposure requires difficult subjective and complex judgments, including forecasts of economic conditions and how these economic conditions might impair the ability of our borrowers to repay their loans.  The level of uncertainty concerning current economic conditions may adversely affect the accuracy of our estimates, which may, in turn, impact the sufficiency and adequacy of the allowance for loan and lease losses.
 
While we believe that our allowance for loan and lease losses is adequate to cover current losses, we cannot assure you that we will not increase the allowance for loan and lease losses further or that our regulators will not require us to increase this allowance in future periods.  Either of these occurrences could materially adversely affect our business, financial condition, results of operations and cash flows.
 
Our use of appraisals in deciding whether to make a loan on, or secured by, real property does not ensure the value of the real property collateral
 
In considering whether to make a loan secured by real property, we require a recent appraisal of the property.  However, an appraisal is only an estimate of the value of the property at the time the appraisal is made, and appraisers may make mistakes of fact or judgment which adversely affect the reliability of their appraisal.  If the appraisal does not reflect the amount adequate to cover the indebtedness in the event of sale or foreclosure, the loan may not be granted. In addition, events occurring after the initial appraisal may cause the value of the real estate to decrease.  As a result of any of these factors, there may be less security than anticipated at the time the loan was originally made. If there is less security and a default occurs, we may not recover the outstanding balance of the loan.
 
All of our lending involves underwriting risks, especially in a competitive lending market
 
At December 31, 2010, commercial real estate loans (excluding residential and farmland) and construction loans represented 63% of the Company’s total loan portfolio.  Real estate lending involves risk associated with the potential decline in the value of underlying real estate collateral and the cash flow from income producing properties.  Declines in real estate values and cash flows can be caused by a number of factors, including adversity in general economic conditions, rising interest rates, changes in tax and other governmental and other policies affecting real estate holdings, environmental conditions, governmental and other use restrictions, development of competitive properties and increasing vacancy rates.  The Company’s dependence on commercial real estate loans increases the risk of loss both in the Company’s loan portfolio
 


and with respect to any other real estate owned when real estate values decline.  The Company seeks to reduce risk of loss through underwriting and monitoring procedures.
 
If a significant number of customers fail to perform under their loans, the Company’s business, profitability, and financial condition would be adversely affected
 
As a lender, the largest risk is the possibility that a significant number of client borrowers will fail to pay their loans when due.  If borrower defaults cause losses in excess of the allowance for loan and lease losses, it could have an adverse effect on the Bank’s business, profitability, and financial condition.  A regular evaluation process designed to determine the adequacy of the allowance for loan and lease losses is in place.  Although this evaluation process uses historical and other objective information, the classification of loans and the establishment of loan losses are dependent to a great extent upon experience and judgment.  Although management believes that the allowance for loan and lease losses is at a level adequate to absorb any inherent losses in the loan portfolio, there is no assurance that there will not be further increases to the allowance for loan and lease losses or that the regulators will not require an increase to this allowance.
 
The Bank’s earnings are subject to interest rate risks, especially if rates continue to decline
 
Traditionally, the major portion of the Bank’s net income comes from the interest rate spread, which is the difference between the interest rates paid on interest-bearing liabilities, such as deposits and other borrowings, and the interest rates received on interest-earning assets, such as loans extended to clients and securities held in the investment portfolio.  Interest rates are highly sensitive to many factors beyond our control, such as inflation, recession, global economic disruptions, and unemployment.  Fluctuations in interest rates affect the demand of customers for products and services.  The Bank is subject to interest rate risk to the degree that interest-bearing liabilities reprice or mature more slowly or more rapidly or on a different basis from interest-earning assets.  Given the current volume and mix of interest-bearing liabilities and interest earning assets, the interest rate spread can be expected to decrease when market interest rates are rising, and to increase when market interest rates are declining, i.e., the Bank is slightly “liability sensitive.”  Although management believes our current level of interest rate sensitivity is reasonable, significant fluctuations in interest rates may have an adverse impact on the interest rate spread.  Any material decline in the interest rate spread would have a material adverse effect on the Bank’s business and profitability.
 
The Bank has specific risks associated with Small Business Administration Loans
 
The Bank originated $4.9 million and $8.5 million in SBA loans in 2010 and 2009, respectively, of which $4.8 million and $5.8 million, respectively, was funded.  The Bank intends to increase its SBA loan origination in the future.  The Bank recognized $430,000 and $379,000, respectively, in 2010 and 2009 in gains recognized on secondary market sales of SBA loans.  The Bank has regularly sold the guaranteed portions of these loans in the secondary market in previous years.  We can provide no assurance that Mission Community Bank will be able to continue originating these loans, or that a secondary market will exist for, or that it will continue to realize premiums upon the sale of the SBA loans.  The federal government presently guarantees from 50% to 90% of the principal amount of each qualifying SBA loan, with most loans receiving a guarantee of at least 75%.  We can provide no assurance that the federal government will maintain the SBA program, or if it does, that such guaranteed portion will remain at its current funding level.  Furthermore, it is possible that the Bank could lose its preferred lender status which, subject to certain limitations, allows it to approve and fund SBA loans without the necessity of having the loan approved in advance by the SBA.  It is also possible that the federal government could reduce the amount of loans that it guarantees.  We believe that the SBA loan portfolio does not involve more than a normal risk of collectability.
 
In addition, we are dependent on the expertise of the personnel in our SBA loan department in order to originate and service SBA loans.  If we are unable to retain qualified employees in our SBA Department in the future our income from the origination, sale and servicing of SBA loans could be substantially reduced.  Further, in 2006, as rates on SBA loans climbed, a significant portion of SBA borrowers prepaid their loans, substantially reducing the servicing income we receive on these loans.  If there are similar increases in interest rates in the future, our income from servicing of SBA loans could be substantially reduced.
 
If we are not successful in carrying out the new aspects of our business plan our profitability will be adversely affected
 
We have implemented a strategy to grow our general commercial banking activities and have implemented new initiatives in this regard, including increased emphasis on our business banking, agribusiness lending and business
 


development activities, and we anticipate a branch expansion at our new South Higuera facility in San Luis Obispo.  If we are not successful in implementing any or all of these new aspects of our business plan, this would have a negative impact on our earnings.
 
Due to the possible loss of our status as a Community Development Financial Institution, we may lose our ability to obtain grants and awards as a CDFI like those we have received in the past.
 
Although our primary focus is as a community bank engaged in the general commercial banking business, we also engage in community development activities and a portion of our community development business has historically been augmented by our status as a Community Development Financial Institution (“CDFI”).  CDFI status increases the potential for receiving grants and awards that, in turn, enable a financial institution to increase the level of community development financial services that it provides to the communities.  Since 2001, we have received an aggregate of $3.4 million in grants made possible due to our status as a CDFI.
 
As a result of the change in control which occurred in the second quarter of 2010, pursuant to which our principal shareholder increased its percentage ownership in Mission Community Bancorp from 24.7% to more than 75%, the top tier holding company for Mission Community Bancorp does not meet the criteria under the defining Act for a CDFI and, therefore, each of Mission Community Bancorp and Mission Community Bank may lose its status as a Community Development Financial Institution.  In addition to losing the benefits of CDFI status, including the ability to attract awards and grants, if Mission Community Bancorp loses its CDFI status, it may be required to redeem its Series A and Series C preferred stock that were issued to the Community Development Financial Institutions Fund.  The funds required to redeem this preferred stock would be approximately $1.0 million.
 
Maintaining or increasing the Bank’s market share depends on the introduction and market acceptance of new products and services
 
Our success depends, in part, upon our ability to adapt our products and services to evolving industry standards and consumer demand.  There is increasing pressure on financial services companies to provide products and services at lower prices.  In addition, the widespread adoption of new technologies, including Internet-based services, could require us to make substantial expenditures to modify or adapt our existing products or services.  A failure to achieve market acceptance of any new products we introduce, or a failure to introduce products that the market may demand, could have an adverse effect on our business, profitability, or growth prospects.
 
The Bank faces substantial competition in its primary market area
 
We conduct our banking operations primarily in San Luis Obispo County and northern Santa Barbara County in the Central Coast of California.  Increased competition in our market may result in reduced loans and deposits.  Ultimately, we may not be able to compete successfully against current and future competitors.  Many competitors offer the same banking services that we offer in our service area.  These competitors include national banks, regional banks and other community banks.  We also face competition from many other types of financial institutions, including without limitation, savings and loan institutions, finance companies, brokerage firms, insurance companies, credit unions, mortgage banks and other financial intermediaries.  Additionally, banks and other financial institutions with larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the credit needs of larger customers.  Areas of competition include interest rates for loans and deposits, efforts to obtain deposits, and range and quality of products and services provided, including new technology-driven products and services.
 
Technology and other changes are allowing parties to complete financial transactions that historically have involved banks through alternative methods.  For example, consumers can now maintain funds in brokerage accounts or mutual funds that would have historically been held as bank deposits.  Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks.  The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits.  The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on the Company’s financial condition and results of operations.
 
In addition, with recent increased concerns about bank failures, customers increasingly are concerned about the extent to which their deposits are insured by the FDIC.  Customers may withdraw deposits in an effort to ensure that the amount they have on deposit with their bank is fully insured.  Decreases in deposits may adversely affect the Company’s funding costs and net income.
 


If the Bank fails to retain its key employees, its growth and profitability could be adversely affected
 
Our future success depends in large part upon the continuing contributions of our key management personnel.  If we lose the services of one or more key employees within a short period of time, we could be adversely affected.  Competition for such employees among financial institutions in California is intense.  Due to the lack of an experienced candidate pool in the San Luis Obispo area for the types of personnel we need to operate the Bank, we may be unable to quickly recruit new candidates to fill the positions of key personnel which we are unable to retain.  Qualified employees demand competitive salaries which we may not be able to offer.  Also, the Company is a recipient of capital funding through the Treasury’s Troubled Asset Relief Program (“TARP”), and the American Recovery and Reinvestment Act of 2009 places significant constraints on executive compensation paid by recipients of TARP funds.  Any inability to attract and retain additional key personnel in the future could adversely affect us.  We can provide no assurance that we will be able to retain any of our key officers and employees or attract and retain qualified personnel in the future.  However, we have entered into employment agreements with James Lokey, the Company’s Chief Executive Officer, which continues through June 30, 2013, with Anita Robinson, the Company’s President and the Chief Executive Officer of the Bank and MAM, which continues until December 31, 2012, and with Brooks W. Wise, Executive Vice President of the Company and President of the Bank, which continues until April 1, 2011.
 
The Company may be unable to manage future growth
 
We may encounter problems in managing our future planned growth.  In December 2008 we opened an additional “de novo” branch in Santa Maria, California.  We may open other branches and loan production offices in the future, including a planned full-service branch at 3380 S. Higuera Street in San Luis Obispo that is expected to open in April 2011.  In addition, we intend to investigate opportunities to acquire other financial institutions that would complement our existing business, as such opportunities may arise.  No assurance can be provided, however, that we will be able to identify additional locations to open additional branches or to identify a suitable acquisition target or consummate any such acquisition.  Further, our ability to manage growth will depend primarily on our ability to attract and retain qualified personnel, monitor operations, maintain earnings and control costs.  Any failure by us to accomplish these goals could result in interruptions in our business plans and could also adversely affect current operations.
 
The Bank’s larger funding sources could strain the Bank’s liquidity resources if a substantial amount is withdrawn in a short period of time
 
The Bank has a mix of deposits which includes 11 customers with deposits of $1 million or more totaling $52.8 million, approximately $32.4 million of which has been placed into the CDARS program.  If a substantial number of these large deposit customers choose to withdraw their funds when they mature, or if the Bank’s borrowing facility through the Federal Home Loan Bank of San Francisco (“FHLB”) were reduced, and the Bank is unable to develop alternate funding sources, the Bank may have difficulty funding loans or meeting deposit withdrawal requirements.
 
Recently enacted legislation and the Company’s participation in the TARP Capital Purchase Program may increase costs and limit the Company’s ability to pursue business opportunities.
 
The Emergency Economic Stabilization Act of 2008 (the “EESA”), as augmented by the American Recovery and Reinvestment Act of 2009, commonly referred to as the “Stimulus Bill”, was intended to stabilize and provide liquidity to the U.S. financial markets.  Though EESA, the Stimulus Bill and other emergency measures had the desired effect of providing liquidity and stabilizing the financial markets, it is impossible to predict what longer-term impacts this legislation, the related regulations and other governmental programs will have on such markets.  A continuation or worsening of current financial market conditions could adversely affect the Company’s business, financial condition and results of operations.  The programs established or to be established under the EESA and TARP have resulted in increased regulation of TARP Capital Purchase Program participants like the Company and may result in increased regulation of the industry in general.  Specifically, so long as shares of the Company’s Series D Preferred Stock issued as part of the TARP Capital Purchase Program remain outstanding, the Company man not declare or pay any dividends on its common stock, or repurchase or redeem any of its common stock, unless all accrued and unpaid dividends on the Series D Preferred Stock are fully paid.  In addition, the Company must comply with the U.S. Treasury’s standards for executive compensation, and severance payments to our senior executive officers.  Compliance with such regulations may increase the Company’s costs and limit its ability to pursue business opportunities.
 


The Company’s participation in the TARP Capital Purchase Program may adversely affect the value of the Company’s common stock and the rights of the Company’s common shareholders.
 
The terms of the preferred stock the Company issued under the Treasury’s Capital Purchase Program could reduce investment returns to the Company’s common shareholders by restricting dividends, diluting existing shareholders’ ownership interests, and restricting capital management practices. Without the prior consent of the Treasury, the Company is prohibited from increasing the Company’s common stock dividends for the first three years while the Treasury holds the preferred stock, which stock was acquired by the U.S. Treasury in January 2009.
 
Also, the preferred stock requires quarterly dividends to be paid at the rate of 5% per annum for the first five years and 9% per annum thereafter until the stock is redeemed by the Company. The payments of these dividends will decrease the excess cash the Company otherwise has available to pay dividends on the Company’s common stock and other series of preferred stock and to use for general corporate purposes, including working capital.
 
Finally, the Company is prohibited from paying dividends on its common stock and other series of preferred stock unless the Company has fully paid all required dividends on the preferred stock issued to the Treasury.  If for any reason the Company is unable to pay all required dividends on the TARP preferred stock, then the Company would be precluded from paying dividends on its common stock and other series of preferred stock.
 
The Company’s expenses have increased as a result of increases in FDIC insurance premiums.
 
Under the Federal Deposit Insurance Act, the FDIC, absent extraordinary circumstances, must establish and implement a plan to restore the deposit insurance reserve ratio to 1.35% of insured deposits at any time that the reserve ratio falls below 1.35%. Recent bank failures coupled with deteriorating economic conditions have significantly reduced the Deposit Insurance Fund’s reserve balance, which has been in a negative position since the end of 2009, and the FDIC currently has until September 30, 2020 to bring the reserve ratio back to the statutory minimum.  As noted above under “Regulation and Supervision—Deposit Insurance,” the FDIC has implemented a restoration plan that adopts a new assessment base and establishes new assessment rates starting with the second quarter of 2011.  The FDIC also imposed a special assessment in 2009 and required most depository institutions to prepay three years of FDIC insurance premiums at the end of 2009.  The prepayments were designed to help address the liquidity issues created by potential timing differences between the collection of premiums and charges against the DIF, but it is generally expected that assessment rates will remain relatively high in the near term due to the significant cost of bank failures and the relatively large number of troubled banks. Although we do not anticipate any increases in the Bank’s assessment rates in the near future, and in fact believe that our assessments may go down in the near term, should there be any further significant premium increases or special assessments in the future, this could have a material adverse effect on our financial condition and results of operations.
 
If the Bank cannot attract deposits, the Company’s growth may be inhibited.
 
The Bank’s ability to increase its assets in the long-term depends in large part on its ability to attract additional deposits at competitive rates.  The Bank intends to seek additional deposits by offering deposit products that are competitive with those offered by other financial institutions in our markets and by establishing personal relationships with our customers.  We cannot provide assurance that these efforts will be successful.  Any inability to attract additional deposits at competitive rates could have a material adverse effect on the Company’s business, financial condition, results of operations and cash flows.
 
Liquidity risk could impair our ability to fund operations and jeopardize our financial condition.
 
Liquidity is essential to the Company’s business.  An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a material adverse effect on our liquidity.  Access to funding sources in amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general.  Factors that could detrimentally impact our access to liquidity sources include a decrease in the level of our business activity due to a market downturn or adverse regulatory action against us.  Our ability to acquire deposits or borrow could also be impaired by factors that are not specific to us, such as a severe disruption of the financial markets or negative views and expectations about the prospects for the financial services industry as a whole, such as the recent turmoil faced by banking organizations in the domestic and worldwide credit markets.
 


The recent repeal of federal prohibitions on payment of interest on demand deposits could increase our interest expense.
 
All federal prohibitions on the ability of financial institutions to pay interest on demand deposit accounts were repealed as part of the Dodd-Frank Act. As a result, beginning on July 21, 2011, financial institutions could commence offering interest on demand deposits to compete for clients.   We do not yet know what interest rates other institutions may offer.  Our interest expense will increase and our net interest margin will decrease if we begin offering interest on demand deposits to attract additional customers or maintain current customers, which could have a material adverse effect on our business, financial condition and results of operations.
 
 

We may be exposed to risk of environmental liabilities with respect to properties to which we take title.
 
In the course of our business, we may foreclose and take title to real estate, and could be subject to environmental liabilities with respect to those properties.  We may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property.  The costs associated with investigation or remediation activities could be substantial.  In addition, if we are the owner or former owner of a contaminated site, we may be subject to contamination emanating from the property.  If we become subject to significant environmental liabilities, our business, financial condition, results of operations and cash flows may be materially and adversely affected.
 
If the Company’s information systems were to experience a system failure or a breach in its network security, the Company’s business and reputation could suffer.
 
The Company relies heavily on communications and information systems to conduct its business. The computer systems and network infrastructure we use could be vulnerable to unforeseen problems.  The Company’s operations are dependent upon its ability to protect its computer equipment against damage from fire, power loss, telecommunications failure or a similar catastrophic event.  In addition, the Company must be able to protect its computer systems and network infrastructure against physical damage, security breaches and service disruption caused by the Internet or other users.  Such computer break-ins and other disruptions would jeopardize the security of information stored in and transmitted through the Company’s computer systems and network infrastructure.  The Company has policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of its information systems and will continue to implement security technology and monitor and update operational procedures to prevent such damage.  However, if such failures, interruptions or security breaches were to occur, they could result in damage to the Company’s reputation, a loss of customer business, increased regulatory scrutiny, or possible exposure to financial liability, any of which could have a material adverse effect on the Company’s financial condition and results of operations.
 
The Company’s business may be adversely affected by the highly regulated environment in which it operates
 
Our operations are subject to extensive governmental supervision, regulation and control and recent legislation has substantially affected the banking business.  It cannot presently be predicted whether or in what form any pending or future legislation may be adopted or the extent to which the banking industry and our operations would be affected. Some of the legislative and regulatory changes may benefit us.  However, other changes could increase our costs of doing business or reduce our ability to compete in certain markets.
 
 
 
 
Item 2.
Properties
 
The Company occupies a property owned by the Bank at 581 Higuera Street, San Luis Obispo, California, where the Bank’s Downtown San Luis Obispo branch office is located.  For its administration offices, the Bank had been leasing, until December 2009, approximately 2,950 square feet at 569 Higuera St. in San Luis Obispo at a cost of $6,328 per month.  The leases expire on June 30, 2011.  A reserve has been set aside to either buy out the remainder of the lease or to apply to remaining lease payments.  Management has been negotiating with the landlord on the termination of these leases.  The administration office was located next to the Bank’s main branch office.
 


In October 2007, the Bank executed a 15-year build-to-suit triple-net lease for a full-service branch and administrative office at South Higuera Street and Prado Road (3380 S. Higuera Street) in San Luis Obispo, California.  The Bank moved its Administrative and Business Banking Center employees into this new facility in December 2009.  It is anticipated that Bank will open a full-service branch at this location in April 2011.  Currently the lease provides for lease payments of $39,139 per month.  The lease provides for two five-year renewal options.
 
The Bank also leases a branch office at 1226 Park Street, Paso Robles, California, at a cost of $6,085 per month.  The lease expires on July 31, 2013.
 
The Bank’s branch office at 154 West Branch Street, Arroyo Grande, California, is leased at a cost of $3,605 per month.  The lease expired in December 2010 and was renewed for a two-year period.
 
In March 2008, the Bank entered into a 5-year lease for an office building at 1670 South Broadway in Santa Maria, California, where the Bank opened a full-service branch office in December 2008.  The current rental cost is $9,028 per month.  The lease provides for two 5-year renewal options.  An option to purchase the property for a specified amount during the last two months of 2010 was not exercised.
 
The Bank’s Business Banking Center facility at 3440 and 3480 S. Higuera Street, San Luis Obispo, was leased for a five-year period at a cost of $6,925 per month.  The lease expired on December 31, 2009 and the Bank vacated the premises, moving the Business Banking Center’s operations to the new main office at 3380 S. Higuera Street.
 
In March 2011, the Bank entered into a three-year lease for an office suite in Oxnard, California, at an initial rate of $3,081 per month.  This space will be occupied by the Bank’s new Food and Agribusiness loan production office.
 
During 2005, the Bank purchased a parcel located near the intersection of 6th and Spring Streets in Paso Robles, where the Bank was planning to build a new branch office to replace the existing leased branch office in Paso Robles.  An adjacent parcel was purchased in 2006.  The property is carried as other real estate owned in the consolidated balance sheet.   Management and the Board of Directors are evaluating the future plan for this site, which is either to sell or plan for a future branch office.
 
For the years ended December 31, 2010 and 2009, the Bank’s total occupancy costs were approximately $1,270,000 and $1,002,000, respectively.  In the opinion of management, the premises are adequate for the Bank’s purposes and the Bank has sufficient insurance to cover its interest in the premises.  Note E to the Consolidated Financial Statements contains additional information about properties.
 
Bancorp is restricted by the bank holding company regulations in its power to hold real estate property for investment.  The Company does not currently invest in real estate, other than for purposes of operations and mortgage interests in real estate securing loans made by the Bank in the ordinary course of business, and has no plans to do so in the future.
 

Item 3.                      Legal Proceedings
 
The Company is, from time to time, subject to various pending and threatened legal actions which arise out of the normal course of its business.  After taking into consideration information furnished by counsel to the Company as to the current status of these claims or proceedings to which the Bank is a party, Management is of the opinion that the ultimate aggregate liability represented by these claims, if any, will not have a material adverse affect on the financial condition or results of operations of the Company.
 
There are no material proceedings adverse to the Company to which any director, officer, affiliate of the Company or 5% shareholder of the Company, or any associate of any such director, officer, affiliate or 5% shareholder is a party, and none of the above persons has a material interest adverse to the Company.
 

 
Item 4.                      Reserved
 


 
PART II
 

Item 5.
Market  for Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities
 
Market Information

The Company’s common stock is not listed on any exchange or market though it has traded infrequently in the over-the-counter market under the symbol “MISS.”  Howe Barnes, Wedbush Morgan Securities, and Hudson Securities, Inc. make a market in the Company’s Common Stock.  Certain information concerning the Common Stock is reported on the Nasdaq OTC Bulletin Board (www.otcbb.com).
 
The information in the following table indicates the daily high and low bid prices of the Company’s Common Stock for each quarterly period during the last two years based upon information provided by the OTC Bulletin Board. These prices do not include retail mark-ups, mark-downs or commission.
 

     
Bid Prices
 
     
Low
   
High
 
2009
1st Quarter
   $ 6.00      $ 10.05  
 
2nd Quarter
    7.30       9.00  
 
3rd Quarter
    7.30       7.45  
 
4th Quarter
    5.50       7.45  
2010
1st Quarter
    3.60       5.05  
 
2nd Quarter
    3.95       5.00  
 
3rd Quarter
    3.00       5.00  
 
4th Quarter
    3.00       4.45  


Holders

As of March 25, 2011, there were 319 holders of record of Bancorp’s Common Stock.
 

Dividends

The Company’s shareholders are entitled to receive dividends, when and as declared by its Board of Directors, out of funds legally available for dividends, subject to the restrictions set forth in the California General Corporation Law (the “Corporation Law”).  The Corporation Law provides that a corporation may make a distribution to its shareholders if the corporation’s retained earnings equal at least the amount of the proposed distribution.  It also provides that, in the event that sufficient retained earnings are not available for the proposed distribution, a corporation may nevertheless make a distribution to its shareholders if it meets two conditions, which generally stated are as follows: (i) the corporation’s assets equal at least 1.25 times its liabilities, and (ii) the corporation’s current assets equal at least its current liabilities or, if the average of the corporation’s earnings before taxes on income and before interest expenses for the two preceding fiscal years was less than the average of the corporation’s interest expenses for such fiscal years, then the corporation’s current assets must equal at least 1.25 times its current liabilities.
 
The availability of operating funds for Mission Community Bancorp and its ability to pay a cash dividend depends largely on the ability the Bank and Mission Asset Management, Inc. to pay a cash dividend to Bancorp.  The payment of cash dividends by Mission Asset Management, Inc. is subject to the provisions of the California General Corporation Law as set forth above.  The payment of cash dividends by the Bank is subject to certain restrictions.  In general, dividends may not be paid from any of the Bank’s capital or surplus.  Dividends must be paid out of available net profits, after deduction of all current operating expenses, actual losses, accrued dividends on preferred stock, if any, and all federal and state taxes.  Additionally, a California state bank is prohibited from declaring a dividend on its shares of common stock until its surplus fund equals its common capital, or, if its surplus fund does not equal its common capital, until at least one-tenth of the bank’s net profits, for the preceding half year in the case of quarterly or semi-annual dividends, or the preceding full year in the case of an annual dividend, are transferred to its surplus fund each time dividends are declared.  Regulatory approval is required if the total of all dividends declared by a bank in any calendar year exceeds the total of its net profits for that year combined with its retained net profits of the two preceding years, less any required transfers to surplus or a fund for the retirement of any preferred stock.
 
 Further, the bank regulatory agencies have established guidelines with respect to the maintenance of appropriate levels of capital by banks or bank holding companies under their jurisdiction.  Compliance with the standards set forth in such guidelines and the restrictions that are or may be imposed under the prompt corrective action provisions of federal law could limit the amount of dividends which the Bank or the Company may pay.
 
Furthermore, bank regulators also have authority to prohibit the payment of dividends by a bank when it determines such payment to be an unsafe and unsound banking practice.  Due to the Company’s and the Bank’s net losses from 2008 through 2010, the Company’s and the Bank’s regulators have required that the Company and the Bank obtain approval in advance prior to the payment of any dividends, even though each remains well capitalized.
 
Quarterly dividends totaling $255,800 were paid on the Company’s Series D (TARP) preferred stock in 2010 and Series D dividends totaling $217,430 were paid in 2009.  No dividends were declared or paid on the Company’s common or Series A through C preferred stock in 2009 or 2010.
 
Whether or not stock or cash dividends will be paid in the future by the Company and/or the Bank will be determined by the Board of Directors after consideration of various factors including, but not limited to, profitability, regulatory capital ratios, and financial condition.  Additionally, certain provisions of the preferred stock issuances restrict the ability of the Company to pay cash dividends on common stock unless the required dividends on the preferred stock are also paid.
 
The Company has issued and outstanding $3,093,000 of junior subordinated debt securities due October 2033.  The indenture pursuant to which these debt securities were issued provides that the Company must make interest payments on the debentures before any dividends can be paid on its capital stock and, in the event of the Company’s bankruptcy, dissolution or liquidation, the holder of the debt securities must be paid in full before any distributions may be made to the holders of our capital stock.  In addition, the Company has the right to defer interest payments on the junior subordinated debt securities for up to five years, during which time no dividends may be paid to holders of the Company’s capital stock.
 
On January 9, 2009, in exchange for aggregate consideration of $5,116,000, Mission Community Bancorp issued to the Treasury Department a total of 5,116 shares of a new Series D Preferred Stock having a liquidation preference of $1,000 per share.  This transaction was a part of the TARP Capital Purchase Program.  The Series D Preferred pays cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter.  Until January 1, 2012, the consent of the Treasury Department will be required for the Company to issue dividends on the Company’s common stock.  Further, if the Company should miss six quarterly dividend payments due on the Series D Preferred Stock, whether or not consecutive, the holders of the Series D Preferred Stock (currently the U.S. Treasury) would have the right to elect two directors to the Company’s Board of Directors.  The Company has applied for an additional issuance of preferred stock as part of the U.S. Treasury’s recently created Small Business Lending Fund program.  The Company’s application is currently pending and subject to receipt of all required regulatory approvals.  See “Item 1—description of Business—Recent Developments.”
 


Equity Compensation Plans
 
The following table shows, as of December 31, 2010, each category of equity compensation along with i) the number of securities to be issued upon the exercise of outstanding options, warrants and rights, ii) the weighted-average exercise price of the outstanding options, warrants and rights, and iii) the remaining number of securities available for future issuance under the plans, excluding stock options currently outstanding.
 

 
Equity Compensation Plan Information
 
                   
   
Number of securities to be issued upon exercise of outstanding options, warrants and rights
   
Weighted average exercise price of outstanding options, warrants and rights
   
Number of additional securities available for future grant under the plan
 
Equity compensation plans approved by security holders
    183,432     $ 10.39       60,408  
                         
Equity compensation plans not approved by security holders
    -       -       -  
                         
Total
    183,432     $ 10.39       60,408  

 
See Note J to the consolidated financial statements for a discussion of the Company’s Stock Option Plans.
 
Report of Offering of Securities and Use of Proceeds Therefrom
 
In an unregistered sale of equity securities, Bancorp sold on April 27, 2010, to Carpenter Community BankFund, L.P., Carpenter Community BanFund-A, L.P. and Carpenter Community BankFund-CA, L.P. (collectively, the “Investment Funds”) 2,000,000 shares of its authorized but unissued common stock and warrants to purchase 2,000,000 shares of its common stock at an exercise price of $5.00 per share in an initial closing pursuant to a Securities Purchase Agreement dated December 22, 2009, as amended, (“the Securities Purchase Agreement”) by and between Bancorp and Carpenter Fund Manager GP, LLC (“the Manager”) on behalf of and as general partner of the Investment Funds.  The securities were purchased for an aggregate purchase price of $10 million or $5.00 per unit of one share of common stock and one warrant.
 
On June 15, 2010 Bancorp sold an additional 3,000,000 shares of its authorized but unissued common stock and five-year warrants to purchase 3,000,000 shares of its common stock to the Investment Funds at an exercise price of $5.00 per share pursuant to the Securities Purchase Agreement at a price of $5.00 per unit of one share of common stock and one warrant or an aggregate purchase price of $15 million.
 
There were no underwriting discounts or commissions paid with respect to the sales pursuant to the Securities Purchase Agreement.  Each of those sales above was made pursuant to an exemption from registration set forth in Section 4(2) of the Securities Act of 1933, as amended, and the rules and regulations promulgated pursuant thereto, as a privately negotiated transaction not involving a public offering.
 
The Company used a substantial majority of the proceeds from sales of securities pursuant to the Securities Purchase agreement to enable a newly-formed wholly owned subsidiary of the Company, Mission Asset Management, Inc., to purchase from the Bank certain non-performing loans and other real estate owned assets.
 
Prior to April 27, 2010, the Manager was the largest shareholder of the Company, beneficially owning 333,334 shares of the common stock of the Company or 24.7% of the issued and outstanding shares.  Immediately following the sales of securities pursuant to the Securities Purchase Agreement, the Manager was the beneficial owner of 5,333,334 shares of the common stock of the Company (not including warrants) or 84.0% of the issued and outstanding shares.
 


The Securities Purchase Agreement provided that the Company would conduct a Rights Offering (“the Rights Offering”) to its existing shareholders, pursuant to which each shareholder would be offered the right to purchase additional shares of common stock, paired with a warrant, at a price of $5.00 per unit of common stock and warrant.  Bancorp filed a registration statement with the Securities and Exchange Commission for the offer and sale of the rights, shares of common stock and common stock purchase warrants, on August 31, 2010.  The Rights Offering commenced on October 8, 2010, and closed on December 15, 2010.  Rights to purchase an aggregate of 748,672 shares of common stock and five-year warrants to purchase an additional 748,672 shares of common stock were exercised in the Rights Offering for gross proceeds to Bancorp of $3,743,360.  The proceeds from the Rights Offering were used to provide additional working capital for Bancorp.  Following the closing of the Rights Offering, the Manager is the beneficial owner of 75.2% of the issued and outstanding common shares.
 


Item 6.                            Selected Financial Data
The following is selected consolidated financial data with respect to the Company’s consolidated financial statements for the three years ended December 31, 2010, 2009 and 2008. The information presented has been derived from the audited consolidated financial statements included in Item 7 of Part II of this Form 10-K.  This information should be read in conjunction with such consolidated financial statements and the notes thereto.


   
Year Ended December 31,
 
                   
In thousands, except share and per share data
 
2010
   
2009
   
2008
 
Interest income
  $ 8,882     $ 10,283     $ 11,073  
Interest expense
    1,991       3,877       4,830  
Net interest income
    6,891       6,406       6,243  
Provision for loan losses
    5,800       5,056       4,245  
Non-interest income
    1,711       833       346  
Non-interest expense
    9,486       8,275       7,121  
Loss before income taxes
    (6,684 )     (6,092 )     (4,777 )
Income tax expense (benefit)
    -       835       (929 )
Net loss
  $ (6,684 )   $ (6,927 )   $ (3,848 )
Net loss allocable to common stock
  $ (6,754 )   $ (6,557 )   $ (3,465 )
                         
Balance Sheet Data at End of Year
                       
Assets
  $ 217,801     $ 193,105     $ 215,490  
Earning assets
    206,015       183,548       199,880  
Total loans
    120,225       136,410       153,311  
Deposits
    173,240       163,770       144,804  
Total shareholders' equity
    39,143       18,638       20,517  
Preferred equity
    5,684       6,227       1,686  
Common equity
    33,459       12,411       18,831  
Number of common shares outstanding
    7,094,274       1,345,602       1,345,602  
Average Balance Sheet Data
                       
Assets
  $ 204,864     $ 217,268     $ 190,792  
Earning assets
    193,067       207,865       181,232  
Loans
    128,666       148,636       142,342  
Deposits
    164,956       159,866       130,841  
Shareholders' equity
    30,916       24,791       18,451  
Per Common Share Data
                       
Basic loss per share
  $ (1.54 )   $ (4.87 )   $ (3.18 )
Diluted loss per share
    (1.54 )     (4.87 )     (3.18 )
Average number of common shares outstanding - basic
    7,094,274       1,345,602       1,090,569  
Average number of common shares outstanding - diluted
    7,094,274       1,345,602       1,090,569  
Book value per common share
  $ 4.72     $ 9.22     $ 13.99  
Cash dividends declared
    -       -       -  
Performance Ratios
                       
Return (loss) on average assets
    (3.26 )%     (3.19 )%     (2.02 )%
Return (loss) on average shareholders' equity
    (21.62 )%     (27.94 )%     (20.86 )%
Average equity to average assets
    15.09 %     11.41 %     9.67 %
Efficiency ratio
    117.04 %     118.35 %     108.07 %
Leverage ratio
    19.37 %     10.06 %     10.31 %
Net interest margin
    3.64 %     3.15 %     3.53 %
Non-interest revenue to total revenue
    19.89 %     11.51 %     5.25 %
Asset Quality
                       
Non-performing assets
  $ 15,141     $ 8,363     $ 4,580  
Allowance for loan losses
    3,198       5,537       3,942  
Net charge-offs
    8,139       3,461       1,453  
Non-performing assets to total assets
    6.95 %     4.33 %     2.13 %
Allowance for loan losses to loans
    2.66 %     4.06 %     2.57 %
Net charge-offs to average loans
    6.33 %     2.33 %     1.02 %



Item 7.  Management’s Discussion and Analysis

 
Executive Summary

The Company incurred a net loss of $(6.7) million for 2010, as compared to a net loss of $(6.9) million in 2009.  Although a pre-tax loss was incurred in 2009, income tax expense of $835 thousand was recognized, resulting from an increased valuation allowance for deferred tax assets.  No income tax benefit was recognized in 2010, as the valuation allowance for deferred tax assets was increased such that a 100% valuation allowance was maintained.

As the recession that began in 2007 continued into 2009, demand for quality loans declined and total assets decreased to $193.1 million at December 31, 2009, a 10.4% decline from December 31, 2008.  As of December 31, 2010, total assets had increased to $217.8 million—a 12.8% increase from year-end 2009.  Loan balances in 2010 continued the decline begun in 2009, yet deposit growth was strong in both 2009 and 2010.  Deposits increased $19.0 million, or 13.1%, in 2009, and another $9.5 million, or 5.8%, in 2010.  With the deposit growth and contraction in loan balances, borrowed funds were reduced by $39.7 million in 2009 and by another $5.7 million in 2010.  Total earning assets (including securities and interest-bearing deposits in other banks) decreased by $22.6 million in 2009, and then increased by another $18.9 million in 2010.  This restructuring of the balance sheet has substantially strengthened the Company’s liquidity position over the past two years.

On a per share basis, the Company’s net loss for the year ended December 31, 2010, was $(1.54) per diluted share.  This compares with a net loss of $(4.87) per diluted share in 2009.

The following are the major factors impacting the Company’s results of operations and financial condition over the past two years.
 
·
A high level of provision for loan losses.  Real estate conditions weakened as the overall economy contracted during the first year of the Great Recession.  As the real estate contraction became more prolonged in 2009 and 2010, more of our borrowers were unable to weather the storm.  We charged off $1.8 million of construction and land development loans and $0.9 million of commercial and residential real estate loans in 2009.  Net charge-offs totaled $3.5 million in 2009, up from $1.5 million in 2008.  We had set aside additional reserves in 2008 that covered the 2009 charge-offs, but by year-end 2009 we had increased the allowance for loan and lease losses to $5.1 million—approximately $1.6 million higher than at the end of 2008.  In 2010, the provision for loan and lease losses increased to $5.8 million, although $5.25 million of that amount was directly related to a reclassification of certain loans to “held for sale,” as discussed below.
 
·
A reclassification of certain loans to “held for sale.”  In order to allow for an orderly workout of some of the Bank’s larger classified loans, the Bank in mid-year 2010 reclassified $22.2 million of those loans to held for sale.  Those loans, along with all of the Bank’s OREO properties, were then sold by the Bank to the Company’s new Mission Asset Management, Inc. subsidiary.  Generally accepted accounting principles require that loans held for sale be carried at the lower of amortized cost or fair value.  Therefore, in conjunction with the reclassification, the Bank wrote down the value of those loans by $5.488 million, through charge-offs to the allowance for loan and lease losses.  The loan charge-offs did not directly affect net income but $5.250 million in loan loss provision was required to replenish the allowance for loan and lease losses to the appropriate level following the substantial level of charge-offs as a result of the reclassification to held for sale.  Excluding the loan loss provision related to this reclassification, the 2010 provision for loan losses would have been $550 thousand.
 
·
An increase in non-performing assets.  Even as portions of the economy began to recover in 2009 and 2010, real estate related segments of the economy remained in recessionary territory, further stressing our loan portfolio.  Non-performing loans, including troubled debt restructurings, increased in 2009 to $6.7 million, up from $4.5 million at the end of 2008.  By December 31, 2010, non-performing loans had increased to $12.0 million.  Foreclosed real estate increased from $83 thousand at the end of 2008 to $1.6 million as of December 31, 2009, and $3.1 million at the end of 2010.
 
·
A changing net interest margin.  The net interest margin for 2009 was 3.15%, down 0.38 percentage points from 2008.  For 2010, the margin recovered to 3.66%, an increase of 0.51 percentage points from 2009.  Short-term interest rates dropped 4 full percentage points in 2008 and remained at that low level throughout 2009 and 2010.  The steep rate drop in 2008 put downward pressure on the margin, as competition for deposits in the local market would not permit decreases in deposit rates at the same speed or to the same degree as loan rates were falling.  As reductions in deposit rates eventually caught up with the drop in loan rates, and high-cost borrowed funds were repaid, the margin began a steady improvement in April 2009, which continued until April 2010.  By mid-year 2010, an increase in non-accrual loans and a much more liquid balance sheet put more downward pressure on the margin.


 
·
We increased our valuation allowance for deferred tax assets.  The valuation allowance ($7.4 million in 2010 and $4.6 million in 2009) was established because the Company’s cumulative net operating losses exceed its ability to fully recognize deferred tax assets by carrying the losses back to previous tax years.  The valuation allowance can begin to be reversed—providing a potential increase to net income in future years—as the Company returns to profitability.
 
·
We raised $33.9 million in additional capital ($33.5 million net of stock issuance costs) over the past two years.  In 2009 the Company issued to the United States Department of the Treasury (“the Treasury”) a total of 5,116 shares of Series D Fixed Rate Cumulative Perpetual Preferred Stock at $1,000 per share.  This transaction was a part of the Capital Purchase Program of the TARP.  The $5.1 million in new capital was subsequently invested in Mission Community Bank as Tier 1 capital.  In 2010 the Company’s largest shareholder purchased an additional 5,000,000 shares of common stock and warrants to purchase 5,000,000 shares of common stock for an aggregate purchase price of $25 million.  A substantial majority of the proceeds from sales of these securities was used to enable a newly-formed subsidiary of the Company, Mission Asset Management, Inc., to purchase from the Bank certain non-performing loans and other real estate owned assets.  Subsequently, the Company conducted a Rights Offering to its other shareholders, pursuant to which each shareholder received, with respect to each share of common stock owned by the shareholder, the right to purchase 15 additional shares of common stock, each paired with a warrant, at a price of $5.00 per unit of common stock and warrant.  Rights to purchase 748,672 shares of common stock and warrants to purchase an additional 748,672 shares of common stock were exercised in the Rights Offering for gross proceeds to Bancorp of $3,743,360.

Critical Accounting Policies
 
A critical accounting policy is defined as one that is both material to the presentation of the Company’s financial statements and requires management to make difficult, subjective or complex judgments that could have a material effect on the Company’s financial condition and results of operations and may change in future periods.  Note A to the Consolidated Financial Statements describes the significant accounting policies used in the preparation of the Consolidated Financial Statements.  Not all of these accounting policies require management to make difficult, subjective or complex judgments or estimates.  However, management believes that the following policies could be considered critical.

Reserves and Contingencies

In the normal course of business, the Company must manage and control certain risks inherent to the business of banking.  These include credit risk, interest rate risk, fraud risk, and operations and settlement risk.  The Company has established reserves for risk of losses, including loan losses.

The allowance for loan and lease losses represents management’s estimate of the probable credit losses that have occurred as of the date of the financial statements, as further described in Note A in the Notes to the Consolidated Financial Statements.  See also Allowance for Loan and Lease Losses below.  These reserves or accruals are reviewed by management at least quarterly.  If the latest estimate of loss (or the actual loss) differs from the accrual or reserve recorded to date, the financial impact is reflected in the period in which the estimate is revised (or the actual loss is determined).  Management believes that the allowance for loan and lease losses is a “critical accounting estimate” because it is based upon management’s assessment of various factors affecting the collectability of the loans, including current economic conditions, past credit experience, delinquency status, the value of the underlying collateral, if any, and a continuing review of the portfolio of loans.  We cannot provide you with any assurance that economic difficulties or other circumstances which would adversely affect our borrowers and their ability to repay outstanding loans will not occur.  Such economic difficulties or other circumstances could be reflected in increased losses in our loan portfolio, which could result in actual losses that exceed reserves previously established.

Other real estate owned (“OREO”) represents properties acquired through foreclosure or physical repossession.  Write-downs to fair value at the time of transfer to OREO are charged to allowance for loan and lease losses.  Subsequent to foreclosure, management periodically evaluates the value of OREO held for sale and records a valuation allowance for any subsequent declines in fair value less selling costs.  Subsequent declines in value are charged to operations.  Fair value is based on management’s assessment of information available to the Company at the end of a reporting period and depends upon a number of factors, including economic conditions, the Company’s historical experience, and issues specific to individual properties.  Management’s evaluation of these factors involves subjective estimates and judgments that may change.

Compensation cost is recognized for all stock based awards that vest subsequent to January 1, 2006 based on the grant-date


fair value of the awards.  We believe this is a “critical accounting estimate” since the grant-date fair value is estimated using the Black-Scholes-Merton option-pricing formula, which involves making estimates of the assumptions used, including the expected term of the option, expected volatility over the option term, expected dividend yield over the option term and risk-free interest rate.  In addition, when determining the compensation expense to amortize over the vesting period, management makes estimates about the expected forfeiture rate of options.

Loans designated as held for sale are carried at the lower of cost or fair market value.  The estimate of fair value is a critical accounting estimate because it is susceptible to changes in assumptions or other factors that are outside the control of management.  In addition, the assumptions used in determining the fair value of a loan held for sale may be based on a combination of observable and unobservable inputs.

Revenue recognition

The Company’s primary source of revenue is interest income from loans and investment securities.  Interest income is recorded on an accrual basis.  Note A in the Notes to the Consolidated Financial Statements contains an explanation of the process for determining when the accrual of interest income is discontinued on impaired loans and under what circumstances loans are returned to an accruing status.

The Company also records gains in connection with the sale of the guaranteed portion of certain SBA-guaranteed loans for which the Bank retains the right to service the loans.  Recording of such gains involves the use of estimates and assumptions related to the expected life of the loans and future cash flows from loan servicing fees.  Notes A and C in the Notes to the Consolidated Financial Statements contain additional information regarding the Company’s accounting policy for revenue recorded in connection with the sale of loans.  SBA loan servicing rights are based upon estimates and are subject to the risk of prepayments and market value fluctuation.

Income Taxes

A net deferred income tax asset arises from differences in the dates that items of income and expense enter into our reported income and taxable income.  Deferred tax assets and liabilities are established for these items as they arise.  From an accounting standpoint, deferred tax assets are reviewed to determine if a valuation allowance is required based on both positive and negative evidence currently available.  We have determined the need to establish a valuation allowance for deferred tax assets, based on the weight of available evidence, that it is less likely that some portion or all of the deferred tax assets may be realized.

Additionally, we review our uncertain tax positions annually.  An uncertain tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur.  The amount actually recognized is the largest amount of tax benefit that is greater than 50% likely to be recognized on examination.  For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.  A significant amount of judgment is applied to determine both whether the tax position meets the “more likely than not” test as well as to determine the largest amount of tax benefit that is greater than 50% likely to be recognized.  Differences between the position taken by management and that of taxing authorities could result in a reduction of a tax benefit or increase to tax liability, which could adversely affect future income tax expense.

Basis of Presentation
 
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities 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.

The following discussion and analysis is intended to assist in an understanding of the significant factors that affected our consolidated financial condition and results of operations for the years ended December 31, 2010 and 2009.  This discussion, which refers to the Company on a consolidated basis, should be read in conjunction with the Company’s consolidated financial statements and corresponding notes.

Bancorp is inactive except for interest expense associated with the junior subordinated debentures (related to the trust preferred securities), salaries and benefits of a small number of employees performing executive and administrative functions, and minimal other expenses.



The Bank operates as a traditional community bank, but has also used management’s expertise as a CDFI to provide a selection of financial services identified as “community development” activities, with a focus on financial services to under-served markets, small businesses and business professionals.  Historically, Bancorp and the Bank have received and used both grants and deposits under programs authorized by CDFI.  Due to a recent change in control, it is anticipated that the Bank and the Company will lose their respective status as CDFI’s in the near future and, accordingly, will no longer be eligible for grants and deposit programs available to CDFI’s from various government and public/private entities.  The CDFI status is dependent on management’s specialized knowledge of working with various governmental programs and requires a significant increase in reporting and documentation as compared with traditional bank activities.

MCDC provides financing and loan servicing for small businesses and low- to moderate-income areas based on direct loans or funding pools established in conjunction with others.  MCDC provides loan servicing for several small loans owned by the San Luis Obispo County Economic Vitality Corporation.  MCDC also manages a loan pool for the San Luis Obispo County Housing Trust Fund to assist in providing affordable housing.  MCDC had also been servicing the San Simeon Earthquake Recovery Loan Fund (the “Earthquake Fund”), a loan pool funded by the Bank and other local banks.  By December 31, 2010, as the loans made by the Earthquake Fund had been paid off, the full amount of the participating banks’ initial investments was returned.  The consortium is considering alternative community development uses for the loan pool.

Mission Asset Management, Inc. (“MAM”) was established in 2010 to facilitate the orderly sale or resolution of the Bank’s foreclosed real estate and certain lower-quality loans.  To that end, in 2010 the Bank reclassified $22.4 million of classified loans (including $10.3 million of nonaccrual loans) to “held for sale,” writing down the value of those loans to $16.9 million through charge-offs to the allowance for loan and lease losses.  Those loans, along with $1.0 million of other real estate, were sold from the Bank to MAM at the aggregate purchase price of $17.9 million.

MCSC provides technical assistance services and training to the underserved segments of the community including small businesses, minorities and low-income entrepreneurs.  During 2006, MCSC was awarded a five-year, $750,000 grant from the U.S. Small Business Administration to fund one of 99 Women’s Business Centers nationwide.  While MCSC has not engaged in any direct lending, it may provide some lending in the near future.  As of December 31, 2010, the Bank has had limited direct benefit from its association with MCSC.  See also Note M to the Consolidated Financial Statements for additional information regarding MCSC.
 
Results of Operations

 Average Balance Sheets and Analysis of Net Interest Income

The principal component of earnings for most banks is net interest income.  Net interest income is the difference between the interest earned on loans and investments and the interest paid on deposits and other interest-bearing liabilities.

The banking industry uses two key ratios to measure relative profitability of net interest income.  The net interest rate spread measures the difference between the average yield on earning assets and the average rate paid on interest bearing liabilities.  The interest rate spread ignores the beneficial impact of non-interest bearing deposits and capital, and provides a direct perspective on the effect of market interest rate movements.  The net interest margin is defined as net interest income as a percentage of average interest-earning assets.  This ratio includes the positive impact of obtaining a portion of the funding for earning assets with non-interest bearing deposits and capital.

The following table presents, for the periods indicated, the total dollar amounts of interest income from average interest-earning assets and the resultant yields. Also presented are the dollar amounts of interest expense and average interest-bearing liabilities, expressed both in dollars and in rates.


 
 
Net Interest Analysis
                                                     
 (Dollars in thousands)
                                                     
   
For the Year Ended
 
   
December 31, 2010
   
December 31, 2009
   
December 31, 2008
 
   
Average
         
Average
   
Average
         
Average
   
Average
         
Average
 
   
Balance
   
Interest
   
Rate
   
Balacce
   
Interest
   
Rate
   
Balance
   
Interest
   
Rate
 
ASSETS
                                                     
Interest-earning assets:
                                                     
  Loans, net of unearned income*
  $ 128,666     $ 7,539       5.91 % *   $ 148,636     $ 8,889       6.03 % *   $ 142,342     $ 9,598       6.80 % *
  Investment securities*
    48,141       1,296       2.87 % *     35,945       1,259       3.70 % *     23,966       1,122       4.99 % *
  Federal funds sold
    -       -       -       7,419       16       0.21 %     7,314       122       1.67 %
  Other interest income
    16,260       47       0.29 %     15,865       119       0.75 %     7,610       231       3.03 %
Total interest-earning assets / interest income
    193,067       8,882       4.68 %     207,865       10,283       5.02 %     181,232       11,073       6.19 %
Non-interest-earning assets:
                                                                       
  Allowance for loan losses
    (4,253 )                     (3,635 )                     (2,118 )                
  Cash and due from banks
    3,251                       2,720                       2,987                  
  Premises and equipment
    3,318                       2,833                       3,529                  
  Other assets
    9,481                       7,485                       5,162                  
Total assets
  $ 204,864                     $ 217,268                     $ 190,792                  
                                                                         
LIABILITIES AND SHAREHOLDERS' EQUITY
                                                                 
Interest-bearing liabilities:
                                                                       
  Interest-bearing deposits:
                                                                       
    Interest-bearing demand accounts
  $ 18,353       135       0.73 %   $ 12,594       145       1.15 %   $ 17,187       361       2.10 %
    Savings and Money Market deposit accounts
    38,846       348       0.90 %     30,585       370       1.21 %     19,309       327       1.70 %
    Certificates of deposit
    84,513       1,192       1.41 %     93,540       2,150       2.30 %     72,187       2,471       3.42 %
    Total interest-bearing deposits
    141,712       1,675       1.18 %     136,719       2,665       1.95 %     108,683       3,159       2.91 %
  Federal Home Loan Bank advances
    3,616       181       4.99 %     28,161       1,096       3.89 %     37,232       1,450       3.89 %
  Other borrowed funds
    613       32       5.28 %     10       -       0.61 %     34       1       2.81 %
  Subordinated debt
    3,093       103       3.34 %     3,093       116       3.75 %     3,093       220       7.12 %
    Total borrowed funds
    7,322       316       4.32 %     31,264       1,212       3.88 %     40,359       1,671       4.14 %
Total interest-bearing liabilities / interest expense
    149,034       1,991       1.34 %     167,983       3,877       2.31 %     149,042       4,830       3.24 %
Non-interest-bearing liabilities:
                                                                       
  Non-interest-bearing deposits
    23,244                       23,147                       22,158                  
  Other liabilities
    1,670                       1,347                       1,141                  
  Total liabilities
    173,948                       192,477                       172,341                  
Shareholders' equity
    30,916                       24,791                       18,451                  
Total liabilities and shareholders' equity
  $ 204,864                     $ 217,268                     $ 190,792                  
Net interest-rate spread
                    3.34 %                     2.71 %                     2.95 %
Impact of non-interest-bearing
                                                                       
  sources and other changes in
                                                                       
  balance sheet composition
                    0.30 %                     0.44 %                     0.58 %
Net interest income / margin on earning assets
    $ 6,891       3.64 % **           $ 6,406       3.15 % **           $ 6,243       3.53 % **
                                                                         
*Yields on municipal securities and loans have been adjusted to their fully-taxable equivalents
                                                 
** Net interest income as a % of earning assets
                                                                       
Non-accrual loans are included in the calculation of the average balances of loans; interest not accrued is excluded.

Net interest income is affected by changes in the amount and mix of our interest-earning assets and interest-bearing liabilities, referred to as the change due to volume.  Average interest-earning assets grew by $26.6 million in 2009 over 2008 and decreased by $15.6 million in 2010 over 2009.  All categories of interest-earning assets—both long-term and liquid assets—grew substantially in 2009, but loans contracted in 2010 (based on average balances outstanding during the year), as demand for new loans has been weak since the recession began.  Interest-bearing liabilities increased $18.9 million in 2009 as compared to 2008, and then contracted by $19.0 million in 2010.  Borrowed funds—a relatively high cost source of funds—were paid off in 2009 and 2010, as the Bank experienced strong growth in deposits and management executed on a plan to reduce non-core funding.

Net interest income is also affected by changes in the yields we earn on interest-earning assets and the rates we pay on interest-bearing deposits and borrowed funds, referred to as the change due to rate.  The average yield on interest-earning assets decreased by 117 basis points (1.17%) in 2009, while the average rate paid on interest-bearing liabilities decreased by only 93 basis points, causing pressure on the net interest margin.  As a result, the net interest margin decreased 38 basis points in 2009, from 3.53% to 3.15%.  The 400-basis-point drop in the prime interest rate in 2008 put downward pressure on the margin, as competition for deposits in the local market would not permit decreases in deposit rates at the same speed or to the same degree as loan rates were falling.  As reductions in deposit rates eventually caught up with the drop in loan rates, and high-cost borrowed funds were repaid, the margin began a steady improvement in April 2009, which continued until April 2010.  By mid-year 2010, an increase in non-accrual loans and a much more liquid balance sheet put more downward pressure on the margin.


The following table sets forth changes in interest income and interest expense for each major category of interest-earning assets and interest-bearing liabilities, and the amount of those variances attributable to volume and rate changes for the years indicated.


Rate / Volume Variance Analysis
                                   
 (In thousands)
 
Year Ended December 31, 2010
   
Year Ended December 31, 2009
 
   
Compared to 2009
   
Compared to 2008
 
   
Increase (Decrease)
   
Increase (Decrease)
 
   
in interest income and expense
   
in interest income and expense
 
   
due to changes in:
   
due to changes in:
 
   
Volume
   
Rate
   
Total
   
Volume
   
Rate
   
Total
 
Interest-earning assets:
                                   
  Loans, net of unearned income
  $ (1,173 )   $ (177 )   $ (1,350 )   $ 411     $ (1,120 )   $ (709 )
  Investment securities
    368       (331 )     37       467       (330 )     137  
  Federal funds sold
    (16 )     -       (16 )     2       (108 )     (106 )
  Other interest income
    3       (75 )     (72 )     139       (251 )     (112 )
Total increase (decrease) in interest income
    (818 )     (583 )     (1,401 )     1,019       (1,809 )     (790 )
                                                 
Interest-bearing liabilities:
                                               
   Transaction accounts
    53       (63 )     (10 )     (80 )     (136 )     (216 )
   Savings deposits
    87       (109 )     (22 )     155       (112 )     43  
   Certificates of deposit
    (191 )     (767 )     (958 )     617       (938 )     (321 )
      Total interest-bearing deposits
    (51 )     (939 )     (990 )     692       (1,186 )     (494 )
   FHLB advances
    (1,159 )     244       (915 )     (353 )     (1 )     (354 )
   Other borrowed funds
    29       3       32       (1 )     -       (1 )
   Subordinated debt
    -       (13 )     (13 )     -       (104 )     (104 )
       Total borrowed funds
    (1,130 )     234       (896 )     (354 )     (105 )     (459 )
Total increase (decrease) in interest expense
    (1,181 )     (705 )     (1,886 )     338       (1,291 )     (953 )
Increase (decrease) in net interest income
  $ 363     $ 122     $ 485     $ 681     $ (518 )   $ 163  

Changes not solely attributable to rate or volume have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the changes in each.

For most of the time period included in the preceding tables the Bank was asset sensitive (see the Asset and Liability Management section of this discussion).  For 2009, the positive change in net interest income due to volume more than offset the negative change due to rates, as the average balance of interest-earning assets increased to a greater extent than interest-bearing liabilities over the course of the year.  The result was a $163 thousand increase in net interest income in 2009 as compared to 2008.  For 2010, a continual reduction in deposit rates, combined with a substantially lower balance of higher-cost borrowed funds led to a $485 thousand increase in net interest income as compared to 2009.  Although FHLB borrowings have been paid off over the past three years, those that remained through much of 2010 were some of the higher-cost borrowings on the Bank’s balance sheet, increasing the average rate on borrowed funds.  As of December 31, 2010, the Bank’s balance sheet has shifted to a slightly liability sensitive position.


Provision for Loan Losses

Credit risk is inherent in the business of making loans.  The Bank makes provisions for loan losses when required to bring the total allowance for loan and lease losses to a level deemed appropriate for the risk in the loan portfolio. The determination of the appropriate level for the allowance is based on such factors as historical loss experience, the volume and type of lending conducted, the amount of nonperforming loans, regulatory policies, general economic conditions, and other factors related to the collectability of loans in the portfolio.  The provision for loan losses is charged to earnings and totaled $5,800,000 for 2010 and $5,056,000 for 2009.

See Allowance for Loan and Lease Losses below for additional information on the procedures for monitoring the adequacy of the allowance, as well as detailed information concerning the allowance for loan and lease losses.



Non-interest Income

Non-interest income increased $878 thousand in 2010 as compared to 2009, due to a $250 thousand increase in gains realized on the sale of securities, as well as a $519 increase in grants and awards related to the Bank’s community development activity and a $51 thousand increase in gains on the sale of SBA loans.

The Bank historically has derived a material portion of its non-interest income from the sale and servicing of SBA guaranteed loans.  Gain on sale of SBA loans increased $192 thousand in 2009 (to $379 thousand), as compared to 2008, and increased another $51 thousand (to $430 thousand) in 2010.  In accordance with new accounting standards for the sale of a portion of a loan in 2010, gains on SBA loans sold and subject to a 90-day premium refund obligation have been deferred for that 90-day period.  Once the premium refund obligation has elapsed the transaction is recorded as a sale and the resulting gain on sale is recorded.  In February 2011, the SBA eliminated the refund obligation period, so the bank will not be required to defer gain recognition for SBA loan sales after February 15, 2011.

Loan servicing fees (net of amortization) increased $42 thousand in 2009 (to $114 thousand) and increased another $21 thousand (to $134 thousand) in 2010.

For both 2010 and 2009, non-interest income included one negative item: write-downs on fixed assets and other real estate.  In 2009, write-downs on other real estate (both foreclosed properties and property that had been held for a future branch site) totaled $472 thousand.  An additional $2 thousand write-down was taken on abandonment of leasehold improvements in 2009.  In 2010, write-downs on other real estate totaled $460 thousand.

Non-interest Expense

Non-interest expense increased in 2010 by $1.211 million, or 15%.

Non-interest expenses that had material changes from 2009 to 2010 were:
 
·
Salary and benefits increased by $218 thousand, or 6%.  Actual outlays and accruals for salaries and benefits increased by only $136 thousand from 2009 to 2010.  However, salary and benefit costs deferred as loan origination costs in accordance with ASC 310-20 (an offset to salaries and benefits) were $82 thousand less in 2010 as compared to 2009.  Loan origination costs deferred under ASC 310-20 are amortized against interest income on loans over the life of the loans.
 
·
Occupancy expense increased by $267 thousand, or 27%, primarily due to lease costs and amortization of tenant improvements associated with the Bank’s new main office at South Higuera Street and Prado Road in San Luis Obispo.
 
·
Professional fees—including legal, accounting, internal audit, loan review and other consultants—were up $111 thousand, or 23%, in 2010, primarily due to legal, accounting loan review and consulting fees related to non-performing assets.
 
·
Insurance and regulatory assessments increased by $68 thousand, or 11%, because FDIC deposit insurance assessments were up by $98 thousand.  These increased assessments were the result of scheduled increases to deposit insurance rates.
 
·
Loan and lease expenses increased by $50 thousand, or 35%, principally due to $61 thousand in adjustments to the fair value of certain loans held for sale.
 
·
Other real estate expenses increased by $154 thousand, or 426%, as the Company’s investment in other real estate (primarily foreclosures) has increased from $1.0 million as of December 31, 2008, to $2.2 million at December 31, 2009, and to $3.1 million at the end of 2010.
 
·
Prepayment fee on borrowed funds—In October 2010 the Bank chose to prepay the remaining $3.0 million of its borrowings from the Federal Home Loan Bank of San Francisco (“FHLB”), incurring a prepayment penalty of $377,966.  Those borrowings were scheduled to mature in 2013 and carried an average interest rate of 4.89%.  Prepayment of these borrowings will reduce the Bank’s interest expense from 2011 through 2013 by a total of approximately $431,000.
 
·
Marketing costs decreased $32 thousand, or 18% in 2010 as compared to 2009, as reductions were made in the Bank’s budget for advertising and sponsorships.


Income Taxes

The Company’s combined federal and state effective income tax rate was 0.0% in 2010 and (26.8)% (tax expense) in 2009.


The tax expense in 2009, even though the Company incurred a pre-tax loss, was due to an increase in the deferred tax valuation allowance that was established because the Bank’s losses in 2008 and 2009 exceeded its ability to fully recognize deferred tax assets by carrying the loss back to previous tax years.  As of December 31, 2010 and 2009, the ability of the Bank to reduce the deferred tax valuation allowance and recognize those deferred tax assets was entirely dependent on the Bank generating taxable income in future years.  The valuation allowance can begin to be reversed—providing a potential increase to net income in future years—as the Company returns to profitability.  See Note I to the consolidated financial statements for more information on income taxes.


Financial Condition

Investment Activities

Banks purchase and own investment securities for yield, to provide liquidity and to balance the overall interest-rate sensitivity of its assets and liabilities. The Bank does not maintain a trading account.

Investment goals are to obtain the highest yield consistent with maintaining a stable overall asset and liability position while limiting economic risks.  In accordance with this policy, management actively manages its investment portfolio between available for sale and held to maturity investments, the composition of which has shifted over time.  All securities in the Bank’s portfolio are classified as available for sale.

Investment policies and limits have been established by the board of directors.  Investments can include federally-insured certificates of deposit, obligations of the U.S. Treasury and U.S. agencies, mortgage-related instruments issued or backed by U.S. agencies, municipal bonds rated Baa or better (Moody’s), Aaa-rated private label mortgage-backed and asset-backed securities, and corporate securities rated A or A-1.  Guidelines have been established for diversification of the portfolio among these investment categories and per-transaction limits have been established as well.  The Bank’s chief financial officer reports investment purchase and sale activity to the Board on a monthly basis and more detailed quarterly reports are presented to the Board’s Investment Committee.


The following table presents the distribution of investments by sector, the maturity dates of the investments, and the weighted average yields of the investments:


Investment securities composition
                                                     
   
December 31, 2010
   
December 31, 2009
   
December 31, 2008
 
         
Approx.
               
Approx.
               
Approx.
       
   
Amortized
   
Market
   
%
   
Amortized
   
Market
   
%
   
Amortized
   
Market
   
%
 
   
Cost
   
Value
   
Yield
   
Cost
   
Value
   
Yield
   
Cost
   
Value
   
Yield
 
   
(Dollars in thousands)
 
U.S. Government agencies:
                                                     
Within one year
  $ -     $ -           $ 500     $ 502       4.00 %   $ 2,000     $ 2,036       3.38 %
One to five years
    20,100       19,878       1.23 %     14,442       14,465       2.12 %     500       518       4.00 %
Five to ten years
    -       -               500       502       5.05 %     1,000       1,016       5.18 %
After 10 years
    983       983       3.72 %     -       -               -       -          
Total U.S. Government agencies
    21,083       20,861       1.35 %     15,442       15,469       2.27 %     3,500       3,570       3.98 %
Mortgage-backed
                                                                       
and asset-backed securities:
                                                                       
Within one year
    2       2       6.50 %     245       249       4.28 %     334       334       4.07 %
One to five years
    -       -               18       17       6.49 %     577       582       4.66 %
Five to ten years
    15,302       15,297       2.30 %     8,674       8,747       3.50 %     1,810       1,873       4.83 %
After 10 years
    34,693       34,352       2.69 %     9,522       9,698       3.96 %     14,689       15,053       4.94 %
Total mortgage-backed
                                                                       
and asset-backed securities
    49,997       49,651       2.57 %     18,459       18,711       3.75 %     17,410       17,842       4.90 %
Municipal securities:
                                                                       
Within one year
    -       -               -       -               -       -          
One to five years
    -       -               -       -               -       -          
Five to ten years
    374       378       4.15 %     -       -               -       -          
After 10 years
    2,543       2,544       5.98 %     2,918<