Item  405 of Regulation S-K is not contained herein, and will not be contained, to the best of 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. (Check one):

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 Act)

o Yes       þ No

The aggregate market value of common equity held by non-affiliates was $72.1 million as of June 30, 2007, based on the closing sale price of the registrant’s common equity on that date.

Number of shares of Common Stock outstanding as of March 18, 2008: 5,581,243

The registrant hereby incorporates its proxy statement for its 2008 annual meeting of stockholders in Part III, Items 10-14.

 

 

TABLE OF CONTENTS

		Page
PART I
Item 1. Business
General			4
Principal Products and Services
Lending Activities			5
Asset Quality			11
Investment Activities			18
Sources of Funds			26
Subsidiaries			29
Employees			29
Regulation of Harrington West Financial Group			29
Regulation of Los Padres Bank			30
Legislation			35
Item 1A. Risk Factors			37
Item 1B. Unresolved Staff Comments			45
Item 2. Properties			45
Item 3. Legal Proceedings			47
Item 4. Submission of Matters to a Vote of Security Holders			47
PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities			48
Item 6. Selected Financial Data			49
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Mission			50
Multiple Market Strategy			50
Product Line Diversification			51
Modern Financial Skills			51
Control Banking Risks			52
Performance Measurement			52
Profitability Drivers			52
Critical Accounting Policies			53
Results of Operation			54
Changes in Financial Condition			61
Asset and Liability Management			63
Liquidity and Capital Resources			67
Contractual Obligations and Commercial Commitments			68
Off Balance Sheet Arrangements			69
Inflation and Changing Prices			70
Effect of Newly, But Not Yet Effective Accounting Standards			70
Item 7A. Quantitative and Qualitative Disclosures About Market Risk			70
Item 8. Financial Statements and Supplementary Data			70
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure			114
Item 9A. Controls and Procedures			114
Item 9A(T). Controls and Procedures			114
Item 9B. Other Information			115
PART III
Item 10. Directors, Executive Officers and Corporate Governance			115
Item 11. Executive Compensation			115
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters			115
Item 13. Certain Relationships, Related Transactions and Director Independence			116
Item 14. Principal Accountant Fees and Services			116
PART IV
Item 15. Exhibits, Financial Statement Schedules			117
SIGNATURES			119
CERTIFICATIONS			120

PART I

Cautionary Statement Regarding Forward-Looking Statements.

     This Form 10-K contains and incorporates by reference forward-looking statements about our financial condition, results of operations and business. These statements may include statements regarding projected performance for future periods. You can find many of these statements by looking for words such as “believes,” “expects,” “anticipates,” “estimates,” “intends,” “will,” “plans” or similar words or expressions. These forward-looking statements involve substantial risks and uncertainties. Some of the factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, but are not limited to, the following:

	•		we may experience higher defaults on our loan portfolio than we expect;
	•		changes in management’s estimate of the adequacy of the allowance for loan losses;
	•		changes in management’s valuation of our mortgage-backed swaps and related securities portfolio and interest rate contracts;
	•		increases in competitive pressure among financial institutions;
	•		general economic conditions, either nationally or locally in areas in which we conduct or will conduct our operations, or conditions in financial markets may be less favorable than we currently anticipate;
	•		our net income from operations may be lower than we expect;
	•		natural disasters;
	•		we may lose more business or customers than we expect, or our operating costs may be higher than we expect;
	•		the availability of capital to fund our growth and expansion;
	•		changes in the interest rate environment and their impact on customer behavior, our interest margins and our securities portfolio;
	•		political and global changes arising from the war on terrorism;
	•		the impact of re-pricing and competitors’ pricing initiatives on loan and deposit products;
	•		our ability to adapt successfully to technological changes to meet customers’ needs and developments in the market place;
	•		our ability to access cost-effective funding;
	•		our ability to successfully implement our strategy to continue to grow our business in California, Kansas and Arizona;
	•		our returns from our securities portfolio may be lower than we expect;

•

legislative or regulatory changes or changes in accounting principles, policies or guidelines may adversely affect our ability to conduct our business.

     Because these forward-looking statements are subject to risks and uncertainties, our actual results may differ materially from those expressed or implied by these statements. (See “Item 1A. Risk Factors”.)You are cautioned not to place undue reliance on our forward-looking statements, which speak only as of the date of this Form 10-K. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. The future results and stockholder values of our common stock may differ materially from those expressed in these forward-looking statements. Many of the factors that will determine these results and values are beyond our ability to control or predict.

     We do not undertake any obligation to release publicly any revisions to any forward-looking statements to reflect events or circumstances after the date of this Form 10-K or to reflect the occurrence of unanticipated events.

Item 1. Business.

General

     We are Harrington West Financial Group, Inc., a Delaware corporation and a diversified, community-based, financial institution holding company headquartered in Solvang, California, with executive offices in Scottsdale, Arizona. We conduct our operations primarily through our wholly-owned subsidiary, Los Padres Bank, FSB, a federally chartered savings bank, located in central California and Scottsdale, Arizona, and its division in the Kansas City metropolitan area, Harrington Bank. Los Padres Bank provides an array of financial products and services for businesses and retail customers through its sixteen full-service offices. At December 31, 2007, we had consolidated total assets of $1.2 billion, total deposits of $836.3 million and stockholders’ equity of $55.0 million.

     We are focused on providing our diversified products and personalized service approach in three distinct markets: (i) the central coast of California, (ii) the Kansas City metropolitan area and (iii) the Phoenix/Scottsdale metropolitan area. Los Padres Bank operates eleven offices on the central coast of California, three offices in the Kansas City metropolitan area under the Harrington Bank brand name, and two banking offices in the Phoenix/Scottsdale, Arizona metropolitan area. In 2006, we opened our third Harrington Bank office in Johnson County, Kansas in the Kansas City metro. HWFG’s controlled banking center development plan remains on track. The Surprise, Arizona banking center is scheduled to open in the Spring of 2008, the Gilbert, Arizona banking center near the end of 2008, and the Dear Valley Airpark, Arizona banking center in the Fall of 2009. This development will bring HWFG’s total banking centers to 5 in metro Phoenix, 11 on the central coast of California and 19 throughout all of HWFG’s markets. HWFG is exploring augmenting these banking centers with the use of existing, shared ATM networks and its existing desktop deposit applications. Each of our markets has its own local independent management team operating under the Los Padres or Harrington names. Our loan underwriting, corporate administration and treasury functions are centralized in Solvang, California to create operating efficiencies. Our commercial lending operations are centralized in Mission, Kansas.

     Los Padres Bank is primarily engaged in attracting deposits from individuals and businesses and using these deposits, together with borrowed funds, to originate commercial real estate, commercial business, single-family and multi-family residential and consumer loans. We also generate fee income from the brokering of mortgage loans, deposit services, early prepayments of some loans, and loan originations. We maintain a portfolio of highly liquid mortgage-backed and related securities as a means of managing our excess liquidity and enhancing our profitability. We utilize various interest rate contracts as a means of managing our interest rate risk. We also operate Harrington Wealth Management Company, which provides trust and investment management services to individuals and small institutional clients on a fee basis, by employing a customized

asset allocation approach and investing predominantly in low fee, indexed mutual funds and exchange traded funds.

Lending Activities

     General. At December 31, 2007, Los Padres Bank’s net loan portfolio totaled $782.6 million, representing approximately 64.0% of our $1.2 billion of total assets at that date. Los Padres Bank’s primary focus with respect to its lending operations has historically been the direct origination of single-family residential, multi-family residential, consumer and commercial real estate as well as commercial and industrial loans. While we continue to emphasize single-family residential loan products that meet our customer’s needs, we now generally broker such loans on behalf of third party investors in order to generate fee income and have been increasing our emphasis on loans secured by commercial real estate, consumer loans, construction and land acquisition and commercial and industrial loans. We also offer multi-family residential loans. The following table sets forth the composition of our loan portfolio by type of loan at the dates indicated.

										December 31,
		2007								2006								2005
		Amount				Percent				Amount				Percent				Amount				Percent
										(Dollars in Thousands)
Real estate loans:
Single-family		$	125,545				15.9	%		$	106,675				13.9	%		$	115,925				17.0	%
Multi-family			82,717				10.5	%			79,896				10.4	%			80,855				11.9	%
Commercial			266,345				33.7	%			264,915				34.6	%			253,208				37.2	%
Construction (1)			126,447				16.0	%			112,645				14.7	%			70,883				10.4	%
Land acquistion			45,278				5.7	%			54,738				7.1	%			36,085				5.3	%
Commercial and industrial loans			117,842				14.9	%			119,074				15.6	%			96,566				14.2	%
Consumer loans			24,483				3.1	%			25,304				3.3	%			26,653				3.9	%
Other loans (2)			2,753				0.3	%			2,206				0.4	%			1,271				0.1	%
Total loans receivable			791,410				100.0	%			765,453				100.0	%			681,446				100.0	%
Less:
Allowance for loan losses			(6,446	)							(5,914	)							(5,661	)
Net deferred loan fees			(1,865	)							(2,103	)							(2,498	)
Net (discounts) premiums			(473	)							(403	)							(397	)
			(8,784	)							(8,420	)							(8,556	)
Loans receivable, net		$	782,626							$	757,033							$	672,890

     The following table sets forth certain information at December 31, 2007, regarding the dollar amount of loans maturing in our loan portfolio based on the contractual terms to maturity or scheduled amortization, but does not include potential prepayments. Loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less.

										Due 5 or
						Due 1-5				more years
						years after				after
		Due 1 year				December				December
		or less				31, 2007				31, 2007				Total
Real estate loans:
Single-family residential		$	1,309			$	7,451			$	116,784			$	125,545
Multi-family residential			2,140				15,311				65,267				82,717
Commercial			25,215				99,814				141,316				266,345
Construction (1)			83,500				12,350				30,598				126,447
Land acquisition			34,461				10,607				210				45,278
Commercial and industrial loans			65,444				39,980				12,418				117,842
Consumer loans			5				814				23,663				24,483
Other loans (2)			2,428				325				—				2,753
Total		$	214,502			$	186,652			$	390,256			$	791,410

     Scheduled contractual amortization of loans does not reflect the expected term of our loan portfolio. The average life of loans is substantially less than their contractual terms because of prepayments and due-on-sale clauses, which gives us the right to declare a conventional loan immediately due and payable in the event that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase when current mortgage loan rates are higher than rates on existing mortgage loans and, conversely, decrease when rates on existing mortgage loans are lower than current mortgage loan rates. Under the latter circumstance, the weighted average yield on loans decreases as higher-yielding loans are repaid or refinanced at lower rates.

     The following table sets forth the dollar amount of total loans due after one year from December 31, 2007, as shown in the preceding table, which have fixed interest rates or which have floating or adjustable interest rates.

						Floating or
						adjustable
		Fixed rate				rate				Total
Real estate loans:
Single-family residential		$	95,872			$	28,364			$	124,236
Multi-family residential			49,859				30,718				80,577
Commercial			139,914				101,216				241,130
Construction (1)			18,472				24,475				42,947
Land acquisition			820				9,997				10,817
Commercial and industrial loans			24,920				27,478				52,398
Consumer loans			796				23,682				24,478
Other loans (2)			25				300				325
Total		$	330,678			$	246,230			$	576,908

     Origination, Purchase and Sale of Loans. The lending activities of Los Padres Bank are subject to the written, non-discriminatory underwriting standards and loan origination procedures established by Los Padres Bank’s board of directors and management. Loan originations are obtained by a variety of sources, including referrals from real estate brokers, builders, existing customers, walk-in customers and advertising. In its present marketing efforts, Los Padres Bank emphasizes its community ties, customized personal service, competitive rates and terms, and its efficient underwriting and approval process. Loan applications are taken by lending personnel, and the loan department supervises the obtainment of credit reports, appraisals and other documentation involved with a loan. Property valuations are performed by independent outside appraisers approved by Los Padres Bank’s board of directors. Los Padres Bank requires title, hazard and, to the extent applicable, flood insurance on all security property.

     Mortgage loan applications are initially processed by loan officers who do not have approval authority. All real estate loans which are either at or below the Federal Home Loan Mortgage Corporation’s (“Freddie Mac”), lending limit and which meet all of the bank’s underwriting guidelines can be approved by designated senior management of Los Padres Bank. All consumer loans up to $250 thousand may be approved by designated senior management of Los Padres Bank. All loans in excess of these amounts up to $1.0 million ($500 thousand for commercial and industrial loans) require the approval of two members of Los Padres Bank’s Executive Loan Committee, which consists of designated senior management of Los Padres Bank. Loans in excess of $1.0 million ($500 thousand for commercial and industrial loans), but not exceeding $5.0 million, require the approval of a majority of Los Padres Bank’s Loan Committee, consisting of designated senior management of Los Padres Bank. All loans in excess of $5.0 million, up to Los Padres Bank’s legal lending limit, must be approved by either Los Padres Bank’s Loan Oversight Committee, comprised of both designated senior management and certain members of the Board of Directors, or the Board of Directors of Los Padres Bank.

     A savings institution generally may not make loans to any one borrower and related entities in an amount which exceeds 15% of its unimpaired capital and surplus, although loans in an amount equal to an additional 10% of unimpaired capital and surplus may be made to a borrower if the loans are fully secured by

readily marketable securities. At December 31, 2007, Los Padres Bank’s regulatory limit on loans-to-one borrower was $13.8 million.

     The risks associated with lending are well defined. Credit risk is managed through the adherence, with few exceptions, to specific underwriting guidelines. We rely on our internal credit approval and administrative process to originate loans as well as our internal asset review process, which oversees our loan quality in order to ensure that our underwriting standards are maintained. We believe that the low level of our non-performing assets is evidence of our adherence to our underwriting guidelines.

     As a federally chartered savings bank, Los Padres Bank has general authority to originate and purchase loans secured by real estate located throughout the United States. Despite this nationwide lending authority, we estimate that at December 31, 2007, the majority of the loans in Los Padres Bank’s portfolio are secured by properties located or made to customers residing in each of our primary market areas located in the California central coast, the Kansas City metropolitan area, and the Phoenix/Scottsdale metropolitan area.

     Single-Family Residential Real Estate Loans. Los Padres Bank has historically concentrated its lending activities on the origination of loans secured by first mortgage liens on existing single-family residences. The single-family residential loans originated by Los Padres Bank are generally made on terms, conditions and documentation, which permit the sale of such loans to Freddie Mac, the Federal National Mortgage Association (“Fannie Mae”), and other institutional investors in the secondary market. Since January 2001, as a means of generating additional fee income and in order to reflect management’s decision to emphasize holding higher spread earning loans in its portfolio, Los Padres Bank has been brokering conforming permanent single-family residential loans on behalf of third parties in order to generate fee income. During the years ended December 31, 2007 and 2006, Los Padres Bank brokered $27.1 million and $48.5 million, respectively, of such single-family residential loans on behalf of third parties.

     Los Padres Bank still holds a portfolio of single-family residential loans. Los Padres Bank will retain in its portfolio single-family residential loans that, due to the nature of the collateral, carry higher risk adjusted spreads. Examples of these types of loans include construction loans that have converted into permanent loans and non-conforming single-family loans, whether as a result of a non-owner occupied or rural property, balloon payment or other exception from agency guidelines. At December 31, 2007, Los Padres Bank had $125.5 million of single-family residential loans in its portfolio, which amounted to 15.9% of total loans receivable as of such date. At December 31, 2007, total loans due after one year had $95.9 million or 76.3% of Los Padres Bank’s single-family residential loans with fixed interest rates and $28.4 million or 23.7% with interest rates which adjust in accordance with a designated index. Single-family residential loans have terms of up to 30 years and generally have loan-to-value ratios of 80% or less, or 90% or less to the extent the borrower carries private mortgage insurance for the balance in excess of the 80% loan-to-value ratio.

     Multi-Family Residential and Commercial Real Estate Loans. At December 31, 2007, Los Padres Bank had an aggregate of $82.7 million and $266.3 million invested in multi-family residential and commercial real estate loans, respectively, or 10.5% and 33.6% of total loans receivable, respectively.

     Los Padres Bank’s multi-family residential loans are secured by multi-family properties of five units or more, while Los Padres Bank’s commercial real estate loans are secured by industrial, warehouse and self-storage properties, office buildings, office and industrial condominiums, retail space and strip shopping centers, mixed-use commercial properties, mobile home parks, nursing homes, hotels and motels. Substantially all of these properties are located in Los Padres Bank’s primary market areas. Los Padres Bank typically originates commercial real estate and multi-family loans for terms of up to 20 years based upon a 30-year loan amortization period. Los Padres Bank will originate these loans on both a fixed-rate or adjustable-rate basis, with the latter adjusting on a periodic basis of up to one year based on the London Interbank Offered Rate (“LIBOR”), the one-year U.S. Treasury index of constant comparable maturities, a designated prime rate, or the 11th District Cost of Funds Index. Adjustable-rate loans may have an established ceiling and floor, and the maximum loan-to-value for these loan products is generally 75%. As part of the criteria for underwriting

commercial real estate loans, Los Padres Bank generally requires a debt coverage ratio (the ratio of net cash from operations before payment of debt service to debt service) of 1.3:1 or more. It is also Los Padres Bank’s general policy to seek additional protection to mitigate any weaknesses identified in the underwriting process. Additional coverage may be provided through secondary collateral and personal guarantees from the principals of the borrowers.

     Commercial real estate lending entails different and significant risks when compared to single-family residential lending because such loans typically involve large loan balances to single borrowers and because the payment experience on such loans is typically dependent on the successful operation of the project or the borrower’s business. In addition, the balloon payment features of these loans may require the borrower to either sell or refinance the underlying property in order to make the payment. These risks can also be significantly affected by supply and demand conditions in the local market for apartments, offices, warehouses or other commercial space. Los Padres Bank attempts to minimize its risk exposure by requiring that the loan does not exceed established loan-to-value and debt coverage ratios, and by monitoring the operation and physical condition of the collateral.

     Construction Loans. Los Padres Bank originates loans to finance the construction of single-family and multi-family residences and commercial properties located in its primary market area. At December 31, 2007, Los Padres Bank’s construction loans amounted to $126.4 million or 16.0% of total loans receivable, $49.0 million of which were for the construction of residential properties, $41.1 million of which were for land acquisition and the development of residential properties, and $36.3 million of which were for the construction of commercial properties.

     Los Padres Bank primarily provides construction loans to individuals building their primary or secondary residence as well as to local developers with whom Los Padres Bank is familiar and who have a record of successfully completing projects. Residential construction loans to developers generally are made with terms not exceeding two years, have interest rates which are fixed or adjust, with the latter adjusting on a periodic basis of up to one year based upon a designated prime rate or LIBOR, and are generally made with loan-to-value ratios of 80% or less. Residential construction loans to individuals are interest only loans for the term of the construction and then generally convert to a permanent loan. Los Padres Bank’s construction/permanent loans have been successful due to its ability to offer borrowers a single closing and, consequently, reduced costs. Los Padres Bank also offers adjustable-rate loans based on a designated prime rate or other indices with terms of up to two years for the construction of commercial properties. Such loans are generally made at a maximum loan-to-value ratio of 85% of discounted appraised value or less.

     Construction lending and acquisition and development lending are generally considered to involve a higher degree of risk of loss than long-term financing on improved, owner-occupied real estate. Risk of loss on construction loans and acquisition and development loans is dependent largely upon the accuracy of the initial appraisal of the property’s projected value at completion of construction as well as the estimated cost, including interest, of construction. During the construction phase, a number of factors could result in delays and cost overruns. If either estimate proves to be inaccurate or the borrower is unable to provide additional funds, the lender may be required to advance funds beyond the amount originally committed to permit completion of the project and/or be confronted at the maturity of the construction loan with a project whose value is insufficient to assure full payment. Los Padres Bank attempts to minimize the foregoing risks primarily by limiting its construction lending to experienced developers and by limiting the total amount of loans to builders for speculative construction projects. It is also Los Padres Bank’s general policy to obtain regular financial statements and tax returns from builders so that it can monitor their financial strength and ability to repay.

     Land acquisition and development. Los Padres Bank has decreased its loans for land acquisition and development (loans for the initial acquisition of land and off-site improvements) from $54.7 million at December 31, 2006 to $45.3 million at December 31, 2007. Land acquisition and development loans are typically issued with short terms, bearing adjustable-rates of interest based on a designated prime rate or

LIBOR and are generally made with loan-to-value ratios of 70% or less with secondary credit support in the form of borrower and investor guarantees.

     Commercial and Industrial Loans. Los Padres Bank is placing increased emphasis on the origination of commercial business loans because of the higher risk-adjusted spreads generally associated with these types of loans. At December 31, 2007, Los Padres Bank’s commercial and industrial loans amounted to $117.8 million or 14.9% of total loans receivable.

     The commercial and industrial loans that Los Padres Bank is originating include lines of credit, term loans and letters of credit. These loans are typically secured by collateral and are used for general business purposes, including working capital financing, equipment financing, capital investment and general investment. Depending on the collateral pledged to secure the extension of credit, maximum loan-to-value ratios are 80% or less. Loan terms generally vary from one to seven years. The interest rates on such loans are generally variable and are indexed to the Wall Street Journal Prime Rate, plus a margin. Commercial and industrial loans typically have shorter maturity terms and higher interest spreads than mortgage loans, but generally involve more credit risk than mortgage loans because of the type and nature of the collateral. Los Padres Bank’s business customers are typically small to medium sized, privately-held companies with local or regional businesses that operate in Los Padres Bank’s primary markets.

     Consumer and Other Loans. Los Padres Bank is authorized to make loans for a wide variety of personal or consumer purposes. Los Padres Bank has been originating consumer loans in recent years in order to provide a wider range of financial services to its customers and because such loans generally carry higher interest rates than mortgage loans. The consumer and other loans offered by Los Padres Bank include home equity lines of credit, home improvement loans, vehicle loans, secured and unsecured personal lines of credit and deposit account secured loans. At December 31, 2007, $27.2 million or 3.4% of Los Padres Bank’s total loans receivable consisted of consumer loans.

     Home equity lines of credit are originated by Los Padres Bank for up to 90% of the appraised value, less the amount of any existing prior liens on the property. Los Padres Bank also offers home improvement loans in amounts up to 80% of the appraised value, less the amount of any existing prior liens on the property. Home improvement loans have a maximum term of 15 years and carry fixed or adjustable interest rates. Home equity lines of credit have a maximum repayment term of 15 years and carry interest rates that adjust monthly in accordance with a designated prime rate. Los Padres Bank will secure each of these types of loans with a mortgage on the property, generally a second mortgage, and may originate the loan even if another institution holds the first mortgage. At December 31, 2007, home equity lines of credit and home improvement loans totaled $23.7 million or 88.0% of Los Padres Bank’s total consumer loan portfolio and an aggregate of $46.0 million were committed and un-drawn under these loans and lines of credit.

     Los Padres Bank currently offers loans secured by deposit accounts, which amounted to $992.6 thousand or 3.7% of Los Padres Bank’s total consumer and other loan portfolio at December 31, 2007. Such loans are originated for up to 90% of the deposit account balance, with a hold placed on the account restricting the withdrawal of the account balance.

     At December 31, 2007, vehicle loans, secured and unsecured personal line of credit loans amounted to $1.1 million or 4.0% of Los Padres Bank’s total consumer and other loan portfolio.

     Consumer loans generally have shorter terms and higher interest rates than mortgage loans but generally involve more credit risk than mortgage loans because of the type and nature of the collateral. In addition, consumer lending collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness and personal bankruptcy. Los Padres Bank believes that the generally higher yields earned on consumer loans compensate for the increased credit risk associated with such loans and Los Padres Bank intends to continue to offer consumer loans in order to provide a full range of services to its customers.

Asset Quality

     General. Los Padres Bank’s Internal Asset Review Committee and the Internal Asset Oversight Committee, consisting of Los Padres Bank’s senior executive officers and certain members of the Board of Directors, monitors the credit quality of Los Padres Bank’s assets, reviews classified and other identified loans and determines the proper level of reserves to allocate against Los Padres Bank’s loan portfolio, in each case subject to guidelines approved by Los Padres Bank’s board of directors.

     Loan Delinquencies. When a borrower fails to make a required payment on a loan, Los Padres Bank attempts to cure the deficiency by contacting the borrower and seeking payment. Contacts are generally made following the sixteenth day after a payment is due, at which time a late payment is assessed. In most cases, deficiencies are cured promptly. If a delinquency extends beyond 16 days, the loan and payment history is reviewed and efforts are made to collect the payment. While Los Padres Bank generally prefers to work with borrowers to resolve such problems, when the account becomes 45 days delinquent, Los Padres Bank will institute foreclosure by issuing a Notice of Intent to Foreclose or other proceedings, as necessary, to minimize any potential loss. After 75 days and the loan is not brought current or no workout agreement has been initiated, a Notice of Default is recorded.

     Non-Performing Assets. Los Padres Bank will place loans on non-accrual status when, in the judgment of management, the probability of collection of interest is deemed to be insufficient to warrant further accrual. When such a loan is placed on non-accrual status, previously accrued but unpaid interest is deducted from interest income. Los Padres Bank generally does not accrue interest on loans past due 60 days or more.

     Non-performing loans are defined as non-accrual loans 90 days past due. Non-performing assets are defined as non-performing loans and real estate acquired by foreclosure or deed-in-lieu thereof. Troubled debt restructurings are defined as loans which Los Padres Bank has agreed to modify by accepting below market terms either by granting interest rate concessions or by deferring principal and/or interest payments. The following table sets forth the amounts and categories of our non-performing assets and troubled debt restructurings at the dates indicated.

		December 31,
		2007				2006				2005
		(Dollars in thousands)
Non-accruing loans:
Single-family residential		$	—			$	—			$	—
Multi-family residential			—				—				—
Commercial real estate			—				—				—
Land acquisition and development			1,843				—				—
Commercial and industrial			—				98				—
Consumer and other			—				—				—
Total non-accruing loans			1,843				98				—
Total non-performing loans			1,843				—				—
Troubled debt restructurings			—				—				—
Real estate owned, net of reserves			—				—				—
Total non-performing assets and troubled debt restructurings		$	1,843			$	98			$	—
Total non-performing loans and troubled debt restructurings as a percentage of total loans			0.23	%			0.01	%			0.00	%
Total non-performing assets and troubled debt restructurings as a percentage of total assets			0.15	%			0.01	%			0.00	%

     At December 31, 2007, and 2006, we had one, and two non-performing loans, respectively. At December 31, 2007, we had non-performing loans representing an increase of $1.7 million from December 31, 2006. Refer to “Changes in Financial Condition”, pg 62 for additional information.

     The interest income that would have been recorded during the years ended December 31, 2007, and 2006 if Los Padres Bank’s non-accruing loans at the end of such periods had been current in accordance with their terms during such periods is $178.2 thousand, and $6.8 thousand, respectively. The interest income that was recorded during the years ended December 31, 2007, and 2006 with respect to Los Padres Bank’s non-accruing loans was $140.6 thousand and $4.0 thousand, respectively.

     Classified Assets. Federal regulations require that each insured savings institution classify its assets on a regular basis. In addition, in connection with examinations of insured institutions, federal examiners have authority to identify problem assets and, if appropriate, classify them. Los Padres Bank has established three classifications for potential problem assets: “substandard,” “doubtful” and “loss.” Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified as loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. Los Padres Bank has established another category, designated “special mention,” for assets that do not currently expose Los Padres Bank to a sufficient degree of risk to warrant classification as substandard, doubtful or loss. Assets classified as substandard or doubtful require Los Padres

Bank to establish allowances for loan losses based on the methodology described below. If an asset or portion thereof is classified as loss, the insured institution must either establish specific allowances for loan losses in the amount of 100% of the portion of the asset classified loss, or charge-off such amount. At December 31, 2007, Los Padres Bank had $6.8 million of classified loans, $6.4 million of which was classified as substandard and $467 thousand was classified as doubtful or loss. As of December 31, 2007, Los Padres Bank had $35.0 million of loans that were designated special mention. At December 31, 2006, Los Padres Bank had $1.4 million of classified loans, $1.3 million of which was classified as substandard and $98 thousand were classified as doubtful or loss. As of December 31, 2006, Los Padres Bank had $12.1 million of loans that were designated special mention. Our classified and special mention loans, in addition to the non-performing loans discussed above, are the extent of the loans in our portfolio that give us some repayment concern at this time.

     Allowance for Loan Losses. The allowance for loan losses reflects management’s judgment of the level of allowance adequate to provide for probable incurred losses inherent in the loan portfolio as of the balance sheet date. On a quarterly basis, Los Padres Bank assesses the overall adequacy of the allowance for loan losses, utilizing a consistent and systematic approach which includes the application of an allocated allowance for specifically identified problem loans, a formula allowance for non-homogeneous loans, a formula allowance for large groups of smaller balance homogeneous loans and an unallocated allowance.

     Allocated allowance for specifically identified problem loans. A specific reserve is established for impaired loans in accordance with SFAS No. 114, Accounting by Creditors for Impairment of a Loan as amended by SFAS No. 118. A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. The specific reserve is determined based on the present value of expected future cash flows discounted at the loan’s effective interest rate, except that as a practical expedient, we may measure impairment based on a loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent.

     Formula allowance for non-homogeneous loans. Los Padres Bank segments its non-homogeneous loan portfolio into pools with similar characteristics based on loan type (collateral driven) and risk factor (loan grade). Currently, these loans are segmented into four categories by collateral, further stratified by loan grade (pass, special mention, substandard, and doubtful). The general pool categories are multi-family residential, commercial real estate, land acquisition and development, and commercial and industrial. These non-homogeneous loans are reviewed individually.

     The formula allowance is calculated by applying adjusted loss rates to these pools. Pool loss rates are established by examining historical charge-off data for groups of loans and adjusting them for a variety of qualitative factors deemed appropriate by management. The analysis of historical loss data in determining the initial loss rates is based on an average ten-year period. Where Los Padres Bank has no or nominal actual charge-off data for certain loan types, industry data and management’s judgment is utilized as representative starting loss rates.

     Formula allowance for large groups of smaller balance homogeneous loans. The allocated loan loss allowance for large groups of smaller balance homogeneous loans is focused on loss experience for the pool rather than on an analysis of individual loans. Large groups of smaller balance homogeneous loans consist of consumer loans and single-family residential loans. The allowance for groups of performing loans is based on historical losses over a ten year period.

     Unallocated Allowance. The unallocated allowance contains amounts that are based on management’s evaluation of conditions that are not directly measured in the determination of the formula and specific allowances. The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments. The

conditions evaluated in connection with the unallocated allowance include the following, which existed at the balance sheet date:

	•		trends in criticized and non-accrual assets;
	•		the levels and trends in charge-offs, recovery history and loan restructuring;
	•		changes in volumes and terms of the loan portfolio;
	•		any credit concentrations or changes in the level of such concentrations;
	•		changes in the effectiveness of the internal asset review process;
	•		changes in lending policies, procedures and practices;
	•		changes in the experience, ability and depth of lending management;
	•		changes in the national, regional and local economic conditions;
	•		changes in value of underlying collateral for collateral-dependent loans; and
	•		the trend in local real estate values.

     Management and the Internal Asset Review Committee review these conditions quarterly in discussion with our senior credit officers. To the extent that any of these conditions is evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management’s estimate of the effect of such condition may be reflected as a specific allowance, applicable to such credit or portfolio segment. Where any of these conditions is not evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management’s evaluation of the probable loss related to such condition is reflected in the unallocated allowance which varies from plus or minus 5% of the total allowance for loan losses.

     The allowance for loan losses is based upon estimates of probable incurred losses inherent in the loan portfolio. The actual losses can vary from the estimated amounts. Our methodology includes several features that are intended to reduce the differences between estimated and actual losses. The loss migration model that is used to establish the loan loss factors is designed to be self-correcting by taking into account our loss experience over prescribed periods. Similarly, by basing the loan loss factors over a period reflective of two business cycles, the methodology is designed to take our recent loss experience for consumer and commercial and industrial loans into account. Furthermore, based on management’s judgment, our methodology permits adjustments to any loss factor used in the computation of the formula allowance for significant factors, which affect the collectibility of the portfolio as of the evaluation date, but are not refle