UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20529

FORM 10-K

(Mark One)

      x                         ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2005

or

      o                            TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(b) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period N/A to N/A

Commission file number 000-23925

MID-STATE BANCSHARES

(Exact name of registrant as specified in its charter)

 

(805) 473-6829

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock

(no par value)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Role 405 of the Securities Act.   Yes o   No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.   Yes  o   No x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or shorter period that the Registrant was required to file such reports)   Yes  x    No o, and (2) has been subject to such filing requirements for the past 90 days.   Yes  x    No o

Indicate by check mark if disclosure of delinquent filers pursuant to 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. o

Indicate by check mark whether the registrant is a large accelerated filer, accelerated filer, or a non-accelerated filer (as defined in Exchange Act Rule 12b-2).  Large accelerated filer o   accelerated filer x   non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act.).   Yes  o    No  x

The aggregate market value of the common stock held by non-affiliates of the registrant as of June 30, 2005 was $601,176,762.

The number of shares of common stock of the registrant outstanding as of March 3, 2006 was 22,431,314.

The following documents are incorporated by reference herein:  Part III, Items 10 through 14 are incorporated from Registrant’s definitive proxy statement for the 2006 Annual Meeting of Shareholders.

This annual report on Form 10K is 103 pages long including the signature pages, certifications and consent.

TABLE OF CONTENTS

 

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PART I

Certain statements contained in this Annual Report on Form 10-K (“Annual Report”), including, without limitation, statements containing the words “estimates”, “believes”, “anticipates”, “intends”, “may”, “expects”, “could” and words of similar import, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities and Exchange Act of 1934. These forward- looking statements relate to, among other things, our current expectations regarding future operating results, net interest margin, strength of the local economy and allowance for credit losses. They involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others, the following: general economic and business conditions in those areas in which the Company operates, competition, natural disasters, growth in loans and deposits, fluctuations in interest rates, changes in business strategy or development plans, changes in governmental regulation, credit quality, economic, political and global changes arising from the war on terrorism and the conflict in Iraq, and other factors referenced in this report, including in “Item 1A. Risk Factors.”  When relying on forward-looking statements to make decisions with respect to our Company, investors and others are cautioned to consider these and other risks and uncertainties. The Company disclaims any obligation to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements contained herein to reflect future events or developments.

This discussion should be read in conjunction with our financial statements, including the notes thereto, appearing elsewhere in this report.

ITEM 1.                BUSINESS

Mid-State Bancshares and Mid-State Bank & Trust

Mid-State Bancshares (the Company) is the parent company to Mid-State Bank & Trust (the Bank), its 100% owned principal subsidiary. The Company is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (BHC Act) and is subject to the supervision and regulation of the Board of Governors of the Federal Reserve System (Federal Reserve Board).

The Company, through the Bank, derives its income primarily from interest received on loans, and to a lesser extent, from interest on investment securities, fees received in connection with loans and other services offered, including loan servicing and deposit services. The Company’s major operating expenses are the interest it pays on deposits and borrowings and general operating expenses. The Company’s operations, like those of other financial institutions operating in California, are significantly influenced by economic conditions in California, including the strength of the real estate market, the fiscal and regulatory policies of the federal government and of the regulatory authorities that govern financial institutions. See “Supervision and Regulation.”

Mid-State Bank & Trust was incorporated under the laws of the State of California and commenced operations on June 12, 1961 as a California state chartered bank. The Bank’s accounts are insured by the Federal Deposit Insurance Corporation (FDIC), but it is not a member of the Federal Reserve System. At December 31, 2005 the Company had total assets of approximately $2.4 billion, total deposits of $2.1 billion and total shareholders’ equity of $273 million.

The Bank operates 40 full service retail-banking offices along the central coast of California in Santa Barbara, San Luis Obispo and Ventura counties. The Bank’s headquarters is located in Arroyo Grande and it also serves the communities of Paso Robles, Cambria, Templeton,  Atascadero, Cayucos, Morro Bay, Los Osos, San Luis Obispo, Pismo Beach, Grover Beach, Guadalupe, Nipomo, Santa Maria, Orcutt, Lompoc, Vandenberg Village, Buellton, Santa Ynez, Solvang, Goleta, Oxnard, Camarillo, Ojai, Oak View, Ventura and Santa Barbara. It also plans to open a new branch office and commercial banking office in

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Westlake Village in the Spring of 2006. The headquarters’ street address is 1026 Grand Ave., Arroyo Grande, CA 93420. Its mailing address is P.O. Box 6002, Arroyo Grande, CA 93421-6002. The telephone number is: (805) 473-6829. The Bank can also be reached through its internet address at www.midstatebank.com. Investors can obtain copies of this Annual Report on Form 10-K or other filings made by the Company with the Securities and Exchange Commission (SEC) filings through this website which provides a link to the SEC internet website. See the section entitled “Where you can Find Additional Information” at the end of this section on page 20.

The Bank is a full-service community bank offering a broad range of banking products and services, including accepting time and demand deposits, originating loans and leases, providing trust services, and making other investments. The Bank originates several types of loans, including secured and unsecured commercial and consumer loans, residential real estate mortgage loans, and residential construction loans. The Bank’s loans are both short-term and intermediate term in length and consist of both fixed and adjustable rate contracts. Special services and requests beyond the lending limits of the Bank are arranged through correspondent banks.

Bank Subsidiaries

The Bank operates two wholly owned subsidiaries—Mid-Coast Land Company and MSB Properties, Inc. Mid-Coast Land Company was founded in 1984 pursuant to section 751.3 of the Financial Code of the State of California. Section 751.3 provided that state-chartered banks were authorized to invest in a corporation that engaged in real estate activities. Under the Federal Deposit Insurance Corporation Improvement Act (FDICIA) which became law in December 1991, the Bank, through Mid-Coast Land Company, was required to divest itself of its real estate development activities. That process was completed in January 2003. The holdings and results of operations of Mid-Coast Land Company are included within the consolidated financial statements of the Company. On a stand-alone basis, Mid-Coast Land Company had after-tax earnings of $409 thousand in 2005, $379 thousand in 2004, and $322 thousand in 2003. For further information concerning Mid-Coast Land Company, see the Subsidiary Activity section of the Management’s Discussion and Analysis section included in Item 7 of this Report.

MSB Properties Inc. was incorporated under the laws of the State of California in May of 1968, allowing for the ownership of property which may be reasonably necessary for the expansion of the Bank’s business, or which is otherwise reasonably related to the conduct of the Bank’s business, pursuant to Section 752 of the Financial Code of the State of California.

The holdings and results of operations of MSB Properties are included within the consolidated financial statements of the Company. On a stand-alone basis, MSB Properties had earnings of $1.2 million, $1.2 million, and $1.4 million in 2005, 2004, and 2003, respectively. For further information concerning MSB Properties, see the Subsidiary Activity portions of the Management’s Discussion and Analysis section included in Item 7. of this Report.

Acquisition of Ojai Valley Bank

On October 31, 2003, Mid-State Bancshares and its wholly owned subsidiary Mid-State Bank & Trust acquired 100 percent of the outstanding common stock of Ojai Valley Bank. The results of Ojai Valley Bank’s operations have been included in the consolidated financial statements since that date. Ojai Valley Bank was a community bank serving the communities of Ojai and Oak View in Ventura County. The merger expanded Mid-State Bank & Trust’s Ventura County presence with these two additional offices.

The aggregate purchase price was $25.0 million, including $11.8 million in cash paid to Ojai Valley Bank shareholders, $11.8 million in Mid-State Bancshares’ common stock issued and $1.3 million for other merger related expenses. The value of the 498,153 shares issued was determined based on the average closing market price of Mid-State Bancshares’ common stock over the twenty consecutive trading days that

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Mid-State Bancshares’ stock traded ending October 24, 2003. The average price of Mid-State Bancshares’ stock over that period was $23.78. The merger was accounted for utilizing the purchase method of accounting.

Services

The Bank offers a full range of commercial banking services including checking accounts, NOW accounts, health savings accounts, savings accounts, money market accounts, and various types of time certificates of deposit (including various maturities and individual retirement accounts). The Bank makes a variety of construction and land development loans, real estate related loans, home equity credit lines, installment loans, agricultural and commercial loans, business equipment leases and SBA loans. Other services offered by the Bank include, but are not limited to, trust services, safe deposit boxes, travelers cheques, notary public, merchant depository services for VISA and Mastercard, cash management, home banking, telephone voice response system and ATM’s. The Bank’s organization and structure is designed to serve the banking needs of individuals and small to medium sized businesses in Santa Barbara, Ventura and San Luis Obispo counties.

Deposit and Liability Management

Deposits represent the Bank’s primary source of funds. As of December 31, 2005 the Bank had approximately 32,734 non interest bearing demand deposit accounts representing $567.8 million, or an average of $17,345 per account. The Bank also had approximately 125,926 NOW, Money Market and Savings accounts amounting to $1,067 million, or about $8,477 average per account. There were 16,088 time certificates of deposit outstanding at December 31, 2005, representing $434.3 million with an average deposit balance of approximately $26,998. Of the total time certificates of deposit, $202.1 million represented holders who carried an amount on deposit of $100,000 or more, approximately 47% of the total.

The Bank is not dependent on a single or a few customers for its deposits. Most deposits are obtained from individuals and small-to-medium sized businesses. This results in the relatively small average balances noted above and allows the Bank to be less subject to the adverse effects of the loss of a large depositor. As of December 31, 2005, no individual, corporate, or public depositor accounted for more than 2% of the Bank’s total deposits.

Liquidity is the Bank’s ability to meet fluctuations in deposit levels and to provide for the credit needs of its customers. The objective in liquidity management is to maintain a balance between the sources and uses of funds. Principal sources of liquidity include interest and principal payments on loans and investments, proceeds from the maturity of investments and growth in deposits. The Bank holds overnight Fed Funds Sold as a cushion for temporary liquidity needs. For 2005, Fed Funds Sold averaged $36.1 million representing 1.5% of average assets. In addition, the Bank maintains Federal Funds lines of credit totaling $70 million with major correspondents, subject to customary terms for such arrangements.

The Bank’s internally calculated liquidity ratio, which measures the percentage of total liabilities (excluding equity) which are used to fund cash, cash equivalents and non-pledged marketable securities, was 29.7%—in excess of the Bank’s policy minimum of 15%.

Liquidity demands at the Holding Company have been limited historically to dividend payments it makes to its stockholders, the repurchase of its common stock, and certain payments to vendors. Management does not anticipate any further demands requiring liquidity in the near term. Currently, the liquidity needs of the Holding Company are funded by dividends it receives from the Bank.

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Loans

The Bank’s loan-to-deposit ratio stood at approximately 73.6% at year-end 2005. The ratio has increased in recent years from 60.6% at the end of 2003. It is the Bank’s policy to maintain its loan-to-deposit ratio in the 60% to 80% range while maintaining credit quality.

The Bank maintains an allowance for loan losses which is netted against loans on the balance sheet. Additions to the allowance are made by charges to expense. All loans deemed to be uncollectible are charged to the allowance; subsequent recoveries are credited to the allowance. The amount in the loan loss allowance is an estimate of the losses inherent in the loan portfolio as determined by a variety of factors considered by Management. Factors include, but are not limited to, the current economic climate, type and quality of loans in the portfolio, trends in delinquencies, historical loss rates, non-accrual totals, diversification of the portfolio, value of available collateral and the cost of collateral liquidation.

As of December 31, 2005, the Bank’s allowance for loan losses stood at $11.9 million. Additionally, the Bank has an allowance for losses on unfunded commitments totaling $1.8 million. Collectively, these allowances for losses represent 554.5% of non-performing loans (non-accrual loans plus loans 90 days or more past due). Outside factors, not within the Bank’s control, such as adverse changes in the economy, can affect the adequacy of the allowances and there can be no assurance that in any given period, the Bank might not suffer losses which are substantial in relation to the size of the allowances. During 2005, the Bank experienced net charge-offs after recoveries, of $1.9 million, or 0.13% of average loans.

Underwriting and Credit Administration

The lending activities of Mid-State Bank & Trust are guided by the lending policies approved by the Bank’s Board of Directors. The credit policy is managed through periodic reviews and approved annually by the Board.

Each loan is evaluated using underwriting criteria established in the Bank’s lending policy. Lending authority is granted to officers of the Bank on a limited basis, dependent upon individual knowledge and experience. During 2005, the approval process was revised. Loan requests exceeding individual limits are now submitted to the Bank’s Loan Committee, which consists of the president, chief credit officer, executive vice president of commercial banking, 2 senior credit administrators and one non-management director. The Loan Committee meets on a regular basis in order to provide timely responses to the Bank’s clients. Additionally, a Board Loan Committee consisting of the president, chief credit officer and 3 non-management directors meet monthly to review all credits made over certain dollar thresholds and to establish Bank credit policy and monitor adherence to it. The new structure has satisfied Management’s and the Board’s concern for improved efficiency in the approval process.

The Bank’s credit administration function includes an internal review and the regular use of an independent outside loan review firm.

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Loan Portfolio

At December 31, 2005 and 2004, the Bank’s gross loan portfolio totaled $1.5 billion and $1.4 billion, respectively. The portfolio was distributed as follows:

		December 31,
		2005		2004
Construction and Land Development		18.4	%	16.1	%
Real Estate—Farmland		3.2	%	2.3	%
Real Estate —Residential		13.6	%	13.7	%
Real Estate—Non Farm, Non Residential		36.8	%	37.5	%
Home Equity Credit Lines		12.0	%	11.2	%
Cash Reserve		0.2	%	0.3	%
Installment		1.2	%	1.3	%
Agricultural Production		2.3	%	2.8	%
Commercial, Other		12.3	%	14.8	%
		100.0	%	100.0	%

 

The interest rates charged for the loans made by the Bank vary with the degree of risk, size and maturity of the loans. Rates are generally affected by competition, the client’s deposit relationship with the Bank, and the Bank’s cost of funds.

Commercial Loans.   The Bank provides financial services to diverse commercial and professional businesses in the marketplace. Commercial loans consist primarily of short term loans (normally with a maturity of one year or less) for working capital and business expansion. Commercial loans typically include revolving lines of credit, either uncollateralized or collateralized by inventory, loans secured by accounts receivable and equipment loans. Emphasis is placed on the borrower’s earnings history, capitalization, secondary sources of repayment, and in some instances, third-party guarantees or highly liquid collateral (such as time deposits and investment securities). Commercial loan pricing is generally at a rate tied to the prime rate (as quoted in the Wall Street Journal) or the Bank’s reference rates. Certain equipment loans may be made at fixed rates for short to medium terms.

The Bank participates in Small Business Administration (SBA) loan guarantee programs. Those programs used include both the 504 program, which is focused toward longer-term financing of buildings and other long-term assets, and the 7A program, which is primarily used for financing of equipment, inventory and working capital needs of eligible businesses, generally over a seven to twenty-five year term. The Bank’s collateral position in the SBA loans is enhanced by the SBA guarantee in the case of 7A loans, and by lower loan-to-value ratios under the 504 program. The Bank is designated as a preferred lender by the SBA, allowing it to process these loans more quickly. Under the SBA’s Preferred Lending Program, the SBA delegates a substantial degree of lending authority to participating lenders, such as the Bank. The Bank also participates in other government sponsored loan programs offered by various government agencies, such as through the California Coastal Rural Development Corporation, Central Coast Development Companies and others.

Agricultural Loans.   The Bank provides production loans to help finance the seasonal needs of farming operations, including crop and livestock financing, inventory purchases, and receivable financing. The Bank has very limited vineyard lending exposure (less than $10 million at December 31, 2005). Equipment loans are also financed on everything from field equipment to office automation systems. Emphasis is placed on the borrower’s earnings history, capitalization, secondary sources of repayment, and in some instances, third-party guarantees or highly liquid collateral (such as time deposits and investment securities). Agricultural loan pricing, like commercial loan pricing, is generally at a rate tied to the prime

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rate (as quoted in the Wall Street Journal) or the Bank’s reference rates. Certain equipment loans may be made at fixed rates for short to medium terms.

Real Estate Construction and Development Loans.   The Bank’s real estate construction loan activity has focused on providing short-term (maturity of two years or less) loans to individuals and developers with whom the Bank has established relationships, for the construction primarily of single family residences in the Bank’s market area.

Residential real estate construction loans are typically secured by first deeds of trust. The economic viability of the project and the borrower’s credit-worthiness are primary considerations in the loan underwriting decision. The Bank utilizes approved independent local appraisers as well as in-house staff, and loan-to-value ratios that generally do not exceed 80% of the appraised value of the property. The Bank monitors projects during the construction phase through regular construction inspections and a disbursement program tied to the percentage of completion of each project.

The Bank also occasionally makes land loans to individuals and developers who intend to construct a single-family residence(s) on the lot, generally within 24 months. In addition, the Bank makes commercial real estate construction loans for construction of office and warehouse properties, generally to high-net-worth clients with adequate liquidity.  The economic viability of the project and the borrower’s credit-worthiness are primary considerations in the loan underwriting decision. Such loans are typically secured by first deeds of trust.

Commercial Real Estate Term Loans and Loans Secured by Farmland.   The Bank provides medium-term commercial real estate loans secured by commercial or industrial buildings or farmland where the properties are either used by the owner for business purposes (owner-user properties) or have income derived from tenants (investment properties). As a general rule, the Bank’s loan policies require the principal balance of the loan to not exceed 75% of the stabilized appraised value of the underlying real estate collateral. The loans, which are typically secured by first deeds of trust only, generally have terms of no more than ten years and are amortized over 25 to 30 years. Some of these loans have rates tied to Wall Street Journal prime rate that adjust whenever the prime rate changes. The remaining loans adjust every three, five or seven years depending upon the index to which the loan is tied.

Residential Real Estate Loans.   The Bank provides a variety of real estate loans secured by residential real estate. These loans are generally secured by first or second trust deeds on individual residential properties. Most of these loans are sold, servicing retained, in the secondary market. Certain shorter term mortgages, especially jumbo adjustable rate mortgages, may be kept in portfolio and not sold in the secondary market depending on the Bank’s appetite for these earning assets. These consist of adjustable rate loans with a short fixed rate period of 3, 5 or 7 years, then adjusted annually using an index of the 1 year treasury constant maturity or 1 year LIBOR. These loans are originated using FNMA/FHMLC underwriting guidelines. Although the loans are held for investment, they are eligible for sale in the secondary market.

Home Equity Credit Lines.   The Bank provides lines of credit secured by a first or second deed of trust on the borrower’s residential real property. The loans have a 15 year draw period followed by a 15 year amortization of the outstanding principal balance. The loans have an interest rate that adjusts monthly with the Wall Street Journal published prime rate. The total combined percentage of Home Equity Credit Line and first mortgage is dependent on several factors such as credit score, income ratios, stability of employment etc, and can go as high as 100%.

Consumer and Other Loans.   The Bank’s consumer and other loan portfolio is divided between installment loans secured by automobiles, other consumer purposes and revolving, unsecured consumer debt such as reserve lines of credit. Installment loans tend to be fixed rate and longer-term (one-to-five-

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year maturity). The Bank’s portfolio of revolving credit plans, issued as an additional service to its clients, is minimal at just 0.2% of total loans.

Investment Securities

The Bank maintains a portfolio of investment securities to provide income and to serve as a secondary source of liquidity for its operations in conjunction with Federal Funds Sold (see Deposit and Liability Management above). The Bank’s investment policy provides for the purchase of United States Treasury Securities, United States Government Agency Securities, Mortgage Backed Securities, Obligations of State and Political Subdivisions, and Other Securities as permitted by Federal and State regulation. As of December 31, 2005, the aggregate carrying value of the Investment Portfolio was $619.3 million. Of this total, $22.6 million was invested in U.S. Treasury Securities, $214.6 million in U.S. Government Agencies, $8.9 million in Mortgage Backed Securities, $356.7 million in Obligations of State and Political Subdivisions and $16.5 million in Other Securities. The types of securities held are influenced by several factors, which include: rate of return, maturity, and risk. Generally, the Bank endeavors to stagger the maturities of its securities so that it has regular maturities for liquidity purposes. The Bank does not participate in any swap or hedge activity on the investment portfolio (or any other part of the balance sheet) and has no plans to begin such activity.

Acceptable securities may be pledged to secure public deposits from State and Public Agencies. As of December 31, 2005, the Bank had public funds totaling approximately $60.7 million. The Bank has made available $110.0 million of securities to securitize these funds. Excess collateral can be released as needed.

Senior Housing Crime Prevention Foundation Investment

The Bank owns a $30 million holding of the Preferred Stock of Senior Housing Crime Prevention Foundation Investment Corporation (SHCPF-I) which is carried under a separate caption on the Consolidated Statement of Financial Positions. That investment is secured by a federal agency security issued by FNMA. The Bank has the right after five years on April 29, 2010 to require SHCPF to redeem all or a part of the shares of the Preferred Stock. Dividends are paid to the Bank on the Preferred Stock at a rate which is 1.875% below the interest earned on the underlying FNMA agency security. This 1.875% differential is used by SHCPF to fund the various programs of the Senior Housing Crime Prevention Foundation at 53 nursing home facilities in the Bank’s tri-county service area. These include, among other things, the senior crime stoppers program which is reducing crimes against the elderly living in those facilities. The benefits to the Bank of this program include full Community Reinvestment Act (CRA) credit for our $30 million investment, positive public relations, and significant marketing opportunities with the operators of the facilities, their owners, Board of Directors, employees, family members and residents.

Economic Climate

The economy in the Bank’s trade area is based upon agriculture, oil, tourism, light industry, government services, aerospace industries and retail trade. Services supporting those involved in these industries have also developed in the areas of medical, financial and educational services. Population in the Tri-county area, according to the California Department of Finance, is estimated at July 2005 to be 1,493,039. Ventura County represents about 54% of this total with Santa Barbara and San Luis Obispo Counties accounting for 28% and 18% respectively. Certain economic activities are unique to the area such as the space launching facilities at Vandenberg Air Force Base and the production of seeds for various flowers grown worldwide. While major oil companies have elected to do business elsewhere (due to very stringent county business regulations), smaller production companies have moved in to continue the oil industry in the area. The moderate climate allows a year round growing season for numerous vegetables and fruits. Vineyards and cattle ranches make large contributions to the local economy. There are large

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numbers of retail businesses and light manufacturers with only limited numbers of high tech firms throughout the service area. Access to numerous recreational activities, including both mountains and beaches, provide a fairly stable tourist industry from larger metropolitan areas such as the Los Angeles/Orange County basin and the San Francisco Bay area. Real estate values throughout the Tri-counties have steadily increased in recent years. With the diversity of the various types of industries in the Bank’s service area, the Central Coast, while not immune from economic fluctuations, has historically tended to enjoy a more stable level of economic activity than many other areas of California.

Competition

The banking business in California generally, and in the Bank’s primary service areas specifically, is highly competitive with respect to both loans and deposits and is dominated by a relatively small number of major banks with many offices and operations over a wide geographic area. Among the advantages such major banks have over the Bank are their ability to finance wide-ranging advertising campaigns and to allocate their investment assets to regions of higher yield and demand. Such banks offer certain services such as international banking which is not offered directly by the Bank, but which can be offered indirectly by the Bank through correspondent institutions. In addition, by virtue of their greater total capitalization, such banks have substantially higher lending limits than the Bank. (Legal lending limits to an individual customer are based upon a percentage of a bank’s total capital accounts.)  The Bank’s secured and unsecured lending limits at December 31, 2005, were approximately $56.1 million and $33.7 million, respectively. These levels compare to $56.5 million and $33.9 million, respectively, at December 31, 2004 (see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—External Factors Impacting the Bank—Competitive Factors”).

Other entities, both governmental and private industry, seeking to raise capital through the issuance and sale of debt or equity securities, also provide competition for the Bank in the acquisition of deposits. Banks also compete with money market funds and other providers of money market instruments.

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. Commercial banks also compete for loans with savings and loan associations, credit unions, consumer finance companies, mortgage companies, insurance companies and other lending institutions.

The financial services industry is undergoing rapid technological changes involving frequent introductions of new technology-driven products and services that have further increased competition. There can also be no assurance that these technological improvements, if made, will increase the Bank’s operational efficiency or that the Bank will be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers.

The trend toward consolidation of banking assets exhibited over the past few years in California continued in 2005 but other new institutions are coming on line to replace them. Statewide in 2005, there were 15 banks which either completed or announced merger into another institution. According to the California State Department of Financial Institutions however, 21 applications for new banks were filed in 2005 in California, with 10 of those having received approval.

Employees

At December 31, 2005, the Bank had a total of 880 employees, a number of which are part-time. On a full-time equivalent basis, employees represent 823 positions. The Bank believes that its employee relations are positive.

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Effect of Governmental Policies and Legislation

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 local, domestic and foreign economic conditions, including recession, unemployment and inflation.

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 United States Government securities which effect short term rates such as the Fed Funds rate, 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 on the Bank 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 intermediaries. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial intermediaries are frequently made in Congress, the California legislature and before various bank regulatory and other professional agencies. See “Financial Services Modernization Legislation,” and “Sarbanes-Oxley Act of 2002.”

Supervision and Regulation

The Bank is extensively regulated under both federal and state law. Set forth below, is a summary description of certain laws which relate to the regulation of the Company and the Bank. The description does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations.

Mid-State Bancshares

The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the “Bank Holding Company Act”), and is registered as such with, and subject to the supervision of, the Federal Reserve Board. It  is required to file with the Federal Reserve Board quarterly and annual reports 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 bank holding companies and their subsidiaries.

The Company is required to obtain the approval of the Federal Reserve Board before it may acquire all or substantially all of the assets of any bank, or ownership or control of the voting shares of any bank if, after giving effect to such acquisition of shares, the Company would own or control more than 5% of the voting shares of such bank. Prior approval of the Federal Reserve Board is also required for the merger or consolidation of the Company and another bank holding company.

The Company is prohibited by the Bank Holding Company Act, except in certain statutorily prescribed instances, from acquiring direct or indirect ownership or control of more than 5% of the outstanding voting shares of any company that is not a bank or bank holding company and from engaging, directly or indirectly, in activities other than those of banking, managing or controlling banks or furnishing

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services to its subsidiaries. However, the Company may, subject to the prior approval of the Federal Reserve Board, engage in any, or acquire shares of companies engaged in, activities that are deemed by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.

The Federal Reserve Board may require that the Company terminate an activity or terminate control of or liquidate or divest subsidiaries or affiliates when the Federal Reserve Board determines that the activity or the control or the subsidiary or affiliates constitutes a significant risk to the financial safety, soundness or stability of any of its banking subsidiaries. The Federal Reserve Board also has the authority to regulate provisions of certain bank holding company debt, including authority to impose interest ceilings and reserve requirements on such debt. Under certain circumstances, the Company must file written notice and obtain approval from the Federal Reserve Board prior to purchasing or redeeming its equity securities.

Under the Federal Reserve Board’s regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe and unsound manner. In addition, it is the Federal Reserve Board’s policy that in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company’s failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve Board to be an unsafe and unsound banking practice or a violation of the Federal Reserve Board’s regulations or both.

The Company and the Bank are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services. For example, with certain exceptions, neither the Company nor the Bank may condition an extension of credit to a customer on either (1) a requirement that the customer obtain additional services provided by the Company and the Bank or (2) an agreement by the customer to refrain from obtaining other services from a competitor.

The Company’s common stock is registered with the Securities and Exchange Commission (the “SEC”) under the Securities Exchange Act of 1934, as amended. As such, we are subject to the information, proxy solicitation, insider trading, corporate governance, and other requirements and restrictions of such Act.

The Bank

The Bank is chartered under the laws of the State of California and its deposits are insured by the FDIC to the extent provided by law. The Bank is subject to the supervision of, and is regularly examined by, the California Department of Financial Institutions (DFI) and the FDIC. Such supervision and regulation include comprehensive reviews of all major aspects of the Bank’s business and condition.

Various requirements and restrictions under the laws of the United States and the State of California affect the operations of the Bank. Federal and California statutes relate to many aspects of the Bank’s operations, including reserves against deposits, interest rates payable on deposits, loans, investments, mergers and acquisitions, borrowings, dividends and locations of branch offices. Further, the Bank is required to maintain certain levels of capital.

If, as a result of an examination of a bank, the FDIC or the DFI should determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, or other aspects of the Bank’s operations are unsatisfactory or that the Bank or its management is violating or has violated any

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law or regulation, various remedies are available to these regulatory agencies. Such remedies include the power to enjoin “unsafe or unsound” practices, to require affirmative action to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in capital, to restrict the growth of the Bank, to assess civil monetary penalties, to remove officers and directors, and ultimately to terminate the Bank’s deposit insurance, which for a California chartered bank would result in a revocation of the bank’s charter.

Capital Standards

The Federal Reserve Board and the FDIC have adopted risk-based minimum capital guidelines intended 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 these guidelines, 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 low credit risk, such as certain U.S. Treasury securities, to 100% for assets with relatively high credit risk, such as certain business loans.

A banking organization’s risk-based capital ratios are obtained by dividing its qualifying capital by its total risk ­adjusted assets. The regulators measure risk-adjusted assets, which includes off balance sheet items, against both total qualifying capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and Tier 1 capital. Tier 1 capital consists primarily of common stock, retained earnings, non-cumulative perpetual preferred stock (cumulative perpetual preferred stock for bank holding companies) and minority interests in certain subsidiaries, less most intangible assets. Tier 2 capital may consist of a limited amount of the allowance for loan and lease losses, cumulative preferred stock,  long term preferred stock, eligible term subordinated debt and certain other instruments with some characteristics of equity. The inclusion of elements of Tier 2 capital is subject to certain other requirements and limitations of the federal banking agencies. The federal banking agencies require a minimum ratio of qualifying total capital to risk-adjusted assets of 8% and a minimum ratio of Tier 1 capital to risk-adjusted assets of 4%. Mid-State Bank & Trust’s ratios are 12.0% and 11.3%, respectively, as of December 31, 2005. On a consolidated basis, Mid-State Bancshares’ ratios are 12.3% and 11.6%, respectively, at the same date.

In addition to the risk-based guidelines, federal banking regulators require banking organizations to maintain a minimum amount of Tier 1 capital to total assets, referred to as the leverage ratio. For a banking organization rated in the highest of the five categories used by regulators to rate banking organizations, the minimum leverage ratio of Tier 1 capital to total assets is 3%.  For all banking organizations not rated in the highest category, the minimum leverage ratio must be at least 100 to 200 basis points above the 3% minimum, or 4% to 5%. Mid-State Bank & Trust’s ratio is 8.9% as of December 31, 2005. On a consolidated basis, Mid-State Bancshares’ ratio is 9.2% at the same date. In addition to these uniform risk-based capital guidelines and leverage ratios that apply across the industry, the regulators have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios.

Future changes in regulations or practices could further reduce the amount of capital recognized for purposes of capital adequacy. Such a change could affect the ability of the Bank to grow and could restrict the amount of profits, if any, available for the payment of dividends to the Company.

On January 1, 1998 legislation became effective which, among other things, gave the DFI power to take possession of the business and properties of a bank in the event that the tangible shareholders’ equity of the bank is less than the greater of (i) 3% of the bank’s total assets or (ii) $1.0 million.

For additional information concerning the capital ratios of the Company and the Bank, see, “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

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Under applicable regulatory guidelines, the Bank was considered “Well Capitalized” as of December 31, 2005.

Prompt Corrective Action and Other Enforcement Mechanisms

Federal banking agencies possess broad powers to take corrective and other supervisory action to resolve the problems of insured depository institutions, including but not limited to those institutions that fall below one or more prescribed minimum capital ratios described above. An institution that, based upon its capital levels, is classified as well capitalized, adequately capitalized, or undercapitalized may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, determines that an unsafe or unsound condition or an unsafe or unsound practice warrants such treatment. At each successive lower capital category, an insured depository institution is subject to more restrictions. The federal banking agencies, however, may not treat a significantly undercapitalized institution as critically undercapitalized unless its capital ratio actually warrants such treatment.

In addition to measures taken under the prompt corrective action provisions, commercial banking organizations may be subject to potential enforcement 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 imposition of a conservator or the issuance of a cease-and-desist order that can be judicially enforced;

·       the termination of insurance of deposits (in the case of a depository institution);

·       the imposition of civil money penalties;

·       the issuance of directives to increase capital;

·       the issuance of formal and informal agreements;

·       the issuance of removal and prohibition orders against institution-affiliated parties; and

·       the enforcement of such actions through injunctions or restraining orders based upon a judicial determination that the agency would be harmed if such equitable relief was not granted.

Additionally, a holding company’s inability to serve as a source of strength to its subsidiary banking organizations could serve as an additional basis for a regulatory action against the holding company.

Banks are also subject to certain Federal Reserve Board restrictions on extensions of credit to executive officers, directors, principal shareholders or any related interests of such persons (i.e., insiders). Extensions of credit (1) must be made on substantially the same terms and pursuant to the same credit underwriting procedures as those for comparable transactions with persons who are neither insiders nor employees, and (2) must not involve more than the normal risk of repayment or present other unfavorable features. Banks are also subject to certain lending limits and restrictions on overdrafts to insiders. A violation of these restrictions may result in regulatory sanctions on the bank or its insiders.

Premiums for Deposit Insurance

The Bank’s deposits are currently insured to a maximum of $100,000 per depositor through the Bank Insurance Fund administered by the FDIC. The Bank is required to pay deposit insurance premiums, which are assessed semiannually and paid quarterly. The premium amount is based upon a risk classification system established by the FDIC. Banks with higher levels of capital and a low degree of

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supervisory concern are assessed lower premiums than banks with lower levels of capital or a higher degree of supervisory concern.

The FDIC is also empowered to make special assessments on insured depository institutions in amounts determined by the FDIC to be necessary to give it adequate assessment income to repay amounts borrowed from the U.S. Treasury and other sources or for any other purpose the FDIC deems necessary.

The FDIC is authorized to terminate a depository institution’s deposit insurance upon a finding by the FDIC that the institution’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the institution’s regulatory agency.

The President signed the budget reconciliation package (S. 1932) that contains the comprehensive Federal Deposit Insurance Reform Act of 2005. This legislation, among other things, (i) merges the Bank Insurance Fund (BIF) and the Savings Associations Insurance Fund (SAIF) into the Deposit Insurance Fund (DIF); (ii) establishes a process for indexing coverage levels to account for inflation; (iii) sets a cap on the DIF; (iv) sets up a system of dividends; (v) gives certain banks credit for past over-payments to the fund; (vi) gives the FDIC added flexibility should the fund ever face financial difficulty; and (vii) increases deposit insurance coverage to $250,000 for certain retirement accounts. The legislation will become effective six months after the FDIC completes their regulations covering the above items.

Sarbanes-Oxley Act of 2002

On July 30, 2002, the Sarbanes-Oxley Act of 2002 (“SOX”), was signed into law to address corporate and accounting fraud. SOX establishes a new accounting oversight board that will enforce auditing standards and restricts the scope of services that accounting firms may provide to their public company audit clients. Among other things, SOX also (i) requires chief executive officers and chief financial officers to certify to the accuracy of periodic reports filed with the SEC; (ii) imposes new disclosure requirements regarding internal controls, off-balance-sheet transactions, and pro forma (non-GAAP) disclosures; (iii) accelerates the time frame for reporting of insider transactions and periodic disclosures by public companies; and (iv) requires companies to disclose whether or not they have adopted a code of ethics for senior financial officers and whether the audit committee includes at least one “audit committee financial expert.”

Under SOX, the SEC is required to regularly and systematically review corporate filings, based on certain enumerated factors. To deter wrongdoing, SOX: (i) subjects bonuses issued to top executives to disgorgement if a restatement of a company’s financial statements was due to corporate misconduct; (ii) prohibits an officer or director from misleading or coercing an auditor; (iii) prohibits insider trades during pension fund “blackout periods”; (iv) imposes new criminal penalties for fraud and other wrongful acts; and (v) extends the period during which certain securities fraud lawsuits can be brought against a company or its officers.

As a public reporting company, the Company is subject to the requirements of SOX and related rules and regulations issued by the SEC and NASDAQ. The Company has incurred additional expense as a result of the requirements of the Act, but does not expect that such compliance will have a material impact on its business overall.

Financial Services Modernization Legislation

On November 12, 1999, the Gramm-Leach-Bliley Act of 1999 (the “Financial Services Modernization Act”) was signed into law. The Financial Services Modernization Act is intended to modernize the banking industry by removing barriers to affiliation among banks, insurance companies, the securities industry and other financial service providers. It provides financial organizations with the flexibility of structuring such

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affiliations through a holding company structure or through a financial subsidiary of a bank, subject to certain limitations. The Financial Services Modernization Act establishes a new type of bank holding company, known as a financial holding company, which may engage in an expanded list of activities that are “financial in nature,” which include securities and insurance brokerage, securities underwriting, insurance underwriting and merchant banking. The Company has not chosen to seek “financial holding company” status.

The Financial Services Modernization Act also sets forth a system of functional regulation that makes the Federal Reserve Board the “umbrella supervisor” for holding companies, while providing for the supervision of the holding company’s subsidiaries by other federal and state agencies. In addition, the Bank is subject to other provisions of the Financial Services Modernization Act, including those relating to CRA, privacy and safe-guarding confidential customer information, regardless of whether the Company elects to become a financial holding company or to conduct activities through a financial subsidiary of the Bank. The Company does not, however, currently intend to file notice with the Federal Reserve Board to become a financial holding company or to engage in expanded financial activities through a financial subsidiary of the Bank.

The Company and the Bank do not believe that the Financial Services Modernization Act will have a material adverse effect on their operations in the near-term. However, to the extent that it permits banks, securities firms, and insurance companies to affiliate, the financial services industry may experience further consolidation. The Financial Services Modernization Act is intended to grant to community banks certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis. Nevertheless, this act may have the result of increasing the amount of competition that the Company and the Bank face from larger institutions and other types of companies offering financial products, many of which may have substantially more financial resources than the Company and the Bank.

USA Patriot Act of 2001

On October 26, 2001, President Bush signed the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism, or the Patriot Act, of 2001. Among other things, the Patriot Act (i) prohibits banks from providing correspondent accounts directly to foreign shell banks; (ii) imposes due diligence requirements on banks opening or holding accounts for foreign financial institutions or wealthy foreign individuals (iii) requires financial institutions to establish an anti-money-laundering compliance program, and (iv) eliminates civil liability for persons who file suspicious activity reports. The Patriot Act also increases governmental powers to investigate terrorism, including expanded government access to account records. The Department of the Treasury is empowered to administer and make rules to implement the Patriot Act. There are various measures pending in the U.S. Congress which would extend the provisions of the Act. While the Company and the Bank believes the Patriot Act affects their recordkeeping and reporting expenses, they do not believe that it has a material adverse effect on their business and operations.

Bank Secrecy Act

In 1970, Congress passed the Currency and Foreign Transactions Reporting Act, otherwise known as the Bank Secrecy Act (the “BSA”), which established requirements for recordkeeping and reporting by banks and other financial institutions. The BSA was designed to help identify the source, volume and movement of currency and other monetary instruments into and out of the United States in order to help detect and prevent money laundering connected with drug trafficking, terrorism and other criminal activities. The primary tool used to implement BSA requirements is the filing of Suspicious Activity Reports. Today, the BSA requires that all banking institutions develop and provide for the continued administration of a program reasonably designed to assure and monitor compliance with certain recordkeeping and reporting requirements regarding both domestic and international currency

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transactions. These programs must, at a minimum, provide for a system of internal controls to assure ongoing compliance, provide for independent testing of such systems and compliance, designate individuals responsible for such compliance and provide appropriate personnel training.

Transactions between Affiliates

Transactions between a bank and its “affiliates” are quantitatively and qualitatively restricted under the Federal Reserve Act. The Federal Reserve Board issued Regulation W on October 31, 2002, which comprehensively implements Sections 23A and 23B of the Federal Reserve Act. Sections 23A and 23B and Regulation W restrict loans by a depository institution to its affiliates, asset purchases by a depository institution from its affiliates, and other transactions between a depository institution and its affiliates. Regulation W unifies in one public document the Federal Reserve Board’s interpretations of Section 23A and 23B. Regulation W had an effective date of April 1, 2003.

Community Reinvestment Act

The Bank is subject to certain fair lending requirements and reporting obligations involving home mortgage lending operations and CRA activities. The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of their local communities, including low and moderate income neighborhoods. In addition to substantial penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and CRA into account when regulating and supervising other activities.

When a bank holding company applies for approval to acquire a bank or other bank holding company, the Federal Reserve will review the assessment of each subsidiary bank of the applicant bank holding company, and such records may be the basis for denying the application. A bank’s compliance with its CRA obligations is based on a performance-based evaluation system which bases CRA ratings on an institution’s lending service and investment performance, resulting in a rating by the appropriate bank regulatory agency of “outstanding”, “satisfactory”, “needs to improve” or “substantial noncompliance.” At its last examination by the FDIC, the Bank received a CRA rating of “Satisfactory.”

Safety and Soundness Standards

The Federal Deposit Insurance Corporation Improvement Act (“FDICIA”) imposes certain specific restrictions on transactions and requires federal banking regulators to adopt overall safety and soundness standards for depository institutions related to internal control, loan underwriting and documentation and asset growth. Among other things, FDICIA limits the interest rates paid on deposits by undercapitalized institutions, restricts the use of brokered deposits, limits the aggregate extensions of credit by a depository institution to an executive officer, director, principal shareholder or related interest, and reduces deposit insurance coverage for deposits offered by undercapitalized institutions for deposits by certain employee benefits accounts. The federal banking agencies may require an institution to submit to an acceptable compliance plan as well as have the flexibility to pursue other more appropriate or effective courses of action given the specific circumstances and severity of an institution’s noncompliance with one or more standards.

Privacy

Federal banking rules limit the ability of banks and other financial institutions to disclose non-public information about consumers to non-affiliated third parties. Pursuant to these rules, financial institutions must provide:

·       initial notices to customers about their privacy policies, describing the conditions under which they may disclose non-public information to non-affiliated third parties and affiliates;

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·       annual notices of their privacy policies to current customers; and

·       a reasonable method for customers to “opt out” of disclosures to non-affiliated third parties.

These privacy provisions affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors. We have implemented our privacy policies in accordance with the law.

In recent years, a number of states have implemented their own versions of privacy laws. For example, in 2003, California adopted standards that are more restrictive than federal law, allowing bank customers the opportunity to bar financial companies from sharing information with their affiliates.

Federal Home Loan Bank System

The Bank is a member of the Federal Home Loan Bank (“FHLB”) of San Francisco. Among other benefits, each FHLB serves as a reserve or central bank for its members within its assigned region. Each FHLB is financed primarily from the sale of consolidated obligations of the FHLB system. Each FHLB makes available loans or advances to its members in compliance with the policies and procedures established by the Board of Directors of the individual FHLB.

A new capital plan of the FHLB of San Francisco was approved by the Federal Housing Finance Board and was implemented on April 1, 2004. The new capital plan incorporates a single class of stock with a par value of $100 per share, and may be issued, exchanged, redeemed, and repurchased only at par value. Each member must own stock in an amount equal to the greater of:

·       a membership stock requirement with an initial cap of $25 million (1.00% of “membership asset value” as defined), or

·       an activity based stock requirement (based on percentage of outstanding advances).

The new capital stock is redeemable with five years’ written notice, subject to certain conditions. The effect of this plan was that the Bank had to purchase $5.9 million of additional FHLB stock bringing the total of its holdings to $8.2 million.

Predatory Lending

The term “predatory lending,” much like the terms “safety and soundness” and “unfair and deceptive practices,” is far-reaching and covers a potentially broad range of behavior. As such, it does not lend itself to a concise or a comprehensive definition. But typically predatory lending involves at least one, and perhaps all three, of the following elements:

·       making unaffordable loans based on the assets of the borrower rather than on the borrower’s ability to repay an obligation, or asset-based lending;

·       inducing a borrower to refinance a loan repeatedly in order to charge high points and fees each time the loan is refinanced, or loan flipping; and

·       engaging in fraud or deception to conceal the true nature of the loan obligation from an unsuspecting or unsophisticated borrower.

Federal Reserve Board regulations aimed at curbing such lending significantly widened the pool of high-cost home-secured loans covered by the Home Ownership and Equity Protection Act of 1994, a federal law that requires extra disclosures and consumer protections to borrowers. The following scenarios trigger coverage under the Home Ownership and Equity Protection Act of 1994:

·       interest rates for first lien mortgage loans in excess of 8 percentage points above comparable Treasury securities,

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·       subordinate-lien loans of 10 percentage points above Treasury securities, and

·       fees such as optional insurance and similar debt protection costs paid in connection with the credit transaction, when combined with points and fees if deemed excessive.

In addition, the regulation bars loan flipping by the same lender or loan servicer within a year. Lenders also will be presumed to have violated the law—which says loans shouldn’t be made to people unable to repay them—unless they document that the borrower has the ability to repay. Lenders that violate the rules face cancellation of loans and penalties equal to the finance charges paid. The Company does not expect these rules and potential state action in this area to have a material impact on our financial condition or results of operation.

Accounting Changes

From time to time the Financial Accounting Standards Board (“FASB”) issues pronouncements which govern the accounting treatment for the Company’s financial statements. For a description of the recent pronouncements applicable to the Company see the Notes to the Financial Statements included in Item 8 of this Report.

Off Balance Sheet and Other Related Party Transactions

As noted in Footnote 12 to the financial statements, the Company is contingently liable for letter of credit accommodations made to its customers in the ordinary course of business totaling $40.9 million at December 31, 2005 compared to $30.2 million one year earlier. Additionally, the Company has undisbursed loan commitments, also made in the ordinary course of business, totaling $658.0 million, which compares to $626.4 million outstanding one year earlier.

There are no Special Purpose Entity (“SPE”) trusts, corporations, or other legal entities established by the Company which reside off-balance sheet. There are no other off-balance sheet items other than the aforementioned items related to letter of credit accommodations and undisbursed loan commitments.

As noted in Footnote 5 to the financial statements, the Company does make loans to related parties (directors and officers) in the ordinary course of business at prevailing rates and terms. These loans totaled $14.1 million at the end of 2005, compared to the $8.7 million outstanding one year earlier. While loans to insiders and related parties are generally prohibited under SOX, as a bank, the Bank is exempt from this rule.

Where You Can Find More Information.

Under the Securities Exchange Act of 1934 Sections 13 and 15(d), periodic and current reports must be filed with the SEC. The Company electronically files the following reports with the SEC: Form 10-K (Annual Report), Form 10-Q (Quarterly Report), Form 11-K (Annual Report for Employees’ Stock Purchase and Savings Plans), Form 8-K (Current Report), Forms 3, 4, and 5 (Changes in Beneficial Ownership) and Form DEF 14A (Proxy Statement). The Company may file additional forms. The SEC maintains an Internet site, www.sec.gov, in which all forms filed electronically may be accessed. Additionally, all forms filed with the SEC and additional shareholder information, such as certain corporate governance documents including the Company’s and Bank’s audit committee charter, compensation committee charter, nominating/corporate governance committee charter, corporate governance guidelines, and corporate code of conduct (which includes the code of ethics required by the SEC and applicable to senior executive officers of the Company and Bank), are available free of charge on the Company’s website: www.midstatebank.com. The Company posts these reports to its website as soon as reasonably practicable after filing them with the SEC. None of the information on or hyperlinked from the Company’s website is incorporated into this Annual Report on Form 10-K.

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ITEM 1A.        RISK FACTORS

An investment in our common stock is subject to risks inherent to our business. The material risks and uncertainties that management believes may affect our business are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing our business. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair our business operations. This report is qualified in its entirety by these risk factors.

If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of our common stock could decline significantly, and you could lose all or part of your investment.

Risks Associated with our Business.

We are highly dependent on real estate and a downturn in the real estate market could hurt our business.

A significant portion of our loan portfolio is dependent on real estate. At December 31, 2005, real estate served as the principal source of collateral with respect to approximately 84% of our loan portfolio. A decline in current economic conditions or rising interest rates could have an adverse effect on the demand for new loans, the ability of borrowers to repay outstanding loans, the value of real estate and other collateral securing loans and the value of real estate owned by us, as well as our financial condition and results of operations in general and the market value of our common stock.

Acts of nature, including earthquakes, floods and fires, which may cause uninsured damage and other loss of value to real estate that secures these loans, may also negatively impact our financial condition.

We also have a concentration in commercial real estate loans.

We also have a high concentration in commercial real estate or CRE loans. CRE loans generally involve a higher degree of credit risk than residential mortgage lending due, among other things, to the large amounts loaned to individual borrowers. Losses incurred on loans to a small number of borrowers could have a material adverse impact on our income and financial condition. In addition, unlike residential mortgage loans, commercial real estate loans generally depend on the cash flow from the property to service the debt. Cash flow may be significantly affected by general economic conditions.

Banking regulators have recently issued proposed guidance regarding institutions that have particularly high concentrations of CRE within their lending portfolios. This guidance suggests that institutions that exceed certain levels of CRE lending may be required, in the future, to maintain higher capital ratios than institutions with lower concentrations in CRE lending. If and when this proposed guidance becomes final, we may be subject to enhanced regulatory scrutiny and subject to higher capital requirements.

Our real estate lending also exposes us to the risk of environmental liabilities.

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 these properties. We may be held liable to a governmental entity or to third persons 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, as the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. If we ever become subject to significant

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environmental liabilities, our business, financial condition, liquidity and results of operations could be materially and adversely affected.

Insufficient loan demand could have an adverse impact on our business.

We are significantly affected by the level of loan demand available in our markets. Strong local pressure from competitors to make loans to existing and potential customers also affects our ability to make sufficient loans. The inability to make sufficient loans directly affects the interest income we earn. Lower loan demand will generally result in lower interest income since funds will be placed in lower yielding investments.

Our business is subject to interest rate risk and changes in interest rates may adversely affect our performance and financial condition.

Our earnings are impacted by changing interest rates. Changes in interest rates impact the demand for new loans, the credit profile of our borrowers, the rates received on loans and securities and rates paid on deposits and borrowings. The difference between the rates received on loans and securities and the rates paid on deposits and borrowings is known as interest rate spread. Increasing levels of competition in the banking and financial services business may decrease our net interest spread by forcing us to offer lower lending interest rates and pay higher deposit interest rates.

A sustained decrease in market interest rates could adversely affect our earnings. When interest rates decline, borrowers tend to refinance higher-rate, fixed-rate loans at lower rates, prepaying their existing loans. Under those circumstances, we would not be able to reinvest those prepayments in assets earning interest rates as high as the rates on the prepaid loans. In addition, our commercial real estate and commercial loans, which carry interest rates that, in general, adjust in accordance with changes in the prime rate, will adjust to lower rates. We are also significantly affected by the level of loan demand available in our market. Given our current volume and mix of interest-bearing liabilities and interest-earning assets, our interest rate spread can be expected to increase when market interest rates are rising, and to decline when market interest rates are declining. The Federal Reserve Board’s decrease in rates during 2001, 2002 and 2003 substantially impacted our interest rate spread, as the spread for 2004 declined to 5.36% (taxable equivalent) from 5.54% (taxable equivalent) in 2003 and from 5.74% (taxable equivalent) in 2002. Increases in short term rates by the Federal Reserve Board in the latter half of 2004 through 2005 and into 2006 are having the effect of beginning to reverse this trend with our interest spread rising to 5.74% (taxable equivalent) in 2005. Although we believe our current level of interest rate sensitivity is reasonable, significant fluctuations in interest rates may have an adverse impact on our business, financial condition and results of operations.

Failure to successfully execute our strategy could adversely affect our performance.

Our financial performance and profitability depends on our ability to execute our corporate growth strategy. See “Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Challenges and Opportunities in 2006.”   Continued growth, however, may present operating and other problems that could adversely affect our business, financial condition and results of operations.  Accordingly, there can be no assurance that we will be able to execute our growth strategy or maintain the level of profitability that we have recently experienced. Factors that may adversely affect our ability to attain our long-term financial performance goals include those stated elsewhere in this section, as well as:

·       Inability to control non-interest expense, including, but not limited to, rising employee and healthcare costs;

·       Inability to increase non-interest income; and

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·       Continuing ability to expand, through de novo branching or finding acquisition targets at valuation levels we find attractive.

Our primary market area is an increasingly competitive and overcrowded banking market. Our ability to achieve the growth outlined in our corporate strategic goals may be dependent in part on an ability to grow through the successful addition of new branches or the identification and acquisition of potential targets at acceptable pricing levels either inside or outside of our primary market. If we are unable to attract significant new business through strategic branching, or acquiring new business through our acquisition of other banks, our growth in loans and deposits and, therefore, our earnings, may be adversely affected.

Economic conditions on the California Central Coast could adversely affect our operations and/or cause us to sustain losses.

Our retail and commercial banking operations are concentrated primarily in San Luis Obispo and Santa Barbara Counties. As a result of this geographic concentration, our results of operations depend largely upon economic conditions in this area. A significant source of risk arises from the possibility that losses will be sustained if a significant number of our borrowers, guarantors and related parties fail to perform in accordance with the terms of their loans. This risk increases when the economy is weak. We have adopted underwriting and credit monitoring procedures and credit policies, including the establishment and review of the allowance for credit losses, that management believes are appropriate to minimize this risk by assessing the likelihood of nonperformance, tracking loan performance and diversifying our credit portfolio. These policies and procedures, however, may not prevent unexpected losses that could materially adversely affect our results of operations in general and the market value of our stock.

Potential acquisitions may affect our business and shareholder value.

We are currently seeking merger or acquisition partners that are culturally similar and have experienced management and possess either significant market presence or have potential for improved profitability through financial management, economies of scale or expanded services. We do not currently have any specific plans, arrangements or understandings regarding such expansion. We cannot say with any certainty that we will be able to consummate such acquisitions. In attempting to make such acquisitions, we anticipate competing with other financial institutions, many of which have greater financial and operational resources. Acquiring other banks, businesses, or branches involves various risks commonly associated with acquisitions, including, among other things:

·       Potential exposure to unknown or contingent liabilities of the target company.

·       Exposure to potential asset quality issues of the target company.

·       Difficulty and expense of integrating the operations and personnel of the target company.

·       Potential disruption to our business.

·       Potential diversion of management’s time and attention.

·       The possible loss of key employees and customers of the target company.

·       Difficulty in estimating the value of the target company.

·       Potential changes in banking or tax laws or regulations that may affect the target company.

We regularly evaluate merger and acquisition opportunities and conduct due diligence activities related to possible transactions with other financial institutions and financial services companies. As a result, merger or acquisition discussions and, in some cases, negotiations may take place and future

20

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mergers or acquisitions involving cash, debt or equity securities may occur at any time. Acquisitions typically involve the payment of a premium over book and market values, and, therefore, some dilution of our stock’s tangible book value and net income per common share may occur in connection with any future transaction. Furthermore, failure to realize the expected revenue increases, cost savings, increases in geographic or product presence, and/or other projected benefits from an acquisition could have a material adverse effect on our financial condition and results of operations.

Likewise, we may expand our branch network through de novo branches in existing or new markets. These de novo branches will have expenses in excess of revenues for varying periods after opening that could decrease our reported earnings.

We face strong competition from financial service companies and other companies that offer banking services that could hurt our business.

The financial services business in our market areas is highly competitive. It is becoming increasingly competitive due to changes in regulation, technological advances, and the accelerating pace of consolidation among financial services providers. We face competition both in attracting quality assets and deposits and in making loans. We compete for loans principally through the interest rates and loan fees we charge and the efficiency and quality of services we provide. Increasing levels of competition in the banking and financial services business may reduce our market share, decrease loan demand, cause the prices we charge for our services to fall, or decrease our net interest margin by forcing us to offer lower lending interest rates and pay higher deposit interest rates. Therefore, our results may differ in future periods depending upon the nature or level of competition.

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 that would have historically been held as bank deposits in brokerage accounts or mutual funds. 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 our financial condition and results of operations.

We may not be able to attract and retain skilled people.

Our success depends, in large part, on our ability to attract and retain key people. Competition for the best people in most of our activities can be intense and we may not be able to hire people or to retain them. The unexpected loss of services of one or more of our key personnel could have a material adverse impact on our business because of their skills, knowledge of our market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.

Our internal operations are subject to a number of risks.

We are subject to certain operations risks, including, but not limited to, data processing system failures and errors, customer or employee fraud and catastrophic failures resulting from terrorist acts or natural disasters. We maintain a system of internal controls to mitigate against such occurrences and maintain insurance coverage for such risks that are insurable, but should such an event occur that is not prevented or detected by our internal controls, uninsured or in excess of applicable insurance limits, it could have a significant adverse impact on our business, financial condition or results of operations.

Information Systems.   We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems.

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While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.

Technological Advances.   The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on our business and, in turn, our financial condition and results of operations.

Severe Weather, Natural Disasters, Acts Of War Or Terrorism and Other External Events.   Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on our ability to conduct business. Such events could affect the stability of our deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause us to incur additional expenses. For example, the Central Coast of California is subject to earthquakes and fires. Operations in our market could be disrupted by both the evacuation of large portions of the population as well as damage and or lack of access to our banking and operation facilities. While we have not experienced such an occurrence to date, other severe weather or natural disasters, acts of war or terrorism or other adverse external events may occur in the future. Although management has established disaster recovery policies and procedures, the occurrence of any such event could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.

We depend on cash dividends from our subsidiary bank to meet our cash obligations.

As a holding company, dividends from our subsidiary bank provide a substantial portion of our cash flow used to service our obligations, including cash dividends. See “Item 5—Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.”  Various statutory provisions restrict the amount of dividends our subsidiary bank can pay to us without regulatory approval.

Impairment of goodwill recorded on our balance sheet could lead to a charge against future period’s earnings.

Pursuant to Generally Accepted Accounting Practices (GAAP), we are required to periodically assess our goodwill, intangibles and other long-lived assets to determine if they are impaired. Disruptions to our business, end market conditions and protracted economic weakness, unexpected significant declines in operating results of reporting units, divestitures and market capitalization declines may result in additional charges to goodwill and other asset impairments. Future impairment charges could substantially affect our reported earnings in the period of such charge. In addition, such charges would reduce our consolidated net worth and our shareholders’ equity.

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Risks Associated with our Industry.

We are subject to government regulation that could limit or restrict our activities, which in turn could adversely impact our operations.

The financial services industry is regulated extensively. Federal and State regulation is designed primarily to protect the deposit insurance funds and consumers, and not to benefit our shareholders. These regulations can sometimes impose significant limitations on our operations.

New laws and regulations or changes in existing laws and regulations or repeal of existing laws and regulations may adversely impact our business. We have to comply with all governmental regulations such as the Sarbanes Oxley Act of 2002, the Bank Secrecy Act, the Patriot Act, the Community Reinvestment Act, and many others. The cumulative cost of compliance with these regulations could be significant and affect the ability of the Company to earn an adequate return for its shareholders. For example, operating expenses were impacted by the significant cost of compliance with the new Sarbanes-Oxley Section 404 provisions in the years ended December 31, 2005 and 2004.

Further, federal monetary policy, particularly as implemented through the Federal Reserve System, significantly affects economic conditions for us.

New legislative and regulatory proposals may affect our operations and growth.

Proposals to change the laws and regulations governing the operations and taxation of, and federal insurance premiums paid by, banks and other financial institutions and companies that control such institutions are frequently raised in the U.S. Congress, state legislatures and before bank regulatory authorities. The likelihood of any major changes in the future and the impact such changes might have on us or our subsidiaries are impossible to determine. Similarly, proposals to change the accounting treatment applicable to banks and other depository institutions are frequently raised by the SEC, the federal banking agencies, the IRS and other appropriate authorities. The likelihood and impact of any additional future changes in law or regulation and the impact such changes might have on us or our subsidiaries are impossible to determine at this time.

Risks Associated with our Stock.

Our Stock Trades Less Frequently Than Others.

Although our common stock is listed for trading on the NASDAQ National Market, the trading volume in our common stock is less than that of other larger financial services companies. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of our common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control. Given the lower trading volume of our common stock, significant sales of our common stock, or the expectation of these sales, could cause our stock price to fall.

Our Stock Price Is Affected by a Variety of Factors.

Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive. Our stock price can fluctuate significantly in response to a variety of factors discussed in this section, including, among other things:

·       Actual or anticipated variations in quarterly results of operations.

·       Recommendations by securities analysts.

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·       Operating and stock price performance of other companies that investors deem comparable to our company.

·       News reports relating to trends, concerns and other issues in the financial services industry.

·       Perceptions in the marketplace regarding our company and/or its competitors.

Our Common Stock Is Not An Insured Deposit.

Our common stock is not a bank deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company. As a result, if you acquire our common stock, you may lose some or all of your investment.

Our Articles Of Incorporation and By-Laws, As Well As Certain Banking Laws, May Have An Anti-Takeover Effect.

Provisions of our articles of incorporation, bylaws and federal banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire us, even if doing so would be perceived to be beneficial to our shareholders. The combination of these provisions may hinder a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of our common stock.

ITEM 1B.       UNRESOLVED STAFF COMMENTS.

The Company does not have any unresolved staff comments received from the staff of the Securities and Exchange Commission (SEC).

24

ITEM 2.                PROPERTIES

The Company’s principal office is located at 1026 Grand Avenue, Arroyo Grande, California. As of December 31, 2005, the Bank owned 23 of its branch offices, 4 non-banking support offices and leased 20 other Bank locations (covered by 22 leases). The Company believes its present facilities are in good condition and are adequate for its present needs. The Company does not anticipate difficulty in renewing existing leases as they expire or in finding alternative facilities. See Note 6 to the Consolidated Financial Statements for a further description of the Company’s lease obligations.

Ownedby Bank or Subsidiary:				Location of Offices				Encumbrance
Arroyo Grande*				991 Bennett Avenue					NONE
Arroyo Grande				1026 Grand Avenue					NONE
Arroyo Grande*				550 Camino Mercado					NONE
Arroyo Grande*				398 Sunrise Terrace					NONE
Atascadero				6950 El Camino Real					NONE
Buellton				West Highway 246 & Central					NONE
Cambria				1070 Main Street					NONE
Goleta Valley				5956 Calle Real					NONE
Grover Beach				899 Grand Avenue					NONE
Grover Beach*				140 North Second Street					NONE
Guadalupe				905 Guadalupe Street					NONE
Lompoc				828 North “H” Street					NONE
Los Osos				1001 Los Osos Valley Road					NONE
Morro Bay				251 Harbor Street					NONE
Nipomo				615 West Tefft Street					NONE
Paso Robles				845 Spring Street					NONE
Pismo Beach				801 Price Street					NONE
San Luis Obispo				75 Santa Rosa					NONE
San Luis Obispo				2276 Broad Street					NONE
Santa Barbara				33 East Carrillo Street					NONE
Santa Barbara				2222 Bath Street					NONE
Santa Maria				720 North Broadway					NONE
Santa Maria				2739 Santa Maria Way					NONE
Santa Maria				1554 South Broadway					NONE
Santa Maria				519 E. Main Street					NONE
Templeton				1025 Las Tablas Road					NONE
Vandenberg Village				3745 Constellation Road					NONE

 

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Leased by Bank or Subsidiary

Arroyo Grande		1132 West Branch Street		$3,500.00 per month
West Branch In Store Office				Expires February, 2010
Camarillo		470 Arneill Road		$7,089.98 per month
Camarillo Financial Center				Expires June, 2009
Cayucos		107 North Ocean Avenue		$1,782.00 per month
				Expires November, 2007
Goleta Valley		5340 Hollister Avenue		$5,210.28 per month
Hollister Office				Expires February, 2007
Ojai		410 Ventura Avenue		$2,124.27 per month
Oak View				Expires December, 2010
Ojai		1207 Maricopa Highway		$8,003.00 per month
Ojai Valley				Expires December, 2014
Orcutt		1110 East Clark Avenue		$11,292.00 per month
				Expires October, 2010
Oxnard		300 Esplanade Drive,		$14,676.95 per month
Esplanade Financial Center		Suite 101		Expires September, 2012
Oxnard*		300 Esplanade Drive,		$12,145.25 per month
		Suite 110		Expires August, 2012
Oxnard		155 “A” Street		$6,030.42 per month
Downtown Oxnard Office				Expires July, 2010
Oxnard		121-125 Gonzales Boulevard		$6,907.43 per month
Northside Plaza Office***				Expires July, 2007
Paso Robles		705 Golden Hill Road		$9,585.00 per month
Creston Road Office				Expires October, 2012
Pismo Beach		865 Oak Park Boulevard		$10,683.00 per month
Oak Park Office				Expires March, 2008
Santa Barbara		914 Carpinteria Street		$10,407.00 per month
Milpas Office				Expires May, 2017
Santa Maria**		720 North Broadway		$2,522.00 per month
North Broadway Office—Land				Expires Dec, 2008
Santa Ynez		3600 Sagunto Street		$2,759.00 per month
				Expires May, 2012
Solvang		1600 Copenhagen Drive		$12,099.16 per month
				Expires April, 2008
Ventura		300 S. Mills Road		$17,306.94 per month
Mills Road Financial Center				Expires August, 2012
Ventura		304 E. Main Street		$10,652.00 per month
Downtown Ventura Office				Expires November, 2012
Ventura		6401 E. Telephone Road		$11,985.56 per month
County Center Office				Expires September, 2012
Westlake Village		2663 Townsgate Road		$16,732.00 per month
				Expires September, 2015
Westlake VillageCommercial		2663 Townsgate Road,		$7,614.81 per month
Banking Office*		Suite 113/119		Expires December, 2011

 

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Former Bank Offices Leased by Bank—Which Are Sub-Leased

Nipomo		630 W. Tefft Street		$4,156.00 per month
Ground Lease				Expires February, 2015

*                    The Bank’s rental expense for 2005 was $2,042,000. See note 6 of the Company’s financial statements included in Item 8 of this Report for certain additional information concerning the amount of the Bank’s lease commitment. All offices listed are full service branch offices, except those with asterisks noted above. Asterisks represent non-banking support offices (e.g., Administration, Data Processing, Supplies Warehouse, Credit Services, et. al.)

**             Ground lease on property adjacent to a fully owned facility.

***      Office closed June 30, 2005. Remaining rental charges expensed in 2005.

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. The Company is not a party to any pending legal or administrative proceedings as of December 31, 2005 (other than ordinary routine litigation incidental to the Company’s business) and no such proceedings are known to be contemplated. The Company does not expect the resolution of these items to have a material impact on its financial condition or operating results.

There are no material proceedings adverse to the Company to which any director, officer, affiliate of the Company, 5% shareholder of the Company, or any associate of any such director, officer, affiliate or 5% shareholder of the Company is a party, and none of the above persons has a material interest adverse to the Company.

ITEM 4.                SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the fourth quarter of 2005.

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PART II

ITEM 5.                MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information

The Company’s Common Stock trades on the NASDAQ National Market under the symbol “MDST.” The following table summarizes those trades of the Company’s Common Stock on NASDAQ, setting forth the approximate high and low closing sales prices for each quarterly period ended since January 1, 2004. The closing sales price on December 31, 2005 was $26.75 compared to the close one year earlier of $28.65.

				Closing Sales Prices
Quarter Ended 2004				Low		High
March 31				$23.00		$26.99
June 30				$21.03		$24.50
September 30				$23.00		$26.13
December 31				$25.45		$30.61

 

				Closing Sales Prices
Quarter Ended 2005				Low		High
March 31				$25.80		$28.89
June 30				$24.00		$28.94
September 30				$26.70		$31.29
December 31				$25.84		$29.61

 

There are approximately 5,000 holders of Mid-State Bancshares common stock as of December 31, 2005.

Equity Plan Compensation Information

The following table summarizes information as of December 31, 2005 relating to equity compensation plans of the Company pursuant to which grants of options, restricted stock or other rights to acquire shares may be granted from time to time.

Plan Category

Number of Securities To be issued upon Exercise of Options

Weighted Average Exercise Price of Outstanding Options

Number of Securities Remaining Available for Future Issuance

Equity compensation Plans approved by Stockholders

2,000,958

$19.20

1,027,372

Equity compensation Plans not approved by Stockholders

-None-

N/A

N/A

Total

2,000,958

$19.20

1,027,372

 

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Dividends

The following table sets forth the per share amount and month of payment for all cash dividends paid since January 1, 2004 by the Company to its shareholders.

Payable Date					Dividend
January 15, 2004				$0.13 per share
April 15, 2004				$0.14 per share
July 15, 2004				$0.14 per share
October 15, 2004				$0.14 per share
January 14, 2005				$0.16 per share
April 15, 2005				$0.16 per share
July 15, 2005				$0.16 per share
October 14, 2005				$0.16 per share
January 17, 2006				$0.18 per share

 

The Company is a legal entity separate and distinct from the Bank. The Company’s shareholders are entitled to receive dividends when declared by its Board of Directors, out of funds legally available therefore, 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. The Corporation Law 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 1-1/4 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 11¤4 times its current liabilities.

The ability of the Company to pay a cash dividend depends largely on the Bank’s ability to pay a cash dividend to the Company. The payment of cash dividends by the Bank is subject to restrictions set forth in the California Financial Code (the Financial Code). The Financial Code provides that a bank may not make a cash distribution to its shareholders in excess of the lesser of (a) the bank’s retained earnings; or (b) the bank’s net income for its last three fiscal years, less the amount of any distributions made by the bank or by any majority-owned subsidiary of the bank to the shareholders of the bank during such period. However, a bank may, with the approval of the DFI, make a distribution to its shareholders in an amount not exceeding the greater of (x) its retained earnings; (y) its net income for its last fiscal year; or (z) its net income for its current fiscal year. In the event that the DFI determines that the shareholders’ equity of a bank is inadequate or that the making of a distribution by the bank would be unsafe or unsound, the DFI may order the bank to refrain from making a proposed distribution. The FDIC may also restrict the payment of dividends if such payment would be deemed unsafe or unsound or if after the payment of such dividends, the Bank would be included in one of the “undercapitalized” categories for capital adequacy purposes pursuant to federal law. (See, “Item 1—Prompt Corrective Action and Other Enforcement Mechanisms.”) Additionally, while the Federal Reserve Board has no general restriction with respect to the payment of cash dividends by an adequately capitalized bank to its parent holding company, the Federal Reserve Board might, under certain circumstances, place restrictions on the ability of a particular bank to pay dividends based upon peer group averages and the performance and maturity of the particular bank, or object to management fees to be paid by a subsidiary bank to its holding company on the basis that such fees cannot be supported by the value of the services rendered or are not the result of an arm’s length transaction.

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Whether or not dividends will be paid in the future will be determined by the Board of Directors after consideration of various factors. The Company’s profitability and regulatory capital ratios in addition to other financial conditions will be key factors considered by the Board of Directors in making such determinations regarding the payment of dividends by the Company.

Transfer Agent

Mellon Investor Services, LLC serves as the Company’s transfer agent. Shareholder inquiries regarding holdings of Mid-State Bancshares Common Stock can be directed to:

Mellon Investor Services, LLC
P. O. Box 3315
South Hackensack, NJ       07606

Or

Mellon Investor Services, LLC
480 Washington Boulevard
Jersey City, NJ 07310-1900

By Phone:
1-(888)-540-9878 (U.S. & Canada)
1-(201)-329-8660 (Outside U.S.)
TDD for Hearing Impaired: (800) 231-5469
Foreign Shareowners: (201) 680-6578
TDD Foreign Shareowners: (201) 680-6610

Web Site Address: www.melloninvestor.com/isd

Mellon Investor Services maintains the records for registered Mid-State Bancshares shareholders and can help with such services as change of name or address, consolidation of accounts, duplicate mailings, dividend reinvestment enrollment, lost stock certificates, transfer of stock to another person, and additional administrative services. For more information, they can be contacted via the Internet at www.melloninvestor.com.

Stock Repurchase Program

The Board of Directors at its regular meeting of June 15, 2005, authorized the purchase of up to 1,141,373 additional shares since its prior authorizations in May 2002 and January 2004 had expired. The June 2005 authorization does not have an expiration date. The repurchase program seeks to reduce the number of outstanding shares resulting in an improvement to the Company’s earnings per share and to its return on equity. All of these shares were purchased at current market prices on the date of transaction in compliance with the SEC rules. The total number of shares repurchased was 845,055, 658,867, and 800,006 in 2005, 2004 and 2003, respectively. The average price paid per share in 2005, 2004, and 2003 was $27.29, $25.26, and $20.27, respectively. As of December 31, 2005, the Company could repurchase up to an additional 816,675 shares under the June 2005 authorization.

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During the fourth quarter of 2005, share repurchase activity was as follows:

Period				Total Number of Shares Purchased				Average Price Paid Per Share				Cumulative Shares Purchased Pursuant To June 15, 2005 Authorization				Remaining Shares to Purchase Pursuant to June 15, 2005 Authorization
October 2005					62,402				$26.72				265,237				876,136
November 2005					59,461				$28.29				324,698				816,675
December 2005					—-				—				324,698				816,675
Fourth Quarter 2005 Totals					121,863				$27.49				324,698				816,675

 

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ITEM 6.                SELECTED FINANCIAL DATA

Selected Consolidated Financial Data—Mid-State Bancshares

(In thousands—except per share data)				2005			2004			2003			2002			2001
Year Ended December 31:
Interest Income (not taxable equivalent)				$	128,326		$	109,936		$	105,240		$	109,332		$		114,002
Interest Expense				15,503			8,450			9,699			16,381			26,480
Net Interest Income				112,823			101,486			95,541			92,951			87,522
Provision for Loan Losses				—			(2,700		)	(969		)	600			4,100
Net Interest Income after provision for loan losses				112,823			104,186			96,510			92,351			83,422
Non-interest income				21,441			27,764			29,059			24,321			23,254
Non-interest expense				77,674			79,294			74,691			70,925			64,744
Income before income taxes				56,590			52,656			50,878			45,747			41,932
Provision for income taxes				19,099			17,547			17,714			15,892			14,530
Net Income				$	37,491		$	35,109		$	33,164		$	29,855		$		27,402
Per share:
Net Income—basic				$	1.65		$	1.50		$	1.41		$	1.25		$		1.22
Net Income—diluted				$	1.61		$	1.47		$	1.40		$	1.20		$		1.18
Weighted avg. shares for Basic E.P.S. calculation				22,788			23,422			23,443			23,962			22,452
Weighted avg. shares for Diluted E.P.S. calculation				23,300			23,897			23,762			24,837			23,252
Cash dividends				$	0.66		$	0.58		$	0.50		$	0.41		$		0.37
Book value at period-end				$	12.10		$	11.89		$	11.56		$	10.72		$		9.74
Tangible book value at period-end				$	9.69		$	9.48		$	9.15		$	8.94		$		7.96
Ending Shares				22,520			23,099			23,567			23,697			24,089
Period Averages:
Total Assets				$	2,367,764		$	2,269,873		$	2,045,252		$	1,892,137		$		1,570,098
Total Tangible Assets				2,312,889			2,213,639			2,000,406			1,850,671			1,558,507
Total Loans & Leases				1,472,885			1,310,842			1,131,932			1,109,245			999,501
Total Earning Assets				2,120,123			2,050,218			1,857,241			1,718,280			1,444,631
Total Deposits				2,049,280			1,970,248			1,763,215			1,623,510			1,351,256
Common Equity				276,412			277,054			261,103			244,295			195,955
Common Tangible Equity				221,537			220,820			217,982			202,829			184,364
At December 31,
Cash and cash equivalents				$	109,791		$	112,669		$	123,763		$	128,036		$		102,970
Investments and Fed Funds Sold				619,332			650,817			822,179			625,483			524,345
Loans held for sale				10,176			12,988			13,410			22,560			13,604
Loans, net of deferred fees, before allowance				1,519,014			1,421,894			1,154,932			1,087,551			1,136,099
Allowance for Loan & Lease Losses				(11,896		)	(13,799		)	(16,063		)	(17,370		)	(19,073			)
Goodwill and Core Deposit Intangibles				54,323			55,572			56,947			40,949			42,021
Other assets				90,759			55,946			53,664			47,531			53,698
Total Assets				$	2,391,499		$	2,296,087		$	2,208,832		$	1,934,740		$		1,853,664
Non-interest bearing deposits				$	567,782		$	517,139		$	487,624		$	390,212		$		367,370
Interest bearing deposits				1,501,824			1,477,406			1,424,807			1,262,735			1,216,796
Other borrowings				25,903			6,582			7,627			10,973			17,714
Allowance for losses—unfunded commitments				1,761			1,783			1,941			1,771			1,586
Other liabilities				21,667			18,550			14,279			14,914			15,647
Shareholders’ equity				272,562			274,627			272,554			254,135			234,551
Total Liabilities and Shareholders’ equity				$	2,391,499		$	2,296,087		$	2,208,832		$	1,934,740		$	1,853,664

 

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Selected Consolidated Financial Data—Mid-State Bancshares (Continued)

(In thousands—except per share data)				2005				2004				2003				2002				2001
Asset Quality
Non-accrual loans				$		2,463		$		10,700		$		12,312		$		16,748		$		2,986
Loans past due 90 days or more				—				—				—				—				690
Other real estate owned				—				—				3,428				—				—
Total non performing assets				$	2,463			$	10,700			$	15,740			$	16,748			$	3,676
Financial Ratios
For the year:
Return on assets				1.58			%	1.55			%	1.62			%	1.58			%	1.75			%
Return on tangible assets				1.62			%	1.59			%	1.66			%	1.61			%	1.76			%
Return on equity				13.56			%	12.67			%	12.70			%	12.22			%	13.98			%
Return on tangible equity				16.92			%	15.90			%	15.21			%	14.79			%	14.90			%
Net interest margin (not taxable equivalent)				5.32			%	4.95			%	5.14			%	5.41			%	6.06			%
Net interest margin (taxable equivalent)(2)				5.74			%	5.36			%	5.54			%	5.74			%	6.36			%
Net loan losses (recoveries) to average loans				0.13			%	(0.03			%)	0.06			%	0.19			%	0.22			%
Dividend Payout Ratio				40.0			%	38.6			%	35.3			%	32.8			%	30.3			%
Efficiency ratio				57.9			%	61.3			%	59.9			%	60.5			%	58.4			%
At December 31:
Equity to average assets (leverage ratio)				9.2			%	9.3			%	9.6			%	10.6			%	10.2			%
Tier One capital to risk-adjusted assets				11.6			%	12.1			%	13.8			%	14.7			%	13.8			%
Total capital to risk-adjusted assets				12.3			%	13.0			%	15.0			%	16.0			%	15.0			%
Loan loss allowance to loans, gross(1)				0.9			%	1.1			%	1.6			%	1.8			%	1.8			%
Non-accrual loans to total loans, gross				0.2			%	0.8			%	1.1			%	1.5			%	0.3			%
Non performing assets to total assets				0.1			%	0.5			%	0.7			%	0.9			%	0.2			%
Allowance for losses to non performing loans(1)				554			%	146			%	146			%	114			%	562			%

(1)          Includes allowance for loan losses and allowance for losses-unfunded commitments.

(2)          Taxable equivalent converts tax exempt income as if it were taxable.

ITEM 7.                MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Introduction and Business of the Company

The Company has as its single, wholly owned subsidiary, Mid-State Bank & Trust (the Bank). The Bank has two wholly owned subsidiaries—MSB Properties, Inc. and Mid Coast Land Company (discussed above in Part I of this report and later in this Management’s Discussion and Analysis). The Bank was founded in 1961 and operates a full service commercial banking business serving its customers on the Central Coast of California. Headquartered in Arroyo Grande, it operates 41 offices in communities throughout San Luis Obispo, Santa Barbara and Ventura Counties and serves nearly 100 thousand households and businesses.

The following discussion and analysis will provide insight and supplementary information into the accompanying consolidated financial statements of the Company. It also provides Management’s assessment of the operating trends over the past few years and certain of their expectations for 2006. Unless otherwise noted below, the discussion and analysis section deals almost exclusively with the Community Banking segment of the Company. The other two segments, Mid-Coast Land Company and Trust Services, contribute a small percentage (less than 3%) to the overall earnings of the Company.

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2005 RESULTS AND ACCOMPLISHMENTS

Financial Summary

The Company, on a consolidated basis, reported net income of $37.5 million in 2005, $35.1 million in 2004 and $33.2 million in 2003. The diluted Earnings Per Share (EPS) was $1.61 for 2005 compared to $1.47 in 2004 and $1.40 in 2003. Consolidated total assets at December 31, 2005 were $2.391 billion compared to $2.296 billion at December 31, 2004, up 4.1%. Total deposits also increased from $1.995 billion as of December 31, 2004 to $2.070 billion as of December 31, 2005. Shareholders’ common equity stood at $272.6 million at year end down from its $274.6 million level one year earlier. There were a number of factors working to both increase and decrease this account which showed a net decline. Those factors working to increase shareholders’ common equity included; 1) $37.5 million of net income generated for the year and 2) $4.0 million received for the exercise of stock options. These were offset however by; 1) $15.0 million in dividends paid out during 2005, 2) $23.1 million paid for the repurchase of common stock outstanding, and 3) a $6.5 million reduction in accumulated other comprehensive income.

The table below illustrates net income by subsidiary unit.

Income (Loss) by subsidiary (000’s)				2005			2004			2003
Bank only, pre-tax				$	55,097		$	50,711		$	48,684
MSB Properties, pre-tax				2,041			2,079			2,376
Mid Coast Land Co., pre-tax				705			654			556
Parent only, pre-tax				(1,253		)	(788		)	(738		)
Tax (expense)				(19,099		)	(17,547		))	(17,714		)
Net Income—Mid-State Bancshares				$	37,491		$	35,109		$	33,164

 

Executive Summary

Management considers the following to be the most significant items affecting net income during 2005 compared to 2004.

·       During 2005, with the Federal Reserve orchestrating a number of increases in short term interest rates, the Prime Rate (to which many of the Company’s loans are tied) increased 8 times over the course of the year from 5.25% at the start of the year to 7.25% by the end of the year. Because of its general asset sensitivity, the Company saw an improvement in its net interest margin (from 5.36% in 2004 to 5.74% in 2005, taxable equivalent). Coupled with a $69.9 million increase in earning assets, this allowed the Company to show a $11.3 million increase in net interest income.

·       The Company took a benefit to provision for loan losses of $2.7 million in 2004 compared to no provision during 2005. The benefit taken to the provision for loan losses in 2004 reflected strong credit quality standards, consistent performance of the loan portfolio in recent years, improving trends in classified loans, improving trends in delinquencies and charge-offs, an improved outlook for the collection of the Company’s non accrual loans, and an improved outlook for economic activity in general. The Company did not need to take any benefit to the provision for loan losses in 2005. Because of the continued quality of the portfolio, it also did not have to take a charge to the provision for loan losses in 2005.

·       The Company realized non-recurring gains in 2004 of $1.1 million on the sale of OREO and $475 thousand in securities gains. The Company had only minor securities gains of $88 thousand in 2005 and no OREO gains.

·       The net decrease in total non-interest expense amounted to $1.6 million in 2005 compared to 2004. Factors contributing to this decrease included 1) decreases in merchant credit card processing fees of $4.3 million on 2005 compared to 2004; 2) increases in salaries and employee benefits of $2.8

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million related primarily to the Company’s incentive bonus program and 3) all other operating expenses increasing by $180 thousand from one year to another. The decrease in merchant credit card processing charges was a result of outsourcing this function to a third party. There was a similar drop in non-interest income.

Management considers the following to be the most significant items affecting net income during 2004 compared to 2003.

·       The Company took a benefit to provision for loan losses of $2.7 million in 2004 compared to a benefit of $969 thousand in 2003 resulting in a positive pre-tax improvement in earnings of $1.7 million. The benefit taken to the provision for loan losses in 2004 reflected strong credit quality standards, consistent performance of the loan portfolio in recent years, improving trends in classified loans, improving trends in delinquencies and charge-offs, an improved outlook for the collection of the Company’s non accrual loans, and an improved outlook for economic activity in general.

·       Average earning assets increased by $193.0 million in 2004 compared to 2003 more than offsetting the decline in the net interest margin (from 5.54% in 2003 to 5.36% in 2004 (taxable equivalent) thereby allowing the Company to show a $5.9 million increase in net interest income.

·       The Company realized non-recurring gains in 2004 of $1.1 million on the sale of OREO and $475 thousand in securities gains. The Company had only minor securities gains of $40 thousand in 2003.

·       Increases in the non-interest expense amounted to $4.6 million in 2004 compared to 2003. Factors contributing to this increase included 1) increases in outside professional services of $913 thousand related to Section 404 Sarbanes-Oxley compliance efforts; 2) increases in advertising and promotional expenditures of approximately $1.0 million in 2004 compared to 2003; 3) increases in costs reflecting the merger with Ojai Valley Bank effective October 31, 2003 which resulted in two months of costs in the 2003 figures compared to a full 12 months in 2004, estimated to be an increase of $1.4 million; 4) increase in employee benefits primarily related to workers compensation and group insurance increases of $198 thousand (excluding the impact of the Ojai employees) and 5) all other operating expenses increasing by $11 million, net of declines—the primary impact being salary increases of $1.5 million (excluding the impact of Ojai employees).

·       There was a decline in the net gains realized on mortgage loans sold of $2.8 million in 2004 compared to 2003 as a result of the dramatic slowdown in refinance activity during the year.

Challenges and Opportunities in 2006

Management considers the following to be major challenges and opportunities for the Company in 2006. They should be read in conjunction with the information contained in “Item 1A. Risk Factors.”

·       The number of additional increases in short term interest rates that the Board of Governors of the Federal Reserve System will cause to occur in 2006. The Company’s asset and liability, maturity and rate structure are such that its net interest margin should improve in a rising rate environment. However, many pundits expect the number of additional increases in 2006 to be limited. Since the Company received benefit to its spread and its net interest margin from the rate increases in 2005, the extent to which it may receive additional benefit in 2006 could be limited.

·       The ability of the economy to continue its recovery and enhance the Company’s ability to grow its loan portfolio either through loan originations or purchases consistent with the Company’s credit standards. Loan growth in recent years has been adequate, however, competition is intense and no assurance can be given that in future periods the Company will be able to obtain a sufficient share of the business available.

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·       The ability of the Company to generate new revenue sources either through new customers in existing or new markets, increased fees on existing products or the introduction of new products. Because the Company is well capitalized and its stock price is trading at favorable multiples of book value and earnings, it is well positioned to make strategic acquisitions in selected markets but only at valuation levels we find attractive.

·       The ability of the Company to contain salary and benefits costs which have risen in recent years, especially in view of the expensing of stock options (initial estimates for 2006 put the impact at approximately $1.0 million pre-tax, or $0.03 per share—see Note 1 and Note 15 of the Notes to the Consolidated Financial Statements which follows in Item 8 of this report) and the start-up costs of new banking facilities (a branch office and commercial banking office) in the Westlake Village market.

·       The ability of the Company to fully integrate its relatively new Ventura County offices and presence into the Company and take advantage of the expanded market opportunities it sees there. The Company believes its expanded presence in Ventura County will allow it to take advantage of the large and growing economic base in that part of its market area. Expansion into the Westlake Village market in the Spring of 2006 should enhance this effort.

·       The ability of the Company to make its internal support functions more efficient by exploring, and then implementing, a plan to consolidate their operations in one location in a cost effective manner.

·       The ability of the Company to continue to be competitive on deposit and loan pricing in the face of intense competition from its competitors. These competitive pressures could affect both interest income in a downward manner and deposit costs in an upward manner leading to a compression of the net interest margin.

·       The ability of the Company to attract and retain qualified personnel.

·       Since the Company has the capacity, it may increase its Other Borrowings during 2006 in an effort to diversify its funding sources and purchase earning assets which create a positive spread for the income statement, allowing it to more profitably leverage its strong capital base.

Other Events and Items of Note in 2005

The Company’s stock repurchase program continued in 2005 with 845,055, shares repurchased, which compares to 658,867 and 800,006 shares repurchased in 2004 and 2003, respectively. The average price paid for the stock over this three year period was $27.29, $25.26, and $20.27, respectively. As of December 31, 2005, the Company had 816,675 shares remaining to repurchase under its June 2005 authorization approved by the Board of Directors to re-purchase up to 1,141,373 additional shares. The authorization does not have an expiration date.

EXTERNAL FACTORS IMPACTING THE BANK

Economic Conditions

In last year’s annual report we noted that, “Management is encouraged that 2005 should again be a solid year for the economy in the Company’s trade area...... our local trade area again appears to be in a solid position at the start of 2005 to continue the recovery underway and maintain low unemployment rates. The Board of Governors of the Federal Reserve System have started raising short term interest rates and Management expects this trend to continue with the target Fed Funds rate reaching the mid 3% range by year-end. Management also expects that longer term rates will rise much more modestly, if at all, in-keeping with a continued trend towards a flatter yield curve.” We note that this forecast proved reasonably accurate. The Federal Reserve increased short term rates throughout 2005 with the bellwether Federal

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Funds Rate reaching 4.25% at December 31, 2005. While the national unemployment rate dropped from 5.4% at the start of 2005 to 4.9% by the end of the year, locally, unemployment rates also fell with San Luis Obispo County falling to 3.6% at the end of 2005 compared to 4.0% at the start of the year and Santa Barbara County falling to 4.1% from 4.8% one year earlier. The yield curve also, as expected, flattened dramatically with the spread between the three month and ten year Treasury declining from 202 basis points at the start of 2005 to just 31 basis points at the end of the year. The ten year Treasury is actually little changed from its 4.24% level at the start of the year having closed at 4.39% at the end of 2005. Management is of the opinion that the flattening of the yield curve portrays a general belief that future inflation will be in-line with recent historical experience (e.g.—the Consumer Price Index was up 3.4% and 3.3% in 2005 and 2004, respectively) and we have no reason to change that expectation. Notwithstanding spikes in energy prices, inflation does appear to be in check.

The most comprehensive review of local economic conditions in our market known to Management comes from the University of California at Santa Barbara (UCSB) Economic Forecast Project. According to UCSB, Gross County Product in the tri-county area was estimated at $82.0 billion in 2005, up 6.9% from the $76.7 level in the prior year. Adjusted for real dollars, it was up 3.7% following a 3.3% growth rate in 2004 and 3.2% in 2003. These rates of growth were down from the double digit increases witnessed in the late 1990’s. For California as a whole, real Gross State Product was +4.5% in 2005, +4.6% in 2004 and +3.4% in 2003, slightly ahead of the Tri County experience. Expectations by UCSB for 2006 are for further improvements with the real State Product growing 3.8% and the real Tri County Gross Product growing somewhat slower at a 3.5% pace. A survey of business owners across the tri-county area conducted by UCSB in the third quarter of 2005 found general optimism with respect to expected business activity over the coming year. Survey participants were queried, “Will you be expanding or downsizing your firm in the next twelve months?” While 50.5% of the respondents said they did not expect to expand or contract, fully 27.0% expected to expand 1% to 9% and 14.4% expected to expand 10% or more. In contrast, only 8.1% of respondents expected to contract. Reflecting similar optimism, when asked, “In six months, do you expect your firm to be better or worse off?”, over 58% expected to be better off or much better off compared to just 7% expecting to be worse off. All of this evidence indicates to Management that growth should continue in 2006 in the local economy at similar levels to 2005 with nominal growth in the 6.5% to 7.0% range and real growth in the 3% to 4% range.

Median home prices are at historical highs throughout the Bank’s service area. The median price of a home in 2005 is estimated to have reached $539 thousand in San Luis Obispo County, up 21% from a year earlier. In Santa Barbara County, that figure is estimated to have reached $685 thousand, up 25% from one year earlier. And in Ventura County, the median home price is estimated to have grown at a somewhat slower 13% pace from one year before. In spite of numerous residential building projects in the Bank’s trade area and housing affordability indices falling below 20% in most locales, the local real estate market still appears relatively healthy with a combination of historically low interest rate levels and demand ahead of supply. The strong trends in both residential and non-residential real estate exhibited in recent years are believed to be slowing somewhat though as we enter 2006. Lenders continue to be very prudent in their lending practices having learned the lessons of the early 1990’s and hence building is far less speculative. Collectively, all factors considered, Management does not see significant risk of a dramatic slowdown in real estate in 2006. However, Management would not be surprised to see flat housing prices in 2006 or even some modest downward pressure on prices, as a correction to the dramatic increases seen over the past several years. It is also significant that high real estate prices have created a demographic trend of “aging” home owners replacing “working-class” residents who find first time home ownership difficult. This is contributing to an out-migration by young families with working-aged heads of households. The impact of this demographic trend has implications on the local economy and the types of businesses that operate here with service and retail oriented businesses likely to be more predominant compared to manufacturing and industrial type businesses.

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With positive indicators continuing in the national economic statistics and a solid economic base locally, Management is encouraged that 2006 should again be a positive year overall for the economy in the Company’s trade area. As mentioned last year, this optimism must be tempered by the potential for disruption resulting from geopolitical issues surrounding homeland security and terrorism. The effects of episodes such as the 9/11 terrorist attacks, the wars in Afghanistan and Iraq, and the international tensions surrounding these events, can have a significant impact on economic activity. In spite of this caveat, our local trade area again appears to be in a solid position at the start of 2006 to continue solid economic growth and maintain low unemployment rates. The Board of Governors of the Federal Reserve System are widely believed to be reaching the end of their drive to raise short term interest rates and Management expects only modest additional increases with the target Fed Funds rate reaching the 5% range by year-end. Management again expects that longer term rates will rise modestly, with a continuing flat yield curve in place through 2006.

Competitive Factors

Competitive pressures from other financial institutions continue to be intense both in the Company’s trade area and throughout the nation. Many banks are suffering from insufficient loan volumes and have become very aggressive on the pricing of those good credits available. In the Company’s tri-counties service area, 68 financial institutions (banks and savings institutions) operate 336 offices serving $24.6 billion in deposits based on data as of June 30, 2005. These figures are up from 66 institutions operating 321 offices with $23.1 billion in deposits one year earlier. Additionally, while Management does not have specific metrics on competition from broker dealers, there is significant competition from brokerage houses providing competing deposit and investment products. Also, “conduit financing” from Wall Street is competing with the Bank for larger loan transactions.

It should be noted that the trend toward consolidation of banking assets exhibited over the past few years in California continued in 2005. Statewide, 15 banks are merging out of existence based on announced merger transactions. According to the State Department of Financial Institutions however, 21 new banks have filed in 2005 to start a new bank in California, with 10 of those having been already approved.

ANALYSIS OF STATEMENT OF FINANCIAL POSITION

Loans

The Bank experienced an increase in net loans from $1,408.1 million at the end of 2004, to $1,507.1 million at the end of 2005. This represents an increase in the loan portfolio of $99.0 million, or 7.0%, following the $269.2 million, or 23.6% increase in 2004. The loan portfolio represents approximately 63% of the Bank’s assets. Additionally, loans held for sale (which are single family residential mortgages pending sale) total $10.2 million at the end of 2005, down from $13.0 million one year earlier.

 

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