REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Shareholders and Board of Directors

Pacific State Bancorp and Subsidiary

We have audited the accompanying consolidated balance sheet of Pacific State Bancorp and subsidiary as of December 31, 2008 and 2007 and the related consolidated statements of operations, changes in shareholders' equity, comprehensive income and cash flows for each of the years in the three-year period ended December 31, 2008.  These consolidated financial statements are the responsibility of the Company's management.  Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pacific State Bancorp and subsidiary as of December 31, 2008 and 2007, and the consolidated results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America.

/s/ Perry-Smith LLP

Sacramento, California

March 24, 2009

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SELECTED FINANCIAL DATA

The information set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operation" and the Company’s audited consolidated financial statements and notes thereto, included elsewhere in this report.

(Dollars in thousands, except per share data)	Year Ended December 31,
	2008			2007			2006			2005			2004
Statements of Operations:
Total Interest Income	$	27,275		$	31,242		$	26,495		$	18,782		$	13,509
Net Interest Income		15,035			17,400			17,307			13,536			10,451
Provision for Loan Losses		7,001			1,425			360			35			504
Total Non-interest Income		(5,268	)		2,465			2,583			2,481			2,525
Total Non-interest Expenses		13,328			10,997			10,360			9,100			7,429
(Benefit from)Provision for Income Taxes		(5,372	)		2,894			3,627			2,596			1,874
Net (Loss) Income		(5,190	)		4,549			5,543			4,286			3,169
Balance Sheets:
Total Assets		421,453			431,074			386,752			309,611			254,361
Total Investments		39,738			41,352			23,107			28,539			23,582
Total Loans, net		301,945			308,458			287,318			241,556			199,535
Allowance for Loan Losses  (ALL)		6,019			3,948			2,478			2,356			2,214
Total Deposits		340,980			341,821			340,996			273,074			223,761
Subordinated Debentures		8,764			8,764			8,764			8,764			8,764
Shareholders' Equity		27,284			34,036			29,059			21,373			16,830
Performance Ratios:
(Loss) Return on Average Assets		(1.20	)%		1.13	%		1.67	%		1.53	%		1.37	%
(Loss) Return on Average Equity		(14.95	)%		14.22	%		22.91	%		22.98	%		21.64	%
Average Equity to Average Assets		8.00	%		7.95	%		7.30	%		6.65	%		6.34	%
Tier 1 Risk-Based Capital		10.25	%		11.40	%		10.65	%		10.44	%		10.10	%
Total Risk-Based Capital		11.50	%		12.60	%		11.83	%		11.88	%		12.60	%
Net Interest Margin		3.84	%		4.79	%		5.76	%		5.41	%		5.14	%
Average Earning Assets to Average Total Assets		90.40	%		90.31	%		93.33	%		89.22	%		88.18	%
Nonperforming Assets to Total Assets		5.59	%		0.10	%		--			--			--
ALL to Total Loans		1.95	%		1.26	%		0.86	%		0.98	%		1.10	%
Nonperforming Loans to ALL		391.43	%		10.94	%		--			--			--
Share Data:
Common Shares Outstanding		3,718,598			3,707,698			3,665,968			3,517,113			3,448,042
Book Value Per Share	$	7.34		$	9.19		$	7.94		$	6.08		$	4.88
Basic (Loss) Earnings Per Share	$	(1.40	)	$	1.23		$	1.57		$	1.23		$	0.92
Diluted Earnings Per Share	$	(1.40	)	$	1.14		$	1.41		$	1.10		$	0.84

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PACIFIC STATE BANCORP AND SUBSIDIARY

CONSOLIDATED BALANCE SHEET

December 31, 2008 and 2007

(In thousands, except share amounts)

	2008			2007
ASSETS
Cash and due from banks	$	16,700		$	13,794
Federal funds sold		21,811			31,880
Total cash and cash equivalents		38,511			45,674
Interest-bearing deposits in other banks		-			3,000
Investment securities (Notes 3 and 7)		39,738			41,352
Loans, less allowance for loan losses of $6,019 in 2008 and $3,948 in 2007 (Notes 4, 10 and 13)		301,945			308,458
Premises and equipment, net (Note 5)		16,811			14,269
Other real estate		2,029			-
Company owned life insurance (Note 14)		6,751			8,025
Accrued interest receivable and other assets (Note 9)		15,668			10,296
Total assets	$	421,453		$	431,074
LIABILITIES AND
SHAREHOLDERS' EQUITY
Deposits:
Non-interest bearing	$	69,874		$	67,071
Interest bearing (Note 6)		271,106			274,750
Total deposits		340,980			341,821
Other borrowings (Note 7)		40,000			40,000
Subordinated debentures (Note 8)		8,764			8,764
Accrued interest payable and other liabilities		4,425			6,453
Total liabilities		394,169			397,038
Shareholders' equity (Note 11):
Preferred stock - 2,000,000 shares authorized; none issued or outstanding		-			-
Common stock - no par value; 24,000,000 shares authorized; issued and outstanding –3,718,598 shares in 2008 and 3,707,698 shares in 2007		10,767			10,418
Retained earnings		18,814			24,004
Accumulated other comprehensive loss, net of taxes (Notes 3 and 15)		(2,297	)		(386	)
Total shareholders' equity		27,284			34,036
Total liabilities and shareholders' equity	$	421,453		$	431,074

The accompanying notes are an integral

part of these consolidated financial statements

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PACIFIC STATE BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENT OF OPERATIONS

For the Years Ended December 31, 2008, 2007 and 2006

(In thousands, except per share amounts)

	2008			2007		2006
Interest income:
Interest and fees on loans	$	24,565		$	27,902	$	24,901
Interest on Federal funds sold		376			1,285		273
Interest and dividends on investment securities:
Taxable		2,095			1,843		1,093
Exempt from Federal income taxes		150			134		158
Dividends		89			78		70
Total interest income		27,275			31,242		26,495
Interest expense:
Interest on deposits (Note 6)		10,425			12,844		8,102
Interest on borrowings (Note 7)		1,351			296		376
Interest on subordinated debentures (Note 8)		464			702		710
Total interest expense		12,240			13,842		9,188
Net interest income before provision for loan losses		15,035			17,400		17,307
Provision for loan losses (Note 4)		7,001			1,425		360
Net interest income after provision for loan losses		8,034			15,975		16,947
Non-interest income:
Service charges		823			889		864
Gain on sale of loans		188			150		294
Gain on sale of assets		471			-		-
Gain on death benefit from company owned life insurance		2,574			-		-
Other income		890			1,426		1,425
Other than temporary impairment charge (Note 3)		(8,923	)		-		-
Loss on sale of securities (Note 3)		(1,291	)		-		-
Total non-interest income		(5,268	)		2,465		2,583
Non-interest expenses:
Salaries and employee benefits (Note 14)		5,546			5,336		5,479
Occupancy (Notes 5 and 10)		1,251			1,180		980
Furniture and equipment (Notes 5 and 10)		1,032			708		672
Other expenses (Note 12)		5,499			3,773		3,229
Total non-interest expenses		13,328			10,997		10,360
(Loss) income before (benefit from) provision for income taxes		(10,562	)		7,443		9,170
(Benefit from) provision for income taxes (Note 9)		(5,372	)		2,894		3,627
Net (loss) income	$	(5,190	)	$	4,549	$	5,543
Basic (loss) earnings per share (Note 11)	$	(1.40	)	$	1.23	$	1.57
Diluted (loss) earnings per share (Note 11)	$	(1.40	)	$	1.14	$	1.41

The accompanying notes are an integral

part of these consolidated financial statements

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PACIFIC STATE BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY

For the Years Ended December 31, 2008, 2007 and 2006

(In thousands, except share amounts)

	Common Stock							Accumulated Other Compre- hensive			Total
	Shares		Amount		Retained Earnings			Loss (Net of Taxes)			Shareholders' Equity
Balance, January 1, 2006		3,517,113	$	7,556	$	13,912		$	(95	)	$	21,373
Net income						5,543						5,543
Net change in unrealized gains (losses) on available-for-sale investment securities, net of tax									48			48
Stock-based compensation expense				229								229
Stock options exercised and related tax benefit (Note 11)		135,421		1,616								1,616
Proceeds from issuance of stock		13,434		250								250
Balance, December 31, 2006		3,665,968		9,651		19,455			(47	)		29,059
Net income						4,549						4,549
Net change in unrealized gains (losses) on available-for-sale investment securities, net of tax									(339	)		(339	)
Stock-based compensation expense				309								309
Stock options exercised and related tax benefit (Note 11)		41,730		458								458
Balance, December 31, 2007		3,707,698		10,418		24,004			(386	)		34,036
Net loss						(5,190	)					(5,190	)
Net change in unrealized gains (losses) on available-for-sale investment securities, net of tax (Note 3)									(1,911	)		(1,911	)
Stock-based compensation expense				270								270
Stock options exercised and related tax benefit (Note 11)		10,900		79								79
Balance, December 31, 2008		3,718,598	$	10,767	$	18,814		$	(2,297	)	$	27,284

The accompanying notes are an integral

part of these consolidated financial statements

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PACIFIC STATE BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENT OF COMPREHENSIVE  (LOSS) INCOME

For the Years Ended December 31, 2008, 2007 and 2006

(In thousands)

	2008			2007			2006
Net (loss) income	$	(5,190	)	$	4,549		$	5,543
Other comprehensive (loss) income:
Unrealized holding (losses) gains arising during the year, net of tax		(1,911	)		(339	)		48
Reclassification adjustment for unrealized loss and other than temporary impairment charge included in net loss, net of tax		6,011			-			-
Total comprehensive (loss) income	$	(1,090	)	$	4,210		$	5,591

The accompanying notes are an integral

part of these consolidated financial statements

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PACIFIC STATE BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENT OF CASH FLOWS

For the Years Ended December 31, 2008, 2007 and 2006

(In thousands)

	2008			2007			2006
Cash flows from operating activities:
Net (loss) income	$	(5,190	)	$	4,549		$	5,543
Provision for loan losses		7,001			1,425			360
Net decrease (increase) in deferred loan origination costs		65			(168	)		173
Depreciation, amortization and accretion		503			93			404
Gain on sale of loans		(188	)		(150	)		(294	)
Loss on sale of premises or equipment		-			57			-
Stock-based compensation expense		270			309			229
Tax benefit from exercise of stock options		(4	)		(223	)		(736	)
Company owned life insurance earnings		(318	)		(246	)		(208	)
Gain on death benefit from company owned life insurance		(2,574	)		-			-
Decrease (increase) in accrued interest receivable and other assets		402			(651	)		(392	)
Loss on sale of securities		1,291			-			-
Other than temporary impairment charge		8,923			-			-
(Benefit) provision for deferred income taxes		(5,301	)		(755	)		12
(Decrease) increase  in accrued interest
payable and other liabilities		(2,028	)		3,420			418
Net cash provided by operating activities		2,852			7,660			5,509
Cash flows from investing activities:
Decrease (increase) in interest bearing deposits at other banks		3,000			(3,000	)		-
Purchases of available-for-sale investment securities		(48,361	)		(53,022	)		(11,257	)
Proceeds from the sale of available-for-sale securities		13,635			-			-
Proceeds from matured and called available-for-sale investment securities		22,735			33,805			16,364
Proceeds from principal repayments from available-for-sale government-guaranteed mortgage-backed securities		1,261			1,068			722
Proceeds from principal repayments from held-to-maturity government-guarantee mortgage-backed securities		26			5			23
Purchase of FRB and FHLB stock		(14	)		(831	)		(180	)
Net increase in loans		(4,210	)		(22,247	)		(45,786	)
Redemption (purchase) of company owned life insurance		4,166			(1,700	)		(1,460	)
Purchases of premises and equipment		(5,397	)		(3,082	)		(3,128	)
Net cash used in investing activities		(9,253	)		(48,984	)		(44,702	)
Cash flows from financing activities:
Net increase (decrease) in demand, interest-bearing and savings deposits		7,746			(21,893	)		(12,262	)
Net (decrease) increase in time deposits		(8,587	)		22,718			80,184
Proceeds from exercise of stock options		75			235			880
Excess tax benefit from exercise of stock options		4			223			736
Proceeds from stock issuance		-			-			250
Net increase in other borrowings		-			35,100			900
Net cash (used in) provided by financing activities		(762	)		36,383			70,688
(Decrease) increase in cash and cash equivalents		(7,163	)		(4,941	)		31,495
Cash and cash equivalents at beginning of period		45,674			50,615			19,120
Cash and cash equivalents at end of period	$	38,511		$	45,674		$	50,615
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Interest expense	$	12,565		$	13,048		$	10,475
Income taxes	$	925		$	2,500		$	3,805
Non-cash investing activities:
Net unrealized loss (gain) on available-for-sale investment securities	$	3,253		$	(565	)	$	78

The accompanying notes are an integral

part of these consolidated financial statements

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PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. NATURE OF OPERATIONS

On June 24, 2002, Pacific State Bancorp ("Bancorp") commenced operations as a bank holding company by acquiring all of the outstanding shares of Pacific State Bank ("Bank") in a one bank holding company reorganization.  This corporate structure gives Bancorp and the Bank greater flexibility in terms of operation, expansion, and diversification.

Pacific State Bancorp's subsidiaries include the Bank, Pacific State Statutory Trust II and Pacific State Statutory Trust III.  Pacific State Statutory Trust II and Pacific State Statutory Trust III are unconsolidated Delaware statutory business trusts formed in March 2004 and June 2007, respectively, for the exclusive purpose of issuing and selling trust preferred securities and holding subordinated debentures issued by Bancorp.  The proceeds from the issuance of subordinated debentures in 2004 were utilized by Bancorp to provide capital to the Bank and for general corporate purposes.  The proceeds from the issuance of subordinated debenture in 2007 were utilized to retire subordinated debentures issued in 2002.

The Bank commenced operations in 1987 and is a California state-chartered member bank of the Federal Reserve System.  The Bank operates nine branches in California, including two branches in Stockton and branches in Modesto, Groveland, Arnold, Angels Camp, Tracy, Lodi and Hayward.  The Bank's primary source of revenue is providing loans to customers who are predominately small and middle-market businesses and individuals.

NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The accounting and reporting policies of Pacific State Bancorp and its subsidiary (collectively, the "Company") conform with accounting principles generally accepted in the United States and prevailing practice within the banking industry.  The more significant of these policies applied in the preparation of the accompanying consolidated financial statements are discussed below.

PRINCIPLES OF CONSOLIDATION

The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Pacific State Bank.  Significant intercompany transactions and balances have been eliminated in consolidation.  For financial reporting purposes, the Company's investment in Pacific State Statutory Trusts II and III ("Trusts") are accounted for under the equity method and are included in accrued interest receivable and other assets in the consolidated balance sheet.  The subordinated debentures issued and guaranteed by the Company and held by the Trusts are included as subordinated debentures in the consolidated balance sheet.

SEGMENT INFORMATION

Management has determined that because all of the banking products and services offered by the Company are available in each branch of the Bank, all branches are located within the same economic environment and management does not allocate resources based on the performance of different lending or transaction activities, it is appropriate to aggregate the Bank branches and report them as a single operating segment.  No customer accounts for more than 10 percent of revenues for the Company or the Bank.

USE OF ESTIMATES

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions.  These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from these estimates.

RECLASSIFICATIONS

Certain reclassifications have been made to prior years' balances to conform to classifications used in 2008.

CASH AND CASH EQUIVALENTS

For the purpose of the statement of cash flows, cash, due from banks and Federal funds sold are considered to be cash equivalents.  Generally, Federal funds are sold for one-day periods.

INVESTMENT SECURITIES

Investment securities are classified into the following categories:

·Available-for-sale securities, reported at fair value, with unrealized gains and losses excluded from earnings and reported, net of taxes, as accumulated other comprehensive income (loss) within shareholders' equity.

·Held-to-maturity securities, which management has the positive intent and ability to hold to maturity, reported at amortized cost, adjusted for the accretion of discounts and amortization of premiums.

Management determines the appropriate classification of its investments at the time of purchase and may only change the classification in certain limited circumstances.  The Company did not have any investments classified as trading at December 31, 2008 or 2007.  All transfers between categories are accounted for at fair value. There were no transfers between categories in 2008 or 2007.

Gains or losses on the sale of investment securities are computed on the specific identification method.  Interest earned on investment securities is reported in interest income, net of applicable adjustments for accretion of discounts and amortization of premiums.

Investment securities are evaluated for impairment on at least a quarterly basis and more frequently when economic or market conditions warrant such an evaluation to determine whether a decline in their value is other than temporary.  Management utilizes criteria such as the magnitude and duration of the decline and the intent and ability of the Company to retain its investment in the securities for a period of time sufficient to allow for an anticipated recovery in fair value, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary.  The term "other than temporary" is not intended to indicate that the decline is permanent, but indicates that the prospects for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment.  Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.

As a member of the Federal Reserve System, the Federal Home Loan Bank System and the Farmer Mac Home Administration System, the Bank is required to maintain an investment in restricted capital stock of each system.  These investments are carried at cost and are redeemable at par and are included in accrued interest receivable and other assets in the consolidated balance sheet.

LOANS

Loans are stated at principal balances outstanding.  Interest is accrued daily based upon outstanding loan balances.  However, when, in the opinion of management, loans are considered to be impaired and the future collectability of interest and principal is in serious doubt, loans are placed on nonaccrual status and the accrual of interest income is suspended.  Any interest accrued but unpaid is charged against income.  Payments received are applied to reduce principal to the extent necessary to ensure collection.  Subsequent payments on these loans, or payments received on nonaccrual loans for which the ultimate collectability of principal is not in doubt, are applied first to earned but unpaid interest and then to principal.

An impaired loan is measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical matter, at the loan's observable market price or the fair value of collateral if the loan is collateral dependent.  A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due (including both principal and interest) in accordance with the contractual terms of the loan agreement.  Interest income on impaired loans, if appropriate, is recognized on a cash basis.

Loan origination fees, commitment fees, direct loan origination costs and purchase premiums and discounts on loans are deferred and recognized as an adjustment of yield, and amortized to interest income over the contractual term of the loan.  The unamortized balance of deferred fees and costs is reported as a component of net loans.

The Company may purchase loans or acquire loans through a business combination for which differences exist between the contractual cash flows and the cash flows expected to be collected due, at least in part, to credit quality.  When the Company acquires such loans, the yield that may be accreted (accretable yield) is limited to the excess of the Company’s estimate of undiscounted cash flows expected to be collected over the Company’s initial investment in the loan.  The excess of contractual cash flows over cash flows expected to be collected may not be recognized as an adjustment to yield, loss, or a valuation allowance.  Subsequent increases in cash flows expected to be collected generally should be recognized prospectively through adjustment of the loan’s yield over its remaining life.  Decreases in cash flows expected to be collected should be recognized as an impairment.  The Company may not "carry over" or create a valuation allowance in the initial accounting for loans acquired under these circumstances.  At December 31, 2008 and 2007, there were no such loans being accounted for under this policy.

-8-

PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

LOAN SALES AND SERVICING

The Company accounts for the transfer and servicing of financial assets based on the financial and servicing assets it controls and liabilities it has incurred, derecognizes financial assets when control has been surrendered and derecognizes liabilities when extinguished.

Government Guaranteed Loans

Included in the loan portfolio are loans which are 75% to 90% guaranteed by the Small Business Administration (SBA), Farmer Mac and USDA Business and Industry.  The guaranteed portion of these loans may be sold to a third party, with the Company retaining the unguaranteed portion.  The Company generally receives a premium in excess of the adjusted carrying value of the loan at the time of sale.  The Company may be required to refund a portion of the sales premium if the borrower defaults or prepays within ninety days of the settlement date.  At December 31, 2008, there were no premiums subject to these recourse provisions.

The Company's investment in the loan is allocated between the retained portion of the loan, the servicing asset (liability) and the sold portion of the loan based on their relative fair values on the date the loan is sold.  The gain on the sold portion of the loan is recognized as income at the time of sale.  The carrying value of the retained portion of the loan is discounted based on the estimated value of a comparable non-guaranteed loan.  The servicing asset (liability) is recognized and amortized over the estimated life of the related loan.  Significant future prepayments of these loans will result in the recognition of additional amortization of related servicing assets (liabilities).

The Company serviced government-guaranteed loans for others totaling $53,112,000 and $47,714,000 as of December 31, 2008 and 2007 respectively.

Servicing Rights

Servicing rights acquired through 1) a purchase or 2) the origination of loans which are sold with servicing rights retained are recognized as separate assets or liabilities.  Servicing assets or liabilities are recorded at the difference between the contractual servicing fees and adequate compensation for performing the servicing, and are subsequently amortized in proportion to and over the period of the related net servicing income or expense.  Servicing assets are periodically evaluated for impairment.  Servicing rights were not significant at December 31, 2008 and 2007.

ALLOWANCE FOR LOAN LOSSES

The allowance for loan losses is maintained to provide for losses related to impaired loans and other losses that can be expected to occur in the normal course of business.  The determination of the allowance is based on estimates made by management, to include consideration of the character of the loan portfolio, specifically identified problem loans, potential losses inherent in the portfolio taken as whole and economic conditions in the Company's service area.

Classified loans and loans determined to be impaired are individually evaluated by management for specific risk of loss.  In addition, reserve factors are assigned to currently performing loans based on management's assessment of the following for each identified loan type: (1) inherent credit risk, (2) historical losses and, (3) where the Company has not experienced losses, the loss experience of peer banks.  These estimates are particularly susceptible to changes in the economic environment and market conditions.

The Bank's Loan Committee reviews the adequacy of the allowance for loan losses at least quarterly, to include consideration of the relative risks in the portfolio and current economic conditions and other factors.  The allowance is adjusted based on that review if, in the judgment of the Loan Committee and management, changes are warranted.

This allowance is established through a provision for loan losses which is charged to expense.  Additions to the allowance are expected to maintain the adequacy of the total allowance after net charge-offs and loan growth.  The allowance for loan losses at December 31, 2008 and 2007, respectively, reflects management's estimate of probable losses in the portfolio.

Allowance for Losses Related to Undisbursed Loan and Lease Commitments

The Bank maintains a separate allowance for losses related to undisbursed loan and lease commitments. Management estimates the amount of probable losses by applying the loss factors used in the allowance for loan and lease loss methodology to an estimate of the expected usage of undisbursed commitments for each loan or lease type. The allowance totaled $222,000 at December 31, 2008 and 2007, and is included in accrued interest payable and other liabilities on the consolidated balance sheet.

-9-

PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

OTHER REAL ESTATE

Other real estate includes real estate acquired in full or partial settlement of loan obligations.  When property is acquired, any excess of the Company's recorded investment in the loan balance and accrued interest income over the estimated fair market value of the property, net of estimated selling costs, is charged against the allowance for loan losses.  A valuation allowance for losses on other real estate is maintained to provide for temporary declines in value.  The allowance is established through a provision for losses on other real estate which is included in other expenses.  Subsequent gains or losses on sales or writedowns resulting from permanent impairments are recorded in other income or expenses as incurred.  At December 31, 2008 the Company has $2,029,000 in other real estate and no other real estate at December 31 2007.

PREMISES AND EQUIPMENT

Premises and equipment are carried at cost.  Depreciation is determined using the straight-line method over the estimated useful lives of the related assets.  The useful lives of premises are estimated to be ten to thirty-nine years.  The useful lives of furniture, fixtures and equipment are estimated to be three to fifteen years.  Leasehold improvements are amortized over the life of the asset or the life of the related lease, whichever is shorter.  When assets are sold or otherwise disposed of, the cost and related accumulated depreciation and amortization are removed from the accounts, and any resulting gain or loss is recognized in income for the period.  The cost of maintenance and repairs is charged to expense as incurred.

The Company evaluates premises and equipment for financial impairment as events or changes in circumstances indicate that the carrying amount of such assets may not be fully recoverable.

GOODWILL AND INTANGIBLE ASSETS

As a result of the Company's 2002 acquisition of the Stockton branch of California Bank & Trust, the Company recognized a core deposit intangible asset of $448,000 and goodwill of $718,000.  The valuation of the core deposit intangible was based on the estimated fair value of deposits acquired and is amortized over a period of ten years.  The current balance of the core deposit intangible of $27,000 is included in accrued interest receivable and other assets in the consolidated balance sheet.  Goodwill is not amortized, but is measured along with the core deposit intangible for impairment.  At December 31, 2008 and 2007, no impairment of the core deposit intangible or goodwill has been recognized in the Company’s consolidated financial statements.

INCOME TAXES

The Company files its income taxes on a consolidated basis with its subsidiary.  The allocation of income tax expense (benefit) represents each entity’s proportionate share of the consolidated provision for income taxes.

Deferred tax assets and liabilities are recognized for the tax consequences of temporary differences between the reported amounts of assets and liabilities and their tax basis.  Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.  On the consolidated balance sheet, net deferred tax assets are included in accrued interest receivable and other assets.

On January 1, 2007, the Company adopted Financial Accounting Standards Board ("FASB") Interpretation No. 48, Accounting for Uncertainty in Income Taxes ("FIN 48").  FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes.  FIN 48 prescribes a recognition threshold and measurement standard for the financial statement recognition and measurement of an income tax position taken or expected to be taken in a tax return.  In addition, FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.

The provisions of FIN 48 have been applied to all tax positions of the Company as of January 1, 2007.  Only tax positions that met the more-likely-than-not recognition threshold on January 1, 2007 were recognized or continue to be recognized.  The Company previously recognized income tax positions based on management's estimate of whether it was reasonably possible that a liability has been incurred for unrecognized income tax benefits by applying FASB Statement No. 5, Accounting for Contingencies.  The adoption of FIN 48 did not have a material impact on the Company’s financial position, results of operations or cash flows.

The Company recognizes interest accrued and penalties related to unrecognized tax benefits, if any in tax expense.

-10-

PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

EARNINGS (LOSS) PER SHARE

Basic earnings (loss) per share (EPS), which excludes dilution, is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period.  Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock, such as stock options, result in the issuance of common stock which shares in the earnings of the Company.  The Company had a net loss for 2008, therefore all stock options are antidilutive.  All data with respect to computing earnings per share is retroactively adjusted to reflect stock splits and dividends and the treasury stock method is applied to determine the dilutive effect of stock options in computing diluted EPS.

STOCK-BASED COMPENSATION

At December 31, 2008, the Company had one shareholder approved stock-based compensation plan which is described more fully in Note 11.  The Company accounts for its stock based compensation plan in accordance with FASB Statement No. 123(R), Share-Based Payment (SFAS 123(R)),using the modified prospective transition method.  Under that transition method, compensation cost recognized in fiscal years 2006, 2007 and 2008 includes: (a) compensation cost for all share-based payments vesting during 2006, 2007 and 2008 that were granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation cost for all share-based payments vesting during 2006, 2007 and 2008 that were granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R).  For further information on grants and vesting please refer to Note 11. The Company applied the alternative transition method in calculating its pool of excess tax benefits available to absorb future tax deficiencies as provided by FSP FAS 123(R)-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards. Compensation cost is recognized net of estimated forfeitures. Results for prior periods have not been restated.

As a result of applying SFAS 123(R), the Company recorded an expense of $270,000 or $203,000 after tax in 2008, $309,000 or $239,000 after tax in 2007 and $229,000 or $133,000 after tax in 2006.

Determining Fair Value

The Company bases the fair value of the options previously granted on the date of grant using a Black-Scholes-Merton option pricing model that uses assumptions based on expected option life, the level of expected stock volatility and the risk-free interest rate.  Stock volatility is based on the historical volatility of the Company's stock. The risk-free rate is based on the U.S. Treasury yield curve and the expected term of the options. The expected term of the options represents the period that the Company's share-based awards are expected to be outstanding based on the terms of the optionee’s employment agreement and position within the Company, previous option activity, the number of shares currently owned and the expected time of when those options would be exercised. The Company has not paid cash dividends. The Company estimates the forfeiture rate in calculating the compensation expense to be insignificant.  The Company did not grant any stock options in 2008.  In 2007 the Company granted 30,000 stock options using a risk free rate of 4.98%, volatility rate of 34.79% and forfeiture rate of 2%.  This resulted in a fair market value under the Black-Scholes-Merton model of $9.22 per option.

TRANSACTION ACCOUNT GUARANTEE PROGRAM

The Bank is participating in the FDIC's Transaction Account Guarantee Program.  Under this program, through December 31, 2009, all noninterest-bearing transaction accounts are fully guaranteed by the FDIC for the entire amount in the account and the Bank is assessed an annual fee of 10 basis points for all deposit amounts exceeding the existing deposit insurance limit of $250,000.  Coverage under the Transaction Account Guarantee Program is in addition to and separate from the coverage available under the FDIC's general deposit insurance rules.

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PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NEW FINANCIAL ACCOUNTING STANDARDS

Fair Value Measurements

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which defines and establishes a framework for measuring fair value used in FASB pronouncements issued by FASB that require or permit fair value measurement.  This statement expands disclosures using fair value to measure assets and liabilities in interim and annual periods subsequent to the period of initial recognition.  SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those years.  Management adopted this statement on January 1, 2008.  The impact of adoption was not material to the Company's financial condition or results of operations.  See Note 16 – Fair Value Measurements.

Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active

In October 2008, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) Financial Accounting Standard 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active.  The FSP clarifies the application of FASB Statement No. 157, Fair Value Measurements and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active.  The FSP was effective immediately, and includes prior period financial statements that have not yet been issued.  The Company is subject to the provisions of the FSP effective immediately; however, the impact of FSP 157-3 was not material to the Company's financial condition or results of operations.

The Fair Value Option for Financial Assets and Financial Liabilities

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS No. 159), including an amendment of FASB Statement No. 115.  SFAS No.159 permits fair value accounting to be irrevocably elected for certain financial assets and liabilities on an individual contract basis at the time of acquisition or at a remeasurement event date.  Upon adoption of SFAS No. 159, fair value accounting may also be elected for existing financial assets and liabilities.  For those instruments for which fair value accounting is elected, changes in fair value will be recognized in earnings and fees and costs associated with origination or acquisition will be recognized as incurred rather than deferred.  The Company adopted SFAS No. 159 on January 1, 2008, but did not elect the fair value option for any assets or liabilities either existing at the time of adoption or acquired thereafter for the year ended December 31, 2008.

Business Combinations

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141 (revised 2007), Business Combinations (SFAS No. 141R).  SFAS No. 141(R), among other things, establishes principles and requirements for how the acquirer in a business combination (i) recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquired business, (ii) recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase, and (iii) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination.  The Company is required to adopt SFAS No. 141(R) for all business combinations for which the acquisition date is on or after January 1, 2009.  Earlier adoption is prohibited.  This Standard will change theCompany's accounting treatment for business combinations on a prospective basis.

Noncontrolling Interests in Consolidated Financial Statements

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 160, Noncontrolling Interests in Consolidated Financial Statements, an Amendment of ARB No. 51 (SFAS No. 160).  SFAS No. 160 establishes accounting and reporting standards for noncontrolling interests in a subsidiary and for the deconsolidation of a subsidiary.  Minority interests will be recharacterized as noncontrolling interests and classified as a component of equity.  It also establishes a single method of accounting for changes in a parent's ownership interest in a subsidiary and requires expanded disclosures.  This statement is effective for fiscal years beginning on or after December 15, 2008, with early adoption prohibited. The Company does not expect the adoption of this Statement will have a material impact on its financial position, results of operations or cash flows.

Disclosures about Derivative Instruments and Hedging Activities

In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, Disclosures about Derivative Instruments and Hedging Activities (SFAS No. 161).  This statement requires enhanced disclosures to enable investors to better understand the effects of derivative instruments and hedging activities on an entity's financial position, financial performance, and cash flows, by requiring disclosure of the fair value of derivative instruments and their gains and losses in a tabular format.  It also provides more information about an entity's liquidity by requiring disclosure of derivative features that are related to credit risk.  It requires cross-referencing within footnotes to enable financial statement users to locate important information about derivative instruments.  SFAS No. 161 is effective for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged.  Management does not expect the adoption of this Statement will have a material impact on its financial position, results of operations or cash flows.

The Hierarchy of Generally Accepted Accounting Principles

In May 2008, the FASB issued Statement of Financial Accounting Standards No. 162, The Hierarchy of Generally Accepted Accounting Principles (SFAS No. 162).  This standard identifies a consistent framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements that are presented in conformity with U.S. generally accepted accounting principles (GAAP) for nongovernmental entities. It establishes that the GAAP hierarchy should be directed to entities because it is the entity (not the auditor) that is responsible for selecting accounting principles for financial statements that are presented in conformity with GAAP.  SFAS No. 162 is effective November 15, 2008 and there was no effect on the Company's consolidated financial statements upon adoption.

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PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 3. INVESTMENT SECURITIES

The amortized cost and estimated fair value of investment securities at December 31, 2008 and 2007 consisted of the following:

AVAILABLE-FOR-SALE (AFS)

Table 1: 2008 AFS Securities	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
(In thousands)
Debt securities:
U.S.Treasury securities	$	9,937	$	240	$	-		$	10,177
Obligations of states and political sub-divisions		3,154		11		(130	)		3,035
Mortgage-backed securities		22,355		318		(2	)		22,671
Corporate bonds		8,143		4		(4,338	)		3,809
Total	$	43,589	$	573	$	(4,470	)	$	39,692

Net unrealized losses on available-for-sale investment securities totaling $2,297,000 were recorded, net of $1,600,000 in tax benefit, as accumulated other comprehensive loss within shareholders' equity at December 31, 2008.  The Company realized losses of $7,789,000 on sales and calls of securities in 2008.  The $7,789,000 included realized losses on an other than temporary charge of $6,498,000 in the third quarter of 2008 related to Fannie Mae and Freddie Mac preferred stock.  The Company subsequently sold the preferred stock in the fourth quarter of 2008, realizing an additional loss of $345,000.  The Company recorded another other than temporary impairment charge of $2,425,000 on a single issue trust preferred debenture in the fourth quarter of 2008 which has not been sold and realized losses on other securities totaling $946,000 in the fourth quarter of 2008.  $6,011,000, net of tax benefit of $4,203,000, of unrealized losses was reclassified from accumulated other comprehensive income to loss on sale of securities and other than temporary impairment charge on the consolidated statement of operations at the time the losses were realized or determined to be other than temporarily impaired.

Table 2: 2007 AFS Securities	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
(In thousands)
Debt securities:
U.S. Treasury securities	$	17,424	$	58	$	-		$	17,482
U.S. Government agencies		2,946		4		(15	)		2,935
Obligations of states and political sub-divisions		3,059		102					3,161
Mortgage-backed securities		8,754		47		(677	)		8,124
Corporate bonds		9,755		-		(163	)		9,592
Total	$	41,938	$	211	$	(855	)	$	41,294

Net unrealized losses on available-for-sale investment securities totaling $644,000 were recorded, net of $258,000 in tax benefit, as accumulated other comprehensive loss within shareholders' equity at December 31, 2007.  There were no proceeds or gross realized gains or losses from the sale or call of available-for-sale investment securities for the year ended December 31, 2007.

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PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

HELD-TO-MATURITY (HTM)

Table 3: 2008 HTM Securities	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value
(In thousands)
Debt securities:
Mortgage-backed securities	$	46	$	-	$	-	$	46

Table 4: 2007 HTM Securities	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value
(In thousands)
Debt securities:
Mortgage-backed securities	$	58	$	-	$	-	$	58

There were no sales or transfers of held-to-maturity investment securities during the years ended December 31, 2008, 2007 and 2006.

Investment securities with unrealized losses at December 31, 2008 and 2007 are summarized and classified according to the duration of the loss period as follows:

Table 5: 2008 Unrealized Security Losses on AFS	Less than 12 Months					12 Months or More					Total
(In thousands)	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
Debt securities:
Obligations of states and political sub-divisions	$	1,325	$	(130	)	$	-		-		$	1,325	$	(130	)
Mortgage-backed securities		10		(1	)		433		(1	)		443		(2	)
Corporate bonds		-		-			2,726		(4,338	)		3,226		(4,338	)
	$	1,335	$	(131	)	$	3,159	$	(4,339	)	$	4,994	$	(4,470	)

Table 6: 2007 Unrealized Security Losses on AFS	Less than 12 Months					12 Months or More					Total
(In thousands)	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
Debt securities:
U.S. Government Agencies	$	993	$	(7	)	$	884	$	(8	)	$	1,877	$	(15	)
Mortgage-backed securities		5,393		(664	)		880		(13	)		6,273		(677	)
Corporate bonds		2,080		(79	)		930		(84	)		3,010		(163	)
	$	8,466	$	(750	)	$	2,694	$	(105	)	$	11,160	$	(855	)

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PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. Government Agency Securities

At December 31, 2008, the Company did not own U.S. Government Agency Securities.  At December 31, 2007, the Company held 5 U.S. Government Agency Securities of which 1 was in a loss position for less than twelve months and 3 were in a loss position and had been in a loss position for twelve months or more.  Management believes the unrealized losses on the Company’s investments in U.S. Government Agency Securities were caused by interest rate increases and is not attributable to changes in credit quality.  Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company has the ability and intent to hold these investments until a recovery of fair value, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2007.

Obligations of states and political sub-divisions

At December 31, 2008, the Company held 10 municipal debt securities, of which 3 were in an unrealized loss position.  Management believes the unrealized losses on the Company’s investments in municipal bonds were caused by market conditions and is not attributable to changes in credit quality.  Because the decline in market value is attributable to changes in market conditions and not credit quality, and because the Company has the ability and intent to hold these investments until a recovery of fair value, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2008.

Mortgage-Backed Securities

At December 31, 2008, the Company held 16 mortgage-backed investment securities of which 4 were in a loss position for less than twelve months and none of the securities were in a loss position for twelve months or more.  Management believes that the unrealized losses on the Company's investments in mortgage-backed investment securities were caused by market conditions and is not attributable to changes in credit quality.  The contractual cash flows of those investments are guaranteed by an agency of the U.S. government.  Because the decline in market value is attributable to changes in market conditions and not credit quality, and because the Company has the ability and intent to hold those investments until a recovery of fair value, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at December 31, 2008.

At December 31, 2007, the Company held 9 mortgage-backed investment securities of which 4 were in a loss position for less than twelve months and 1 was in a loss position and had been in a loss position for twelve months or more.  Management believes that the unrealized losses on the Company's investments in mortgage-backed investment securities were caused by interest rate increases and is not attributable to changes in credit quality.  The contractual cash flows of those investments are guaranteed by an agency of the U.S. government.  Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company has the ability and intent to hold those investments until a recovery of fair value, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at December 31, 2007.

Corporate Bonds

At December 31, 2008, the Company held 9 corporate debt securities, of which 7 were in an unrealized loss position.  Management believes the unrealized losses on the Company’s investments in corporate bonds were caused by the demand for these particular securities declining throughout the year but because the Company has the ability and intent to hold these investments until a recovery of fair value, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2008, with exception of the investment discussed below.

At December 31, 2008, the Company's investment securities included $2,500,000 of trust preferred debentures issued by Temecula Valley Bancorp, Inc.  Due to Temecula Valley Bancorp’s recent announcement of deferring interest payments on this security and the subsequent decline in price of the security, the Company recorded an other than temporary impairment write down of $2,425,000 as of December 31, 2008.

At December 31, 2007, the Company held 6 corporate debt securities, of which 4 were in an unrealized loss position.  Management believes the unrealized losses on the Company’s investments in corporate bonds were caused by interest rate increases and is not attributable to changes in credit quality.  Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company has the ability and intent to hold these investments until a recovery of fair value, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2007.

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PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The amortized cost and estimated fair value of investment securities at December 31, 2008 by contractual maturity are shown below.  Expected maturities will differ from contractual maturities because the issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties.

Table 7: Security Maturity Schedule	Available-for-Sale				Held-to-Maturity
(In thousands)	Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value
Within one year	$	5,138	$	5,234	$	-	$	-
After one year through five years		5,004		5,151		-		-
After five years through ten years		187		187		-		-
After ten years		10,905		6,449		-		-
		21,234		17,021		-		-
Investment securities not due at a single maturity date:
Mortgage-backed securities		22,355		22,671		46		46
	$	43,589	$	39,692	$	46	$	46

Investment securities with amortized costs totaling $21,566,000 and $20,942,000 and estimated market values totaling $21,044,000 and $20,984,000 were pledged to secure treasury tax and loan accounts, public deposits and Federal Reserve Bank advances at December 31, 2008 and 2007, respectively.  Certain other investment securities are pledged to secure borrowings with the Federal Home Loan Bank (see Note 7).

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PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES

Outstanding loans are summarized below:

Table 8: Loans Outstanding by Category	December 31,
	2008			2007
	(In thousands)
Commercial	$	81,284		$	83,012
Agricultural		13,153			12,646
Real estate - commercial mortgage		135,013			121,157
Real estate - construction		64,762			80,168
Installment		13,609			15,215
Gross loans		307,821			312,198
Deferred loan origination costs, net		143			208
Allowance for loan losses		(6,019	)		(3,948	)
Net loans	$	301,945		$	308,458

Changes in the allowance for loan losses were as follows:

Table 9: Changes in Allowance for Loan Losses	Year Ended December 31,
	2008			2007			2006
	(In thousands)
Balance, beginning of year	$	3,948		$	2,478		$	2,356
Provision charged to operations		7,001			1,425			360
Losses charged to allowance		(5,868	)		(161	)		(24	)
Recoveries		938			206			1
Reclassification of reserve for unfunded commitments		-			-			(215	)
Balance, end of year	$	6,019		$	3,948		$	2,478

There were eleven loans on nonaccrual status in the amount of $23,560,000 as of December 31, 2008.  The Company recorded an allowance of $2,212,000 related to the loans on nonaccrual status.  There was one loan on nonaccrual status in the amount of $432,000 as of December 31, 2007.  There were no loans considered impaired at December 31, 2006.  The Company did not recognize any interest income on impaired or nonaccrual loans during 2008, 2007 and 2006.

The average outstanding balance of impaired loans for the years ended December 31, 2008, 2007 and 2006 was $9,591,000, $36,000 and $0, respectively.  The interest foregone on nonaccrual loans was $736,000 at December 31, 2008.  The interest foregone on nonaccrual loans was not significant at December 31, 2007 and 2006.  Salaries and employee benefits totaling $954,000, $1,006,000 and $227,000 have been deferred as loan origination costs for the years ended December 31, 2008, 2007 and 2006, respectively.

-17-

PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 5. PREMISES AND EQUIPMENT

Premises and equipment consisted of the following:

Table 10: Premises and Equipment	December 31,
	2008			2007
(In thousands)
Land	$	4,955		$	4,956
Buildings and improvements		6,326			5,987
Furniture, fixtures and equipment		5,159			4,525
Leasehold improvements		1,807			1,807
Construction in progress		4,172			1,879
Total gross premises and equipment		22,419			19,154
Less accumulated depreciation and amortization		(5,608	)		(4,885	)
Total premises and equipment	$	16,811		$	14,269

Depreciation and amortization included in occupancy, furniture and equipment expense totaled $826,000, $745,000, and $682,000 for the years ended December 31, 2008, 2007 and 2006, respectively.

NOTE 6. INTEREST-BEARING DEPOSITS

Interest-bearing deposits consisted of the following:

Table 11: Interest Bearing Deposits	December 31,
	2008		2007
(In thousands)
Savings	$	8,920	$	5,154
Money market		55,294		54,411
NOW accounts		18,390		18,096
Time deposits, $100,000 or more		106,018		127,731
Time deposits under $100,000		82,484		69,358
Total interest bearing deposits	$	271,106	$	274,750

Aggregate annual maturities of time deposits are as follows:

Table 12: Time Deposit Maturity Schedule	Year Ending December 31, 2008
(In thousands)
2009	$	171,554
2010		7,764
2011		2,869
2012		5,345
2013		970
Total time deposits	$	188,502

-18-

PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Interest expense recognized on interest-bearing deposits consisted of the following:

Table 13: Deposit Interest Expense	December 31,
	2008		2007		2006
(In thousands)
Savings	$	42	$	46	$	56
Money market		1,386		1,985		2,122
NOW accounts		232		246		315
Time deposits, $100,000 or more		5,069		6,657		3,906
Time deposits under $100,000		3,696		3,910		1,703
Total deposit interest expense	$	10,425	$	12,844	$	8,102

NOTE 7. OTHER BORROWINGS

The Company has unsecured short-term borrowing arrangements totaling $26,000,000 with four of its correspondent banks.  There were no borrowings outstanding under these arrangements at December 31, 2008 and 2007.

The Company has a borrowing arrangement with the Federal Home Loan Bank of San Francisco (FHLB) which allow the Company to borrow on either a short-term or long-term basis up to approximately $93,112,000 and $77,886,000 as of December 31, 2008 and 2007 respectively based on specific percentages of the collateral pledged.  For the years ended December 31, 2008 and 2007, various mortgage loans secured a borrowing capacity of $85,571,000 and $71,741,000 and investment securities secured borrowing capacity of $7,541,000 and $6,145,000, respectively.  The Bank had an outstanding letter of credit with the Federal Home Loan Bank in the amount of $26,282,000 at December 31, 2008.

Advances from the FHLB at December 31, 2008 and 2007 consisted of the following:

Table 14: FHLB Advances

(Dollars in thousands)

December 31,
2008						2007
Balance		Rate			Maturity Date	Balance		Rate			Maturity Date
$	10,000		3.00	%	July 2, 2009	$	35,000		3.80	%	January 2, 2008
	1,000		1.27	%	December 15, 2009		2,500		4.41	%	December 17, 2012
	10,000		3.22	%	January 4, 2010		2,500		4.28	%	December 18, 2012
	15,000		3.33	%	August 23, 2010	$	40,000
	1,000		2.20	%	December 15, 2010
	1,000		2.61	%	December 15, 2011
	1,000		2.82	%	December 17, 2012
	1,000		2.97	%	December 16, 2013
$	40,000

-19-

PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 8. SUBORDINATED DEBENTURES

The following is a summary of the subordinated debentures payable to the Company's subsidiary grantor trusts at December 31, 2008 and 2007 (dollars in thousands):

Table 15: Subordinated Debentures Outstanding	December 31,
(In thousands)	2008		2007
Subordinated debentures due to Pacific State Statutory Trust II with interest payable quarterly based on 3-month LIBOR plus 2.79% (4.66% at December 31, 2008), and redeemable with no premium beginning March 17, 2009 and due March 17, 2034.	$	3,609	$	3,609
Subordinated debentures due to Pacific State Statutory Trust III with interest payable quarterly based on 3-month LIBOR plus 1.45% (3.45% at December 31, 2008), and redeemable with no premium beginning September 16, 2012 and due September 16, 2037.		5,155		5,155
Total subordinated debentures	$	8,764	$	8,764

The Company has guaranteed, on a subordinated basis, distributions and other payments due on the trust preferred securities issued by the subsidiary grantor trusts.  Interest expense recognized by the Company for the years ended December 31, 2008, 2007 and 2006 related to the subordinated debentures was $464,000, $702,000 and $710,000, respectively.

NOTE 9. INCOME TAXES

The (benefit from) provision for income taxes for the years ended December 31, 2008, 2007 and 2006 consisted of the following:

Table 16: Income Tax (Benefit) Provision	Federal			State			Total
2008
Current	$	306			(399	)	$	(93	)
Deferred		(3,839	)		(1,440	)		(5,279	)
Benefit from income taxes	$	(3,533	)	$	(1,839	)	$	(5,372	)
2007
Current	$	2,776		$	873		$	3,649
Deferred		(592	)		(163	)		(755	)
Provision for income taxes	$	2,184		$	710		$	2,894
2006
Current	$	2,671		$	944		$	3,615
Deferred		54			(42	)		12
Provision for income taxes	$	2, 725		$	902		$	3,627

-20-

PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Deferred tax assets (liabilities) consisted of the following:

Table 17: Deferred Tax Assets and Liabilities	December 31,
	2008			2007
	(In thousands)
Deferred tax assets:
Allowance for loan losses	$	2,064		$	1,462
Future benefit of state tax deduction		-			280
Deposit purchase premium		109			102
Deferred compensation		762			517
Off balance sheet reserve		92			92
Bank premises and equipment		-			9
Nonaccrual interest		341			-
Other than temporary impairment charges		1,455			-
Net operating loss		4,646			-
Unrealized losses on available-for-sale investment securities		1,602			258
Total deferred tax assets		11,071			2,720
Deferred tax liabilities:
Bank premises and equipment	$	(116	)	$	-
Mark to market adjustment		(1,604	)		(37	)
Future expense of state tax refund		(645	)		-
Goodwill		(130	)		(110	)
FHLB dividends		(103	)		(66	)
Prepaid expense		(188	)		(200	)
Total deferred tax liabilities		(2,141	)		(413	)
Net deferred tax assets	$	8,930		$	2,307

The Company and its subsidiaries file income tax returns in the United States and California jurisdictions.  With few exceptions, the Company is no longer subject to Federal income tax examinations for years before 2004 and State income tax examinations by tax authorities for years before 2003.

The Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, on January 1, 2007.  No adjustments were identified for unrecognized tax benefits which would require an adjustment to the January 1, 2007 beginning tax reserve.  The Company had no tax reserve for uncertain positions at year-end.  The Company does not anticipate providing a reserve for uncertain positions in the next 12 months.  In accordance with FIN 48, the Company has elected to record interest accrued and penalties related to unrecognized tax benefits in tax expense.  During the years ended December 31, 2008 and 2007 the Company did not have an accrual for interest and/or penalties associated with uncertain tax positions.

The provision for income taxes differs from amounts computed by applying the statutory Federal income tax rates to operating income before income taxes.  The significant items comprising these differences for the years ended December 31, 2008, 2007 and 2006 consisted of the following:

Table 18: Income Tax Rate Reconciliation	2008			2007			2006
Federal income tax, at statutory rate		(34.0	)%		34.0	%		34.0	%
State franchise tax, net of Federal tax effect		(9.5	)%		6.3	%		6.5	%
Tax exempt investment security income, net		(0.3	)%		(0.4	)%		(0.7	)%
Company owned life insurance, net		(1.0	)%		(1.1	)%		(0.8	)%
Gain on Company owned life insurance		(8.3	)%		-	%		-	%
Other		2.2	%		0.1	%		0.6	%
Effective tax rate		(50.9	)%		38.9	%		39.6	%

-21-

PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 10. COMMITMENTS AND CONTINGENCIES

LEASES

The Company leases branch offices and certain equipment under non-cancelable operating leases.  The leases expire on various dates through 2016 and have various renewal options ranging from five to ten years.

Future minimum lease payments are as follows (in thousands):

Table 19: Future Lease Commitments	Year Ending December 31, 2008
(In thousands)
2009	$	274
2010		199
2011		205
2012		212
2013		218
Thereafter		593
Total	$	1,701

Rental expense included in occupancy, furniture and equipment expense totaled $496,000, $383,000 and $319,000 for the years ended December 31, 2008, 2007 and 2006, respectively.

FEDERAL RESERVE REQUIREMENTS

Banks are required to maintain a combination of reserves with the Federal Reserve Bank and vault cash equal to a percentage of their reservable deposits.  The reserve balances held with the Federal Reserve Bank or in the form of vault cash totaled $4,451,000 and $3,951,000 as of December 31, 2008 and 2007, respectively.

CORRESPONDENT BANKING AGREEMENTS

The Company maintains funds on deposit with other federally insured financial institutions under correspondent banking agreements.  Some of those insured financial institutions have elected to participate in the FDIC sponsored Transaction Account Guarantee Program.  Under that program, through December 31, 2009, all noninterest-bearing transaction accounts are fully guaranteed by the FDIC for the entire amount in the account.  Coverage under the Transaction Account Guarantee Program is in addition to and separate from the coverage available under the FDIC's general deposit insurance rules.  Uninsured deposits held at institutions not participating in this program totaled $65,000 at December 31, 2008.This program was not in effect in 2007 and uninsured deposits totaled $9,484,000 at December 31, 2007.

FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK

The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business in order to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates.  These financial instruments consist of commitments to extend credit and standby letters of credit.  These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized on the balance sheet.

The Company's exposure to credit loss in the event of nonperformance by the other party for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments.  The Company uses the same credit policies in making commitments and standby letters of credit as it does for loans included on the balance sheet.

-22-

PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The following financial instruments represent off-balance-sheet credit risk:

Table 20: Commitments

	December 31,
		2008		2007
	(In thousands)
Commitments to extend credit		$	55,522	$	121,255
Standby letters of credit		$	1,557	$	3,491

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  The Company evaluates each customer's creditworthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management's credit evaluation of the borrower.  Collateral held varies, but may include accounts receivable, inventory, equipment, income-producing commercial properties and residential real estate.

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance or financial obligation of a customer to a third party.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers.  The fair value of the liability related to these standby letters of credit, which represents the fees received for issuing the guarantees, was not significant at December 31, 2008 and 2007.  The Company recognizes these fees as revenue over the term of the commitment or when the commitment is used.

At December 31, 2008, commercial loan commitments represent approximately 51% of total commitments and are generally secured by various assets of the borrower.  Real estate loan commitments represent approximately 34% of total commitments and are generally secured by property with a loan-to-value ratio not to exceed 75% to 80%.  With the decline in the real estate market, the Company has experienced increasing loan-to-value ratios.  In cases where loan-to-value ratios have increased to a level above underwriting standards, the Company has reduced available lines to meet those standards.  In addition, the Company has reduced open construction commitments from $46,358,000 at December 31, 2007 to $11,778,000 at December 31, 2008.  Consumer loan commitments represent the remaining 15% of total commitments and are generally unsecured.  In addition, the majority of the Company's commitments have either variable interest rates or short term fixed rates.

CONCENTRATIONS OF CREDIT RISK

The Company's customers are primarily located in San Joaquin, Stanislaus, Calaveras, Alameda, and Tuolumne Counties.  At December 31, 2008, approximately 26% of the Company's loans are for general commercial uses, including professional, retail and small business, and 4% are for agricultural uses.  Additionally, 21% of the Company's loans are for the construction of residential and commercial real estate and 44% are loans which are collateralized by mortgages on residential and commercial real estate.  Generally, real estate loans are secured by real property while commercial and other loans are secured by funds on deposit and business or personal assets.  The remaining 5% of the Company's loans are consumer installment loans.  Repayment is generally expected from the proceeds of property sales and permanent financing for real estate construction loans and borrower cash flows for other loans.

CONTINGENCIES

The Company is subject to legal proceedings and claims which arise in the ordinary course of business.  In the opinion of management, the amount of ultimate liability with respect to such actions will not materially affect the consolidated financial position or consolidated results of operations of the Company.

NOTE 11. SHAREHOLDERS' EQUITY

DIVIDENDS

The Company's ability to pay cash dividends is dependent on dividends paid to it by the Bank and limited by California corporation law.  Under California law, the holders of common stock of the Company are entitled to receive dividends when and as declared by the Board of Directors, out of funds legally available, subject to certain restrictions.  The California general corporation law prohibits the Company from paying dividends on its common stock unless: (i) its retained earnings, immediately prior to the dividend payment, equals or exceeds the amount of the dividend or (ii) immediately after giving effect to the dividend, the sum of the Company's assets (exclusive of goodwill and deferred charges) would be at least equal to 125% of its liabilities (not including deferred taxes, deferred income and other deferred liabilities) and the current assets of the Company would be at least equal to its current liabilities, or, if the average of its earnings before taxes on income and before interest expense for the two preceding fiscal years was less than the average of its interest expense for the two preceding fiscal years, at least equal to 125% of its current liabilities.  In addition, the Company's ability to pay dividends is subject to certain covenants contained in the indentures related to the trust preferred securities issued by the Trusts.

Upon declaration by the Board of Directors of the Company, all shareholders of record will be entitled to receive dividends.  A significant source of cash for the Company is dividends from the Bank.  The California Financial Code restricts the total dividend payment of any bank in any calendar year to the lesser of (1) the bank's retained earnings or (2) the bank's net income for its last three fiscal years, less distributions made to shareholders during the same three-year period.  As a member of the Federal Reserve System, the Bank is also subject to similar restrictions imposed by Federal law.  At December 31, 2008, Bank retained earnings of $4,653,000 were free of such restrictions and available for dividend payments to Bancorp.

-23-

PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(CONTINUED)

EARNINGS (LOSS) PER SHARE

A reconciliation of the numerators and denominators of the basic and diluted earnings (loss) per share computations is as follows:

Table 21: (Loss) Earnings Per Share Calculation	For The Year Ended December 31,
(Amounts in thousands, except per share data)	2008			2007		2006
Basic (Loss) Earnings Per Share Computations:
Net (loss) income	$	(5,190	)	$	4,549	$	5,543
Average common shares outstanding		3,710			3,687		3,537
Basic (loss) earnings per share	$	(1.40	)	$	1.23	$	1.57
Diluted Earnings (Loss) Per Share Computations:
Net (loss) income	$	(5,190	)	$	4,549	$	5,543
Average common shares outstanding		3,710			3,687		3,537
Effect of stock options		-			317		386
Total Weighted Average Shares and Common Stock Equivalents		3,710			4,004		3,923
Diluted (loss) earnings per share	$	(1.40	)	$	1.14	$	1.41

In 2008, there were no adjustments for the effect of stock options since any adjustment would be anti-dilutive to the Company’s net loss.  30,000 stock options were not included in the 2007 calculation as they were anti-dilutive.  All of the stock options outstanding were included in the computation of diluted earnings per share for the year ended December 31, 2006 as none of the stock options were anti-dilutive.

STOCK OPTION PLAN

The Company currently has one shareholder approved stock option plan, the Pacific State Bancorp 1997 Stock Option Plan. At December 31, 2008, the plan has 663,769 shares remaining as reserved for issuance for options already granted. Under the 1997 Plan 26,954 shares of common stock remain reserved for future issuance to directors through nonstatutory agreements.  The plan requires that the price may not be less than the fair market value of the Company’s common stock at the date of grant and that the stock must be paid in full at the time the option is exercised.  The Plan does not provided for the settlement of awards in cash and new shares are issued upon the exercise of the options. There was one grant of 30,000 stock options made in 2007 and no options were granted in 2008 or 2006. The options under the plan expire on dates determined by the Board of Directors, but not longer than ten years from the date of grant. The vesting period is generally over five years.

STOCK OPTION COMPENSATION EXPENSE

The compensation cost that has been charged against income for stock options was $270,000, $309,000 and $229,000 for the years ended December 31, 2008, 2007 and 2006, respectively.  The total income tax benefit recognized in shareholders equity for stock options exercised was $4,000, $223,000, and $736,000 for the years ended December 31, 2008, 2007 and 2006, respectively.

At December 31, 2008, the total compensation cost related to nonvested stock option awards granted to employees under the Company’s stock option plans but not yet recognized was $200,000.  Stock option compensation expense is recognized on a straight-line basis over the vesting period of the option.  This cost is expected to be recognized over a weighted average remaining period of 1.9 years and will be adjusted for subsequent changes in estimated forfeitures.  The total fair value of options vested during the years ended December 31, 2008, 2007 and 2006 was $270,000, $309,000 and $229,000, respectively.

-24-

PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(CONTINUED)

A summary of the activity within the plan follows:

	2008				2007
Table 22: Stock Option Activity	Shares		Weighted Average Exercise Price		Shares	Weighted Average Exercise Price
Options outstanding,
beginning of year	656,769		$	7.69	668,499	$	7.04
Options granted	-		$	-	30,000	$	19.70
Options exercised	(10,900)	)	$	4.98	(41,730)	)$	5.62
Options cancelled	-		$	-	-	$	-
Options outstanding,
end of year	645,869		$	7.73	656,769	$	7.69
Options exercisable,
end of year	621,869		$	7.27	515,622	$	7.01

The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the quoted price of the Company’s common stock for options that were in-the-money at December 31, 2008.  The intrinsic value of options outstanding and exercisable as of December 31, 2008 relating to the above stock option plans was $1,000. The intrinsic value of options vested or expected to vest as of December 31, 2008 relating to the above stock option plans was $1,000.  The weighted average remaining contractual term for options outstanding and exercisable was 4.85 years. During the years ended December 31, 2008, 2007 and 2006, the aggregate intrinsic value of options exercised was $52,000, $569,000, and $1,011,000, respectively.

The cash received from options exercised for the years ended December 31, 2008, 2007 and 2006 was $75,000, $235,000 and $880,000, respectively.  The actual tax benefit realized for the tax deductions from options exercised was $4,000, $223,000 and $736,000 for the years ended December 31, 2008, 2007 and 2006, respectively.

-25-

PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

REGULATORY CAPITAL

The Company and the Bank are subject to certain regulatory capital requirements administered by the Board of Governors of the Federal Reserve System (FRB) and the Federal Deposit Insurance Corporation (FDIC).  Failure to meet these minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of its assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices.  The Company’s and the Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of its assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices.  The Company’s and the Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average assets as set forth on the following table.  Each of these components is defined in the regulations.  Management believes that the Company and the Bank met all their capital adequacy requirements as of December 31, 2008 and 2007.

In addition, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt correction action.  To be considered well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth below.  There are no conditions or events since December 31, 2008 that management believes have changed the Bank's category.

Table 23: Regulatory Capital	Actual					Adequacy Purposes					Action Provisions
(Dollars in thousands)	Amount		Ratio			Minimum Amount		Minimum Ratio			Minimum Amount		Minimum Ratio
December 31, 2008
Pacific State Bancorp:
Total capital (to risk-weighted assets)	$	41,903		11.5	%	$	29,143		8.0	%		N/A		N/A
Tier 1 capital (to risk weighted assets)	$	37,336		10.3	%	$	14,562		4.0	%		N/A		N/A
Tier 1 capital (to average assets)	$	37,336		8.6	%	$	17,310		4.0	%		N/A		N/A
Pacific State Bank:
Total capital (to risk-weighted assets)	$	41,275		11.3	%	$	29,107		8.0	%	$	36,384		10.0	%
Tier 1 capital (to risk-weighted assets)	$	36,708		10.1	%	$	14,554		4.0	%	$	21,830		6.0	%
Tier 1 capital (to average assets)	$	36,708		8.7	%	$	16,819		4.0	%	$	21,023		5.0	%
December 31, 2007
Pacific State Bancorp:
Total capital (to risk-weighted assets)	$	46,285		12.6	%	$	29,433		8.0	%		N/A		N/A
Tier 1 capital (to risk weighted assets)	$	42,018		11.4	%	$	14,717		4.0	%		N/A		N/A
Tier 1 capital (to average assets)	$	42,018		10.2	%	$	16,524		4.0	%		N/A		N/A
Pacific State Bank:
Total capital (to risk-weighted assets)	$	44,368		12.1	%	$	29,256		8.0	%	$	36,570		10.0	%
Tier 1 capital (to risk-weighted assets)	$	40,198		11.0	%	$	14,628		4.0	%	$	21,942		6.0	%
Tier 1 capital (to average assets)	$	40,198		9.8	%	$	16,428		4.0	%	$	20,535		5.0	%

-26-

PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(CONTINUED)

NOTE 12. OTHER EXPENSES

Other expenses consisted of the following:

Table 24: Other Expenses	Year Ended December 31,
	(In thousands)
	2008		2007		2006
Professional fees	$	1,253	$	294	$	349
Data processing		588		328		286
Advertising and promotion		408		564		365
Directors fees		321		290		274
Postage, stationery and supplies		272		212		184
Telephone		265		251		210
Appraisal fees		262		266		337
Other real estate owned		94		-		-
Other operating expenses		2,036		1,568		1,224
Total other expense	$	5,499	$	3,773	$	3,229

NOTE 13. LOANS TO RELATED PARTIES

During the normal course of business, the Company enters into loans with related parties, including executive officers and directors.  These loans are made with substantially the same terms, including rates and collateral, as loans to unrelated parties.  The following is a summary of the aggregate activity involving related party borrowers (in thousands):

Table 25: Related Party Loans

Balance, January 1, 2008	$	4,672,000
Disbursements		3,531,000
Amounts repaid		(5,930,000	)
Balance, December 31, 2008	$	2,273,000
Undisbursed commitments to related parties, December 31, 2008	$	2,604,000

NOTE 14. EMPLOYEE BENEFIT PLANS

The 401(k) Savings Plan established by the Bank in 1990 was converted into a Company plan in 2002.  Under the provisions of the plan, the Company matches one-half of the employees' contributions up to a maximum of three percent of an employee's annual salary.  All employees who are at least 21 years of age and have completed one year of service are eligible under the plan.  The Company's contributions vest at a rate of 20% after one year of service and an additional 20% for each year thereafter.  Contributions to the plan totaled $66,000, $18,000 and $21,000 for the years ended December 31, 2008, 2007 and 2006, respectively.

SALARY CONTINUATION AND RETIREMENT PROGRAMS

The Board of Directors approved salary continuation and retirement programs for six key employees in 2003, one in 2007 and an additional 2 in 2008.  Two of these agreements have been terminated due to the death of one employee and the resignation of another.  The accrued balances related to the terminated contracts were reversed from expense in 2008.  Under these plans, the employees will receive monthly payments for twenty years after retirement.  These benefits are substantially equivalent to those available under split-dollar life insurance policies purchased by the Company on the lives of the employees.  In addition, the estimated present value of these future benefits is accrued over the period from the effective dates of the plans until the participants' expected retirement dates based on a 7% discount rate.  The expense recognized under these plans for the years ended December 31, 2008 and 2007 totaled $90,000 and $231,000, respectively.  Accrued compensation payable under the plans totaled $1,106,000 and $1,016,000 at December 31, 2008 and 2007, respectively.

In connection with these plans, the Company purchased single premium life insurance policies with cash surrender values totaling $6,751,000 at December 31, 2008.  During 2008, one employee covered by the Company owned life insurance policy passed away.  As a result, the Company received $1,591,000 in cash surrender value and $2,574,000 in death benefit in cash.  Income earned on these policies, net of expenses, totaled $318,000, $246,000 and $208,000 for the years ended December 31, 2008, 2007 and 2006, respectively.  Income earned on these policies is not subject to federal or state income tax under certain circumstances.

-27-

PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 15. COMPREHENSIVE (LOSS) INCOME

Comprehensive (loss) income is a more inclusive financial reporting methodology that includes disclosure of other comprehensive (loss) income that historically has not been recognized in the calculation of net income.  The Company's only source of other comprehensive income (loss) is unrealized gains and losses on the Company's available-for-sale investment securities.  Total comprehensive income and the components of accumulated other comprehensive income (loss) are presented in the consolidated statement of changes in shareholders' equity.

At December 31, 2008, 2007 and 2006, the Company held securities classified as available-for-sale which had changes in net unrealized gains or losses as follows:

Table 26: Other Comprehensive Income
(In thousands)	2008			2007			2006
Unrealized holding (losses) gains	$	(3,897	)	$	(565	)	$	78
Tax benefit (expense) on unrealized holding gains		1,600			258			(30	)
Total other comprehensive (loss) income	$	(2,297	)	$	(307	)	$	48

-28-

PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(CONTINUED)

NOTE 16. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS

The estimated carrying and fair values of the Company's financial instruments are as follows:

Table 27: Fair Value of Financial Instruments

	December 31, 2008				December 31, 2007
	Carrying		Fair		Carrying		Fair
(In thousands)	Amount		Value		Amount		Value
Financial assets:
Cash and due from banks	$	16,700	$	16,700	$	13,794	$	13,794
Federal funds sold		21,811		21,811		31,880		31,880
Interest bearing deposits in other banks		-		-		3,000		3,000
Investment securities		39,738		39,738		41,352		41,352
Loans, net		301,945		305,257		308,458		306,198
Company owned life insurance		6,751		6,751		8,025		8,025
Accrued interest receivable		1,394		1,394		8,002		8,002
Other investments		2,447		2,447		2,294		2,294
Financial liabilities:
Deposits		340,980		343,084		341,821		343,373
Other borrowings		40,000		40,019		40,000		40,019
Subordinated debentures		8,764		2,918		8,764		8,630
Accrued interest payable	$	2,102	$	2,102	$	2,891	$	2,891

These estimates do not reflect any premium or discount that could result from offering the Company's entire holdings of a particular financial instrument for sale at one time, nor do they attempt to estimate the value of anticipated future business related to the instruments.  In addition, the tax ramifications related to the realization of unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of these estimates.

The following methods and assumptions were used to estimate the fair value of financial instruments.  For cash and cash equivalents, variable-rate loans and leases, accrued interest receivable and payable, FHLB stock, demand deposits and short-term borrowings, the carrying amount is estimated to be fair value.  For investment securities, fair values are based on quoted market prices, quoted market prices for similar securities and indications of value provided by brokers.  The fair values for fixed-rate loans are estimated using discounted cash flow analyses, using interest rates currently being offered at each reporting date for loans with similar terms to borrowers of comparable creditworthiness. Fair values for fixed-rate certificates of deposit are estimated using discounted cash flow analyses using interest rates offered at each reporting date by the Company for certificates with similar remaining maturities.  The fair value of subordinated debentures was determined based on the current market for like-kind instruments of a similar maturity and structure.  The fair values of commitments are estimated using the fees currently charged to enter into similar agreements and are not significant and, therefore, not included in the above table.

FAIR VALUE MEASUREMENTS UNDER SFAS 157

On January 1, 2008, the Company adopted Financial Accounting Standards Board (FASB) Statement No. 157 (SFAS 157), Fair Value Measurements.  SFAS No. 157 defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles, and expands disclosures about fair value measurement.  Upon adoption of SFAS No. 157, there was no cumulative effect adjustment to beginning retained earnings and no impact on the consolidated financial statements.

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PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Fair Value Hierarchy

In accordance with SFAS No. 157, the Company groups its assets and liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.  Valuations within these levels are based upon:

Level 1 – Quoted market prices for identical instruments traded in active exchange markets.

Level 2 – Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable or can be corroborated by observable market data.

Level 3 – Model-based techniques that use at least one significant assumption not observable in the market.  These unobservable assumptions reflect the Company's estimates of assumptions that market participants would use on pricing the asset or liability.  Valuation techniques include management judgment and estimation which may be significant.

Assets Recorded at Fair Value

The following tables present information about the Company's assets and liabilities measured at fair value on a recurring and nonrecurring basis as of December 31, 2008:

Recurring Basis:

The Company is required or permitted to record the following assets at fair value on a recurring basis under other accounting pronouncements.

Description	Fair Value		Level 1		Level 2		Level 3
Available-for-sale investment securities	$	39,738	$	39,738	$	-	$	-

Fair values for available-for-sale investment securities, which include debt securities of U.S. Government treasuries, U.S. Governmental agencies, obligations of states and political subdivisions and corporate bonds are based on quoted market prices for similar securities.

Non-recurring Basis:

The Company may be required, from time to time, to measure certain assets at fair value on a non-recurring basis.  These include assets that are measured at the lower of cost or market value that were recognized at fair value which was below cost at the reporting date.

Description	Fair Value		Level 1		Level 2		Level 3
Impaired loans	$	10,111	$	-	$	-	$	10,111

The fair value of impaired loans is based on the fair value of the collateral for all collateral dependent loans and for other impaired loans is estimated using a discounted cash flow model.  Impaired loans were determined to be collateral dependent and categorized as Level 3 due to ongoing real estate market conditions resulting in inactive market data, which in turn required the use of unobservable inputs and assumptions in fair value measurements.

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PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(CONTINUED)

NOTE 17. PARENT ONLY CONDENSED FINANCIAL STATEMENTS

CONDENSED BALANCE SHEET

December 31, 2008 and 2007

(In thousands)

Table 28: Condensed Balance Sheet	2008			2007
ASSETS
Cash and cash equivalents	$	470		$	-
Investment in bank subsidiary		35,157			40,621
Investment in Pacific State Statutory Trust II and III		264			264
Other assets		204			1,976
Total assets	$	36,095		$	42,861
LIABILITIES AND
SHAREHOLDERS' EQUITY
Liabilities:
Subordinated debentures	$	8,764		$	8,764
Other liabilities		47			61
Total liabilities		8,811			8,825
Shareholders' equity:
Common stock		10,767			10,418
Retained earnings		18,814			24,004
Accumulated other comprehensive loss, net of taxes		(2,297	)		(386	)
Total shareholders' equity		27,284			34,036
Total liabilities and shareholders' equity	$	36,095		$	42,861

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PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(CONTINUED)

CONDENSED STATEMENT OF INCOME

For the Years Ended December 31, 2008, 2007 and 2006

(In thousands)

Table 29: Condensed Income Statement	2008			2007			2006
Income:
Dividends declared by bank subsidiary	$	650		$	-		$	250
Interest		15			21			12
Total income		665			21			262
Expenses:
Interest on subordinated debentures		464			702			710
Salaries and employee benefits		99			95			92
Professional		95			102			78
Other expenses		227			148			67
Total expenses		885			1,047			947
Loss before equity in undistributed income of subsidiary		(220	)		(1,026	)		(685	)
Equity in undistributed income of subsidiary		(5,328	)		5,153			5,843
(Loss) Income before income tax benefit		(5,548	)		4,127			5,158
Income tax expense (benefit)		(358	)		(422	)		(385	)
Net (loss) income	$	(5,190	)	$	4,549		$	5,543

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PACIFIC STATE BANCORP AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(CONTINUED)

CONDENSED STATEMENT OF CASH FLOWS

For the Years Ended December 31, 2008, 2007 and 2006

(In thousands)

Table 30: Condensed Cash Flow	2008			2007			2006
Cash flows from operating activities:
Net (loss) income	$	(5,190	)	$	4,549		$	5,543
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Undistributed net loss (income) of subsidiary		5,328			(5,153	)		(5,843	)
Decrease (increase) in other assets		1,497			(529	)		(1,138	)
(Decrease) increase in other liabilities		(14	)		61			(20	)
Net cash provided by (used in) operating           activities		1,621			(1,072	)		(1,458	)
Cash flows from investing activities:
Proceeds from matured and called available-for-sale investment securities		-			-			204
Proceeds from the retirement of Pacific State Statutory Trust I		-			155			-
Investment in bank subsidiary		(1,500	)		-			-
Investment in Pacific State Statutory Trust III		-			(155	)		-
Net cash provided by (used in) operating activities		(1,500	)		-			204
Cash flows from financing activities:
Proceeds from issuance of junior subordinated debentures		-			5,000			-
Retirement of junior subordinated debentures		-			(5,000	)		-
Stock options exercised and related tax benefit		349			458			1,616
Proceeds from the issuance of common stock		-			-			250
Net cash provided by financing activities		349			458			1,866
Increase (decrease) in cash and cash equivalents		470			(614	)		612
Cash and cash equivalents at beginning of year		-			614			2
Cash and cash equivalents at end of year	$	470		$	-		$	614
Non-cash investing activities:
Net change in unrealized loss on available-for-sale investment securities	$	(1,911	)	$	(565	)	$	78

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FORWARD LOOKING STATMENTS

Certain statements discussed or incorporated by reference in this Annual Report including, but not limited to, information concerning possible or assumed future results of operations of the Company set forth in the Management's Discussion and Analysis of Financial Condition and Results of Operation, are forward-looking statements within the meaning of the Securities Exchange Act of 1934 (the "Exchange Act"). Forward-looking statements include statements in which words such as "expect," "anticipate," "intend," "plan," "believe," "estimate," "consider" or variants or similar expressions are used. The Company’s actual future results and shareholder values may differ materially from those anticipated and expressed in these forward-looking statements, which are based on management's beliefs and assumptions and on information currently available to management, and are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Such risks and uncertainties include, among others, (1) competitive pressures in the banking industry; (2) changes in the interest rate environment; (3) general economic conditions, either nationally or regionally; (4) changes in the regulatory environment; (5) changes in business conditions and inflation; and (6) changes in securities markets. Many of these factors are beyond the Company’s ability to control or predict.  Investors are cautioned not to put undue reliance on any forward-looking statements.  In addition, the Company does not have any intention or obligation to update forward-looking statements contained in this Annual Report, even if new information, future events or other circumstances have made them incorrect or misleading. Except as specifically noted herein all references to the "Company" refer to Pacific State Bancorp, a California corporation.

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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

GENERAL DESCRIPTION OF BUSINESS

Pacific State Bancorp (the “Company”) is a holding company with one bank subsidiary, Pacific State Bank, (the “Bank”), and two unconsolidated subsidiary grantor trusts, Pacific State Statutory Trusts II and III.  Pacific State Bancorp commenced operations on June 24, 2002 after acquiring all of the outstanding shares of Pacific State Bank.  The Bank is a California state chartered bank formed November 2, 1987. The Bank is a member of the Federal Reserve System. The Bank’s primary source of revenue is interest on loans to customers who are predominantly small to middle-market businesses and middle-income individuals.  Pacific State Statutory Trusts II and III are unconsolidated, wholly owned statutory business trusts formed in March 2004 and June 2007, respectively for the exclusive purpose of issuing and selling trust preferred securities.

The Bank conducts a general commercial banking business, primarily in the five county region that comprises Alameda, Calaveras, San Joaquin, Stanislaus and Tuolumne counties.  The Bank offers commercial banking services to residents and employers of businesses in the Bank’s service area, including professional firms and small to medium sized retail and wholesale businesses and manufacturers.  The Company as of March 13, 2009 had 92 employees, including 41 officers. The Bank does not engage in any non-bank lines of business. The business of the Bank is not to any significant degree seasonal in nature.  The Bank has no operations outside California and has no material amount of loans or deposits concentrated among any one or few persons, groups or industries.  The Bank operates nine branches with its Administrative Office and one branch located at 1899 W. March Lane, in Stockton, California; additional branches are located in Stockton and in the communities of Angels Camp, Arnold, Groveland, Lodi, Modesto, Tracy and Hayward, California.

Pacific State Bancorp common stock trades on the NASDAQ Global Market under the symbol of “PSBC”.

BUSINESS PLAN

The focus of the Company’s business plan is to attract “Business Relationship” small, medium and large accounts, but not to the exclusion of any other business which the Company can reasonably and profitably attract.  In order to provide a level of service to attract such customers, the Company has structured its specific services and charges on a basis which management believes to be profitable, taking into consideration other aspects of the account relationship.  The Company offers a full range of banking services to its customers intended to attract the following specific types of accounts: relatively large consumer accounts; professional group and association accounts, including the accounts of groups or firms of physicians, dentists, attorneys and accountants; and accounts of small to medium-sized businesses engaged in retail, wholesale, light industrial, manufacturing, agricultural and service activities.

TRUST SUBSIDIARIES

The Company during 2004 and 2007 established two subsidiary grantor trusts.  Pacific State Statutory Trusts II and III (the “Trusts”).  The Trusts were established for the sole purpose of issuing capital securities (“Capital Securities”) pursuant to declarations of trust (the “Declarations”).  The proceeds from the sale of the Capital Securities were loaned to the Company as subordinated debentures (the “Debentures”) issued to the Trusts pursuant to indentures (the “Indentures”).  Interest payments on the Debentures will flow through the Trusts to the Pooling Vehicles, which are the holders of the Capital Securities and similar securities issued by other financial institutions.  Payments of distributions by the Trusts to the Pooling Vehicle are guaranteed by the Company. See Note 8 to the Company’s consolidated financial statements included with this report.

Proceeds from the issuance of the 2004 subordinated debentures were used to provide the Bank with an additional $3.5 million in capital in order to support the continued growth of the Bank.  Proceeds from the issuance of the 2007 subordinated debentures were used to retire the 2002 subordinated debenture issuance.

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PRODUCT LINES AND SERVICES

The Bank currently offers the following general banking services at all of its branches: commercial, construction, agricultural and real estate loans and personal credit lines, interest on checking, U.S. Savings bond services, domestic and foreign drafts, banking by appointment, automatic transfer of funds between savings and checking accounts, business courier services, checking and savings accounts for personal and business purposes, domestic letters of credit, a depository for MasterCard and Visa drafts, federal depository services, cash management assistance, wire and telephone transfers, Individual Retirement Accounts, time certificates of deposit, courier service for non-cash deposits, Visa and MasterCard, revolving lines of credit to consumers secured by deeds of trust on private residences, unsecured overdraft protection credit lines attached to checking accounts,  ATM cards and MasterMoney debit cards via the Star, Cirrus, Plus, MasterCard and Visa networks.

The Bank is not authorized to offer trust services.  The Federal Reserve Bank of San Francisco is the Company’s primary correspondent relationship.  The Bank currently also has correspondent relationships with City National Bank in Beverly Hills, California, First Tennessee Bank in Memphis, Tennessee, Wells Fargo Bank, San Francisco, California and Pacific Coast Bankers Bank, San Francisco, California.

The Bank recognizes that, in order to be competitive, it must attract a certain number of consumer accounts.  Individual Retirement Accounts, Visa and MasterCard, revolving lines of credit to consumers secured by deeds of trust on private residences, and unsecured overdraft protection credit lines attached to checking accounts currently offered by the Bank are designed to appeal particularly to consumers.  Moreover, participation in large-scale ATM networks assists the Company in competing for consumer accounts.

The Bank is an approved Small Business Administration and 504 lender, FSA, USDA Business and Industry, USDA Part-time Farmer Program and FHA and VA lender.  The Bank is a national leader in the underwriting of U.S. Department of Agriculture business and industry loans, as well as a Preferred Lender for this program.

CRITICAL ACCOUNTING POLICIES

General

Pacific State Bancorp’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our consolidated financial statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use.

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standard (“SFAS”) No. 123(R), “Share Based Payment”; see information under the header “Share Based Compensation” in Note 2 to the consolidated financial statements included with this report. Other estimates that we use are related to the assumptions and estimates related to share based compensation, expected useful lives of our depreciable assets and the determination whether any impairment exists related to our investments and intangible and other long-lived assets.  In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.

A critical accounting estimate is one that requires a company to make assumptions about matters that are highly uncertain at the time the accounting estimate is made.  If different estimates that the company reasonably could have used for the accounting estimate in the current period were made, or if changes in the accounting estimate that are reasonably likely to occur from period to period occurred, they could have a material impact on the presentation of the company's financial condition, changes in financial condition or results of operations.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting. (1) Statement of Financial Accountings Standards (SFAS) No. 5 "Accounting for Contingencies", which requires that losses be accrued when they are probable of occurring and estimable and (2) SFAS No. 114, "Accounting by Creditors for Impairment of a Loan", which requires that losses on impaired loans be accrued and measured based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.  When a loan is not expected to be repaid in accordance with its contractual terms.

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Share Based Compensation

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (R), Share-Based Payment (“SFAS 123 (R)”). Under SFAS 123(R), compensation cost recognized for all awards that vest subsequent to the date of adoption based are on the grant-date fair value estimated in accordance with SFAS No. 123, Accounting for Stock-Based Compensation and SFAS 123(R). The grant-date fair value is estimated using the Black-Scholes-Merton option-pricing formula, which involves making estimates of the assumptions used, including the expected term of the option, expected volatility over the option term, expected dividend yield over the option term and risk-free interest rate.  In addition, when determining the compensation expense to amortize over the vesting period, management makes estimates about the expected forfeiture rate of options.

Securities

Debt securities are classified based on management’s intention on the date of purchase and recorded on the Consolidated Balance Sheet as debt securities as of the trade date. Debt securities which management has the intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost. Debt securities that are bought and held principally for the purpose of resale in the near term are classified as trading account assets and are stated at fair value with unrealized gains and losses included in trading account profits (losses).  All other debt securities that management has the intent and ability to hold for the foreseeable future are classified as available-for-sale (AFS) and carried at fair value with net unrealized gains and losses included in accumulated OCI on an after-tax basis. If there is an other-than-temporary deterioration in the fair value of any individual debt security classified as AFS, the Company will reclassify the associated net unrealized loss out of accumulated OCI with a corresponding adjustment to other income. If there is an other-than-temporary deterioration in the fair value of any individual security classified as held-to-maturity the Company will write down the security to fair value with a corresponding adjustment to other income. Interest on debt securities, including amortization of premiums and accretion of discounts, is included in interest income. Realized gains and losses from the sales of debt securities, which are included in gains (losses) on sales of debt securities, are determined using the specific identification method.

RESULTS OF OPERATIONS

Year Ended December 31, 2008 Compared to Year Ended December 31, 2007

Net loss for the year ended December 31, 2008, was $5,190,000 representing a decrease of $9,739,000 or 214% over net income of $4,549,000 for the year ended December 31, 2007. The primary causes of the decrease in net income were the increase in the provision for loan losses of $5,576,000 or 391% over 2007 levels, other than temporary impairment charges of $8,923,000, and a loss on the sale of securities of $1,291,000 which were not experienced in 2007.  In addition to the increase in the provision for loan losses, other than temporary impairment charges and losses on the sale of securities, noninterest expense increased by $2,331,000, or 21%, over 2007 levels due primarily to increased legal and professional fees associated with loan collections.

In 2008 the Company faced many difficult challenges with respect to its investment and loan portfolios.  The Company took significant losses related to Fannie Mae and Freddie Mac preferred stock positions.  The value of the preferred stock positions were impaired after the United States Treasury Department placed the organizations into receivership and canceled dividend payments associated with the preferred stock.  The Company subsequently sold the preferred stock at a realized loss of $6,843,000.  The Company also recognized an impairment charge on a single issue trust preferred security in the amount of $2,425,000 and experienced other net realized losses of $946,000 in the investment portfolio.

As the economic environment has deteriorated, additional reserves were required for loan losses.  The Company recorded $7,001,000 in provision for additional loan losses in 2008.  The reserve for loan losses as of December 31, 2008 was $6,019,000 or 1.95% of loans.

Despite the Company’s losses, Pacific State Bancorp continued to achieve strong growth in average earning assets, increasing by $28,373,000 or 8%.  Offsetting the growth in average earning assets was a decrease in the average yield earned on average earning assets by 163 basis points or 19%.  In order to fund the growth in average earning assets, the Company increased its average interest bearing liabilities by $28,407,000 or 9%.  The average rate paid on interest bearing liabilities decreased by 88 basis points or 19%.  The decrease in the rate received on average earning assets offset the growth in average earning assets which resulted in decreased total interest earned by $3,967,000 or 13%.  The Company experienced a similar result in interest bearing liabilities.  The rate paid on average interest bearing liabilities was large enough to offset the increase in interest bearing liabilities.  The result was decreased interest expense of $1,602,000, or 12%.  The net result is a decrease in net interest income of $2,365,000 or 14%.  A more in depth discussion of average balances and the rates received or paid on those balances is presented in the section titled “Net Interest Income” below.

Loss on average assets (ROA) was 1.20% for the year ended 2008 while the return on average assets was 1.13% for the year ended 2007.  The loss on average equity (ROE) was 14.95% in 2008 compared with a return on average equity of 14.22% in 2007.  Diluted loss per share for 2008 was $1.40 compared to diluted earnings per share of $1.14 in 2007, a decrease of 223%.  The decrease in earnings per share was primarily due to the decrease in net income of 214%.

The Company’s average total assets increased to $433.5 million in 2008 or 7.7% over $402.5 million in 2007.  The Company’s total assets decreased to $421.5 million as of December 31, 2008 or 2.1% below $431.1 million at December 31, 2007.  Total gross loans decreased in 2008 to $308.0 million from $312.4 million in 2007, a decrease of $4.4 million or 1.4%.  Total deposits decreased to $341.0 million, or 0.25%, compared to $341.8 million in 2007.  The growth in the average balance sheet compared to an overall decrease in the period end balance sheet is the result of growth in the middle of 2008 with contraction at the end of the year.  The contraction at the end of 2008 is the result of the poor economic environment in which the Company operates.

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Year Ended December 31, 2007 Compared to Year Ended December 31, 2006

Net income for the year ended December 31, 2007, was $4,549,000 representing a decrease of $994,000 or 17.93% over net income of $5,543,000 for the year ended December 31, 2006. The primary cause of the decrease in net income was the increase in the provision for loan losses of $1,065,000 or $627,000 after the recorded tax effect, over 2006 levels.  In addition to the increase in the provision for loan losses, noninterest expense increased by $637,000, or $375,000 after the recorded tax effect, over 2006 levels.  The increase in noninterest expense is primarily attributable to the full year recognition of expenses in 2007 related to the opening of two new branches in late 2006.  In 2007 the Company achieved strong growth in average earning assets, increasing by $63,105,000 or 21%.  The average yield earned on average earning assets decreased by 23 basis points or 3%.  In order to fund the growth in average earning assets, the Company increased its average interest bearing liabilities by $60,751,000 or 25%.  The average rate paid on interest bearing liabilities increased by 78 basis points or 20%.  The growth in average earning assets increased total interest earned by $4,747,000 or 18%, while the increase in interest bearing liabilities increased interest expense by $4,654,000, resulting in an increase of net interest income of $93,000.  A more in depth discussion of average balances and the rates received or paid on those balances is presented in the section titled “Net Interest Income” below.

Return on average assets (ROA) decreased to 1.13% while the return on average equity (ROE) decreased to 14.22% in 2007 compared with 1.67% and 22.91%, respectively, in 2006. Diluted earnings per share for 2007 and 2006 were $1.14 and $1.41, respectively, a decrease of 19.15%.  The decrease in earnings per share was primarily due to the decrease in net income of 17.93%.

The Company’s average total assets increased to $402.5 million in 2007 or 21.53% over $331.2 million in 2006.  The Company’s total assets increased to $431.1 million as of December 31, 2007 or 11.46% over $386.8 million at December 31, 2006.  Total gross loans increased in 2007 to $312.4 million from $289.8 million in 2006, an increase of $22.6 million or 7.80%.  Total deposits grew to $341.8 million, or 0.23%, compared to $341.0 million in 2006. Total borrowings grew to $48.8 million, or 256.20%, compared to $13.7 million in 2006.  The increases in the balance sheet and, particularly in loans and borrowings, were attributable to the continued growth of the bank.

Net Interest Income

The primary source of income for the Company is net interest income. Net interest income represents the excess of interest and fees earned on interest-earning assets (loans, securities and federal funds sold) over the interest paid on deposits and borrowed funds. Net interest margin is net interest income expressed as a percentage of average earning assets.

Net interest income decreased $2.4 million or 14% to $15.0 million in 2008 from $17.4 million in 2007 and increased $93 thousand or 0.54% in 2007 from $17.3 million in 2006.  Total average earning assets increased $28.4 million or 8% to $391.9 million from $363.5 million in 2008.  Average loan balances outstanding during 2008 increased $22.3 million or 7%, while average balances of investments, federal funds sold and interest bearing deposits in banks increased by $6.1 million or 10%.  The average yield on loans in 2008 decreased by 167 basis points compared to 2007.  The average yield on investments, federal funds sold and interest bearing deposits increased 138 basis points in 2008 compared to 2007.  The decrease in loan yields is related to fluctuating market conditions based on economic data, competition and the lagging effect of interest rate cuts.  As a result of the change in mix of earning assets, the overall yield on average earning assets during 2008 decreased 163 basis points to 6.96% from 8.59% for 2007.

Net interest income increased $93 thousand or 0.54% to $17.4 million in 2007 from $17.3 million in 2006 and $3.8 million or 27.86% in 2006 from $13.5 million in 2005.  Total average earning assets increased $63.1 million or 21.01% to $363.5 million from $300.4 million in 2006.  Average loan balances outstanding during 2007 increased $30.8 million or 11.45%, while average balances of investments, federal funds sold and interest bearing deposits in banks increased by $32.3 million or 104.00%.  The average yields on loans in 2007 increased by 5 basis points.  The average yield on investments, federal funds sold and interest bearing deposits increased 14 basis points in 2007 compared to 2006.  The slight increase in yields is related to fluctuating market conditions based on economic data, competition and the lagging effect of prior year interest rate cuts.  As a result of the change in mix of earning assets, the overall yield on average earning assets during 2007 decreased 23 basis points to 8.59% from 8.82% for 2006.

Total interest expense decreased $1.6 million or 12%, to $12.2 million in 2008, from $13.8 million in 2007.  Total interest expense increased $4.7 million or 51% to $13.8 million in 2007, from $9.2 million in 2006.  In 2008 the average balance of interest-bearing liabilities increased $28.4 million or 9% to $330.2 million from $301.8 million for the year ended December 31, 2007.  In 2007 the average balance of interest-bearing liabilities increased $60.8 million or 25% to $301.8 million from $241.0 million for the year ended December 31, 2006.  Additionally, the average rate paid on interest-bearing liabilities decreased to 3.71% in 2008 from 4.59% in 2007 and increased in 2007 from 3.81% in 2006.  The decrease in the average interest rate paid on interest-bearing liabilities represents 88 basis points or 12% in 2008 and an increase of 78 basis points or 21% in 2007.

Average interest-bearing demand deposits decreased $9.2 million or 11% to $78.1 million in 2008 from $87.3 million in 2007.  The average rate paid on these deposits during 2008 decreased 47 basis points.  Average certificates of deposit increased $7.7 million or 4% to $207.9 million in 2008 from $200.2 million in 2007. The average rate paid on certificates of deposit during 2007 increased 83 basis points.  As a result of the increases in interest rates described above and overall changes in the mix of interest-bearing deposits, the average rate paid on all interest bearing deposits and borrowings increased 78 basis points for 2007 to 4.59% from 3.81% in 2006.

The following table sets forth the Company's daily average balance sheet, related interest income or expense and yield or rate paid for the periods indicated.  The yield on tax-exempt securities has not been adjusted to a tax-equivalent yield basis. Average balances are based on daily averages.

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AVERAGE BALANCES, INTEREST INCOME/EXPENSE AND YIELDS/RATES PAID

Table 31: Net Interest Margin

	For Year Ended December 31,
(Dollars in thousands)
				Interest		Average						Interest		Average						Interest		Average
	Average			Income or		Yield or			Average			Income or		Yield or			Average			Income or		Yield or
Assets:	Balance			Expense		Cost			Balance			Expense		Cost			Balance			Expense		Cost
Interest-earning assets:
Loans	$	322,489		$	24,565		7.62	%	$	300,239		$	27,902		9.29	%	$	269,395		$	24,901		9.24	%
Investment securities		48,306			2,290		4.74	%		37,089			2,033		5.48	%		25,418			1,321		5.20	%
Federal funds sold		20,057			376		1.87	%		25,115			1,285		5.12	%		5,602			273		4.87	%
Interest Bearing Deposits in Banks		1,041			44		4.23	%		1,077			22		2.04	%		-			-		0.00	%
Total average earning assets	$	391,893		$	27,275		6.96	%	$	363,520		$	31,242		8.59	%	$	300,415		$	26,495		8.82	%
Non-earning assets:
Cash and due from banks		13,522								15,398								13,655
Bank premises and equipment		15,399								12,940								10,609
Other assets		16,629								13,322								9,058
Allowance for loan loss		(3,939	)							(2,665	)							(2,536	)
Total average assets	$	433,504							$	402,515							$	331,201
Liabilities and Shareholders' Equity:
Interest-bearing liabilities:
Deposits
Interest-bearing Demand	$	71,935		$	1,618		2.25	%	$	81,898		$	2,231		2.72	%	$	92,280		$	2,438		2.64	%
Savings		6,122			42		0.69	%		5,352			46		0.86	%		6,359			56		0.88	%
Time Deposits		207,848			8,765		4.22	%		200,154			10,567		5.28	%		125,994			5,608		4.45	%
Other borrowing		44,265			1,815		4.10	%		14,359			998		6.95	%		16,379			1,086		6.63	%
Total average interest-bearing liabilities	$	330,170		$	12,240		3.71	%	$	301,763		$	13,842		4.59	%	$	241,012		$	9,188		3.81	%
Noninterest-bearing liabilities:
Demand deposits		64,242								64,242								64,593
Other liabilities		4,378								4,524								1,405
Total average liabilities		398,790								370,529								307,010
Shareholders' equity:		34,714								31,986								24,191
Total average liabilities and shareholders' equity	$	433,504							$	402,515							$	331,201
Net interest income				$	15,035							$	17,400							$	17,307
Net interest margin							3.84	%							4.79	%							5.76	%

-39-

The following table sets forth changes in interest income and expense for each major category of earning assets and interest-bearing liabilities, and the amount of change attributable to volume, rates and the combination of volume and rates (mix) for the periods indicated.  The yield on tax-exempt securities has not been adjusted to a tax-equivalent yield basis.

ANALYSIS OF CHANGES IN NET INTEREST INCOME AND EXPENSE

Table 32: Rate/Volume Table	Years ended December 31,
	2008 over 2007
	Net
	Change			Rate(1)			Volume(2)
(In thousands)
Interest Income:
Loans and leases	$	(3,337	)	$	(5,405	)	$	2,068
Investment securities		257			(358	)		615
Federal funds sold		(909	)		(650	)		(259	)
Interest bearing deposits in banks		22			23			(1	)
Total interest income		(3,967	)		(6,390	)		2,423
Interest Expense:
Interest-bearing demand		(613	)		(342	)		(271	)
Savings		(4	)		(11	)		7
Time deposits		(1,802	)		(2,208	)		406
Other borrowing		817			(1,262	)		2,079
Total interest expense		(1,602	)		(3,822	)		2,220
Net interest income	$	(2,365	)	$	(2,568	)	$	203

Table 33: Rate/Volume Table	Years ended December 31,
	2007 over 2006
	Net
	Change			Rate(1)			Volume(2)
(In thousands)
Interest Income:
Loans and leases	$	3,001		$	150		$	2,851
Investment securities		712			105			607
Federal funds sold		1,012			61			951
Interest bearing deposits in banks		22			-			22
Total interest income		4,747			316			4,431
Interest Expense:
Interest-bearing demand		(207	)		67			(274	)
Savings		(10	)		(1	)		(9	)
Time deposits		4,959			1,658			3,301
Other borrowing		(88	)		46			(134	)
Total interest expense		4,654			1,770			2,884
Net interest income	$	93		$	(1,454	)	$	1,547

(1) The rate change in net interest income represents the change in rate multiplied by the current year’s average balance.

(2) The volume change in net interest income represents the change in average balance multiplied by the current year’s rate.

-40-

NON-INTEREST INCOME

The Company’s non-interest income normally consists primarily of service charges on deposit accounts, gain on sale of loans and ATM and other service fees.  For the year ended December 31, 2008, non-interest income represented a reduction of 24% of the Company’s revenues versus a contribution of 7% in 2007, and 9% in 2006.  In 2008 the Company’s non-interest income was severely impacted by extraordinary negative activity.  The Company recorded an other than temporary impairment charge on available for sale securities of $8.9 million and a  loss on the sale of available for sale securities of $1.3 million, reduced somewhat by a gain on the sale of assets of $471 thousand and a gain on Company owned life insurance of $2.6 million.

Total non-interest income decreased significantly to a net loss of $5.3 million in 2008 from a net gain of $2.5 million in 2007 which was a slight increase from $2.6 million in 2006. Service charge income decreased $66 thousand or 7% to $823 thousand in 2008.  The decrease in service charges in 2008 was the result of decreased account activity.  Service charge income increased $25 thousand in 2007 or 3% to $889 thousand, up from $864 thousand for the comparable period in 2006.  The increase in service charge income in 2007 was is the result of the increase in deposit accounts as a result of the growth of the Company.  The increase in service charges in 2007 and 2006 was offset by a decrease in gain on sales of loans of $144 thousand or 49.98% between 2007 and 2006 and $515 thousand or 63.66% between 2006 and 2005. The increase in the gain on sale of loans in 2008 and the decrease in 2007 compared to 2006 are due to both the timing of the sale of the loans and the changes in the number and dollar amount of loans sold.  Other income decreased $536 thousand to $890 thousand in 2008 over 2007 and increased $1 thousand or 1% in 2007 from $1,425 thousand in 2006.  Other income decreased in 2008 compared to 2007 primarily because of a decrease in prepayment penalties assessed on loans.  Other income remained constant in 2007 over 2006 levels.

The following table sets forth a summary of non-interest income for the periods indicated.

Table 34: Noninterest Income	Years Ended December 31,
	2008			2007		2006
	(In thousands)
Service charges	$	823		$	889	$	864
Gain on sale of loans		188			150		294
Gain on sale of assets		471			-		-
Gain on Company owned life insurance		2,574			-		-
Other income		890			1,426		1,425
Other than temporary impairment charge		(8,923	)		-		-
Loss on sale of securities		(1,291	)		-		-
Total non-interest income	$	(5,268	)	$	2,465	$	2,583

NON-INTEREST EXPENSE

Non-interest expense consists of salaries and related employee benefits, occupancy and equipment expenses, professional fees, appraisal fees, directors’ fees, postage, stationery and supplies expenses, telephone expenses, data processing expenses, advertising and promotion expense and other operating expenses. Non-interest expense for 2008 was $13.3 million compared to $11.0 million for 2007 and $10.4 million in 2006, representing an increase of $2.3 million or 21% for 2008, and $0.6 million or 6% for 2007.  The increase in salary and benefits in 2008 over 2007 of $210,000 was primarily the result of increased staffing levels and decreased deferred costs recognized associated with loan production.  The decrease of $143,000 in 2007 over 2006 levels was primarily related to staff turnover, efficiencies realized on upgraded IT systems and management focus on controlling increases in salaries and benefits.  The increase in occupancy and equipment expense of $395 thousand in 2008 over 2007 is attributable to increased use of machines for branch data capture, information technology upgrades and expensing of certain assets no longer in use.  The increase in occupancy and equipment expense of $236 thousand in 2007 over 2006 is attributable to the addition of the new branches in Lodi and Hayward in 2006.  Data processing expense increased by $97 thousand in 2008 over 2007 levels; the increase is primarily attributable to increasing volumes of electronic clearing of paper check items.  Data processing expense increased by $205 thousand in 2007 over 2006 levels; the increase was primarily attributable to the costs associated with implementing electronic clearing of paper check items.  Advertising expense decreased in 2008 due to a focus on controlling costs and evaluating the effectiveness of prior years’ advertising.  Advertising expense increased in 2007 and 2006 due to a focus on increasing market share and increased costs associated with retaining customers.  The Company incurred expenses associated with other real estate owned in 2008 due to the foreclosure and marketing of properties where a borrower discontinued payments in agreement with loan terms.  Other expense increased in 2008 over 2007 primarily due to deposit insurance assessments, correspondent bank charges, armored car expense, loan collection expense and other costs associated with the growth of the Company.  Professional fees increased significantly, due to the increase of legal costs associated with loan collection.  Other expense increased in 2007 over 2006 primarily due to correspondent bank charges and other costs associated with the growth of the Company.

-41-

The following table sets forth a summary of non-interest expense for the periods indicated.

Table 35: Noninterest Expense	Year Ended December 31,
	(In thousands)
	2008		2007		2006
Salaries and employee benefits	$	5,546	$	5,336	$	5,479
Occupancy and equipment		2,283		1,888		1,652
Professional fees		1,253		294		349
Appraisal fees		262		266		337
Directors fees		321		290		274
Postage, stationery and supplies		272		212		184
Telephone		265		251		210
Data processing		588		328		286
Advertising and promotion		408		564		365
Other real estate owned		94		-		-
Other operating expenses		2,036		1,568		1,224
Total noninterest expense	$	13,328	$	10,997	$	10,360

PROVISION FOR INCOME TAXES

The Company’s provision for income taxes includes both federal income and state franchise taxes and reflects the application of federal and state statutory rates to the Company’s net income before taxes.  The principal difference between statutory tax rates and the Company’s effective tax rate is the benefit derived from investing in tax-exempt securities and Company owned life insurance. Increases and decreases in the provision for taxes primarily reflect changes in the Company’s net income before tax.  The following table reflects the Company’s tax provision and the related effective tax rate for the periods indicated.

The following table reflects the Company’s tax provision and the related effective tax rate for the periods indicated.

Table 36: Tax (Benefit) Provision	Years Ended December 31,
(Dollars in thousands)	2008			2007			2006
Tax (benefit from) provision	$	(5,372	)	$	2,894		$	3,627
Effective Tax Rate		(50.9	)%		38.9	%		39.6	%

-42-

FINANCIAL CONDITION

Investment Securities

The Company classifies its investment securities as "held-to-maturity" or "available-for-sale" at the time of investment purchase. Generally, all securities are purchased with the intent and ability to hold them for long-term investment, and the Company has both the ability and intent to hold “held-to-maturity” investments to maturity. The Company does not engage in trading activities.

Investment securities held-to-maturity are carried at cost adjusted for the accretion of discounts and amortization of premiums. Securities available-for-sale may be sold to implement the Company’s asset/liability management strategies and in response to changes in interest rates, prepayment rates and similar factors. Securities available-for-sale are recorded at fair value and unrealized gains or losses, net of income taxes, are reported as accumulated other comprehensive income or loss, in a separate component of shareholder's equity. Gain or loss on sale of investment securities is based on the specific identification method.

Investment securities held-to-maturity at December 31, 2008, consisted of mortgage-backed securities totaling $46 thousand with a remaining contractual maturity of 6 to 14 years and a weighted-average yield to maturity of 5.77%.

The following table summarizes the contractual maturities of the Company’s investment securities at their carrying value and their weighted-average yields at December 31, 2008. The yield on tax-exempt securities has been adjusted to a tax-equivalent yield basis.

Table 37: Investment Yields

(Dollars in thousands)	Within One Year					One to Five Years					Five to Ten Years					Over Ten Years					Total
	Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield
Available-for-sale securities:
US Government Agencies and Treasuries	$	4,932		2.09	%	$	5,005		2.32	%	$	-		-	%	$	-		-	%	$	9,937		2.21	%
Municipal Obligations		205		5.06	%		-		-	%		168		7.00	%		2,781		6.98	%		3,154		6.87	%
Corporate and Other Bonds		-		-	%		-		-	%		-		-	%		8,143		6.16	%		8,143		6.16	%
Mortgage- backed securities		1		7.00	%		435		3.45	%		-		-	%		21,919		4.96	%		22,355		4.93	%
Total available-for-sale securities		5,138		2.21	%		5,440		2.41	%		168		7.00	%		32,843		5.43	%		43,589		4.68	%
Held-to-maturity Securities
Mortgage-backed securities	$	-		-	%	$	-		-	%	$	28		6.20	%	$	18		5.09	%	$	46		5.77	%

The following table summarizes the carrying value of the Company’s investment securities held on the dates indicated.

Table 38: Investment Balances	As of December 31,
(Dollars in thousands)	2008		2007		2006
Available-for-sale securities – at fair value:
U.S. Government agencies and treasuries	$	10,177	$	20,417	$	13,733
Municipal obligations		3,035		3,161		2,760
Corporate and other bonds		3,809		9,592		2,506
Mortgage- backed securities		22,671		8,124		4,035
Total available-for-sale	$	39,692	$	41,294	$	23,034
Held-to-maturity securities – at amortized cost:
Mortgage-backed securities	$	46	$	58	$	73

As of December 31, 2008, the aggregate book value of the Company’s investment in securities of a single issuer did not exceed 10% of the company’s shareholders’ equity.

LOANS AND ASSET QUALITY

The Company concentrates its lending activities primarily within Alameda, Calaveras, San Joaquin, Stanislaus and Tuolumne Counties.

The Company manages its credit risk through diversification of its loan portfolio and the application of underwriting policies and procedures and credit monitoring practices. Although the Company has a diversified loan portfolio, a significant portion of its borrowers' ability to repay the loans is dependent upon the professional services and residential real estate development industry sectors. Generally, the loans are secured by real estate or other assets and are expected to be repaid from cash flows of the borrower or proceeds from the sale of collateral.

-43-

The following table sets forth the amounts of loans outstanding by category as of the dates indicated:

Table 39: Loan Categories

(Dollars in thousands)	As of December 31,
	2008			2007			2006			2005			2004
Commercial and Agricultural	$	94,437		$	95,658		$	89,045		$	60,645		$	55,569
Real estate-construction		64,762			80,168			75,654			43,352			22,965
Real estate-commercial mortgage		135,013			121,157			112,532			126,166			109,895
Installment		13,609			15,215			12,526			13,536			13,121
Deferred Loan Fees and Costs		143			208			40			213			199
Allowance for Loan Losses		(6,019	)		(3,948	)		(2,478	)		(2,356	)		(2,214	)
Total Net Loans	$	301,945		$	308,458		$	287,318		$	241,556		$	199,535

Net loans have decreased $6.5 million or 2%, to $302.0 million at December 31, 2008 from $308.5 million at December 31, 2007.  The Company’s loan portfolio contracted in the commercial and agricultural categories by $1.2 million or 1% in 2008.  Real estate construction loans have decreased $15.4 million or 19%, real estate commercial mortgage loans increased $13.9 million or 11% and installment loans have decreased $1.6 million or 11% in 2008.  The portfolio mix has changed in 2008 as compared with the mix of the previous year: while commercial and agricultural loans remained at 31% in 2008, real estate construction loans decreased to 21% compared to 26% in 2007, real estate - commercial mortgage loans increased to 44%, compared to 39% and installment loans remained at 4% in 2008.  The shift in the mix reflects the changes in lending needs within the Company’s service area.  In addition, the Company has reclassified loans from real estate – construction to real estate – commercial mortgage as construction projects are completed and a permanent loan is provided.  The overall change in the mix of the loan portfolio did not significantly impact the overall risk profile in the loan portfolio.

The following table sets forth the maturity distribution of the Company’s commercial and agricultural loans and construction loans outstanding as of December 31, 2008, which, based on remaining scheduled repayments of principal, were due within the periods indicated.

Table 40: Commercial, Agriculture and Construction Loan Maturities

(Dollars in thousands)	Within One Year		After One through Five Years		After Five Years		Total
Commercial and agricultural loans	$	40,642	$	32,070	$	21,725	$	94,437
Construction Loans		54,522		7,070		3,170		64,762
Total	$	95,164	$	39,140	$	24,895	$	159,199
Loans due after one year with:
Fixed Rates			$	29,570	$	5,736	$	35,306
Variable Rates			$	9,570	$	19,159	$	28,729

The Company’s practice is to place a loan on nonaccrual status when one of the following events occurs:(i) Any installment of principal or interest is 90 days or more past due (unless in management's opinion the loan is well-secured and in the process of collection), (ii) management determines the ultimate collection of principal or interest to be unlikely or (iii) the terms of the loan have been renegotiated due to a serious weakening of the borrower's financial condition. Nonperforming loans are loans that are on nonaccrual, are 90 days past due and still accruing or have been restructured.

-44-

The following table sets forth a summary of the Company’s nonperforming loans and other assets as of the dates indicated:

Table 41: Nonperforming Assets

	As of December 31,
(Dollars in Thousands)	2008		2007		2006		2005		2004
Nonaccrual loans	$	23,560	$	432	$	--	$	--	$	--
90 days past due and still accruing interest		--		--		--		--		--
Other Real Estate Owned	$	2,029		--		--		--		--

The Company had a total of eleven loans on nonaccrual at December 31, 2008.  Three loans accounted for $17 million or 72% of the total balance of nonaccrual loans.  In each case, the Company holds commercial real estate as collateral and in one case holds a single family residence as collateral in addition to the commercial real estate.  The Company had one nonaccrual loan as of December 31, 2007 and did not have any nonaccrual loans at December 31, 2006.

ALLOWANCE FOR LOAN LOSSES (ALL)

In determining the amount of the Company’s Allowance for Loan Losses (“ALL”), management assesses probable loss characteristics of the loan portfolio including the concentrations, nature and diversification of the portfolio. Each credit is assigned a credit risk rating factor, and this factor, multiplied by the dollars associated with the credit risk rating, is used to calculate one component of the ALL. In addition, management estimates the probable loss on individual credits that are receiving increased management attention due to identified increases in credit risk.  Management reviews the credit risk report with the Directors Loan Committee as well as with the full Board of Directors, monthly.

The adequacy of the ALL is calculated upon three components. First is the credit risk rating of the loan portfolio, including all outstanding loans.  Every extension of credit has been assigned a risk rating based upon a comprehensive definition intended to measure the inherent risk of lending money. Each rating has an assigned risk factor expressed as a reserve percentage. Central to this assigned risk factor is the historical loss record of the Company. Secondly, established specific reserves are available for individual loans currently on management's watch and classified loan lists. These are the estimated potential losses associated with specific borrowers based upon the collateral and event(s) causing the risk ratings. The third component is unallocated. This reserve is for qualitative factors that may affect the portfolio as a whole, such as those factors described below.  Management believes the assigned risk grades and our methods for managing risk are satisfactory.

The Company makes provisions to the ALL on a regular basis through charges to operations that are reflected in the Company’s statements of income as a provision for loan losses. When a loan is deemed uncollectible, it is charged against the allowance. Any recoveries of previously charged-off loans are credited back to the allowance. There is no precise method of predicting specific losses or amounts that ultimately may be charged-off on particular categories of the loan portfolio. Similarly, the adequacy of the ALL and the level of the related provision for probable loan losses is determined on a judgment basis by management based on consideration of a number of factors including (i) economic conditions, (ii) borrowers' financial condition, (iii) loan impairment, (iv) evaluation of industry trends, (v) industry and other concentrations, (vi) loans which are contractually current as to payment terms but demonstrate a higher degree of risk as identified by management, (vii) continuing evaluation of the performing loan portfolio, (viii) monthly review and evaluation of problem loans identified as having a loss potential, (ix) monthly review by the Board of Directors, and (x) assessments by regulators and other third parties. Certain members of Management and the Board of Directors evaluate the allowance and determine its desired level considering objective and subjective measures, such as knowledge of the borrowers' businesses, valuation of collateral, the determination of impaired loans and exposure to potential losses.

While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions and other qualitative factors. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s ALL. Such agencies may require the Company to provide additions to the allowance based on their judgment of information available to them at the time of their examination. There is uncertainty concerning future economic trends. Accordingly it is not possible to predict the effect future economic trends may have on the level of the provision for possible loan losses in future periods.

The Company’s principal lines of lending are (i) commercial and agricultural, (ii) real estate construction and (iii) commercial and residential real estate. The primary sources of repayment of the Company’s commercial loans are the borrowers' conversion of short-term assets to cash and operating cash flow. The net assets of the borrower or guarantor are usually identified as a secondary source of repayment. The principal factors affecting the Company’s risk of loss from commercial lending include each borrower's ability to manage its business affairs and cash flows, local and general economic conditions and real estate values in the Company’s service area. The Company manages its commercial loan portfolio by monitoring its borrowers' payment performance and their respective financial condition and makes periodic adjustments, if necessary, to the risk grade assigned to each loan in the portfolio. The Company’s evaluations of its borrowers are facilitated by management's knowledge of local market conditions and periodic reviews by a consultant of the Company’s credit administration policies.

The principal source of repayment of the Company’s real estate construction loans is the sale of the underlying collateral or the availability of permanent financing from the Company or other lending source. The principal risks associated with real estate construction lending include project cost overruns and deterioration of real estate values as a result of various factors, including competitive pressures and economic downturns. The Company manages its credit risk associated with real estate construction lending by establishing loan-to-value ratios and loan-to-cost ratios on projects on an as-completed basis, inspecting project status in advance of controlled disbursements and matching maturities with expected completion dates. Generally, the Company requires a loan-to-value ratio of not more than 80% on single family residential construction loans.

The principal source of repayment of the Company’s real estate mortgage loans is the borrowers' operating cash flow. Similar to commercial loans, the principal factors affecting the Company’s risk of loss in real estate mortgage lending include each borrower’s ability to manage its business affairs and cash flows, local and general economic conditions and real estate values in the Company’s service area. The Company manages its credit risk associated with real estate mortgage lending primarily by establishing maximum loan-to-value ratios and using strategies to match the borrower's cash flow to loan repayment terms.

The Company’s specific underwriting standards and methods for each of its principal lines of lending include industry-accepted analysis and modeling and certain proprietary techniques. The Company’s underwriting criteria are designed to comply with applicable regulatory guidelines, including required loan-to-value ratios. The Company’s credit administration policies contain mandatory lien position and debt service coverage requirements, and the Company generally requires a guarantee from 20% or more owners of its corporate borrowers.

The ALL should not be interpreted as an indication that charge-offs in future periods will occur in the stated amounts or proportions.

-45-

The following table summarizes the Company’s loan loss experience as well as provisions and charges to the allowance for loan losses and certain ratios for the periods indicated:

Table 42: Allowance for Loan Loss Activity

(Dollars in thousands)	Years Ended December 31,
	2008			2007			2006			2005			2004
Beginning Balance:	$	3,948		$	2,478		$	2,356		$	2,214		$	1,653
Provision for loan losses		7,001			1,425			360			35			504
Charge-offs:
Commercial		(1,905	)		(143	)		(10	)		-			(9	)
Real Estate		(3,266	)		-			-			-			-
Other		(697	)		(18	)		(14	)		(17	)		-
Total Charge-offs		(5,868	)		(161	)		(24	)		(17	)		(9	)
Recoveries:
Commercial		925			203			-			124			66
Other		13			3			1			-			-
Total Recoveries		938			206			1			124			66
Reclassification of the reserve for unfunded commitments		-			-			(215	)		-			-
Ending Balance	$	6,019		$	3,948		$	2,478		$	2,356		$	2,214
ALL to total loans		1.95	%		0.86	%		0.98	%		1.10	%		1.05	%
Net charge-offs (recoveries) to average loans		1.53	%		0.01	%		(.01	) %		(.03	) %		.12	%

The provision for loan losses was $7,001,000 for 2008 compared to $1,425,000 for 2007 and $360,000 for 2006. The increase of $5,576,000 in the provision for loan losses in 2008 over 2007 reflected a severe economic downturn in the region there the Company operates.  The region has experienced declining real estate values which have left certain construction loans with a loan-to-value of greater than 100%.  In those cases where the loan is dependent on the collateral to repay the loan, the Company has charged-off loan principal to bring the loan back into compliance with policy.  In other cases, the value of the collateral has decreased below the principal on the loan, but cash flows from business operations are expected to repay the loan.  In these cases the business is evaluated to determine if there are sufficient cash flows available through business operations to repay the loan.  If operating cash flow has deteriorated, additional reserve is recorded against the loan.  The increase of $1,065,000 in the provision for loan losses, in 2007 over 2006 represented potential losses from specific customers and not degradation of overall credit quality in the loan portfolio.  The Company recorded net charge-offs of $4,930,000 or 1.53% of average loans during 2008.  Net (recoveries) charge-offs were $(45,000) or .02% of average loans for 2007 compared to $23,000 or .01% of average loans for 2006.

The following table summarizes the allocation of the allowance for loan losses (ALL) by loan type and the loans as a percent of loans outstanding in each loan category at the dates indicated

Table 43: Allocation of Allowance for Loan Loss

(Dollars in thousands)
	2008				2007				2006				2005				2004
Commercial and Agricultural	$	1,428	30.68	%	$	1,584	30.77	%	$	1,086	25.82	%	$	994	24.89	%	$	880	27.57	%
Real estate – construction		2,882	21.04	%		757	25.68	%		269	26.11	%		196	17.79	%		115	11.39	%
Real estate – commercial		1,312	43.86	%		563	39.58	%		642	44.01	%		501	51.77	%		422	54.52	%
Installment		246	4.42	%		293	3.97	%		279	4.06	%		300	5.55	%		308	6.52	%
Unallocated		151	-			751	-			202	-			365	-			489	-
Total	$	6,019	100.00	%	$	3,948	100.00	%	$	2,478	100.00	%	$	2,356	100.00	%	$	2,214	100.00	%

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DEPOSITS

The Company primarily obtains deposits from local businesses and professionals as well as through certificates of deposit, savings and checking accounts.

The following table sets forth the remaining maturities of certificates of deposit at December 31, 2008

Table 44: Deposit Maturity Schedule
(Dollars in thousands)	Under $100,000		Over $100,000
Three Months or less	$	16,947	$	40,845
Over three through six months		23,617		30,145
Over six through twelve months		26,542		33,458
Over twelve months		7,982		8,966
Total	$	75,088	$	113,414

LIQUIDITY AND MARKET RISK

The purpose of liquidity management is to ensure efficient and economical funding of the Company’s assets consistent with the needs of the Company’s depositors and, to a lesser extent, shareholders. This process is managed not by formally monitoring the cash flows from operations, investing and financing activities as described in the Company’s statement of cash flows, but through an understanding principally of depositor and borrower needs. As loan demand increases, the Company can use asset liquidity from maturing investments along with deposit growth to fund the new loans.

With respect to assets, liquidity is provided by receipts from cash and money market investments such as interest-bearing time deposits, federal-funds sold, available-for-sale investment securities, and by principal and interest payments on loans. With respect to liabilities, liquidity is provided by core deposits, shareholders' equity and the ability of the Company to borrow funds and to generate deposits.

Because estimates of the liquidity needs of the Company may vary from actual needs, the Company maintains a substantial amount of liquid assets to absorb short-term increases in loans or reductions in deposits. As loan demand decreases or loans are paid off, investment assets can absorb these excess funds or deposit rates can be decreased to run off excess liquidity. Therefore, there is some correlation between financing activities associated with deposits and investing activities associated with lending. The Company’s liquid assets (cash and due from banks, federal funds sold, interest bearing deposits in banks and available-for-sale investment securities) totaled $78.2 million or 19% of total assets at December 31, 2008, $89.9 million or 21% of total assets at December 31, 2007 and $73.7 million or 19% of total assets at December 31, 2006. The Company expects that its primary source of liquidity will be earnings of the Company, acquisition of core deposits, and wholesale borrowing arrangements.

MARKET RISK

Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates and processes such as interest rates, commodity prices and equity prices.  As typical for a financial institution, the Company’s market risk arises primarily from interest rate risk exposure.  Fluctuation in interest rates will ultimately impact both the level of income and expense recorded on a large portion of the Company’s assets and liabilities, and the market value of all interest earning assets and interest bearing liabilities, other than those that possess a short term to maturity.  Based upon the nature of its operations, the Company is not subject to foreign currency exchange or commodity pricing.  However, the Company’s commercial real estate loan portfolio, concentrated primarily in Northern California, is subject to risks associated with the local economies.

The fundamental objective of the Company’s management of its assets and liabilities is to maximize the economic value of the Company while maintaining adequate liquidity and managing exposure to interest rate risk deemed by management to be acceptable.  Management believes an acceptable degree of exposure to interest rate risk results from management of assets and liabilities through using floating rate loans and deposits, maturities, pricing and mix to attempt to neutralize the potential impact of changes in market interest rates.  The Company’s profitability is dependent to a large extent upon its net interest income, which is the difference between its interest income on interest earning assets, such as loans and securities, and interest expense on interest bearing liabilities, such as deposits, trust preferred securities and other borrowings.  The Company, like other financial institutions, is subject to interest rate risk to the degree that its interest earning assets reprice differently from its interest bearing liabilities.  The Company manages its mix of assets and liabilities with the goal of limiting exposure to interest rate risk, ensuring adequate liquidity, and coordinating its sources and uses of funds.

The Company seeks to control its interest rate risk exposure in a manner that will allow for adequate levels of earnings and capital over a range of possible interest rate environments.  The Company has adopted formal policies and practices to monitor and manage interest rate exposure.  As part of this effort, the Company measures interest rate risk utilizing both an internal asset liability measurement system as well as independent third party reviews to confirm the reasonableness of the assumptions used to measure and report the Company’s interest rate risk, enabling management to make any adjustments necessary.

Interest rate risk is managed by the Company’s Asset Liability Committee (“ALCO”), which includes members of senior management and several members of the Board of Directors.  The ALCO monitors interest rate risk by analyzing the potential impact on interest income from potential changes in interest rates and considers the impact of alternative strategies or changes in balance sheet structure.  The ALCO manages the Company’s balance sheet in part to maintain the potential impact on net interest income within acceptable ranges despite changes in interest rates.  The Company’s exposure to interest rate risk is reviewed on a quarterly basis by the ALCO.

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NET INTEREST INCOME SIMULATION

In order to measure interest rate risk at December 31, 2008, the Company used a simulation model to project changes in net interest income that result from forecasted projection and changes in interest rates.  This analysis, which is performed quarterly by management, calculates the difference between net interest income forecasted using a rising and falling interest rate scenario and net interest income forecasted using a base market derived from the current interest rates.  The income simulation model includes various assumptions regarding the re-pricing relationships for each of the Company’s products.  Many of the Company’s assets are floating rate loans, which are assumed to reprice immediately and to the same extent as the change in market rates according to their contracted index.  The Company’s non-term deposit products reprice more slowly, usually changing less than the change in market rates and at the discretion of the Company.

The analysis indicates the impact of changes in net interest income for the given set of rate changes and assumptions.  It assumes that the balance sheet grows modestly, but that its structure will remain similar to the structure at year-end.  It does not account for all factors that impact this analysis, including the potential impact of loan prepayments, deposit drifts or other balance sheet movements including changes by management to mitigate the impact of interest rate changes or secondary impacts such as changes to the Company’s credit risk profile as interest rates change.  Changes that vary significantly from the assumptions may have significant effects on the Company’s net interest income.

The following table reflects the Company’s projected net interest income sensitivity analysis based on year-end data:

Table 45: Interest Income Sensitivity	December 31, 2008
Change in Rates	Adjusted Net Interest Income		Percent Change From Base
	(In thousands)
Up 200 basis points	$	14,785		(1.47	)%
Up 150 basis points	$	14,848		(1.05	)%
Up 100 basis points	$	14,911		(0.63	)%
Base Scenario	$	15,005		0.00	%
Down 100 basis points	$	15,152		0.98	%
Down 150 basis points	$	15,236		1.54	%
Down 200 basis points	$	15,324		2.13	%

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CONTRACTUAL OBLIGATIONS

The following table summarizes the contractual obligations of the Company as of December 31, 2008:

Table 46: Contractual Obligations			Less than						More than
	Total		one year		1-3 years		3-5 years		5 years
Subordinated Debentures, floating rate
of 4.66% payable March 17, 2034	$	3,609	$	-	$	-	$	-	$	3,609
Subordinated Debentures, floating rate
of 3.45% payable September 16, 2037		5,155		-		-		-		5,155
FHLB Loans weighted average fixed rate of 3.10%		40,000		11,000		27,000		2,000		-
Operating lease obligations		1,701		274		404		430		593
Salary continuation program (1)		1,106		-		-		-		1,106
Total	$	51,571	$	11,274	$	27,404	$	2,430	$	10,463

(1)   Salary continuation program obligations represent the amount accrued as of December 31, 2008 under the terms of the program.

In addition to those obligations listed above, in the normal course of business, the Company will make cash distributions for, among other items, the payment of interest on interest bearing deposit accounts and debt obligations, payments for quarterly tax estimates and contributions to certain employee benefit plans.

CAPITAL RESOURCES

Capital adequacy is a measure of the amount of capital needed to sustain asset growth and act as a cushion for losses. Capital protects depositors and the Federal deposit insurance fund from potential losses and is a source of funds for the investments the Company needs to remain competitive.  Historically, capital has been generated principally from the retention of earnings.

Overall capital adequacy is monitored on a day-to-day basis by the Company’s management and reported to the Company’s Board of Directors on a quarterly basis.  The Bank’s regulators measure capital adequacy by using a risk-based capital framework and by monitoring compliance with minimum leverage ratio guidelines. Under the risk-based capital standard, assets reported on the Company’s balance sheet and certain off-balance sheet items are assigned to risk categories, each of which is assigned a risk weight.

      This standard characterizes an institution's capital as being "Tier 1" capital (defined as principally comprising shareholders' equity and qualifying subordinated debentures ) and "Tier 2" capital (defined as principally comprising the qualifying portion of subordinated debt and the qualifying portion of the ALL), the total amount not to exceed 100% of Tier 1 capital.

 The minimum ratio of total risk-based capital to risk-adjusted assets, including certain off-balance sheet items, is 8%.

At December 31, 2008, 2007 and 2006 the Company’s capital met all minimum regulatory requirements.

 As of December 31, 2008, the most recent notification by the Federal Depository Insurance Corporation (FDIC) categorized the Bank as well capitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized the Bank must meet the minimum ratios as set forth below. There are no conditions or events since that notification that management believes have changed the institution’s category.  For more information on the Company’s and the Bank’s risk-based capital ratios, see note 11 to the Financial Statements contained in this report.

IMPACT OF INFLATION

Inflation affects the Company’s financial position as well as its operating results. It is management's opinion that the effects of inflation on the financial statements have not been material.

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QUARTERLY FINANCIAL INFORMATION (UNAUDITED)

The following table presents the summary unaudited results for the stated eight quarters:

Table 47: Quarterly Financial Results

	2008										2007
(In thousands, except per share data)	4th Quarter			3rd Quarter			2nd Quarter		1st Quarter		4th Quarter		3rd Quarter		2nd Quarter		1st Quarter
Diluted (loss) earnings per share	$	(1.52	)	$	(0.30	)	$	0.15	$	0.27	$	0.13	$	0.33	$	0.35	$	0.33
Basic (loss) earnings per share	$	(1.52	)	$	(0.32	)	$	0.16	$	0.30	$	0.14	$	0.35	$	0.38	$	0.36
Interest income	$	5,792		$	6,948		$	7,234	$	7,301	$	7,667	$	7,937	$	8,132	$	7,506
Net interest income	$	3,220		$	4,048		$	3,848	$	3,919	$	4,175	$	4,241	$	4,653	$	4,331
Provision for loan losses	$	5,591		$	600		$	600	$	210	$	1,165	$	40	$	55	$	165
Total non-interest (loss) income	$	(3,400	)	$	(2,937	)	$	597	$	472	$	484	$	589	$	706	$	686
Total non-interest expense	$	4,450		$	3,558		$	2,825	$	2,495	$	2,585	$	2,711	$	3,002	$	2,699
(Loss) Income before taxes	$	(10,221	)	$	(3,047	)	$	1,020	$	1,686	$	909	$	2,079	$	2,313	$	2,142
Net (loss) Income	$	(5,654	)	$	(1,209	)	$	579	$	1,094	$	513	$	1,301	$	1,409	$	1,326

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MARKET PRICE FOR REGISTRANT’S COMMON EQUITY, DIVIDENDS AND RELATED STOCKHOLDER MATTERS

The Company’s common stock is listed for trading on the NASDAQ Global Market under the symbol PSBC. Prior to July 12, 2005, trading information regarding the common stock was available via the OTC Bulletin Board. The following table, which summarizes trading activity during the Company’s last two fiscal years, is based on information provided by Yahoo.com Historical Quotes.  The quotations reflect the price that would be received by the seller without retail mark-up, mark-down or commissions and may not have represented actual transactions.

Table 48: Quarterly Sales Prices	Sales Prices
Quarter Ended:	High		Low		Volume
December 31, 2008	$	6.10	$	1.90		209,500
September 30, 2008		9.70		5.01		208,300
June 30, 2008		12.43		8.00		106,000
March 31, 2008		14.80		10.86		111,600
December 31, 2007		18.89		12.44		132,100
September 30, 2007		20.74		15.51		310,600
June 30, 2007		21.90		16.75		149,300
March 31, 2007	$	24.23	$	19.87		503,000

As of March 15, 2009, there were approximately 280 holders of record of the common stock of the Company.

DIVIDENDS

The Company’s primary source of cash is dividends from the Bank.  The Bank’s ability to pay dividends is subject to certain regulatory requirements.  The California Financial Code restricts the total dividend payment of any bank in any calendar year to the lesser of (1) the bank’s retained earnings or (2) the bank’s net income for its last three fiscal years, less distributions made to shareholders’ during the same three-year period.  As of December 31, 2008, the Bank had $4.7 million in retained earnings available for dividends to the Company. In addition, the Company’s ability to pay dividends to its shareholders is subject to certain covenants contained in the indentures related to the trust preferred securities issued by the Trusts.

The power of the Board of Directors of an insured depository institution to declare a cash dividend or other distribution with respect to capital is subject to statutory and regulatory restrictions which limit the amount available for such distribution depending upon the earnings, financial condition and cash needs of the institution, as well as general business conditions.

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Stock Performance Graph

The following chart, compare the yearly percentage changes in cumulative shareholder return on our common stock during the five fiscal years ended December 31, 2008, with (i) the Total Return Index for the Nasdaq Stock Market (U.S. Companies) (ii) the Standard and Poor’s 500 and (iii) the Total Return Index for the Nasdaq Bank Stocks, as reported by the Center for Research in Securities Prices.  The comparison assumes $100.00 was invested on December 31, 2003, in our common stock and the comparison indices, and assumes the reinvestment of all cash dividends prior to any tax effect and retention of all stock dividends.  Price information from December 31, 2003 to December 31, 2008, was obtained by using Nasdaq closing prices as of the last trading day of each year.

	Period Ending
Index	12/31/2003		12/31/2004		12/31/2005		12/31/2006		12/31/2007		12/31/2008
Pacific State Bancorp	$	100.00	$	254.03	$	229.24	$	269.39	$	155.76	$	23.54
Nasdaq Bank Stocks	$	100.00	$	110.99	$	106.18	$	117.87	$	91.85	$	8.11
Nasdaq U.S.	$	100.00	$	108.59	$	110.08	$	120.56	$	132.39	$	78.72
S&P 500	$	100.00	$	108.99	$	112.26	$	127.55	$	132.06	$	81.23

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