The following is an analysis of the financial condition and results of operations of the Company for years ended December 31, 2008, 2007 and 2006. The analysis should be read in connection with the consolidated financial statements and notes thereto appearing elsewhere in this report.

When viewing financial information found on this Form 10-K as of and for the periods ended December 31, 2008, 2007 and 2006, it is important to consider that the Company acquired Business First on October 12, 2007. Therefore, the Company's financial position and results of operations will not reflect the acquisition for periods prior to that date. 2008 represents the first full calendar year for which balances and operating results for Business First are fully reflected in the Company's financial statements.

Financial Overview

For the years ended December 31, 2008, 2007 and 2006 the Company earned $1.7 million, $6.9 million and $6.7 million or $0.21, $0.96 and $0.96 per share on a fully diluted basis, respectively. On a year over year basis, net income declined approximately $5.3 million or 76.2%. The primary factor behind the decline can be attributed to substantial provisions the Bank made to the allowance for loan losses during 2008.

The following provides financial highlights as of and for the year ended December 31, 2008:

· Interest income for the year ended December 31, 2008 was approximately $50.2 million, which represents an increase of approximately $5.0 million or 11.0%. The rise in interest income is mainly attributable to the acquisition of Business First. The Business First acquisition occurred during the fourth quarter of 2007, thus 2008 represents the first year that balances for Business First and corresponding interest income and expense are reflected for a full calendar year. For the year ended December 31, 2008, the Business First acquisition accounted for approximately $12.1 million in interest income.

· Interest expense for the year ended December 31, 2008 was approximately $12.6 million, which represents a decline of approximately $2.2 million or 14.8%. The primary reason behind the year over year decline in interest expense can be attributed to the dramatic declines in the overnight Fed Funds rate made by the FOMC during 2008. For the year ended December 31, 2008, Business First accounted for approximately $1.8 million of interest expense.

· Net interest income for the year ended December 31, 2008 was approximately $37.6 million. When compared to the same period ended a year earlier, this represents an increase of approximately $7.2 million or 23.5%. The year over year rise in net interest income can be attributed to the acquisition of Business First, the abundant availability of inexpensive alternative funding sources and the re-pricing of our deposits in conjunction with the moves made by the FOMC to lower the overnight Fed Funds rate. Given that a relatively large portion of the Bank's deposits possess a floating interest rate, Management was able to re-price the Bank's interest bearing liabilities more rapidly, mitigating substantial declines in the net interest margin during 2008. For the year ended December 31, 2008, the net interest margin was 5.21%, representing a decline of 26 basis points when compared to the 5.47% reported for the year ended December 31, 2007.

· For the year ended December 31, 2008, non-interest income totaled approximately $6.2 million or $0.9 million higher than the $5.3 million reported for the same period ended a year earlier. The majority of the year over year increase can be attributed to higher service charges on deposit accounts obtained in the acquisition of Business First. Additionally, during the second quarter of 2008, the Bank recognized income in the approximate amount of $0.3 million related to the initial public offering of Visa, Inc.

· Non-interest expenses for the year ended December 31, 2008 were approximately $29.4 million or $5.5 million higher than the $23.9 million reported for the same period ended a year earlier.

The following provides a summary of significant changes contributing to the year over year increase in non-interest expenses:

· Increases in salaries and employee benefits accounted for approximately 37.3% or $2.1 million of the year over year increase. Additional staff from the Business First acquisition as well as branch expansion within 2008 contributed significantly to higher salaries and employee benefits.

· Also contributing to the year over year increase in non-interest expenses was an approximate $0.4 million increase in data processing costs related to increased transaction volume stemming from the Business First acquisition.

· Higher regulatory fees also contributed to the year over year increase. During 2008, the Company incurred regulatory fees that were approximately $0.3 million higher that that reported for the same period ended a year earlier, resulting from the absence of a one-time credit the Company recognized during 2007 for past contributions it made to the FDIC insurance fund.

· Expenses related to the amortization of the Bank's core deposit intangible ("CDI") were approximately $0.5 million higher in 2008 when compared to 2007.

· Occupancy expenses for 2008 were approximately $0.8 million higher than that reported for the same period ended a year earlier. Additional rental costs stemming from the Business First acquisition, branch expansion, and the impact of the sale leaseback transaction the Bank entered into during the second quarter of 2007 all contributed to the year over year increase within this category.

As the Company moves into 2009, Management has implemented various cost containment measures and continues to explore other areas where additional efficiencies may be gained. See also, "Non-Interest Expenses" under Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations on this Form 10-K for a more detailed analysis of the Company's non-interest expenses.

· As a result of the items mentioned in the preceding discussion the Company's operating efficiency ratio for the year ended December 31, 2008 was 67.27%. For the years ended December 31, 2007 and 2006 the operating efficiency ratio was 66.83% and 65.47%, respectively.

· Return on equity ("ROE") for the year ended December 31, 2008 was 2.29%. ROE declined substantially from that reported for 2007 as a result of the substantial provisions the Bank made to the allowance for loan losses during 2008. For the years ended December 2007 and 2006 the Company reported returns on equity of 12.37% and 14.10%, respectively.

· Return on average assets ("ROAA") for the year ended December 31, 2008 was 0.21%. A lower ROAA from that reported for 2007 is attributable in large part to the substantial increases in loan loss provisions previously mentioned. For the years ended December 31, 2007 and 2006 the Company reported returns on average assets of 1.14% and 1.32%, respectively.

· At December 31, 2008 net loan balances were $668.0 million or approximately $62.7 million higher than that reported at December 31, 2007. See also, "Loans" under Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations on this Form 10-K for a more detailed discussion on the Company's loan portfolio.

· Total deposit balances at December 31, 2008 were approximately $41.3 million lower than the $644.8 million reported at December 31, 2007. The dramatic decline in the over night Federal Funds rate during 2008 and Management's response in lowering offering rates in an effort to mitigate declines in the net interest margin, contributed greatly to the year over year decline. Declines in deposit balances were most evident within promotional deposit products and money market balances. See also, "Deposits and Borrowed Funds" under Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations on this Form 10-K for a more detailed discussion regarding deposit balances.

· Federal Home Loan Bank ("FHLB") borrowings were $109.0 million at December 31, 2008. This represents an increase of approximately $101.0 million when compared to the $8.0 million reported at December 31, 2007. The substantial increase in FHLB borrowing can be attributed to the large decline in deposit balances during 2008 as a result of Management's effort to maintain an appropriate cost of funds in a declining rates environment.

· At December 31, 2008, the allowance for loan losses was $10.4 million. As a percentage of total gross and non-performing loan balances, the allowance for loan losses was 1.53% and 55.75%, respectively. For the year ended December 31, 2008, provision for loan losses was approximately $12.2 million. When compared to the same period ended a year earlier, this represents increases of approximately $11.5 million. The increased provision for loan losses can be attributed in part to weakened economic conditions, increases in the trend of delinquent loans, as well as loans the Bank charged-off during 2008.

At December 31, 2008, the balance of loans placed on non-accrual status was approximately $18.3 million. This represents an increase of approximately $18.0 million from the $0.3 million reported at December 31, 2007. During 2008, the Bank charged-off approximately $8.1 million in loans and recovered approximately $0.1 million in loan balances previously charged-off. At December 31, 2008 the balance of Other Real Estate Owned ("OREO") was $1.3 million. During the fourth quarter of 2008, the Bank moved approximately $1.1 million in non-performing loan balances to Other Real Estate Owned status. See also "Non Performing Assets" under Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations on this Form 10-K for additional information related to non-performing assets.

Recent Developments

During the third and fourth quarters of 2008, the credit and equity markets came under significant duress as confidence by many in the U.S. financial system began to wane. During the later part of 2007 and throughout 2008, U.S. financial institutions were forced to significantly write-down the values of certain classes of assets in response to the weakened real estate market. This lead to great strains on the capital levels of many financial institutions, which in turn lead to a lack of confidence by many and others providing funding to the nation's banks, leading to a crisis of liquidity. With liquidity levels of many financial institutions significantly weakened, borrowing costs began to rise considerably and the flow of credit to consumers and between banks all but came to a halt. In response to this, the weakened economy and other factors, the U.S. Congress passes the Emergency Economic Stabilization Act of 2008 (the "EESA"). Under the EESA, the Department of the U.S. Treasury formed the Troubled Asset Relief Program (the "TARP"). The TARP gives the U.S. Treasury the power to make purchases of certain troubled assets as well as the direct purchase of equity from U.S. financial institutions under the CPP. Although the Company's liquidity levels remain adequate and the Bank and Company remain well capitalized, the Company applied to participate in the CPP to keep all capital raising options available. Recently, the Company received preliminary approval on January 9, 2009 to sell $21.0 million in preferred equity to the U.S. Treasury. On February 27, 2009, the Company received shareholder approval to add an authorized class of preferred stock to the Company's Articles of Incorporation that will allow the Company to participate in the CPP and also allow for more flexibility in capital raising efforts in general. For a more detailed discussion regarding the Company's participation in the CPP, see Note.
24. Subsequent Events, of the Consolidated Financial Statements filed on this Form 10-K.

On October 12, 2007 the Company acquired Business First National Bank ("Business First"). Business First was merged with and into Heritage Oaks Bank, a wholly owned subsidiary of the Company. The consideration paid for Business First was approximately $19.5 million, consisting of approximately 75% common stock and 25% cash. Business First shareholders received 0.5758 shares of Heritage Oaks Bancorp common stock for each share of Business First they owned and $3.44 per share in cash. For more information related to the acquisition of Business First, see Note 23. Business Combinations, of the Consolidated Financial Statements filed on this Form 10-K.

In April 2007, the Company redeemed all the Floating Rate Junior Subordinated Debt Securities it held associated with Heritage Oaks Capital Trust I. The redemption price was 100% of the principal amount redeemed, or $8.2 million, plus $0.4 million for the standard interest payment due on April 22, 2007. As a result of the redemption of these securities, the trust was dissolved on June 1, 2007. Subsequently, the Company, in September 2007, issued $5.2 million in Junior Subordinated Debt Securities to Heritage Oaks Capital Trust III. Interest on these securities is payable quarterly at a fixed rate of 6.89%. The Company used the proceeds from the sale of the securities to assist in the acquisition of Business First, for general corporate purposes, and for capital contributions to the Bank for future growth. For a more detailed discussion regarding these securities, see Note 8. Borrowings, of the Consolidated Financial Statements filed on this Form 10-K.

In June 2007, the Company completed the sale of four of the Bank's properties to First States Group, L.P. ("First States"), an unaffiliated party, for $12.8 million. In connection with the sale, the Bank entered into four separate lease agreements with First States Investors, LLC to lease back three branches and one administrative facility under which the Bank will continue to utilize for the normal course of business. Each of the four leases provide for an initial term of 15 years with the option to renew for two 10 year terms. In connection with the sale of the properties mentioned, the Bank will recognize a gain of approximately $3.4 million. This gain will be recognized over a fifteen year period in accordance with SFAS No. 13 "Accounting for Leases." In addition to deferring the gain on sale, the Bank has recorded an income tax liability and a deferred tax asset in the approximate amounts of $1.4 million, directly related to the deferred gain on sale. For the year ended December 31, 2007, the Company recognized a gain of approximately $0.1 million related to the sale-leaseback transaction, which was recorded as an offset to rental expense. The Company entered into this transaction in order to convert non-earning assets to earning assets. See also Item 2. Properties, of this Form 10-K for additional information related to this transaction.

Results of Operations

The Company reported net income of $1.7 million for the year ended December 31, 2008 compared to $6.9 million and $6.7 million for the years 2007 and 2006, respectively. Basic earnings per share were $0.22, $0.99 and $1.00 at December 31, 2008, 2007 and 2006, respectively. Diluted earnings per share were $0.21, $0.96 and $0.96 at December 31, 2008, 2007 and 2006, respectively. Earnings were negatively impacted on a year over year basis due in large part to the substantial increase in provisions the Bank made to the allowance for loan losses. Additionally, the dramatic decline in interest rates during 2008 contributed to a lower net interest margin, placing additional pressure on earnings. For the year ended December 31, 2008, the Company's net interest margin was 5.21%, compared to the 5.47% and 5.94% reported for the years ended December 31, 2007 and 2006, respectively.

Net Interest Income and Margin

Net interest income, the primary component of the net earnings of a financial institution, refers to the difference between the interest paid on deposits and borrowings, and the interest earned on loans and investments. The net interest margin is the amount of net interest income expressed as a percentage of average earning assets. Factors considered in the analysis of net interest income are the composition and volume of earning assets and interest-bearing liabilities, the amount of non-interest-bearing liabilities, non-accruing loans, and changes in market interest rates.

The table below sets forth average balance sheet information, interest income and expense, average yields and rates and net interest income and margin for the years ended December 31, 2008, 2007 and 2006. The average balance of non-accruing loans has been included in loan totals:

                                         For The Year Ended,                        For The Year Ended,                        For The Year Ended,
                                          December 31, 2008                          December 31, 2007                          December 31, 2006
                                                Yield/        Income/                      Yield/        Income/                      Yield/       Income/
(dollar amounts in thousands)    Balance         Rate         Expense       Balance         Rate         Expense       Balance         Rate        Expense
Interest Earning Assets
Investments with other banks    $     214           3.74 %   $       8     $     499           1.60 %   $       8     $     315           2.86 %   $      9
Investment securities taxable      42,080           5.28 %       2,223        25,585           4.87 %       1,246        27,455           4.46 %      1,225
Investment securities
non-taxable                        17,079           4.34 %         741        16,535           4.29 %         710        16,319           4.30 %        702
Federal funds sold                  6,583           2.13 %         140        15,878           4.94 %         785        11,179           4.82 %        539
Loans (1) (2)                     656,105           7.17 %      47,038       497,374           8.53 %      42,425       400,229           8.47 %     33,897
Total interest earning assets     722,061           6.95 %      50,150       555,871           8.13 %      45,174       455,497           7.99 %     36,372

Allowance for possible loan
losses                             (7,845 )                                   (4,784 )                                   (3,931 )
Other assets                       65,359                                     54,649                                     52,311

Total assets                    $ 779,575                                  $ 605,736                                  $ 503,877

Interest Bearing Liabilities
Savings/NOW/money market        $ 293,063           1.49 %   $   4,375     $ 207,684           2.36 %   $   4,911     $ 160,841           1.55 %   $  2,497
Time deposits                     159,496           3.34 %       5,328       145,565           4.78 %       6,960       106,342           4.21 %      4,472
Other borrowings                   79,164           2.50 %       1,979        34,991           5.42 %       1,896        27,854           5.21 %      1,452
Federal funds purchased             3,406           2.55 %          87         1,138           5.54 %          63         1,020           5.49 %         56
Long-term debt                     13,403           5.93 %         795        12,234           7.53 %         921         9,694           8.65 %        839
Total interest-bearing
liabilities                       548,532           2.29 %      12,564       401,612           3.67 %      14,751       305,751           3.05 %      9,316
Demand deposits                   151,529                                    141,123                                    146,458
Other liabilities                   7,766                                      7,074                                      4,432
Total liabilities                 707,827                                    549,809                                    456,641

Stockholders' Equity
Common stock                       46,829                                     32,909                                     29,367
Additional paid in capital            852                                        507                                          -
Retained earnings                  24,435                                     22,463                                     18,003
Valuation allowance
investments                          (368 )                                       48                                       (134 )
Total stockholders' equity         71,748                                     55,927                                     47,236

Total liabilities and
stockholders' equity            $ 779,575                                  $ 605,736                                  $ 503,877

Net interest income                                          $  37,586                                  $  30,423                                  $ 27,056
Net interest margin (3)                             5.21 %                                     5.47 %                                     5.94 %

(1) Non-accruing loans have been included in total loans.

(2) Loan fees of $1,297; $1,227; and $1,275 for the years ending December 31, 2008; 2007; and 2006 respectively have been included in interest income computation.

(3) Net interest margin has been calculated by dividing the net interest income by total average earning assets.

The table below sets forth changes from 2007 to 2008 for average interest-earning assets and their respective average yields:

                                          Average Balance                                                      Average Yield
                                        For The Year Ended,                                                 For The Year Ended,
                                            December 31,                       Variance                         December 31,
(dollar amounts in thousands)           2008            2007           dollar         percentage          2008                2007           Variance
Interest-Earning Assets:
Time deposits with other banks      $        214     $       499     $      (285 )         -57.11 %            3.74 %             1.60 %           2.14 %
Investment securities taxable             42,080          25,585          16,495            64.47 %            5.28 %             4.87 %           0.41 %
Investment securities non-taxable         17,079          16,535             544             3.29 %            4.34 %             4.29 %           0.04 %
Federal funds sold                         6,583          15,878          (9,295 )         -58.54 %            2.13 %             4.94 %          -2.82 %
Loans (1) (2)                            656,105     $   497,374         158,731            31.91 %            7.17 %             8.53 %          -1.36 %

Total interest earning assets       $    722,061     $   555,871     $   166,190            29.90 %            6.95 %             8.13 %          -1.18 %

(1) Non-accruing loans have been included in loan totals.

(2) Loan fees of $1,297 and $1,227 have been included in the interest income computation for the years ended December 31, 2008 and 2007, respectively.

Net interest income for the year ended December 31, 2008 was approximately $37.6 million or $7.2 million and 23.5% higher than the $30.4 million reported for the year ended December 31, 2007. Average earning assets at December 31, 2008 were approximately $722.1 million or $166.2 million and 29.9% higher than that reported a year earlier. Of the year over year increase in average earning assets approximately $136.5 million can be attributed to the acquisition of Business First. The Business First acquisition occurred during the fourth quarter of 2007, thus 2008 represents the first year that average balances for Business First are reflected for a full calendar year.

The increase in average earning assets can be attributed in large part to an approximate $158.7 million increase in average gross loan balances during 2008. Of this increase, approximately $137.2 million can be attributed to the acquisition of Business First. For the year ended December 31, 2008, the yield earned on the loan portfolio was 7.17%, which represents a decline of approximately 136 basis points from the 8.53% reported for 2007. The decline in the yield of the loan portfolio is primarily attributable to the dramatic decline in the overnight Fed Funds rate during 2008. It is the decline in the yield on the loan portfolio that contributed greatly to the decline in the yield on average earning assets. For the year ended December 31, 2008, the yield on average earning assets was 6.95%. This when compared to the 8.13% the Company reported for the year ended December 31, 2007, represents a decline of approximately 118 basis points. The yield on average earning assets for the year ended December 31, 2006 was 7.99%.

The table below sets forth changes from 2007 to 2008 for average interest-bearing liabilities and the respective average rates paid:

                                  Average Balance                                                Average Rate
                                For The Year Ended,                                          For The Year Ended,
                                    December 31,                    Variance                     December 31,
(dollar amounts in
thousands)                       2008          2007         dollar        percentage         2008            2007         Variance
Interest-Bearing
Liabilities:
Savings/NOW/money market      $  293,063     $ 207,684     $  85,379            41.11 %         1.49 %          2.36 %        -0.87 %
Time deposits                    159,496       145,565        13,931             9.57 %         3.34 %          4.78 %        -1.44 %
Other borrowings (1) (2)          79,164        34,991        44,173           126.24 %         2.50 %          5.42 %        -2.92 %
Federal funds purchased            3,406         1,138         2,268           199.30 %         2.55 %          5.54 %        -2.98 %
Long term debt                    13,403        12,234         1,169             9.56 %         5.93 %          7.53 %        -1.60 %

Total interest-bearing
liabilities                   $  548,532     $ 401,612     $ 146,920            36.58 %         2.29 %          3.67 %        -1.38 %

(1) Consists of Federal Home Loan Bank borrowings of $76,881 and $33,136 and repurchase agreements of $2,283 and $1,855 for the years ended December 31, 2008 and 2007, respectively.

(2) Average rate paid on Federal Home Loan Bank borrowings and repurchase agreements of 2.51% and 5.44% and 2.01% and 4.91% for the years ended December 31, 2008 and 2007, respectively.

Average interest bearing liabilities increased approximately $146.9 million from the $401.6 million reported at December 31, 2007. The year over year increase can be attributed to higher average balances of savings, NOW and money market accounts of which approximately $41.1 million of the change can be attributed to the acquisition of Business First. Additionally, the year over year increase in FHLB borrowing also contributed significantly to the increase in interest bearing liabilities. For the year ended December 31, 2008, the rate the Company paid on interest bearing liabilities was 2.29% or 138 basis points lower than the 3.67% reported for 2007. A significantly lower overnight Fed Funds rate during the majority of 2008, contributed significantly to the year over year decline in the rate paid on average interest bearing liabilities. As the Federal Reserve moved aggressively to lower rates during 2008 in response to, among other things, weakness in the credit markets and general economic conditions, . . .