Certain matters discussed or incorporated by reference in this Annual Report on Form 10-K including, but not limited to, matters described in "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations," are "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, and subject to the safe-harbor provision of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements may contain words related to future projections including, but not limited to, words such as "believe," "expect," "anticipate," "intend," "may," "will," "should," "could," "would," and variations of those words and similar words that are subject to risks, uncertainties and other factors that could cause actual results to differ materially from those projected. Factors that could cause or contribute to such differences include, but are not limited to, the following: (1) the duration of financial and economic volatility and actions taken by the United States Congress and governmental agencies, including the United States Department of the Treasury, to deal with challenges to the U.S. financial system; (2) variances in the actual versus projected growth in assets and return on assets; (3) loan and lease losses; (4) expenses; (5) changes in the interest rate environment including interest rates charged on loans, earned on securities investments and paid on deposits and other borrowed funds; (6) competition effects; (7) fee and other noninterest income earned; (8) general economic conditions nationally, regionally, and in the operating market areas of the Company and its subsidiaries; (9) changes in the regulatory environment including government intervention in the U.S. financial system; (10) changes in business conditions and inflation; (11) changes in securities markets, public debt markets, and other capital markets; (12) data processing and other operational systems failures or fraud; (13) a decline in real estate values in the Company's operating market areas; (14) the effects of uncontrollable events such as terrorism, the threat of terrorism or the impact of the current military conflicts in Afghanistan and Iraq and the conduct of the war on terrorism by the United States and its allies, worsening financial and economic conditions, natural disasters, and disruption of power supplies and communications; and (15) changes in accounting standards, tax laws or regulations and interpretations of such standards, laws or regulations, as well as other factors. The factors set forth under "Item 1A - Risk Factors" in this report and other cautionary statements and information set forth in this report should be carefully considered and understood as being applicable to all related forward-looking statements contained in this report when evaluating the business prospects of the Company and its subsidiaries.

Forward-looking statements are not guarantees of performance. By their nature, they involve risks, uncertainties and assumptions. Actual results and shareholder values in the future may differ significantly from those expressed in forward-looking statements. You are cautioned not to put undue reliance on any forward-looking statement. Any such statement speaks only as of the date of the report, and in the case of any documents that may be incorporated by reference, as of the date of those documents. We do not undertake any obligation to update or release any revisions to any forward-looking statements, or to report any new information, future event or other circumstances after the date of this report or to reflect the occurrence of unanticipated events, except as required by law. However, your attention is directed to any further disclosures made on related subjects in our subsequent reports filed with the Securities and Exchange Commission on Forms 10-K, 10-Q and 8-K.

Critical Accounting Policies

General. North Valley Bancorp's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our 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 and lease portfolio. Actual losses could differ significantly from the historical factors that we use. Other estimates that we use are related to the expected useful lives of our depreciable 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 the accounting for such transactions could change.

A summary of the Company's most significant accounting policies and accounting estimates is contained in Note 1 to the consolidated financial statements. An accounting estimate recognized in the financial statements is a critical accounting estimate if the accounting estimate requires management to make assumptions about matters that are highly uncertain at the time the accounting estimate is made and different estimates that management could reasonably have used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the presentation of the Company's financial condition, changes in financial condition, or results of operations. Management considers the Company's allowance for loan and lease losses, pro forma costs related to the Company's share-based payments programs, and management's assessment of goodwill and investment impairment to be critical accounting policies.

The allowance for loan and lease losses is established through a provision for loan and lease losses based on management's evaluation of the risks inherent in the loan and lease portfolio. In determining levels of risk, management considers a variety of factors, including, but not limited to, asset classifications, economic trends, industry experience and trends, geographic concentrations, estimated collateral values, historical loan and lease loss experience, and the Company's underwriting policies. The allowance for loan and lease losses is maintained at an amount management considers adequate to cover losses in loans and leases receivable which are considered probable and estimable. While management uses the best information available to make these estimates, future adjustments to allowances may be necessary due to economic, operating, regulatory, and other conditions that may be beyond the Company's control. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan and lease losses. Such agencies may require the Company to recognize additions to the allowance based on judgments different from those of management.

Stock Based Compensation.At December 31, 2008, the Company had four stock-based compensation plans: the North Valley Bancorp 1989 Director Stock Option Plan, the 1998 Employee Stock Incentive Plan, the 1999 Director Stock Option Plan and the 2008 Stock Incentive Plan, which are described more fully in Note 1 and 13 to the Consolidated Financial Statements included herein in Item 8 - Financial Statements and Supplementary Data. Compensation cost is recognized all share-based payments over the requisite service periods of the awards based on the grant-date fair value of the options determined using the Black-Scholes-Merton based option valuation model. Critical assumptions that are assessed in computing the fair value of share-based payments include stock price volatility, expected dividend rates, the risk free interest rate and the expected lives of such options. Compensation cost recorded is net of estimated forfeitures expected to occur prior to vesting. For further information on the computation of the fair value of share-based payments, see Note 1 and 13 to the Consolidated Financial Statements.

Goodwill. Business combinations involving the Company's acquisition of the equity interests or net assets of another enterprise may give rise to goodwill. Goodwill represents the excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed in transactions accounted for under the purchase method of accounting. Goodwill of $15,187,000 was recorded in the Company's acquisition of YCB. The value of goodwill is ultimately derived from the Company's ability to generate net earnings after the acquisition. A decline in net earnings could be indicative of a decline in the fair value of goodwill and result in impairment. For that reason, goodwill is assessed for impairment at a reporting unit level at least annually. Management conducted its assessment of impairment during the fourth quarter of 2008 and based on its evaluation determined that there was no impairment.

Impairment of Investment Securities. Investment securities are evaluated for other-than-temporary 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 below amortized cost is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline, the financial condition of the issuer, rating agency changes related to the issuer's securities and the intent and ability of the Bank to retain its investment in the issues 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.

During the third quarter of 2008, the Company recognized impairment on its FNMA Preferred Stock of $3,284,000. The Company purchased 100,000 shares of this security in June 2003 at par, $50.00 per share, and recognized an impairment charge in the fourth quarter of 2007 to its December 31, 2007 market value of $32.84 per share. Due to the United States Treasury and the Federal Housing Finance Agency (FHFA) decision to place FNMA and FHLMC under conservatorship on September 7, 2008, the Company concluded that these securities were further impaired and were written down by $3,284,000 to zero at September 30, 2008.

The Company applies the asset and liability method to account for income taxes. Deferred tax assets and liabilities are calculated by applying applicable tax laws to the differences between the financial statement basis and the tax basis of assets and liabilities. The effect on deferred taxes of changes in tax laws and rates is recognized in income in the period that includes the enactment date. On the consolidated balance sheet, net deferred tax assets are included in other assets.

Since January 1, 2007, the Company has accounted for uncertainty in income taxes under Financial Accounting Standards Board ("FASB") Interpretation No. 48, Accounting for Uncertainty in Income Taxes("FIN 48"). Under the provisions of FIN 48, only tax positions that met the more likely than not recognition threshold, that the tax position would be sustained in a tax examination, on January 1, 2007 were recognized or continue to be recognized.

When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination.

Business Organization

North Valley Bancorp (the "Company") is a bank holding company for NVB, a state-chartered, Federal Reserve Member bank. NVB operates out of its main office located at 300 Park Marina Circle, Redding, CA 96001, with twenty-six branches, including two supermarket branches, and an LPO in Northern California. The Company's principal business consists of attracting deposits from the general public and using the funds to originate commercial, real estate and installment loans to customers, who are predominately small and middle market businesses and middle income individuals. The Company's primary source of revenues is interest income from its loan and investment securities portfolios. The Company is not dependent on any single customer for more than ten percent of its revenues.

The acquisition of Yolo Community Bank ("YCB") on August 31, 2004 was accounted for under the purchase method of accounting. YCB changed its name to NVB Business Bank ("NVB BB") effective February 11, 2005. After the close of business on June 30, 2006, NVB BB was merged into North Valley Bank.

Overview

For the year ended December 31, 2008, the Company recorded a net loss of $1,794,000, or $0.24 per diluted share, compared to net income of $6,534,000, or $0.86 per diluted share, for the year ended December 31, 2007. For 2008, the Company realized a loss on average shareholders' equity of 2.23% and a loss on average assets of 0.20%, as compared to a return on average shareholders' equity of 8.31% and a return on average assets of 0.72%, for 2007.

During 2008, total assets decreased $69,468,000, or 7.3%, to $879,551,000 at year end. The loan portfolio decreased $52,831,000, or 7.1%, compared to $746,253,000 at December 31, 2007, and totaled $693,422,000 at December 31, 2008. The primary reason for the decrease was the Company's decision to decrease its Real Estate - Construction portfolio to reduce the Company's exposure to this lending segment. This portfolio decreased $89,003,000 from $225,758,000 at December 31, 2007 to $136,755,000 at December 31, 2008. This reduction was primarily from principal reductions and pay-offs but was also a result of certain charge-offs and properties taken into other real state owned (OREO). Investment securities also decreased as of December 31, 2008 compared to 2007 by $28,006,000, or 26.8% to $76,366,000 from $104,372,000. The loan to deposit ratio at year end 2008 was 91.9% as compared to 101.3% at year end 2007. Total deposits increased $18,205,000, or 2.5%, to $754,944,000 at year end 2008. The reduction in loans and investment securities along with the increased deposits created a funding source to reduce the level of other borrowings which decreased $83,676,000 to $3,516,000 at December 31, 2008 from $87,192,000 at December 31, 2007. This facilitated the Company's efforts to de-leverage the balance sheet to preserve and maintain strong capital levels in these uncertain economic times. For the year ended December 31, 2008, the Company declared quarterly dividends totaling $2,988,000, or $0.40 per share, to stockholders of the Company. Subsequent to December 31, 2008 the Company's Board of Directors determined that it was in the best interest of the Company to suspend indefinitely the payment of quarterly cash dividends on its common stock beginning in 2009.

Due to the lower interest rates throughout 2008, the average rate paid on interest bearing liabilities decreased 36 basis points to 2.55% from 2.91% in 2007. Average total interest bearing liabilities increased $23,317,000 in 2008.

Overall the net interest margin for 2008 declined 78 basis points to 4.31% from the 5.09% achieved in 2007. The net interest margin contracted each quarter throughout 2008 as the decrease in the yields on earning assets outpaced the decrease in the cost of interest bearing deposits and borrowed funds throughout the year.

Nonperforming loans (defined as nonaccrual loans and loans 90 days or more past due and still accruing interest) totaled $18,936,000 at December 31, 2008, an increase of $17,172,000 from December 31, 2007. Nonperforming loans as a percentage of total loans were 2.73% at December 31, 2008, compared to 0.24% at December 31, 2007. Nonperforming assets (nonperforming loans and OREO) totaled $29,344,000 at December 31, 2008, an increase of $26,678,000 from December 31, 2007. Nonperforming assets as a percentage of total assets were 3.34% at December 31, 2008 compared to 0.28% at December 31, 2007. The allowance for loan and lease losses at December 31, 2008 was $11,327,000, or 1.63% of total loans, compared to $10,755,000, or 1.44% of total loans at December 31, 2007

On February 26, 2009, as a result of the Bank's most recent DFI report of examination, the Board of Directors of the Bank adopted resolutions that, among other matters, state a commitment to maintain a minimum tier 1 leverage capital ratio and tangible shareholders' equity to total tangible assets ratio of not less than 8.0%, to implement a capital contingency plan and not declare or pay any cash dividends to the Company which would be used to pay cash dividends to the Company's shareholders without the prior written approval of the Commissioner. The Bank's tier 1 leverage ratio at December 31, 2008 was 10.79%.

Results of Operations

Net Interest Income and Net Interest Margin (fully taxable equivalent basis). Net interest income is the difference between interest earned on loans and investments and interest paid on deposits and borrowings, and is the primary revenue source for the Company. Net interest margin is net interest income expressed as a percentage of average earning assets. These items have been adjusted to give effect to $474,000, $559,000 and $723,000 in taxable-equivalent interest income on tax-free investments for the years ending December 31, 2008, 2007 and 2006.

Net interest income for 2008 was $35,611,000, a $5,834,000, or a 14.1%, decrease from net interest income of $41,445,000 in 2007. Interest income decreased $7,518,000, or 12.5%, to $52,565,000 in 2008 due primarily to decreased yields on earning assets, and secondarily due to foregone interest income of $2,305,000 for the loans placed on nonaccrual status. The average loans outstanding increased $40,749,000, or 6.0%, to $725,255,000. This higher loan volume added $3,199,000 to interest income. The average yield earned on the loan portfolio decreased 125 basis points to 6.60% for 2008. This decrease in yield reduced interest income by $6,709,000 (excluding the impact of the foregone interest). The total decrease to interest income from the loan portfolio was $5,815,000. The average balance of the investment portfolio decreased $22,783,000, or 18.7%, which accounted for a $1,118,000 decrease in interest income and the decrease in average yield of the investment portfolio of 21 basis points reduced interest income by $199,000.

The net interest margin for 2008 decreased 78 basis points to 4.31% from 5.09% in 2007. The net interest margin for the 4th quarter of 2008 was 4.15%, which was a 74 basis point decline from 4.89% in the 4th quarter of 2007 and a 22 basis point decline from the 3rd quarter of 2008.

Net interest income for 2007 was $41,445,000, a $1,772,000, or a 4.1%, decrease from net interest income of $43,217,000 in 2006. Interest income increased $2,181,000, or 3.8%, to $60,083,000 in 2007 due primarily to higher volume of earning assets, the change in mix of those assets to higher yielding loans and secondarily due to slightly increased yields on earning assets. The average loans outstanding increased $42,339,000, or 6.6%, to $684,506,000. This higher loan volume added $3,311,000 to interest income. The average yield earned on the loan portfolio increased 3 basis points to 7.85% for 2007. This increase added $160,000 to interest income. The total increase to interest income from the loan portfolio was $3,471,000, which was offset in part by the effect of lower average balances in the investment portfolio. The average balance of the investment portfolio decreased $30,788,000, or 20.2%, which accounted for a $1,489,000 decrease in interest income somewhat offset by the increase in average yield of 7 basis points, or $81,000. Yields earned on the investment portfolio in 2007 increased by 7 basis points to 4.90% as some of the lower yield and shorter duration securities matured.

Interest expense in 2007 increased $3,953,000, or 26.9%, to $18,638,000. The largest increase was in time certificates of deposits as the average rates paid on these accounts increased 88 basis points to 4.60%. This rate increase added $1,918,000 to interest expense. The next largest increase to interest expense was related to an increase in average rate paid on savings and money market accounts, which increased 54 basis points to 1.88%. This rate increase added $1,057,000 to interest expense which was slightly offset due to lower average balances in 2007 compared to 2006. The average rate paid on borrowings increased 37 basis points to 5.87% for 2007 compared to 5.50% for 2006. This increase in average rate paid was more than offset by a decrease in average balance of borrowed funds in 2007 compared to 2006.

The net interest margin for 2007 decreased 31 basis points to 5.09% from 5.40% in 2006. The net interest margin for the 4th quarter of 2007 was 4.89%, which was a 52 basis point decline from 5.41% in the 4th quarter of 2006 and a 17 basis point decline from the 3rd quarter of 2007.

Average Daily Balance Sheets
(Dollars in thousands, except percentages)


                                      2008                                2007                              2006

                        Average    Yield/      Interest       Average    Yield/    Interest     Average    Yield/    Interest
                        Balance     Rate        Amount        Balance     Rate      Amount      Balance     Rate      Amount


Assets

Federal funds sold     $     899      1.33 % $          12   $   7,586      5.25 % $     398   $   5,747      4.87 % $     280
Investments:
Taxable securities        77,400      4.03 %         3,120      94,475      4.37 %     4,130     117,894      4.25 %     5,011
Nontaxable
securities(1)             19,381      6.71 %         1,301      20,917      6.78 %     1,418      22,864      6.87 %     1,570
FNMA preferred stock
(1)                        2,450      9.59 %           235       6,622      6.42 %       425      12,049      6.64 %       800


Total investments         99,231      4.69 %         4,656     122,014      4.90 %     5,973     152,807      4.83 %     7,381

Total loans and
leases (2)(3)            725,255      6.60 %        47,897     684,506      7.85 %    53,712     642,167      7.82 %    50,241


Total earning
assets/interest
income                   825,385      6.37 %        52,565     814,106      7.38 %    60,083     800,721      7.23 %    57,902

Nonearning assets        100,357                               100,205                           108,884
. . .