Overview

Certain matters discussed or incorporated by reference in this Annual Report on Form 10-K are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Such risks and uncertainties include, but are not limited to, those described in Management's Discussion and Analysis of Financial Condition and Results of Operations. Such risks and uncertainties include, but are not limited to, the following factors: i) competitive pressures in the banking industry and changes in the regulatory environment; ii) exposure to changes in the interest rate environment and the resulting impact on the Company's interest rate sensitive assets and liabilities; iii) decline in the health of the economy nationally or regionally which could reduce the demand for loans or reduce the value of real estate collateral securing most of the Company's loans; iv) credit quality deterioration that could cause an increase in the provision for loan losses; v) Asset/Liability matching risks and liquidity risks; volatility and devaluation in the securities markets, and vi) expected cost savings from recent acquisitions are not realized. Therefore, the information set forth therein should be carefully considered when evaluating the business prospects of the Company.

The Company

On June 12, 2001, the United Security Bank (the "Bank") became the wholly owned subsidiary of United Security Bancshares (the "Company") through a tax-free holding company reorganization, accounted for on a basis similar to the pooling of interest method. In the transaction, each share of Bank stock was exchanged for a share of Company stock on a one-to-one basis. No additional equity was issued as part of this transaction. In the following discussion, references to the Bank are references to United Security Bank. References to the Company are references to United Security Bancshares (including the Bank).

On June 28, 2001, United Security Bancshares Capital Trust I (the "Trust") was formed as a Delaware business trust for the sole purpose of issuing Trust Preferred securities. On July 16, 2001, the Trust completed the issuance of $15 million in Trust Preferred securities, and concurrently, the Trust used the proceeds from that offering to purchase Junior Subordinated Debentures of the Company. The Company contributed $13.7 million of the $14.5 million in net proceeds received from the Trust to the Bank to increase its regulatory capital and used the rest for the Company's business. Effective January 1, 2007, the Company adopted the fair value provisions of SFAS No. 159 for its junior subordinated debt issued by the Trust. As a result of the adoption of SFAS No. 159, the Company recorded a fair value adjustment of $1.3 million, reflected as an adjustment to beginning retained earnings. On July 25, 2007, the Company redeemed the $15.0 million in subordinated debentures plus accrued interest of $690,000 and a 6.15% prepayment penalty totaling $922,500. Concurrently, the Trust Preferred securities issued by Capital Trust I were redeemed. The prepayment penalty of $922,500 had previously been a component of the fair value adjustment for the junior subordinated debt at the initial adoption of SFAS No. 159.

Effective December 31, 2001, United Security Bank formed a subsidiary Real Estate Investment Trust ("REIT") through which preferred stock was offered to private investors, to raise capital for the bank in accordance with the laws and regulations in effect at the time. The principal business purpose of the REIT was to provide an efficient and economical means to raise capital. The REIT also provided state tax benefits beginning in 2002. On December 31, 2003 the California Franchise Tax Board (FTB) announced certain tax transactions related to real estate investment trusts (REITs) and regulated investment companies (RICs) will be disallowed pursuant to Senate Bill 614 and Assembly Bill 1601, which were signed into law in the 4th quarter of 2003 (For further discussion see Income Taxes section of Results of Operations contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations).

Effective April 23, 2004, the Company completed its merger with Taft National Bank headquartered in Taft, California. Taft National Bank ("Taft") was merged into United Security Bank and Taft's two branches began operating as branches of United Security Bank. The total consideration paid to Taft shareholders was 241,447 shares of the Company's common stock valued at just over approximately $6.0 million. As a result of the merger, the Company acquired $15.4 million in cash and short-term investments, $23.3 million in loans, and $48.2 million in deposits. This transaction was accounted for using the purchase accounting method, and resulted in the purchase price being allocated to the assets acquired and liabilities assumed from Taft based on the fair value of those assets and liabilities. The consolidated statements of income include the operations of Taft from the date of the acquisition forward.

During August 2005, the Bank formed a new subsidiary named United Security Emerging Capital Fund (the Fund) for the purpose of providing investment capital for Low-Income Communities (LIC's). The new subsidiary was formed as a Community Development Entity (CDE) and as such, must be certified by the Community Development Financial Institutions Fund of the United States Department of the Treasury in order to apply for New Market Tax Credits (NMTC). The Fund submitted an application to the Department of the Treasury to become certified as a CDE in August 2005 and was approved in February 2006. Subsequent to that application, the Fund submitted an application to apply for an allocation of New Market Tax Credits in September 2005. The Fund was not awarded funding from the Department of Treasury during the 2006 allocation process, but applied for the 2007 allocation of New Market Tax Credits in August 2006. The Fund was not awarded funding during the 2007 allocation process. The Fund did not apply for allocations of New Market Credits during 2007 or 2008. If the Fund's NMTC is ever approved for the allocation of New Market Credits, the Fund can attract investments and make loans and investments in LIC's and thereby qualify its investors to receive Federal Income Tax Credits. The maximum that can be applied for under the New Markets Tax Credit program by any one CDE is $150 million, and the Bank is subject to an investment limitation of 10% of its risk-based capital. Federal new market tax credits would be applied over a seven-year period, 5% for the first three years, and 6% for the next four years for a total of 39%.

On February 16, 2007, the Company completed its merger of Legacy Bank, N.A. with and into United Security Bank, a wholly owned subsidiary of the Company. Legacy Bank which began operations in 2003 operated one banking office in Campbell, California serving small business and retail banking clients. With its small business and retail banking focus, Legacy Bank provides a unique opportunity for United Security Bank to serve a loyal and growing small business niche and individual client base in the San Jose area. Upon completion of the merger, Legacy Bank's branch office began operating as a branch office of United Security Bank. As of February 16, 2007 Legacy Bank had net assets of approximately of $8.6 million, including net loans of approximately $62.4 million and deposits of approximately $69.6 million.

In the merger with Legacy Bank, the Company issued 976,411 shares of its stock in a tax free exchange for all of the Legacy Bank common shares. The total value of the transaction was approximately $21.7 million. The merger transaction was accounted for using the purchase accounting method, and resulted in the purchase price being allocated to the assets acquired and liabilities assumed from Legacy based on the fair value of those assets and liabilities. Fair-market-value adjustments and intangible assets totaled approximately $12.9 million, including $8.8 million in goodwill. The allocations of purchase price based upon the fair market value of assets acquired and liabilities assumed were finalized during the fourth quarter of 2007.

During July 2007, the Company formed USB Capital Trust II, a wholly-owned special purpose entity, for the purpose of issuing Trust Preferred Securities. Like USB Capital Trust I formed in July 2001, USB Capital Trust II is a Variable Interest Entity (VIE) and a deconsolidated entity pursuant to FIN 46. On July 23, 2007 USB Capital Trust II issued $15 million in Trust Preferred securities. The securities have a thirty-year maturity and bear a floating rate of interest (repricing quarterly) of 1.29% over the three-month LIBOR rate (initial coupon rate of 6.65%). Interest will be paid quarterly. Concurrent with the issuance of the Trust Preferred securities, USB Capital Trust II used the proceeds of the Trust Preferred securities offering to purchase a like amount of junior subordinated debentures of the Company. The Company will pay interest on the junior subordinated debentures to USB Capital Trust II, which represents the sole source of dividend distributions to the holders of the Trust Preferred securities. The Company may redeem the junior subordinated debentures at anytime before October 2008 at a redemption price of 103.3, and thereafter each October as follows: 2008 at 102.64, 2009 at 101.98, 2010 at 101.32, 2011 at 100.66, and at par anytime after October 2012.

The Bank currently has eleven banking branches, one construction lending office, and one financial services office, which provide banking and financial services in Fresno, Madera, Kern, and Santa Clara counties. As a community-oriented bank holding company, the Company continues to seek ways to better meet its customers' needs for financial services, and to expand its business opportunities in today's ever-changing financial services environment. The Company's strategy is to be a better low-cost provider of services to its customer base while enlarging its market area and corresponding customer base to further its ability to provide those services.

Current Trends Affecting Results of Operations and Financial Position

The Company's overall operations are impacted by a number of factors, including not only interest rates and margin spreads, which impact results of operations, but also the composition of the Company's balance sheet. One of the primary strategic goals of the Company is to maintain a mix of assets that will generate a reasonable rate of return without undue risk, and to finance those assets with a low-cost and stable source of funds. Liquidity and capital resources must also be considered in the planning process to mitigate risk and allow for growth.

The following table summarizes the year-to-date averages of the components of interest-bearing assets as a percentage of total interest bearing assets, and the components of interest-bearing liabilities as a percentage of total interest-bearing liabilities:

                                            YTD Average       YTD Average       YTD Average
                                             12/31/08          12/31/07          12/31/06
Loans                                              84.23 %           85.00 %           80.26 %
Investment securities                              14.30 %           13.46 %           15.65 %
Interest-bearing deposits in other banks            1.39 %            1.02 %            1.33 %
Federal funds sold                                  0.08 %            0.52 %            2.76 %
  Total earning assets                            100.00 %          100.00 %          100.00 %

NOW accounts                                        7.92 %            8.82 %           11.21 %
Money market accounts                              22.89 %           25.99 %           31.56 %
Savings accounts                                    7.50 %            8.79 %            8.02 %
Time deposits                                      42.51 %           50.05 %           44.72 %
Other borrowings                                   16.84 %            3.40 %            0.96 %
Trust Preferred Securities                          2.34 %            2.95 %            3.53 %
   Total interest-bearing liabilities             100.00 %          100.00 %          100.00 %

Continued deterioration in the real estate markets and the economy in general have impacted the Company's operations during 2008 although, the Company continues its business development and expansion efforts throughout a diverse market area.

With market rates of interest declining 100 basis points during the fourth quarter of 2007, another 400 basis points during the year ended December 31, 2008, the Company has experienced significant declines in its net interest margin. The Company's net interest margin was 4.33% for the year ended December 31, 2008, as compared to 5.35% and 5.67% for the years ended December 31, 2007 and December 31, 2006, respectively. With approximately 64.0% of the loan portfolio in floating rate instruments at December 31, 2008, the effects of market rates continue to be realized almost immediately on loan yields. Loans yielded 6.75% during the year ended December 31, 2008, as compared to 9.07% and 9.13% for the years ended December 31, 2007 and December 31, 2006, respectively. With a significant increase in nonaccrual loans during 2008, and specifically during the second half of 2008, the Company reversed approximately $1.0 million in interest income during the year, reducing the loan yield by approximately 17 basis points during the year ended December 31, 2008. Loan yield was enhanced during 2007, as a nonperforming loan was paid off during the first quarter of 2007, providing an additional $902,000 in previously unrecognized interest income that would not have otherwise been recognized during 2007, and an enhancement to loan yield of approximately 15 basis points for the year ended December 31, 2007. Although market rates of interest declined so rapidly during 2008, deposit repricing was slow to follow the decline in loan rates during the second half of 2008. However, with the recent stock market declines, combined with more substantial FDIC insurance coverage, deposit rates have begun to decline as investors have sought safety in bank deposits. Borrowing rates have declined significantly during the fourth quarter of 2008, resulting in overnight and short-term borrowing rates of less than 0.50% at December 31, 2008. The Company has benefited from these rate declines, as it has utilized overnight and short-term borrowing lines through the Federal Reserve and Federal Home Loan Bank to a greater degree during 2008. The Company's average cost of funds was 2.75% for the year ended December 31, 2008 as compared to 3.91% and 3.24% for the years ended December 31, 2007 and 2006, respectively.

Total noninterest income of $8.3 million reported for the year ended December 31, 2008 decreased $1.3 million or 13.7% as compared to the year ended December 31, 2007, primarily as the result of reductions of approximately $1.1 million in SFAS No. 159 fair market value gains between the two twelve-month periods on the Company's junior subordinated debt. Noninterest income continues to be driven by customer service fees, which totaled $4.7 million for the year ended December 31, 2008, representing a modest decline of $134,000 or 2.8% over the $4.8 million in customer service fees reported for the year ended December 31, 2007, but an increase of $877,000 or 23.2% over the noninterest income of $3.8 million reported for the year ended December 31, 2006. Customer service fees represented 55.8%, 49.6%, and 41.8% of total noninterest income for the years ended December 31, 2008, 2007, and 2006, respectively. Shared appreciation income on lending activities, while not a consistent income stream, did increase approximately $223,000 between the years ended December 31, 2008 and December 31, 2007.

Noninterest expense increased approximately $547,000 or 2.4% between the years ended December 31, 2007 and December 31, 2008, and increased $3.3 million or 16.8% between the years ended December 31, 2006 and December 31, 2008. Reductions in salary expense, data processing, and professional fees, were more than offset by impairment losses on other real estate owned through foreclosure (OREO) and intangible assets. Impairment losses on the Company's intangible assets totaled $648,000 and impairment charges on OREO properties totaled another $887,000 during the year ended December 31, 2008. Salary expense decreased $220,000 or 2.0% between the years ended December 31, 2007 and December 31, 2008 due in large part to significant decreases in bonus and incentive expenses during 2008. Professional fees declined $329,000 or 18.2% between the years ended December 31, 2007 and December 31, 2008 as the result of reductions in corporate legal fees between the two periods.

During both the third and fourth quarters of 2008, the Company's Board of Directors declared a one-percent (1%) stock dividend on the Company's outstanding common stock. The stock dividends for the third and fourth quarters of 2008 replace the normal quarterly cash dividends and reflect a similar value. Although the Company's capital position remains strong, the change in the dividend from cash to stock was employed as a precaution against uncertainties in the current economic environment, and specifically the real estate1-4 family residential real estate market which has had an impact on the Company's construction and related land and lot loan portfolio. The Company believes, given the current uncertainties in the economy and unprecedented declines in real estate valuations in our markets, it is prudent to retain capital in this environment, and better position the Company for future growth opportunities. Based upon the number of outstanding common shares on the respective record dates, an additional 117,732 and 118,449 shares were issued to shareholders during October 2008 and January 2009, respectively. For purposes of earnings per share calculations, the Company's weighted average shares outstanding and potentially dilutive shares used in the computation of earnings per share have been restated after giving retroactive effect to the 1% stock dividends to shareholders for all periods presented.

The Company has sought to maintain a strong, yet conservative balance sheet during the year ended December 31, 2008. Total assets of $761.1 million at December 31, 2008 decreased approximately $10.6 million during the year ended December 31, 2008, with decreases of $48.2 million in gross loans, offset by increases of $23.5 million other real estate owned through foreclosure, and increases of $20.9 million in investments and interest-bearing deposits in other banks. Approximately half of the decline in loans experienced during 2008 was the result of OREO properties that were transferred from the loan portfolio in settlement of loan obligations, the majority of which were transferred during the fourth quarter of 2008. The most significant declines in loan balances experienced during 2008 were in construction loans which decreased $58.4 million or 32.8% and in real estate mortgage loans which decreased $15.9 million or 11.1% between December 31, 2007 and December 31, 2008. On average, loan volume remained stable between 2008 and 2007, with loans averaging $587.9 million or 89.7% of average earning assets for the year ended December 31, 2008 as compared to $580.9 million or 89.4% of average earning assets for the year ended December 31, 2007.

Deposits of $508.5 million at December 31, 2008 declined $126.1 million or 19.9% during the year ended December 31, 2008 primarily as the result of a decline in brokered time deposits, and deposits obtained from the State of California. As part of its asset/liability strategy, the Company chose to let brokered time deposits mature during 2008, and to use alternative lower-cost funding sources including FHLB term advances and overnight borrowings from the Federal Reserve. This strategy has worked well for the Company during 2008 and helped to reduce funding costs significantly, although the Company will seek to attract additional deposits during 2009 as they continue to become less expensive, relative to wholesale funding sources. Wholesale borrowings, including FHLB advances and Federal Reserve overnight borrowings, increased $122.8 million during 2008 to a balance of $155.0 million at December 31, 2008. The average cost of those wholesale borrowings was 2.32% and 5.17% for the years ended December 31, 2008 and December 31, 2007, representing a cost reduction of 285 basis points between the two twelve-month periods. Although the Company has realized significant interest expense reductions by utilizing these borrowing lines, the use of such lines are monitored closely to ensure sound balance sheet management in light of the current economic and credit environment.

The cost of the Company's subordinated debentures issued by USB Capital Trust II has declined significantly as market rates of interest have fallen during the year ended December 31, 2008. With pricing at 3-month-LIBOR plus 129 basis points, the effective cost of the subordinated debt was 2.73% at December 31, 2008, representing a rate reduction of 326 basis points between December 31, 2007 and December 31, 2008. As a result of interest rate changes experienced during 2008 in relation to market spreads for junior subordinated debentures, the Company recorded an additional $1.4 million pretax fair value gain on its junior subordinated debt bringing the total cumulative gain recorded on the debt to $3.7 million at December 31, 2008.

Nonperforming assets increased significantly during the second half of 2008 as real estate markets continue to suffer from the mortgage crisis which began during mid-2007. Nonaccrual loans totaled $51.1 million at December 31, 2008, representing an increase of $29.5 million as compared to the balance of $21.6 million reported at December 31, 2007. The increase in nonaccrual loans experienced during 2008 is comprised largely of construction and real estate development loans. In determining the adequacy of the underlying collateral related to theses loans, management monitors trends within specific geographical areas, loan-to-value ratios, appraisals, and other credit issues related to the specific loans. During the later part of 2008, the Company successfully worked with many of its borrowers to re-margin loans as collateral values declined, then weakening the Company's credit position and increasing the potential for losses. Impaired loans of $54.4 million at December 31, 2008 increased $33.7 million during the year ended December 31, 2008 and increased $716,000 during the fourth quarter of 2008. Classified loans (comprised of the total of nonaccrual, impaired, and substandard loans) totaled $88.1 million at December 31, 2008, representing an increase of $36.4 million from the balance of $51.8 million reported at December 31, 2007, but a decrease of $17.0 million from the balance of $105.1 million reported at September 30, 2008. The decrease in classified loans experienced during the fourth quarter of 2008 is primarily the result of more than $23.0 in nonaccrual loans that were transferred to OREO during that quarter. Other real estate owned through foreclosure increased $23.5 million between December 31, 2007 and December 31, 2008, as five properties were moved through foreclosure proceedings during the first nine months of 2008, and an additional nine properties were moved during the fourth quarter of 2008, when all other means of collection failed. One of those foreclosed properties totaling $1.6 million was subsequently sold during the second quarter of 2008. As a result of these events, nonperforming assets as a percentage of total assets increased from 3.66% at December 31, 2007 to 10.68% at December 31, 2008.

Management continues to monitor economic conditions in the real estate market for signs of further deterioration or improvement which may impact the level of the allowance for loan losses required to cover identified losses in the loan portfolio. Increased charge-offs and additional loan loss provisions made during the year ended December 31, 2008 impacted earnings during much of 2008, but the provisions made to the allowance for credit loses, totaling $265,000, $548,000, $6.4 million, and $2.4 million during the first, second, third, and fourth quarters of 2008, respectively, are adequate to cover inherent losses in the loan portfolio. Loan and lease net charge-offs totaled $5.4 million for the year ended December 31, 2008 as compared to net charge-offs of $4.4 million and $263,000 for the years ended December 31, 2007 and December 31, 2006, respectively.

The Company continues to emphasize relationship banking and core deposit growth, and has focused greater attention on its market area of Fresno, Madera, and Kern Counties, as well as Campbell, in Santa Clara County. The San Joaquin Valley and other California markets have shown weaker demand for construction lending and commercial lending from small and medium size businesses, as commercial and residential real estate markets declined during 2007 and throughout 2008. The year ended December 31, 2008 has presented significant challenges for the banking industry with tightening credit markets, weakening real estate markets, and increased loan losses adversely affecting the industry.

The Company continually evaluates its strategic business plan as economic and market factors change in its market area. Growth and increasing market share will be of primary importance during 2009 and beyond. The banking industry is currently experiencing continued pressure on net margins as well as asset quality resulting from conditions in the sub-prime real estate market, and a general deterioration in credit markets. As a result, market rates of interest and asset quality will continue be an important factor in the Company's ongoing strategic planning process.

Application of Critical Accounting Policies and Estimates

The Company's consolidated financial statements are prepared in accordance with generally accepted accounting principles and follow general practices within the industry in which it operates. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. When third-party information is not available, valuation adjustments are estimated using the Company's own assumptions about the assumptions that market participants would use in pricing the asset or liability.

The most significant accounting policies followed by the Company are presented in Note 1 to the Company's consolidated financial statements included herein. These policies, along with the disclosures presented in the other financial statement notes and in this financial review, provide information on how . . .