Discussions of certain matters in this Report on Form 10-Q may constitute forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and as such, may involve risks and uncertainties. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies, and expectations, are generally identifiable by the use of words such as "believe", "expect", "intend", "anticipate", "estimate", "project", "assume", "plan", "predict", "forecast" or similar expressions. These forward-looking statements relate to, among other things, expectations of the business environment in which the Company operates, projections of future performance, potential future performance, potential future credit experience, perceived opportunities in the market, and statements regarding the Company's mission and vision. The Company's actual results, performance, and achievements may differ materially from the results, performance, and achievements expressed or implied in such forward-looking statements due to a wide range of factors. These factors include
(1) difficult and adverse conditions in the global and domestic capital and credit markets, (2) continued volatility and further deterioration of the capital and credit markets, (3) significant changes in banking laws or regulations, including, without limitation, as a result of the Emergency Economic Stabilization Act, the American Reinvestment and Recovery Act, and possible amendments to the Troubled Asset Relief Program (TARP), including the Capital Purchase Program and related executive compensation requirements, (4) continued uncertainty about the impact of TARP and other recent federal programs on the financial markets including levels of volatility and credit availability,
(5) a more adverse than expected decline or continued weakness in general business and economic conditions, either nationally, regionally or locally in areas where the Company conducts its business, which may affect, among other things, the level of nonperforming assets, charge-offs and provision expense,
(6) changes in interest rates, reducing interest rate margins or increasing interest rate risks, (7) changes in market liquidity which may reduce interest margins and impact funding sources, (8) increased competition in the Company's markets, (9) changes in the financial performance and/or condition of the Company's borrowers, (10) current and further deterioration in the housing and commercial real estate markets particularly in California, and (11) increases in Federal Deposit Insurance Corporation premiums due to market developments and regulatory changes. In addition, acts and threats of terrorism or the impact of military conflicts have increased the uncertainty related to the national and California economic outlook and could have an effect on the future operations of the Company or its customers, including borrowers. See "Item 1A - Risk Factors" in this Report on Form 10-Q and in "Item 1A- Risk Factors" in our Annual Report on Form 10-K for the Year ended December 31, 2008 for further discussions of factors that could cause actual results to differ from forward looking statements. The Company does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.

EXECUTIVE SUMMARY

This summary is intended to identify the most important matters on which management focuses when it evaluates the financial condition and performance of the Company. When evaluating financial condition and performance, management looks at certain key metrics and measures. The Company's evaluation includes comparisons with peer group financial institutions and its own performance objectives established in the internal planning process.

The primary activity of the Company is commercial banking. The Company's operations are located entirely in the southern and eastern regions of the general San Francisco Bay area of California in the counties of Santa Clara, Alameda and Contra Costa. The largest city in this area is San Jose and the Company's market includes the headquarters of a number of technology based companies in the region known commonly as Silicon Valley. The Company's customers are primarily closely held businesses and professionals.

· Since the November 2008 sale of $40 million in preferred shares to the U.S. Department of the Treasury's through its Capital Purchase Program, the Company has made $66.0 million in new loan commitments and $126.4 million in renewed loan commitments through March 31, 2009. Of those, $34.4 million in new loan commitments and $80.4 million in renewed loan commitments were made during the first quarter of 2009.

· Capital ratios exceed regulatory well-capitalized standards, including a consolidated leverage ratio of 10.4% at March 31, 2009.

· Total assets were $1.46 billion, an increase of 3% from March 31, 2008 and a 3% decrease from December 31, 2008.

· Loans increased 7% to $1.21 billion from $1.13 billion a year ago, but decreased from $1.25 billion at December 31, 2008.

· Reflecting the difficult economic environment, nonperforming assets increased to $56.9 million, or 3.89% of total assets. Consequently, the provision for loan losses was $10.4 million in the first quarter of 2009.

· Heritage Bank of Commerce signed an agreement to purchase the deposits of Wachovia Bank branches in Santa Cruz and Monterey, California. At December 31, 2008, the deposits at the two branches were approximately $463 million. No loans will be purchased as part of the transaction, which is subject to bank regulatory approval and customary closing conditions and is expected to close during the third quarter of 2009.

· In the first quarter of 2006, Heritage Commerce Corp commenced the payment of cash dividends to common stock shareholders. Although the Company remains "well-capitalized" as of March 31, 2009, the Board of Directors has approved a suspension of the payment of cash dividends in view of its desire to preserve the capital of the Company to support its banking activities in the markets it serves during this challenging economy. The Board of Directors will periodically review its position throughout 2009 and into 2010.

Performance Overview

For the three months ended March 31, 2009, net loss was $4.0 million. Net loss available to common shareholders was $4.5 million, or $(0.38) per diluted common share for the first quarter ended March 31, 2009, which included a $10.4 million provision for loan losses and $585,000 in dividends and discount accretion on preferred stock. In the quarter ended March 31, 2008, net income was $1.7 million, or $0.14 per diluted common share, including a provision of $1.7 million and no dividends or discount accretion on preferred stock. The Company's return on average assets was -1.08% and return on average equity was -8.65% for the first quarter of 2009 compared to 0.50% and 4.33% a year ago.

The following are major factors impacting the Company's results of operations:

· Net interest income decreased 15% to $11.2 million in the first quarter of 2009 from $13.1 million in the first quarter of 2008, primarily due to a decrease in market interest rates.

· Net interest margin was 3.35%, compared with 4.32% for the first quarter a year ago, and 3.64% for the fourth quarter of 2008. Reversals of accrued interest on loans placed on nonaccrual status totaled $428,000 in the first quarter of 2009, reducing net interest margin by 13 basis points.

· Provision for loan losses increased to $10.4 million for the first quarter of 2009, compared to $1.7 million in the first quarter of 2008, primarily due to the increase in nonperforming loans.

· Noninterest income increased 7% to $1.6 million in the first quarter of 2009 from $1.5 million in the first quarter of 2008, primarily due to increased service charges on deposit accounts.

· The efficiency ratio was 88.9% in the first quarter of 2009, compared to 72.4% in the first quarter of 2008, primarily due to a lower net interest margin and higher noninterest expense.

· The income tax benefit for the quarter ended March 31, 2009 was $5.1 million, as compared to income tax expense of $684,000 in the first quarter of 2008. The negative effective income tax rate for the quarter ended March 31, 2009 was due to reduced pre-tax earnings.

The following are important factors in understanding our current financial condition and liquidity position:

· Total assets increased $45 million, or 3%, to $1.46 billion at March 31, 2009 from $1.41 billion at March 31, 2008, primarily due to loans and deposits generated by additional relationship managers hired in the past year, and a new office in Walnut Creek.

· Total loans increased $80 million, or 7%, at March 31, 2009 compared to $1.13 billion at March 31, 2008, but decreased from $1.25 billion at December 31, 2008.

· Total deposits remained the same at $1.2 billion at March 31, 2009, compared to March 31, 2008, and increased from $1.15 billion at December 31, 2008.

· The Company's noncore funding (which consists of time deposits $100,000 and over, brokered deposits, securities under agreement to repurchase, notes payable and other short-term borrowings) to total assets ratio was 30% at March 31, 2009, compared to 19% at March 31, 2008, and 32% at December 31, 2008.

· The Company's loan to deposit ratio was 104% at March 31, 2009, compared to 97% at March 31, 2008, and 108% at December 31, 2008.

The composition and cost of the Company's deposit base are important in analyzing the Company's net interest margin and balance sheet liquidity characteristics. Except for brokered time deposits, the Company's depositors are generally located in its primary market area. Depending on loan demand and other funding requirements, the Company also obtains deposits from wholesale sources including deposit brokers. The Company had $195.8 million in brokered deposits at March 31, 2009. The increase in brokered deposits of $129.9 million from March 31, 2008 was primarily to fund loan growth. The Company also seeks deposits from title insurance companies, escrow accounts and real estate exchange facilitators, which were $40.4 million at March 31, 2009. The Company has a policy to monitor all deposits that may be sensitive to interest rate changes to help assure that liquidity risk does not become excessive due to concentrations. Deposits for the first quarter of 2009 remained the same at $1.2 billion, compared to the first quarter of 2008. The Company has not experienced any increased demand outside its ordinary course of business from its customers to withdraw deposits as a result of recent developments in the financial institution industry.

Liquidity

Our liquidity position refers to our ability to maintain cash flows sufficient to fund operations and to meet obligations and other commitments in a timely fashion. We believe that our liquidity position is more than sufficient to meet our operating expenses, borrowing needs and other obligations for 2009. As of March 31, 2009, we had $31 million in cash and cash equivalents and approximately $332.5 million in available borrowing capacity from various sources including the Federal Home Loan Bank ("FHLB"), the Federal Reserve Bank of San Francisco ("FRB"), and Federal funds facilities with several financial institutions.

Lending

Our lending business originates primarily through our branch offices located in our primary market. The economy in our primary service area has weakened throughout 2008 and the first quarter of 2009, causing the Company to experience loan contraction in the first quarter of 2009. Commercial and land and construction loans decreased from December 31, 2008, as a result of the weakening economy. We will continue to use and improve existing products to expand market share at current locations. Total loans increased to $1.2 billion at March 31, 2009 compared to $1.1 billion at March 31, 2008.

Net Interest Income

The management of interest income and expense is fundamental to the performance of the Company. Net interest income, the difference between interest income and interest expense, is the largest component of the Company's total revenue. Management closely monitors both total net interest income and the net interest margin (net interest income divided by average earning assets).

Because of our focus on commercial lending to closely held businesses, the Company will continue to have a high percentage of floating rate loans and other assets. Given the current volume, mix and repricing characteristics of our interest-bearing liabilities and interest-earning assets, we believe our interest rate spread is expected to increase in a rising rate environment, and decrease in a declining interest rate scenario.

The Company, through its asset and liability policies and practices, seeks to maximize net interest income without exposing the Company to an excessive level of interest rate risk. Interest rate risk is managed by monitoring the pricing, maturity and repricing options of all classes of interest bearing assets and liabilities. This is discussed in more detail under Liquidity and Asset/Liability Management.

From September 18, 2007 through December 16, 2008, the Board of Governors of the Federal Reserve System reduced short-term interest rates by 500 basis points. This decrease in short-term rates immediately affected the rates applicable to the majority of the Company's loans. While the decrease in interest rates also lowered the cost of interest bearing deposits, which represents the Company's primary funding source, these deposits tend to price more slowly than floating rate loans. The rapid, substantial drop in the short-term interest rates, including the prime rate, has significantly compressed the Company's net interest margin.

Management of Credit Risk

Because of our focus on business banking, loans to single borrowing entities are often larger than would be found in a more consumer oriented bank with many smaller, more homogeneous loans. The average size of our loan relationships makes the Company more susceptible to larger losses. As a result of this concentration of larger risks, the Company has maintained an allowance for loan losses which is higher than might be indicated by its actual historic loss experience. In setting the loan loss allowance, management takes into consideration many factors including loan growth, changes in the composition of the loan portfolio, the general economic condition in the Company's market area, and the impact on the industrial sectors the Company services, as well as management's overall assessment of the quality of the loan portfolio and the lending staff and managers who service the portfolio. A complete discussion of the management of credit risk appears under Provision for Loan Losses and Allowance for Loan Losses.

Noninterest Income

While net interest income remains the largest single component of total revenues, noninterest income is an important component. Prior to the third quarter of 2007, a significant percentage of the Company's noninterest income was associated with its SBA lending activity, consisting of gains on the sale of loans sold in the secondary market and servicing income from loans sold with servicing retained. However, beginning in the third quarter of 2007, the Company decided to change its strategy regarding its SBA loan business. The Company now retains most of its SBA production, which allows us to generate more interest income rather than noninterest income. Other sources of noninterest income include the increase in cash surrender value of life insurance and service charges on deposits. Noninterest income will continue to be affected by the Company's strategic decision to retain rather than sell its loans.

Management considers the control of operating expenses to be a critical element of the Company's performance. Over the last three years the Company has undertaken several initiatives to reduce its noninterest expense and improve its efficiency. Nonetheless, noninterest expense increased in the first quarter of 2009 compared to the first quarter of 2008, due to lower deferred cost related to lower loan volume, severance pay resulting from a reduction in the number of full-time equivalent employees, increased professional fees due to problem loan expense and the pending acquisition of two branch offices, and a substantial increase in FDIC insurance costs. Management monitors progress in reducing noninterest expense through review of the Company's efficiency ratio. The Company's efficiency ratio was 88.9% in the first quarter of 2009 compared with 72.4% in the first quarter of 2008. The efficiency ratio increased in 2009 primarily due to compression of the Company's net interest margin and higher noninterest expense.

Capital Management and Share Repurchases

Heritage Commerce Corp and Heritage Bank of Commerce meet the regulatory definition of "well-capitalized" at March 31, 2009. As part of its asset and liability process, the Company continually assesses its capital position to take into consideration growth, expected earnings, risk profile and potential corporate activities that it may choose to pursue.

Our capital position has been considerably strengthened. As of March 31, 2009, our consolidated total risk-based capital ratio was 12.7%, or $165.1 million, more than the 10% regulatory requirement for well-capitalized banks. Our Tier 1 risk-based capital ratio of 11.4% and our Tier 1 leverage ratio of 10.4% as of March 31, 2009 also significantly exceeded regulatory guidelines for well-capitalized banks. On November 21, 2008, the Company issued to the U.S. Treasury under its Capital Purchase Program 40,000 shares of Series A Preferred Stock and warrants to purchase 462,963 shares of common stock at an exercise price of $12.96 for $40 million. The terms of the U.S. Treasury TARP Capital Purchase Program could reduce investment returns to our shareholders by restricting dividends to common shareholders, diluting existing shareholders' interests, and restricting capital management practices.

In July, 2007, the board of directors authorized the repurchase of up to $30 million of common stock through July, 2009. From August 13, 2007 through May 27, 2008, the Company purchased 1,645,607 shares for a total of $29.9 million to complete the repurchase plan.

Starting in 2006, the Company initiated the payment of quarterly cash dividends. The Company paid cash dividends of $3.8 million or $0.32 per common share in 2008 representing 217% of 2008 earnings. The Company accrued $500,000 of dividends in the first quarter of 2009 on the preferred stock issued to the U.S. Treasury under the TARP Capital Purchase Program. However, to preserve the capital of the Company in support of its banking activities during this challenging economy, the Board of Directors suspended common stock dividends, beginning in the second quarter of 2009.

RESULTS OF OPERATIONS

The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on interest-bearing liabilities. The second is noninterest income, which primarily consists of loan servicing fees, customer service charges and fees, and Company-owned life insurance income. The majority of the Company's noninterest expenses are operating costs that relate to providing a full range of banking services to our customers.

Net Interest Income and Net Interest Margin

In the first quarter of 2009, net interest income was $11.2 million, compared to $13.1 million in the first quarter of 2008. The level of net interest income depends on several factors in combination, including yields on earning assets, the cost of interest-bearing liabilities, the relative volumes of earning assets and interest-bearing liabilities, and the mix of products which comprise the Company's earning assets, deposits, and other interest-bearing liabilities. To maintain its net interest margin, the Company must manage the relationship between interest earned and paid.

The following Distribution, Rate and Yield table presents the average amounts outstanding for the major categories of the Company's balance sheet, the average interest rates earned or paid thereon, and the resulting net interest margin on average interest earning assets for the periods indicated. Average balances are based on daily averages.

Distribution, Rate and Yield

                                           For the Three Months Ended           For the Three Months Ended
                                                 March 31, 2009                       March 31, 2008
                                                      Interest    Average                  Interest    Average
                                         Average       Income/     Yield/      Average      Income/    Yield/
NET INTEREST INCOME AND NET INTEREST
MARGIN                                   Balance       Expense      Rate       Balance      Expense     Rate
                                                               (Dollars in thousands)
Assets:
Loans, gross                           $  1,236,361   $  15,030      4.93%   $ 1,075,605   $  18,355     6.86%
Securities                                  110,169         999      3.68%       137,810       1,501     4.38%
Interest bearing deposits in other
financial institutions                        5,215           4      0.31%         1,065           7     2.64%
Federal funds sold                              176           -      0.00%         4,408          32     2.92%
 Total interest earning assets            1,351,921      16,033      4.81%     1,218,888      19,895     6.56%
Cash and due from banks                      24,481                               38,559
Premises and equipment, net                   9,468                                9,272
Goodwill and other intangible assets         47,349                               48,084
Other assets                                 51,325                               61,414
 Total assets                          $  1,484,544                          $ 1,376,217

Liabilities and shareholders'
equity:
Deposits:
Demand, interest bearing               $    136,317          99      0.29%   $   148,469         601     1.63%
Savings and money market                    346,857         792      0.93%       476,592       2,889     2.44%
Time deposits, under $100                    46,108         296      2.60%        34,625         320     3.72%
Time deposits, $100 and over                176,837         874      2.00%       146,732       1,389     3.81%
Brokered time deposits                      203,952       1,969      3.92%        47,115         518     4.42%
Notes payable to subsidiary grantor
trusts                                       23,702         500      8.56%        23,702         557     9.45%
Securities sold under agreement to
repurchase                                   32,722         243      3.01%        22,164         156     2.83%
Note payable                                 10,278          82      3.24%         1,154           9     3.14%
Other short-term borrowings                  39,622          26      0.27%        39,945         352     3.54%
 Total interest bearing liabilities       1,016,395       4,881      1.95%       940,498       6,791     2.90%
Demand, noninterest bearing                 253,481                              249,173
Other liabilities                            29,244                               28,118
 Total liabilities                        1,299,120                            1,217,789
Shareholders' equity                        185,424                              158,428
 Total liabilities and shareholders'
equity                                 $  1,484,544                          $ 1,376,217

Net interest income / margin                          $  11,152      3.35%                 $  13,104     4.32%

Note: Yields and amounts earned on loans include loan fees and costs. Nonaccrual loans are included in the average balance calculation above.

The Volume and Rate Variances table below sets forth the dollar difference in interest earned and paid for each major category of interest-earning assets and interest-bearing liabilities for the noted periods, and the amount of such change attributable to changes in average balances (volume) or changes in average interest rates. Volume variances are equal to the increase or decrease in the average balance times the prior period rate, and rate variances are equal to the increase or decrease in the average rate times the prior period average balance. Variances attributable to both rate and volume changes are equal to the change in rate times the change in average balance and are included below in the average volume column.

Volume and Rate Variances

                                                          For the Three Months Ended March 31,
                                                                     2009 vs. 2008
                                                         Increase (Decrease) Due to Change In:
                                                        Average          Average           Net
                                                         Volume            Rate           Change
                                                                 (Dollars in thousands)
Income from the interest earning assets:
  Loans, gross                                        $      1,955    $      (5,280)    $  (3,325)
  Securities                                                 (251)             (251)         (502)
  Interest bearing deposits in other financial
institutions                                                   (3)               (6)           (3)
  Federal funds sold                                             -              (32)          (32)
Total interest income from interest earnings assets   $      1,706    $      (5,568)    $  (3,862)

Expense from the interest bearing liabilities:
  Demand, interest bearing                            $        (7)    $        (495)    $    (502)
  Savings and money market                                   (301)           (1,796)       (2,097)
  Time deposits, under $100                                     74              (98)          (24)
  Time deposits, $100 and over                                 150             (665)         (515)
  Brokered time deposits                                     1,514              (63)         1,451
  Notes payable to subsidiary grantor trusts                     -              (57)          (57)
  Securities sold under agreement to repurchase                 79                 8            87
  Note payable                                                  73                 -            73
  Other short-term borrowings                                  (1)             (325)         (326)
Total interest expense on interest bearing
liabilities                                           $      1,581    $      (3,490)    $  (1,910)
Net interest income                                   $        126    $      (2,078)    $  (1,952)

The Company's net interest margin, expressed as a percentage of average earning assets, was 3.35% in the first quarter of 2009 compared to 4.32% in the first quarter of 2008. A substantial portion of the Company's earning assets are . . .