Introduction

Pacific Mercantile Bancorp is a bank holding company that owns all of the stock of Pacific Mercantile Bank (the "Bank"), which is a commercial bank that provides a full range of banking services to small and medium-size businesses and to professionals and the general public in Orange, Los Angeles, San Bernardino and San Diego counties, in Southern California. Substantially all of our operations are conducted and substantially all of our assets are owned by the Bank, which accounts for substantially all of our consolidated revenues, expenses and operating income,

The following discussion presents information about our consolidated results of operations for the three month period ended March 31, 2009 and 2008 and our consolidated financial condition, liquidity and capital resources at March 31, 2009 and should be read in conjunction with our interim consolidated financial statements and the notes thereto included elsewhere in this Report.

Forward-Looking Information

Statements contained in this Report that are not historical facts or that discuss our expectations, beliefs or views regarding our future operations or future financial performance, or financial or other trends in our business, 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. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include the words "believe," "expect," "anticipate," "intend," "plan," "estimate," "project," or words of similar meaning, or future or conditional verbs such as "will," "would," "should," "could," or "may." The information contained in such forward-looking statements is based on current information and assumptions about future events over which we do not have control and our business is subject to a number of risks and uncertainties that could cause our financial condition or actual operating results in the future to differ significantly from our expected financial condition or operating results that are set forth in those statements. Certain of those risks and uncertainties are summarized below, in this Item 2, under the caption "Risks that could Affect our Future Financial Performance" and those, as well as other, risks are discussed in detail in Item 1A, "Risk Factors," in Part II of this Report and in Item 1A in our Annual Report on Form 10-K for our fiscal year ended December 31, 2008 and readers of this Report are urged to read that summary below and the information contained in Item 1A in Part II of this report and in Item 1A of our 2008 10-K in conjunction with this Report.

Due to those risks and uncertainties, readers are cautioned not to place undue reliance on the forward-looking statements contained in this Report, which speak only as of the date of this Report, or to make predictions about future performance based solely on historical financial performance. We also disclaim any obligation to update forward-looking statements contained in this Report or in our 2008 10-K or any other prior filings with Securities and Exchange Commission.

Overview of Operating Results in the Three Months Ended March 31, 2009

The following table sets forth information regarding the interest income that we
generated, the interest expense that we incurred, our net interest income,
noninterest income, noninterest expense, and our net income (loss) and net
income (loss) per share for the three months ended March 31, 2009 and 2008.



                                                             Three Months Ended March 31,
                                                           2009              2008        Percent
                                                         Amounts           Amounts       Change
Interest income                                        $     13,513      $     15,904      (15.0 )%
Interest expense                                              8,121             9,019      (10.0 )%

Net interest income                                    $      5,392      $      6,885      (21.7 )%
Provision for loan losses                              $      3,450      $      1,075      220.9 %

Net interest income after provision for loan losses    $      1,942      $      5,810      (66.6 )%
Noninterest income                                     $      2,455      $      1,474       66.6 %
Noninterest expense                                    $      6,653      $      5,696       16.8 %

Income before income tax                               $     (2,256 )    $      1,588     (242.1 )%
Income tax (benefit) provision                                 (122 )             588     (120.7 )%

Net income (loss)                                      $     (2,134 )    $      1,000     (313.4 )%

Net income (loss) per diluted share                    $      (0.20 )    $       0.09     (322.2 )%

Weighted average number of diluted shares                10,434,665        10,676,259       (2.3 )%

As the table above indicates, we incurred a net loss of $2.1 million, or $0.20 per diluted share, in the three months ended March 31, 2009, as compared to net income of $1.0 million, or $0.09 per diluted share, in the same three months of 2008. That net loss was primarily attributable to:

• A decline in net interest income of $1.5 million, or 21.7%, in the three months ended March 31, 2009, primarily due to a decline in interest income of $2.4 million, or 15.0%, which was only partially offset by a $900,000, or 10%, decline in interest expense during that three month period. The decline in interest income was attributable to:

† reductions in interest rates by the Federal Reserve Board in response to the economic downturn, which has led to decreases in prevailing interest rates that reduced the yields on our loans and other interest-earning assets;

† an increase of $11.2 million, or 104%, in non-performing loans, on which we had to cease accruing interest, during the three months ended March 31, 2009 as compared to non-performing loans at March 31, 2008, which we believe was attributable to the continued deterioration of economic conditions and the on-going credit crisis in the United States that have adversely affected the financial condition of an increasing number of borrowers and prevented them from (i) refinancing their non-performing loans on more affordable terms and (ii) selling the real properties that collateralized and had been expected to provide a source of repayment of their loans.

• An increase of $2.4 million, or approximately 221%, in the provision we made for possible loan losses in the three months ended March 31, 2009, in order to increase the loan loss reserve to provide for the increases that occurred in nonperforming loans during that period and the risk of further increases in non-performing loans due to worsening economic conditions and the prospect that these conditions will not improve significantly during 2009. This increase in the provision for possible loan losses resulted in an increase in our loan loss reserve to $16.3 million, or approximately 1.93% of loans outstanding, at March 31, 2009 as compared to $15.5 million, or 1.83%, of the loans outstanding at December 31, 2008.

• An increase of $957,000, or 16.8%, in noninterest expense due primarily to
(i) the addition of personnel in our credit administration and mortgage banking departments, (ii) increases in expenses incurred in connection with foreclosures of non-performing loans and the carrying costs of the properties acquired by foreclosure ("Other Real Estate Owned" or "OREO") and (iii) an increase by the FDIC in insurance premiums imposed on all FDIC-insured banks as a means of funding increases in the FDIC's insurance fund necessitated by an increase in bank failures attributable to the economic problems and conditions that led to the economic recession and credit crisis.

In light of prevailing economic conditions and the uncertainties regarding the ultimate severity of the economic recession and credit crisis, we believe that our actions in charging off nonperforming loans and increasing the loan loss reserve are prudent in the current weak economy.

The following table indicates the impact that the decreases in our net interest income in and the net loss for the three months ended March 31, 2009 had on our net interest margin and the returns on average assets and average equity during that three month period:

                                                       Three Months Ended
                                                            March 31,
                                                        2009           2008
         Net interest margin (1) (2)                       1.92 %      2.60 %
         Return on average assets (1)                     (0.74 )%     0.37 %
         Return on average shareholders' equity (1)      (10.43 )%     4.08 %

(1) Annualized.

(2) Net interest income expressed as a percentage of total average interest earning assets.

At March 31, 2009, non-performing loans, together with other nonperforming assets consisting of OREO, totaled $39 million, or 3.2% of total assets, as compared to $29.9 million or 2.7% of total assets at December 31, 2008.

However, notwithstanding the net loss incurred in the quarter ended March 31, 2009, the ratio of the Bank's total capital to risk-weighted assets was 10.9% at March 31, 2009, which exceeded the ratio required, under bank regulatory guidelines, for the Bank to continue to be rated, for capital adequacy purposes, as a well-capitalized banking institution.

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States ("GAAP") and general practices in the banking industry. Certain of those accounting policies are considered critical accounting policies, because they require us to make estimates and assumptions regarding circumstances or trends that could affect the value of those assets, such as, for example, assumptions regarding economic conditions or trends that could impact our ability to fully collect our loans or ultimately realize the carrying value of certain of our other assets. Those estimates and assumptions are made based on current information available to us regarding those economic conditions or trends or other circumstances. If changes were to occur in the events, trends or other circumstances on which our estimates or assumptions were based, or other unanticipated events were to happen that might affect our operating results, under GAAP it could become necessary to reduce the carrying values of the affected assets on our balance sheet. In addition, because reductions in the carrying value of assets are sometime effectuated by or require charges to income, such reductions also may have the effect of reducing our income.

Our critical accounting policies relate to the determinations we make with respect to our allowance for loan losses, the fair value of securities available for sale and the valuation of deferred tax assets.

Allowance for Loan Losses. The failure of borrowers to repay their loans is an inherent risk of the banking business. Therefore, like virtually all banks and other lending institutions, we follow the practice of maintaining reserves (often referred to as an allowance) against which we charge losses on the loans we make (the "allowance for loan losses"). The accounting policies and practices we follow in determining the sufficiency of that allowance require us to make judgments and assumptions about economic and market conditions and trends that can affect the ability of our borrowers to meet their loan payment obligations to us. Accordingly, we use historical loss factors, adjusted for current economic market conditions and other economic indicators, to estimate the potential losses inherent in our loan portfolio and assess the sufficiency of our allowance for loan losses. If unanticipated changes were to occur in those conditions or trends, actual loan losses could be greater than those predicted by those loss factors and our prior assessments of economic conditions and trends. In such an event, it could be necessary for us to increase the allowance for loan losses by means of a charge to income referred to in our financial statements as the "provision for loan losses." Such an increase would reduce the carrying value of the loans on our balance sheet, and the additional provision for loan losses taken to increase that allowance would reduce our income in the period when it is determined that an increase in the allowance for loan losses is necessary. See the discussion in the subsections entitled "Results of Operations-Provision for Loan Losses" and "Financial Condition-Allowance for Loan Losses and Nonperforming Loans" below.

Fair Value of Securities Available for Sale. We determine the fair value of our investment securities by obtaining quotes from third party vendors and securities brokers. When quotes are not available, a reasonable fair value is determined by using a variety of industry standard pricing methodologies including, but not limited to, discounted cash flow analysis, matrix pricing, and option adjusted spread models, as well as fundamental analysis. These pricing methodologies require us to make various assumptions relating to such matters as the effects of prepayments on future yields on and duration of such securities, monetary policies and demand and supply for the individual securities. Consequently, if changes were to occur in the market or other conditions on which those assumptions were based, it could become necessary for us to reduce the fair values of our securities, which would result in changes to accumulated other comprehensive income (loss) on our balance sheet. If the Company determines that any reductions in the fair values of any securities are other than temporary, it will be necessary for the Company to record an impairment loss in our statement of operations.

Utilization and Valuation of Deferred Income Tax Benefits. We recognize deferred tax assets and liabilities for the future tax consequences resulting from differences between the financial statement carrying amounts of those assets and liabilities and their respective tax bases, and for tax credits. We evaluate our deferred tax assets for recoverability using a consistent approach that takes account of our historical profitability and projections of future taxable income that can affect the recoverability of our deferred tax assets. We are required to establish a valuation allowance for deferred tax assets and record a charge to income or stockholders' equity if we determine, based on available evidence, at the time the determination is made, that it is more likely than not that some portion or all of the tax benefits comprising the deferred tax assets will not be recovered. In evaluating the need for a valuation allowance, we estimate future taxable income based on management-approved business plans and ongoing tax planning strategies. This process involves significant management judgments that are subject to change from period to period based on changes in tax laws or variances between our projected operating performance, our actual results and other factors. Accordingly, we have included the assessment of a deferred tax asset valuation allowance as a critical accounting policy.

Results of Operations

Net Interest Income

One of the principal determinants of a bank's income is net interest income, which is the difference between (i) the interest that a bank earns on loans, investment securities and other interest-earning assets, on the one hand, and
(ii) its interest expense, which consists primarily of the interest it must pay to attract and retain deposits and the interest that it pays on borrowings and other interest-bearing liabilities, on the other hand. As a general rule, all other things being equal, the greater the difference between the amount of our interest income and the amount of our interest expense, the greater will be our income; whereas, a decline in that difference will generally result in a decline in our net income. A bank's interest income and interest expense are, in turn, affected by a number of factors, some of which are outside of its control, including national and local economic conditions and the monetary policies of the Federal Reserve Board which affect interest rates, the demand for loans and the ability of borrowers to meet their loan payment obligations. Net interest income, when expressed as a percentage of total average interest earning assets, is a banking organization's "net interest margin."

The following table sets forth our interest income, interest expense and net interest income (in thousands of dollars) and our net interest margin in the three months ended March 31, 2009 and 2008, respectively:

                                             Three Months Ended
                                                  March 31,
                                        2009         2008       Percent
                                       Amount       Amount      Change
                Interest income       $ 13,513     $ 15,904       (15.0 )%
                Interest expense         8,121        9,019       (10.0 )%

                Net interest income   $  5,392     $  6,885       (21.7 )%

                Net interest margin       1.92 %       2.60 %

As the above table indicates, our net interest income decreased by $1.5 million, or 22%, in the first quarter of 2009. The decrease was primarily attributable to a decrease in interest income of $2.4 million, or 15%, in the three month period of 2009, which more than offset a decrease in interest expense of $900,000, or 10% in the three months ended March 31, 2009 over the respective corresponding period of 2008.

The decrease in interest income in the three months ended March 31, 2009, was due primarily to (i) a 200 basis points decline in prevailing market rates of interest, which we believe was primarily the result of reductions, commenced in September 2008, in the federal funds rate implemented by the Federal Reserve Board in response to the economic downturn, and (ii) increases in non-performing loans on which we ceased accruing interest income. The decrease was partially offset by the positive effect on our interest income of an increase of $69 million, or 8.8%, in our average loans outstanding, compared to the three months ended March 31, 2008, which generate higher yields than other earning assets. We used lower-yielding federal funds and proceeds from the sale of securities available for sale to fund those increases in loans.

The decrease in interest expense during the three month period ended March 31, 2009 was primarily attributable to the aforementioned decrease in prevailing market rates of interest, which enabled us to reduce interest rates on interest bearing deposits, partially offset by increases in the volume of interest-bearing deposits and a change in the mix of our deposits to a greater proportion of time deposits which bear higher rates of interest than other types of deposits. The increase in the proportion of time deposits was necessitated by a decrease in the volume of demand, savings and money market deposits, which we believe was due to (i) the worsening of economic conditions in the United States which led consumers to make greater use of their savings to pay on-going expenses, (ii) downsizing by businesses which led to reductions in balances in business transaction accounts and (iii) the loss in confidence by consumers and investors in banks, which led to a shift of funds out of banks to treasury securities.

Due primarily to the decline in net interest income, our net interest margin decreased by 68 basis points to 1.92% in the three months ended March 31, 2009, from 2.60% in the same period of 2008. In the three months ended March 31, 2009, the yield on interest-earning assets declined to 4.80% from 6.02% in the same period of 2008, which more than offset a decline in the average interest rate paid on interest bearing liabilities to 3.68%, from 4.40% in the same three month period of 2008. The decrease in the net interest margin also reflects timing differences in the impact of the decline in market rates of interest on our interest income and interest expense. Those declines resulted in automatic decreases in the interest rates on our adjustable rate loans, whereas the impact of those declines on the interest we paid on deposits has been more gradual primarily as a result of the maturity schedule of our time deposits

Average Balances

Information Regarding Average Assets and Average Liabilities

The following table sets forth information regarding our average balance sheet,
yields on interest earning assets, interest expense on interest-bearing
liabilities, the interest rate spread and the interest rate margin for the three
months ended March 31, 2009 and 2008.



                                                          Three Months Ended March 31,
                                                   2009                                  2008
                                                   Interest    Average                   Interest    Average
                                       Average      Earned/    Yield/        Average      Earned/    Yield/
                                       Balance       Paid       Rate         Balance       Paid       Rate
                                                             (Dollars in thousands)
Interest earning assets:
Short-term investments(1)            $   138,607   $      89      0.26 %   $    37,283   $     284      3.06 %
Securities available for sale and
stock(2)                                 151,135       1,439      3.86 %       242,717       2,733      4.53 %
Loans(3)                                 851,596      11,985      5.71 %       783,057      12,887      6.62 %

Total earning assets                   1,141,338      13,513      4.80 %     1,063,057      15,904      6.02 %
Noninterest earning assets                38,479                                30,415

Total Assets                         $ 1,179,817                           $ 1,093,472

Interest-bearing liabilities:
Interest-bearing checking accounts   $    25,237          26      0.42 %   $    19,326          30      0.62 %
Money market and savings accounts        101,351         280      1.12 %       161,225       1,024      2.55 %
Certificates of deposit                  524,965       5,603      4.33 %       409,838       5,105      5.01 %
Other borrowings                         213,425       2,028      3.85 %       216,336       2,554      4.75 %
Junior subordinated debentures            17,682         184      4.22 %        17,682         306      6.96 %

Total interest-bearing liabilities       882,660       8,121      3.68 %       824,407       9,019      4.40 %

Noninterest-bearing liabilities          213,932                               170,869

Total Liabilities                      1,096,592                               995,276
Shareholders' equity                      83,225                                98,196

Total Liabilities and
Shareholders' Equity                 $ 1,179,817                           $ 1,093,472

Net interest income                                $   5,392                             $   6,885

Interest rate spread                                              1.12 %                                1.62 %

Net interest margin                                               1.92 %                                2.60 %

(1) Short-term investments consist of federal funds sold and interest bearing deposits with financial institutions.

(2) Stock consists of Federal Home Loan Bank Stock and Federal Reserve Bank Stock.

(3) Loans include the average balance of nonaccrual loans. Those nonaccrual loans contributed to the declines, shown in this table, in interest earned and in the interest rate spread and our net interest margin in the three months ended March 31, 2009.

The following table sets forth the changes in interest income, including loan fees, and interest paid in the three months ended March 31, 2009, as compared to the same period in 2008, and the extent to which those changes were attributable to changes in (i) the volumes of or in the rates of interest earned on interest-earning assets and (ii) the volumes of or in the rates of interest paid on our interest-bearing liabilities.

                                                     Three Months Ended March 31,
                                                            2009 vs. 2008
                                                     Increase (decrease) due to:
                                                Volume(1)        Rate(1)       Total
                                                        (Dollars in thousands)
   Interest income:
   Short-term investments(1)                    $      240       $   (435 )   $   (195 )
   Securities available for sale and stock(2)         (931 )         (363 )     (1,294 )
   Loans                                             1,017         (1,919 )       (902 )

   Total earning assets                                326         (2,717 )     (2,391 )
   Interest expense:
   Interest-bearing checking accounts                    8            (12 )         (4 )
   Money market and savings accounts                  (296 )         (448 )       (744 )
   Certificates of deposit                           1,264           (766 )        498
   Borrowings                                          (35 )         (491 )       (526 )
   Junior subordinated debentures                       -            (122 )       (122 )

   Total interest-bearing liabilities                  941         (1,839 )       (898 )

   Net interest income                          $     (615 )     $   (878 )   $ (1,493 )

(1) Short-term investments consist of federal funds sold and interest bearing deposits with financial institutions.

(2) Stock consists of Federal Reserve Bank stock and Federal Home Loan Bank stock.

The above table indicates that the decrease of $1.5 million in our net interest income in the three months ended March 31, 2009, as compared to the like period of 2008, was primarily the result of decreases of $878,000 and $615,000 in rate and volume variances, respectively. The decrease in volume variance in the three months ended March 31, 2009 was primarily the result of changes in the mix of
(i) our earning assets from higher yielding loans to lower yielding short-term investments and securities available for sale, and (ii) our deposits to a greater proportion of higher cost certificates of deposit, and a lesser proportion of lower cost transaction savings and money market deposits. The decline in rate variance was a result of a decrease in interest rates on average earning assets of 122 basis points, which was only partially offset by a decrease of 72 basis points in interest rates paid on interest bearing liabilities.

Provision for Loan Losses

. . .