The following discussion provides information about the results of operations, financial condition, liquidity, and capital resources of Heritage Commerce Corp (the "Company) and its wholly owned subsidiary, Heritage Bank of Commerce ("HBC"). This information is intended to facilitate the understanding and assessment of significant changes and trends related to our financial condition and the results of operations. This discussion and analysis should be read in conjunction with our consolidated financial statements and the accompanying notes presented elsewhere in this report.

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 loan 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, (11) conditions which make it difficult to raise capital on terms that are favorable to the Company and its shareholders, (12) informal or formal regulatory or supervisory actions taken by bank regulators, and (13) 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.

Performance Overview

For the three months ended June 30, 2009, the net loss was $5.4 million. Net loss allocable to common shareholders was $6.0 million, or $(0.51) per common share for the quarter ended June 30, 2009, which

included a $10.7 million provision for loan losses and $591,000 in dividends and discount accretion on preferred stock. In the quarter ended June 30, 2008, net loss allocable to common shareholders was $3.1 million, or $(0.26) per common share, including a provision for loan losses of $7.8 million and no dividends or discount accretion on preferred stock. The annualized returns on average assets and average equity for the second quarter of 2009 were -1.48% and -11.90%, compared to -0.85% and -8.34% for the second quarter of 2008.

For the six months ended June 30, 2009, the net loss was $9.3 million. Net loss allocable to common shareholders was $10.5 million, or $(0.89) per common share, which included a $21.1 million provision for loan losses and $1.2 million in dividends and discount accretion on preferred stock. In the six months ended June 30, 2008, net loss allocable to common shareholders was $1.4 million, or $(0.11) per common share, including a provision for loan losses of $9.5 million and no dividends or discount accretion on preferred stock. The annualized returns on average assets and average equity for the first six months of 2009 were -1.28% and -10.27%, compared to -0.20% and -1.81% for the first six months of 2008, respectively.

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

† Net interest income decreased 10% to $11.7 million in the second quarter of 2009 from $13.0 million in the second quarter of 2008, primarily due to compression of the net interest margin. However, net interest income increased $537,000 from the first quarter of 2009, primarily due to improvement in the net interest margin.

† The net interest margin was 3.55%, compared with 4.00% for the second quarter a year ago, and 3.35% for the first quarter of 2009. The Company's net interest margin decreased to 3.45% for the six months ended June 30, 2009 compared to 4.15% for the first six months of 2008. The 20 basis points increase in the net interest margin in the second quarter of 2009, compared to the first quarter of 2009, was primarily due to lower cost of funds. The decrease in the net interest margin from the second quarter and first six months of 2008 was primarily the result of the 275 basis point decline in short-term interest rates from March 18, 2008 through December 16, 2008.

† Provision for loan losses increased to $10.7 million for the second quarter of 2009, compared to $7.8 million in the second quarter of 2008 and $10.4 million in the first quarter of 2009. The provision for loan losses for the six months ended June 30, 2009 was $21.1 million, compared to $9.5 million for the same period a year ago.

† Noninterest income decreased 11% to $1.6 million in the second quarter of 2009 from $1.8 million in the second quarter of 2008, and decreased 2% to $3.2 million in the first six months of 2009 from $3.3 million in the first six months of 2008.

† The efficiency ratio was 90.90% and 89.94% in the quarter and six months ended June 30, 2009, compared to 74.51% and 73.45% in the quarter and six months ended June 30, 2008, respectively, primarily due to compression of the net interest margin and higher noninterest expense.

† The income tax benefit for the quarter and six months ended June 30, 2009 was $4.1 million and $9.2 million, respectively, as compared to of $955,000 and $271, 000 for the same periods in 2008. The negative effective income tax rates for the quarter and six months ended June 30, 2009 and June 30, 2008 were due to the loss before income taxes.

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

† Total assets decreased by $62.2 million, or 4%, to $1.44 billion at June 30, 2009 from $1.50 billion at December 31, 2008.

† $20.5 million of Small Business Administration ("SBA") loans were transferred to loans held-for-sale at June 30, 2009 in anticipation of loan sales.

† Total loans, excluding loans held-for-sale, decreased $47.5 million, or 4%, to 1.16 billion at June 30, 2009 compared to $1.21 billion at June 30, 2008, and decreased $87.0 million, or 7%, compared to $1.25 billion at December 31, 2008. Land and construction loans decreased $25.8 million from December 31, 2008 to $230.8 million at June 30, 2009.

† Nonperforming assets increased $4.9 million to $61.7 million, or 4.30% of total assets, from $56.9 million, or 3.89% of total assets at March 31, 2008, and increased $20.6 million from $41.1 million, or 2.74% of total assets at December 31, 2008.

† The allowance for loan losses increased to $31.4 million, or 2.70% of total loans, compared to $23.9 million, or 1.97%, at March 31, 2009, and $25.0 million, or 2.00% at December 31, 2008.

† Deposits remained flat at $1.16 billion at June 30, 2009, compared to June 30, 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 31% at June 30, 2009, compared to 28% at June 30, 2008, and 32% at December 31, 2008.

† The Company's loan to deposit ratio was 99.84% at June 30, 2009, compared to 104.23% at June 30, 2008, and 108.20% at December 31, 2008.

† HBC's capital ratios exceed the regulatory well-capitalized standards, including a leverage ratio of 9.5%, a tier 1 risk-based capital ratio of 10.5%, and a total risk-based capital ratio of 11.7% at June 30, 2009.

Deposits

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 $224.7 million in brokered deposits at June 30, 2009. The increase in brokered deposits of $116.1 million from June 30, 2008 was primarily to replace the decrease in real estate related deposit accounts. The Company seeks deposits from title insurance companies, escrow accounts and real estate exchange facilitators, which were $30.8 million at June 30, 2009, compared to $113.3 million at June 30, 2008. 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 remained essentially flat at $1.16 billion at June 30, 2009, compared to June 30, 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 June 30, 2009, we had $31.5 million in cash and cash equivalents and approximately $306.3 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. The Company also had $5.9 million in unpledged investment securities available at June 30, 2009.

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 2009, causing the Company to experience loan contraction in the first and second quarters of 2009. Commercial loans account for 39% of the total loan portfolio, and commercial real estate loans (of which 50% are owner occupied) account for 36% of the portfolio. Land and construction loans decreased $25.8 million from December 31, 2008, and account for 20% of the portfolio. We will continue to use and improve existing products to expand market share at current locations.

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. In addition, we believe there are measures and initiatives we can take to improve the net interest margin, including increasing loan rates, adding floors on floating rate loans, reducing nonperforming assets, managing deposit interest rates, and reducing higher cost deposits.

From March 18, 2008 through December 16, 2008, the Board of Governors of the Federal Reserve System reduced short-term interest rates by 275 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.

The net interest margin is also adversely impacted by the reversal of interest on nonaccrual loans, and the reinvestment of loan payoffs into lower yielding Treasury securities and other short-term investments.

Management of Credit Risk

We continue to proactively identify, quantify, and actively manage our problem loans. Early identification of problem loans and potential future losses will enable us to resolve credit issues with potentially less risk and ultimate losses. 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.

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. From the third quarter of 2007 through the second quarter of 2009, the Company retained most of its SBA production. In the second quarter of 2009, $20.5 million of SBA loans were transferred to loans held-for-sale to potentially enhance liquidity and improve noninterest income in future periods. Other sources of noninterest income include: loan servicing fees, service charges and fees, and company owned life insurance income.

Noninterest Expense

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 second quarter and first half of 2009 compared to the same periods in 2008, due to a substantial increase in FDIC insurance costs, increased professional fees and loan workout expense. The Company's efficiency ratio was 90.90% and 89.94% in the second quarter and first half of 2009, respectively, compared with 74.51% and 73.45 for the same periods in 2008. The efficiency ratio increased in 2009 primarily due to compression of the Company's net interest margin.

Capital Management

Heritage Commerce Corp and Heritage Bank of Commerce meet the regulatory definition of "well-capitalized" at June 30, 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.

As of June 30, 2009, HBC's total risk-based capital ratio was 11.7%, compared to the 10% regulatory requirement for well-capitalized banks. Our Tier 1 risk-based capital ratio of 10.5% and our leverage ratio of 9.5% as of June 30, 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.

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 first quarter of 2009. The Company accrued $500,000 of dividends in the second quarter of 2009 on the preferred stock issued to the U.S. Treasury under the TARP Capital Purchase Program.

In addition to the quarterly dividend payments on our preferred stock, we also service the interest payments on our outstanding trust preferred subordinated debt securities.

RESULTS OF OPERATIONS

The Company earns income from two primary sources. Our primary source of revenue is net interest income, which is interest income generated by earning assets less interest expense on interest-bearing liabilities. Our second source of revenue 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

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
                                             June 30, 2009                         June 30, 2008
NET INTEREST INCOME AND NET                       Interest    Average                   Interest    Average
INTEREST MARGIN                      Average       Income/    Yield/       Average       Income/    Yield/
(in $000's, unaudited)               Balance       Expense     Rate        Balance       Expense     Rate
Assets:
Loans, gross                       $  1,206,479   $  14,862      4.94 %  $  1,170,274   $  17,250      5.93 %
Securities                              107,158         958      3.59 %       131,428       1,433      4.39 %
Interest bearing deposits in
other financial institutions              6,828           4      0.23 %           470           2      1.71 %
Federal funds sold                          139           -      0.00 %         2,815          14      2.00 %
Total interest earning assets         1,320,604      15,824      4.81 %     1,304,987      18,699      5.76 %
Cash and due from banks                  23,090                                35,476
Premises and equipment, net               9,380                                 9,144
Goodwill and other intangible
assets                                   47,189                                47,860
Other assets                             56,899                                58,929
Total assets                       $  1,457,162                          $  1,456,396

Liabilities and shareholders'
equity:
Deposits:
Demand, interest bearing           $    134,141          79      0.24 %  $    155,130         367      0.95 %
Savings and money market                346,847         662      0.77 %       467,428       1,862      1.60 %
Time deposits, under $100                44,612         259      2.33 %        34,507         271      3.16 %
Time deposits, $100 and over            169,954         718      1.69 %       174,534       1,363      3.14 %
Brokered time deposits                  199,655       1,676      3.37 %        77,900         793      4.09 %
Notes payable to subsidiary
grantor trusts                           23,702         487      8.24 %        23,702         526      8.93 %
Securities sold under agreement
to repurchase                            30,000         227      3.03 %        35,890         255      2.86 %
Note payable                                  -           -       N/A          10,407          75      2.90 %
Other short-term borrowings              43,099          27      0.25 %        39,187         219      2.25 %
Total interest bearing
liabilities                             992,010       4,135      1.67 %     1,018,685       5,731      2.26 %
Demand, noninterest bearing             255,011                               260,361
Other liabilities                        28,745                                28,690
Total liabilities                     1,275,766                             1,307,736
Shareholders' equity:                   181,396                               148,660
Total liabilities and
shareholders' equity               $  1,457,162                          $  1,456,396

Net interest income / margin                      $  11,689      3.55 %                 $  12,968      4.00 %

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

                                       For the Six Months Ended             For the Six Months Ended
                                            June 30, 2009                         June 30, 2008
NET INTEREST INCOME AND NET                      Interest    Average                  Interest    Average
INTEREST MARGIN                     Average       Income/    Yield/       Average      Income/    Yield/
(in $000's, unaudited)              Balance       Expense     Rate        Balance      Expense     Rate
Assets:
Loans, gross                      $  1,221,329   $  29,892      4.94 %  $ 1,122,940   $  35,605      6.38 %
Securities                             108,655       1,957      3.63 %      134,619       2,934      4.38 %
Interest bearing deposits in
other financial institutions             6,021           8      0.27 %          768           9      2.36 %
Federal funds sold                         157           -      0.00 %        3,611          46      2.56 %
Total interest earning assets        1,336,162      31,857      4.81 %    1,261,938      38,594      6.15 %
Cash and due from banks                 23,786                               37,017
Premises and equipment, net              9,424                                9,208
Goodwill and other intangible
assets                                  47,269                               47,976
. . .