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 and six month periods ended June 30, 2009 and comparisons of those results with the results of operations for the corresponding three and six month periods of 2008, and our consolidated financial condition, liquidity and capital resources at June 30, 2009. The information in this discussion 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 or in the markets in which we operate, 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," "forecast" 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 on assumptions about future events over which we do not have control and our business and the markets in which we operate are 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 and could, therefore, also affect the price performance of our shares. Certain of those risks and uncertainties are summarized below, in this Item 2, under the caption "Risks that could Affect our Future Financial Performance" as well as other risks that 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. Therefore, 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 their review of the following discussion regarding our results of operations for the three and six months ended, and our financial condition at, June 30, 2009.

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, except as may otherwise be required by law or Nasdaq rules.

Overview of Operating Results in the Three and Six Months Ended June 30, 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 and six month periods set forth below.



                                          Three Months Ended June 30,                        Six Months Ended June 30,
                                      2009              2008          Percent           2009              2008          Percent
                                    Amounts           Amounts         Change          Amounts           Amounts         Change
Interest income                   $     12,421      $     15,128        (17.9 )%    $     25,935      $     31,032        (16.4 )%
Interest expense                         8,005             8,613         (7.1 )%          16,126            17,632         (8.5 )%

Net interest income                      4,416             6,515        (32.2 )%           9,809            13,400        (26.8 )%
Provision for loan losses                6,592             2,741        140.5 %           10,043             3,816        163.2 %


Net interest income (loss)
after provision for loan losses         (2,176 )           3,774       (157.7 )%            (234 )           9,584       (102.4 )%
Noninterest income                         660               410         61.0 %            3,115             1,884         65.3 %
Noninterest expense                      7,878             5,694         38.4 %           14,531            11,390         27.6 %

Income (loss) before income tax         (9,394 )          (1,510 )     (522.1 )%         (11,650 )              78          N/M
Income tax (benefit) provision          (4,847 )            (680 )     (612.8 )%          (4,969 )             (92 )        N/M


Net income (loss)                 $     (4,547 )    $       (830 )     (447.8 )%    $     (6,681 )    $        170          N/M

Net income (loss) per diluted
share                             $      (0.44 )    $      (0.08 )     (450.0 )%    $      (0.64 )    $       0.02          N/M
Weighted average number of
diluted shares                      10,434,665        10,478,242         (0.4 )%      10,434,665        10,641,513         (1.9 )%

As the table above indicates, we incurred a net loss of $4.5 million, or $0.44 per diluted share, in the three months ended June 30, 2009, as compared to a net loss of $830,000, or $0.08 per diluted share, in the same three months of 2008. In the six months ended June 30, 2009 we incurred a net loss of $6.7 million, or $0.64 per diluted share, compared to net income of $170,000, or $0.02 per diluted shares, in the same six months of 2008. The net losses in the three and six months ended June 30, 2009 were primarily attributable to:

• Declines in net interest income of $2.1 million, or 32.2%, and $3.6 million, or 26.8%, respectively, in the three and six month periods ended June 30, 2009, which were due primarily to decreases during these periods in interest income of $2.7 million, or 17.9%, and $5.1 million, or 16.4%, respectively, only partially offset by decreases in interest expense of $608,000, or 7.1%, and $1.5 million, or 8.5%, respectively, during those same three and six month periods. The decreases in interest income were primarily attributable to:

• reductions in interest rates by the Federal Reserve Board in response to the economic recession and credit crisis, which has led to decreases in prevailing interest rates that have reduced the yields we were able to earn on our loans and other interest-earning assets; and

• an increase, during the six months ended June 30, 2009, of $37.3 million, or 234%, in non-performing loans, on which we were required to cease accruing interest, which we believe was attributable to the continuing economic recession and the on-going credit crisis that have adversely affected the financial condition of an increasing number of borrowers, preventing them from (i) meeting their loan payment obligations, (ii) refinancing their non-performing loans on more affordable terms, and (iii) selling the real properties that collateralized and had been expected to provide a source of repayment of their loans.

• Increases in the provisions we made for loan losses of $3.9 million or 141% and $6.2 million, or 163%, in the three and six months ended June 30, 2009, respectively, as compared to the same respective periods of 2008, in order to increase the loan loss reserve to provide for (i) the increases that occurred in non-performing loans during those periods and the risk of additional increases in non-performing loans in future months due to the continuance of the economic recession and credit crisis and the prospect that these conditions will not improve significantly during the remainder of 2009. These increases in the provision for loan losses resulted in an increase in the amount of our allowance for loan losses to $20.4 million, or approximately 2.46% of loans outstanding, at June 30, 2009, as compared to $15.5 million, or 1.83%, of the loans outstanding at December 31, 2008.

We believe that our actions in charging off nonperforming loans and increasing the allowance for loan losses were prudent in light of prevailing economic conditions and the uncertainties regarding the ultimate duration of the economic recession and credit crisis.

The following table indicates the impact that the decreases in our net interest income and the net losses incurred in the three and six months ended June 30, 2009 have had on our net interest margin and the returns on average assets and average equity during those periods:

                                         Three Months Ended June 30,               Six Months Ended June 30,
                                          2009                  2008               2009                  2008
Net interest margin (1) (2)                   1.50 %               2.41 %              1.70 %              2.49 %
Return on average assets (1)                 (1.49 )%             (0.30 )%            (1.13 )%             0.03 %
Return on average shareholders'
equity (1)                                  (21.06 )%             (3.47 )%           (16.63 )%             0.35 %

(1) Annualized.

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

At June 30, 2009, non-performing loans, together with other nonperforming assets consisting of OREO, totaled $71 million, or 5.9% of total assets, as compared to $29.9 million or 2.6% of total assets at December 31, 2008.

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 assumptions and judgments 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, such as securities available for sale and our deferred tax assets. Those assumptions and judgments are made based on current information available to us regarding those economic conditions or trends or other circumstances. If adverse changes were to occur in the events, trends or other circumstances on which our assumptions or judgments had been based, or other unanticipated events were to happen that might affect our operating results, under GAAP it could become necessary for us 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 our 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 borrowers to meet their loan payment obligations to us. Accordingly, we conduct periodic reviews of our loan portfolio, and we use historical loss factors, adjusted for current economic and market conditions and other economic indicators, in order 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 that we had predicted on the basis of those loss factors and our prior assessments of economic conditions and trends. In such an event, it could become necessary for us to increase the allowance for loan losses, based on our judgments as to how such changes will affect the collectibility of loans in our loan portfolio and the sufficiency of the allowance for loan losses. Increases in that allowance are made 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 any additional provisions made for possible loan losses 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 used by market participants, including 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 and judgments relating to such matters as the effects of prepayments on future yields on and the duration of such securities, monetary policies and demand and supply for the individual securities. Consequently, if adverse changes were to occur in the market or other conditions on which those assumptions or judgments 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, assuming that such reductions in fair values are expected to be temporary. On the other hand, if believe that any reduction in the fair values of any securities are other than temporary, it would be necessary for us to record an impairment loss in our statement of operations.

Utilization and Valuation of Deferred Income Tax Benefits. Deferred tax assets consist of income tax benefits which we believe we will be able to use to reduce our income tax liabilities in future periods. Such future tax benefits are attributable primarily to (i) tax credits and (ii) differences between financial statement carrying amounts of those assets and liabilities and their respective tax bases. We make periodic assessments of the probability that we will be able to use those tax benefits. In making those assessments we use a consistent approach to take into account our historical profitability and projections of future taxable income that can affect our ability to use those tax benefits. If we conclude, based on all available evidence, that it has become more likely than not that we will not be able to use those tax benefits in their entirety, we are required to establish a valuation allowance which will have the effect of reducing the amount of the deferred tax assets by the amount of the tax benefits we no longer believe we will be able to use by recording a charge in the amount to income or shareholders' equity. In evaluating the need for a valuation allowance, we evaluate carryback opportunities and estimate future taxable income based on management-approved business plans and ongoing tax strategies. This process involves significant management judgments that are subject to change from period to period based upon changes in tax laws or variances between our projected operating performance, our actual results and other factors.

Results of Operations

Net Interest Income

One of the principal determinants of a bank's income is its 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 or "spread" between the amount of our interest income and the amount of our interest expense, the greater will be our net income; whereas, a decline in that difference or "spread" 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, competition in the market place for loans or deposits, 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 and six months ended June 30, 2009 and 2008, respectively:

                                          Three Months Ended June 30,                Six Months Ended June 30,
                                        2009          2008        Percent         2009          2008        Percent
                                       Amount        Amount       Change         Amount        Amount       Change
Interest income                       $ 12,421      $ 15,128        (17.9 )%    $ 25,935      $ 31,032        (16.4 )%
Interest expense                         8,005         8,613         (7.1 )%      16,126        17,632         (8.5 )%

Net interest income                   $  4,416      $  6,515        (32.2 )%    $  9,809      $ 13,400        (26.8 )%

Net interest margin                       1.50 %        2.41 %                      1.70 %        2.49 %

As the above table indicates, our net interest income decreased by $2.1 million, or 32%, in the second quarter of 2009, and by $3.6 million, or 27%, in the six months ended June 30, 2009. The decreases were primarily attributable to decreases in interest income of $2.7 million, or 18%, and $5.1 million, or 16%, respectively, in those three and six month periods, which more than offset decreases in interest expense of $600,000, or 7%, and $1.5 million, or about 9%, respectively, in the three and six months ended June 30, 2009.

Those decreases in interest income in the three and six months ended June 30, 2009 were due primarily to (i) declines of 500 basis points in prevailing market rates of interest primarily as a result of reductions, commenced in September 2007, in the federal funds rate implemented by the Federal Reserve Board in response initially to a slowing in economic growth and, then, to the economic recession and credit crisis, as a result of which the federal funds rate declined to 0.25% at June 30, 2009 from 5.25% on September 17, 2007, and
(ii) the increases, described above, in non-performing loans, on which we ceased accruing interest income. Those decreases were only partially offset by the effects on interest income of increases, in the three and six months ended June 30, 2009, of $53 million and $58 million, respectively, in average loans outstanding, which generate higher yields than other earning assets.

The decreases in interest expense during the three and six month periods ended June 30, 2009 were primarily attributable to the aforementioned decreases in prevailing market rates of interest, which enabled us to reduce interest rates on substantially all types of interest bearing deposits, including certificates of deposit. However, those decreases in interest expense were partially offset by increases, during the three and six months ended June 30, 2009, in the volume of certificates of deposit, on which we pay interest at higher rates than on other types of deposits.

Due primarily to the decline in prevailing market rates of interest, our net interest margin decreased to 1.50% in the three months ended June 30, 2009, from 2.41% in the same period of 2008, and to 1.70% in the six months ended June 30, 2009, from 2.49% in the same six months of 2008. In the three months ended June 30, 2009, the yield on interest-earning assets declined to 4.21% from 5.60% in the same period of 2008, which more than offset a decline in the average interest rate paid on interest bearing liabilities to 3.33%, from 4.09% in the same three month period of 2008. Similarly, in the six months ended June 30, 2009, the average rate of interest earned on average earning assets declined to 4.50%, from 5.79% in the same six months of 2008, and was only partially offset by a decrease in the average interest rate paid on interest bearing liabilities to 3.39%, from 4.24% in the same period of 2008. The decreases in net interest margin also reflect timing differences in the impact that the declines in market rates of interest have 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 certificates of deposit.

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 June 30, 2009 and 2008.



                                                           Three Months Ended June 30,
                                                   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)            $   204,629   $     156      0.31 %    $    68,062   $     339      2.01 %
Securities available for sale and
stock(2)                                 138,137         657      1.91 %        229,348       2,549      4.47 %
Loans                                    841,270      11,608      5.53 %        788,545      12,240      6.24 %

Total earning assets                   1,184,036      12,421      4.21 %      1,085,955      15,128      5.60 %
Noninterest earning assets                39,735                                 38,383

Total Assets                         $ 1,223,771                            $ 1,124,338


Interest-bearing liabilities:
Interest-bearing checking accounts   $    25,900          34      0.53 %    $    19,233          24      0.50 %
Money market and savings accounts        107,903         306      1.14 %        142,691         695      1.96 %
Certificates of deposit                  624,465       5,750      3.69 %        434,865       5,073      4.69 %
Other borrowings                         185,852       1,750      3.78 %        232,538       2,580      4.46 %
Junior subordinated debentures            17,682         165      3.74 %         17,682         241      5.48 %

Total interest-bearing liabilities       961,802       8,005      3.33 %        847,009       8,613      4.09 %

Noninterest-bearing liabilities          175,412                                181,394

Total Liabilities                      1,137,214                              1,028,403
Shareholders' equity                      86,557                                 95,935

Total Liabilities and
Shareholders' Equity                 $ 1,223,771                            $ 1,124,338

Net interest income                                $   4,416                              $   6,515

Interest rate spread                                              0.88 %                                 1.51 %

Net interest margin                                               1.50 %                                 2.41 %

(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.

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 six months ended June 30, 2009 and 2008.

. . .