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Article by DailyStocks_admin    (08-10-08 04:56 AM)

State Bancorp Inc. CEO Thomas M OBrien bought 44758 shares on 8-06-2008 at $13.41

BUSINESS OVERVIEW

General

State Bancorp, Inc. (the “Company”), a one-bank holding company headquartered in Jericho, New York, was formed in 1986. The Company operates as the parent for its wholly owned subsidiary, State Bank of Long Island and subsidiaries (the “Bank”), a New York State chartered commercial bank founded in 1966, and its unconsolidated wholly owned subsidiaries, State Bancorp Capital Trust I and II (collectively called the “Trusts”), entities formed in 2002 and 2003, respectively, to issue trust preferred securities. The Bank conducts a general banking business focused on the small to mid-sized business, municipal and consumer markets in Long Island and New York City. The Bank, emphasizing high-quality personal service, has grown to be the largest independent commercial bank headquartered on Long Island. The income of the Company is derived through the operations of the Bank and its subsidiaries, SB Portfolio Management Corp. (“SB Portfolio”), SB Financial Services Corp. (“SB Financial”), Studebaker-Worthington Leasing Corp. (“SWLC”), New Hyde Park Leasing Corp. and its subsidiaries, P.W.B. Realty, L.L.C. (“PWB”) and State Title Agency, LLC, and SB ORE Corp.

The Bank serves its customer base through sixteen full-service branches and a lending center in Jericho, NY. In February 2008, the Bank opened a corporate banking branch in Manhattan. Of the Bank’s full-service branch locations, eight are in Nassau County, five are in Suffolk and three are in Queens County. The Bank offers a full range of banking services to individuals, corporations, municipalities, and small to medium–sized businesses. Retail and commercial products include checking accounts, NOW accounts, money market accounts, savings accounts, certificates of deposit, individual retirement accounts, commercial loans, construction loans, home equity loans, commercial mortgage loans, consumer loans, small business lines of credit, equipment leases, cash management services and telephone and online banking. In addition, the Bank also provides safe deposit services, merchant credit card services, access to annuity products and mutual funds, residential loans, a consumer debit card with membership in a national ATM network, and a wide range of wealth management and financial planning services. The Company’s loan and lease portfolio is concentrated in commercial and industrial loans and commercial mortgages. The Bank does not engage in subprime lending and does not offer payment option ARMs or negative amortization loan products.

SB Portfolio and SB Financial are each wholly owned subsidiaries of the Bank. SB Portfolio provides investment management services to the Bank while SB Financial provides balance sheet management services such as interest rate risk modeling, asset/liability management reporting and general advisory services to the Bank.

The Company also owns SWLC, a nationwide provider of business equipment leasing. The Company recently concluded a comprehensive review of SWLC. After carefully assessing its available alternatives during the fourth quarter of 2007, the Company made the strategic decision to exit the leasing business, and is in active discussions to sell the leasing business conducted through SWLC for an amount that approximates tangible book value to an out-of-state firm whose main focus is the equipment leasing business.

At December 31, 2007, the Company, on a consolidated basis, had total assets of approximately $1.6 billion, total deposits of approximately $1.3 billion, and stockholders’ equity of approximately $114 million. Unless the context otherwise requires, references herein to the Company include the Company and its subsidiaries on a consolidated basis.

Neither the Company nor any of its direct or indirect subsidiaries is dependent upon a single customer or very few customers. No material amount of deposits is obtained from a single depositor. The Bank does not rely on foreign sources of funds or income and the Bank does not have any foreign commitments, with the exception of letters of credit issued on behalf of several of its domestic customers.

The Company expects that compliance with provisions regulating environmental controls will have no material effect upon the capital, expenditures, earnings or competitive position of the Company. The Company operates in the banking industry and management considers the Company to be aggregated in one reportable operating segment. The Bank has not experienced any material seasonal fluctuations in its business. The Company has not had material expenditures for research and development. The Company employed 344 full-time and part-time officers and employees as of December 31, 2007.

The Company’s Internet address is www.statebankofli.com. The Company makes available on its website, free of charge, its periodic and current reports, proxy and information statements and other information we file with the Securities and Exchange Commission (“SEC”) and amendments thereto as soon as reasonably practicable after the Company files such material with, or furnishes such material to, the SEC, as applicable. Unless specifically incorporated by reference, the information on our website is not part of this annual report. Such reports are also available on the SEC’s website at www.sec.gov, or at the SEC’s Public Reference Room at 100 F Street, N.E., Room 1580, Washington, DC, 20549. Information may be obtained on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.

Market Area and Competition

The Company considers its business to be highly competitive in its market areas. The Company’s core niche of small business, middle market commercial and industrial and municipal customers is highly sought after by an ever expanding array of competitors entering the marketplace through de novo branching, acquisitions and strategic alliances. Although the Bank is considerably smaller in size than many of these institutions operating in its market areas, it has demonstrated the ability to compete effectively with them. During the second half of 2007, we faced a greater intensity of competition from other financial institutions that have attempted to sustain their liquidity by offering retail deposits with above-market rates.

The New York metropolitan area has a high density of financial institutions, a number of which are significantly larger and have greater financial resources than we have. Additionally, over the past several years, various large out-of-state financial institutions have entered the New York metropolitan area market. All are our competitors to varying degrees. The Company vies with local, regional and national depository financial institutions and other businesses with respect to its lending services and in attracting deposits, including commercial banks, savings banks, insurance companies, credit unions and money market funds. In addition, during 2007, turmoil in the marketplace has resulted in a number of mortgage companies exiting the market and, therefore, dislocations in the secondary residential mortgage market. The turmoil in the mortgage market has impacted the global markets as well as the domestic markets and has led to a significant credit and liquidity crisis in the second half of 2007 and continuing into 2008. These events have led to fewer participants, and thus, less competition in mortgage originations, stricter underwriting standards and wider pricing spreads.

The Company’s current market area, consisting primarily of Nassau and Suffolk Counties in New York and New York City, provides tremendous opportunity for deposit growth and commercial and industrial lending. The Company believes that there are a significant number of small to mid-size businesses in its current market area that seek a locally-based commercial bank that can offer a broad array of financial products and services. Many of these businesses have been displaced as a result of recent bank mergers in the area. Given the variety of financial products and services offered by the Company, its focus on customer service, and its local management, the Company believes that it can better serve the growing needs of both new and existing customers in its current market areas. The new Manhattan branch, staffed by a team of seasoned commercial bankers affords the Company opportunity to capture market share in that attractive market.

The Company’s current markets have attractive per capita income and median household income demographics. The median household income for Nassau, Suffolk and Queens Counties are $85,994, $76,847 and $51,190, respectively. Nassau County’s 2007 median household income is the tenth highest in the United States. Although these three counties are mature in terms of population growth, residents of these counties continue to experience favorable income trends.

The Company believes the decline of the local real estate market and the associated downward pressures on the economy will continue throughout 2008. Accordingly, 2008 will be approached with a degree of caution as the Company expects there will be some credit weakness present. The Company will maintain its prudent underwriting and loan portfolio risk management practices as the loan portfolio is expanded in the middle market and commercial real estate areas in the Manhattan market.

Competitive Strengths

The Company believes that the following business strengths differentiate the Company from its peers:

•

Strong Net Interest Margin . Prior to 2005, the Company's strong historical earnings had been driven by its impressive net interest margin. For the year ended December 31, 2007 and the year ended December 31, 2006, the Company’s net interest margin was 3.82% and 4.01%, respectively. The Company’s strong margin results from its relatively stable low-cost deposit base coupled with a business mix which emphasizes high-yielding commercial and industrial loans and commercial mortgages.

•

Successful Repositioning in 2007. The Company’s 2007 earnings amounted to $6.2 million versus $11.5 million in 2006. Earnings in 2007 were negatively impacted by several strategic actions intended to improve the Company’s future earnings potential. In the second quarter, a $3.1 million pre-tax charge was recognized in connection with the previously disclosed Voluntary Exit Window program. This cost-control program resulted in the early retirement of 18 officers and employees. In the fourth quarter, a non-cash goodwill impairment accounting charge of $2.4 million was recorded as a result of the Company’s decision to exit the leasing business with the intent to sell substantially all of the assets of SWLC. Additionally in the fourth quarter, the Company recorded a reduction in the provision for income taxes resulting from the final and conclusive settlement of the previously disclosed audit by the New York State Tax Department. See “Legal Proceedings.”

•

Largest Independent Commercial Bank Headquartered on Long Island. The Bank is the largest independent commercial bank headquartered on Long Island, with a network of branches stretching from the Three Village area, located in Suffolk County, to Manhattan. According to data published by the Federal Deposit Insurance Corporation (the “FDIC”), based on total deposits as of June 30, 2007, the Company’s market share in Nassau, Suffolk and Queens Counties was 1.69%, 1.23% and 0.19%, respectively.

•

Stable Credit Quality. The Company emphasizes a credit culture based on traditional credit measures and underwriting standards. The results of the Company’s continued focus on credit quality are evidenced by a ratio of non-performing assets to total loans and leases of 0.56% at December 31, 2007 and 0.22% at December 31, 2006 and a net charge-offs to average total loans and leases ratio of 0.61% for the year ended December 31, 2007 and 0.19% for the year ended December 31, 2006. At December 31, 2007 and December 31, 2006, the Company held no other real estate owned (“OREO”) and there were no restructured, accruing loans and leases.

•

Strong C apital Base . The Company’s capital ratios exceeded all regulatory requirements at December 31, 2007. The Bank’s Tier I leverage ratio was 7.43% at December 31, 2007 and 6.69% at December 31, 2006. The Bank’s Tier I risk-weighted ratio was 10.62% at December 31, 2007 and 10.07% at December 31, 2006. The Bank’s total risk-weighted capital ratio was 11.85% at December 31, 2007 and 11.32% at December 31, 2006. Each of these ratios is substantially in excess of the regulatory guidelines, as established by federal banking regulatory agencies, for a “well capitalized” institution, the highest regulatory capital category.

•

Realignment of Organizational Structure. During 2007, the Company has strengthened its corporate governance and internal controls through the appointment of a General Counsel, Chief Auditor, Comptroller, BSA Officer, Information Security Officer and Security Director. Additionally the Company has appointed a Chief Marketing and Corporate Planning Officer, a Director of Credit Review and a Chief Information Officer.

Supervision and Regulation

General

The Company is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the “BHCA”), and is therefore subject to supervision and examination by the Board of Governors of the Federal Reserve System (“FRB”). The Bank is a member of the FHLB-NY and its deposit accounts are insured up to the applicable limits by the FDIC under the Deposit Insurance Fund (“DIF”). The Bank is subject to the regulation and supervision and examination of the New York State Banking Department (the “Banking Department”) and the FDIC.

The following summary discussion sets forth certain of the material elements of the legal and regulatory framework applicable to banks and bank holding companies and their subsidiaries. The regulation of banks and bank holding companies is extremely complex and this summary is qualified in its entirety by reference to the applicable statutes, regulations and regulatory guidance. Management believes the Company is in compliance in all material respects with these laws and regulations. A change in applicable statutes and regulations or regulatory policy cannot be predicted, but may have a material effect on the business of the Company and/or the Bank.

Bank holding companies and banks are prohibited by law from engaging in unsafe and unsound banking practices. Federal and New York State banking laws, regulations and policies extensively regulate the Company and the Bank including prescribing standards relating to capital, earnings, dividends, the repurchase or redemption of shares, loans or extension of credit to affiliates and insiders, internal controls, information systems, internal audit systems, loan documentation, credit underwriting, asset growth, impaired assets and loan to value ratios. Such laws and regulations are intended primarily for the protection of depositors, other customers and the federal deposit insurance funds and not for the protection of security holders. Bank regulatory agencies have broad examination and enforcement power over bank holding companies and banks, including the power to impose substantial fines, limit dividends and restrict operations and acquisitions.

A bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit all available resources to support such institutions in circumstances where it might not do so absent such policy. Consistent with this “source of strength” policy, the FRB takes the position that a bank holding company generally should not maintain a rate of cash dividends unless its net income available to common stockholders is sufficient to fully fund the dividends and the prospective rate of earnings retention appears to be consistent with the company’s capital needs, asset quality and overall financial condition. In addition, any loans by the Company to the Bank would be subordinate in right of payment to depositors and to certain other indebtedness of the Bank.

Acquisitions

As a bank holding company, the Company may not acquire direct or indirect ownership or control of more than 5% of the voting shares of any company, including a bank, without the prior approval of the FRB, except as specifically authorized under the BHCA. Under the BHCA, the Company, subject to the approval of or notice to the FRB, may acquire shares of non-banking corporations, the activities of which are deemed by the FRB to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.

The Change in Bank Control Act prohibits a person or group of persons from acquiring “control” of a bank holding company unless the FRB has been notified and has not objected to the transaction. Under a rebuttable presumption established by the FRB, the acquisition of 10% or more of a class of voting stock of a bank holding company with a class of securities registered under Section 12 of the Exchange Act, would, under the circumstances set forth in the presumption, constitute acquisition of control of the Company. In addition, any entity is required to obtain the approval of the FRB under the BHCA before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of the Company’s outstanding common stock, or otherwise obtaining control or a “controlling influence” over the Company. The New York Banking Law (the “Banking Law”) similarly regulates a change in control affecting the Bank and requires the approval of the New York State Banking Board.

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, as amended (the “Interstate Banking Act”), generally permits bank holding companies to acquire banks in any state, and preempts all state laws restricting the ownership by a bank holding company of banks in more than one state. The Interstate Banking Act also permits a bank to merge with an out-of-state bank and convert any offices into branches of the resulting bank if both states have not opted out of interstate branching; permits a bank to acquire branches from an out-of-state bank if the law of the state where the branches are located permits the interstate branch acquisition; and permits banks to establish and operate de novo interstate branches whenever the host state opts-in to de novo branching. Bank holding companies and banks seeking to engage in transactions authorized by the Interstate Banking Act must be adequately capitalized and managed. The Banking Law authorizes interstate branching by merger or acquisition on a reciprocal basis, and permits the acquisition of a single branch without restriction, but does not provide for de novo interstate branching.

Capital Adequacy

The federal bank regulators have adopted risk-based capital guidelines for bank holding companies and banks. The minimum ratio of qualifying total capital (“total capital”) to risk-weighted assets (including certain off-balance sheet items) is 8%. At least half of the total capital must consist of common stock, retained earnings, qualifying noncumulative perpetual preferred stock, minority interests in the equity accounts of consolidated subsidiaries and, for bank holding companies, a limited amount of non-cumulative perpetual preferred stock, trust preferred securities and certain other so-called “restricted core capital elements” less most intangibles including goodwill (“Tier I capital”). The remainder (“Tier II capital”) may consist of certain other preferred stock, certain other capital instruments, and limited amounts of subordinated debt and the allowance for loan and lease losses. Restricted core capital elements are currently limited to 25% of Tier I capital.

The federal banking regulators have adopted risk-based capital and leverage guidelines that require the Company’s and the Bank’s capital-to-assets ratios meet certain minimum standards. The risk-based capital ratio is determined by allocating assets and specified off-balance sheet financial instruments into four weighted categories, with higher levels of capital being required for the categories perceived as representing greater risk. For a further discussion, see the Notes to the Company’s Consolidated Financial Statements.

In addition, the FRB has established minimum guidelines for the “leverage ratio” of Tier I capital to average total assets for bank holding companies and banks. The FRB’s guidelines provide for a minimum leverage ratio of 3% for bank holding companies and banks that meet certain specified criteria, including those having the highest supervisory rating. All other banking organizations are required to maintain a leverage ratio of at least 4%. At December 31, 2007, the FRB had not advised the Company of any specific minimum leverage ratio applicable to it.

The FRB guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.

At December 31, 2007, the Bank’s Tier I leverage ratio was 7.43% while its risk-based capital ratios were 10.62% for Tier I capital and 11.85% for total capital. These ratios exceed the minimum regulatory guidelines for a well-capitalized institution.

Prompt Corrective Action

The Federal Deposit Insurance Act (“FDIA”) requires, among other things, that federal banking regulators take prompt corrective action in respect of FDIC-insured depository institutions that do not meet minimum capital requirements. The FDIA specifies five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized.” A depository institution’s capital tier will depend upon how its capital levels compare to various relevant capital measures and certain other factors, as established by regulation.

Under applicable regulations, an FDIC-insured bank is deemed to be: (i) well capitalized if it maintains a leverage ratio of at least 5%, a Tier I capital ratio of at least 6% and a total capital ratio of at least 10% and is not subject to an order, written agreement, capital directive, or prompt corrective action directive to meet and maintain a specific level for any capital measure; (ii) adequately capitalized if it maintains a leverage ratio of at least 4% (or a leverage ratio of at least 3% if it received the highest supervisory rating in its most recent report of examination, subject to appropriate federal banking agency guidelines, and is not experiencing or anticipating significant growth), a Tier I capital ratio of at least 4% and a total capital ratio of at least 8% and is not defined to be well capitalized; (iii) undercapitalized if it has a leverage ratio of less than 4% (or a leverage ratio that is less than 3% if it received the highest supervisory rating in its most recent report of examination, subject to appropriate federal banking agency guidelines, and is not experiencing or anticipating significant growth), a Tier I capital ratio less than 4% or a total capital ratio of less than 8% and it does not meet the definition of a significantly undercapitalized or critically undercapitalized institution; (iv) significantly undercapitalized if it has a leverage ratio of less than 3%, a Tier I capital ratio of less than 3% or a total capital ratio of less than 6% and it does not meet the definition of critically undercapitalized; and (v) critically undercapitalized if it maintains a level of tangible equity capital of less than 2% of total assets. A bank may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position if it receives an unsatisfactory examination rating. The FDIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the capital category in which an institution is classified. A depository institution that is not well capitalized is also subject to certain limitations on brokered deposits and Certificate of Deposit Account Registry Service (“CDARS”) deposits.

The FDIA generally prohibits an FDIC-insured depository institution from making any capital distribution (including payment of dividends) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to restrictions on borrowing from the Federal Reserve and to growth limitations, and are required to submit a capital restoration plan. For a capital restoration plan to be acceptable, any holding company must guarantee the capital plan up to an amount equal to the lesser of 5% of the depository institution’s assets at the time it became undercapitalized and the amount of the capital deficiency at the time it fails to comply with the plan. In the event of the holding company’s bankruptcy, such guarantee would take priority over claims of its general unsecured creditors. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized.

Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cessation of receipt of deposits from correspondent banks. Critically undercapitalized depository institutions are subject to appointment of a receiver or conservator.

Deposit Insurance

The FDIC merged the Savings Association Insurance Fund and the Bank Insurance Fund to create the DIF on March 31, 2006. The Bank is a member of the DIF and pays its deposit insurance assessments to the DIF. Effective January 1, 2007, the FDIC established a new risk-based assessment system for determining the deposit insurance assessments to be paid by insured depository institutions. Under this new assessment system, the FDIC assigns an institution to one of four risk categories, with the first category having two sub-categories, based on the institution’s most recent supervisory ratings and capital ratios. Base assessment rates range from two to four basis points for Risk Category I institutions and are seven basis points for Risk Category II institutions, twenty-five basis points for Risk Category III institutions and forty basis points for Risk Category IV institutions. For institutions within Risk Category I, assessment rates generally depend upon Capital adequacy, Asset quality, Management, Earnings, Liquidity, Sensitivity to market risk, or CAMELS component ratings, and financial ratios, or for large institutions with long-term debt issuer ratings, assessment rates will depend on a combination of long-term debt issuer ratings and CAMELS component ratings. The FDIC has the flexibility to adjust rates, without further notice-and-comment rulemaking, provided that no such adjustment can be greater than three basis points from one quarter to the next, that adjustments cannot result in rates more than three basis points above or below the base rates and that rates cannot be negative. Effective January 1, 2007, the FDIC set the assessment rates at three basis points above the base rates. Assessment rates, therefore, currently range from five to forty-three basis points of deposits. The deposit insurance assessment rates are in addition to the assessments for payments on the bonds issued in the late 1980’s by the Financing Corporation (“FICO”) to recapitalize the now defunct Federal Savings and Loan Insurance Corporation. For 2007, the Bank had an assessment rate of five basis points and a total expense of $167 thousand for the assessment for deposit insurance and the FICO payments. The FDIC also established 1.25% of estimated insured deposits as the designated reserve ratio of the DIF. The FDIC is authorized to change the assessment rates as necessary, subject to the previously discussed limitations, to maintain the required reserve ratio of 1.25%.

The FDIC also approved a one-time assessment credit to institutions that were in existence on December 31, 1996 and paid deposit insurance assessments prior to that date, or are a successor to such an institution. The Bank received a $649 thousand one-time assessment credit, of which $547 thousand was used to offset 100% of the 2007 deposit insurance assessment, excluding the FICO payments. The remaining credit of $102 thousand can be used to offset up to 90% of the 2008 deposit insurance assessment.

Under the FDIA, the FDIC may terminate the insurance of an institution’s deposits upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. The management of the Company does not know of any practice, condition or violation that might lead to termination of its deposit insurance.

Transactions with Affiliates and the Bank

The Bank is subject to the affiliate and insider transaction rules set forth in Sections 23A, 23B, 22(g) and 22(h) of the Federal Reserve Act (“FRA”), and Regulation W issued by the FRB. These provisions, among other things, prohibit or limit an insured bank from extending credit to, or entering into certain transactions with, its affiliates (which for the Bank would include the Company) and principal stockholders, directors and executive officers. The FRB requires depository institutions that are subject to Sections 23A and 23B to implement policies and procedures to ensure compliance with Regulation W regarding transactions with affiliates.

Section 402 of the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) prohibits the extension of personal loans to directors and executive officers of issuers (as defined in Sarbanes-Oxley). The prohibition, however, does not apply to mortgages advanced by an insured depository institution, such as the Bank, that are subject to the insider lending restrictions of Section 22(h) of the FRA.

CEO BACKGROUND

Thomas M. O’Brien has served as President and Chief Executive Officer of the Company and the Bank since 2007 and President and Chief Operating Officer of the Company and the Bank from 2006 until 2007. Mr. O’Brien is responsible for developing and executing the strategic plans and policies as approved by the Board of Directors. Prior to joining the Company, Mr. O’Brien served as President and Chief Executive Officer of Atlantic Bank of New York from 2000 to April 2006. Following Atlantic Bank of New York’s acquisition by New York Community Bancorp in April 2006, Mr. O’Brien served as President of New York Commercial Bank, a subsidiary of New York Community Bancorp, until July 2006.

Brian K. Finneran has served as Executive Vice President and Chief Financial Officer of the Company and the Bank since 1997. Mr. Finneran is responsible for treasury operations, budgeting, investments, asset/liability management, accounting operations, financial and tax reporting and planning, and municipal and professional services banking.

Frederick C. Braun, III has served as Executive Vice President and Chief Lending Officer of the Bank since 1997. Mr. Braun is responsible for commercial, industrial, real estate and personal lending of the Bank.

Patricia M. Schaubeck, an attorney, has served as General Counsel of the Company and the Bank since 2007. Prior to joining the Bank, Ms. Schaubeck practiced law with the Long Island firm of Ruskin Moscou Faltischek, P.C. where she represented financial institutions and real estate clients from 2001 to May 2007. From 1999 to 2001, Ms. Schaubeck served as Associate General Counsel with Haven Bancorp, Inc. in Westbury, New York. Ms. Schaubeck has also been associated with White & Case, LLP and other New York City law firms as well as serving in various capacities with New York Bancorp, Inc., a Queens-based savings and loan holding company.

MANAGEMENT DISCUSSION FROM LATEST 10K

Executive Summary

The Company is a one-bank holding company, which was formed in 1986. The Company operates as the parent for its wholly owned subsidiary, State Bank of Long Island and its subsidiaries (the “Bank”), a New York State chartered commercial bank founded in 1966, and the Company’s unconsolidated wholly owned subsidiaries, State Bancorp Capital Trust I and State Bancorp Capital Trust II (collectively the “Trusts”), entities formed in 2002 and 2003, respectively, to issue trust preferred securities. The income of the Company is principally derived through the operation of the Bank and its subsidiaries, SB Portfolio, SB Financial, SWLC, New Hyde Park Leasing Corp. and SB ORE Corp.

The Bank serves its customer base through sixteen full-service branches and a lending center in Jericho, NY. Of the Bank’s branch locations, eight are in Nassau County, five are in Suffolk County and three are in Queens County. In February 2008, the Bank opened a corporate banking branch in Manhattan. The Bank offers a full range of banking services to corporations, municipalities, small to medium-sized businesses and individuals. Retail and commercial products include checking accounts, NOW accounts, money market accounts, savings accounts, certificates of deposit, individual retirement accounts, commercial loans, construction loans, home equity loans, commercial mortgage loans, consumer loans, small business lines of credit, equipment leases, cash management services and telephone and online banking. In addition, the Bank also provides access to residential loans, annuity products, mutual funds and a wide range of wealth management and financial planning services. The Company’s loan and lease portfolio is concentrated in commercial and industrial loans and commercial mortgages. The Bank does not engage in subprime lending and does not offer payment option ARMs or negative amortization loan products.

SB Portfolio and SB Financial are each wholly owned subsidiaries of the Bank. SB Portfolio provides investment management services to the Bank while SB Financial provides balance sheet management services such as interest rate risk modeling, asset/liability management reporting and general advisory services to the Bank. The Company also owns SWLC, a nationwide provider of business equipment leasing that has been conducting business for over thirty years. The Company recently made the strategic decision to exit the leasing business, and is in active discussions to sell SWLC for an amount that approximates tangible book value to an out-of-state firm whose main focus is the equipment leasing business.

As of December 31, 2007, the Company, on a consolidated basis had total assets of approximately $1.6 billion, total deposits of approximately $1.3 billion and stockholders’ equity of approximately $114 million. Unless the context otherwise requires, references herein to the Company include the Company and its subsidiaries on a consolidated basis.

For the year ended December 31, 2007, the Company recorded record levels of loans and leases and stockholders’ equity. In 2007, a number of significant strategic initiatives across the organization were implemented to comprehensively address the challenges that curtailed the Company’s strategic growth and profitability in recent years. These initiatives centered on a restructuring of critical areas of the Company, resulting in the realignment of resources, combined with the addition of several individuals in key management positions throughout the Company. These investments have resulted in a solid foundation upon which we can effectively execute our strategic plans for future growth. The aggressive realignment of our organizational structure has allowed us to more efficiently pursue our business growth opportunities. Compared with the fourth quarter of 2006, full-time equivalent head count, including the impact of the intended sale of the leasing business conducted through SWLC discussed below, is projected to be down by 47 or 14%. The Company has also strengthened its corporate governance and internal controls through the appointment of a General Counsel, Chief Auditor, Comptroller, BSA Officer, Information Security Officer and Security Director. The marketing and planning functions have also been strengthened with the appointment of a Chief Marketing and Corporate Planning Officer. The Company also appointed a Director of Credit Review and, during the fourth quarter, we completed an exhaustive assessment of our technology and operational infrastructure and appointed a Chief Information Officer to implement system enhancements to support our future expansion.

The Company recently concluded a comprehensive review of its wholly owned subsidiary SWLC. After carefully assessing its available alternatives, the Company has made the strategic decision to exit the leasing business, and is in active discussions to sell the leasing business conducted through SWLC to an out-of-state firm whose main focus is the equipment leasing business. The Company chose this course of action in order to significantly reduce its operating expenses, improve its operating efficiency ratio and to more effectively allocate capital resources to its core commercial lending and branch banking operations. The decision to exit the leasing business represents the final phase of our corporate restructuring and allows the Company to redeploy the capital resources formerly committed to the leasing operation towards its core commercial lending and branch banking operations. The divesture, expected to be completed in the second quarter of 2008, will result in a decrease in net interest income of approximately $4 million, an annual operating expense savings to the Company of approximately $3 million and an improved operating efficiency ratio. As a result of this decision, the Company recorded a goodwill impairment accounting charge of $2.4 million in 2007 in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, representing the entire remaining goodwill balance resulting from the 2001 acquisition of SWLC.

The Company has experienced deposit and loan pricing pressures that are expected to continue into 2008. The Company is facing an ever expanding array of competitors for its very attractive core niche of small business, middle market commercial and industrial and municipal customers. These competitors are entering the marketplace through de novo branching, acquisitions and strategic alliances. The Company remains focused on expanding its core commercial business relationships, expense reduction initiatives, capital management and strategies to improve non-interest income generation. The Company expects to continue to expand its staff of professional bankers in several areas to achieve the foregoing objectives. We anticipate that future industry consolidation should provide the Company with the opportunity to add experienced, relationship-oriented bankers to its staff to support future growth and market penetration. Having successfully completed a senior management transition earlier this year, the Company is poised to remain focused on the basics of commercial banking: loan growth, deposit generation, increased market share, improved operational efficiency and enhanced brand building.

The Company recorded net income of $6.2 million in 2007 versus $11.5 million in 2006. The reduction in net income during 2007 results from several factors, most significantly a reduction in net interest income combined with lower non-interest income and increases in the provision for loan and lease losses and total operating expenses. Partially offsetting these unfavorable variances in 2007 was a reduction in the provision for income taxes. Basic earnings per common share of $0.45 were recorded in 2007 versus $1.02 a year ago. Diluted earnings per common share of $0.45 and $1.00 were recorded in 2007 and 2006, respectively. The reduction in net interest income in 2007 is attributable to a 19 basis point decline in the Company’s net interest margin, reflecting continued loan and deposit pricing pressure. The decline in non-interest income in 2007 is due to reductions in deposit service charges coupled with an increase in net security losses, offset partially by increased earnings from bank owned life insurance. The increase in the provision for loan and lease losses in 2007 is a result of higher net charge-offs combined with increases in non-performing and classified assets. The increase in total operating expenses in 2007 is primarily the result of higher salaries and other employee benefits, legal expenses and the previously mentioned goodwill impairment accounting charge. The increase in salaries and other employee benefits in 2007 is predominately due to the one-time charge pertaining to termination costs associated with those employees who participated in the Voluntary Exit Window program, details of which were reported in the Company’s Form 8-K filing with the SEC on June 5, 2007. The Board of Directors took this action to increase operating efficiency, among other reasons, by reducing overhead costs as part of an ongoing program to improve profitability. Legal expenses increased in 2007 compared to 2006 largely due to a $12.1 million reversal of previously accrued compensatory damages and interest recorded in 2006 related to the Island Mortgage Network, Inc. (“IMN”) litigation settlement. As reported in a Form 8-K filing with the SEC on July 24, 2007, the Company is a nominal defendant in a purported shareholder derivative lawsuit (see Part I-Item 3.-“Legal Proceedings”). The 2007 legal expenses include outside counsel fees of $1.9 million relating to this matter.

Total assets of the Company were $1.6 billion at December 31, 2007 compared to $1.8 billion at December 31, 2006. This decrease was principally attributable to a reduction of $110 million in the available for sale securities portfolio, substantially due to a net reduction in Government agency securities, coupled with declines in overnight securities purchased under agreements to resell and federal funds sold of $70 million and $29 million, respectively. The foregoing reductions resulted largely from the funding of the $65 million IMN judgment, the withdrawal of seasonal deposits by municipal entities and the maturities of promotional rate retail CDs. At December 31, 2007, total deposits were $1.3 billion compared to $1.6 billion at December 31, 2006. Short-term borrowed funds, consisting primarily of Federal Home Loan Bank of New York (“FHLB”) advances, totaled $139 million at December 31, 2007, compared to no such borrowings at December 31, 2006. The increase in borrowings was a replacement for higher-cost maturing retail CDs and municipal deposits.

As a result of the decrease in the Company’s net income in 2007 versus 2006, return on average assets declined to 0.37% in 2007 from 0.68% in 2006. Reflecting the 2007 decline in net income and an increase in average shareholders’ equity in 2007 versus 2006, return on average stockholders’ equity declined to 5.70% in 2007 from 18.39% in 2006. Due to the combined effect of the interest rate environment prevailing in 2007 coupled with competition in both loan and deposit pricing, the Company’s net interest margin narrowed by 19 basis points to 3.82% in 2007 versus 4.01% in 2006.

The Company’s primary market area of Nassau, Suffolk and Queens Counties provides tremendous opportunity for deposit growth and commercial and industrial lending. Over five million people live and work in the tri-county area and over 137,000 businesses are located here. The recent decline of the real estate market does not appear to have impacted the Company to any significant degree during 2007; however, management and staff at the Company continue to monitor this market closely. To date, we have not experienced an adverse impact from the subprime mortgage crisis since, by policy, we do not engage in subprime lending. Further, the primary focus of the Company’s loan portfolio is commercial real estate and commercial and industrial loans with residential lending constituting approximately 10% of our loan portfolio at December 31, 2007. Loan demand was stable in 2007 and the Company is poised to expand its loan portfolio in 2008. The average balance of total loans and leases for 2007 increased by 7% versus 2006. The Company’s securities portfolio contains no subprime structured debt, exotic structures or other hard to value instruments. At December 31, 2007, the market value of the securities portfolio represented 100.2% of book value. Additionally the Company’s liquidity remains strong as a result of our stable deposit base, ample borrowing capacity secured by liquid assets and other funding sources. Management of the Company is aware, however, that economic conditions are inextricably linked to both the outlook for interest rates and consumer and business confidence. Business expansion showed signs of weakness in 2007, with some economists predicting a downturn in the national economy in 2008. This outlook, in conjunction with the volatility of world events, the uncertain outlook for a sustained return to a more traditionally shaped yield curve and the uncertain long-term outlook for the real estate values, may result in negatively impacted near-term economic growth in the Company’s trade area.

Recognizing the economic uncertainty previously noted, we expect to achieve modest loan growth in our core competencies of commercial and industrial credits and commercial mortgages in 2008. We expect that interest rate spreads will continue to tighten due to competitive pressures, resulting in a narrowing of our interest rate margin on most loan and lease offerings. Funding costs are expected to rise slightly during 2008 as competitive pressures are expected to push up deposit rates and the continued disintermediation of low cost core deposit balances into CD products remains a factor. We expect that, notwithstanding the improved shape of the yield curve, our net interest margin may decline modestly in 2008 from current levels.

It is management’s intent for the Company’s branch network to provide funding to support anticipated asset growth, supplemented with short-term borrowings as needed. The Company will continue to pursue product delivery and back office expense reductions and operating efficiencies along with revenue-generating sales initiatives to improve net income. Some of these initiatives may result in the occurrence of initial implementation costs to allow the realization of longer term financial benefits.

Results of Operations and Financial Condition

Net Interest Income

Distribution of Assets, Liabilities and Stockholders’ Equity: Net Interest Income and Rates

The following table presents the average daily balances of the Company’s assets, liabilities and stockholders’ equity, together with an analysis of net interest earnings and average rates, for each major category of interest-earning assets and interest-bearing liabilities. Interest and average rates are computed on a fully taxable-equivalent basis, adjusted for certain disallowed interest expense deductions, using a tax rate of 34%.

Analysis of Changes in Net Interest Income

The following table presents a comparative analysis of the changes in the Company’s interest income and interest expense due to the changes in the average volume and the average rates earned on interest-earning assets and due to the changes in the average volume and the average rates paid on interest-bearing liabilities. Interest and average rates are computed on a fully taxable-equivalent basis, adjusted for certain disallowed interest expense deductions, using a tax rate of 34%.

2007 versus 2006

Net interest income, the difference between interest earned on loans and leases and investments, and interest paid on deposits and borrowed funds, is the Company’s primary source of operating earnings. Net interest income is influenced by the average balance and mix of the Company’s interest-earning assets, the yield on those assets and the current level of market interest rates. These rates are significantly influenced by the actions of the Federal Reserve Open Market Committee (“FOMC”), which periodically adjusts the federal funds rate, the rate at which banks borrow funds from one another on an overnight basis. During the last four months of 2007, the FOMC lowered the federal funds rate three times from 5.25% to its year-end 2007 level of 4.25%.

Net interest income decreased 3.3% to $60.2 million as a result of a 19 basis point decline in the Company’s net interest margin to 3.82% in 2007. The decline in the Company’s net interest margin was due primarily to the interest rate environment prevailing throughout 2007, characterized by higher short term rates and relative lack of slope in the yield curve, combined with significant competition in loan and deposit pricing. Partially offsetting the narrower margin was a 2% increase in average interest-earning assets, primarily loans. Growth in commercial loans and commercial mortgages resulted in a 7% increase in average loans and leases outstanding to $1.0 billion during 2007 versus 2006. The average investment portfolio contracted by 6% to $505 million during 2007 versus 2006, principally due to an anticipated runoff of U.S. Government Agency securities. Cash flows from this runoff were utilized, in part, to support loan growth. Also supporting the increase in interest-earning assets were increases in average borrowings, consisting primarily of Federal Home Loan Bank of New York (“FHLB”) overnight and short-term advances, and stockholders’ equity of $97 million and $47 million, respectively. This funding partially offsets the $66 million decrease in average deposits that resulted primarily from outflows of higher-cost promotional rate retail CDs and municipal deposits.

Average core deposit balances, consisting of demand, savings, money fund and NOW deposits, declined by $42 million in 2007 to $940 million as compared to 2006, and provided funding at an average cost of 1.97% in 2007 as compared to 1.79% in 2006. These core deposit balances funded 59% and 63% of the Company’s average interest-earning assets during 2007 and 2006, respectively, and represented 66% of total average deposits in both years. Core deposit balances provide lower-cost funding that allows the Company to reduce its dependence on higher-cost borrowings.

The narrowing of the Company’s net interest margin to 3.82% during 2007 from 4.01% a year ago resulted from a 36 basis point increase in the Company’s cost of funds, principally due to competitive deposit pricing pressure combined with a shift in the funding mix from core deposits to borrowings. This higher cost of funds was offset somewhat by a 17 basis point increase in the Company’s earning asset yield to a weighted average rate of 7.01%. The higher asset yield resulted from the impact of higher rates and loan growth in 2007. The higher yield was achieved despite the competitive pressures faced on pricing loan products that caused the average yield on loans and leases to decline by eight basis points, which caused the average yield on all interest earning assets to increase at a slower pace than the average cost of funds.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

Executive Summary – State Bancorp, Inc. (the “Company”) is a one-bank holding company, which was formed in 1986. The Company operates as the parent for its wholly owned subsidiary, State Bank of Long Island and its subsidiaries (the “Bank”), a New York State chartered commercial bank founded in 1966, and the Company’s unconsolidated wholly owned subsidiaries, State Bancorp Capital Trust I and State Bancorp Capital Trust II (collectively the “Trusts”), entities formed in 2002 and 2003, respectively, to issue trust preferred securities. The income of the Company is principally derived through the operation of the Bank and its subsidiaries, SB Portfolio, SB Financial, SWLC, New Hyde Park Leasing Corp. and SB ORE Corp.

The Bank maintains its corporate headquarters in Jericho, NY and serves its customer base through seventeen branches in Nassau, Suffolk, Queens and Manhattan. The Bank offers a full range of banking services to our diverse customer base which includes commercial real estate owners and developers, small to middle market businesses, professional service firms, municipalities and consumers. Retail and commercial products include checking accounts, NOW accounts, money market accounts, savings accounts, certificates of deposit, individual retirement accounts, commercial loans, construction loans, commercial mortgage loans, consumer loans, small business lines of credit, cash management services and telephone and online banking. In addition, the Bank also provides access to residential loans, annuity products, mutual funds and a wide range of wealth management and financial planning services. The Company’s loan and lease portfolio is concentrated in commercial and industrial loans and commercial mortgages. The Bank does not engage in subprime lending and does not offer payment option ARMs or negative amortization loan products.

SB Portfolio and SB Financial are each wholly owned subsidiaries of the Bank. SB Portfolio provides investment management services to the Bank while SB Financial provides balance sheet management services such as interest rate risk modeling, asset/liability management reporting and general advisory services to the Bank. An agreement has been signed with Main Street Bank of Kingwood, Texas for the sale of substantially all of the assets of the Bank’s leasing subsidiary, SWLC, at an amount that approximates tangible book value. The sale, which is subject to customary closing conditions, is expected to be completed in the second quarter of 2008. We anticipate that the sale will result in a decrease in net interest income on an annualized basis of approximately $4 million, an annual operating expense savings to the Company of approximately $3 million and an improved operating efficiency ratio. The sale proceeds will be utilized to fund growth in the Company’s commercial loan and commercial mortgage portfolios.

As of March 31, 2008, the Company, on a consolidated basis, had total assets of approximately $1.6 billion, total deposits of approximately $1.3 billion and stockholders’ equity of approximately $116 million. Unless the context otherwise requires, references herein to the Company include the Company and its subsidiaries on a consolidated basis.


Having successfully completed a senior management transition in 2007, the Company is refocused on loan growth, deposit generation, increased market share, improved operational efficiency and enhanced brand building. However, the Company has experienced deposit and loan pricing pressures that are expected to continue throughout the current year. The Company faces numerous competitors for its very attractive core niche of small business, middle market commercial and industrial and municipal customers. Some of these competitors have entered the marketplace through de novo branching, acquisitions and strategic alliances. The Company remains focused on expanding its core commercial business relationships, expense reduction initiatives, capital management and strategies to improve non-interest income generation. The Company expects to continue to expand its staff of professional bankers in selected areas to achieve the foregoing objectives. We anticipate that future industry consolidation should provide the Company with the opportunity to add experienced, relationship-oriented bankers to its staff to support future growth and market penetration.

The Company recorded net income of $3.0 million and $1.7 million for the first quarter of 2008 and 2007, respectively. The increase in net income during 2008 primarily reflects growth in net interest income and non-interest income, and a reduction in total operating expenses. Diluted earnings per common share of $0.21 were recorded in the first quarter of 2008 compared to $0.13 in the first quarter of 2007. The growth in the Company’s net interest income during the first quarter of 2008 as compared to a year ago resulted primarily from a decrease in the Company’s cost of funds, as the Company has chosen to use more attractively priced borrowings to fund some loan volume rather than offer high rates to raise deposits in a highly competitive environment . Total operating expenses decreased by 5.8% to $11.1 million

during the first quarter of 2008 when compared to the first quarter of 2007. The decrease in total operating expenses primarily reflects reductions in salaries and other employee benefits and marketing and advertising, partially offset by an increase in legal expenses. The Company is a nominal defendant in a purported shareholder derivative lawsuit (see Part II – Item 1 – “Legal Proceedings”). First quarter 2008 legal expenses include $1.1 million of legal fees and expenses consisting of the advancement of legal costs for possible indemnification of individual defendants and outside legal costs incurred by the Company and the Company’s Special Litigation Committee.

Total assets of the Company were $1.6 billion at March 31, 2008 and December 31, 2007. At March 31, 2008 and December 31, 2007, total deposits were $1.3 billion. Short-term borrowed funds, primarily Federal Home Loan Bank of New York (“FHLB”) advances and federal funds purchased, totaled $179 million at March 31, 2008, compared to $139 million at December 31, 2007. The increase in borrowings was a replacement for higher-cost maturing retail certificates of deposit and municipal deposits.

As a result of the increase in the Company’s net income in the first quarter of 2008 versus the first quarter of 2007, returns on average assets and average stockholders’ equity improved. The Company’s return on average assets improved to 0.72% in the first quarter of 2008 from 0.41% in the first quarter of 2007, while our return on average stockholders’ equity improved to 10.45% in the first quarter of 2008 from 6.66% in the first quarter of 2007. Primarily due to the decrease in the Company’s cost of funds mentioned above, the Company’s net interest margin improved by 32 basis points to 4.00% in the first quarter of 2008 from 3.68% in the first quarter of 2007.

The Company’s primary market area of Nassau, Suffolk, Queens and Manhattan provides tremendous opportunity for deposit growth and commercial and industrial lending. Management and staff at the Company continue to closely monitor the overall effects of the recent decline in the local real estate market and its potential impact on the Company. To date, we have not experienced a material impact from the subprime mortgage crisis since, by policy, we do not engage in subprime lending. Further, the primary focus of the Company’s loan and lease portfolio is commercial real estate and commercial and industrial loans with residential lending constituting less than 10% of our total portfolio at March 31, 2008. Loan demand remains stable, and the Company continues to expand its loan portfolio. The Company’s securities portfolio contains no subprime structured debt, exotic structures or other hard to value instruments. At March 31, 2008, the market value of the securities portfolio represented 100.2% of book value. Management of the Company is aware, however, that the significant decline in the residential lending market, deterioration in real estate values and the continuing credit crisis have contributed to the current downturn in the national economy which is likely to impact the outlook for interest rates and consumer and business confidence. These factors, along with the uncertain outlook for a sustained return to a more traditionally shaped yield curve and the uncertain long-term outlook for real estate values, may impact near-term economic growth in the Company’s market area and adversely affect the Company’s future performance.

Recognizing the economic uncertainty previously noted, we expect to achieve modest loan growth in our core competencies of commercial and industrial credits and commercial mortgages throughout 2008. We expect that interest rate spreads may tighten due to competitive pressures, resulting in a narrowing of our interest rate margin on most loans. The Company has chosen to use more attractively priced borrowings to fund some loan volume rather than deploy high rates to raise deposits in a highly competitive environment. Thus, funding costs are expected to rise during 2008 as competitive pressures are expected to push up deposit rates. The continued disintermediation of low cost core deposit balances into CD products remains a factor. Management expects that, notwithstanding the improved shape of the yield curve, the Company’s net interest margin may decline modestly during the remainder of 2008 from current levels.

It is management’s intent for the Company’s branch network to provide funding to support anticipated asset growth, supplemented with short-term borrowings as needed. The Company will continue to pursue product delivery and back office expense reductions and operating efficiencies along with revenue-generating sales initiatives to improve net income. Some of these initiatives may result in the recording of initial costs in order to achieve longer term financial benefits.

Critical Accounting Policies, Judgments and Estimates - The discussion and analysis of the financial condition and results of operations of the Company are based on the Unaudited Condensed Consolidated Financial Statements contained in this Quarterly Report on Form 10-Q, which are prepared in conformity with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions affecting the reported amounts of assets, liabilities, revenues and expenses. Management evaluates those estimates and assumptions on an ongoing basis, including those related to the allowance for loan and lease losses, income taxes, other-than-temporary impairment of investment securities and recognition of contingent liabilities. Management bases its estimates on historical experience and various other factors and assumptions that are believed to be reasonable under the circumstances. These form the basis for making judgments on the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from those estimates under different assumptions or conditions.

Allowance for Loan and Lease Losses - In management’s opinion, one of the most critical accounting policies impacting the Company’s financial statements is the evaluation of the allowance for loan and lease losses. Management carefully monitors the credit quality of the portfolio and charges off the amounts of those loans and leases deemed uncollectible. Management evaluates the fair value of collateral supporting any impaired loans and leases using independent appraisals and other measures of fair value. This process involves subjective judgments and assumptions and is subject to change based on factors that may be outside the control of the Company.

Management of the Company recognizes that, despite its best efforts to minimize risk through its credit review process, losses will inevitably occur. In times of economic slowdown, regional or national, the credit risk inherent in the Company’s loan and lease portfolio will increase. The timing and amount of loan and lease losses that occur are dependent upon several factors, most notably qualitative and quantitative factors about both the micro and macro economic conditions as reflected in the loan and lease portfolio and the economy as a whole. Factors considered in the evaluation of the allowance for loan and lease losses include, but are not limited to, estimated losses from loan and lease and other credit arrangements, general economic conditions, changes in credit concentrations or pledged collateral, historical loan and lease loss experience and trends in portfolio volume, maturity, composition, delinquencies and non-accruals. The allowance for loan and lease losses is established to absorb probable loan and lease charge-offs. Additions to the allowance are made through the provision for loan and lease losses, which is a charge to current operating earnings. The adequacy of the provision and the resulting allowance for loan and lease losses is determined by management’s continuing review of the loan and lease portfolio, including identification and review of individual problem situations that may affect a borrower’s ability to repay, delinquency and non-performing loan data, collateral values, regulatory examination results and changes in the size and character of the loan and lease portfolio. Despite such a review, the level of the allowance for loan and lease losses remains an estimate and cannot be precisely determined.

Based on current economic conditions, management has determined that the current level of the allowance for loan and lease losses appears to be adequate in relation to the probable losses present in the portfolio. Management considers many factors in this analysis, among them credit risk grades assigned to commercial loans, delinquency trends, concentrations within segments of the loan and lease portfolio, recent charge-off experience and local economic conditions. Commercial loans are assigned credit risk grades using a scale of one to ten with allocations for probable losses made for pools of similar risk-graded loans. Loans with signs of credit deterioration, generally in grades eight through ten, are termed “classified” loans in accordance with guidelines established by the Company’s regulators. Management assigns allocation factors ranging from 24% to 100% of the outstanding classified loan balance, which are based on the Company’s historic loss experience, and uses these amounts when analyzing the adequacy of the allowance for loan and lease losses. Loans that have potential weaknesses, generally in grade seven, that require close monitoring by senior management, are termed “criticized” loans in accordance with regulatory guidelines. Criticized loans are assigned an allocation factor of 4% based on historic loss experience. Non-accrual loans and leases in excess of $250 thousand are individually evaluated for impairment and are not included in these risk grade pools. A loan is considered “impaired” when, based on current information and events, it is probable that both the principal and interest due under the original contractual terms will not be collected. The Company measures impairment of collateralized loans based on the estimated fair value of the collateral, less estimated costs to sell. For loans that are not collateral-dependent, impairment is measured by using the present value of expected cash flows, discounted at the loan’s effective interest rate. Allocations for loans which are performing satisfactorily, generally in grades one through six, are based on historic experience for other performing loans and leases and are currently assigned an allocation factor of 0.50% of the loan balance. An allowance allocation factor for portfolio macro factors ranging from 1-20 basis points is calculated to cover potential losses from a number of variables, not the least of which is the current economic uncertainty.

It is the present intent of management to continue to monitor the level of the allowance for loan and lease losses in order to properly reflect its estimate of the exposure, if any, represented by fluctuations in the local real estate market and the underlying value that market provides as collateral to certain segments of the loan and lease portfolio. The provision is continually evaluated relative to portfolio risk and regulatory guidelines and will continue to be closely reviewed throughout the coming year. In addition, various bank regulatory agencies, as an integral part of their examination process, closely review the allowance for loan and lease losses. Such agencies may require the Company to recognize additions to the allowance based on their judgment of information available to them at the time of their examinations.

Accounting for Income Taxes - The Company accounts for income taxes in accordance with SFAS No. 109 and FIN 48, which require the recording of deferred income taxes that reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Management exercises significant judgment in the evaluation of the amount and timing of the recognition of the resulting tax assets and liabilities. The judgments and estimates required for the evaluation are periodically updated based upon changes in business factors and the tax laws.

Other-Than-Temporary Impairment of Investment Securities – If the Company deems any investment security’s decline in market value to be other-than-temporary, the security is written down to a new cost basis and the resulting loss is charged against earnings. The determination of whether a decline in market value is other-than-temporary is necessarily a matter of subjective judgment. The timing and amount of any realized losses reported in the Company’s financial statements could vary if management’s conclusions were to change as to whether an other-than-temporary impairment exists. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. In analyzing an issuer’s financial condition, the Company’s management considers whether the securities are issued by the U.S. Government or its agencies, whether downgrades by bond rating agencies have occurred and industry analysts’ reports. The Company’s management currently conducts impairment evaluations at least on a quarterly basis and has concluded that, at March 31, 2008, there were no other-than-temporary impairments of the Company’s investment securities.

Recognition of Contingent Liabilities – The Company and the Bank are subject to proceedings and claims that arise in the normal course of business. Management assesses the likelihood of any adverse outcomes to these matters as well as potential ranges of probable losses.

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