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Payments of distributions on the trust preferred securities and payments on redemption of the trust preferred securities are guaranteed by the Company on a limited basis.  The Company also entered into an agreement as to expenses and liabilities with the Trusts pursuant to which it agreed, on a subordinated basis, to pay any costs, expenses or liabilities of the Trusts other than those arising under the trust preferred securities.  The obligations of the Company under the junior subordinated debentures, the related indenture, the trust agreement establishing the Trusts, the guarantee and the agreement as to expenses and liabilities, in the aggregate, constitute a full and unconditional guarantee by the Company of the Trusts’ obligations under the trust preferred securities.

Issuance costs of $615 thousand related to the trust preferred securities were deferred and are being amortized over the period until mandatory redemption of the securities in March 2030, December 2031 and September 2034, respectively.  During the three months ended June 30, 2004 and 2003, respectively, $5 thousand and $4 thousand of these issuance costs were amortized.  During the six months ended June 30, 2004 and 2003, respectively, $9 thousand and $9 thousand of these issuance costs were amortized.  Unamortized issuance costs were $549 thousand and $490 thousand at June 30, 2004 and 2003, respectively.

Dividends accrued and unpaid to securities holders totaled $425 thousand and $379 thousand on June 30, 2004 and 2003, respectively.

Note 7.  Commitments, Contingencies and Off-Balance Sheet Activities

Credit-related financial instruments:  The Company is a party to credit-related financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit, standby letters of credit and commercial letters of credit.  Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.

The Company’s exposure to credit loss is represented by the contractual amount of these commitments.  The Company follows the same credit policies in making commitments as it does for on-balance-sheet instruments.

At June 30, 2004 and December 31, 2003, the following financial instruments were outstanding whose contract amounts represent credit risk:

Mortgage loans sold with recourse are loans sold to outside investors, with the Company retaining servicing and responsibility for collection in the event of a default.  For 2004 and 2003, no such defaults occurred or were expected to occur.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require a payment of a fee.  The commitments for equity lines of credit may expire without being drawn upon.  Therefore, the total commitment amounts do not necessarily represent future cash requirements.  The amount of collateral obtained, if it is deemed necessary by the Company, is based on management’s credit evaluation of the customer.  Unfunded commitments under commercial lines of credit, revolving credit lines and overdraft protection agreements are commitments for possible future extensions of credit to existing customers.  Overdraft protection agreements are uncollateralized, but most other unfunded commitments have collateral.  These unfunded lines of credit usually do not contain a specified maturity date and may not necessarily be drawn upon to the total extent to which the Company is committed.

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Commercial and standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party.  Those letters of credit are primarily issued to support public and private borrowing arrangements.  Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is the same as that involved in extending loans to customers.  The Company generally holds collateral supporting those commitments, if deemed necessary. In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Company would be required to fund the commitment.  The maximum potential amount of future payments the Company could be required to make is represented by the contractual amount shown in the summary above.  If the commitment is funded, the Company would be entitled to seek recovery from the customer.  At June 30, 2004 and December 31, 2003, no amounts have been recorded as liabilities for the Company’s potential obligations under these commitments.  The fair value of these commitments is approximately equal to the fees collected when granting these letters of credit.  These fees collected were $23 thousand and $30 thousand as of June 30, 2004 and December 31, 2003, respectively, and are included in “other liabilities” on the Company’s balance sheet.

Concentrations of credit risk:  The majority of the loans, commitments to extend credit, and standby letters of credit have been granted to customers in Los Alamos and surrounding communities.  Although the Company has a diversified loan portfolio, a substantial portion of its loans are made to businesses and individuals associated with, or employed by, Los Alamos National Laboratory (“the Laboratory”).  The ability of such borrowers to honor their contracts is predominately dependent upon the continued operation and funding of the Laboratory.  Investments in securities issued by states and political subdivisions involve governmental entities within the state of New Mexico.  The distribution of commitments to extend credit approximates the distribution of loans outstanding.  Standby letters of credit were granted primarily to commercial borrowers.

Contingencies:  In the normal course of business, the Company is involved in various legal proceedings.  In the opinion of management, after consulting with counsel, any liability resulting from such proceedings would not have a material adverse effect on the Company’s consolidated financial statements.

Note 8.  Pro Forma Impact of Stock-Based Compensation Plans

As allowed under SFAS No. 123, Accounting for Stock-Based Compensation, the Company measures stock-based compensation cost in accordance with the methods prescribed in Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees.  As stock options are granted at fair value, there are no charges to earnings associated with stock options granted.  Accordingly, no compensation cost has been recognized for grants made to date.  Had compensation cost been determined based on the fair value method prescribed in FASB Statement No. 123, reported net income and earnings per common share would have been reduced to the pro forma amounts shown below (dollars in thousands, except earnings per share data):

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

This discussion is intended to focus on certain financial information regarding the Company and the Bank and is written to provide the reader with a more thorough understanding of its financial statements. The following discussion and analysis of the Company’s financial position and results of operations should be read in conjunction with the information set forth in Item 3, Quantitative and Qualitative Disclosures about Market Risk and the annual audited consolidated financial statements filed on Form 10-K.

Special Note Concerning Forward-Looking Statements

This Form 10-Q contains, and future oral and written statements of the Company may contain, forward-looking statements, within the meaning of such term in the Private Securities Litigation Reform Act of 1995, with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of our management and on information currently available to management, are generally identifiable by the use of words such as “believe,” “expect,” “anticipate,” “plan,” “intend,” “estimate,” “may,” “will,” “would,” “could,” “should” or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and we undertake no obligation to update any statement in light of new information or future events.

Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on our operations and future prospects include, but are not limited to, the following:

•                                          The strength of the United States economy in general and the strength of the local economies in which we conduct our operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of our assets.

•                                          The economic impact of any future terrorist threats or attacks, and the response of the United States to any such threats and attacks.

•                                          The effects of, and changes in, federal, state and local laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters.

•                                          The effects of changes in interest rates (including the effects of changes in the rate of prepayments of the Company’s assets) and the policies of the Board of Governors of the Federal Reserve System.

•                                          Our ability to compete with other financial institutions as effectively as we currently intend due to increases in competitive pressures in the financial services sector.

•                                          Our inability to obtain new customers and to retain existing customers.

•                                          The timely development and acceptance of products and services, including products and services offered through alternative delivery channels such as the Internet.

•                                          Technological changes implemented by us and by other parties, including third party vendors, which may be more difficult or more expensive than anticipated or which may have unforeseen consequences to us and its customers.

•                                          Our ability to develop and maintain secure and reliable electronic systems.

•                                          Our ability to retain key executives and employees and the difficulty that we may experience in replacing key executives and employees in an effective manner.

•                                          Consumer spending and saving habits which may change in a manner that affects our business adversely.

•                                          Business combinations and the integration of acquired businesses which may be more difficult or expensive than expected.

•                                          The costs, effects and outcomes of existing or future litigation.

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•                                          Changes in accounting policies and practices, as may be adopted by state and federal regulatory agencies and the Financial Accounting Standards Board.

•                                          Our ability to manage the risks associated with the foregoing as well as anticipated.

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Additional information concerning the Company and our business, including other factors that could materially affect our financial results, will be included in our filings with the Securities and Exchange Commission.

Critical Accounting Policies

Allowance for Loan Losses:  Management believes the allowance for loan losses accounting policy is critical to the portrayal and understanding of our financial condition and results of operations.  As such, selection and application of this “critical accounting policy” involves judgments, estimates, and uncertainties that are susceptible to change.  In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.

The allowance for loan losses is maintained at an amount that management believes will be adequate to absorb probable losses on existing loans, based on an evaluation of the collectibility of loans and prior loss experience.  This evaluation also takes into consideration such factors as changes in the nature and volume of the loan portfolio, the value of underlying collateral, overall portfolio quality, review of specific problem loans and current economic conditions that may affect the borrower’s ability to pay.  While management uses the best information available to make its evaluation, future adjustments to the allowance may be necessary if there are significant changes in these factors.  In addition, as an integral part of their examination process regulatory agencies periodically review our allowance for loan losses and may require us to make additions to the allowance based on their evaluation of information available at the time of their examinations.

We maintain our allowance for loan losses at a level that management believes will be adequate to absorb probable losses on existing loans based on an evaluation of the collectibility of loans and prior loss experience.  Three methods are used to evaluate the adequacy of the allowance for loan losses: (1) historical loss experience, based on loss experience by quality classification in the previous twelve calendar quarters; (2) specific identification, based upon management’s assessment of loans and the probability that a charge off will occur in the upcoming quarter; and (3) loan concentrations, based on current or expected economic factors in the geographic and industry sectors where management believes we may eventually experience some loan losses.

Mortgage Servicing Right (MSR) Assets:  Servicing residential mortgage loans for third-party investors represents a significant business activity of the Bank.  As of June 30, 2004, mortgage loans serviced for others totaled $905.7 million.  The MSRs on these loans totaled $9.3 million as of June 30, 2004.  The expected and actual rates of mortgage loan prepayments are the most significant factors driving the value of MSRs.  Increases in mortgage loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced.  In determining the fair value of the MSRs, mortgage interest rates, which are used to determine prepayment rates and discount rates, are held constant over the estimated life of the portfolio.  Fair valu es of the MSRs are provided by an independent third-party broker of MSRs on a monthly basis.  The values given by the broker are based upon current market conditions and assumptions, which incorporate the expected life of the loans, estimated costs to service the loans, servicing fees to be received and other factors.  MSRs are carried at the lower of the initial capitalized amount, net of accumulated amortization, or fair value.

The fair value of the MSRs is driven primarily by the effect current mortgage interest rates have on the likelihood borrowers will prepay the underlying mortgages by refinancing at a lower rate.  Accordingly, higher interest rates decrease the likelihood of repayment, extending the life of the MSRs and increasing the value of these assets.  Lower interest rates increase the likelihood of repayment, contracting the life of the MSRs and decreasing the value of these assets.  This can have a significant impact on our income.  In the three months ended June 30, 2004, we recognized income of $1.8 million due to the higher values of these MSRs.  In the six months ended June 30, 2004, we recognized income of $1.4 million.  For the year ending December 31, 2003, we recognized an expense of $754 thousand for these assets.  We can have no certainty on the direction and amount of interest rate changes looking forward, and therefore, we can have no certainty on the amount or direction of the change in valuation.

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Overview

The Company improved its earnings in the second quarter of 2004 over the first quarter of 2004, largely due to the recovery of impairment on mortgage servicing rights as interest rates increased.  Although mortgage loan refinance activity (and its associated income) was much lower in 2004 compared to 2003, the Company managed to increase income 18.4% from the second quarter of 2003 to the second quarter of 2004, also due to the recovery of this impairment.  The Company’s balance sheet growth remained flat, growing only 1.3% from December 31, 2003 to June 30, 2004.  However, there was a shift from lower-yielding assets (investment securities) to higher-yielding assets (loans), increasing net interest margin on a fully tax-equivalent basis from 3.84% for the year ended December 31, 2003 to 3.90% for the six months ended June 30, 2004.  The Company also increased its risk-based capital by issuing $6 million in trust preferred securities during this quarter, enabling us to continue to grow and remain well-capitalized.  Construction on the second office in Santa Fe neared completion during this quarter, and it is scheduled to open in August, 2004.

Income Statement Analysis

Net Income-General.  Net income for the three months ended June 30, 2004 was $3.4 million, compared to $2.8 million for the same period of 2003.  Diluted earnings per share increased by $0.07 to $0.49 for the three months ended June 30, 2004 from $0.42 for the same period of 2003.  This represented an increase in earnings per share of 16.7%.  The increase in net income was primarily the result of a decrease in other expenses, coupled with an increase in net interest income.  The decrease in other expenses was primarily due to the recovery of impairment on mortgage servicing rights, resulting from an increased market value of these rights in a rising interest rate environment.

Net income for the six months ended June 30, 2004 was $5.8 million, compared to $6.4 million for the same period of 2003.  Diluted earnings per share decreased by $0.10 to $0.85 for the six months ended June 30, 2004 from $0.95 for the same period of 2003.  This represented a decrease in earnings per share of 10.5%.  The decrease in net income was primarily the result of a decrease in non-interest income, which was partially offset by an increase in net interest income and a decrease in other expenses.

The profitability of the Company’s operations depends primarily on its net interest income, which is the difference between total interest earned on interest earning assets and total interest paid on interest bearing liabilities. The Company’s net income is affected by its provision for loan losses as well as other income and other expenses. The provision for loan losses reflects the amount thought to be adequate to cover probable credit losses in the loan portfolio. Non-interest income or other income consists of mortgage loan servicing fees, loan and other fees, service charges on deposits, gain on sale of loans, gain on sale of securities and other operating income. Other expenses include salaries and employee benefits, occupancy expenses, data processing expenses, marketing, amortization and valuation of mortgage servicing rights, supplies expense and other expenses.

The amount of net interest income is affected by changes in the volume and mix of interest earning assets, the level of interest rates earned on those assets, the volume and mix of interest bearing liabilities, and the level of interest rates paid on those interest bearing liabilities. The provision for loan losses is dependent on changes in the loan portfolio and management’s assessment of the collectibility of the loan portfolio, as well as economic and market conditions. Other income and other expenses are impacted by growth of operations and growth in the number of accounts through both acquisitions and core banking business growth. Growth in operations affects other expenses as a result of additional employees, branch facilities and promotional marketing expense. Growth in the number of accounts affects other income including service fees as well as other expenses such as computer services, supplies, postage, telecommunications and other miscellaneous expenses.

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Net Interest Income.  The following tables present, for the periods indicated, the total dollar amount of interest income from average interest earning assets and the resultant yields, as well as the interest expense on average interest bearing liabilities, and the resultant costs, expressed both in dollars and rates. Borrowings made by the Company’s Employee Stock Ownership Plan (“ESOP”) to outside parties are not included in this analysis, as the interest expense on this borrowing is born by the ESOP. Funding for the ESOP is recognized as part of compensation expense:

(1)                                  Non-accrual loans are included in average loans.

(2)                                  Interest income includes loan origination fees of $629 thousand and $801 thousand for the three months ended June 30, 2004 and 2003, respectively.

(3)                                  Non-taxable investment income is presented on a fully tax equivalent basis, adjusting for federal and state exemption of interest income and certain other permanent income tax differences.

(4)                                  Interest rate spread represents the difference between the average yield on interest earning assets and the average cost of interest bearing liabilities and is presented on a fully tax equivalent basis.

(5)                                  Net interest margin represents net interest income as a percentage of average interest earning assets.

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For the second quarter of 2004, net interest income on a fully tax equivalent basis increased $420 thousand (4.9%) to $9.0 million from $8.5 million for the second quarter of 2003.  The increase in net interest income resulted from a decrease in interest expense of $901 thousand (18.2%), while interest income on a fully tax equivalent basis decreased $481 thousand (3.6%).  Interest expense decreased due to a decrease in rate on interest bearing liabilities of 52 basis points, which accounted for a decrease in interest expense of $1.2 million.  This was partially offset by an increase in average interest-bearing liabilities of $40.9 million (5.0%), which accounted for an increase in interest expense of $262 thousand.  Interest income on a fully tax equivalent basis decreased due to a decrease in the rate on interest earning assets of 52 basis points, which accounted for a decrease in interest income on a fully tax equivalent basis of $1.3 million.  This was partially offset by an increase in average earning assets of $50.5 million (5.7%), which accounted for an increase of $829 thousand in interest income on a fully tax equivalent basis.  The net interest margin expressed on a fully tax equivalent basis decreased 2 basis points to 3.84% for 2004 from 3.86% for 2003.

(1)                                  Non-accrual loans are included in average loans.

(2)                                  Interest income includes loan origination fees of $1.4 million and $1.8 million for the six months ended June 30, 2004 and 2003, respectively.

(3)                                  Non-taxable investment income is presented on a fully tax equivalent basis, adjusting for federal and state exemption of interest income and certain other permanent income tax differences.

(4)                                  Interest rate spread represents the difference between the average yield on interest earning assets and the average cost of interest bearing liabilities and is presented on a fully tax equivalent basis.

(5)                                  Net interest margin represents net interest income as a percentage of average interest earning assets.