Cupertino National Bank isn't taking the rate spike lying down.

The recent rate increase caught the $195 million-asset bank with a strategy that relied on low interest rates - mortgage banking. So, the Cupertino, Calif.-based bank is doing the banking equivalent of an audible in football: changing the play after the huddle.

Cupertino is gutting the salaried work force in its mortgage division while boosting its commercial lending staff.

The Santa Clara Valley, the region south of San Francisco where Cupertino National resides, is quickly becoming the most topsy-turvy community bank market in California. No bank in the wealthy enclave, also known as Silicon Valley, has been unaffected by at least one of the trends of rising interest rates, mergers and acquisitions, and the stiffening of the real estate market.

Income Drops

In Cupertino's case, the interest rate rise reduced the income from their mortgage banking operation, which generates about 25% of its revenues. The drop exposed the weakness in its commercial banking operations. The bank expects to earn at least $150,000 less in the second quarter than it did during the same period a year ago.

"I thought, 'Well, they're still a bank, right?'" said one analyst of Cupertino. "They are not a thrift, so you have to ask why their core commercial banking operations aren't able to pick up the slack."

But Cupertino said the demand just isn't there.

"The economy is still flat in Northern California," said C. Donald Allen, chief executive. "The problem is that if your bank has ambitions to grow, the only growth you're going to get is from some other bank."

And the bank market is getting more crowded. Comerica has bought into nearby San Jose in recent years, and Heritage Bank of Commerce was just started in San Jose with $14 million in seed captial.

Mr. Allen said too many banks are already chasing too few quality loans, driving down margins.

Mortgage Employees Laid Off

To try to cope, the bank has cut its salaried employees in the mortgage division from 19 to seven while increasing its commissioned sales force by five people. Mr. Allen said the cuts should return the division to profitability by the fourth quarter.

In the commercial division, Cupertino added lending officers and support staff. It also created a new unit to service emerging companies that are supported by the venture capital community. [CHART OMITTED]

Steve Didion, a bank analyst with Hoefer & Arnett in San Francisco, said some community banks have taken on operational risks associated with interest rates.

"I worry about it," he said. "Some banks have staffed up to enable them to make money in a falling rate environment. Those costs can be hard to justify now."

On top of the operational adjustments, Cupertino National revised its investment strategy, boosting the size of its portfolio to deal with interest rate risk management better and, the bank hopes, make more money off it.

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