Index to Financial Statements

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-K

 


 

(Mark One)

 

xANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For The Fiscal Year Ended December 31, 2003

  For The Fiscal Year Ended December 31, 2004

 

OR

 

¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from             to             

  For the transition period from            to            

 

Commission File Number 0-25051

 


PROSPERITY BANCSHARES, INC.SM®

(Exact name of registrant as specified in its charter)

 


 

TEXAS 74-2331986
(State or other jurisdiction of
incorporation or organization)
 (I.R.S. Employer
Identification No.)

PROSPERITY BANK PLAZA


4295 SAN FELIPE


HOUSTON, TEXAS

 77027
(Address of principal executive offices) (Zip Code)

 

Registrant’s Telephone Number, Including Area Code: (713) 693-9300

 


 

Securities registered pursuant to Section 12(b) of the Act: None

 

Securities registered pursuant to Section 12(g) of the Act:

 

Common Stock, par value

 

$1.00 per share

 


 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.      Yes  x    No  ¨

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).      Yes  x    No  ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendment of this Form 10-K.  ¨

 

The aggregate market value of the shares of Common Stock held by non-affiliates, based on the closing price of the Common Stock on the Nasdaq National Market System on June 30, 20032004 was approximately $253.3$380.3 million.

 

As of March 8, 2004,1, 2005, the number of outstanding shares of Common Stock was 20,944,705.27,471,396.

 

Documents Incorporated by Reference:

 

Portions of the Company’s Proxy Statement relating to the 20042005 Annual Meeting of Shareholders, which will be filed within 120 days after December 31, 2003,2004, are incorporated by reference into Part III, Items 10-14 of this Form 10-K.

 



Index to Financial Statements

PROSPERITY BANCSHARES, INC.SM®

20032004 ANNUAL REPORT ON FORM 10-K

 

TABLE OF CONTENTS

 

PART I

   
   Item 1.  

Business

  21
      

General

  21
      

20032004 Mergers and Acquisitions

  32
      

Recent Developments

  32
      

Available Information

  3
      

Officers and Associates

  3
      

Banking Activities

  43
      

Business Strategies

  4
      

Competition

  54
      

Supervision and Regulation

  5
   Item 2.  

Properties

  1211
   Item 3.  

Legal Proceedings

  15
   Item 4.  

Submission of Matters to a Vote of Security Holders

  15

PART II

   
   Item 5.  

Market for Registrant’s Common Equity, and Related Shareholder Matters and Issuer Purchases of Equity Securities

  16
   Item 6.  

Selected Consolidated Financial Data

  18
   Item 7.  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

  20
      

Overview

  2021
      

Critical Accounting Policies

  2122
      

Results of Operations

  2122
      

Financial Condition

  2627
   Item 7A.  

Quantitative and Qualitative Disclosures about Market Risk

  4142
   Item 8.  

Financial Statements and Supplementary Data

  4143
   Item 9.  

Changes In and Disagreements with Accountants on Accounting and Financial Disclosure

  4244
   Item 9A.  

Controls and Procedures

  42
44

PART III

   
   Item 10.  

Directors and Executive Officers of the Registrant

  4246
   Item 11.  

Executive Compensation

  4246
   Item 12.  

Security Ownership of Certain Beneficial Owners and Management

  4246
   Item 13.  

Certain Relationships and Related Transactions

  4246
   Item 14.  

Principal Accounting Fees and Services

  42
46

PART IV

   
   Item 15.  

Exhibits and Financial Statement Schedules and Reports on Form 8-K

  4247
   Signatures   


Index to Financial Statements

PART I

Special Cautionary Notice Regarding Forward-Looking Statements

Statements and financial discussion and analysis contained in this annual report on Form 10-K that are not historical facts are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on assumptions and involve a number of risks and uncertainties, many of which are beyond the Company’s control. Many possible events or factors could affect the future financial results and performance of the Company and could cause such results or performance to differ materially from those expressed in the forward-looking statements. These possible events or factors include, without limitation:

changes in interest rates and market prices, which could reduce the Company’s net interest margins, asset valuations and expense expectations;

changes in the levels of loan prepayments and the resulting effects on the value of the Company’s loan portfolio;

changes in local economic and business conditions which adversely affect the Company’s customers and their ability to transact profitable business with the company, including the ability of the Company’s borrowers to repay their loans according to their terms or a change in the value of the related collateral;

increased competition for deposits and loans adversely affecting rates and terms;

the timing, impact and other uncertainties of future acquisitions, including the Company’s ability to identify suitable future acquisition candidates, the success or failure in the integration of their operations, and the ability to enter new markets successfully and capitalize on growth opportunities;

increased credit risk in the Company’s assets and increased operating risk caused by a material change in commercial, consumer and/or real estate loans as a percentage of the total loan portfolio;

the failure of assumptions underlying the establishment of and provisions made to the allowance for credit losses;

changes in the availability of funds resulting in increased costs or reduced liquidity;

increased asset levels and changes in the composition of assets and the resulting impact on the Company’s capital levels and regulatory capital ratios;

the Company’s ability to acquire, operate and maintain cost effective and efficient systems without incurring unexpectedly difficult or expensive but necessary technological changes;

the loss of senior management or operating personnel and the potential inability to hire qualified personnel at reasonable compensation levels;

changes in statutes and government regulations or their interpretations applicable to financial holding companies and the Company’s present and future banking and other subsidiaries, including changes in tax requirements and tax rates;

acts of terrorism, an outbreak of hostilities or other international or domestic calamities, weather or other acts of God and other matters beyond the Company’s control; and

other risks and uncertainties listed from time to time in the Company’s reports and documents filed with the Securities and Exchange Commission.

A forward-looking statement may include a statement of the assumptions or bases underlying the forward-looking statement. The Company believes it has chosen these assumptions or bases in good faith and that they are reasonable. However, the Company cautions you that assumptions or bases almost always vary from actual results, and the differences between assumptions or bases and actual results can be material.

The Company undertakes no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless the securities laws require the Company to do so.

ITEM 1. BUSINESS

 

General

 

Prosperity Bancshares, Inc.SM® , a Texas corporation (the “Company”), was formed in 1983 as a vehicle to acquire the former Allied Bank in Edna, Texas which was chartered in 1949 as The First National Bank of Edna. The Company is a registered financial holding company that derives substantially all of its revenues and income from the operation of its bank subsidiary, Prosperity Bank® (“Prosperity Bank®” or the “Bank”). The Bank provides a broad line of financial products and services to small and medium-sized businesses and consumers. TheAs of December 31, 2004, the Bank operates fifty-one (51)operated fifty-eight (58) full-service banking locations; with twenty-nine (29) in the Greater Houston Consolidated Metropolitan Statistical Area (“CMSA”), eleven (11) in eight contiguous counties situated south and southwest of Houston and extending into South Texas, seven (7) in the Austin, Texas area and eleven (11) in the Dallas/Fort Worth area. The Greater Houston CMSA includes Austin, Brazoria, Chambers, Fort Bend, Galveston, Harris, Liberty, Montgomery, San Jacinto and Waller counties. The Company’s headquarters are located at Prosperity Bank Plaza, 4295 San Felipe in Houston, Texas and its telephone number is (713) 693-9300. The Company’s website address is www.prosperitybanktx.com.

 

The Company’s market consists of the communities served by its locations in the Greater Houston Texas CMSA, additional locations in eight contiguous counties located to the south and southwest of Houston, andTexas, its eleven banking locations in the Dallas/Fort Worth, Texas area Texas.and its seven locations in the Austin, Texas area. US Highway 59 (scheduled to become Interstate Highway 69), which serves as the primary “NAFTA Highway” linking the interior United States and Mexico, runs directly through the center of the Company’s market area. The increased traffic along this NAFTA Highway has enhanced economic activity in the Company’s market area and created opportunities for growth. The diverse nature of the economies in each local market served by the Company provides the Company with a varied customer base and allows the Company to spread its lending risk throughout a number of different industries including farming, ranching, petrochemicals, manufacturing, tourism, recreation and professional service firms and their principals. The Company’s market areas outside of Houston, Dallas and DallasAustin are dominated by either small community banks or branches of large regional banks. Management believes that the Company, as one of the few mid-sized financial institutions that combines responsive community banking with the sophistication of a regional bank holding company, has a competitive advantage in its market areas and excellent growth opportunities through acquisitions, new Banking Center locations and additional business development.

 

Operating under a community banking philosophy, the Company seeks to develop broad customer relationships based on service and convenience while maintaining its conservative approach to lending and strong asset quality. The Company has grown through a combination of internal growth, the acquisition of community banks, branches of banks and the opening of new banking centers. Utilizing a low cost of funds and employing stringent cost controls, the Company has been profitable in every full year of its existence, including the period of adverse economic conditions in Texas in the late 1980s. From 1988 to 1992, as a sound and profitable institution, the Company took advantage of this economic downturn and acquired the deposits and certain assets of failed banks in West Columbia, El Campo and Cuero, Texas and two failed banks in Houston, which diversified the Company’s franchise and increased its core deposits. The Company opened a full-service Banking Center in Victoria, Texas in 1993 and the following year established a Banking Center in Bay City, Texas. The Company expanded its Bay City presence in 1996 with the acquisition of an additional branch location from Norwest Bank Texas (now Wells Fargo), and in 1997, the Company acquired the Angleton, Texas branch of Wells Fargo Bank. In 1998, the Company enhanced its West Columbia Banking Center with the purchase of a commercial bank branch located in West Columbia and acquired Union State Bank in East Bernard, Texas.

In 1999,

Index to Financial Statements

From December 31, 1998 through December 31, 2004, the Company acquired South Texas Bancshares, Inc.grew through internal growth and its wholly owned subsidiary, The Commercial National Bank of Beeville, with locations in Beeville, Mathis and Goliad, Texas. The Company acquired trust powers in connection with the South Texas Acquisition. Additionally, in September 2000, the Company purchased certain assets and assumed certain liabilities of five branches of Compass Bank located in El Campo, Hitchcock, Needville, Palacios and Sweeny, Texas. With the exceptioncompletion of the El Campo location, the former Compass branches are being operated as full-service Banking Centers. The El Campo location has been combined with the Company’s El Campo Banking Center. In February 2001, the Company completed a merger with Commercial Bancshares, Inc., (“Commercial”), whereby Commercial was merged with the Company and Heritage Bank, Commercial’s wholly owned subsidiary, was merged with the Bank. Heritage Bank had 12 full-service banking locations in the Houston metropolitan area and in three adjacent counties. The transaction was accounted for as a pooling of interests and therefore the historical financial data of the Company has been restated to include the accounts and operations of Commercial for all periods prior to the effective time of the Commercial merger. The Company incurred approximately $2.4 million in merger related expenses in connection with the Commercial merger.following acquisitions:

 

In May 2002, the Company completed the acquisition of Texas Guaranty Bank, N.A. (the “Texas Guaranty Acquisition”). Texas Guaranty Bank operated three (3) offices in the western portion of Houston, Texas, all of which became full service banking centers of Prosperity Bank®. In July 2002, the Company acquired The First State Bank, Needville, Texas (the “First State Acquisition”). Prosperity Bank’s® existing Needville Banking Center relocated into the former First State Bank location effective July 15, 2002. In June 2003, the Needville Banking Center relocated into a newly constructed building on Highway 36. Additionally, in

September 2002, the Company acquired Paradigm Bancorporation, Inc. (the “Paradigm Acquisition”) in a stock transaction for approximately 2.58 million shares of Prosperity common stock for all outstanding shares of Paradigm. Paradigm operated a total of eleven (11) banking offices - six (6) in the greater Houston metropolitan area and five (5) in the nearby Southeast Texas cities of Dayton, Galveston, Mont Belvieu, and Winnie. The Company subsequently closed three banking offices and consolidated them into existing Banking Centers. On October 1, 2002, the Company acquired Southwest Bank Holding Company, Dallas, Texas (the “Southwest Acquisition”) for approximately $19.6 million in cash. Southwest’s wholly owned subsidiary, Bank of the Southwest, Dallas, Texas, became a subsidiary of the Company but was merged into the Bank on January 2, 2003. Southwest was privately held and operated two (2) banking offices in Dallas, Texas. On November 1, 2002, the Company acquired First National Bank of Bay City, Bay City, Texas (the “FNB Acquisition”), through the merger of FNB with and into Prosperity Bank® for approximately $5.1 million in cash. FNB operated one (1) location in Bay City, Texas, which was closed and consolidated with Prosperity Bank’s® Bay City Banking Center.

Acquired Entity


  Completion Date

  Number of
Banking Centers
Added (1)


South Texas Bancshares, Inc.

  1999  3

Compass Bank (5 branches)

  2000  4

Commercial Bancshares, Inc.

  2001  12

Texas Guaranty Bank, N.A.

  2002  3

The First State Bank of Needville(2)

  2002  —  

Paradigm Bancorporation, Inc.

  2002  8

Southwest Bank Holding Company

  2002  2

First National Bank of Bay City(2)

  2002  —  

Abrams Centre Bancshares, Inc.

  2003  1

Dallas Bancshares, Inc.

  2003  1

MainBancorp, Inc.

  2003  4

First State Bank of North Texas

  2003  3

Liberty Bancshares, Inc.

  2004  6

Village Bank & Trust, s.s.b.

  2004  1

(1)The number of banking centers added gives effect to any locations of the acquired entity that were consolidated into existing banking centers of the Company.
(2)The only banking center of the acquired entity was closed and consolidated into an existing banking center of the Company.

 

20032004 Mergers and Acquisitions

 

On December 9, 2003,August 1, 2004, the Company completed the mergerits acquisition of First StateVillage Bank of North Texas, Dallas, Texasand Trust, s.s.b. (“FSBNT”Village”) into the Bank., Austin, Texas. Under the terms of the agreement, the Company paid approximately $12.6$19.1 million in cash and issued approximately 393,074 shares of its common stock for all of the issued and outstanding sharescapital stock of First State. First StateVillage. Village was privately held and operated four (4)one (1) banking officesoffice in the Dallas, Texas area. One banking center was closed and consolidated with an existing banking center located nearby.Lakeway area of Austin, Texas. As of SeptemberJune 30, 2003, First State2004, Village had total assets of $100.7$110.9 million, loans of $20.1$79.7 million, deposits of $91.4$97.3 million and shareholders’ equity of $8.8$10.4 million.

 

On NovemberAugust 1, 2003,2004, the Company completed the mergerits acquisition of MainBancorp,Liberty Bancshares, Inc. (“Liberty”), Austin, Texas, (“MainBancorp”), into the Company. In connection with the transaction, MainBancorp’s wholly owned subsidiary,mainbank,n.a., Dallas, Texas,pursuant to which Liberty was merged into the Bank. Under the terms of the agreement, the Company issued approximately 1,500,000 shares ofand its Common Stock and paid approximately $9.1 million in cash for all outstanding shares of MainBancorp. In addition, the Company assumed options to acquire 100,851 shares of its Common Stock. MainBancorp was privately held and operated four (4) banking offices in Dallas, Texas area. As of September 30, 2003, MainBancorp had, on a consolidated basis, total assets of $177.1 million, loans of $90.8 million, deposits of $153.7 million and shareholders’ equity of $22.6 million.

On June 1, 2003, the Company completed the merger of Dallas Bancshares, Dallas, Texas (“Dallas Bancshares”), into the Company. In connection with the transaction, Dallas Bancshares’ wholly owned subsidiary, BankDallas,Liberty Bank, S.S.B., was merged into the Bank. Under the terms of the agreement, the Company paid approximately $7.0$8.9 million in cash. Dallas Bancsharescash and issued approximately 1.3 million shares of its Common Stock for all of the issued and outstanding capital stock of Liberty and Liberty Bank and converted all outstanding stock options to acquire Liberty common stock into options to acquire approximately 108,000 shares of Prosperity common stock. Liberty was privately held and operated one (1)six (6) banking officeoffices in Dallas,Austin, Texas. As of March 31, 2003, Dallas BancsharesJune 30, 2004, Liberty had, on a consolidated basis, total assets of $42.0$178.7 million, loans of 28.3$120.3 million, deposits of $37.6$158.9 million and shareholders’ equity of $4.3 million.

On May 6, 2003, the Company completed the merger of Abrams Centre Bancshares, Dallas, Texas (“Abrams”), into the Company. In connection with the acquisition, Abrams’ wholly owned subsidiary, Abrams Centre National Bank, was merged into the Bank. Under the terms of the agreement, the Company paid approximately $16.3 million in cash. Abrams operated two (2) banking offices in Dallas, Texas. One banking center was closed and consolidated with an existing banking center located nearby in November 2003. As of March 31, 2003, Abrams had, on a consolidated basis, total assets of $96.5 million, loans of $31.7 million, deposits of $70.8 million and shareholders’ equity of $14.0$16.5 million.

 

Recent Developments

 

On March 1, 2005, the Company completed its acquisition of FirstCapital Bankers, Inc. (“First Capital”), Corpus Christi, Texas. Under the terms of the agreement, First Capital was merged into the Company and First Capital’s wholly owned subsidiary, FirstCapital Bank, s.s.b. was merged into the Bank. The Company completedissued approximately 5.079 million shares of its common stock for all of the saleissued and outstanding capital stock of First Capital and converted all outstanding options to acquire First Capital common stock into options to acquire approximately 234,000 shares of Prosperity common stock. First Capital was privately held and operated thirty-two (32) banking offices in and around Corpus Christi, Houston and Victoria, Texas, five of which were closed and consolidated with existing banking centers of the Company. As of December 31, 2004, First Capital had, on a consolidated basis, total assets of $761.6 million, loans of $499.0 million, deposits of $629.6 million and shareholders’ equity of $61.7 million.

Index to Financial Statements

On December 31, 2004, the Company redeemed in full the $12.4 million in junior subordinated debentures issued to Prosperity Capital Trust I. Prosperity Capital Trust I in turn redeemed in full the trust assets managed bypreferred securities and common securities it to another financial institution on December 31, 2003. The transaction was accounted for as a purchase and assumption and did not have a material impact on 2003 results.issued.

 

Available Information

 

The Company’s website address is www.prosperitybanktx.com. The Company makes available free of charge on or through its website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission. However, the information foundInformation contained on the Company’s website is not incorporated by reference into this annual report on Form 10-K and is not part of this or any other report.

 

Officers and Associates

 

The Company’s directors and officers are important to the Company’s success and play a key role in the Company’s business development efforts by actively participating in a number of civic and public service activities in the communities served by the Company, such as the Rotary Club, Lion’s Club, Pilot Club, United Way and Chamber of Commerce. In addition, the Company’s

Banking Centers in Bay City, Clear Lake, Cleveland, Dayton, Galveston, Liberty, Mont Belvieu, and Wharton maintain Business Development Boards, whose function is to solicit new business, develop customer relations and provide valuable community knowledge to their respective Banking Center Presidents or Managers.

 

The Company has invested heavily in its officers and associates by recruiting talented officers in its market areas and providing them with economic incentive in the form of stock options and bonuses based on cross-selling performance. The senior management team has substantial experience in both the Houston, Dallas and DallasAustin markets and the surrounding communities in which the Company has a presence. Each Banking Centerbanking center location is administered by a local President or Manager with knowledge of the community and lending expertise in the specific industries found in the community. The Company entrusts its Banking Centerbanking center Presidents and Managers with authority and flexibility within general parameters with respect to product pricing and decision making in order to avoid the bureaucratic structure of larger banks. The Company operates each Banking Centerbanking center as a separate profit center, maintaining separate data with respect to each Banking Center’sbanking center’s net interest income, efficiency ratio, deposit growth, loan growth and overall profitability. Banking Center Presidentscenter presidents and Managersmanagers are accountable for performance in these areas and compensated accordingly. The Company has no 1-800 telephone numbers. Each Banking Centerbanking center has its own listed local business telephone number, which enables a customer to be served by a local banker with decision making authority.

 

As of December 31, 2003,2004, the Company and the Bank had 629653 full-time equivalent associates, 230237 of whom were officers of the Bank. The Company provides medical and hospitalization insurance to its full-time associates. The Company considers its relations with associates to be excellent. Neither the Company nor the Bank is a party to any collective bargaining agreement.

 

Banking Activities

 

The Company, through the Bank, offers a variety of traditional loan and deposit products to its customers, which consist primarily of consumers and small and medium-sized businesses. The Bank tailors its products to the specific needs of customers in a given market. At December 31, 2003,2004, the Bank maintained approximately 139,000 separate deposit accounts and 16,10015,400 separate loan accounts and approximately 22.4% of the Bank’s total deposits were noninterest-bearing demand deposits. For the year ended December 31, 2003,2004, the Company’s average cost of funds was 1.33%1.30%. The Company’s average cost of deposits (excluding borrowings) was 1.15% for the year ended December 31, 2004.

 

The Company has been an active mortgage lender, with commercial mortgage and 1-4 family residential loans comprising 64.7%60.8% of the Company’s total loans as of December 31, 2003.2004. The Company also offers loans for automobiles and other consumer durables, home equity loans, debit cards, personal computerinternet banking and other cash management services and telebanking.automated telephone banking. By offering certificates of deposit, checking with interest accounts, savings accounts and overdraft protection at competitive rates, the Company gives its depositors a full range of traditional deposit products. The Company has successfully introduced the Royal account, which for a monthly fee provides consumers with a package of benefits including unlimited free checking, free personalized checks, free travelers checks, free cashier’s checks, free money orders, free ATM or debit card, imaged statements, free Advantage Overdraft protection ranging from $200 to $1,000 on qualifying accounts, free Internet Banking, discounted Internet Bill Pay pricing and certain travel discounts.

 

The businesses targeted by the Company in its lending efforts are primarily those that require loans in the $100,000 to $4.0$8.0 million range. The Company offers these businesses a broad array of loan products including term loans, lines of credit and loans for working capital, business expansion and the purchase of equipment and machinery, interim construction loans for builders and owner-occupied commercial real estate loans. For its business customers, the Company has developed a specialized checking product called Small Business Checking which provides fixed discounted fees for checking.

Index to Financial Statements

Business Strategies

 

The Company’s main objective is to increase deposits and loans internally, as well as through additional expansion opportunities, while maintaining efficiency, individualized customer service and maximizing profitability. To achieve this objective, the Company has employed the following strategic goals:

 

Continue Community Banking Emphasis. The Company intends to continue operating as a community banking organization focused on meeting the specific needs of consumers and small and medium-sized businesses in its market areas. The Company will continue to provide a high degree of responsiveness combined with a wide variety of banking products and services. The Company staffs its Banking Centers with experienced bankers with lending expertise in the specific industries found in the community, giving them authority to make certain pricing and credit decisions, thereby attempting to avoid the bureaucratic structure of larger banks.

 

Increase Loan Volume and Diversify Loan Portfolio. Historically, the Company has elected to sacrifice some earnings for the historically lower credit losses associated with home mortgage loans. While maintaining its conservative approach to lending, the Company has emphasized both new and existing loan products, focusing on growing its construction, commercial mortgage and commercial loan portfolios. During the two-year period from December 31, 20012002 to December 31, 2003,2004, the Company’s construction loans grew from $52.4 million to $109.6 million, or 109.2%. The Company’s commercial and industrial

loans grew from $47.0$93.8 million to $94.0$144.4 million, or 100.0%54.0% and its commercial mortgages increased from $78.4$184.0 million to $260.9$369.2 million, or 232.6%.100.7% for the same period. In addition, the Company targets professional service firms such as legal and medical practices for both loans secured by owner-occupied premises and personal loans to their principals.

 

Continue Strict Focus on Efficiency. The Company plans to maintain its stringent cost control practices and policies. The Company has invested significantly in the infrastructure required to centralize many of its critical operations, such as data processing and loan application processing. For its Banking Centers, which the Company operates as independent profit centers, the Company supplies complete support in the areas of loan review, internal audit, compliance and training. Management believes that this centralized infrastructure can accommodate substantial additional growth while enabling the Company to minimize operational costs through certain economies of scale.

 

Enhance Cross-Selling. The Company recognizes that its customer base provides significant opportunities to cross-sell various products and it seeks to develop broader customer relationships by identifying cross-selling opportunities. The Company uses incentives and friendly competition to encourage cross-selling efforts and increase cross-selling results. Officers and associates have access to each customer’s existing and related account relationships and are better able to inform customers of additional products when customers visit or call the various Banking Centers or use their drive-in facilities. In addition, the Company includes product information in monthly statements and other mailings.

 

Maintain Strong Asset Quality. The Company intends to maintain the strong asset quality that has been representative of its historical loan portfolio. As the Company diversifies and increases its lending activities, it may face higher risks of nonpayment and increased risks in the event of economic downturns. The Company intends, however, to continue to employ the strict underwriting guidelines and comprehensive loan review process that has contributed to its low incidence of nonperforming assets and its minimal charge-offs.

 

Expand Market Share Through Internal Growth and a Disciplined Acquisition Strategy. The Company intends to continue seeking opportunities, both inside and outside its existing markets, to expand either by acquiring existing banks or branches of banks or by establishing new Banking Centers. All of the Company’s acquisitions have been accretive to earnings within 12 months after acquisition date and have supplied the Company with relatively low-cost deposits which have been used to fund the Company’s lending and investing activities. However, the Company makes no guarantee that future acquisitions will be accretive to earnings within any particular time period. Factors used by the Company to evaluate expansion opportunities include the similarity in management and operating philosophies, whether the acquisition will be accretive to earnings and enhance shareholder value, the ability to achieve economies of scale to improve the efficiency ratio and the opportunity to enhance the Company’s market presence.

 

Competition

 

The banking business is highly competitive, and the profitability of the Company depends principally on its ability to compete in its market areas. The Company competes with other commercial banks, savings banks, savings and loan associations, credit unions, finance companies, mutual funds, insurance companies, brokerage and investment banking firms, asset-based nonbank lenders and certain other nonfinancial entities, including retail stores which may maintain their own credit programs and certain governmental organizations which may offer more favorable financing than the Company. The Company has been able to compete effectively with other financial institutions by emphasizing customer service, technology and responsive decision-making with respect to loans; by establishing long-term customer relationships and building customer loyalty; and by providing products and services designed to address the specific needs of its customers. Under the Gramm-Leach-Bliley Act, securities firms and insurance companies that elect

Index to become financial holding companies may acquire banks and other financial institutions.

Financial Statements

Supervision and Regulation

 

The supervision and regulation of bank holding companies and their subsidiaries is intended primarily for the protection of depositors, the deposit insurance funds of the Federal Deposit Insurance Corporation (“FDIC”) and the banking system as a whole, and not for the protection of the bank holding company shareholders or creditors. The banking agencies have broad enforcement power over bank holding companies and banks including the power to impose substantial fines and other penalties for violations of laws and regulations.

 

The following description summarizes some of the laws to which the Company and the Bank are subject. References hereinin this annual report on Form 10-K to applicable statutes and regulations are brief summaries thereof, do not purport to be complete, and are qualified in their entirety by reference to such statutes and regulations. The Company believes that it is in compliance in all material respects with these laws and regulations.

The Company

 

The Company is a financial holding company registered underpursuant to the Gramm-Leach-Bliley Act and a bank holding company registered under the Bank Holding Company Act of 1956, as amended (“BHCA”). Accordingly, the Company is subject to supervision, regulation and examination by the Board of Governors of the Federal Reserve System (“Federal Reserve Board”). The Gramm-Leach-Bliley Act, the BHCA and other federal laws subject financial and bank holding companies to particular restrictions on the types of activities in which they may engage, and to a range of supervisory requirements and activities, including regulatory enforcement actions for violations of laws and regulations.

 

Regulatory Restrictions on Dividends; Source of Strength. It is the policy of the Federal Reserve Board that bank holding companies should pay cash dividends on common stock only out of income available over the past year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. The policy provides that bank holding companies should not maintain a level of cash dividends that undermines the bank holding company’s ability to serve as a source of strength to its banking subsidiaries.

 

Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial strength to each of its banking subsidiaries and commit resources to their support. Such support may be required at times when, absent this Federal Reserve Board policy, a holding company may not be inclined to provide it. As discussed below, a bank holding company, in certain circumstances, could be required to guarantee the capital plan of an undercapitalized banking subsidiary.

 

In the event of a bank holding company’s bankruptcy under Chapter 11 of the U.S. Bankruptcy Code, the trustee will be deemed to have assumed and is required to cure immediately any deficit under any commitment by the debtor holding company to any of the federal banking agencies to maintain the capital of an insured depository institution. Any claim for breach of such obligation will generally have priority over most other unsecured claims.

 

Scope of Permissible Activities. Under the BHCA, bank holding companies generally may not acquire a direct or indirect interest in or control of more than 5% of the voting shares of any company that is not a bank or bank holding company or from engaging in activities other than those of banking, managing or controlling banks or furnishing services to or performing services for its subsidiaries, except that it may engage in, directly or indirectly, certain activities that the Federal Reserve Board determined to be closely related to banking or managing and controlling banks as to be a proper incident thereto. In approving acquisitions or the addition of activities, the Federal Reserve considers whether the acquisition or the additional activities can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition, or gains in efficiency, that outweigh such possible adverse effects as undue concentration of resources decreased or unfair competition, conflicts of interest or unsound banking practices.

 

However,Notwithstanding the foregoing, the Gramm-Leach-Bliley Act, effective March 11, 2000, eliminated the barriers to affiliations among banks, securities firms, insurance companies and other financial service providers and permits bank holding companies to become financial holding companies and thereby affiliate with securities firms and insurance companies and engage in other activities that are financial in nature. The Gramm-Leach-Bliley Act defines “financial in nature” to include securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency; merchant banking activities; and activities that the Federal Reserve Board has determined to be closely related to banking. No regulatory approval will be required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board.

 

Under the Gramm-Leach-Bliley Act, a bank holding company may become a financial holding company by filing a declaration with the Federal Reserve Board if each of its subsidiary banks is well capitalized under the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”) prompt corrective action provisions, is well managed, and has at least a satisfactory rating under the Community Reinvestment Act of 1977 (“CRA”). The Company became a financial holding company on April 18, 2000.

Index to Financial Statements

While the Federal Reserve Board is the “umbrella” regulator for financial holding companies and has the power to examine banking organizations engaged in new activities, regulation and supervision of activities which are financial in nature or determined to be incidental to such financial activities will be handled along functional lines. Accordingly, activities of subsidiaries of a financial holding company will be regulated by the agency or authorities with the most experience regulating that activity as it is conducted in a financial holding company.

 

Safe and Sound Banking Practices. Bank holding companies are not permitted to engage in unsafe and unsound banking practices. The Federal Reserve Board’s Regulation Y, for example, generally requires a holding company to give the Federal Reserve Board prior notice of any redemption or repurchase of its own equity securities, if the consideration to be paid, together with the consideration paid for any repurchases or redemptions in the preceding year, is equal to 10% or more of the company’s consolidated net worth. The Federal Reserve Board may oppose the transaction if it believes that the transaction would constitute an unsafe or

unsound practice or would violate any law or regulation. Depending upon the circumstances, the Federal Reserve Board could take the position that paying a dividend would constitute an unsafe or unsound banking practice.

 

The Federal Reserve Board has broad authority to prohibit activities of bank holding companies and their nonbanking subsidiaries which represent unsafe and unsound banking practices or which constitute violations of laws or regulations, and can assess civil money penalties for certain activities conducted on a knowing and reckless basis, if those activities caused a substantial loss to a depository institution. The penalties can be as high as $1.0 million for each day the activity continues.

 

Anti-Tying Restrictions. Bank holding companies and their affiliates are prohibited from tying the provision of certain services, such as extensions of credit, to other services offered by a holding company or its affiliates.

 

Capital Adequacy Requirements. The Federal Reserve Board has adopted a system using risk-based capital guidelines to evaluate the capital adequacy of bank holding companies. Under the guidelines, specific categories of assets are assigned different risk weights, based generally on the perceived credit risk of the asset. These risk weights are multiplied by corresponding asset balances to determine a “risk-weighted” asset base. The guidelines require a minimum total risk-based capital ratio of 8.0% (of which at least 4.0% is required to consist of Tier 1 capital elements). Total capital is the sum of Tier 1 and Tier 2 capital. As of December 31, 2003,2004, the Company’s ratio of Tier 1 capital to total tangible risk-weighted assets was 15.82%13.56% and its ratio of total capital to total tangible risk-weighted assets was 16.90%14.67%. Tangible risk-weighted assets are calculated as total risk-weighted assets less intangible assets such as goodwill and core deposit intangibles. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Capital Resources.”

 

In addition to the risk-based capital guidelines, the Federal Reserve Board uses a leverage ratio as an additional tool to evaluate the capital adequacy of bank holding companies. The leverage ratio is a company’s Tier 1 capital divided by its average total tangible consolidated assets. Certain highly rated bank holding companies may maintain a minimum leverage ratio of 3.0%, but other bank holding companies are required to maintain a leverage ratio of 4.0%. As of December 31, 2003,2004, the Company’s leverage ratio was 7.10%6.30%.

 

The federal banking agencies’ risk-based and leverage ratios are minimum supervisory ratios generally applicable to banking organizations that meet certain specified criteria, assuming that they have the highest regulatory rating. Banking organizations not meeting these criteria are expected to operate with capital positions well above the minimum ratios. The federal bank regulatory agencies may set capital requirements for a particular banking organization that are higher than the minimum ratios when circumstances warrant. Federal Reserve Board 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.

 

Imposition of Liability for Undercapitalized Subsidiaries. Bank regulators are required to take “prompt corrective action” to resolve problems associated with insured depository institutions whose capital declines below certain levels. In the event an institution becomes “undercapitalized,” it must submit a capital restoration plan. The capital restoration plan will not be accepted by the regulators unless each company having control of the undercapitalized institution guarantees the subsidiary’s compliance with the capital restoration plan up to a certain specified amount. Any such guarantee from a depository institution’s holding company is entitled to a priority of payment in bankruptcy.

 

The aggregate liability of the holding company of an undercapitalized bank is limited to the lesser of 5% of the institution’s assets at the time it became undercapitalized or the amount necessary to cause the institution to be “adequately capitalized.” The bank regulators have greater power in situations where an institution becomes “significantly” or “critically” undercapitalized or fails to submit a capital restoration plan. For example, a bank holding company controlling such an institution can be required to obtain prior Federal Reserve Board approval of proposed dividends, or might be required to consent to a consolidation or to divest the troubled institution or other affiliates.

Index to Financial Statements

Acquisitions by Bank Holding Companies. The BHCA requires every bank holding company to obtain the prior approval of the Federal Reserve Board before it may acquire all or substantially all of the assets of any bank, or ownership or control of any voting shares of any bank, if after such acquisition it would own or control, directly or indirectly, more than 5% of the voting shares of such bank. In approving bank acquisitions by bank holding companies, the Federal Reserve Board is required to consider the financial and managerial resources and future prospects of the bank holding company and the banks concerned, the convenience and needs of the communities to be served, and various competitive factors.

 

Control Acquisitions. The Change in Bank Control Act prohibits a person or group of persons from acquiring “control” of a bank holding company unless the Federal Reserve Board has been notified and has not objected to the transaction. Under a rebuttable presumption established by the Federal Reserve Board, 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, such as the Company, 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 Federal Reserve Board under the BHCA before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of the outstanding Common Stock of the Company, or otherwise obtaining control or a “controlling influence” over the Company.

 

The Bank

 

The Bank is a Texas-chartered banking association, the deposits of which are insured by the Bank Insurance Fund (“BIF”). of the FDIC. The Bank is not a member of the Federal Reserve System; therefore, the Bank is subject to supervision and regulation by the FDIC and the Texas Banking Department. Such supervision and regulation subject the Bank to special restrictions, requirements, potential enforcement actions and periodic examination by the FDIC and the Texas Banking Department. Because the Federal Reserve Board regulates the bank holding company parent of the Bank, the Federal Reserve Board also has supervisory authority which directly affects the Bank.

 

Equivalence to National Bank Powers. The Texas Constitution, as amended in 1986, provides that a Texas-chartered bank has the same rights and privileges that are or may be granted to national banks domiciled in Texas. To the extent that the Texas laws and regulations may have allowed state-chartered banks to engage in a broader range of activities than national banks, the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) has operated to limit this authority. FDICIA provides that no state bank or subsidiary thereof may engage as principal in any activity not permitted for national banks, unless the institution complies with applicable capital requirements and the FDIC determines that the activity poses no significant risk to the insurance fund. In general, statutory restrictions on the activities of banks are aimed at protecting the safety and soundness of depository institutions.

 

Financial Modernization. Under the Gramm-Leach-Bliley Act, a national bank may establish a financial subsidiary and engage, subject to limitations on investment, in activities that are financial in nature, other than insurance underwriting as principal, insurance company portfolio investment, real estate development, real estate investment and annuity issuance. To do so, a bank must be well capitalized, well managed and have a CRA rating of satisfactory or better. Subsidiary banks of a financial holding company or national banks with financial subsidiaries must remain well capitalized and well managed in order to continue to engage in activities that are financial in nature without regulatory actions or restrictions, which could include divestiture of the financial in nature subsidiary or subsidiaries. In addition, a financial holding company or a bank may not acquire a company that is engaged in activities that are financial in nature unless each of the subsidiary banks of the financial holding company or the bank has a CRA rating of satisfactory of better.

 

Although the powers of state chartered banks are not specifically addressed in the Gramm-Leach-Bliley Act, Texas-chartered banks such as the Bank, will have the same if not greater powers as national banks through the parity provision contained in the Texas Constitution.

 

Branching. Texas law provides that a Texas-chartered bank can establish a branch anywhere in Texas provided that the branch is approved in advance by the Texas Banking Department. The branch must also be approved by the FDIC, which considers a number of factors, including financial history, capital adequacy, earnings prospects, character of management, needs of the community and consistency with corporate powers.

 

Restrictions on Transactions with Affiliates and Insiders. Transactions between the Bank and its nonbanking subsidiaries, including the Company, are subject to Section 23A of the Federal Reserve Act. In general, Section 23A imposes limits on the amount of such transactions, and also requires certain levels of collateral for loans to affiliated parties. It also limits the amount of advances to third parties which are collateralized by the securities or obligations of the Company or its subsidiaries.

Index to Financial Statements

Affiliate transactions are also subject to Section 23B of the Federal Reserve Act which generally requires that certain transactions between the Bank and its affiliates be on terms substantially the same, or at least as favorable to the Bank, as those prevailing at the time for comparable transactions with or involving other nonaffiliated persons. The Federal Reserve has also issued Regulation W which codifies prior regulations under Sections 23A and 23B of the Federal Reserve Act and interpretive guidance with respect to affiliate transactions.

 

The restrictions on loans to directors, executive officers, principal shareholders and their related interests (collectively referred to herein as “insiders”) contained in the Federal Reserve Act and Regulation O apply to all insured institutions and their subsidiaries and holding companies. These restrictions include limits on loans to one borrower and conditions that must be met before such a loan can be made. There is also an aggregate limitation on all loans to insiders and their related interests. These loans cannot exceed the institution’s total unimpaired capital and surplus, and the FDIC may determine that a lesser amount is appropriate. Insiders are subject to enforcement actions for knowingly accepting loans in violation of applicable restrictions.

Restrictions on Distribution of Subsidiary Bank Dividends and Assets. Dividends paid by the Bank have provided a substantial part of the Company’s operating funds and for the foreseeable future it is anticipated that dividends paid by the Bank to the Company will continue to be the Company’s principal source of operating funds. Capital adequacy requirements serve to limit the amount of dividends that may be paid by the Bank. Under federal law, the Bank cannot pay a dividend if, after paying the dividend, the Bank will be “undercapitalized.” The FDIC may declare a dividend payment to be unsafe and unsound even though the Bank would continue to meet its capital requirements after the dividend. Because the Company is a legal entity separate and distinct from its subsidiaries, its right to participate in the distribution of assets of any subsidiary upon the subsidiary’s liquidation or reorganization will be subject to the prior claims of the subsidiary’s creditors. In the event of a liquidation or other resolution of an insured depository institution, the claims of depositors and other general or subordinated creditors are entitled to a priority of payment over the claims of holders of any obligation of the institution to its shareholders, including any depository institution holding company (such as the Company) or any shareholder or creditor thereof.

 

Examinations. The FDIC periodically examines and evaluates insured banks. Based on such an evaluation, the FDIC may revalue the assets of the institution and require that it establish specific reserves to compensate for the difference between the FDIC-determined value and the book value of such assets. The Texas Banking Department also conducts examinations of state banks but may accept the results of a federal examination in lieu of conducting an independent examination.

 

Audit Reports. Insured institutions with total assets of $500 million or more must submit annual audit reports prepared by independent auditors to federal and state regulators. In some instances, the audit report of the institution’s holding company can be used to satisfy this requirement. Auditors must receive examination reports, supervisory agreements and reports of enforcement actions. In addition, financial statements prepared in accordance with generally accepted accounting principles, management’s certifications concerning responsibility for the financial statements, internal controls and compliance with legal requirements designated by the FDIC, and an attestation by the auditor regarding the statements of management relating to the internal controls must be submitted. For institutions with total assets of more than $3 billion, independent auditors may be required to review quarterly financial statements. FDICIA requires that independent audit committees be formed, consisting of outside directors only. The committees of such institutions must include members with experience in banking or financial management, must have access to outside counsel, and must not include representatives of large customers.

 

Capital Adequacy Requirements. The FDIC has adopted regulations establishing minimum requirements for the capital adequacy of insured institutions. The FDIC may establish higher minimum requirements if, for example, a bank has previously received special attention or has a high susceptibility to interest rate risk.

 

The FDIC’s risk-based capital guidelines generally require state banks to have a minimum ratio of Tier 1 capital to total tangible risk-weighted assets of 4.0% and a ratio of total capital to total tangible risk-weighted assets of 8.0%. The capital categories have the same definitions for the Bank as for the Company. As of December 31, 2003,2004, the Bank’s ratio of Tier 1 capital to total tangible risk-weighted assets was 14.32%13.09% and its ratio of total capital to total tangible risk-weighted assets was 15.40%14.20%. See “Management’s Discussion and Analysis of Financial Condition and Result of Operation of the Company - Financial Condition - Capital Resources.”

 

The FDIC’s leverage guidelines require state banks to maintain Tier 1 capital of no less than 4.0% of average total tangible assets, except in the case of certain highly rated banks for which the requirement is 3.0% of average total assets. The Texas Banking Department has issued a policy which generally requires state chartered banks to maintain a leverage ratio (defined in accordance with federal capital guidelines) of 5.0%. As of December 31, 2003,2004, the Bank’s ratio of Tier 1 capital to average total assets (leverage ratio) was 6.43%6.07%.

Index to Financial Statements

Corrective Measures for Capital Deficiencies. The federal banking regulators are required to take “prompt corrective action” with respect to capital-deficient institutions. Agency regulations define, for each capital category, the levels at which institutions are “well capitalized,” “adequately capitalized,” “under capitalized,” “significantly under capitalized” and “critically under capitalized.” A “well capitalized” bank has a total risk-based capital ratio of 10.0% or higher; a Tier 1 risk-based capital ratio of 6.0% or higher; a leverage ratio of 5.0% or higher; and is not subject to any written agreement, order or directive requiring it to maintain a specific capital level for any capital measure. An “adequately capitalized” bank has a total risk-based capital ratio of 8.0% or higher; a Tier 1 risk-based capital ratio of 4.0% or higher; a leverage ratio of 4.0% or higher (3.0% or higher if the bank was rated a composite 1 in its most recent examination report and is not experiencing significant growth); and does not meet the criteria for a well capitalized bank. A bank is “under capitalized” if it fails to meet any one of the ratios required to be adequately capitalized. The Bank is classified as “well capitalized” for purposes of the FDIC’s prompt corrective action regulations.

 

In addition to requiring undercapitalized institutions to submit a capital restoration plan, agency regulations contain broad restrictions on certain activities of undercapitalized institutions including asset growth, acquisitions, branch establishment and expansion into new lines of business. With certain exceptions, an insured depository institution is prohibited from making capital distributions, including dividends, and is prohibited from paying management fees to control persons if the institution would be undercapitalized after any such distribution or payment.

As an institution’s capital decreases, the FDIC’s enforcement powers become more severe. A significantly undercapitalized institution is subject to mandated capital raising activities, restrictions on interest rates paid and transactions with affiliates, removal of management and other restrictions. The FDIC has only very limited discretion in dealing with a critically undercapitalized institution and is virtually required to appoint a receiver or conservator.

 

Banks with risk-based capital and leverage ratios below the required minimums may also be subject to certain administrative actions, including the termination of deposit insurance upon notice and hearing, or a temporary suspension of insurance without a hearing in the event the institution has no tangible capital.

 

Deposit Insurance Assessments.The Bank must pay assessments to the FDIC for federal deposit insurance protection. The FDIC has adopted a risk-based assessment system as required by FDICIA. Under this system, FDIC-insured depository institutions pay insurance premiums at rates based on their risk classification. Institutions assigned to higher risk classifications (that is, institutions that pose a greater risk of loss to their respective deposit insurance funds) pay assessments at higher rates than institutions that pose a lower risk. An institution’s risk classification is assigned based on its capital levels and the level of supervisory concern the institution poses to the regulators. In addition, the FDIC can impose special assessments in certain instances. The current range of BIF assessments is between 0% and 0.27% of deposits.

 

The FDIC established a process for raising or lowering all rates for insured institutions semi-annually if conditions warrant a change. Under this system, the FDIC has the flexibility to adjust the assessment rate schedule twice a year without seeking prior public comment, but only within a range of five cents per $100 above or below the premium schedule adopted. Changes in the rate schedule outside the five cent range above or below the current schedule can be made by the FDIC only after a full rulemaking with opportunity for public comment.

 

On September 30, 1996, President Clinton signed into law an act that contained a comprehensive approachIn addition to re-capitalizing the Savings Association Insurance Fund (“SAIF”) and to assure the payment of the Financing Corporation’s (“FICO”) bond obligations. Under this new act,BIF assessments, banks insured under the BIF are required to pay a portion of the interest due on bonds that were issued by FICOthe Financing Corporation (“FICO”) to help shore up the ailing Federal Savings and Loan Insurance Corporation in 1987. The BIF-rate was required to equal one-fifth of the SAIF rate through year-end 1999, or until the insurance funds merged, whichever occurred first. Thereafter, BIF and SAIF payers will be assessed pro rata for the FICO bond obligations. With regard to the assessment for the FICO obligation, for the fourth quarter 2003, both2004, the BIF and SAIF rates were .00152%rate was .00146% of deposits.

 

Enforcement Powers. The FDIC and the other federal banking agencies have broad enforcement powers, including the power to terminate deposit insurance, impose substantial fines and other civil and criminal penalties and appoint a conservator or receiver. Failure to comply with applicable laws, regulations and supervisory agreements could subject the Company or its banking subsidiaries, as well as officers, directors and other institution-affiliated parties of these organizations, to administrative sanctions and potentially substantial civil money penalties. The appropriate federal banking agency may appoint the FDIC as conservator or receiver for a banking institution (or the FDIC may appoint itself, under certain circumstances) if any one or more of a number of circumstances exist, including, without limitation, the fact that the banking institution is undercapitalized and has no reasonable prospect of becoming adequately capitalized; fails to become adequately capitalized when required to do so; fails to submit a timely and acceptable capital restoration plan; or materially fails to implement an accepted capital restoration plan. The Texas Banking Department also has broad enforcement powers over the Bank, including the power to impose orders, remove officers and directors, impose fines and appoint supervisors and conservators.

Index to Financial Statements

Brokered Deposit Restrictions. Adequately capitalized institutions cannot accept, renew or roll over brokered deposits except with a waiver from the FDIC, and are subject to restrictions on the interest rates that can be paid on such deposits. Undercapitalized institutions may not accept, renew, or roll over brokered deposits.

 

Cross-Guarantee Provisions. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”) contains a “cross-guarantee” provision which generally makes commonly controlled insured depository institutions liable to the FDIC for any losses incurred in connection with the failure of a commonly controlled depository institution.

 

Community Reinvestment Act. The CRA and the regulations issued thereunder are intended to encourage banks to help meet the credit needs of their service area, including low and moderate income neighborhoods, consistent with the safe and sound operations of the banks. These regulations also provide for regulatory assessment of a bank’s record in meeting the needs of its service area when considering applications to establish branches, merger applications and applications to acquire the assets and assume the liabilities of another bank. FIRREA requires federal banking agencies to make public a rating of a bank’s performance under the

CRA. In the case of a bank holding company, the CRA performance record of the banks involved in the transaction are reviewed in connection with the filing of an application to acquire ownership or control of shares or assets of a bank or to merge with any other bank holding company. An unsatisfactory record can substantially delay or block the transaction.

 

Consumer Laws and Regulations. In addition to the laws and regulations discussed herein, the Bank is also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. While the list set forth herein is not exhaustive, these laws and regulations include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, and the Fair Housing Act, among others. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits or making loans to such customers. The Bank must comply with the applicable provisions of these consumer protection laws and regulations as part of their ongoing customer relations.

 

The USA Patriot Act of 2001. The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (“USA Patriot Act”) was enacted in October 2001. The USA Patriot Act is intended to strengthen U.S. law enforcement’s and the intelligence communities’ ability to work cohesively to combat terrorism on a variety of fronts. The potential impact of the USA Patriot Act on financial institutions of all kinds is significant and wide ranging. The USA Patriot Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations, including: (i) due diligence requirements for financial institutions that administer, maintain, or manage private bank accounts or correspondent accounts for non-U.S. persons; (ii) standards for verifying customer identification at account opening; (iii) rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering; (iv) reports by nonfinancial trades and business filed with the Treasury Department’s Financial Crimes Enforcement Network for transactions exceeding $10,000; and (v) filing of suspicious activities reports involving securities by brokers and dealers if they believe a customer may be violating U.S. laws and regulations.

 

Privacy. In addition to expanding the activities in which banks and bank holding companies may engage, the Gramm-Leach-Bliley Act also imposed new requirements on financial institutions with respect to customer privacy. The Gramm-Leach-Bliley Act generally prohibits disclosure of customer information to non-affiliated third parties unless the customer has been given the opportunity to object and has not objected to such disclosure. Financial institutions are further required to disclose their privacy policies to customers annually. Financial institutions, however, will be required to comply with state law if it is more protective of customer privacy than the Gramm-Leach-Bliley Act.

 

Sarbanes-Oxley Act of 2002. In June 2003, the Securities and Exchange Commission adopted final rules under Section 404 of the Sarbanes-Oxley Act of 2002. Commencing with its 2004 Annual Report on Form 10-K, the Company will be required to include a report of management on the Company’s internal control over financial reporting. The internal control report must include a statement of management’s responsibility for establishing and maintaining adequate control over financial reporting as of year-end; of the framework used by management to evaluate the effectiveness of the Company’s internal control over financial reporting; and that the Company’s independent accounting firm has issued an attestation report on management’s assessment of the Company’s internal control over financial reporting, which report is also required to be filed as part of the Annual Report.

Instability andof Regulatory Structure

 

Various legislation, such as the Gramm-Leach-Bliley Act which expanded the powers of banking institutions and bank holding companies, and proposals to overhaul the bank regulatory system and limit the investments that a depository institution may make with insured funds, is from time to time introduced in Congress. Such legislation may change banking statutes and the operating environment of the Company and its banking subsidiaries in substantial and unpredictable ways. The Company cannot determine the ultimate effect that the Gramm-Leach-Bliley Act will have, or the effect that any potential legislation, if enacted, or implemented regulations with respect thereto, would have, upon the financial condition or results of operations of the Company or its subsidiaries.

Index to Financial Statements

Expanding Enforcement Authority

 

One of the major additional burdens imposed on the banking industry by FDICIA is the increased ability of banking regulators to monitor the activities of banks and their holding companies. In addition, the Federal Reserve Board and FDIC possess extensive authority to police unsafe or unsound practices and violations of applicable laws and regulations by depository institutions and their holding companies. For example, the FDIC may terminate the deposit insurance of any institution which it determines has engaged in an unsafe or unsound practice. The agencies can also assess civil money penalties, issue cease and desist or removal orders, seek injunctions, and publicly disclose such actions. FDICIA, FIRREA and other laws have expanded the agencies’ authority in recent years, and the agencies have not yet fully tested the limits of their powers.

Effect on Economic Environment

 

The policies of regulatory authorities, including the monetary policy of the Federal Reserve Board, have a significant effect on the operating results of bank holding companies and their subsidiaries. Among the means available to the Federal Reserve Board to affect the money supply are open market operations in U.S. government securities, changes in the discount rate on member bank borrowings, and changes in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may affect interest rates charged on loans or paid for deposits.

 

Federal Reserve Board monetary policies have materially affected the operating results of commercial banks in the past and are expected to continue to do so in the future. The nature of future monetary policies and the effect of such policies on the business and earnings of the Company and its subsidiaries cannot be predicted.

 

ITEM 2. PROPERTIES

 

TheAs of December 31, 2004, the Company conductsconducted business at 5158 full-service banking locations.centers. The Company’s headquarters are located at Prosperity Bank Plaza, 4295 San Felipe, in the Galleria area in Houston, Texas. The Company owns all of the buildings in which its Banking Centersbanking centers are located other than those listed below. The expiration dates of the leases listed below do not include renewal option periods which may be available.

 

Banking Center


  

Expiration Date of Lease


Abrams Centre

  

December 2008

Bellaire

  

October 2007

City West

  

January 2009

Congress

August 2014

Congress Drive-thru

April 2005

Copperfield

  April 2005

January 2006

Downtown

  

October 2012

Fairfield

  

May 20052008

Galveston

  

November 20052010

Gladebrook

  

October 2010

Medical Center

  February

March 2008

Oak Hill

May 2005

Post Oak

  

June 2007

Preston Road

  

September 2013

River Oaks

  

December 20042009

Riverside

July 2018

Waugh Drive

  

February 2011

William Canon

November 2009

Index to Financial Statements

The following table sets forth specific information on each of the Company’s locations:

 

Location


  

Address


  Deposits at December 31, 2003

  

Address


  

Deposits at

December 31, 2004


     (Dollars in thousands)     (Dollars in thousands)

Abrams Centre

  

9330 LBJ Freeway

Dallas, TX 75243

  $44,987  

9330 LBJ Freeway

Dallas, TX 75243

  $35,164

Aldine

  

1906 Aldine Bender

Houston, TX 77032

   16,012  

1906 Aldine Bender

Houston, TX 77032

   18,478

Allandale

  

1610 West North Loop

Austin, TX 78756

   13,520

Angleton

  

116 South Velasco

Angleton, TX 77516

   54,212  

116 South Velasco

Angleton, TX 77516

   56,964

Bay City

  

1600 Seventh St.

Bay City, TX 77404

(includes drive-thru located approximately

¼ mile from main office)

   81,166  

1600 Seventh St.

Bay City, TX 77404

(includes drive-thru located approximately

¼ mile from main office)

   81,277

Beeville

  

100 South Washington

Beeville, TX 78102

   83,466  

100 South Washington

Beeville, TX 78102

   75,150

Bellaire

  

6800 West Loop South Suite 100

Bellaire, TX 77401

   36,024

Blooming Grove

  

109 South Fordyce Street

Blooming Grove, TX 76626

   12,142

Camp Wisdom

  

3515 West Camp Wisdom Road

Dallas, TX 75237

   25,439

Cedar Hill

  

217 East FM 1382

Cedar Hill, TX 75104

   39,996

CityWest

  

2500 CityWest Blvd.

Houston, TX 77042

   17,403

Clear Lake

  

100 West Medical Center Blvd.

Webster, TX 77598

   52,911

Cleveland

  

104 West Crockett

Cleveland, TX 77237

   107,020

Congress

  

900 Congress Avenue

Austin, TX 78701

(includes drive-thru located approximately

¼ mile from main office)

   97,704

Copperfield

  

8686 Highway 6 North

Houston, TX 77095

   11,682

Corsicana

  

100 South Main Street

Corsicana, TX 75110

   20,731

Location


  

Address


  Deposits at December 31, 2003

      (Dollars in thousands)

Bellaire

  

6800 West Loop South Suite 100

Bellaire, TX 77401

  $26,244

Blooming Grove

  

109 South Fordyce Street

Blooming Grove, TX 76626

   11,646

Camp Wisdom

  

3515 W. Camp Wisdom Road

Dallas, TX 75237

   27,074

Cedar Hill

  

217 East FM 1382

Cedar Hill, TX 75104

   46,726

CityWest

  

2500 CityWest Blvd.

Houston, TX 77042

   21,782

Clear Lake

  

100 West Medical Center Blvd.

Webster, TX 77598

   50,760

Cleveland

  

104 West Crockett

Cleveland, TX 77237

   106,194

Copperfield

  

8686 Highway 6 North

Houston, TX 77095

   10,739

Corsicana

  

100 South Main Street

Corsicana, TX 75110

   22,688

Cuero

  

106 North Esplanade

Cuero, TX 77954

   29,962

Cypress

  

25820 U.S. 290

Cypress, TX 77429

   35,698

Dayton

  

106 North Main

Dayton, TX 77535

   60,379

Downtown

  

777 Walker, Suite L140

Houston, TX 77002

   11,261

East Bernard

  

700 Church St.

East Bernard, TX 77435

   57,794

Edna

  

102 North Wells

Edna, TX 77962

   61,497

El Campo

  

1301 North Mechanic

El Campo, TX 77437

   106,453

Ennis

  

207 South Clay

Ennis, TX 75119

   39,550

Fairfield

  

15050 Fairfield Village Square Dr.

Cypress, TX 77433

   6,743

Index to Financial Statements

Location


  

Address


  Deposits at
December 31, 2004


      (Dollars in thousands)

Cuero

  

106 North Esplanade

Cuero, TX 77954

  $34,977

Cypress

  

25820 U.S. 290

Cypress, TX 77429

   36,706

Dayton

  

106 North Main

Dayton, TX 77535

   59,585

Downtown

  

777 Walker, Suite L140

Houston, TX 77002

   13,503

East Bernard

  

700 Church St.

East Bernard, TX 77435

   56,389

Edna

  

102 North Wells

Edna, TX 77962

   66,974

El Campo (Bank headquarters)

  

1301 North Mechanic

El Campo, TX 77437

   105,138

Ennis

  

207 South Clay

Ennis, TX 75119

   38,053

Fairfield

  

15050 Fairfield Village Square Dr.

Cypress, TX 77433

   7,758

Galveston

  

2424 Market St.

Galveston, TX 77550

   7,926

Gladebrook

  

3934 FM 1960 West, Suite 100

Houston, TX 77068

   23,647

Goliad

  

145 North Jefferson

Goliad, TX 77963

   15,489

Highway 6-West

  

1070 Highway 6 South

Houston, TX 77077

   8,512

Hitchcock

  

8300 Highway 6

Hitchcock, TX 77563

   10,049

Kiest

  

333 West Kiest Boulevard

Dallas, TX 75224

   46,123

Lakeway

  

1415 Ranch Road 620 South

Lakeway, TX 78734

   84,059

Liberty

  

520 Main St.

Liberty, TX 77575

   56,819

Location


  

Address


  Deposits at December 31, 2003

      (Dollars in thousands)

Galveston

  

2424 Market St.

Galveston, TX 77550

  $4,870

Gladebrook

  

3934 FM 1960 West, Suite 100

Houston, TX 77068

   23,277

Goliad

  

145 North Jefferson

Goliad, TX 77963

   14,581

Highway 6-West

  

1070 Highway 6 South

Houston, TX 77077

   7,679

Hitchcock

  

8300 Highway 6

Hitchcock, TX 77563

   11,655

Kiest

  

333 West Kiest Boulevard

Dallas, TX 75224

   48,860

Liberty

  

520 Main St.

Liberty, TX 77575

   52,596

Magnolia

  

18935 FM 1488

Magnolia, TX 77355

   31,265

Mathis

  

103 North Highway 359

Mathis, TX 78368

   31,197

Medical Center

  

7505 South Main St., Suite 100

Houston, TX 77030

   32,542

Memorial

  

12602 Memorial Drive

Houston, TX 77024

   22,057

Mont Belvieu

  

10305 Eagle Drive

Mont Belvieu, TX 77580

   13,875

Needville

  

13325 Highway 36

Needville, TX 77461

   25,103

Palacios

  

600 Henderson

Palacios, TX 77465

   24,301

Post Oak

  

3040 Post Oak Blvd. Suite 150

Houston, TX 77056

   106,450

Preston Road

  

18800 Preston Road

Dallas, TX 75252

   23,461

Red Oak

  

500 North I-35 Service Road

Red Oak, TX 75154

   58,501

River Oaks (headquarters)

  

4295 San Felipe

Houston, TX 77027

   135,598

Sweeny

  

206 North McKinney

Sweeny, TX 77480

   10,316

Index to Financial Statements

Location


  

Address


  Deposits at
December 31, 2004


      (Dollars in thousands)

Magnolia

  

18935 FM 1488

Magnolia, TX 77355

  $30,697

Mathis

  

103 North Highway 359

Mathis, TX 78368

   32,146

Medical Center

  

7505 South Main St., Suite 100

Houston, TX 77030

   27,524

Memorial

  

12602 Memorial Drive

Houston, TX 77024

   22,503

Mont Belvieu

  

10305 Eagle Drive

Mont Belvieu, TX 77580

   13,654

Needville

  

13325 Highway 36

Needville, TX 77461

   24,880

Oakhill

  

6132 Hwy 290 West

Austin, TX 78735

   16,587

Palacios

  

600 Henderson

Palacios, TX 77465

   24,075

Post Oak

  

3040 Post Oak Blvd. Suite 150

Houston, TX 77056

   104,814

Preston Road

  

18800 Preston Road

Dallas, TX 75252

   15,152

Red Oak

  

500 North I-35 Service Road

Red Oak, TX 75154

   54,587

Research

  

8770 Research Blvd.

Austin, TX 78758

   9,026

River Oaks (Company headquarters)

  

4295 San Felipe

Houston, TX 77027

   143,104

Riverside

  

1708 South Lakeshore Blvd.

Austin, TX 78741

   3,528

Sweeny

  

206 North McKinney

Sweeny, TX 77480

   12,008

Tanglewood

  

5707 Woodway

Houston, TX 77057

   13,204

Turtle Creek

  

3802 Oak Lawn Avenue

Dallas, TX 75219

   23,468

Location


Address


Deposits at December 31, 2003

(Dollars in thousands)

Tanglewood

5707 Woodway

Houston, TX 77057

$10,854                        

Turtle Creek

3802 Oak Lawn Avenue

Dallas, TX 75219

29,920                        

Victoria

2702 North Navarro

Victoria, TX 77901

55,127                        

Waugh Drive

55 Waugh Drive

Houston, TX 77007

45,102                        

West Columbia

510 East Brazos

West Columbia, TX 77486

43,795                        

Westmoreland

2415 S. Westmoreland Rd.

Dallas, TX 75211

68,723                        

Wharton

143 West Burleson

Wharton, TX 77488

73,660                        

Winnie

146 Spur 5

Winnie, TX 77665

11,695                        

Woodcreek

2828 FM 1960 East

Houston, TX 77073

53,655                        

Index to Financial Statements

Location


  

Address


  Deposits at
December 31, 2004


      (Dollars in thousands)

Victoria

  

2702 North Navarro

Victoria, TX 77901

  $58,334

Waugh Drive

  

55 Waugh Drive

Houston, TX 77007

   48,981

West Columbia

  

510 East Brazos

West Columbia, TX 77486

   48,906

Westmoreland

  

2415 South Westmoreland Rd.

Dallas, TX 75211

   61,125

Wharton

  

143 West Burleson

Wharton, TX 77488

   76,180

William Cannon

  

1901 William Cannon

Austin, TX 78745

   2,544

Winnie

  

146 Spur 5

Winnie, TX 77665

   11,897

Woodcreek

  

2828 FM 1960 East

Houston, TX 77073

   64,839

 

ITEM 3. LEGAL PROCEEDINGS

 

Neither the Company nor the Bank is currently a party to any material legal proceeding.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

No matters were submitted to a vote of security holders during the fourth quarter of 2003.2004.

Index to Financial Statements

PART II.

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, AND RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

The Company’s Common Stock began trading on November 12, 1998 and is listed on the Nasdaq National Market System under the symbol “PRSP”. Prior to that date, the Common Stock was privately held and not listed on any public exchange or actively traded. As of March 8, 2004,1, 2005, there were 20,944,70527,471,396 shares outstanding and 6411,020 shareholders of record. The number of beneficial owners is unknown to the Company at this time.

 

The following table presents the high and low sales prices for the Common Stock reported on the Nasdaq National Market during the two years ended December 31, 2003:2004:

 

2004


  High

  Low

Fourth Quarter

  $29.53  $26.09

Third Quarter

   27.75   23.23

Second Quarter

   24.60   21.89

First Quarter

   25.15   22.30

2003


  High

  Low

  High

  Low

Fourth Quarter

  $24.350  $20.750  $24.35  $20.75

Third Quarter

   22.990   18.650   22.99   18.65

Second Quarter

   19.900   16.160   19.90   16.16

First Quarter

   19.840   16.300   19.84   16.30

2002


  High

  Low

Fourth Quarter

  $19.950  $15.280

Third Quarter

   19.950   15.000

Second Quarter

   18.590   15.550

First Quarter

   16.275   13.475

 

Dividends

 

Holders of Common Stock are entitled to receive dividends when, as and if declared by the Company’s Board of Directors out of funds legally available therefor. While the Company has declared dividends on its Common Stock since 1994, and paid quarterly dividends aggregating $0.3075 per share in 2004 and $0.25 per share in 2003, and $0.22 per share in 2002, there is no assurance that the Company will continue to pay dividends in the future.

 

The principal source of cash revenues to the Company is dividends paid by the Bank with respect to the Bank’s capital stock. There are certain restrictions on the payment of such dividends imposed by federal and state banking laws, regulations and authorities. Under federal law, the Bank cannot pay a dividend if it will cause the Bank to be “undercapitalized.” The Bank is also subject to risk-based capital rules that restrict its ability to pay dividends. The risk-based capital rules set a specific schedule for achieving minimum capital levels in relation to risk-weighted assets. Regulatory authorities can impose stricter limitations on the ability of the Bank to pay dividends if they consider the payment to be an unsafe or unsound practice.

 

The cash dividends declared per share by quarter (and paid on the first business day of the subsequent quarter) for the Company’s last two fiscal years were as follows:

 

  2003

  2002

  2004

  2003

Fourth quarter

  $0.0625  $0.055  $0.0825  $0.0625

Third quarter

   0.0625   0.055   0.0750   0.0625

Second quarter

   0.0625   0.055   0.0750   0.0625

First quarter

   0.0625   0.055   0.0750   0.0625

Index to Financial Statements

Recent Sales of Unregistered Securities

 

None.

 

Securities Authorized for Issuance under Equity Compensation Plans

 

TheAs of December 31, 2004, the Company currently hashad two stock option plans, both of which were approved by the Company’s shareholders. In December 2004, the Company’s Board of Directors approved the Prosperity Bancshares, Inc. 2004 Stock Incentive Plan (“2004 Plan”), which authorizes the issuance of up to 1,250,000 shares of Common Stock, subject to shareholder approval. The Company’s shareholders approved the 2004 Plan at a special meeting of shareholders on February 23, 2005. The following table provides information as of December 31, 20032004 regarding the Company’s equity compensation plans under which the Company’s equity securities are authorized for issuance:issuance, other than the 2004 Plan:

 

Plan category


  

Number of securities to

be issued upon exercise

of outstanding options,

warrants and rights

(a)


 

Weighted-average

exercise price of

outstanding options
(b)


  

Number of securities

remaining available for

future issuance under

equity compensation

plans (excluding

securities reflected

in column (a))

(c)


  

Number of securities to
be issued upon exercise
of outstanding options,
warrants and rights

(a)


 

Weighted-average

exercise price of

outstanding options

(b)


  

Number of securities

remaining available for

future issuance under

equity compensation

plans (excluding

securities reflected

in column (a))

(c)


Equity compensation plans approved by security holders

  599,692(1) $11.69  553,500  918,409(1) $19.64  136,500

Equity compensation plans not approved by security holders

  —     —    —    —     —    —  
  

 

  
  

 

  

Total

  599,692  $11.69  553,500  918,409  $19.64  136,500

(1)Includes (a) 17,06514,782 shares which may be issued upon exercise of options outstanding assumed by the Company in connection with the acquisition of Paradigm Bancorporation, Inc. at a weighted average exercise price of $10.77$10.65 and (b) 31,127 shares which may be issued upon exercise of options outstanding assumed by the Company in connection with the acquisition of MainBancorp, Inc. at a weighted average exercise price of $16.26.

Issuer Purchases of Equity Securities

None.

Index to Financial Statements

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

ITEM 6.SELECTED CONSOLIDATED FINANCIAL DATA

 

The following selected consolidated financial data for, and as of the end of, each of the years in the five-year period ended December 31, 20032004 are derived from and should be read in conjunction with the Company’s consolidated financial statements and the notes thereto and the information contained in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The consolidated financial statements as of December 31, 20032004 and 20022003 and for each of the years in the three-year period ended December 31, 20032004 and the report thereon of Deloitte & Touche LLP are included elsewhere in this document. The historical financial data of the Company has been restated to include the accounts and operations of Commercial Bancshares, Inc. for all periods prior to February 23, 2001. All per share data for 2002 and prior years has been restated to include the two-for-one stock split effective May 31, 2002.

 

  As of and for the Years Ended December 31,

   As of and for the Years Ended December 31,

 
  2003

 2002

 2001

 2000

 1999

   2004

 2003

 2002

 2001

 2000

 
  (Dollars in thousands, except per share data)   (Dollars in thousands, except per share data) 

Income Statement Data:

      

Interest income

  $90,845  $80,742  $76,520  $70,079  $56,458   $111,756  $90,845  $80,742  $76,520  $70,079 

Interest expense

   23,716   25,931   35,785   35,564   26,189    29,789   26,346   28,101   37,410   36,751 
  


 


 


 


 


  


 


 


 


 


Net interest income

   67,129   54,811   40,735   34,515   30,269    81,967   64,499   52,641   39,110   33,328 

Provision for credit losses

   483   1,010   700   275   420    880   483   1,010   700   275 
  


 


 


 


 


  


 


 


 


 


Net interest income after provision for credit losses

   66,646   53,801   40,035   34,240   29,849    81,087   64,016   51,631   38,410   33,053 

Noninterest income

   16,887   11,528   8,590   7,760   6,151    23,071   16,966   11,594   8,635   7,796 

Noninterest expense

   44,572   34,453   30,295(1)  26,767   21,822    51,707   42,021   32,349   28,715(1)  25,616 
  


 


 


 


 


  


 


 


 


 


Income before taxes

   38,961   30,876   18,330(1)  15,233   14,178    52,451   38,961   30,876   18,330(1)  15,233 

Provision for income taxes

   12,413   9,555   5,372(1)  4,532   4,747    17,744   12,413   9,555   5,372(1)  4,532 
  


 


 


 


 


  


 


 


 


 


Net income

  $26,548  $21,321  $12,958(1) $10,701  $9,431   $34,707  $26,548  $21,321  $12,958(1) $10,701 
  


 


 


 


 


  


 


 


 


 


Per Share Data(2):

      

Basic earnings per share

  $1.38  $1.25  $0.80(3) $0.67  $0.59   $1.61  $1.38  $1.25  $0.80(3) $0.67 

Diluted earnings per share

   1.36   1.22   0.79(3)  0.65   0.58    1.59   1.36   1.22   0.79(3)  0.65 

Book value per share

   10.49   8.19   5.47   4.98   4.32    12.32   10.49   8.19   5.47   4.98 

Cash dividends declared

   0.25   0.22   0.195   0.18   0.10    0.31   .25   0.22   0.195   0.18 

Dividend payout ratio

   18.29%  18.13%  24.39%  25.75%  19.10%   19.22%  18.29%  18.13%  24.39%  25.75%

Weighted average shares outstanding (basic) (in thousands)

   20,046   17,122   16,172   16,064   15,972    21,534   19,225   17,122   16,172   16,064 

Weighted average shares outstanding (diluted) (in thousands)

   20,357   17,442   16,498   16,454   16,408    21,804   19,536   17,442   16,498   16,454 

Shares outstanding at end of period (in thousands)

   20,930   18,896   16,210   16,144   15,990    22,381   20,930   18,896   16,210   16,144 

Balance Sheet Data (at period end):

      

Total assets

  $2,398,683  $1,822,256  $1,262,325  $1,146,140  $1,027,631   $2,697,228  $2,400,487  $1,823,286  $1,263,169  $1,146,520 

Securities

   1,376,880   950,317   752,322   586,952   514,983    1,302,792   1,376,880   950,317   752,322   586,952 

Loans

   770,053   679,559   424,400   411,203   366,803    1,035,513   770,053   679,559   424,400   411,203 

Allowance for credit losses

   10,345   9,580   5,985   5,523   5,031    13,105   10,345   9,580   5,985   5,523 

Total intangibles

   164,672   124,755   72,410   22,641   24,003 

Total deposits

   2,083,748   1,586,611   1,123,397   1,033,546   878,589    2,317,076   2,083,748   1,586,611   1,123,397   1,033,546 

Borrowings and notes payable

   30,936   37,939   18,080   13,931   53,119    38,174   30,936   37,939   18,080   13,931 

Total shareholders’ equity

   219,588   154,739   88,725   80,333   69,025    275,647   219,588   154,739   88,725   80,333 

Company-obligated mandatorily redeemable preferred securities of subsidiary trusts(4)

   58,000   33,000   27,000   12,000   12,000 

Junior subordinated debentures

   47,424(4)  59,804   34,030   27,844   12,380 

Average Balance Sheet Data:

      

Total assets

  $2,005,677  $1,469,860  $1,191,190  $1,045,882  $875,781   $2,543,088  $2,006,869  $1,470,758  $1,191,783  $1,046,262 

Securities

   1,108,153   818,362   666,241   550,431   465,788    1,383,790   1,108,153   818,362   666,241   550,431 

Loans

   697,235   524,885   419,553   383,054   319,178    871,736   697,235   524,885   419,553   383,054 

Allowance for credit losses

   9,525   7,350   5,586   5,245   4,272    11,454   9,525   7,350   5,586   5,245 

Total goodwill and intangibles

   139,405   81,485   38,531   22,807   20,292 

Total deposits

   1,749,045   1,300,884   1,061,195   920,526   767,879    2,189,695   1,749,045   1,300,884   1,061,195   920,526 

Total shareholders’ equity

   170,167   114,234   85,319   72,952   64,911    243,274   170,167   114,234   85,319   72,952 

Company-obligated mandatorily redeemable preferred securities of subsidiary trusts(4)

   47,583   28,750   18,875   12,000   1,500 

Junior subordinated debentures

   59,288(5)  39,400   29,648   19,468   12,380 

 

(Table continued on next page)

   As of and for the Years Ended December 31,

 
   2003

  2002

  2001

  2000

  1999

 
   (Dollars in thousands, except per share data) 

Performance Ratios:

                

Return on average assets

  1.32% 1.45% 1.09%(5) 1.02% 1.08%

Return on average equity

  15.60  18.66  15.19(5) 14.67  14.53 

Net interest margin (tax-equivalent)(6)

  3.78  4.16  3.86  3.69  3.77 

Efficiency ratio(7)

  51.58  50.36  60.14(5) 62.29  59.29 

Asset Quality Ratios(8):

                

Nonperforming assets to total loans and other real estate

  0.13% 0.38% 0.00% 0.32% 0.34%

Net loan charge-offs (recoveries) to average loans

  0.23  0.08  0.06  (0.04) (0.11)

Allowance for credit losses to total loans

  1.34  1.41  1.41  1.34  1.37 

Allowance for credit losses to nonperforming loans(9)

  1,115.97  408.53  n/m(10) 700.89  657.65 

Capital Ratios(8):

                

Leverage ratio

  7.10% 6.56% 7.57% 6.17% 6.17%

Average shareholders’ equity to average total assets

  8.52  8.52  7.16  6.98  7.41 

Tier 1 risk-based capital ratio

  15.82  14.10  18.34  13.80  13.89 

Total risk-based capital ratio

  16.90  15.30  19.52  14.93  15.74 

Index to Financial Statements
   As of and for the Years Ended December 31,

 
   2004

  2003

  2002

  2001

  2000

 
   (Dollars in thousands, except per share data) 

Performance Ratios:

                

Return on average assets

  1.36% 1.32% 1.45% 1.09%(6) 1.02%

Return on average equity

  14.27  15.60  18.66  15.19(6) 14.67 

Net interest margin

  3.56  3.52  3.86  3.50  3.43 

Efficiency ratio(7)

  49.23  51.58  50.36  60.14(6) 62.29 

Asset Quality Ratios(8):

                

Nonperforming assets to total loans and other real estate

  0.17% 0.13% 0.38% 0.00% 0.32%

Net loan charge-offs (recoveries) to average loans

  0.06  0.23  0.08  0.06  (0.04)

Allowance for credit losses to total loans

  1.27  1.34  1.41  1.41  1.34 

Allowance for credit losses to nonperforming loans(9)

  949.6  1,519.1  408.53  n/m(10) 700.89 

Capital Ratios(8):

                

Leverage ratio

  6.30% 7.10% 6.56% 7.57% 6.17%

Average shareholders’ equity to average total assets

  9.57  8.48  7.77  7.16  6.98 

Tier 1 risk-based capital ratio

  13.56  15.82  14.10  18.34  13.80 

Total risk-based capital ratio

  14.67  16.90  15.30  19.52  14.93 

(1)Certain income statement data for the year ended December 31, 2001 includes the merger-related expenses of $2.4 million, net of tax.tax, incurred in connection with the Commercial merger.
(2)Adjusted for a two-for one stock split effective May 31, 2002.
(3)Earnings per share amounts for the year ended December 31, 2001 include the merger-related expenses of $2.4 million.
(4)Consists of $12.0$15.5 million of trust preferred securities of Prosperity Capital Trust I due November 12, 2029, $15.0 million of trust preferred securitiesjunior subordinated debentures of Prosperity Statutory Trust II due July 31, 2031, $6.0$6.2 million of trust preferred securitiesjunior subordinated debentures of Paradigm Capital Trust II due February 20, 2031, $12.5$12.9 million of trust preferred securitiesjunior subordinated debentures of Prosperity Statutory Trust III due September 17, 2033 and $12.5$12.9 million of trust preferred securitiesjunior subordinated debentures of Prosperity Statutory Trust IV due December 30, 2033.
(5)Consists of $12.4 million of junior subordinated debentures of Prosperity Capital Trust I due November 12, 2029 (fully redeemed on December 31, 2004), $15.5 million of junior subordinated debentures of Prosperity Statutory Trust II due July 31, 2031, $6.2 million of junior subordinated debentures of Paradigm Capital Trust II due February 20, 2031, $12.9 million of junior subordinated debentures of Prosperity Statutory Trust III due September 17, 2033 and $12.9 million of junior subordinated debentures of Prosperity Statutory Trust IV due December 30, 2033.
(6)Selected performance ratios for the year ended December 31, 2001 include the merger-related expenses of $2.4 million.
(6)Calculated on a tax-equivalent basis using a 35% federal income tax rate for the years ended December 31, 2003, 2002 and 2001 and a 34% federal income tax rate for the years ended December 31, 1999 and 2000.
(7)Calculated by dividing total noninterest expense, excluding securities losses and credit loss provisions, by net interest income plus noninterest income. The interest expense related to debentures issued by the Company in connection with the issuance by subsidiary trusts of trust preferredincome, excluding securities is treated as interest expense for this calculation.gains. Additionally, taxes are not part of this calculation.
(8)At period end, except for net loan charge-offs to average loans and average shareholders’ equity to average total assets, which is for periods ended at such dates.
(9)Nonperforming loans consist of nonaccrual loans, loans contractually past due 90 days or more, restructured loans and any other loan management deems to be nonperforming.
(10)Amount not meaningful. Nonperforming assets totaled $1,000 at December 31, 2001.

Index to Financial Statements

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Special Cautionary Notice Regarding Forward-Looking Statements

Statements and financial discussion and analysis contained in this annual report on Form 10-K that are not historical facts are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on assumptions and involve a number of risks and uncertainties, many of which are beyond the Company’s control. Many possible events or factors could affect the future financial results and performance of the Company and could cause such results or performance to differ materially from those expressed in the forward-looking statements. These possible events or factors include, without limitation:

changes in interest rates and market prices, which could reduce the Company’s net interest margins, asset valuations and expense expectations;

changes in the levels of loan prepayments and the resulting effects on the value of the Company’s loan portfolio;

changes in local economic and business conditions which adversely affect the Company’s customers and their ability to transact profitable business with the company, including the ability of the Company’s borrowers to repay their loans according to their terms or a change in the value of the related collateral;

increased competition for deposits and loans adversely affecting rates and terms;

the timing, impact and other uncertainties of future acquisitions, including the Company’s ability to identify suitable future acquisition candidates, the success or failure in the integration of their operations, and the ability to enter new markets successfully and capitalize on growth opportunities;

increased credit risk in the Company’s assets and increased operating risk caused by a material change in commercial, consumer and/or real estate loans as a percentage of the total loan portfolio;

the failure of assumptions underlying the establishment of and provisions made to the allowance for credit losses;

changes in the availability of funds resulting in increased costs or reduced liquidity;

increased asset levels and changes in the composition of assets and the resulting impact on the Company’s capital levels and regulatory capital ratios;

the Company’s ability to acquire, operate and maintain cost effective and efficient systems without incurring unexpectedly difficult or expensive but necessary technological changes;

the loss of senior management or operating personnel and the potential inability to hire qualified personnel at reasonable compensation levels;

changes in statutes and government regulations or their interpretations applicable to financial holding companies and the Company’s present and future banking and other subsidiaries, including changes in tax requirements and tax rates;

acts of terrorism, an outbreak of hostilities or other international or domestic calamities, weather or other acts of God and other matters beyond the Company’s control; and

other risks and uncertainties listed from time to time in the Company’s reports and documents filed with the Securities and Exchange Commission.

A forward-looking statement may include a statement of the assumptions or bases underlying the forward-looking statement. The Company believes it has chosen these assumptions or bases in good faith and that they are reasonable. However, the Company cautions you that assumptions or bases almost always vary from actual results, and the differences between assumptions or bases and actual results can be material.

Index to Financial Statements

The Company undertakes no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless the securities laws require the Company to do so.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the major elements of the Company’s balance sheets and statements of income. This section should be read in conjunction with the Company’s consolidated financial statements and accompanying notes and other detailed information appearing elsewhere in this Annual Report on Form 10-K. The Commercial Mergermerger was accounted for as a pooling of interests and therefore the historical financial data of the Company has been restated to include the accounts and operations of Commercial for all periods prior to February 23, 2001.

 

For the Years Ended December 31, 2004, 2003 2002 and 20012002

 

Overview

 

The Company generates the majority of its revenues from interest income on loans, service charges on customer accounts and income from investment in securities. The revenues are offset by interest expense paid on deposits and other borrowings and non-interest expenses such as administrative and occupancy expenses. Net interest income is the difference between interest income on earning assets such as loans and securities and interest expense on liabilities such as deposits and borrowings which are used to fund those assets. Net interestInterest income is the Company’s largest source of revenue, representing 62.3%60.8% of total revenue during 2003.2004. The level of interest rates and the volume and mix of earning assets and interest-bearing liabilities impact net interest income and margin. The low rate environment has negatively impacted the Company’s net interest margin however the Company has recognized increased net interest income due primarily to the rates paid on interest bearing liabilities decreasing at a greater rate than the decrease in the rate earned on interest earning assets and an increase in the volume of interest-earning assets.

 

Three principal components of the Company’s growth strategy are internal growth, stringent cost control practices and strategic merger transactions. The Company focuses on continual internal growth. Each Banking Center is operated as a separate profit center, maintaining separate data with respect to its net interest income, efficiency ratio, deposit growth, loan growth and overall profitability. Banking Center Presidents and Managers are accountable for performance in these areas and compensated accordingly. The Company also focuses on maintaining stringent cost control practices and policies. The Company has invested significantly in the infrastructure required to centralize many of its critical operations, such as data processing and loan application processing. Management believes that this centralized infrastructure can accommodate substantial additional growth while enabling the Company to minimize operational costs through certain economies of scale. The Company also intends to continue to seek expansion opportunities. During 2003, eleven banking centers were acquired in the Dallas/Fort Worth area. The acquisitions of Abrams and Dallas Bancshares were completed in May and June 2003, respectively, adding three banking centers in Dallas. The mergers with MainBancorp and FSBNT were completed in November and December 2003, respectively, adding an additional eight banking centers in Dallas. As a part of these acquisitions, two of the acquired banking centers were combined into existing banking centers nearby bringing the total to nine banking centers added in 2003. During 2004, seven banking centers were acquired in the Austin, Texas area. The acquisitions of both Liberty Bancshares, Inc. and Village Bank and Trust, s.s.b. were completed on August 1, 2004.

 

Net income was $34.7 million, $26.6 million $21.3 million and $13.0$21.3 million for the years ended December 31, 2004, 2003 2002 and 2001,2002, respectively, and diluted earnings per share were $1.59, $1.36 $1.22 and $0.79,$1.22, respectively, for these same periods. Earnings growth during both 2004 and 2003 resulted principally from an increase in loan volume and acquisitions, including the Abrams, Dallas Bancshares, Mainbancorp, FSBNT, Liberty and FSBNTVillage acquisitions. Earnings growth during both 20022003 and 20012002 also resulted principally from an increase in loan volume and acquisitions, including the Abrams, Dallas Bancshares, Mainbancorp, FBNT, Texas Guaranty, First State, Paradigm, FNB Southwest and CommercialSouthwest acquisitions. The Company posted returns on average assets of 1.32%1.36%, 1.45%1.32% and 1.09%1.45% and returns on average equity of 15.60%14.27%, 18.66%15.60% and 15.19%18.66% for the years ended December 31, 2004, 2003 2002 and 2001,2002, respectively. The Company’s efficiency ratio was 49.23% in 2004, 51.58% in 2003 and 50.36% in 2002 and 60.14% in 2001.2002.

 

Total assets at December 31, 2004, 2003 and 2002 and 2001 were $2.399$2.697 billion, $1.822$2.400 billion and $1.262$1.823 billion, respectively. Total deposits at December 31, 2004, 2003 and 2002 and 2001 were $2.317 billion, $2.084 billion, $1.587 billion, and $1.123$1.587 billion, respectively, with deposit growth in each period resulting from acquisitions and internal growth. Total loans were $770.1 million$1.036 billion at December 31, 2003,2004, an increase of $90.5$265.5 million or 13.3%34.5% from $679.6$770.1 million at the end of 2002.2003. Total loans were $424.4$679.6 million at year-end 2001.2002. At December 31, 2003,2004, the Company had $681,000$1.4 million in nonperforming loans and its allowance for credit losses was $10.4$13.1 million. Shareholders’ equity was $275.6 million, $219.6 million $154.7 million and $88.7$154.7 million at December 31, 2004, 2003 2002 and 2001,2002, respectively.

 

On February 23, 2001, the Company completed its merger with Commercial Bancshares, Inc. As a result of the Commercial Merger, the Company issued an aggregate of 5,537,220 (after two for one stock split) shares of its Common Stock to the holders of Commercial common stock. In connection with the Commercial Merger, the Company incurred approximately $2.4 million in pretax merger-related expenses and other charges (the “Special Charge”). The transaction was accounted for as a pooling of interests and therefore the historical financial data of the Company has been restated to include the accounts and operations of Commercial for all periods prior to the effective time of the Commercial Merger.

On May 31, 2002, the Company effected a two-for-one stock split in the form of a 100 percent stock dividend to shareholders of record on May 20, 2002. The Company issued approximately 8.1 million shares in connection with the split. All per share and share information for 2002 and prior periods has been restated to reflect this split.

Index to Financial Statements

Critical Accounting Policies

 

The Company’s accounting policies are integral to understanding the results reported. AccountingThe Company’s accounting policies are described in detail in Note 1 to the consolidated financial statements. The Company believes that of its significant accounting policies, the followingallowance for credit losses may involve a higher degree of judgment and complexity:

 

Allowance for Credit Losses - The allowance for credit losses is a reserve established through charges to earnings in the form of a provision for credit losses. Management has established an allowance for credit losses which it believes is adequate for estimated losses in the Company’s loan portfolio. Based on an evaluation of the loan portfolio, management presents a monthly review of the allowance for credit losses to the Bank’s Board of Directors, indicating any change in the allowance since the last review and any recommendations as to adjustments in the allowance. In making its evaluation, management considers factors such as historical loan loss experience, industry diversification of the Company’s commercial loan portfolio, the amount of nonperforming assets and related collateral, the volume, growth and composition of the Company’s loan portfolio, current economic changes that may affect the borrower’s ability to pay and the value of collateral, the evaluation of the Company’s loan portfolio through its internal loan review process and other relevant factors. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. Charge-offs occur when loans are deemed to be uncollectible. The allowance for credit losses includes allowance allocations calculated in accordance with Statement of Financial Accounting Standards (SFAS) No. 114, “Accounting by Creditors for Impairment of a Loan,” as amended by SFAS 118, and allowance allocations determined in accordance with SFAS No. 5, “Accounting for Contingencies.”

 

Results of Operations

 

Net Interest Income

 

The Company’s operating results depend primarily on its net interest income, which is the difference between interest income on interest-earning assets, including securities and loans, and interest expense incurred on interest-bearing liabilities, including deposits and other borrowed funds. Interest rate fluctuations, as well as changes in the amount and type of earning assets and liabilities, combine to affect net interest income. The Company’s net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as a “volume change.” It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as a “rate change.”

 

The Company adopted FIN 46R,Consolidation of Variable Interest Entities”on January 1, 2004. FIN 46R requires that Prosperity Capital Trust I, Prosperity Statutory Trust II, Prosperity Statutory Trust III, Prosperity Statutory Trust IV and Paradigm Capital Trust II be deconsolidated from the consolidated financial statements. After adoption, the trust preferred securities issued by each of the foregoing trusts are no longer shown in the consolidated financial statements. Instead, the junior subordinated debentures issued by the Company to each of these trusts are shown as liabilities in the consolidated balance sheets and interest expense associated with such junior subordinated debentures is shown as interest expense in the consolidated statements of income. The dividend expense associated with the trust preferred securities for the years ended December 31, 2001, 2002 and 2003 was previously shown as noninterest expense. Prior period data has been restated to reflect the adoption of FIN 46R.

2004 versus 20022003. Net interest income before the provision for credit losses for the year ended December 31, 2004 was $82.0 million compared with $64.5 million for the year ended December 31, 2003, was $67.1 million compared with $54.8 million for the year ended December 31, 2002, an increase of $12.3$17.5 million or 22.5%27.1%. The improvement in net interest income for 20032004 was principally due to an increase in total average interest-earning assets to $2.302 billion at December 31, 2004 from $1.830 billion at December 31 2003, from $1.364 billion at December 31 2002, an increase of $466.2$471.3 million or 34.2%25.8%. The improvement in net interest income for 20032004 was also partially offset bydue to a decrease in the yield on earning-assets that exceeded the decrease in the rate paid on interest-bearing liabilities.liabilities that was greater than the decrease in the yield on earning-assets. Total cost of interest-bearing liabilities decreased 7415 basis points from 2.39% at1.79% for the year ended December 31, 20022003 to 1.65% at1.64% for the year ended December 31, 20032004 while total yield on interest-earning assets decreased 96only 10 basis points from 5.92%4.96% at December 31, 20022003 to 4.96%4.86% at December 31, 2004. At December 31, 2004, period end demand deposits represent an important component of funding sources and averaged 22.4% of total period end deposits in 2004 compared with 22.4% in 2003.

 

Net interest margin (not on a tax equivalent basis), defined as net interest income divided by average interest-earning assets, for 20032004 was 3.67% down 353.56% up four basis points from 4.02%3.52% in 2002.2003. The declineincrease in the net interest margin is attributable to declinesan increase in the level of interest rates as managed by the Federal Reserve Board and to lower yields on loans and the securities portfolio resulting from increased amortization of purchased premiums as a result of the high level of refinancings of home mortgages experienced during 2003. Declines in yields on interest-earning assets were partially offset by reductions in the cost of interest-bearing liabilities. Demand deposits represent an important component of funding sources and averaged 20.7% of total deposits in 2003 as compared to 20.3% in 2002.earning assets.

 

20022003 versus 20012002. Net interest income before provision for credit losses for the year ended December 31, 2003 was $64.5 million compared with $52.6 million for the year ended December 31, 2002, was $54.8 million compared with $40.7 million for the year ended December 31, 2001, an increase of $14.1$11.9 million or 34.6%22.5%. The improvement in net interest income for 20022003 was principally due to an increase in total average interest-earning assets and a decrease in the rate paid on interest-bearing liabilities that exceeded the decrease in the yield on interest-earning assets by 94 basis points.assets. Average interest-earning assets increased $247.9$466.2 million from $1.116$1.364 billion atfor the year ended December 31, 20012002 to $1.364$1.830 billion atfor the year ended December 31, 2002.2003. Total cost of interest-bearing liabilities decreased 16073 basis points from 3.99% at2.52% for the year ended December 31, 20012002 to 2.39% at1.79% for the year ended December 31, 2002.2003. Total yield on interest-earning assets decreased 6696 basis points from 6.58% at5.92% for the year ended December 31, 20012002 to 5.92% at4.96% for the year ended December 31, 2002.2003. The net interest margin increased 37(not on a tax equivalent basis) decreased 34 basis points to 4.02% at3.52% for the year ended December 31, 2003 from 3.86% for the year ended December 31, 2002 from 3.65%due to the yield on earning assets decreasing at December 31, 2001.a greater rate than the decrease in the cost of interest bearing liabilities.

Index to Financial Statements

The following table presents for the periods indicated the total dollar amount of average balances, interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. Except as indicated in the footnotes, no tax-equivalent adjustments were made and all average balances are daily average balances. Any nonaccruing loans have been included in the table as loans carrying a zero yield.

 

 Years Ended December 31,

   Years Ended December 31,

 
 2003

 2002

 2001

   2004

 2003

 2002

 
 Average
Outstanding
Balance


 Interest
Earned/
Paid


 Average
Yield/
Rate


 Average
Outstanding
Balance


 Interest
Earned/
Paid


 Average
Yield/
Rate


 Average
Outstanding
Balance


 Interest
Earned/
Paid


 Average
Yield/
Rate


   Average
Outstanding
Balance


 Interest
Earned/
Paid


  Average
Yield/
Rate


 Average
Outstanding
Balance


 Interest
Earned/
Paid


  Average
Yield/
Rate


 Average
Outstanding
Balance


 Interest
Earned/
Paid


  Average
Yield/
Rate


 
 (Dollars in thousands)   (Dollars in thousands) 

Assets

      

Interest-earning assets:

             

Loans.

 $697,235  $46,686 6.70% $524,885  $38,330 7.30% $419,553  $34,731 8.28%  $871,736  $55,779  6.40% $697,235  $46,686  6.70% $524,885  $38,330  7.30%

Securities(1)

  1,108,153   43,911 3.96   818,362   42,104 5.14   666,241   40,353 6.06    1,383,790   55,241  3.99   1,108,153   43,911  3.96   818,362   42,104  5.14 

Federal funds sold and other temporary investments

  24,976   248 0.99   20,956   308 1.47   30,478   1,436 4.71    46,121   736  1.60   24,976   248  0.99   20,956   308  1.47 
 


 

 


 

 


 

   


 

   


 

   


 

   

Total interest-earning assets

  1,830,364   90,845 4.96%  1,364,203   80,742 5.92%  1,116,272   76,520 6.58%   2,301,647   111,756  4.86%  1,830,364   90,845  4.96%  1,364,203   80,742  5.92%
 

 

 

    

   

   

   

Less allowance for credit losses

  (9,525)  (7,350)  (5,586)    (11,454)     (9,525)     (7,350)    
 


 


 


   


    


    


    

Total interest-earning assets, net of allowance

  1,820,839   1,356,853   1,110,686     2,290,193      1,820,839      1,356,853     

Noninterest-earning assets

  184,838   113,007   80,504     252,895      186,030      113,905     
 


 


 


   


    


    


    

Total assets

 $2,005,677  $1,469,860  $1,191,190    $2,543,088     $2,006,869     $1,470,758     
 


 


 


   


    


    


    

Liabilities and shareholders’ equity

             

Interest-bearing liabilities:

             

Interest-bearing demand deposits

 $371,801  $4,187 1.13% $249,045  $3,162 1.27% $199,077  $4,529 2.27%  $485,557  $5,027  1.04% $371,801  $4,187  1.13% $249,045  $3,162  1.27%

Savings and money market accounts.

  406,333   3,502 0.86   315,717   5,219 1.65   252,576   7,978 3.16    495,330   4,002  0.81   406,333   3,502  0.86   315,717   5,219  1.65 

Certificates of deposit

  616,353   14,944 2.42   505,796   16,595 3.28   428,314   22,273 5.20 

Federal funds purchased and other borrowings

  38,824   1,083 2.79   16,435   955 5.81   17,219   1,005 5.84 

Certificates of deposit.

   735,095   15,557  2.12   616,353   14,944  2.42   505,796   16,595  3.28 

Junior subordinated debentures

   59,288   4,046  6.82   39,400   2,630  6.68   29,648   2,170  7.32 

Federal funds purchased and other borrowings.

   40,119   1,157  2.88   38,824   1,083  2.79   16,435   955  5.81 
 


 

 


 

 


 

   


 

   


 

   


 

   

Total interest-bearing liabilities

  1,433,311   23,716 1.65%  1,086,993   25,931 2.39%  897,186   35,785 3.99%   1,815,389   29,789  1.64%  1,472,711   26,346  1.79%  1,116,641   28,101  2.52%
 


 

 


 

 


 

   


 

   


 

   


 

   

Noninterest-bearing liabilities:

             

Noninterest-bearing demand deposits

  354,558   230,326   181,228     473,713      354,558      230,326     

Company obligated mandatorily redeemable trust preferred securities of subsidiary trusts

  38,208   28,750   18,875  

Other liabilities

  9,433   9,557   8,582  

Other liabilities.

   10,712      9,433      9,557     
 


 


 


   


    


    


    

Total liabilities

  1,835,510   1,355,626   1,105,871  

Total liabilities.

   2,299,814      1,836,702      1,356,524     
 


 


 


   


    


    


    

Shareholders’ equity

  170,167   114,234   85,319     243,274      170,167      114,234     
 


 


 


   


    


    


    

Total liabilities and shareholders’equity

 $2,005,677  $1,469,860  $1,191,190  

Total liabilities and shareholders’ equity

  $2,543,088     $2,006,869     $1,470,758     
 


 


 


   


    


    


    

Net interest rate spread

 3.31% 3.53% 2.86%     3.21%   3.17%   3.40%

Net interest income and margin(2)

 $67,129 3.67% $54,811 4.02% $40,735 3.65%   $81,967  3.56% $64,499  3.52% $52,641  3.86%
 

 

 

    

   

   

   

Net interest income and margin (tax-equivalent basis)(3)

 $69,242 3.78% $56,734 4.16% $43,057 3.86%   $83,631  3.63% $66,612  3.64% $54,564  4.00%
 

 

 

    

   

   

   

(1)Yield is based on amortized cost and does not include any component of unrealized gains or losses.
(2)The net interest margin is equal to net interest income divided by average interest-earning assets.
(3)In order to make pretax income and resultant yields on tax-exempt investments and loans comparable to those on taxable investments and loans, a tax-equivalent adjustment has been computed using a federal income tax rate of 35% for the years ended December 31, 2004, 2003 2002 and 20012002 and other applicable effective tax rates.

Index to Financial Statements

The following table presents information regarding the dollar amount of changes in interest income and interest expense for the major components of interest-earning assets and interest-bearing liabilities and distinguishes between the increase (decrease) related to higher outstanding balances and the volatility ofchanges in interest rates. For purposes of this table, changes attributable to both rate and volume which cannot be segregated have been allocated to rate.

 

  Years Ended December 31,

 
  2003 vs. 2002

 2002 vs. 2001

   Years Ended December 31,

 
  (Dollars in thousands)   2004 vs. 2003

  2003 vs. 2002

 
  Increase
(Decrease)
Due to Change in


    Increase
(Decrease)
Due to Change in


   
  

Increase

(Decrease)

Due to


   Increase
(Decrease)
Due to


     Volume

  Rate

 Total

  Volume

  Rate

 Total

 
  Volume

  Rate

 Total

 Volume

 Rate

 Total

    (Dollars in thousands) 

Interest-earning assets:

           

Loans

  $12,586  $(4,230) $8,356  $8,719  $(5,120) $3,599   $11,684  $(2,591) $9,093  $12,586  $(4,230) $8,356 

Securities

   14,909   (13,102)  1,807   9,214   (7,463)  1,751    10,922   408   11,330   14,909   (13,102)  1,807 

Federal funds sold and other temporary investments

   59   (119)  (60)  (449)  (679)  (1,128)   210   278   488   59   (119)  (60)
  

  


 


 


 


 


  

  


 

  

  


 


Total increase (decrease) in interest income

   27,554   (17,453)  10,103   17,484   (13,262)  4,222    22,816   (1,905)  20,911   27,554   (17,451)  10,103 
  

  


 


 


 


 


  

  


 

  

  


 


Interest-bearing liabilities:

                  

Interest-bearing demand deposits

   1,559   (534)  1,025   1,137   (2,504)  (1,367)   1,281   (441)  840   1,559   (534)  1,025 

Savings and money market accounts

   1,498   (3,215)  (1,717)  1,994   (4,753)  (2,759)

Certificates of deposit

   3,627   (5,278)  (1,651)  4,029   (9,707)  (5,678)

Federal funds purchased and other borrowings

   1,301   (1,173)  128   (46)  (4)  (50)

Savings and money market accounts.

   767   (267)  500   1,498   (3,215)  (1,717)

Certificates of deposit.

   2,879   (2,266)  613   3,627   (5,278)  (1,651)

Junior subordinated debentures

   1,328   88   1,416   714   (254)  460 

Federal funds purchased and other borrowings.

   36   38   74   1,301   (1,173)  128 
  

  


 


 


 


 


  

  


 

  

  


 


Total increase (decrease) in interest expense

   7,985   (10,200)  (2,215)  7,114   (16,968)  (9,854)   6,291   (2,848)  3,443   8,699   (10,454)  (1,755)
  

  


 


 


 


 


  

  


 

  

  


 


Increase (decrease) in net interest income

  $19,569  $(7,253) $12,318  $10,370  $3,706  $14,076   $16,525  $943  $17,468  $18,855  $(6,997) $11,858 
  

  


 


 


 


 


  

  


 

  

  


 


 

Provision for Credit Losses

 

The Company’s provision for credit losses is established through charges to income in the form of the provision in order to bring the Company’s allowance for credit losses to a level deemed appropriate by management based on the factors discussed under “Financial Condition - Condition—Allowance for Credit Losses”. The allowance for credit losses at December 31, 20032004 was $10.4$13.1 million, representing 1.34%1.27% of outstanding loans. The provision for credit losses for the year ended December 31, 2004 was $880,000 compared with $483,000 for the year ended December 31, 2003. In 2004, an additional $400,000 provision for credit losses was made in anticipation of increased charge-offs related to loans acquired in merger transactions that year. Total net charge-offs for the year ended December 31, 2004 were $485,000 compared with $1.6 million in net charge-offs for the year ended December 31, 2003. The provision for credit losses for the year ended December 31, 2003 was $483,000 compared with $1.0 million for the year ended December 31, 2002. In 2002, an additional $500,000 provision for credit loss was made in anticipation of increased charge-offs related to loans acquired through acquisitions that year. The increased charge-offs were made in 2003, with net loan charge-offs of $1.618$1.6 million compared towith $396,000 in loannet charge-offs for the year ended December 31, 2002. The Company had $238,000 in net loan charge-offs during 2001.

 

Noninterest Income

 

The Company’s primary sources of recurring noninterest income are service charges on deposit accounts and other banking service related fees. Non-interest income does not include loan origination fees which are recognized over the life of the related loan as an adjustment to yield using the interest method. Banking related service fees include check cashing fees, official check fees, safe deposit box rent and currency handling fees. In 2003,For the year ended December 31, 2004, noninterest income totaled $16.9$23.1 million, an increase of $5.4$6.1 million or 46.5%36.0% compared with $11.5$17.0 million in 2002.2003. The increase was primarily due to an increase in insufficient funds charges and customer service charges which resulted from an increase in the number of accounts due to the Abrams, Dallas Bancshares, MainBancorp and FSBNT acquisitions. The four acquisitions in the fourth quarter of 2003 and the Liberty and Village acquisitions completed in August 2004. The two acquisitions in late 2003 and the two acquisitions in 2004 added approximately 33,500 deposit accounts and over 5,000 debit cards. Noninterest income for 20022003 was $11.5$17.0 million, an increase of $2.9$5.4 million or 34.2% from $8.646.3% compared with $11.6 million in 2001,2002, resulting largely from an increase in service charges due to the additional deposit accounts from the Texas Guaranty, First State,Abrams and Dallas Bancshares in 2003 and the Paradigm, FNB and Southwest acquisitions.acquisitions in the third and fourth quarters of 2002.

Index to Financial Statements

The following table presents, for the periods indicated, the major categories of noninterest income:

 

  Years Ended December 31,

   Years Ended December 31,

  2003

  2002

  2001

   2004

 2003

 2002

  (Dollars in thousands)   (Dollars in thousands)

Service charges on deposit accounts

  $14,236  $9,764  $7,530 

Service charges on deposit accounts.

  $20,215  $14,236 $9,764

Banking related service fees

   780   527   372    1,002   780  527

Trust and investment income

   502   444   273    214   502  444

Gains (losses) on sale of assets

   379   39   (72)

Gains on sales of assets, net

   389(1)  379  39

Gain on sale of securities

   78   —    —  

Other noninterest income

   990   754   487    1,173   1,069  820
  

  

  


  


 

 

Total noninterest income.

  $16,887  $11,528  $8,590 

Total noninterest income

  $23,071  $16,966 $11,594
  

  

  


  


 

 


(1)Includes gains on the sale of TIB-The Independent BankersBank stock acquired in various acquisitions and a gain on the sale of real property acquired in the Paradigm acquisition.

 

Noninterest Expense

 

For the years ended December 31, 2003, 2002 and 2001, noninterest expense totaled $44.6 million, $34.5 million and $30.3 million, respectively.

The following table presents for the periods indicated the major categories of noninterest expense:

   Years Ended December 31,

   2003

  2002

  2001

   (Dollars in thousands)

Salaries and employee benefits

  $22,422  $16,379  $12,955

Non-staff expenses:

            

Net occupancy expense

   4,492   3,439   1,971

Depreciation expense

   2,535   1,830   1,570

Data processing

   2,128   2,131   2,126

Regulatory assessments and FDIC insurance

   427   367   249

Ad valorem and franchise taxes

   851   676   434

Goodwill and core deposit intangibles amortization

   818   192   1,363

Communications expense (1)

   2,528   1,966   1,424

Minority expense-trust preferred securities

   2,551   2,104   1,580

Merger-related expenses

   —     —     2,425

Other

   5,820   7,557   4,198
   

  

  

Total noninterest expense

  $44,572  $34,453  $30,295
   

  

  


(1)Communications expense includes telephone, data circuits, postage and courier expenses.

For the year ended December 31, 2003,2004, noninterest expense totaled $44.6$51.7 million, an increase of $10.1$9.7 million or 29.4% over $34.523.1% compared with $42.0 million for the same period in 2002.2003. This increase is principally due to increases in salaries and employee benefits, net occupancy and depreciation costs, core deposit intangibles amortization and communicationsother expenses offset by a decrease in other expenses.which includes advertising expense. For the year ended December 31, 2002,2003, noninterest expense totaled $34.5$42.0 million, an increase of $10.1$9.7 million or 29.4%29.9% over $30.3$32.3 million for the same period in 2001. Noninterest expense for2002. The increase is primarily attributable to the year ended December 31, 2001 contained $2.4 millionadditional general operating costs associated wit the acquisitions made in merger-related expenses associated with the Commercial merger in 2001.2002. These items and other changes in the various components of noninterest expense are discussed in more detail below.

 

The following table presents, for the periods indicated, the major categories of noninterest expense:

   Years Ended December 31,

   2004

  2003

  2002

   (Dollars in thousands)

Salaries and employee benefits(1)

  $27,860  $22,422  $16,379

Non-staff expenses:

            

Net occupancy expense

   4,814   4,492   3,439

Depreciation expense

   2,843   2,535   1,830

Data processing

   2,036   2,128   2,131

Regulatory assessments and FDIC insurance

   524   427   367

Ad valorem and franchise taxes

   1,154   851   676

Core deposit intangibles amortization

   1,781   818   192

Communications expense(2)

   2,929   2,528   1,926

Other

   7,766   5,820   5,409
   

  

  

Total noninterest expense

  $51,707  $42,021  $32,349
   

  

  


(1)Salaries and employee benefits expense includes $141,000 and $26,000 in 2004 and 2003, respectively, in compensation related to the granting of stock options.
(2)Communications expense includes telephone, data circuits, postage and courier expenses.

Salaries and Employee Benefits. Salaries and employee benefits increased $5.4 million from $22.4 million at December 31, 2003 to $27.9 million at December 31, 2004 primarily due to increased staff associated with the MainBancorp and FSBNT acquisitions in fourth quarter 2003 and the Village and Liberty acquisitions in 2004. The increase is also partially attributable to annual merit increases. The number of associates employed by the Company increased from 629 at December 31, 2003 to 653 at December 31, 2004. In accordance with the Company’s adoption of SFAS 123, salaries and employee benefits expense for the year ended December 31, 2004 includes $141,000 in compensation expense related to the granting of stock options compared with $26,000 for the year ended December 31, 2003. Salaries and employee benefits increased $6.0 million from $16.4 million at December 31, 2002 to $22.4 million at December 31, 2003 primarily due to increased staff associated with the Abrams and Dallas Bancshares MainBancorp and FSBNT acquisitions in 2003 and partially attributable to annual merit increases. The number of associates employed by the company increased from 501 at December 31, 2002 to 629 at December 31, 2003. Salaries and employee benefits increased $3.4 million from $13.0 million at December 31, 2001 to $16.4 million at December 31, 2002 primarily due to increased staff associated with the Texas Guaranty, Paradigm, First State, FNB and Southwest acquisitions in 2002.

Index to Financial Statements

Net Occupancy and Depreciation Expenses. Net occupancy expense increased $322,000 or 7.2% to $4.8 million for the year ended December 31, 2004 compared with $4.5 million for the year ended December 31, 2003. Depreciation expense increased $308,000 from $2.5 million to $2.8 million for the same periods. Both increases are attributable to the addition of seven banking centers associated with the acquisitions made in 2004 and an additional 6 banking centers associated with the FSBNT and MainBancorp acquisitions in fourth quarter 2003. Net occupancy expense increased $1.1 million or 30.6% to $4.5 million atfor the year ended December 31, 2003 fromcompared with $3.4 million atfor the year ended December 31, 2002. Depreciation expense increased $705,000 from $1.8 million to $2.5 million for the same periods. Both increases are attributable to the addition of nine banking centers associated with the acquisitions

madeacquired in 2003. Net occupancy expense increased $1.5 million or 74.5% to $3.4 million at December 31, 2002 from $2.0 million at December 31, 2001. Depreciation expense increased $260,000 from $1.6 million to $1.8 million for the same periods. Both increases are attributable to the addition of 13 banking centers acquired in 2002.

 

Communications Expense. Communications expense includes telephone, data circuits, postage and courier expenses. Communications expense was $2.5$2.9 million for the year ended December 31, 20032004 compared to $2.0with $2.5 million for the same period in 2002,2003, an increase of $562,000$401,000 or 28.6%15.9%. The increase is attributable to the addition of nineseven banking centers in Dallas,Austin, Texas in 2004 and an additional 6 banking centers associated with the FSBNT and MainBancorp acquisitions made in fourth quarter 2003. Communications expense increased $540,000$602,000 or 38.1%31.3% from $1.4$1.9 million atfor the year December 31, 20012002 to $2.0$2.5 million for the same period in 2002.2003. The increase is associated with the addition of 13nine banking centers acquired in 2002.2003.

 

Goodwill and Core Deposit Intangibles Amortization. Goodwill and coreCore deposit intangibles amortization was $818,000$1.8 million for the year ended December 31, 20032004 compared to $192,000with $818,000 for the same period in 2002,2003, an increase of $626,000$963,000 or 326.0%117.7%. The increase is attributable to the addition of $3.1$4.7 million in core deposit intangible assets associated withrelated to the Abrams, Dallas BancsharesMainBancorp and MainBancorpFSBNT acquisitions in 2003.the fourth quarter of 2003 and the Liberty and Village acquisitions completed in August 2004. Core deposit intangibles are being amortized on an accelerated basis over an eight year life. Goodwill and coreCore deposit intangibles amortization decreased $1.2 millionincreased $626,000 or 859.1%326.0% from $1.4 million at$192,000 for the year December 31, 20012002 to $192,000$818,000 for the same period in 2002.2003. The decreaseincrease is associated with an accounting change requiring the amortizationaddition of goodwill to cease as of December 31, 2001.

Minority Expense-Trust Preferred Securities. Non-interest expense was also impacted by an increase$2.6 million in minority interest expensecore deposit intangible assets related to the trust preferred securities due to the issuance of $12.5 millionacquisitions made in trust preferred securities in July 2003 and a second issuance of $12.5 million in trust preferred securities on December 30, 2003. Minority expense-trust preferred securities increased $524,000 from $1.6 million at December 31, 2001 to $2.1 million at December 31, 2002. This increase is primarily related to the issuance of $15.0 million in trust preferred securities in July 2002 and the assumption of an additional $6.0 million in trust preferred securities assumed with the Paradigm acquisition. Beginning in the first quarter 2004, this minority interest expense will be accounted for as interest expense.

 

Other Noninterest Expense.Other operating expenses of $7.8 million for the year ended December 31, 2004 represented an increase of $1.9 million or 33.4% compared with $5.8 million in 2003. The increase is primarily attributable to increased advertising costs and the additional general operating costs associated with the acquisition of seven banking centers in 2004 and the MainBancorp and FSBNT acquisitions in the fourth quarter 2003. Other operating expenses increased $411,000 or 7.6% from $5.4 million at December 31, 2003 represented a decrease of $1.72002 to $5.8 million or 29.8% compared with $7.6 million in 2002. The decrease reflectsfor the Company’s continued success in controlling operating expenses and the cost savings achieved with the acquisitions in 2002. Other operating expenses increased $3.4 million or 80.0% from $4.2 million atyear ended December 31, 2001 to $7.6 million at December 31, 2002.2003. The increase is attributable to acquisitionadditional operating expenses related to the acquisitions made in 2002.2003.

 

Efficiency Ratio. The efficiency ratio is a supplemental financial measure utilized in management’s internal evaluation of the Company and is not defined under generally accepted accounting principles. The efficiency ratio is calculated by dividing total noninterest expense, excluding securities losses and credit loss provisions, by net interest income plus noninterest income. The interest expense related to debentures issued by the Company in connection with the issuance by subsidiary trusts of trust preferredincome, excluding securities is treated as interest expense for this calculation. Additionally, taxesgains. Taxes are not part of this calculation. An increase in the efficiency ratio indicates that more resources are being utilized to generate the same volume of income, while a decrease would indicate a more efficient allocation of resources. The Company’s efficiency ratio was 49.23% at December 31, 2004, a decrease from 51.58% at December 31, 2003, a slight increase from2003. The decrease reflects the Company’s continued success in controlling operating expenses and the cost savings achieved with the acquisitions made in 2004. The Company’s efficiency ratio was 50.36% at December 31, 2002. This increase was principally due the acquisition of MainBancorp and FSBNT in November and December 2003, respectively. The Company’s efficiency ratio was 60.14% at December 31, 2001.

 

Income Taxes

 

The amount of federal income tax expense is influenced by the amount of taxable income, the amount of tax-exempt income, the amount of nondeductible interest expense and the amount of other nondeductible expenses. For the year ended December 31, 2003,2004, income tax expense was $12.4$17.7 million compared with $12.4 million for the year ended December 31, 2003 and $9.6 million for the year ended December 31, 2002 and $5.4 million for the year ended December 31, 2001.2002. The increases were primarily attributable to higher pretax net earnings which resulted from an increase in net interest income for the year ended December 31, 20032004 when compared to the same period in 20022003 and 2001. In addition, the Company incurred $2.4 million in merger-related expenses during the year ended December 31, 2001 which had a tax benefit of approximately $849,000.2002. The effective tax rate in the years ended December 31, 2004, 2003 and 2002 was 33.8%, 31.9% and 2001 was 31.9%, 30.9% and 29.3%, respectively. The effective income tax rates differed from the U.S. statutory rate of 35% during the comparable periods primarily due to the effect of tax-exempt income from loans and securities. Prior to 2002, the effective tax rate was also impacted by non-deductible goodwill amortization.

Goodwill Amortization

In June 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards SFAS No. 142,Goodwill and Other Intangible Assets (SFAS No. 142). SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually in accordance with the provisions of SFAS No. 142. SFAS No. 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 121 and subsequently, SFAS No. 144 after its adoption.

The Company adopted the provisions of SFAS No. 142 as of January 1, 2002. Goodwill and intangible assets determined to have an indefinite useful life acquired in a purchase business combination completed after June 30, 2001 are no longer amortized. Goodwill from business combinations completed prior to June 30, 2001 was amortized through December 31, 2001.

 

Impact of Inflation

 

The effectsCompany’s consolidated financial statements and related notes included in this annual report on Form 10-K have been prepared in accordance with generally accepted accounting principles. These require the measurement of inflation on the local economyfinancial position and on the Company’s operating results have been relatively modest forin terms of historical dollars, without considering changes in the past several years. Sincerelative purchasing power of money over time due to inflation.

Index to Financial Statements

Unlike many industrial companies, substantially all of the Company’s assets and liabilities are monetary in nature, such as cash, securities, loans and deposits, their values are less sensitive tonature. As a result, interest rates have a more significant impact on the Company’s performance than the effects of inflation than to changing interestgeneral levels of inflation. Interest rates which domay not necessarily changemove in accordance with inflation rates. The Company tries to control the impactsame direction or in the same magnitude as the prices of interest rate fluctuations by managing the relationship between its interest rate sensitive assetsgoods and liabilities. See “Financial Condition - Interest Rate Sensitivity and Market Risk.”services. However, other expenses do reflect general levels of inflation.

 

Financial Condition

 

Loan Portfolio

 

At December 31, 2003,2004, total loans were $770.1 million,$1.036 billion, an increase of $90.5$265.5 million or 13.3%34.5% from $679.6$770.1 million at December 31, 2002.2003. The growth in loans is primarily attributable to the combined effect of internal growth and the Abrams, Dallas Bancshares, MainBancorpLiberty and FSBNTVillage acquisitions. At December 31, 2003,2004, total loans at the banking centers acquired in 20032004 totaled $125.9$189.0 million. Total loans at the banking centers acquired in 2002, which includes Texas Guaranty, First State, Paradigm, FNB and Southwest acquisitions, decreased $49.9 million from theirAt December 31, 2002 balance of $225.4 million, while2004, total loans at all banking centers in existence at January 1, 2002 increased approximately $13.5 million from 2002 to 2003. The decrease in loans from the 2002 acquisitions is due to expected pay-offswere 44.7% of deposits and charge-offs previously identified prior to the respective acquisition date and an increase in re-financing that occurred in reaction to the low rate environment. The Company was unwilling to re-finance at low, long-term fixed rates.38.4% of total assets. At December 31, 2003, total loans were 37.0% of deposits and 32.1% of total assets. At December 31, 2002, total loans were 42.8% of deposits and 37.3% of total assets. Loans increased 60.1%13.3% during 20022003 from $424.4 million at December 31, 2001 to $679.6 million at December 31, 2002.2002 to $770.1 million at December 31, 2003. The growth in loans is primarily attributable to internal growth and the 20022003 acquisitions.

 

The following table summarizes the Company’s loan portfolio by type of loan as of the dates indicated:

 

 December 31,

   December 31,

 
 2003

 2002

 2001

 2000

 1999

   2004

 2003

 2002

 2001

 2000

 
 Amount

 Percent

 Amount

 Percent

 Amount

 Percent

 Amount

 Percent

 Amount

 Percent

   Amount

  Percent

 Amount

  Percent

 Amount

  Percent

 Amount

  Percent

 Amount

  Percent

 
 (Dollars in thousands)   (Dollars in thousands) 

Commercial and industrial

 $93,989 12.2% $93,797 13.8% $46,986 11.1% $45,529 11.3% $42,003 11.5%  $144,432  13.9% $93,989  12.2% $93,797  13.8% $46,986  11.1% $46,529  11.3%

Real estate:

                   

Construction and land development.

  36,470 4.7   52,377 7.7   20,963 4.9   20,128 4.9   21,333 5.8 

Construction and land development

   109,591  10.6   36,470  4.7   52,377  7.7   20,963  4.9   20,128  4.9 

1-4 family residential

  237,055 30.8   206,586 30.4   175,253 41.3   175,525 42.7   165,238 45.1    260,453  25.2   237,055  30.8   206,586  30.4   175,253  41.3   175,525  42.7 

Home equity

  27,943 3.6   23,249 3.4   20,541 4.8   16,762 4.1   11,343 3.1    34,453  3.3   27,943  3.6   23,249  3.4   20,541  4.8   16,762  4.1 

Commercial mortgages

  260,882 33.9   183,970 27.1   78,446 18.5   75,896 18.5   64,738 17.7    369,151  35.6   260,882  33.9   183,970  27.1   78,446  18.5   75,896  18.5 

Farmland

  15,247 2.0   11,887 1.7   10,686 2.5   12,218 3.0   8,552 2.3    22,240  2.1   15,247  2.0   11,887  1.7   10,686  2.5   12,218  3.0 

Multifamily residential

  20,679 2.7   15,502 2.3   9,694 2.3   2,961 0.7   3,071 0.8    18,187  1.9   20,679  2.7   15,502  2.3   9,694  2.3   2,961  0.7 

Agriculture

  20,693 2.7   24,683 3.6   15,757 3.7   13,251 3.2   13,592 3.7    21,906  2.1   20,693  2.7   24,683  3.6   15,757  3.7   13,251  3.2 

Other

  2,274 0.3   3,020 0.4   953 0.2   2,563 0.6   2,671 0.7    2,246  0.2   2,274  0.3   3,020  0.4   953  0.2   2,563  0.6 

Consumer.

  54,821 7.1   64,488 9.6   45,121 10.7   45,370 11.0   34,262 9.3 

Consumer (net of unearned discount)

   52,854  5.1   54,821  7.1   64,488  9.6   45,121  10.7   45,370  11.0 
 

 

 

 

 

 

 

 

 

 

  

  

 

  

 

  

 

  

 

  

Total loans.

 $770,053 100.0% $ 679,559 100.0% $ 424,400 100.0% $ 411,203 100.0% $ 366,803 100.0%

Total loans

  $1,035,513  100.0% $770,053  100.0% $679,559  100.0% $424,400  100.0% $411,203  100.0%
 

 

 

 

 

 

 

 

 

 

  

  

 

  

 

  

 

  

 

  

 

The Company is focused on growing its commercial mortgage and commercial loan portfolios. The Company’s commercial mortgages grew from $260.9 million at December 31, 2003 to $369.1 million at December 31, 2004, an increase of $108.3 million or 41.5%. The Company’s commercial and industrial loans grew from $94.0 million at December 31, 2003 to $144.4 million at December 31, 2004, an increase of $50.4 million or 53.7%. The Company offers a variety of commercial lending products including term loans and lines of credit. The Company also offers a broad range of short to medium-term commercial loans, primarily collateralized, to businesses for working capital (including inventory and receivables), business expansion (including acquisitions of real estate and improvements) and the purchase of equipment and machinery. Historically, the Company has originated loans for its own account and has not securitized its loans. The purpose of a particular loan generally determines its structure. All loans in the 1-4 family residential category were originated by the Company.

All loans above $750,000$1.5 million are evaluated and acted upon by an officers’ loan committee, which meets weekly. In addition to an officers’ loan committee evaluation, loans from $2.0$5.0 million to $7.5$10.0 million are evaluated and acted upon by the Directors Loan Committee, which consists of three directors and meets as necessary and loans over $7.5$10.0 million must be evaluated and acted upon by the full board of directors which meets monthly.

 

Commercial Loans. In nearly all cases, the Company’s commercial loans are made in the Company’s primary market areaareas and are underwritten on the basis of the borrower’s ability to service suchthe debt from income. As a general practice, the Company takes as collateral a lien on any available real estate, equipment or other assets owned by the borrower and obtains a personal guaranty of the borrower or principal. Working capital loans are primarily collateralized by short-term assets whereas term loans are primarily collateralized by long-term assets. In general, commercial loans involve more credit risk than residential mortgage loans and commercial mortgage loans and, therefore, usually yield a higher return. The increased risk in commercial loans is due to the type of collateral securing these loans. The increased risk also derives from the expectation that commercial loans generally will be serviced principally from the operations of the business, and those operations may not be successful. Historical trends have shown these types of loans to have higher delinquencies than mortgage loans. As a result commercial loans involveof these additional complexities, variables and risks, andcommercial loans require more thorough underwriting and servicing than other types of loans.

In addition

Index to commercial loans, theFinancial Statements

Commercial Mortgages. The Company makes commercial mortgage loans collateralized by real estate to finance the purchase of real estate. The Company’s commercial mortgage loans are securedcollateralized by first liens on real estate, typically have variable interest rates and amortize over a ten to 15 year period. Payments on loans securedcollateralized by such properties are often dependent on the successful operation or management of the properties. Accordingly, repayment of these loans may be subject to adverse conditions in the real estate market or the economy to a greater extent than other types of loans. The Company seeks to minimize these risks in a variety of ways, including giving careful consideration to the property’s operating history, future operating projections, current and projected occupancy, location and physical condition in connection with underwriting these loans. The underwriting analysis also includes credit verification, appraisals and a review of the financial condition of the borrower.

1-4 Family Residential Loans. A significant portion of the Company’s lending activity has consisted of the origination of 1-4 family residential mortgage loans collateralized by owner-occupied properties located in the Company’s market areas. The Company offers a variety of mortgage loan products which generally are amortized over five to 25 years. Loans collateralized by 1-4 family residential real estate generally have been originated in amounts of no more than 90% of appraised value or have mortgage insurance. The Company requires mortgage title insurance and hazard insurance. The Company has elected to keep all 1-4 family residential loans for its own account rather than selling such loans into the secondary market. By doing so, the Company is able to realize a higher yield on these loans; however, the Company also incurs interest rate risk as well as the risks associated with nonpayments on such loans.

 

Construction Loans. The Company makes loans to finance the construction of residential and, to a limited extent, nonresidential properties. Construction loans generally are securedcollateralized by first liens on real estate and have floating interest rates. The Company conducts periodic inspections, either directly or through an agent, prior to approval of periodic draws on these loans. Underwriting guidelines similar to those described above are also used in the Company’s construction lending activities. Construction loans involve additional risks attributable to the fact that loan funds are advanced upon the security of a project under construction, and the project is of uncertain value prior to its completion. Because of uncertainties inherent in estimating construction costs, the market value of the completed project and the effects of governmental regulation on real property, it can be difficult to accurately evaluate the total funds required to complete a project and the related loan to value ratio. As a result of these uncertainties, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project rather than the ability of a borrower or guarantor to repay the loan. If the Company is forced to foreclose on a project prior to completion, there is no assurance that the Company will be able to recover all of the unpaid portion of the loan. In addition, the Company may be required to fund additional amounts to complete a project and may have to hold the property for an indeterminate period of time. While the Company has underwriting procedures designed to identify what it believes to be acceptable levels of risks in construction lending, no assurance can be given that these procedures will prevent losses from the risks described above.

 

Agriculture Loans. The Company provides agricultural loans for short-term crop production, including rice, cotton, milo and corn, farm equipment financing and agricultural real estate financing. The Company evaluates agricultural borrowers primarily based on their historical profitability, level of experience in their particular agricultural industry, overall financial capacity and the availability of secondary collateral to withstand economic and natural variations common to the industry. Because agricultural loans present a higher level of risk associated with events caused by nature, the Company routinely makes on-site visits and inspections in order to monitor and identify such risks.

 

Consumer Loans. Consumer loans made by the Company include direct “A”-credit automobile loans, recreational vehicle loans, boat loans, home improvement loans, home equity loans, personal loans (collateralized and uncollateralized) and deposit account collateralized loans. The terms of these loans typically range from 12 to 120 months and vary based upon the nature of collateral and size of loan. Consumer loans entail greater risk than do residential mortgage loans, particularly in the case of consumer loans that are unsecured or securedcollateralized by rapidly depreciating assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan balance. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws may limit the amount which can be recovered on such loans.

1-4 Family Residential Loans. Additionally, a significant portion of the Company’s lending activity has consisted of the origination of 1-4 family residential mortgage loans collateralized by owner-occupied properties located in the Company’s market areas. The Company offers a variety of mortgage loan products which generally are amortized over five

Index to 25 years. Loans collateralized by 1-4 family residential real estate generally have been originated in amounts of no more than 90% of appraised value or have mortgage insurance. The Company requires mortgage title insurance and hazard insurance. The Company has elected to keep all 1-4 family residential loans for its own account rather than selling such loans into the secondary market. By doing so, the Company is able to realize a higher yield on these loans; however, the Company also incurs interest rate risk as well as the risks associated with nonpayments on such loans.

Financial Statements

The contractual maturity ranges of the commercial and industrial and construction and land development portfolios and the amount of such loans with predetermined interest rates and floating rates in each maturity range as of December 31, 20032004 are summarized in the following table:

 

  December 31, 2003

  December 31, 2004

  

One Year

or Less


  

After One

Through

Five Years


  

After Five

Years


  Total

  One Year
or Less


  After One
Through
Five Years


  After Five
Years


  Total

  (Dollars in thousands)  (Dollars in thousands)

Commercial and industrial

  $41,248  $35,464  $8,781  $85,493  $72,934  $55,947  $15,551  $144,432

Construction and land development

   22,255   12,872   1,342   36,469   84,235   19,766   5,590   109,591
  

  

  

  

  

  

  

  

Total

  $63,503  $48,336  $10,123  $121,962  $157,169  $75,713  $21,141  $254,023
  

  

  

  

  

  

  

  

Loans with a predetermined interest rate

  $18,728  $21,309  $598  $40,635  $39,873  $23,736  $4,351  $67,960

Loans with a floating interest rate

   44,775   27,027   9,525   81,327   117,296   51,977   16,790   186,063
  

  

  

  

  

  

  

  

Total

  $63,503  $48,336  $10,123  $121,962  $157,169  $75,713  $21,141  $254,023
  

  

  

  

  

  

  

  

 

Nonperforming Assets

 

The Company has several procedures in place to assist it in maintaining the overall quality of its loan portfolio. The Company has established underwriting guidelines to be followed by its officers. Theofficers and the Company also monitors its delinquency levels for any negative or adverse trends. There can be no assurance, however, that the Company’s loan portfolio will not become subject to increasing pressures from deteriorating borrower credit due to general economic conditions.

 

The Company requires appraisals on loans securedcollateralized by real estate. With respect to potential problem loans, an evaluation of the borrower’s overall financial condition is made to determine the need, if any, for possible write-downs or appropriate additions to the allowance for credit losses.

 

The Company generally places a loan on nonaccrual status and ceases accruing interest when the payment of principal or interest is delinquent for 90 days, or earlier in some cases, unless the loan is in the process of collection and the underlying collateral fully supports the carrying value of the loan. The Company generally charges off such loans before attaining nonaccrual status.

 

The Company’s conservative lending approach has resulted in strong asset quality. The Company had $927,000$1.7 million in nonperforming assets as ofat December 31, 2004 compared with $927,000 at December 31, 2003 compared withand $2.6 million at December 31, 2002 and $1,000 at December 31, 2001.2002. Interest foregone on nonaccrual loans for the yearyears ended December 31, 2004 and 2003 was $54,000 and 2002 was $38,000, and $25,000, respectively.

 

The following table presents information regarding past due loans and nonperforming assets at the dates indicated:

 

  December 31,

   December 31,

 
  2003

 2002

 2001

 2000

 1999

   2004

 2003

 2002

 2001

 2000

 
  (Dollars in thousands)   (Dollars in thousands) 

Nonaccrual loans

  $2  $1,125  $1  $10  $756   $297  $2  $1,125  $1  $10 

Restructured loans

   —     —     —     —     5    —     —     —     —     —   

Other non-performing loans

   —     1,100   —     —     —   

Other nonperforming loans

   —     —     1,100   —     —   

Accruing loans 90 or more days past due

   679   120   —     778   4    1,083   679   120   —     778 
  


 


 


 


 


Total nonperforming loans

   1,380   681   2,345   1   788 

Other real estate

   246   219   —     545   500    341   246   219   —     545 
  


 


 


 


 


  


 


 


 


 


Total nonperforming assets

  $927  $2,564  $1  $1,333  $1,265   $1,721  $927  $2,564  $1  $1,333 
  


 


 


 


 


  


 


 


 


 


Nonperforming assets to total loans and other real estate

   0.13%  0.38%  0.00%  0.32%  0.34%   0.17%  0.13%  0.38%  0.00%  0.32%

Index to Financial Statements

Allowance for Credit Losses

 

The following table presents, for the periods indicated, an analysis of the allowance for credit losses and other related data:

 

  Years Ended December 31,

   Years Ended December 31,

 
  2003

 2002

 2001

 2000

 1999

   2004

 2003

 2002

 2001

 2000

 
  (Dollars in thousands)   (Dollars in thousands) 

Average loans outstanding

  $697,235  $524,885  $419,553  $383,054  $319,178   $871,736  $697,235  $524,885  $419,553  $383,054 
  


 


 


 


 


  


 


 


 


 


Gross loans outstanding at end of period

  $770,053  $679,559  $424,400  $411,203  $366,803   $1,035,513  $770,053  $679,559  $424,400  $411,203 
  


 


 


 


 


  


 


 


 


 


Allowance for credit losses at beginning of period

  $9,580  $5,985  $5,523  $5,031  $3,682   $10,345  $9,580  $5,985  $5,523  $5,031 

Balance acquired with the Abrams, Dallas Bancshares, Mainbancorp and FSBNT acquisitions in 2003, Texas Guaranty, First State, Paradigm, FNB and Southwest acquisitions in 2002, the Compass acquisition in 2000 and the South Texas acquisition in 1999, respectively

   1,900   2,981   —     46   566 

Balance acquired with the Liberty and Village acquisitions in 2004, Abrams, Dallas Bancshares, MainBancorp and FSBNT acquisitions in 2003, Texas Guaranty, First State, Paradigm, FNB and Southwest acquisitions in 2002 and the Compass acquisition in 2000, respectively

   2,365   1,900   2,981   —     46 

Provision for credit losses

   483   1,010   700   275   420    880   483   1,010   700   275 

Charge-offs:

      

Commercial and industrial

   (810)  (356)  (180)  (116)  (30)   (139)  (810)  (356)  (180)  (116)

Real estate and agriculture

   (960)  (231)  (175)  (38)  (43)   (613)  (960)  (231)  (175)  (38)

Consumer.

   (471)  (180)  (74)  (63)  (64)

Consumer

   (198)  (471)  (180)  (74)  (63)

Recoveries:

      

Commercial and industrial

   159   111   15   43   236    239   159   111   15   43 

Real estate and agriculture

   198   175   121   263   218    65   198   175   121   263 

Consumer.

   266   85   55   82   46 

Consumer

   161   266   85   55   82 
  


 


 


 


 


  


 


 


 


 


Net (charge-offs) recoveries

   (1,618)  (396)  (238)  171   363    (485)  (1,618)  (396)  (238)  171 
  


 


 


 


 


  


 


 


 


 


Allowance for credit losses at end of period

  $10,345  $9,580  $5,985  $5,523  $5,031   $13,105  $10,345  $9580  $5,985  $5,523 
  


 


 


 


 


  


 


 


 


 


Ratio of allowance to end of period loans

   1.34%  1.41%  1.41%  1.34%  1.37%   1.27%  1.34%  1.41%  1.41%  1.34%

Ratio of net charge-offs (recoveries) to average loans

   0.23   0.08   0.06   (0.04)  (0.11)   0.06   0.23   0.08   0.06   (0.04)

Ratio of allowance to end of period nonperforming loans

   1,116.0   408.5   n/m(1)  700.89   657.65    949.6   1,519.1   408.5   n/m(1)  700.89 

(1)Amount not meaningful. Nonperforming loans totaled $1,000 at December 31, 2001.

 

The allowance for credit losses is a reserve established through charges to earnings in the form of a provision for credit losses. Management has established an allowance for credit losses which it believes is adequate for estimated losses in the Company’s loan portfolio. Based on an evaluation of the loan portfolio, management presents a monthly review of the allowance for credit losses to the Bank’s Board of Directors, indicating any change in the allowance since the last review and any recommendations as to adjustments in the allowance. In making its evaluation, management considers factors such as historical loan loss experience, industry diversification of the Company’s commercial loan portfolio, the amount of nonperforming assets and related collateral, the volume, growth and composition of the Company’s loan portfolio, current economic changes that may affect the borrower’s ability to pay and the value of collateral, the evaluation of the Company’s loan portfolio through its internal loan review process and other relevant factors. Charge-offs occur when loans are deemed to be uncollectible.

 

The Company considers risk elements attributable to particular loan types or categories in assessing the quality of individual loans. Some of the risk elements include:

 

for 1-4 family residential mortgage loans, the borrower’s ability to repay the loan, including a consideration of the debt to income ratio and employment and income stability, the loan to value ratio, and the age, condition and marketability of collateral;

 

for commercial mortgage loans and multifamily residential loans, the debt service coverage ratio (income from the property in excess of operating expenses compared to loan payment requirements), operating results of the owner in the case of owner-occupied properties, the loan

Index to value ratio, the age and condition of the collateral and the volatility of income, property value and future operating results typical of properties of that type;Financial Statements

owner-occupied properties, the loan to value ratio, the age and condition of the collateral and the volatility of income, property value and future operating results typical of properties of that type;

 

for agricultural real estate loans, the experience and financial capability of the borrower, projected debt service coverage of the operations of the borrower and loan to value ratio;

for construction and land development loans, the perceived feasibility of the project including the ability to sell developed lots or improvements constructed for resale or ability to lease property constructed for lease, the quality and nature of contracts for presale or preleasing, if any, experience and ability of the developer and loan to value ratio;

 

for commercial and industrial loans, the operating results of the commercial, industrial or professional enterprise, the borrower’s business, professional and financial ability and expertise, the specific risks and volatility of income and operating results typical for businesses in that category and the value, nature and marketability of collateral; and

 

for non-real estate agricultural loans, the operating results, experience and financial capability of the borrower, historical and expected market conditions and the value, nature and marketability of collateral.

 

In addition, for each category, the Company considers secondary sources of income and the financial strength and credit history of the borrower and any guarantors.

 

The Company follows a loan review program to evaluate the credit risk in the loan portfolio. Through the loan review process, the Company maintains an internally classified loan list which, along with the delinquency list of loans, helps management assess the overall quality of the loan portfolio and the adequacy of the allowance for credit losses. Loans classified as “substandard” are those loans with clear and defined weaknesses such as a highly-leveraged position, unfavorable financial ratios, uncertain repayment sources or poor financial condition, which may jeopardize recoverability of the debt. Loans classified as “doubtful” are those loans which have characteristics similar to substandard accounts but with an increased risk that a loss may occur, or at least a portion of the loan may require a charge-off if liquidated at present. Loans classified as “loss” are those loans which are in the process of being charged off. For each classified loan, the Company generally allocates a specific loan loss reserve equal to a predetermined percentage of the loan amount, depending on the classification.

 

In addition to the internally classified loan list and delinquency list of loans, the Company maintains a separate “watch list” which further aids the Company in monitoring loan portfolios. Watch list loans have one or more deficiencies that require attention in the short term or pertinent ratios of the loan account that have weakened to a point where more frequent monitoring is warranted. These loans do not have all of the characteristics of a classified loan (substandard or doubtful) but do show weakened elements compared with those of a satisfactory credit. The Company reviews these loans to assist in assessing the adequacy of the allowance for credit losses.

 

In order to determine the adequacy of the allowance for credit losses, management considers the risk classification or delinquency status of loans and other factors, such as collateral value, portfolio composition, trends in economic conditions and the financial strength of borrowers. Management actively monitors the Company’s asset quality and establishes specific allowances for loans which management believes require reserves greater than those allocated according to their classification or delinquent status. An unallocated allowance is also established based on the Company’s historical charge-off experience and existing general economic and business conditions affecting the key lending areas of the Company, credit quality trends, collateral values, loan volume and concentrations and seasoning of the loan portfolio. The Company then charges to operations a provision for credit losses to maintain the allowance for credit losses at an adequate level determined by the foregoing methodology.

 

At December 31, 2003, the allowance for credit losses totaled $10.4 million, or 1.34% of total loans. At December 31, 2002, the allowance aggregated $9.6 million, or 1.41% of total loans and at December 31, 2001, the allowance was $6.0 million, or 1.41% of total loans.

The following tables describe the allocation of the allowance for credit losses among various categories of loans and certain other information for the dates indicated. The allocation is made for analytical purposes and is not necessarily indicative of the categories in which future losses may occur. The total allowance is available to absorb losses from any segment of loans.

   December 31,

 
   2003

  2002

 
   Amount

  Percent of
Loans to
Total Loans


  Amount

  Percent of
Loans to
Total Loans


 
   (Dollars in thousands) 

Balance of allowance for credit losses applicable to:

               

Commercial and industrial

  $253  12.2% $559  13.8%

Real estate

   957  77.7   397  72.6 

Agriculture

   35  2.7   42  3.6 

Consumer and other

   34  7.4   71  10.0 

Unallocated

   9,066  —     8,781  —   
   

  

 

  

Total allowance for credit losses

  $10,345  100.0% $9,850  100.0%
   

  

 

  

   December 31,

 
   2001

  2000

  1999

 
   Amount

  Percent of
Loans to
Total Loans


  Amount

  

Percent of

Loans to

Total Loans


  Amount

  

Percent of

Loans to

Total Loans


 
   (Dollars in thousands) 

Balance of allowance for credit losses applicable to:

                      

Commercial and industrial

  $357  11.1% $625  11.3% $620  11.5%

Real estate

   553  74.3   116  73.9   74  74.8 

Agriculture

   11  3.7   17  3.2   22  3.7 

Consumer and other

   10  10.9   28  11.6   25  10.0 

Unallocated

   5,054  —     4,737  —     4,290  —   
   

  

 

  

 

  

Total allowance for credit losses

  $5,985  100.0% $5,523  100.0% $5,031  100.0%
   

  

 

  

 

  

Where management is able to identify specific loans or categories of loans where specific amounts of reserve are required, allocations are assigned to those categories. Federal and state bank regulators also require that a bank maintain a reserve that is sufficient to absorb an estimated amount of unidentified potential losses based on management’s perception of economic conditions, loan portfolio growth, historical charge-off experience and exposure concentrations. Management, along with a number of economists, has perceived during the past year an increasing instability in the national and Southeast Texas economies and a worldwide economic slowdown that could contribute to job losses and otherwise adversely affect a broad variety of business sectors. In addition, as the Company has grown, its aggregate loan portfolio has increased and since the Company has made a decision to diversify its loan portfolio into areas other than 1-4 family residential mortgage loans, the risk profile of the Company’s loans has increased. By virtue of its increased capital levels, the Company is able to make larger loans, thereby increasing the possibility that one uncollectible loan would have a more severe adverse impact.

At December 31, 2004, the allowance for credit losses totaled $13.1 million, or 1.27% of one bad loan having a larger adverse impact than before.total loans. At December 31, 2003, the allowance aggregated $10.4 million or 1.34% of total loans and at December 31, 2002, the allowance was $9.6 million, or 1.41% of total loans.

Index to Financial Statements

The following tables describe the allocation of the allowance for credit losses among various categories of loans and certain other information as of the dates indicated. The allocation is made for analytical purposes and is not necessarily indicative of the categories in which future losses may occur. The total allowance is available to absorb losses from any segment of loans.

   December 31,

 
   2004

  2003

 
   Amount

  Percent of
Loans to
Total Loans


  Amount

  Percent of
Loans to
Total Loans


 
   (Dollars in thousands) 

Balance of allowance for credit losses applicable to:

               

Commercial and industrial

  $274  13.9% $253  12.2%

Real estate

   503  78.7   957  77.7 

Agriculture

   12  2.1   35  2.7 

Consumer and other

   26  5.3   34  7.4 

Unallocated

   12,290  —     9,066  —   
   

  

 

  

Total allowance for credit losses

  $13,105  100.0% $10,345  100.0%
   

  

 

  

   December 31,

 
   2002

  2001

  2000

 
   Amount

  Percent of
Loans to
Total Loans


  Amount

  Percent of
Loans to
Total Loans


  Amount

  Percent of
Loans to
Total Loans


 
   (Dollars in thousands) 

Balance of allowance for credit losses applicable to:

                      

Commercial and industrial

  $559  13.8% $357  11.1% $625  11.3%

Real estate

   397  72.6   553  74.3   116  73.9 

Agriculture

   42  3.6   11  3.7   17  3.2 

Consumer and other

   71  10.0   10  10.9   28  11.6 

Unallocated

   8,781  —     5,054  —     4,737  —   
   

  

 

  

 

  

Total allowance for credit losses

  $9,850  100.0% $5,985  100.0% $5,523  100.0%
   

  

 

  

 

  

 

The Company believes that the allowance for credit losses at December 31, 20032004 is adequate to cover losses inherent in the portfolio as of such date. There can be no assurance, however, that the Company will not sustain losses in future periods, which could be substantial in relation to the size of the allowance at December 31, 2003.2004.

 

Securities

 

The Company uses its securities portfolio both as a source of income, and as a source of liquidity.liquidity for cash requirements and to manage interest rate risk. At December 31, 2003,2004, investment securities totaled $1.30 billion, a decrease of $74.1 million or 5.4% from $1.38 million at December 31, 2003. The decrease in securities is primarily the result of the Company utilizing cash flow from the portfolio to fund loan growth. Securities increased to $1.38 billion an increase of $426.6 million or 44.9%at December 31, 2003 from $950.3 million at December 31, 2002, primarily due to the Company investing excess deposits from acquisitions and internal growth.an increase of $426.7 million or 44.9%. The Company acquired $102.1 million in securities from the Abrams, Dallas Bancshares, MainBancorp and FSNBT acquisitions in 2003. At December 31, 2003,2004, securities represented 57.4%48.3% of total assets compared with 52.2%57.4% of total assets at December 31, 2002.2003.

Securities increased $198.0 million or 26.3% from $752.3 million at December 31, 2001

Index to $950.3 million at December 31, 2002, primarily due to the investment of excess deposits from acquisitions and internal growth. The Company acquired $86.4 million in securities from the Texas Guaranty, First State, Paradigm, Southwest and FNB acquisitions in 2002.

Financial Statements

The following table summarizes the amortized cost of securities as of the dates shown (available-for-sale securities are not adjusted for unrealized gains or losses). The Qualified Zone Academy Bond (“QZAB”) is included in the states and political subdivision category.

 

  December 31,

  December 31,

  2003

  2002

  2001

  2000

  1999

  2004

  2003

  2002

  2001

  2000

  (Dollars in thousands)  (Dollars in thousands)

U.S. Treasury securities and obligations of U.S. government agencies

  $48,762  $97,098  $143,397  $334,562  $316,859

U.S. Treasury securities and obligations of U.S. government agencies.

  $30,726  $48,762  $97,098  $143,397  $334,562

70% non-taxable preferred stock

   44,015   44,029   24,058   19,085   4,049   24,000   44,015   44,029   24,058   19,085

States and political subdivisions

   53,738   58,994   51,503   46,819   40,369   37,698   45,738   50,994   43,503   38,819

Corporate debt securities

   15,619   25,338   22,712   24,879   28,038   10,787   15,902   25,338   22,712   24,906

Equity securities

   283   —     —     2   2

Collateralized mortgage obligations

   178,487   168,282   17,378   18,307   12,267   238,994   178,487   168,282   17,378   18,307

Mortgage-backed securities

   1,032,861   552,515   492,940   142,354   117,436   957,354   1,032,861   552,515   492,940   142,354

Other

   —     —     —     25   25

Qualified Zone Academy Bond (QZAB)

   8,000   8,000   8,000   8,000   8,000
  

  

  

  

  

  

  

  

  

  

Total

  $1,373,765  $946,256  $751,988  $586,033  $519,045  $1,307,559  $1,373,765  $946,256  $751,988  $586,033
  

  

  

  

  

  

  

  

  

  

 

The following table summarizes the contractual maturity of securities and their weighted average yields. Available-for-sale securities are shown at fair value and held-to-maturity securities are shown at amortized cost. Equity securities are included in the corporate debt securities category.

 

  December 31, 2003

   December 31, 2004

 
  

Within One

Year


 

After One Year
but

Within Five
Years


 

After Five Years
but

Within Ten

Years


 

After Ten

Years


   Total

   Within One
Year


 After One Year
but Within Five
Years


 After Five Years
but Within Ten
Years


 After Ten Years

 Total

 
  Amount

  Yield

 Amount

  Yield

 Amount

  Yield

 Amount

  Yield

   Total

  Yield

   Amount

  Yield

 Amount

  Yield

 Amount

  Yield

 Amount

  Yield

 Total

  Yield

 
  (Dollars in thousands)   (Dollars in thousands) 

U.S. Treasury securities and obligations of U.S. government agencies

  $11,606  5.18% $32,432  4.79% $4,052  5.07% $919  7.83%  $49,009  4.96%  $15,338  4.45% $14,280  4.62% $1,043  4.93% $—    % $30,661  4.55%

70% non-taxable preferred stock

   —    —     —    —     19,688  3.78   24,000  4.60    43,688  4.23    —    —     —    —     —    —     17,850  3.69   17,850  3.69 

States and political subdivisions

   5,232  6.04   18,138  6.36   9,553  6.25   14,613  7.73    47,536  6.72 

States and political subdivisions.

   4,693  5.66   14,612  5.41   8,495  6.63   11,263  7.81   39,063  6.40 

Corporate debt securities

   5,306  5.72   10,596  5.74   —    —     —    —      15,902  5.73    3,667  5.48   7,120  5.77   —    —     —       10,787  5.67 

Collateralized mortgage obligations

   —    —     2,300  2.61   1,823  1.70   174,806  4.19    178,929  4.14 

Collateralized mortgage obligations.

   —    —     1,520  2.61   26,053  4.18   211,462  4.09   239,035  4.09 

Mortgage-backed securities

   472  5.61   15,558  5.41   576,759  4.07   441,027  4.05    1,033,816  4.08    265  5.12   11,324  5.55   580,567  4.09   365,240  4.31   957,396  4.19 

Qualified Zone Academy Bond (QZAB)

   —    —     —    —     8,000  2.00   —    —      8,000  2.00    —    —     —    —     8,000  2.00   —       8,000  2.00 
  

   

   

   

     

     

  

 

  

 

  

 

  

 

  

Total

  $22,616  5.52% $79,024  5.34% $619,875  4.07% $655,365  4.19%  $1,376,880  4.22 %  $23,963  4.85% $48,856  5.18% $624,158  4.10% $605,815  4.28% $1,302,792  4.24%
  

  

 

  

 

  

 

  

  

  

  

  

 

  

 

  

 

  

 

  

 

ContractualThe contractual maturity of mortgage-backed securities and collateralized mortgage obligations is not a reliable indicator of their expected life because borrowers have the right to prepay their obligations at any time. TheMortgage-backed securities monthly pay downs cause the average lives of the securities to be much different than their stated lives. For purposes of the above table, tax-exempt states and political subdivisions are calculated on a tax equivalent basis. The QZAB bond is not calculated on a tax-equivalenttax equivalent basis and it generates a tax credit of 7.18%, which is included in gross income. The 70% non-taxable preferred stock includes investments in GovernmentFederal National Mortgage Association (Ginnie(Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) preferred stock.

 

The Company does not own securities of any one issuer (other than the U.S. government and its agencies) for which aggregate adjusted cost exceeds 10% of the consolidated shareholders’ equity at December 31, 20032004 and December 31, 2002.2003.

 

The average yield of the securities portfolio was 3.99% in 2004 compared with 3.96% in 2003 and 5.14% in 2002. The three basis point increase was primarily due to the Company reinvesting funds at higher rates in 2004 compared to 5.14% in 2002 and 6.06% in 2001.2003. The decline in the average yield over the comparable periodsfrom 2002 to 2003 primarily resulted from the investment of new funds received from deposit growth at lower current yields and the reinvestment of proceeds from the early repayment of mortgage-backed securities in similar investments, also at lower current yields. The early repayment of mortgage-backed securities primarily resulted from borrower refinancing due to lower market interest rates. The overall growth in the securities portfolio over the comparable periods was primarily funded by deposit growth.

Index to Financial Statements

The following table summarizes the carrying value by classification of securities as of the dates shown:

 

  December 31,

  December 31,

  2003

  2002

  2001

  2000

  1999

  2004

  2003

  2002

  2001

  2000

  (Dollars in thousands)  (Dollars in thousands)

Available-for-sale

  $263,648  $309,219  $482,233  $334,773  $224,790  $177,683  $263,648  $309,219  $482,233  $334,773

Held-to-maturity

   1,113,232   641,098   270,089   252,179   290,193   1,125,109   1,113,232   641,098   270,089   252,179
  

  

  

  

  

  

  

  

  

  

Total

  $1,376,880  $950,317  $752,322  $586,952  $514,983  $1,302,792  $1,376,880  $950,317  $752,322  $586,952
  

  

  

  

  

  

  

  

  

  

 

The following tables present the amortized cost and fair value of securities classified as available-for-sale at December 31, 2004, 2003 2002 and 2001:2002:

 

 December 31, 2003

 December 31, 2002

  December 31, 2004

  December 31, 2003

 Amortized
Cost


 Gross
Unrealized
Gains


 Gross
Unrealized
Losses


 Fair Value

 Amortized
Cost


 Gross
Unrealized
Gains


 Gross
Unrealized
Losses


 Fair Value

  Amortized
Cost


  Gross
Unrealized
Gains


  Gross
Unrealized
Losses


  Fair Value

  Amortized
Cost


  Gross
Unrealized
Gains


  Gross
Unrealized
Losses


  Fair Value

 (Dollars in thousands) (Dollars in thousands)  (Dollars in thousands)  (Dollars in thousands)

U.S. Treasury securities and obligations of U.S. government agencies

 $15,824 $247 $—   $16,071 $18,511 $65 $—   $18,576  $10,579  $2  $69  $10,512  $15,824  $247  $—    $16,071

70% non-taxable preferred stock

  44,015  —    327  43,688  44,029  —    884  43,145   24,000   —     6,150   17,850   44,015   —     327   43,688

States and political subdivisions

  23,141  1,798  —    24,939  27,115  1,808  —    28,923   14,382   1,366   —     15,748   15,141   1,798   —     16,939

Collateralized mortgage obligations

  17,745  510  68  18,187  18,616  596  14  19,198   13,143   76   35   13,184   17,745   510   68   18,187

Mortgage-backed securities

  159,525  1,179  224  160,480  196,887  2,600  110  199,377   112,050   545   502   112,093   159,525   1,179   224   160,480

Equity securities

  283  —    —    283  —    —    —    —  

Qualified Zone Academy Bond (QZAB)

   8,000   —     —     8,000   8,000   —     —     8,000

Other

   296   —     —     296   283   —     —     283
 

 

 

 

 

 

 

 

  

  

  

  

  

  

  

  

Total.

 $260,533 $3,734 $619 $263,648 $305,158 $5,069 $1,008 $309,219

Total

  $182,450  $1,989  $6,756  $177,683  $260,533  $3,734  $619  $263,648
 

 

 

 

 

 

 

 

  

  

  

  

  

  

  

  

 

  December 31, 2001

  December 31, 2002

  Amortized
Cost


  Gross
Unrealized
Gains


  Gross
Unrealized
Losses


  Fair Value

  Amortized
Cost


  Gross
Unrealized
Gains


  Gross
Unrealized
Losses


  Fair Value

  (Dollars in thousands)  (Dollars in thousands)

U.S. Treasury securities and obligations of U.S. government agencies

  $2,248  $201  $—    $2,449  $18,511  $65  $—    $18,576

70% non-taxable preferred stock

   24,058   107   —     24,165   44,029   —     884   43,145

States and political subdivisions

   28,165   483   73   28,575   19,115   1,808   —     20,923

Corporate debt securities

   —     —     —     —  

Equity securities

   —     —     —     —  

Collateralized mortgage obligations

   17,356   314   22   17,648   18,616   596   14   19,198

Mortgage-backed securities

   410,072   1,646   2,322   409,396   196,887   2,600   110   199,377

Qualified Zone Academy Bond (QZAB)

   8,000   —     —     8,000
  

  

  

  

  

  

  

  

Total

  $481,899  $2,751  $2,417  $482,233  $305,158  $5,069  $1,008  $309,219
  

  

  

  

  

  

  

  

 

The following tables present the amortized cost and fair value of securities classified as held-to-maturity at December 31, 2004, 2003 2002 and 2001:2002:

 

 December 31, 2003

 December 31, 2002

  December 31, 2004

  December 31, 2003

 Amortized
Cost


 Gross
Unrealized
Gains


 Gross
Unrealized
Losses


 Fair Value

 Amortized
Cost


 Gross
Unrealized
Gains


 Gross
Unrealized
Losses


 Fair Value

  Amortized
Cost


  Gross
Unrealized
Gains


  Gross
Unrealized
Losses


  Fair Value

  Amortized
Cost


  Gross
Unrealized
Gains


  Gross
Unrealized
Losses


  Fair Value

 (Dollars in thousands) (Dollars in thousands)  (Dollars in thousands)  (Dollars in thousands)

U.S. Treasury securities and obligations of U.S. government agencies

 $32,938 $1,591 $14 $34,515 $78,587 $3,131 $—   $81,718  $20,147  $661  $6  $20,802  $32,938  $1,591  $14  $34,515

States and political subdivisions

   23,317   510   15   23,812   30,597   1,121   —     31,718

Corporate debt securities

  15,619  743  —    16,362  25,338  942  87  26,193   10,491   301   —     10,792   15,619   743   —     16,362

States and political subdivisions

  30,597  1,121  —    31,718  31,879  1,241  6  33,114

Collateralized mortgage obligations

  160,742  1,338  191  161,889  149,666  1,662  12  151,316   225,851   97   802   225,146   160,742   1,338   191   161,889

Mortgage-backed securities

  873,336  7,806  3,175  877,967  355,628  12,297  5  367,920   845,303   3,559   4,914   843,948   873,336   7,806   3,175   877,967
 

 

 

 

 

 

 

 

  

  

  

  

  

  

  

  

Total

 $1,113,232 $12,599 $3,380 $1,122,451 $641,098 $19,273 $110 $660,261  $1,125,109  $5,128  $5,737  $1,124,500  $1,113,232  $12,599  $3,380  $1,122,451
 

 

 

 

 

 

 

 

  

  

  

  

  

  

  

  

   December 31, 2001

   Amortized
Cost


  Gross
Unrealized
Gains


  Gross
Unrealized
Losses


  Fair Value

   (Dollars in thousands)

U.S. Treasury securities and obligations of U.S. government agencies

  $141,149  $3,180  $204  $144,125

Corporate debt securities

   22,712   609   167   23,154

States and political subdivisions

   23,338   605   12   23,931

Collateralized mortgage obligations

   22   —     —     22

Mortgage-backed securities

   82,868   535   408   82,995

Other

   —     —     —     —  
   

  

  

  

Total

  $270,089  $4,929  $791  $274,227
   

  

  

  

Index to Financial Statements
   December 31, 2002

   Amortized
Cost


  Gross
Unrealized
Gains


  Gross
Unrealized
Losses


  Fair Value

   (Dollars in thousands)

U.S. Treasury securities and obligations of U.S. government agencies

  $78,587  $3,131  $—    $81,718

States and political subdivisions

   31,879   1,241   6   33,114

Corporate debt securities

   25,338   942   87   26,193

Collateralized mortgage obligations

   149,666   1,662   12   151,316

Mortgage-backed securities

   355,628   12,297   5   367,920
   

  

  

  

Total

  $641,098  $19,273  $110  $660,261
   

  

  

  

 

Mortgage-backed securities are securities that have been developed by pooling a number of real estate mortgages and which are principally issued by federal agencies such as Ginnie Mae, FederalGovernment National Mortgage Association (Fannie(Ginnie Mae), Fannie Mae and Freddie Mac. These securities are deemed to have high credit ratings, and minimum regular monthly cash flows of principal and interest are guaranteed by the issuing agencies.

 

However, unlikeUnlike U.S. Treasury and U.S. government agency securities, which have a lump sum payment at maturity, mortgage-backed securities provide cash flows from regular principal and interest payments and principal prepayments throughout the lives of the securities. Mortgage-backed securities which are purchased at a premium will generally suffer decreasing net yields as interest rates drop because home owners tend to refinance their mortgages. Thus, the premium paid must be amortized over a shorter period. Therefore, these securities purchased at a discount will obtain higher net yields in a decreasing interest rate environment. As interest rates rise, the opposite will generally be true. During a period of increasing interest rates, fixed rate mortgage-backed securities do not tend to experience heavy prepayments of principal and consequently, the average life of this security will not be unduly shortened. If interest rates begin to fall, prepayments will increase. At December 31, 2003, 42.64%2004, 38.1% of the mortgage-backed securities held by the Company had contractual final maturities of more than ten years with a weighted average life of 4.683.75 years.

 

Collateralized mortgage obligations (CMOs) are bonds that are backed by pools of mortgages. The pools can be Ginnie Mae, Fannie Mae or Freddie Mac pools or they can be private-label pools. The CMOs are designed so that the mortgage collateral will generate a cash flow sufficient to provide for the timely repayment of the bonds. The mortgage collateral pool can be structured to accommodate various desired bond repayment schedules, provided that the collateral cash flow is adequate to meet scheduled bond payments. This is accomplished by dividing the bonds into classes to which payments on the underlying mortgage pools are allocated in different order. The bond’s cash flow, for example can be dedicated to one class of bondholders at a time, thereby increasing call protection to bondholders. In private-label CMOs, losses on underlying mortgages are directed to the most junior of all classes and then to the classes above in order of increasing seniority, which means that the senior classes have enough credit protection to be given the highest credit rating by the rating agencies.

 

At the date of purchase, the Company is required to classify debt and equity securities into one of three categories: held-to-maturity, trading or available-for-sale. At each reporting date, the appropriateness of the classification is reassessed. Investments in debt securities are classified as held-to-maturity and measured at amortized cost in the financial statements only if management has the positive intent and ability to hold those securities to maturity. Securities that are bought and held principally for the purpose of selling them in the near term are classified as trading and measured at fair value in the financial statements with unrealized gains and losses included in earnings. Investments not classified as either held-to-maturity or trading are classified as available-for-sale and measured at fair value in the financial statements with unrealized gains and losses reported, net of tax, in a separate component of shareholders’ equity until realized.

 

Deposits

 

The Company’s lending and investment activities are primarily funded by deposits. The Company offers a variety of deposit accounts having a wide range of interest rates and terms. The Company’s deposits consist ofterms including demand, savings, money market and time accounts. The Company relies primarily on competitive pricing policies and customer service to attract and retain these deposits. The Company does not have or accept any brokered deposits.

 

Total deposits at December 31, 20032004 were $2.084$2.32 billion, an increase of $497.1$233.3 million or 31.3%11.2% from $1.587$2.08 billion at December 31, 2002.2003. The increase is primarily attributable to internal growth and the Abrams, Dallas Bancshares, MainBancorpLiberty and FSBNTVillage acquisitions in 2003.2004. As of December 31, 2003,2004, the banking centers acquired in 20032004 had approximately $326.3$227.0 million in total deposits. The remaining $170.8 million in deposit growth is attributed to internal growth. Noninterest-bearing deposits of $518.4 million at December 31, 2004 increased $51.0 million or 10.9% from $467.4 million at December 31, 2003 increased $139.7 million or 42.6% from $327.7 million at December 31, 2002. Noninterest2003.

Index to Financial Statements

bearing deposits at December 31, 2002 were $327.7 million compared with $189.0 million at December 31, 2001. Interest-bearingNoninterest-bearing deposits at December 31, 2003 were $1.616 billion, up $357.4$467.4 million or 28.4% from $1.259 billioncompared with $327.7 million at December 31, 2002. Interest-bearing deposits at December 31, 20022004 were $1.80 billion, up $182.4 million or 11.3% from $1.62 billion at December 31, 2003. Interest-bearing deposits at December 31, 2003 of $1.259$1.62 billion represented a $324.3$357.5 million or 34.7%28.4% increase from $934.6 million$1.26 billion at December 31, 2001.2002. Total deposits at December 31, 20012002 were $1.123$1.59 billion.

 

The daily average balances and weighted average rates paid on deposits for each of the years ended December 31, 2004, 2003 2002 and 20012002 are presented below:

  Years Ended December 31,

   Years Ended December 31,

 
  2003

 2002

 2001

   2004

 2003

 2002

 
  Amount

  Rate

 Amount

  Rate

 Amount

  Rate

   Amount

  Rate

 Amount

  Rate

 Amount

  Rate

 
  (Dollars in thousands)   (Dollars in thousands) 

Interest-bearing checking

  $371,801  1.13% $249,045  1.27% $199,077  2.27%  $485,557  1.04% $371,801  1.13% $249,045  1.27%

Regular savings

   88,651  0.66   58,218  1.41   41,472  2.36    110,801  0.59   88,651  0.66   58,218  1.41 

Money market savings

   317,682  0.92   257,499  1.71   211,104  3.31    384,529  0.87   317,682  0.92   257,499  1.71 

Time deposits

   616,353  2.42   505,796  3.28   428,314  5.20    735,095  2.12   616,353  2.42   505,796  3.28 
  

   

   

     

   

   

   

Total interest-bearing deposits

   1,394,487  1.62   1,070,558  2.33   879,967  3.95    1,715,982  1.43   1,394,487  1.62   1,070,558  2.33 

Noninterest-bearing deposits

   354,558  —     230,326  —     181,228  —      473,713  —     354,558  —     230,326  —   
  

   

   

     

   

   

   

Total deposits

  $1,749,045  1.29% $1,300,884  1.92% $1,061,195  3.28%  $2,189,695  1.12% $1,749,045  1.29% $1,300,884  1.92%
  

  

 

  

 

  

  

  

 

  

 

  

 

The Company’s ratio of average noninterest-bearing deposits to average total deposits for the years ended December 31, 2004, 2003, and 2002 and 2001 was 21.6%, 20.3%, 17.7%, and 17.1%17.7%, respectively.

 

The following table sets forth the amount of the Company’s certificates of deposit that are $100,000 or greater by time remaining until maturity:

 

  December 31, 2003

  December 31, 2004

  (Dollars in thousands)  (Dollars in thousands)

Three months or less

  $138,460  $174,012

Over three through six months

   67,726   68,672

Over six through 12 months

   63,514   73,199

Over 12 months

   64,341   95,407
  

  

Total

  $334,041  $411,290
  

  

 

Other Borrowings

 

Deposits are the primary source of funds for the Company’sThe Company utilizes borrowings to supplement deposits to fund its lending and investment activities. As needed, the Company obtains additionalBorrowings consist of funds from the Federal Home Loan Bank (“FHLB”) and correspondent banks. At December 31, 2003,2004, the Company had $13.1 million in FHLB borrowings compared with $11.9 million in FHLB borrowings at December 31, 2003, all of which consisted of long-term FHLB notes payable compared with $37.9payable. The $1.2 million in FHLB borrowings at December 31, 2002increase is attributable to the acquisition of which $12.6 million consisted of long-term FHLB notes payableone note from Village Bank and $25.3 million consisted of FHLB advances. The highest outstanding balance of FHLB advances during 2003 was $59.3 million compared with $31.4 million during 2002.Trust, ssb, partially offset by normal pay downs on the remaining notes. The maturity dates on the FHLB notes payable range from 2004 to 20182028 and the interest rates range from 5.95%4.64% to 6.48%. FHLB advances are considered short-term, overnight borrowings. At December 31, 2002, theThe Company had $12.6 million inno FHLB notes payable compared with $13.3 millionadvances outstanding at December 31, 2001.2004 and 2003. The highest outstanding balance of FHLB advances during 2004 was $50.0 million compared with $59.3 million during 2003. The Company had no federal funds purchased at December 31, 2003, 20022004 or 2001.2003.

 

At December 31, 2003,2004, the Company had $19.0$25.1 million in securities sold under repurchase agreements.agreements compared with $19.0 million at December 31, 2003, an increase of $6.1 million or 31.8%. The increase is primarily attributable to the Liberty acquisition.

Index to Financial Statements

At December 31, 2004, the Company had four issues of junior subordinated debentures outstanding totaling $47.4 million as shown in the following table:

Description


  Issuance Date

  Trust
Preferred
Securities
Outstanding


  Interest Rate

  Junior
Subordinated
Debt Owed to
Trusts


  Maturity Date

Prosperity Statutory Trust II

  July 31, 2001  $15,000,000  3-month LIBOR
+ 3.58%, not to
exceed 12.50%
  $15,464,000  July 31, 2031

Paradigm Capital Trust II(1)

  Aug. 31, 2002   6,000,000  3-month LIBOR
+ 4.50%
   6,186,000  Feb. 20, 2031

Prosperity Statutory Trust III

  Aug. 15, 2003   12,500,000  6.50%(2)   12,887,000  Sept. 17, 2033

Prosperity Statutory Trust IV

  Dec. 30, 2003   12,500,000  6.50%(3)   12,887,000  Dec. 30, 2033

(1)Assumed in connection with the Paradigm acquisition on September 1, 2002.
(2)The debentures bear a fixed interest rate until September 17, 2008, when the rate begins to float on a quarterly basis based on the three-month LIBOR plus 3.00%.
(3)The debentures bear a fixed interest rate until December 30, 2008, when the rate begins to float on a quarterly basis based on the three-month LIBOR plus 2.85%.

 

On December 30, 2003,31, 2004, the Company formedredeemed in full the $12.4 million in junior subordinated debentures issued to Prosperity StatutoryCapital Trust IV (“Trust IV”) and on December 30, 2003, Trust IV issued 12,500 Floating Rate Capital Securities (the “Trust IV Capital Securities”) with an aggregate liquidation value of $12,500,000 to a third party in a private placement. Concurrent with the issuance of the Trust IV Capital Securities, Trust IV issued trust common securities to the Company in the aggregate liquidation value of $387,000. The proceeds of the issuance of the Trust IV Capital Securities and trust common securities were invested in the Company’s Floating Rate Junior Subordinated Deferrable Interest Debentures (the “Trust IV Debentures”). The Trust IV Debentures will mature on December 30, 2033, which date may be shortened to a date not earlier than December 30, 2008, if certain conditions are met (including the Company having received prior approval of the Federal Reserve and any other required regulatory approvals). These Debentures, which are the only assets of Trust IV, are subordinate and junior in right of payment to all present and future senior indebtedness (as defined in the Indenture dated December 30, 2003) of the Company.

The Trust IV Debentures accrue interest at a fixed rate of 6.50 % until December 30, 2008 at which time the Trust IV Debentures will accrue interest at a floating rate equal to the 3-month LIBOR plus 2.85%. The quarterly distributions on the Trust IV Capital Securities will be paid at the same rate that interest is paid on the Trust IV Debentures. The Company used proceeds received from Trust IV to fund the general corporate purposes of the Company and the Bank, including supporting continued expansion activities in the Houston and Dallas metropolitan areas and surrounding counties through the establishment and/or acquisition of additional Banking Centers.

On August 15, 2003, the Company formed Prosperity Statutory Trust III (“Trust III”) and on August 15, 2003, Trust III issued 12,500 Fixed/Floating Rate Capital Securities (the “Trust III Capital Securities”) with an aggregate liquidation value of $12,500,000 to a third party in a private placement. Concurrent with the issuance of the Trust III Capital Securities, Trust III issued trust common securities to the Company in the aggregate liquidation value of $387,000. The proceeds of the issuance of the Trust III Capital Securities and trust common securities were invested in the Company’s Floating Rate Junior Subordinated Deferrable Interest Debentures (the “Trust III Debentures”). The Trust III Debentures will mature on September 17, 2033, which date may be shortened to a date not earlier than September 17, 2008, if certain conditions are met (including the Company having received prior approval of the Federal Reserve and any other required regulatory approvals). These Trust III Debentures, which are the only assets of Trust III, are subordinate and junior in right of payment to all present and future senior indebtedness (as defined in the Indenture dated August 15, 2003) of the Company.

The Trust III Debentures accrue interest at a fixed rate of 6.50 % until September 17, 2008 at which time the Trust III Debentures will accrue interest at a floating rate equal to the 3-month LIBOR plus 3.00%. The quarterly distributions on the Trust III Capital Securities will be paid at the same rate that interest is paid on the Trust III Debentures.

In November 1999, the Company formedI. Prosperity Capital Trust I (“Trust I”), which issued $12.0 million in turn redeemed in full the trust preferred securities and in July 2001,common securities it issued.

Each of the Company formed Prosperity Statutory Trust II (“Trust II”), which issued $15.0 million intrusts is a capital or statutory business trust preferredorganized for the sole purpose of issuing trust securities on July 31, 2001. Trust I and Trust II investedinvesting the proceeds in an equivalent amount of the Company’s junior subordinated debentures. The preferred trust securities of each trust represent preferred beneficial interests in the assets of the respective trusts and are subject to mandatory redemption upon payment of the junior subordinated debentures bearing an interest rate equalheld by the trust. The common securities of each trust are wholly-owned by the Company. Each trust’s ability to the distribution ratepay amounts due on the respective issue of trust preferred securities.securities is solely dependent upon the Company making payment on the related junior subordinated debentures. The debentures issued to Trust I will mature on November 17, 2029, which date may be shortened to a date not earlier than November 17, 2004 if certain conditions are met, including prior approval of the Federal Reserve. The debentures issued to Trust II will mature on July 31, 2031, which date may be shortened to a date not earlier than July 31, 2006, if certain conditions are met, including prior approval of the Federal Reserve. These debentures, which are the only assets of each trust, are subordinate and junior in right of payment to all of the Company’s present and future senior indebtedness (as defined in the respective Indentures) of the Company.

The debentures issued to Trust I accrue interest at an annual rate of 9.60% of the aggregate liquidation amount, payable quarterly. The debentures issued to Trust II accrue interest at a floating rate equal to 3-month LIBOR plus 3.58% of the aggregate liquidation amount, not to exceed 12.50%, payable quarterly. The quarterly distributions on each issuance of trust preferred securities are paid at the same rate that interest is paid on the corresponding debentures.

In connection with the Paradigm acquisition, on September 1, 2002 the Company acquired Paradigm Capital Trust II (“Paradigm Trust”), which has $6.0 million of floating rate preferred securities outstanding. The Company also assumed the obligations under the floating rate debentures held by Paradigm Trust. The floating rate debentures will mature on February 20, 2031, which date may be shortened to a date not earlier than February 20, 2006 if certain conditions are met. These debentures, which are the only assets of Paradigm Trust, are subordinate and junior in right of payment to all present and future senior indebtedness (as defined in the Indenture) of Paradigm, and now the Company as Paradigm’s successor.

The debentures issued to Paradigm Trust accrue interest at a floating rate that adjusts quarterly based on the 3-month LIBOR plus 4.50%. The quarterly distributions on the preferred securities are paid at the same rate that interest is paid on the debentures.

indebtedness. The Company has fully and unconditionally guaranteed theeach trust’s obligations of each of Trust I, Trust II, Trust III, Trust IV and Paradigm Trust under the trust securities issued by each respective issuance of trust preferred securities. The Trusts must redeemto the extent not paid or made by each trust, preferred securities when the debentures are paid at maturity or upon any earlier prepayment of the debentures. The debentures may be prepaid if certain events occur, including a change in the tax status or regulatory capital treatment of the Capital Securities or a change in existing laws that requires the trusts to register as an investment company. provided such trust has funds available for such obligations.

Under the provisions of each issue of the debentures, the Company has the right to defer payment of interest on the debentures at any time, or from time to time, for periods not exceeding five years. If interest payments on either issue of the debentures are deferred, the distributions on the respectiveapplicable trust preferred securities and common securities will also be deferred.

 

For financial reporting purposes, Trust I, Trust II, Trust III, Trust IV and Paradigm Trust are treated as subsidiariesIn late 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46R (FIN 46R), “Consolidation of the Company and consolidated in the corporate financial statements. However, beginning in the first quarter 2004, Trust I, Trust II, Trust III, Trust IV and the Paradigm Trust will no longer be consolidated in the Company’s financial statements for financial reporting purposes. See Note 1 “NewVariable Interest Entities, an interpretation of Accounting Standards” for further discussion. TheResearch Bulletin No. 51 (Revised December 2003).” FIN 46R requires that trust preferred securities are presentedbe deconsolidated from the Company’s consolidated financial statements. The Company adopted FIN 46R on January 1, 2004 and as a separate category on the balance sheet. Althoughresult, no longer reflects the trust preferred securities in its consolidated financial statements. Instead, the junior subordinated debentures are not includedshown as a componentliabilities in the Company’s consolidated balance sheets and interest expense associated with the junior subordinated debentures is shown as interest expense in the Company’s consolidated statements of shareholders’ equity onincome.

the balance sheet, for regulatory purposes, the trust preferred securities are treated as Tier 1 capital by the Federal Reserve. The treatment of the trust preferred securities as Tier 1 capital, in addition

Index to the ability to deduct the expense of the debentures for federal income tax purposes, provided the Company with a cost-effective method of raising capital.

Financial Statements

Interest Rate Sensitivity and Market Risk

 

The Company’s asset liability and funds management policy provides management with the necessary guidelines for effective funds management, and the Company has established a measurement system for monitoring its net interest rate sensitivity position. The Company manages its sensitivity position within established guidelines.

 

As a financial institution, the Company’s primary component of market risk is interest rate volatility. Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on most of the Company’s assets and liabilities, and the market value of all interest-earning assets and interest-bearing liabilities, other than those which have a short term to maturity. Based upon the nature of the Company’s operations, the Company is not subject to foreign exchange or commodity price risk. The Company does not own any trading assets.

Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. Management realizes certain risks are inherent, and that

The Company manages its exposure to interest rates by structuring its balance sheet in the goalordinary course of business. The Company does not enter into instruments such as leveraged derivatives, interest rate swaps, financial options, financial future contracts or forward delivery contracts for the purpose of reducing interest rate risk. Based upon the nature of the Company’s operations, the Company is not subject to identify and accept the risks.foreign exchange or commodity price risk. The Company does not own any trading assets.

 

The Company’s exposure to interest rate risk is managed by the Asset Liability Committee (“ALCO”), which is composed of senior officers of the Company, in accordance with policies approved by the Company’s Board of Directors. The ALCO formulates strategies based on appropriate levels of interest rate risk. In determining the appropriate level of interest rate risk, the ALCO considers the impact on earnings and capital of the current outlook on interest rates, potential changes in interest rates, regional economies, liquidity, business strategies and other factors. The ALCO meets regularly to review, among other things, the sensitivity of assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, purchase and sale activities, commitments to originate loans and the maturities of investments and borrowings. Additionally, the ALCO reviews liquidity, cash flow flexibility, maturities of deposits and consumer and commercial deposit activity. Management uses two methodologies to manage interest rate risk: (i)(1) an analysis of relationships between interest-earning assets and interest-bearing liabilities; and (ii)(2) an interest rate shock simulation model. The Company has traditionally managed its business to reduce its overall exposure to changes in interest rates.

The Company manages its exposure to interest rates by structuring its balance sheet in the ordinary course of business. The Company does not enter into instruments such as leveraged derivatives, interest rate swaps, financial options, financial future contracts or forward delivery contracts for the purpose of reducing interest rate risk.

 

An interest rate sensitive asset or liability is one that, within a defined time period, either matures or experiences an interest rate change in line with general market interest rates. The management of interest rate risk is performed by analyzing the maturity and repricing relationships between interest-earning assets and interest-bearing liabilities at specific points in time (“GAP”) and by analyzing the effects of interest rate changes on net interest income over specific periods of time by projecting the performance of the mix of assets and liabilities in varied interest rate environments. Interest rate sensitivity reflects the potential effect on net interest income of a movement in interest rates. A company is considered to be asset sensitive, or having a positive GAP, when the amount of its interest-earning assets maturing or repricing within a given period exceeds the amount of its interest-bearing liabilities also maturing or repricing within that time period. Conversely, a company is considered to be liability sensitive, or having a negative GAP, when the amount of its interest-bearing liabilities maturing or repricing within a given period exceeds the amount of its interest-earning assets also maturing or repricing within that time period. During a period of rising interest rates, a negative GAP would tend to affect net interest income adversely, while a positive GAP would tend to result in an increase in net interest income. During a period of falling interest rates, a negative GAP would tend to result in an increase in net interest income, while a positive GAP would tend to affect net interest income adversely.

Index to Financial Statements

The following table sets forth anthe Company’s interest rate sensitivity analysis for the Company at December 31, 2003:2004:

 

   Volumes Subject to Repricing Within

   0-30 days

  31-180 days

  181-365
days


  Greater than
one year


  Total

   (Dollars in thousands)

Interest-earning assets:

                    

Securities (net of unrealized gain of $4.1 million)

  $76,537  $152,194  $201,883  $943,151  $1,373,765

Loans.

   273,055   71,062   69,558   356,378   770,053

Federal funds sold and other earning assets

   11,730   162   —     100   11,992
   


 


 


 


 

Total interest-earning assets.

  $361,322  $223,418  $271,441  $1,299,629  $2,155,810
   


 


 


 


 

Interest-bearing liabilities:

                    

Demand, money market and savings deposits

  $939,136  $—    $—    $—    $939,136

Certificates of deposit and other time deposits.

   94,036   278,110   152,679   143,398   677,223

FHLB Advances and FHLB notes payable

   19,058   262   323   11,293   30,936
   


 


 


 


 

Total interest-bearing liabilities

  $1,052,230  $287,372  $153,002  $154,691  $1,647,295
   


 


 


 


 

Period GAP.

  $(690,908) $(63,954) $118,439  $1,144,938  $508,515

Cumulative GAP.

  $(690,908) $(754,862) $(636,423) $508,515    

Period GAP to total assets.

   (28.80)%  (2.67)%  4.94%  47.73%   

Cumulative GAP to total assets.

   (28.80)%  (31.47)%  (26.53)%  21.20%   
   Volumes Subject to Repricing Within

   0-30 days

  31-180 days

  181-365
days


  Greater than
one year


  Total

   (Dollars in thousands)

Interest-earning assets:

                    

Securities (excluding unrealized loss of $4.8 million)

  $49,005  $154,025  $185,213  $919,316  $1,307,559

Loans

   439,646   111,914   91,269   392,684   1,035,513

Federal funds sold and other earning assets

   79,250   100   —     —     79,350
   


 


 


 


 

Total interest-earning assets

  $567,901  $266,039  $276,482  $1,312,000  $2,422,422
   


 


 


 


 

Interest-bearing liabilities:

                    

Demand, money market and savings deposits

  $1,026,120  $—    $—    $—    $1,026,121

Certificates of deposit and other time deposits

   126,910   288,740   160,358   196,590   772,598

Junior subordinated debentures

   22,774   —     —     24,650   47,424

Securities sold under repurchase agreements

   25,058   —     —     —     25,058

FHLB advances and FHLB notes payable

   52   262   323   12,479   13,116
   


 


 


 


 

Total interest-bearing liabilities

  $1,200,914  $289,002  $160,681  $233,719  $1,884,317
   


 


 


 


 

Period GAP

  $(633,013) $(22,963) $115,801  $1,078,281  $538,106

Cumulative GAP

  $(633,013) $(655,976) $(540,175) $538,106    

Period GAP to total assets

   (23.47)%  (0.85)%  4.29%  39.98%   

Cumulative GAP to total assets

   (23.47)%  (24.32)%  (20.03)%  19.95%   

 

Shortcomings are inherentWhile the GAP position is a useful tool in any GAP analysis since certain assetsmeasuring interest rate risk and liabilities may not move proportionally ascontributes toward effective asset and liability management, it is difficult to predict the effect of changing interest rates change. solely on that measure, without accounting for alterations in the maturity or repricing characteristics of the balance sheet that occur during changes in market interest rates. For example, the GAP position reflects only the prepayment assumptions pertaining to the current rate environment. Assets tend to prepay more rapidly during periods of declining interest rates than during periods of rising interest rates. Because of this and other risk factors not contemplated by the GAP position, an institution could have a matched GAP position in the current rate environment and still have its net interest income exposed to increased rate risk. Additionally, the Company had $518.4 million in noninterest bearing deposits at December 31, 2004 which are not reflected in the table above and are not directly impacted by interest rate changes.

In addition to GAP analysis, the Company uses an interest rate risk simulation model and shock analysis to test the interest rate sensitivity of net interest income and the balance sheet, respectively. Contractual maturities and repricing opportunities of loans are incorporated in the model as are prepayment assumptions, maturity data and call options within the investment portfolio. Assumptions based on past experience are incorporated into the model for nonmaturity deposit accounts. Based on the Company’s December 31, 20032004 simulation analysis, the Company estimates that its current net interest income structure would decrease by approximately 4.40%4.60% over the next twelve months assuming an immediate 100 basis point decline in rates and increase by approximately 0.4%1.7% over the next twelve months assuming an immediate 100 basis point increase in rates. The Company estimates that its current net interest income structure would decrease by approximately 9.8%12.6% over the next twelve months assuming an immediate 200 basis point decline in rates and increase by approximately 0.3%2.3% over the next twelve months assuming an immediate 200 basis point increase in rates. The results are primarily from the behavior of demand, money market and savings deposits. The Company has found that historically, interest rates on these deposits change more slowly than changes in the discount and federal funds rates. This assumption is incorporated into the simulation model and is generally not fully reflected in a GAP analysis.

 

Liquidity

 

Liquidity involves the Company’s ability to raise funds to support asset growth or reduce assets to meet deposit withdrawals and other payment obligations, to maintain reserve requirements and otherwise to operate the Company on an ongoing basis. During the three years ended December 31, 2003,2004, the Company’s liquidity needs have primarily been met by growth in core deposits and the issuance of trust preferred securities,junior subordinated debentures, as previously discussed. Although access to purchased funds from correspondent banks is available and has been utilized on occasion to take advantage of investment opportunities, the Company does not generally rely on these external funding sources. The cash and federal funds sold position, supplemented by amortizing investment and loan portfolios, have generally created an adequate liquidity position.

Index to Financial Statements

Asset liquidity is provided by cash and assets which are readily marketable or which will mature in the near future. As of December 31, 2003,2004, the Company had cash and cash equivalents of $83.7$137.9 million, up from $80.8$83.7 million, at December 31, 2002.2003. The increase was mainly due to an increase in total deposits and the numberfederal funds sold of deposit accounts.$67.4 million, partially offset by a decrease in cash of $13.2 million. As of December 31, 2003,2004, the Company had trust preferred securitiesjunior subordinated debentures outstanding of $58.0$47.4 million compared with $33.0$59.8 million at December 31, 2002.

2003.

Contractual Obligations

 

The following tables summarizetable summarizes the Company’s contractual obligations and other commitments to make future payments as of December 31, 20032004 (other than deposit obligations). The Company’s future cash payments associated with its contractual obligations pursuant to its trust preferred securities,junior subordinated debentures, FHLB notes payable and operating leases as of December 31, 20032004 are summarized below. Payments for borrowings do notFHLB notes payable include interest.interest of $6.1 million that will be paid over the future periods. Payments related to leases are based on actual payments specified in underlying contracts.

 

  Payments due in:

  Payments due in:

  1 year
or less


  

More than 1

year but

less than 3 years


  

3 years or

more but less

than 5 years


  

5 years

or more


  Total

  1 year or less

  More than
1 year but less
than 3 years


  3 years or
more but less
than 5 years


  5 years
or more


  Total

  (Dollars in thousands)  (Dollars in thousands)

Company-obligated mandatorily redeemable trust preferred securities of subsidiary trusts

  $—    $—    $—    $58,000  $58,000

Junior subordinated debentures

  $—    $—    $—    $47,424  $47,424

Federal Home Loan Bank notes payable

   1,386   1,511   2,835   6,197   11,929   1,575   4,823   2,377   10,464   19,239

Operating leases

   1,511   2,009   2,249   995   6,764   2,028   3,643   2,521   2,548   10,740
  

  

  

  

  

  

  

  

  

  

Total

  $2,897  $3,520  $5,084  $65,192  $76,693  $3,603  $8,466  $4,898  $60,436  $77,403
  

  

  

  

  

  

  

  

  

  

 

Off-Balance Sheet Items

 

The Company’s commitments associated with outstanding standby letters of credit and commitments to extend credit as of December 31, 2003 are summarized below. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements:

   

1 year

or less


  

More than 1
year but less

than 3 years


  

3 years or
more but less

than 5 years


  5 years
or more


  Total

   (Dollars in thousands)

Standby letters of credit

  $3,468  $535  $66  $—    $4,069

Commitments to extend credit

   59,235   7,144   575   16,655   83,609
   

  

  

  

  

Total

  $62,703  $7,679  $641  $16,655  $87,678
   

  

  

  

  

In the normal course of business, the Company enters into various transactions, which, in accordance with accounting principles generally accepted in the United States, are not included in its consolidated balance sheets. The Company enters into these transactions to meet the financing needs of its customers. These transactions include commitments to extend credit and standby letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in the consolidated balance sheets.

 

Commitments to Extend Credit.The Company enters into contractualCompany’s commitments associated with outstanding standby letters of credit and commitments to extend credit normallyas of December 31, 2004 are summarized below. Since commitments associated with fixed expiration dates or termination clauses, at specified ratesletters of credit and for specific purposes. Substantially all of the Company’s commitments to extend credit are contingent upon customers maintaining specific credit standards atmay expire unused, the time of loan funding. The Company minimizes its exposure to loss under these commitments by subjecting them to credit approval and monitoring procedures. Management assessesamounts shown do not necessarily reflect the credit risk associated with certain commitments to extend credit in determining the level of the allowance for credit losses.actual future cash funding requirements:

   1 year or less

  More than
1 year but
less than 3
years


  3 years or
more but less
than 5 years


  5 years
or more


  Total

   (Dollars in thousands)

Standby letters of credit

  $5,307  $548  $8  $—    $5,863

Commitments to extend credit

   119,400   17,938   1,739   51,768   190,845
   

  

  

  

  

Total

  $124,707  $18,486  $1,747  $51,768  $196,708
   

  

  

  

  

 

Standby Letters of Credit.Standby letters of credit are written conditional commitments issued by the Company to guarantee the performance of a customer to a third party. 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 of the commitment. If the commitment is funded, the Company would be entitled to seek recovery from the customer. The Company’s policies generally require that standby letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements.

 

Commitments to Extend Credit.The Company enters into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Substantially all of the Company’s commitments to extend credit are contingent upon customers maintaining specific credit standards at the time of loan funding. The Company minimizes its exposure to loss under these commitments by subjecting them to credit approval and monitoring procedures. Management assesses the credit risk associated with certain commitments to extend credit in determining the level of the allowance for credit losses.

Index to Financial Statements

Capital Resources

 

Capital management consists of providing equity to support boththe Company’s current and future operations. The Company is subject to capital adequacy requirements imposed by the Federal Reserve Board and the Bank is subject to capital adequacy requirements imposed by the FDIC and the Texas Banking Department.FDIC. Both the Federal Reserve Board and the FDIC have adopted risk-based

capital requirements for assessing bank holding company and bank capital adequacy. These standards define capital and establish minimum capital requirements in relation to assets and off-balance sheet exposure, adjusted for credit risk. The risk-based capital standards currently in effect are designed to make regulatory capital requirements more sensitive to differences in risk profiles among bank holding companies and banks, to account for off-balance sheet exposure and to minimize disincentives for holding liquid assets. Assets and off-balance sheet items are assigned to broad risk categories, each with appropriate relative risk weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance sheet items.

 

The risk-based capital standards issued by the Federal Reserve Board require all bank holding companies to have “Tier 1 capital” of at least 4.0% and “total risk-based” capital (Tier 1 and Tier 2) of at least 8.0% of total risk-weighted tangible assets. “Tier 1 capital” generally includes common shareholders’ equity and qualifying perpetual preferred stock together with related surpluses and retained earnings, less deductions for goodwill and various other intangibles. “Tier 2 capital” may consist of a limited amount of intermediate-term preferred stock, a limited amount of term subordinated debt, certain hybrid capital instruments and other debt securities, perpetual preferred stock not qualifying as Tier 1 capital, and a limited amount of the general valuation allowance for loan losses. The sum of Tier 1 capital and Tier 2 capital is “total risk-based capital.”

 

The Federal Reserve Board has also adopted guidelines which supplement the risk-based capital guidelines with a minimum ratio of Tier 1 capital to average total consolidated tangible assets, or “leverage ratio,” of 3.0% for institutions with well diversified risk, including no undue interest rate exposure; excellent asset quality; high liquidity; good earnings; and that are generally considered to be strong banking organizations, rated composite 1 under applicable federal guidelines, and that are not experiencing or anticipating significant growth. Other banking organizations are required to maintain a leverage ratio of at least 4.0%. These rules further provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain capital positions substantially above the minimum supervisory levels and comparable to peer group averages, without significant reliance on intangible assets.

 

Pursuant to FDICIA, each federal banking agency revised its risk-based capital standards to ensure that those standards take adequate account of interest rate risk, concentration of credit risk and the risks of nontraditional activities, as well as reflect the actual performance and expected risk of loss on multifamily mortgages. The Bank is subject to capital adequacy guidelines of the FDIC that are substantially similar to the Federal Reserve Board’s guidelines. Also pursuant to FDICIA, the FDIC has promulgated regulations setting the levels at which an insured institution such as the Bank would be considered “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” Under the FDIC’s regulations, the Bank is classified “well capitalized” for purposes of prompt corrective action. See “Business—Supervision and Regulation—The Company” and “—The Bank.”

 

Total shareholders’ equity increased to $275.6 million at December 31, 2004 from $219.6 million at December 31, 2003, an increase of $56.1 million or 25.5%. This increase was primarily the result of net income of $34.7 million and an increase in Common Stock issued of $32.0 million in connection with the Liberty acquisition, partially offset by dividends paid on the Common Stock of $6.7 million. During 2003, shareholders’ equity increased by $64.9 million or 41.9% from $154.7 million at December 31, 2002 an increase of $64.90 million or 41.9%. This increase wasdue primarily the result ofto net income of $26.5 million and an increase in Common Stock issued of $43.6 million in connection with the MainBancorp and FSBNT acquisitions partially offset by dividends paid on the Common Stock of $4.9 million and trust preferred issuance costs of $253,500. During 2002, shareholders’ equity increased by $66.0 million or 74.4% from $88.7 million at December 31, 2001 due primarilymillion.

Index to net income of $21.3 million and an increase in Common Stock issued of $45.9 million in connection with the Paradigm acquisition partially offset by dividends paid on the Common Stock of $3.9 million.

Financial Statements

The following table provides a comparison of the Company’s and the Bank’s leverage and risk-weighted capital ratios as of December 31, 20032004 to the minimum and well capitalized regulatory standards:

 

  Minimum Required
for Capital
Adequacy Purposes


 To Be Well Capitalized
Under Prompt
Corrective Action
Provisions


 Actual Ratio at
December 31, 2003


   Minimum Required
for Capital
Adequacy Purposes


 To Be Categorized as
Well Capitalized Under
Prompt Corrective
Action Provisions


 Actual Ratio at
December 31, 2004


 

The Company

      

Leverage ratio

  3.00%(1) N/A  7.10%  3.00%(1) N/A  6.30%

Tier 1 risk-based capital ratio

  4.00  N/A  15.82   4.00  N/A  13.56 

Total risk-based capital ratio

  8.00  N/A  16.90   8.00  N/A  14.67 

The Bank

      

Leverage ratio

  3.00%(2) 5.00% 6.43%  3.00%(2) 5.00% 6.07%

Tier 1 risk-based capital ratio

  4.00  6.00  14.32   4.00  6.00  13.09 

Total risk-based capital ratio

  8.00  10.00  15.40   8.00  10.00  14.20 

(1)The Federal Reserve Board may require the Company to maintain a leverage ratio above the required minimum.
(2)The FDIC may require the Bank to maintain a leverage ratio above the required minimum.

The trust preferred securities issued by the trusts are currently included in the Company’s Tier 1 capital for regulatory purposes. On March 1, 2005, the Federal Reserve Board adopted final rules that continue to allow trust preferred securities to be included in Tier 1 capital, subject to stricter quantitative and qualitative limits. Currently, trust preferred securities and qualifying perpetual preferred stock are limited in the aggregate to no more than 25% of a bank holding company’s core capital elements. The new rule amends the existing limit by providing that restricted core capital elements (including trust preferred securities and qualifying perpetual preferred stock) can be no more than 25% of core capital, net of goodwill and associated deferred tax liability. Because the 25% limit currently is calculated without deducting goodwill, the final rule reduces the amount of trust preferred securities that the Company can include in Tier 1 capital. The amount of such excess trust preferred securities are includable in Tier 2 capital. The new quantitative limits will be fully effective March 31, 2009.

Assuming these final rules were effective at December 31, 2004, approximately $38.0 million of trust preferred securities would count as Tier 1 capital. The excess amount of trust preferred securities may be included in Tier 2 capital. Assuming these final rules were effective at December 31, 2004, the Company’s consolidated capital ratios would have been:

Pro forma Consolidated Risk Based Capital Ratios:

Total capital (to risk weighted assets)

14.67%

Tier I capital (to risk weighted assets)

12.89%

Tier I capital (to average assets)

5.99%

Each of the trusts issuing the trust preferred securities holds junior subordinated debentures the Company issued with a 30-year maturity. The final rule provides that in the last five years before the junior subordinated debentures mature, the associated trust preferred securities will be excluded from Tier 1 capital and included in Tier 2 capital. In addition, the trust preferred securities during this five-year period would be amortized out of Tier 2 capital by one-fifth each year and excluded from Tier 2 capital completely during the year prior to maturity of the debentures.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

For information regarding the market risk of the Company’s financial instruments, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation – Financial Condition—Condition - Interest Rate Sensitivity and Market Risk”. The Company’s principal market risk exposure is to changes in interest rates.

Index to Financial Statements

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

The financial statements, the reports thereon, the notes thereto and supplementary data commence at page 4751 of this Annual Report on Form 10-K.

 

The following table presents certain unaudited quarterly financial information concerning the Company’s results of operations for each of the two years indicated below. The information should be read in conjunction with the historical consolidated financial statements of the Company and the notes thereto appearing elsewhere in this Annual Report on Form 10-K.

 

CONSOLIDATED QUARTERLY FINANCIAL DATA OF THE COMPANY

   CONSOLIDATED QUARTERLY FINANCIAL
DATA OF THE COMPANY


   Quarter Ended 2004

   (unaudited)
   December 31

  September 30

  June 30

  March 31

   (Dollars in thousands, except per share data)

Interest income

  $30,308  $28,763  $26,313  $26,372

Interest expense

   8,106   7,696   6,962   7,025
   

  

  

  

Net interest income

   22,202   21,067   19,351   19,347

Provision for credit losses

   220   420   120   120
   

  

  

  

Net interest income after provision

   21,982   20,647   19,231   19,227

Noninterest income

   6,233   6,111   5,455   5,272

Noninterest expense

   13,987   13,194   12,067   12,459
   

  

  

  

Income before income taxes

   14,228   13,564   12,619   12,040

Provision for income taxes

   4,892   4,618   4,257   3,977
   

  

  

  

Net income

  $9,336  $8,946  $8,362  $8,063
   

  

  

  

Earnings per share:

                

Basic

  $0.417  $0.410  $0.399  $0.385
   

  

  

  

Diluted

  $0.412  $0.405  $0.394  $0.380
   

  

  

  

 

  Quarter Ended 2003

  Quarter Ended 2003

  (unaudited)
  (unaudited)
  December 31

  September 30

  June 30

  March 31

  December 31

  September 30

  June 30

  March 31

  (Dollars in thousands, except per share data)  (Dollars in thousands, except per share data)

Interest income

  $25,054  $21,365  $22,214  $22,212  $25,054  $21,365  $22,214  $22,212

Interest expense

   5,860   5,700   6,075   6,081   6,650   6,375   6,653   6,668
  

  

  

  

  

  

  

  

Net interest income

   19,194   15,665   16,139   16,131   18,404   14,990   15,561   15,544

Provision for credit losses

   123   120   120   120   123   120   120   120
  

  

  

  

  

  

  

  

Net interest income after provision

   19,071   15,545   16,019   16,011   18,281   14,870   15,441   15,424

Noninterest income

   4,770   4,308   3,988   3,821   4,796   4,326   4,005   3,839

Noninterest expense

   13,222   10,364   10,486   10,500   12,458   9,707   9,925   9,931
  

  

  

  

  

  

  

  

Income before income taxes

   10,619   9,489   9,521   9,332   10,619   9,489   9,521   9,332

Provision for income taxes

   3,427   3,019   3,024   2,943   3,427   3,019   3,024   2,943
  

  

  

  

  

  

  

  

Net income

  $7,192  $6,470  $6,497  $6,389  $7,192  $6,470  $6,497  $6,389
  

  

  

  

  

  

  

  

Earnings per share:

                        

Basic

  $0.36  $0.34  $0.34  $0.34  $0.359  $0.341  $0.343  $0.338
  

  

  

  

  

  

  

  

Diluted

  $0.35  $0.34  $0.34  $0.33  $0.353  $0.336  $0.338  $0.333
  

  

  

  

  

  

  

  

   Quarter Ended 2002

   (unaudited)
   December 31

  September 30

  June 30

  March 31

   (Dollars in thousands, except per share data)

Interest income

  $22,837  $20,419  $19,106  $18,380

Interest expense

   6,828   6,464   6,283   6,356
   

  

  

  

Net interest income

   16,009   13,955   12,823   12,024

Provision for credit losses

   650   120   120   120
   

  

  

  

Net interest income after provision

   15,359   13,835   12,703   11,904

Noninterest income

   4,148   2,893   2,326   2,161

Noninterest expense

   10,160   8,506   8,125   7,662
   

  

  

  

Income before income taxes

   9,347   8,222   6,904   6,403

Provision for income taxes

   2,965   2,569   2,109   1,912
   

  

  

  

Net income

   6,382  $5,653  $4,795  $4,491
   

  

  

  

Earnings per share:

                

Basic

  $0.34  $0.33  $0.30  $0.28
   

  

  

  

Diluted

  $0.33  $0.32  $0.29  $0.27
   

  

  

  

Index to Financial Statements

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

 

There have been no disagreements with accountants on any matter of accounting principles or practices or financial statement disclosures during the two year period ended December 31, 2003.2004.

 

ITEM 9A. CONTROLS AND PROCEDURES

 

EvaluationAs of disclosure controls and procedures. The Companythe end of the period covered by this Annual Report on Form 10-K, an evaluation was carried out an evaluation, underby the supervision andCompany’s management, with the participation of it’s management, including theits Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule13a-15(e) under the Securities Exchange Act of 1934). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures were effective as of the end of the period covered by this report. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported to the Company’s management within the time periods specified in the Securities and Exchange Commission’s rules and forms.

 

Changes in internal control over financial reporting. ThereNo changes were no changes inmade to the Company’s internal control over financial reporting that occurred(as defined in Rule13a-15(f) under the Securities Exchange Act of 1934) during the Company’s most recentlast fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.

Management’s Report on Internal Control Over Financial Reporting

The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is a process designed under the supervision of the Company’s Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external purposes in accordance with generally accepted accounting principles.

As of December 31, 2004, management assessed the effectiveness of the Company’s internal control over financial reporting based on the criteria for effective internal control over financial reporting established in “Internal Control — Integrated Framework,” issued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. This assessment included controls over the preparation of the schedules equivalent to the basic financial statements in accordance with the instructions for the Consolidated Financial Statements for Bank Holding Companies (Form FRY-9C) to meet the reporting requirements of Section 112 of the Federal Deposit Insurance Corporation Improvement Act. Based on the assessment, management determined that the Company maintained effective internal control over financial reporting as of December 31, 2004, based on those criteria.

Deloitte & Touche, LLP, the independent registered public accounting firm that audited the consolidated financial statements of the Company included in this Annual Report on Form 10-K, has issued an attestation report on management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004. The report is included in this Item under the heading “Report of Independent Registered Public Accounting Firm.”

Index to Financial Statements

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of

Prosperity Bancshares, Inc.

Houston, Texas

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that Prosperity Bancshares, Inc. and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established inInternal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Because management’s assessment and our audit were conducted to meet the reporting requirements of Section 112 of the Federal Deposit Insurance Corporation Improvement Act (FDICIA), management’s assessment and our audit of the Company’s internal control over financial reporting included controls over the preparation of the schedules equivalent to the basic financial statements in accordance with the instructions for theConsolidated Financial Statements for Bank Holding Companies (Form FR Y-9C). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing, and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to prove reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Index to Financial Statements

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improver management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the criteria established inInternal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the criteria established inInternal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have not examined and, accordingly, we do not express an opinion or any other form of assurance on management’s statement referring to compliance with laws and regulations.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2004 of the Company and our report dated March 8, 2005, expressed an unqualified opinion on those financial statements.

/s/ Deloitte & Touche, LLP

Houston, Texas

March 8, 2005

PART III.

 

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

 

The information under the captions “Election of Directors,” “Continuing Directors and Executive Officers”, “Section 16(a) Beneficial Ownership Reporting Compliance”, “Corporate Governance and “CodeNominating Procedures-Committees of the Board of Directors-Audit Committee” and “Corporate Governance and Nominating Procedures-Code of Ethics” in the Company’s definitive Proxy Statement for its 20042005 Annual Meeting of Shareholders (the “2004“2005 Proxy Statement”) to be filed with the Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, is incorporated herein by reference in response to this item.

 

ITEM 11. EXECUTIVE COMPENSATION

 

The information under the caption “Executive Compensation and Other Matters” in the 20042005 Proxy Statement is incorporated herein by reference in response to this item.

 

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

 

The information under the caption “Beneficial Ownership of Common Stock by Management of the Company and Principal Shareholders” in the 20042005 Proxy Statement is incorporated herein by reference in response to this item.

 

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

 

The information under the caption “Interests of Management and Others in Certain Transactions” in the 20042005 Proxy Statement is incorporated herein by reference in response to this item.

 

ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES

 

The information under the caption “Principal“Fees and Services of Independent Registered Public Accounting Fees and Services”Firm” in the 20042005 Proxy Statement is incorporated herein by reference in response to this item.

Index to Financial Statements

PART IV.

 

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

 

Consolidated Financial Statements and Schedules

 

Reference is made to the Consolidated Financial Statements, the reports thereon, the notes thereto and supplementary data commencing at page 4751 of this Annual Report on Form 10-K. Set forth below is a list of such Consolidated Financial Statements:

 

Independent Auditors’ Report

Report of Independent Registered Public Accounting Firm

Consolidated Balance Sheets as of December 31, 2004 and 2003

Consolidated Statements of Income for the Years Ended December 31, 2004, 2003 and 2002

Consolidated Statements of Changes in Shareholders’ Equity for the Years Ended December 31, 2004, 2003 and 2002

Consolidated Statements of Cash Flows for the Years Ended December 31, 2004, 2003 and 2002

Notes to Consolidated Financial Statements

Consolidated Balance Sheets as of December 31, 2003 and 2002

Consolidated Statements of Income for the Years Ended December 31, 2003, 2002 and 2001

Consolidated Statements of Changes in Shareholders’ Equity for the Years Ended December 31, 2003, 2002 and 2001

Consolidated Statements of Cash Flows for the Years Ended December 31, 2003, 2002 and 2001

Notes to Consolidated Financial Statements

 

Financial Statement Schedules

 

All supplemental schedules are omitted as inapplicable or because the required information is included in the Consolidated Financial Statements or notes thereto.

 

Exhibits

 

Each exhibit marked with an asterisk is filed with this Annual Report on Form 10-K.

 

Exhibit
Number(1)

Number



  

Description


2.1

-   Agreement and Plan of Reorganization, dated as of October 25, 2004, by and between the Company and First Capital Bankers, Inc. (incorporated herein by reference to Exhibit 2.1 to the Company’s Registration Statement on Form S-4 (Registration No. 333-121767)).

2.2  

-   Agreement and Plan of Reorganization dated as of May 1, 2002 by and between Prosperity Bancshares, Inc. and Paradigm Bancorporation, Inc. (incorporated herein by reference to Exhibit 2.1 to the Company’s Registration Statement on Form S-4 (Registration No. 333-91248))

2.22.3  

-   Stock Purchase Agreement dated as of February 22, 2002 by and between Prosperity Bancshares, Inc. and American Bancorp of Oklahoma, Inc. (incorporated herein by reference to Exhibit 2.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2002)

2.32.4  

-   Agreement and Plan of Reorganization dated as of April 26, 2002 by and among Prosperity Bancshares, Inc., Prosperity Bank® and The First State Bank (incorporated herein by reference to Exhibit 2.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2002)

2.42.5  

-   Agreement and Plan of Reorganization by and between the Prosperity Bancshares, Inc and Commercial Bancshares, Inc. dated November 8, 2000 (incorporated herein by reference to Exhibit 2.1 to the Company’s Registration Statement on Form S-4 (Registration No. 333-52342))

2.52.6  

-   Agreement and Plan of Reorganization by and between Prosperity Bancshares, Inc. and South Texas Bancshares, Inc. dated June 17, 1999 (incorporated herein by reference to Exhibit 2.1 to the Company’s Form 10-Q for the quarter ended June 30, 1999)

2.62.7  

-   Agreement and Plan of Reorganization dated June 5, 1998 by and among Prosperity, Prosperity Bank® and Union State Bank (incorporated herein by reference to Exhibit 10.4 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267))

3.1  

-   Amended and Restated Articles of Incorporation of Prosperity (incorporated herein by reference to Exhibit 3.1 to the Company’s Registration Statement on Form 10-Q for the quarter ended March 31, 2001)S-1 (Registration No. 333-63267))

Index to Financial Statements
3.2  

-   Amended and Restated Bylaws of Prosperity (incorporated herein by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267))10-Q for the quarter ended March 31, 2001)

4.1  

-   Form of certificate representing shares of Prosperity common stock (incorporated herein by reference to Exhibit 4 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267))

4.2

-        Form of Indenture by and between Prosperity Bancshares, Inc. and First Union Trust Company, N.A. with respect to the Junior Subordinated Debentures of Prosperity Bancshares, Inc. (incorporated herein by reference to Exhibit 4.1 to the Company’s Registration Statement on Form S-1 (Registration No. 333-89481))

4.3

-        Form of Amended and Restated Trust Agreement of Prosperity Capital Trust I (incorporated herein by reference to Exhibit 4.5 to the Company’s Registration Statement on Form S-1 (Registration No. 333-89481))

4.4

-        Form of Trust Preferred Securities Guarantee Agreement by and between Prosperity and First Union Trust Company, N.A. (incorporated herein by reference to Exhibit 4.7 to the Company’s Registration Statement on Form S-1 (Registration No. 333-89481))

4.5  

-   Indenture dated as of July 31, 2001 by and between Prosperity Bancshares, Inc., as Issuer, and State Street Bank and Trust Company of Connecticut, National Association, with respect to the Floating Rate Junior Subordinated Deferrable Interest Debentures of Prosperity Bancshares, Inc. (incorporated herein by reference to Exhibit 4.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2001)

4.64.3  

-   Amended and Restated Declaration of Trust of Prosperity Statutory Trust II dated as of July 31, 2001 (incorporated herein by reference to Exhibit 4.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2001)

4.74.4  

-   Guarantee Agreement dated as of July 31, 2001 by and between Prosperity Bancshares, Inc. and State Street Bank and Trust Company of Connecticut, National Association (incorporated herein by reference to Exhibit 4.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2001)

10.1†  

-   Prosperity Bancshares, Inc. 1995 Stock Option Plan (incorporated herein by reference to Exhibit 10.1 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267))

10.2†  

-   Prosperity Bancshares, Inc. 1998 Stock Incentive Plan (incorporated herein by reference to Exhibit 10.2 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267))

10.3†  

-   Form of Employment AgreementsProsperity Bancshares, Inc. 2004 Stock Incentive Plan (incorporated herein by reference to Exhibit 10.3 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267))

10.4

-        Loan Agreement dated December 27, 1997 between Prosperity and Norwest Bank Minnesota, National Association (incorporated herein by reference to Exhibit 10.5 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267))

10.5†

-        Form of Employment Agreement by and between Prosperity Bank® and H.E. Timanus, Jr. (incorporated herein by reference to Exhibit 10.510.2 to the Company’s Registration Statement on Form S-4 (Registration No. 333-52342)333- 121767))

10.4†

-   Amended and Restated Employment Agreement by and between Prosperity Bank and David Zalman (incorporated herein by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated January 18, 2005)

10.5†

-   Amended and Restated Employment Agreement by and between Prosperity Bank and H. E. Timanus, Jr. (incorporated herein by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K dated January 18, 2005)

10.6†

-   Employment Agreement between the Company, Prosperity Bank and D. Michael Hunter (incorporated herein by reference to Exhibit 10.4 to the Company’s Registration Statement on Form S-4 (Registration No. 333-121767))

10.7†  

-   Commercial Bancshares, Inc. Incentive Stock Option Plan for Key Employees (incorporated herein by reference to Exhibit 4.5 to the Company’s Registration Statement on Form S-8 (Registration No. 333-57238))

10.7†10.8†  

-   Form of Stock Option Agreement under the Commercial Bancshares, Inc. Incentive Stock Option Plan for Key Employees (incorporated herein by reference to Exhibit 4.6 to the Company’s Registration Statement on Form S-8 (Registration No. 333-57238))

10.8†10.9†  

-   Paradigm Bancorporation, Inc. 1999 Stock Incentive Plan (incorporated herein by reference to Exhibit 4.2 to the Company’s Registration Statement on Form S-8 (Registration No. 333-100815))

10.9†10.10†  

-   MainBancorp, Inc. 1996 Employee Stock Option Plan (incorporated herein by reference to Exhibit 4.2 to the Company’s Registration Statement on Form S-8 (Registration No. 333-110755))

Index to Financial Statements
10.10†10.11†  

-   Form of MainBancorp, Inc. Non-Qualified Stock Option Agreement (incorporated herein by reference to Exhibit 4.3 to the Company’s Registration Statement on Form S-8 (Registration No. 333-110755))

21.110.12†*

-   First Capital Bankers, Inc. 1996 Executive Stock Option Plan

10.13†*

-   First Capital Bankers, Inc. Amended and Restated 1998 Stock Option Plan

21.1*  

-   Subsidiaries of Prosperity Bancshares, Inc.

23.1*23.1*  

-   Consent of Deloitte & Touche LLP

31.1*31.1*  

-   Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.

31.2*31.2*  

-   Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.

32.1*32.1*  

-   Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2*32.2*  

-   Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


Management contract or compensatory plan or arrangement.
*Filed with this Annual Report on Form 10-K.

Reports on Form 8-K

The following reports on Form 8-K were filed during the fourth quarter 2003:

(i)(1)The Company filed a Current Report on Form 8-K under Items 5 and 7 on December 9, 2003 to announcehas other long-term debt agreements that meet the completionexclusion set forth in Section 601(b)(4)(iii)(A) of the acquisition of the First State Bank of North Texas, Dallas, Texas.

(ii)Regulation S-K. The Company filedhereby agrees to furnish a Current Report on Form 8-K under Items 7 and 12 on October 15, 2003copy of such agreements to announce the release of the Company’s earnings for the third quarter 2003.Commission upon request.

(iii)The Company filed a Current Report on Form 8-K under Items 5 and 7 of Form 8-K on October 6, 2003 to announce it had entered into an Agreement and Plan of Merger to acquire the First State Bank of North Texas, Dallas, Texas.

Index to Financial Statements

SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Prosperity Bancshares, Inc., has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Houston and State of Texas on March 12, 2004.14, 2005.

 

PROSPERITY BANCSHARES, INC.sm®
By: 

/s/ DAVID ZALMAN


David Zalman
  

David Zalman

President and Chief Executive Officer

 

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed by the following persons on behalf of the registrant in the indicated capacities on March 12, 2004.14, 2005.

 

Signature


  

Positions


/s/ DAVID ZALMAN


David Zalman

  

President and Chief Executive Officer (principal executive officer); Director

/s/ NED S. HOLMES


Ned S. Holmes

  

Chairman of the Board; Director

/s/ DAVID HOLLAWAY


David Hollaway

  

Chief Financial Officer (principal financial officer and principal accounting officer)

/s/ H.E. TIMANUS, JR.


H.E. Timanus, Jr.

  

Executive Vice President and Chief Operating Officer; Director

/s/ JAMES A. BOULIGNY


James A. Bouligny

  

Director

/s/ CHARLES A. DAVIS, JR.


Charles A. Davis, Jr.

  

Director

/s/ WILLIAM H. FAGAN, M.D.


William Fagan, M.D.

  

Director

/s/ CHARLES J. HOWARD, M.D.


Charles Howard, M.D.

Director


D. Michael Hunter

Director


S. Reed Morian

  

Director

/s/ PERRY MUELLER, JR., D.D.S.


Perry Mueller, Jr., D.D.S.

  

Director

/s/ A. VIRGIL PACE, JR.


A. Virgil Pace, Jr.

  

Director

/s/ TRACY T. RUDOLPH


Tracy T. Rudolph

  

Director

/s/ HARRISON STAFFORD II


Harrison Stafford II

  

Director

/s/ ROBERT STEELHAMMER


Robert Steelhammer

  

Director

Index to Financial Statements

TABLE OF CONTENTS TO FINANCIAL STATEMENTS

 

   Page

Prosperity Bancshares, Inc.sm®

   

Report of Independent Auditors’ ReportRegistered Public Accounting Firm

  4852

Consolidated Balance Sheets as of December 31, 20032004 and 20022003

  4953

Consolidated Statements of Income for the Years Ended December 31, 2004, 2003 2002 and 20012002

  5054

Consolidated Statements of Changes in Shareholders’ Equity for the Years Ended December 31, 2004, 2003 2002 and 20012002

  5155

Consolidated Statements of Cash Flows for the Years Ended December 31, 2004, 2003 2002 and 20012002

  5256

Notes to Consolidated Financial Statements

  5458

Index to Financial Statements

REPORT OF INDEPENDENT AUDITORS’ REPORTREGISTERED PUBLIC ACCOUNTING FIRM

 

To the Shareholders and Board of Directors and Shareholders of

Prosperity Bancshares, Inc. and Subsidiaries:

Houston, Texas

 

We have audited the accompanying consolidated balance sheets of Prosperity Bancshares Inc. and subsidiaries (collectively, the(the “Company”) as of December 31, 20032004 and 20022003, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2003.2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with auditingthe standards generally accepted inof the United States of America.Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Prosperity Bancshares, Inc. and subsidiaries as of December 31, 20032004 and 2002,2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 20032004, in conformity with accounting principles generally accepted in the United StatesState of America.

 

As discussedWe have also audited, in Note 1 toaccordance with the consolidatedstandards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial statements,reporting as of December 31, 2004, based on the criteria established in 2002Internal Control – Integrated Framework issued by the Company adoptedCommittee of Sponsoring Organizations of the provisionsTreadway Commission and our report dated March 8, 2005, expressed an unqualified opinion on management’s assessment of Statementthe effectiveness of Accounting Standards No. 141 “Business Combinations”the Company’s internal control over financial reporting and Statementan unqualified opinion on the effectiveness of Accounting Standards No. 142 “Goodwill and Other Intangible Assets.”the Company’s internal control over financial reporting.

 

/s/ Deloitte & Touche, LLP

 

Houston, Texas

March 8, 20042005

Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

 

  December 31,

   December 31,

 
  2003

 2002

   2004

 2003

 
  (Dollars in thousands)   (Dollars in thousands) 

ASSETS

         

Cash and due from banks

  $71,983  $66,806   $58,760  $71,983 

Federal funds sold

   11,730   13,993    79,150   11,730 
  


 


  


 


Total cash and cash equivalents

   83,713   80,799    137,910   83,713 

Interest bearing deposits in financial institutions

   262   498    200   262 

Available for sale securities, at fair value

   263,648   309,219    177,683   263,648 

Held to maturity securities, at cost

   1,113,232   641,098    1,125,109   1,113,232 

Loans

   770,053   679,559    1,035,513   770,053 

Less allowance for credit losses

   (10,345)  (9,580)   (13,105)  (10,345)
  


 


  


 


Loans, net

   759,708   669,979    1,022,408   759,708 

Accrued interest receivable

   10,119   10,348    10,171   10,119 

Goodwill

   118,012   68,290    153,180   118,012 

Core deposit intangibles, net of accumulated amortization of $1.0 million and $192,000, respectively

   6,743   4,120 

Core deposit intangibles, net of accumulated amortization of $2.8 million and $1.0 million, respectively

   11,492   6,743 

Bank premises and equipment, net

   34,299   27,010    35,793   34,299 

Other real estate owned

   246   219    341   246 

Other assets

   8,702   10,676    22,941   10,505 
  


 


  


 


TOTAL ASSETS

  $2,398,683  $1,822,256   $2,697,228  $2,400,487 
  


 


  


 


LIABILITIES AND SHAREHOLDERS’ EQUITY

         

LIABILITIES:

      

Deposits:

      

Noninterest-bearing

  $467,389  $327,699   $518,358  $467,389 

Interest-bearing

   1,616,359   1,258,912    1,798,718   1,616,359 
  


 


  


 


Total deposits

   2,083,748   1,586,611    2,317,076   2,083,748 

Other borrowings

   30,936   37,939    13,116   11,929 

Securities sold under repurchase agreements

   25,058   19,007 

Accrued interest payable

   2,522   2,550    3,102   2,522 

Other liabilities

   3,889   7,417    15,805   3,889 

Junior subordinated debentures

   47,424   59,804 
  


 


  


 


Total liabilities

   2,121,095   1,634,517    2,421,581   2,180,899 

COMMITMENTS AND CONTINGENCIES

   

COMPANY-OBLIGATED MANDITORILY REDEEMABLE TRUST PREFERRED SECURITIES OF SUBSIDIARY TRUSTS

   58,000   33,000 

SHAREHOLDERS’ EQUITY:

   

Common stock, $1 par value; 50,000,000 shares authorized; 20,966,706 and 18,903,028 shares issued at December 31, 2003 and 2002, respectively; 20,929,618 and 18,895,876 shares outstanding at December 31, 2003 and 2002, respectively

   20,967   18,903 

SHAREHOLDERS EQUITY:

   

Preferred stock, $1 par value; 20,000,000 shares authorized; none issued or outstanding

   —     —   

Common stock, $1 par value; 50,000,000 shares authorized; 22,418,128 and 20,966,706 shares issued at December 31, 2004 and 2003, respectively; 22,381,040 and 20,929,618 shares outstanding at December 31, 2004 and 2003, respectively

   22,418   20,967 

Capital surplus

   102,594   60,312    134,288   102,594 

Retained earnings

   94,610   72,917    122,647   94,610 

Accumulated other comprehensive income—net unrealized gains on available for sale securities, net of tax of $1,090 and of $1,424, respectively

   2,024   2,644 

Less treasury stock, at cost, 37,088 and 7,152 shares, respectively

   (607)  (37)

Accumulated other comprehensive (loss) income — net unrealized (loss) gain on available for sale securities, net of tax benefit of $1,669 and tax of $1,090, respectively

   (3,099)  2,024 

Less treasury stock, at cost, 37,088 shares

   (607)  (607)
  


 


  


 


Total shareholders’ equity

   219,588   154,739    275,647   219,588 
  


 


  


 


TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

  $2,398,683  $1,822,256   $2,697,228  $2,400,487 
  


 


  


 


 

See notes to consolidated financial statements.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

 

  

For the Years Ended

December 31,


  For the Years Ended December 31,

  2003

  2002

  2001

  2004

  2003

  2002

  (Dollars in thousands, except per share data)  (Dollars in thousands, except per
share data)

INTEREST INCOME:

                  

Loans, including fees

  $46,686  $38,330  $34,731  $55,779  $46,686  $38,330

Securities:

                  

Taxable

   40,507   39,289   37,413   52,771   40,507   39,289

Nontaxable

   1,625   1,599   1,597   1,461   1,625   1,599

70% nontaxable preferred dividends

   1,779   1,216   1,343   1,009   1,779   1,216

Federal funds sold.

   232   285   1,401

Federal funds sold

   556   232   285

Deposits in financial institutions

   16   23   35   180   16   23
  

  

  

  

  

  

Total interest income

   90,845   80,742   76,520   111,756   90,845   80,742
  

  

  

  

  

  

INTEREST EXPENSE:

                  

Deposits

   22,633   24,976   34,780   24,586   22,633   24,976

Junior subordinated debentures

   4,046   2,630   2,170

Note payable and other borrowings

   1,083   955   1,005   1,157   1,083   955
  

  

  

  

  

  

Total interest expense

   23,716   25,931   35,785   29,789   26,346   28,101
  

  

  

  

  

  

NET INTEREST INCOME

   67,129   54,811   40,735   81,967   64,499   52,641

PROVISION FOR CREDIT LOSSES

   483   1,010   700   880   483   1,010
  

  

  

  

  

  

NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES

   66,646   53,801   40,035   81,087   64,016   51,631
  

  

  

  

  

  

NONINTEREST INCOME:

                  

Customer service fees

   14,236   9,764   7,530

Service charges on deposit accounts

   20,215   14,236   9,764

Gain on sale of securities

   78   —     —  

Other

   2,651   1,764   1,060   2,778   2,730   1,830
  

  

  

  

  

  

Total noninterest income

   16,887   11,528   8,590   23,071   16,966   11,594
  

  

  

  

  

  

NONINTEREST EXPENSE:

                  

Salaries and employee benefits

   22,422   16,379   12,955   27,861   22,422   16,379

Net occupancy expense

   5,254   2,345   1,971   4,814   4,492   3,439

Data processing

   2,128   2,131   2,126   2,036   2,128   2,131

Goodwill amortization

   —     —     1,363

Core deposit intangible amortization

   818   192   —  

Depreciation expense.

   2,535   1,830   1,570

Minority interest trust preferred securities

   2,551   2,104   1,580

Merger related expenses

   —     —     2,425

Core deposit intangibles amortization

   1,781   818   192

Depreciation expense

   2,843   2,535   1,830

Other

   8,864   9,472   6,305   12,372   9,626   8,378
  

  

  

  

  

  

Total noninterest expense

   44,572   34,453   30,295   51,707   42,021   32,349
  

  

  

  

  

  

INCOME BEFORE INCOME TAXES

   38,961   30,876   18,330   52,451   38,961   30,876

PROVISION FOR INCOME TAXES

   12,413   9,555   5,372   17,744   12,413   9,555
  

  

  

  

  

  

NET INCOME

  $26,548  $21,321  $12,958  $34,707  $26,548  $21,321
  

  

  

  

  

  

EARNINGS PER SHARE:

                  

Basic

  $1.38  $1.25  $0.80  $1.61  $1.38  $1.25
  

  

  

  

  

  

Diluted

  $1.36  $1.22  $0.79  $1.59  $1.36  $1.22
  

  

  

  

  

  

 

See notes to consolidated financial statements.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

 

 Common Stock

 Capital
Surplus


  Retained
Earnings


  Accumulated
Other
Comprehensive
Income


  Treasury
Stock


  Total
Shareholders’
Equity


   Common Stock

 
 Shares

 Amount

   Shares

  Amount

  Capital
Surplus


 Retained
Earnings


 Accumulated
Other
Comprehensive
Income (loss)


 Treasury
Stock


 Total
Shareholders’
Equity


 
 (Amounts in thousands, except share data)   (Dollars in thousands, except share data) 

BALANCE AT JANUARY 1, 2001

 16,150,972  $16,151  $17,949  $45,665  $605  $(37) $80,333 

BALANCE AT JANUARY 1, 2002

  16,218,022  $16,218  $16,865  $55,462  $217  $(37) $88,725 

Net income

  12,958   12,958           21,321   21,321 

Net change in unrealized gain (loss) on available for sale securities

  (388)  (388)          2,427   2,427 
 


         


Total comprehensive income

  12,570           23,748 
 


         


Sale of common stock

 130,600   131   175   306 

Trust preferred issuance costs

  (476)  (476)

Cash paid to dissenting shareholders in connection with the issuance of common stock in exchange for common stock of Commercial

 (63,550)  (64)  (783)  (847)

Cash dividends declared, $0.195 per share

  (3,161)  (3,161)
 

 


 


 


 


 


 


BALANCE AT DECEMBER 31, 2001

 16,218,022   16,218   16,865   55,462   217   (37)  88,725 

Net income

  21,321   21,321 

Net change in unrealized gain (loss)on available for sale securities

  2,427   2,427 
 


Total comprehensive income

  23,748 
 


Sale of common stock

 104,504   105   155   260 

Sale of common stock in connection with the exercise of stock options

  104,504   105   155   260 

Common stock issued in connection with Paradigm acquisition

 2,580,502   2,580   43,295   45,875   2,580,502   2,580   43,295   45,875 

Cash paid in lieu of fractional shares in connection with the Paradigm acquisition

  (3)  (3)         (3)  (3)

Cash dividends declared, $0.22 per share

  (3,866)  (3,866)          (3,866)  (3,866)
 

 


 


 


 


 


 


  
  

  


 


 


 


 


BALANCE AT DECEMBER 31, 2002

 18,903,028   18,903   60,312   72,917   2,644   (37)  154,739   18,903,028   18,903   60,312   72,917   2,644   (37)  154,739 

Net income

  26,548   26,548           26,548   26,548 

Net change in unrealized gain (loss) on available for sale securities

  (620)  (620)

Net change in unrealized (loss) gain on available for sale securities

          (620)  (620)
 


         


Total comprehensive income

  25,928           25,928 
 


         


Sale of common stock

 170,638   171   824   995 

Sale of common stock in connection with the exercise of stock options

  170,638   171   824   995 

Refund of escrow shares in connection with the Paradigm acquisition

  (570)  (570)          (570)  (570)

Common stock issued in connection with the Mainbancorp acquisition

 1,499,966   1,500   33,149   34,649   1,499,966   1,500   33,149   34,649 

Common stock issued in connection with the FSBNT acquisition

 393,074   393   8,538   8,931   393,074   393   8,538   8,931 

Stock option compensation

  25   25          25   25 

Trust preferred issuance costs

  (254)  (254)

Junior subordinated debentures issuance costs

         (254)  (254)

Cash dividends declared, $0.25 per share

  (4,855)  (4,855)          (4,855)  (4,855)
 

 


 


 


 


 


 


  
  

  


 


 


 


 


BALANCE AT DECEMBER 31, 2003

 20,966,706  $20,967  $102,594  $94,610  $2,024  $(607) $219,588   20,966,706   20,967   102,594   94,610   2,024   (607)  219,588 

Net income

          34,707   34,707 

Net change in unrealized (loss) gain on available for sale securities

          (5,123)  (5,123)
 

 


 


 


 


 


 


         


Total comprehensive income

          29,584 
         


Sale of common stock in connection with the exercise of stock options

  206,321   206   840   1,046 

Common stock issued in connection with the Liberty acquisition

  1,245,191   1,245   30,713   31,958 

Stock option compensation

         141   141 

Cash dividends declared, $0.31 per share

          (6,670)  (6,670)
  
  

  


 


 


 


 


BALANCE AT DECEMBER 31, 2004

  22,418,218  $22,418  $134,288  $122,647  $(3,099) $(607) $275,647 
  
  

  


 


 


 


 


 

See notes to consolidated financial statements.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

   For the Years Ended December 31,

 
   2004

  2003

  2002

 
   (Dollars in thousands) 

CASH FLOWS FROM OPERATING ACTIVITIES:

             

Net income

  $34,707  $26,548  $21,321 

Adjustments to reconcile net income to net cash provided by operating activities:

             

Depreciation and amortization

   5,122   3,353   2,022 

Provision for credit losses

   880   483   1,010 

Net amortization of premium on investments

   4,869   9,707   4,317 

(Gain) loss on sale of premises, equipment and other real estate

   (389)  (378)  (39)

(Increase) decrease in accrued interest receivable and other assets

   (5,550)  3,663   7 

Increase (decrease) in accrued interest payable and other liabilities

   6,729   (3,857)  (2,520)
   


 


 


Total adjustments

   11,661   12,971   4,797 
   


 


 


Net cash provided by operating activities

   46,368   39,519   26,118 
   


 


 


CASH FLOWS FROM INVESTING ACTIVITIES:

             

Proceeds from maturities and principal paydowns of held to maturity securities

   257,501   505,733   211,467 

Purchase of held to maturity securities

   (270,855)  (973,480)  (300,816)

Proceeds from maturities and principal paydowns of available for sale securities

   67,201   144,821   128,906 

Proceeds from sales of available for sale securities

   20,000   —     —   

Purchase of available for sale securities

   (299)  (11,949)  (119,527)

Net (increase) decrease in loans

   (68,254)  37,769   37,291 

Purchase of bank premises and equipment

   (895)  (3,485)  (2,171)

Proceeds from sale of bank premises, equipment and other real estate

   2,522   3,243   1,229 

Premium paid for Liberty Bancshares

   (27,601)  —     —   

Net liabilities acquired in the purchase of Liberty Bancshares (net of acquired cash of $46,599)

   36,844   —     —   

Premium paid for Village Bank and Trust

   (12,181)  —     —   

Net liabilities acquired in the purchase of Village Bank and Trust (net of acquired cash of $16,120)

   8,606   —     —   

Premiums paid for Abrams Centre Bancshares, Dallas Bancshares, MainBancorp and FSBNT

   —     (53,856)  —   

Net liabilities acquired in purchase of Abrams Centre Bancshares, Dallas Bancshares, MainBancorp and FSBNT (net of acquired cash of $115,918)

   —     124,840   —   

Premium paid for Texas Guaranty Bank, The First State Bank, Paradigm Bancorporation, First National Bank of Bay City and Southwest Holding Company

   —     —     (49,769)

Net liabilities acquired in purchase of Texas Guaranty Bank, The First State Bank, Paradigm Bancorporation, First National Bank of Bay City and Southwest Holding Company (net of acquired cash of $52,206

   —     —     59,158 

(Table continued on following page)

Index to Financial Statements

PROSPERITY BANCSHARES, INC.® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

   For the Years Ended December 31,

 
   2003

  2002

  2001

 
   (Dollars in thousands) 

CASH FLOWS FROM OPERATING ACTIVITIES:

             

Net income

  $26,548  $21,321  $12,958 

Adjustments to reconcile net income to net cash provided by operating activities:

             

Depreciation and amortization

   3,353   2,022   2,933 

Provision for credit losses

   483   1,010   700 

Net amortization of premium on investments

   9,707   4,317   982 

(Gain) loss on sale of premises, equipment and other real estate

   (378)  (39)  87 

Decrease in accrued interest receivable and other assets

   3,663   7   3,358 

(Decrease) in accrued interest payable and other liabilities

   (3,857)  (2,520)  (1,177)
   


 


 


Total adjustments

   12,971   4,797   6,883 
   


 


 


Net cash provided by operating activities

   39,519   26,118   19,841 
   


 


 


CASH FLOWS FROM INVESTING ACTIVITIES:

             

Proceeds from maturities and principal paydowns of held to maturity securities

   505,733   211,467   212,615 

Purchase of held to maturity securities

   (973,480)  (300,816)  (75,671)

Proceeds from maturities and principal paydowns of available for sale securities

   144,821   128,906   92,386 

Purchase of available for sale securities

   (11,949)  (119,527)  (396,280)

Net decrease (increase) in loans

   37,769   37,291   (13,197)

Purchase of bank premises and equipment

   (3,485)  (2,171)  (3,073)

Proceeds from sale of bank premises, equipment and other real estate

   3,243   1,229   1,312 

Premium paid for Abrams Centre Bancshares

   (7,137)  —     —   

Net liabilities acquired in purchase of Abrams Centre Bancshares (net of acquired cash of $38,458)

   6,269   —     —   

Premium paid for Dallas Bancshares

   (2,998)  —     —   

Net liabilities acquired in the purchase of Dallas Bancshares (net of acquired cash of $10,517)

   28,203   —     —   

Premium paid for MainBancorp

   (29,837)  —     —   

Net liabilities acquired in the purchase of MainBancorp (net of acquired cash of $43,892)

   75,363   —     —   

Premium paid for First State Bank of North Texas

   (13,884)  —     —   

Net liabilities acquired in the purchase of First State Bank of North Texas (net of acquired cash of $23,051)

   15,004   —     —   

Premium paid for Texas Guaranty Bank

   —     (3,649)  —   

Net liabilities acquired in purchase of Texas Guaranty Bank (net of acquired cash of $12,723)

   —     3,815   —   

Premium paid for The First State Bank

   —     (1,721)  —   

Net liabilities acquired in purchase of The First State Bank (net of acquired cash of $4,938)

   —     2,859   —   

Premium paid for Paradigm Bancorporation

   —     (36,489)  —   

Net liabilities acquired in purchase of Paradigm Bancorporation (net of acquired cash of $14,447)

   —     49,223   —   

(Table continued on following page)

PROSPERITY BANCSHARES, INC.sm AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

  

For the Years Ended

December 31,


   For the Years Ended December 31,

 
  2003

 2002

 2001

   2004

 2003

 2002

 
  (Dollars in thousands)   (Dollars in thousands) 

Premium paid for First National Bank of Bay City

   —     (2,217)  —   

Net liabilities acquired in purchase of First National Bank of Bay City (net of acquired cash of $5,816)

   —     2,425   —   

Premium paid for Southwest Bank Holding Company

   —     (5,693)  —   

Net liabilities acquired in purchase of Southwest Bank Holding Company (net of acquired cash of $14,282)

   —     836   —   

Net decrease in interest-bearing deposits in financial institutions

   398   397   887    762   399   397 
  


 


 


  


 


 


Net cash (used in) investing activities

   (225,967)  (33,835)  (181,021)

Net cash provided by (used in) investing activities

   13,351   (225,967)  (33,835)
  


 


 


  


 


 


CASH FLOWS FROM FINANCING ACTIVITIES:

      

Net increase in noninterest-bearing deposits

  $23,579  $10,118  $873 

Net increase in interest-bearing deposits

   125,657   26,228   88,978 

Proceeds (repayments ) of other borrowings (net)

   (24,340)  14,059   4,149 

Net (decrease) increase in noninterest-bearing deposits

  $(9,892) $23,579  $10,118 

Net (decrease) increase in interest-bearing deposits

   (14,727)  125,657   26,228 

Proceeds (repayments) of other borrowings and securities sold under repurchase agreements (net)

   4,622   (24,340)  14,059 

Proceeds from issuance of junior subordinated debentures

   25,000   —     15,000    —     25,000   —   

Trust preferred issuance costs

   (254)  —     (476)

Junior subordinated debentures issuance costs

   —     (254)  —   

Cash paid in lieu of fractional shares

   —     (3)  —      —     —     (3)

Cash paid to dissenting shareholder in connection with the issuance of common stock in exchange for common stock of Heritage Bank

   —     —     (847)

Redemption of junior subordinated debentures issued to Prosperity Capital Trust I (net)

   (12,000)  —     —   

Proceeds from stock option exercises

   995   260   306    1,046   995   260 

Stock option compensation expense

   141   —     —   

Stock issued in connection with the Liberty Acquisition

   31,958   —     —   

Stock issued in connection with the MainBancorp and FSBNT acquisitions

   43,580   —     —      —     43,580   —   

Payments of cash dividends

   (4,855)  (3,866)  (3,161)   (6,670)  (4,855)  (3,866)
  


 


 


  


 


 


Net cash provided by financing activities

   189,362   46,796   104,822 

Net cash (used in) provided by financing activities

   (5,522)  189,362   46,796 
  


 


 


  


 


 


NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS.

  $2,914  $39,079  $(56,358)

NET INCREASE IN CASH AND CASH EQUIVALENTS

  $54,197  $2,914  $39,079 

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD

   80,799   41,720   98,078    83,713   80,799   41,720 
  


 


 


  


 


 


CASH AND CASH EQUIVALENTS, END OF PERIOD

  $83,713  $80,799  $41,720   $137,910  $83,713  $80,799 
  


 


 


  


 


 


INCOME TAXES PAID

  $14,397  $9,182  $6,410   $19,464  $14,397  $9,182 
  


 


 


  


 


 


INTEREST PAID

  $23,744  $26,250  $36,396   $29,368  $26,215  $26,250 
  


 


 


  


 


 


TRANSFER OF AVAILABLE FOR SALE SECURITIES TO HELD TO MATURITY SECURITIES

  $—    $241,756  $170,601   $—    $—    $241,756 
  


 


 


  


 


 


 

See notes to consolidated financial statements.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES

 

Nature of Operations—Prosperity Bancshares, Inc.® (“Bancshares”) and its subsidiaries, Prosperity Holdings Inc.of Delaware, LLC (“Holdings”) and Prosperity Bank®(the “Bank”), (collectivelyand together with Bancshares and Holdings, collectively referred to as the “Company”) provide retail and commercial banking services. The historical financial data of the Company has been restated to include the accounts and operations of Commercial Bancshares, Inc. which was merged into the Company effective February 23, 2001 and was accounted for as a pooling of interests.

 

The Bank operates fifty-one (51)fifty-eight (58) full-service banking locations; with twenty-nine (29) in the Greater Houston Consolidated Metropolitan Statistical Area (“CMSA”), eleven (11) in eight contiguous counties situated south and southwest of Houston and extending into South Texas, and eleven (11) in the Dallas/Fort Worth area and seven (7) in the Austin, Texas area with locations in Dallas-Abrams Centre, Houston-Aldine, Austin-Allandale, Angleton, Bay City, Beeville, Blooming Grove, Houston-Bellaire, Dallas-Camp Wisdom, Dallas-Cedar Hill, Houston-City West, Houston-Clear Lake, Cleveland, Austin-Congress, Corsicana, Houston-Copperfield, Cuero, Cypress, Dayton, Houston-Downtown, East Bernard, Edna, El Campo, Ennis, Fairfield, Galveston, Houston-Gladebrook, Goliad, Houston-Highway 6, Hitchcock, Dallas-Kiest, Austin-Lakeway, Liberty, Magnolia, Mathis, Houston-Medical Center, Houston-Memorial, Mont Belvieu, Needville, Palacios, Oakhill, Houston-Post Oak, Dallas-Preston Road, Dallas-Red Oak, Austin-Research Boulevard, Houston-River Oaks, Austin-Riverside, Sweeny, Houston-Tanglewood, Dallas-Turtle Creek, Victoria, Houston-Waugh Drive, West Columbia, Dallas-Westmoreland, Wharton, Austin-William Cannon, Winnie and Houston-Woodcreek.

 

Principles of Consolidation—The consolidated financial statements include the accounts of Bancshares and its wholly owned subsidiaries. All significant intercompany transactions have been eliminated in consolidation. The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America (“GAAP”) and the prevailing practices within the banking industry. A summary of significant accounting and reporting policies is as follows:

 

Use of Estimates—The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

 

Securities—Securities held to maturity are carried at cost, adjusted for the amortization of premiums and the accretion of discounts. Management has the positive intent and the Company has the ability to hold these assets as long-term securities until their estimated maturities.

 

Securities available for sale are carried at fair value. Unrealized gains and losses are excluded from earnings and reported, net of tax, as a separate component of shareholders’ equity until realized. Securities within the available for sale portfolio may be used as part of the Company’s asset/liability strategy and may be sold in response to changes in interest risk, prepayment risk or other similar economic factors.

 

Declines in the fair value of individual held to maturity and available for sale securities below their cost that are other than temporary would result in write-downs of the individual securities to their fair value. The related write-downs would be included in earnings as realized losses.

 

Premiums and discounts are amortized and accreted to operations using the level-yield method of accounting, adjusted for prepayments as applicable. The specific identification method of accounting is used to compute gains or losses on the sales of these assets. Interest earned on these assets is included in interest income.

 

Loans—Loans are stated at the principal amount outstanding, net of unearned discount and fees. Unearned discount relates principally to consumer installment loans. The related interest income for multipayment loans is recognized principally by the “sum of the digits” method which records interest in proportion to the declining outstanding balances of the loans; for single payment loans, such income is recognized using the straight-line method.

 

Statement of Financial Accounting Standards (“SFAS”) No. 114,Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118,Accounting by Creditors for Impairment of a Loan—Income Recognition and Disclosure applies to all impaired loans, with the exception of groups of smaller-balance homogeneous loans that are collectively evaluated for impairment. A loan is defined as impaired by SFAS No. 114 if, based on current information and events, it is probable that a creditor will be unable to collect all amounts due, both interest and principal, according to the contractual terms of the loan agreement. Specifically, SFAS No. 114 requires that the allowance for credit losses related to impaired loans be determined based on the difference of carrying value of loans and the present value of expected cash flows discounted at the loan’s effective interest rate or, as a practical expedient, the

PROSPERITY BANCSHARES, INC.sm AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. At December 31, 2003, the Company had $2,000 in nonaccrual loans, $679,000 in 90 days or more past due loans, and no restructured loans. At December 31, 2002, the Company had $1.1 million in nonaccrual loans, $120,000 in 90 days or more past due loans, $1.1 million in other non-performing loans and no restructured loans.

Interest revenue received on impaired loans is either applied against principal or realized as interest revenue, according to management’s judgment as to the collectibility of principal.

Nonrefundable Fees and Costs Associated with Lending Activities- Loan origination fees in excess of the associated costs are recognized over the life of the related loan as an adjustment to yield using the interest method.

 

Generally, loan commitment fees are deferred, except for certain retrospectively determined fees, and recognized as an adjustment of yield by the interest method over the related loan life or, if the commitment expires unexercised, recognized in income upon expiration of the commitment.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Nonperforming and Past Due Loans—Included in the nonperforming loan category are loans which have been categorized by management as nonaccrual because collection of interest is doubtful and loans which have been restructured to provide a reduction in the interest rate or a deferral of interest or principal payments. When the payment of principal or interest on a loan is delinquent for 90 days, or earlier in some cases, the loan is placed on nonaccrual status unless the loan is in the process of collection and the underlying collateral fully supports the carrying value of the loan. If the decision is made to continue accruing interest on the loan, periodic reviews are made to confirm the accruing status of the loan. When a loan is placed on nonaccrual status, interest accrued during the current year prior to the judgment of uncollectibility is charged to operations. Interest accrued during prior periods is charged to allowance for credit losses. Generally, any payments received on nonaccrual loans are applied first to outstanding loan amounts and next to the recovery of charged-off loan amounts. Any excess is treated as recovery of lost interest.

 

Restructured loans are those loans on which concessions in terms have been granted because of a borrower’s financial difficulty. Interest is generally accrued on such loans in accordance with the new terms.

 

Allowance for Credit Losses—The allowance for credit losses is a valuation allowance available for losses incurred on loans. All losses are charged to the allowance when the loss actually occurs or when a determination is made that such a loss is probable. Recoveries are credited to the allowance at the time of recovery.

 

Throughout the year, management estimates the probable level of losses to determine whether the allowance for credit losses is adequate to absorb losses in the existing portfolio. Based on these estimates, an amount is charged to the provision for credit losses and credited to the allowance for credit losses in order to adjust the allowance to a level determined to be adequate to absorb losses.

 

Management’s judgment as to the level of losses on existing loans involves the consideration of current and anticipated economic conditions and their potential effects on specific borrowers; an evaluation of the existing relationships among loans, probable credit losses and the present level of the allowance; results of examinations of the loan portfolio by regulatory agencies; and management’s internal review of the loan portfolio. In determining the collectibility of certain loans, management also considers the fair value of any underlying collateral. The amounts ultimately realized may differ from the carrying value of these assets because of economic, operating or other conditions beyond the Company’s control.

 

Estimates of credit losses involve an exercise of judgment. While it is possible that in the short term the Company may sustain losses which are substantial in relation to the allowance for credit losses, it is the judgment of management that the allowance for credit losses reflected in the consolidated balance sheets is adequate to absorb probable losses that exist in the current loan portfolio.

 

Statement of Financial Accounting Standards (“SFAS”) No. 114,Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118,Accounting by Creditors for Impairment of a Loan—Income Recognition and Disclosure applies to all impaired loans, with the exception of groups of smaller-balance homogeneous loans that are collectively evaluated for impairment. A loan is defined as impaired by SFAS No. 114 if, based on current information and events, it is probable that a creditor will be unable to collect all amounts due, both interest and principal, according to the contractual terms of the loan agreement. Specifically, SFAS No. 114 requires that the allowance for credit losses related to impaired loans be determined based on the difference of carrying value of loans and the present value of expected cash flows discounted at the loan’s effective interest rate or, as a practical expedient, the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. At December 31, 2004, the Company had $297,000 in nonaccrual loans, $1.1 million in 90 days or more past due loans, and no restructured loans. At December 31, 2003, the Company had $2,000 in nonaccrual loans, $679,000 in 90 days or more past due loans and no restructured loans.

Interest revenue received on impaired loans is either applied against principal or realized as interest revenue, according to management’s judgment as to the collectibility of principal.

Premises and Equipment—Premises and equipment are carried at cost less accumulated depreciation. Depreciation expense is computed principally using the straight-line method over the estimated useful lives of the assets which range from three to 30 years.

.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — STATEMENTS—(Continued)

 

Amortization of Goodwill—Goodwill and intangible assets determined to have an indefinite useful life acquired in a purchase business combination completed after June 30, 2001 are no longer amortized. Goodwill was amortized using the straight-line method through December 31, 2001. Goodwill is periodicallyannually assessed for impairment or when events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. The Company bases its evaluation on such impairment factors as the nature of the assets, the future economic benefit of the assets, any historical or future profitability measurements, as well as other external market conditions or factors that may be present.

 

Amortization of Core Deposit Intangibles (CDI)CDI is amortized using an accelerated amortization method over an eight year period.

 

Income Taxes—Bancshares files a consolidated federal income tax return. The Bank computes federal income taxes as if it filed a separate return and remits to, or is reimbursed by, Bancshares based on the portion of taxes currently due or refundable.

 

Deferred tax assets and liabilities are recognized for the estimated tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.

 

Stock-Based CompensationCompensation—— TheAs of December 31, 2004, the Company hashad two stock-based employee compensation plans. Prior to 2003, the Company accounted for those plans under the recognition and measurement provisions of APB Opinion No. 25,Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost was reflected in previously reported results, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. In December 2002, the FASB issued Statement No. 148 (SFAS 148).Accounting for Stock-Based Compensation – Compensation—Transition and Disclosure, an amendment to FASB Statement 123. SFAS 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS 148 iswas effective for financial statements for fiscal years ending after December 15, 2002. Effective January 1, 2003, the Company adopted the fair value recognition provisions of FASB Statement No. 123,Accounting for Stock-Based Compensation, as provided by SFAS No. 148 for stock-based employee compensation (see Note 14).

 

For 2002, the Company did not recognize any stock based compensation expense in reported net income. If compensation expense had been recorded based on the fair value at the grant date for awards consistent with SFAS No. 123, the Company’s net income and earnings per share would have been as follows for the yearsyear ended December 31, 2002 and 2001:2002:

 

   Year Ended
December 31,


 
   2002

  2001

 
   

(Dollars in thousands,

except per share data)

 

Net income as reported

  $21,321  $12,958 

Deduct: Total stock based employee compensation expense determined under fair value based method for all awards, net of related tax effects

   (180)  (51)
   


 


Proforma net income

  $21,141  $12,907 
   


 


Earnings per share:

         

Basic-as reported

  $1.25  $0.80 
   


 


Basic-proforma

  $1.24  $0.79 
   


 


Diluted-as reported

  $1.22  $0.79 
   


 


Diluted-proforma

  $1.21  $0.78 
   


 


For 2002 and 2003, the Company did not recognize any stock based compensation expense in reported net income.

   Year Ended
December 31,
2002


 
   (Dollars in
thousands,
except per
share data)
 

Net income as reported

  $21,321 

Deduct: Total stock based employee compensation expense determined under fair value based method for all awards, net of related tax effects

   (180)
   


Proforma net income

  $21,141 
   


Earnings per share:

     

Basic-as reported

  $1.25 
   


Basic-proforma

  $1.24 
   


Diluted-as reported

  $1.22 
   


Diluted-proforma

  $1.21 
   


 

Cash and Cash Equivalents—For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks as well as federal funds sold that mature in three days or less.

 

Reclassifications—Certain reclassifications have been made to 20022003 and 20012002 balances to conform to the current year presentation. All reclassifications have been applied consistently for the periods presented.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — STATEMENTS—(Continued)

 

Earnings Per Share—SFAS No. 128,Earnings Per Share, requires presentation of basic and diluted earnings per share. Basic earnings per share has been computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding for the reporting period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. Net income per common

share for all periods presented has been calculated in accordance with SFAS No. 128. Outstanding stock options issued by the Company represent the only dilutive effect reflected in diluted weighted average shares.

 

The following table illustrates the computation of basic and diluted earnings per share:

 

  December 31,

  December 31,

  2003

  2002

  2001

  2004

  2003

  2002

  Amount

  Per
Share
Amount


  Amount

  Per
Share
Amount


  Amount

  Per
Share
Amount


  Amount

  Per
Share
Amount


  Amount

  Per
Share
Amount


  Amount

  Per
Share
Amount


  (Dollars in thousands, except per share data)  (In thousands, except per share data)

Net income.

  $26,548     $21,321     $12,958   

Net income

  $34,707     $26,548     $21,321   

Basic:

                                    

Weighted average shares outstanding

   20,046  $1.38   17,122  $1.25   16,172  $0.80   21,534  $1.61   19,225  $1.38   17,122  $1.25
     

     

     

     

     

     

Diluted:

                                    

Weighted average shares outstanding

   20,046      17,122      16,172      21,534      19,225      17,122   

Effect of dilutive securities—options

   311      320      326      270      311      320   
  

     

     

     

     

     

   

Total

   20,357  $1.36   17,442  $1.22   16,498  $0.79   21,804  $1.59   19,536  $1.36   17,442  $1.22
  

  

  

  

  

  

  

  

  

  

  

  

 

There were no stock options exercisable at December 31, 2004, 2003 2002 and 20012002 that would have had an anti-dilutive effect on the above computation.

 

New Accounting Standards—FIN No. 45,“Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others—an Interpretation of FASB Statements No. 5, 57 and 107 and Rescission of FASB Interpretation No. 35.” FIN 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002, and were adopted in the Company’s financial statements for the year ended December 31, 2002. Implementation of the remaining provisions of FIN 45 on January 1, 2003 did not have a significant impact on the Company’s financial statements. The Company considers the fees collected in connection with the issuance of letters of credit to be representative of the fair value of its obligation undertaken in issuing the guarantee. Accordingly, under FIN 45, the Company now defers fees collected in connection with the issuance of letters of credit. The fees are then recognized in income proportionately over the life of the letter of credit agreement.Standards—

 

FIN No. 46 “ConsolidationStatements of Variable Interest Entities, an interpretation of Accounting Research Bulleting No. 51.” FIN 46 establishes accounting guidance for consolidation of variable interest entities (VIE) that function to support the activities of the primary beneficiary. The primary beneficiary of a VIE is the entity that absorbs a majority of the VIE’s expected losses, receives a majority of the VIE’s expected residual returns, or both, as a result of ownership, controlling interest, contractual relationship or other business relationship with a VIE. Prior to the implementation of FIN 46, VIE’s were generally consolidated by an enterprise when the enterprise had a controlling financial interest through ownership of a majority of voting interest in the entity. The provisions of FIN 46 were effective immediately for all arrangements entered into after January 31, 2003, and are otherwise effective at the beginning of the first interim period beginning after December 15, 2003. The Company adopted FIN 46 on July 1, 2003.

PROSPERITY BANCSHARES, INC.sm AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

In December 2003, the FASB issued FIN 46R,“Consolidation of Variable Interest Entities.” FIN 46R provides guidance on how to identify a variable interest entity and determine when the assets, liabilities, non-controlling interests and results of operations of a variable interest entity need to be included in a company’s consolidated financial statements. A company that holds variable interest in an entity will be required to consolidate the entity if the company’s interest in the variable interest entity is such that the company will absorb a majority of the variable interest entity’s expected losses and/or receive a majority of the entity’s expected residual returns, if they occur. As of December 31, 2003, the Company had no investments in variable interest entities requiring consolidation. FIN 46R will require that Prosperity Capital Trust I, Prosperity Trust II, Prosperity Statutory Trust III, Prosperity Statutory Trust IV and Paradigm Capital Trust II be deconsolidated from the consolidated financial statements. The Company adopted FIN 46R on January 1, 2004. After adoption, these trust preferred securities will no longer be shown in the consolidated financial statements. Instead, the junior subordinated debentures issued to these trusts will be shown as liabilities in the consolidated balance sheets and interest expense associated with the junior subordinated debentures will be shown in the consolidated statements of income.

SFAS No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits (Revised 2003).” SFAS 132 was revised by the FASB in an effort to improve financial statement disclosures for defined benefit plans. SFAS 132 (revised 2003) requires companies to provide additional details about plan assets, benefit obligations, cash flows, benefit costs and other relevant information. Companies will also be required to report the various elements of pension and other postretirement benefits costs on a quarterly basis in interim financial statements. The new disclosure requirements are effective for fiscal years ending after December 15, 2003, and for quarters beginning after December 15, 2003. The Company adopted the new disclosure requirements in connection with the preparation of its consolidated financial statements for the year ended December 31, 2003.

SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS 133, “Accounting for Derivative Instruments and Hedging Activities.” The amendments (i) reflect decisions of the Derivatives Implementation Group (DIG); (ii) reflect decisions made by the Financial Accounting Standards Board in conjunction with other projects dealing with financial instruments; and (iii) address implementation issues related to the application of the definition of a derivative. SFAS 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003, with all provisions applied prospectively. Adoption of SFAS 149 on July 1, 2003 did not have a significant impact on the Company’s financial statements.

 

SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of bothBoth Liabilities and Equity.” SFAS 150 establishes standards for how an issuer classifies, measures and discloses in its financial statements certain financial instruments with characteristics of both liabilities and equity. SFAS 150 requires that an issuer classify financial instruments that are within its scope as liabilities, in most circumstances. Such financial instruments include (i) financial instruments that are issued in the form of shares that are mandatorily redeemable; (ii) financial instruments that embody an obligation to repurchase the issuer’s equity shares, or are indexed to such an obligation, and that require the issuer to settle the obligation by transferring assets; (iii) financial instruments that embody an obligation that the issuer may settle by issuing a variable number of its equity shares if, at inception, the monetary value of the obligation is predominantly based on a fixed amount, variations in something other than the fair value of the issuer’s equity shares or variations inversely related to changes in the fair value of the issuer’s equity shares; and (iv) certain freestanding financial instruments. The Company expects thatadopted SFAS 150 on January 1, 2004 and its adoption did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

SFAS No. 123, “Share-Based Payment (Revised 2004).”SFAS 123R establishes standards for the accounting for transactions in which an entity (i) exchanges its equity instruments for goods or services, or (ii) incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of the equity instruments. SFAS 123R eliminates the ability to account for stock-based compensation using APB 25 and requires that such transactions be recognized as written will causecompensation cost in the mandatorily redeemable trust preferred securitiesincome statement based on their fair values on the date of subsidiary trustthe grant. SFAS 123R is mandatory for all entities on July 1, 2005.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Financial Accounting Standards Board Interpretations

In December 2003, the FASB issued FIN 46R, “Consolidation of Variable Interest Entities.” FIN 46R provides guidance on how to identify a variable interest entity and determine when the assets, liabilities, non-controlling interests and results of operations of a variable interest entity need to be reclassifiedincluded in a company’s consolidated financial statements. A company that holds variable interest in an entity is required to consolidate the entity if the company’s interest in the variable interest entity is such that the company will absorb a majority of the variable interest entity’s expected losses and/or receive a majority of the entity’s expected residual returns, if they occur. As of December 31, 2004, the Company had no investments in variable interest entities requiring consolidation. FIN 46R requires that Prosperity Capital Trust II, Prosperity Statutory Trust III, Prosperity Statutory Trust IV and Paradigm Capital Trust II be deconsolidated from a mezzanine equity item to a liability and the interest paid with respect toconsolidated financial statements. The Company adopted FIN 46R on January 1, 2004. After adoption, the trust preferred securities willissued by each of the foregoing trusts are no longer shown in the consolidated financial statements. Instead, the junior subordinated debentures issued by the Company to each of these trusts are shown as liabilities in the consolidated balance sheets and interest expense associated with such junior subordinated debentures is shown in the consolidated statements of income.

Emerging Issues Task Force

In May 2004, the EITF reached a consensus on Issue 03-03 (EITF 03-03) “Applicability of EITF Abstracts, Topic No. D-79, ‘Accounting for Retroactive Insurance Contracts Purchased by Entities Other Than Insurance Enterprises,’ to Claims-Made Insurance Policies”. This EITF clarifies that a claims-made insurance policy that provides coverage for specific known claims prior to the policy period contains a retroactive provision that should be reclassified from noninterest expenseaccounted for accordingly; either separately, if practicable, or, if not practicable, the claims-made insurance policy should be accounted for entirely as a retroactive contract. The Company adopted the provisions of EITF No. 03-03 on January 1, 2004. The adoption of EITF 03-03 did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

In March 2004, the EITF reached consensus on Issue 03-01 (EITF 03-01), “The Meaning of Other-Than-Temporary Impairment and Its Application to interest expense.Certain Investments.” EITF 03-01 includes new guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. This Issue specifically addresses whether an investor has the ability and intent to hold an investment until recovery. In addition, Issue 03-01 contains disclosure requirements that provide useful information about impairments that have not been recognized as other-than-temporary for investments with in the scope of this Issue. On October 29, 2003,September 30, 2004, the FASBFinancial Accounting Standards Board deferred the effective date of the Issue’s guidance on how to evaluate and recognize an impairment loss that is other-than-temporary. This Issue’s guidance is pending the issuance of a final FASB Staff Position (“FSP”) relating to the draft FSP EITF Issue 03-01-a,Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-01, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments,” which the Board may issue as early as November. This deferral did not change the disclosure guidance which remains effective for fiscal years ending after December 15, 2003. Matters being considered by the FASB which may impact the Company’s financial reporting include the accounting as a component in determining net income for declines in market value of debt securities which are due solely to changes in market interest rates and the effect of sales of available-for-sale securities which have market values below cost at the time of sale and whether such sale indicates an absence of intent and ability of the investor to hold to a forecasted recovery of the investment’s value to its original cost.

SEC Staff Accounting Bulletins

SEC Staff Accounting Bulletin (SAB) No. 105, “Application of Accounting Principles to Loan Commitments.” SAB 105 summarizes the views of the staff of the SEC regarding the application of generally accepted accounting principles to loan commitments accounted for as derivative instruments. SAB 105 provides that the fair value of recorded loan commitments that are accounted for as derivatives under SFAS 133, “Accounting for Derivative Instruments and Hedging Activities,” should not incorporate the expected future cash flows related to the associated servicing of the future loan. In addition, SAB 105 requires registrants to disclose their accounting policy for loan commitments. The provisions of SAB105 must be applied to loan commitments accounted for as derivatives that are entered into after March 31, 2004. The adoption of this accounting standard did not have a material impact on the Company’s financial statements.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

American Institute of Certified Public Accounting Statements of Position

SOP No. 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer.” SOP 03-3 addresses accounting for differences between the contractual cash flows of certain loans and debt securities and the cash flows expected to be collected when loans or debt securities are acquired in a transfer and those cash flow differences are attributable, at least in part, to credit quality. As such, SOP 03-3 applies to loans and debt securities acquired individually, in pools or as part of a business combination and does not apply to originated loans. The application of SOP 03-3 limits the interest income, including accretion of purchase price discounts, that may be recognized for certain provisionsloans and debt securities. Additionally, SOP 03-3 does not allow the excess of SFAS No. 150.contractual cash flows over cash flows expected to be collected to be recognized as an adjustment of yield, loss accrual or valuation allowance, such as the allowance for possible loan losses. SOP 03-3 requires that increases in expected cash flows subsequent to the initial investment be recognized prospectively through adjustment of the yield on the loan or debt security over its remaining life. Decreases in expected cash flows should be recognized as impairment. In the case of loans acquired in a business combination where the loans show signs of credit deterioration, SOP 03-3 represents a significant change from current purchase accounting practice whereby the acquiree’s allowance for loan losses is typically added to the acquirer’s allowance for loan losses. SOP 03-3 is effective for loans and debt securities acquired by the Company beginning January 1, 2005. Management is currently evaluating the impact the adoption of SOP 03-3 will have on its financial statements.

 

Stock Split—On May 31, 2002, the Company effected a two-for-one stock split in the form of a 100 percent stock dividend to shareholders of record on May 20, 2002. The Company issued approximately 8.1 million shares in connection with the split. All per share and share information has been restated to reflect this stock split.

 

2. ACQUISITIONS

On August 1, 2004, the Company completed its acquisition of Village Bank and Trust, s.s.b. (“Village”), Austin, Texas. Under the terms of the agreement, the Company paid approximately $19.1 million in cash for all of the issued and outstanding capital stock of Village. Village was privately held and operated one (1) banking office in the Lakeway area of Austin, Texas. As of June 30, 2004, Village had total assets of $110.9 million, loans of $79.7 million, deposits of $97.3 million and shareholders’ equity of $10.4 million.

In connection with the purchase, the Company paid a cash premium of $12.2 million, of which $331,000 was identified as core deposit intangibles. The remaining $11.8 million of the premium was recorded as goodwill. The core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branch were recorded at their fair values at the acquisition date.

On August 1, 2004, the Company completed its acquisition of Liberty Bancshares, Inc. (“Liberty”), Austin, Texas, pursuant to which Liberty merged into the Company and its wholly owned subsidiary, Liberty Bank, S.S.B., merged into the Bank. Under the terms of the agreement, the Company paid approximately $8.9 million in cash and issued approximately 1.3 million shares of its Common Stock for all of the issued and outstanding capital stock of Liberty and Liberty Bank and all outstanding stock options of Liberty Bank. Liberty was privately held and operated six (6) banking offices in Austin, Texas. As of June 30, 2004, Liberty had, on a consolidated basis, total assets of $178.7 million, loans of $120.3 million, deposits of $158.9 million and shareholders’ equity of $16.5 million.

In connection with the purchase, the Company paid a cash premium of $27.6 million of which $3.8 million was identified as core deposit intangibles. The remaining $23.8 million of the premium was recorded as goodwill. The core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branches were recorded at their fair values at the acquisition date.

 

On December 9, 2003, the Company completed the merger of First State Bank of North Texas, Dallas, Texas (“FSBNT”) into the Bank. Under the terms of the agreement, the Company paid approximately $12.6 million in cash and issued approximately 393,074 shares of its common stock for all outstanding shares of First State. First State was privately held and operated four (4)

Index to Financial Statements

PROSPERITY BANCSHARES, INC.® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

banking offices in Dallas, Texas. One banking center was closed and consolidated with an existing banking center located nearby. As of September 30, 2003, First State had total assets of $100.7 million, loans of $20.1 million, deposits of $91.4 million and shareholders’ equity of $8.8 million.

PROSPERITY BANCSHARES, INC.sm AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

In connection with the purchase, the Company paid a cash premium of $13.9 million of which $1.9 million was identified as core deposit intangibles. The remaining $12.0 million of the premium was recorded as goodwill. The core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

 

The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branches were recorded at their fair values at the acquisition date.

 

On November 1, 2003, the Company completed the merger of MainBancorp, Inc., Dallas Texas (“MainBancorp”), into the Company. In connection with the transaction, MainBancorp’s wholly owned subsidiary,mainbank,n.a., was merged into the Bank. Under the terms of the agreement, the Company issued approximately 1,500,0001.5 million shares of its Common Stock and paid approximately $9.1 million in cash for all outstanding shares of MainBancorp stock. In addition, the Company assumed options to acquire 100,851 shares of its Common Stock. MainBancorp was privately held and operated four (4) banking offices in Dallas, Texas. As of September 30, 2003, MainBancorp had, on a consolidated basis, total assets of $177.1 million, loans of $90.8 million, deposits of $153.7 million and shareholders’ equity of $22.6 million.

 

In connection with the purchase, the Company paid a cash premium of $27.2 million of which $2.7 million was identified as core deposit intangibles. The remaining $24.5 million of the premium was recorded as goodwill. The core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

 

The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branches were recorded at their fair values at the acquisition date.

 

On June 1, 2003, the Company completed the merger of Dallas Bancshares, Dallas, Texas (“Dallas Bancshares”), into the Company. In connection with the transaction, Dallas Bancshares’ wholly owned subsidiary, BankDallas, was merged into the Bank. Under the terms of the agreement, the Company paid approximately $7.0 million in cash. Dallas Bancshares operated one (1) banking office in Dallas, Texas. As of March 31, 2003, Dallas Bancshares had on a consolidated basis, total assets of $42.0 million, loans of 28.3 million, deposits of $37.6 million and shareholders’ equity of $4.3 million.

 

In connection with the purchase, the Company paid a cash premium of $3.0 million of which $45,000 was identified as core deposit intangibles. The remaining $2.5 million of the premium was recorded as goodwill. The core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

 

The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branches were recorded at their fair values at the acquisition date.

 

On May 6, 2003, the Company completed the merger of Abrams Centre Bancshares, Dallas, Texas (“Abrams”), into the Company. In connection with the acquisition, Abrams’ wholly owned subsidiary, Abrams Centre National Bank, was merged into the Bank. Under the terms of the agreement, the Company paid approximately $16.3 million in cash. Abrams operated two (2) banking offices in Dallas, Texas. One banking center was closed and consolidated with an existing banking center located nearby. As of March 31, 2003, Abrams, on a consolidated basis, had total assets of $96.5 million, loans of $31.7 million, deposits of $70.8 million and shareholders’ equity of $14.0 million.

 

In connection with the purchase, the Company paid a cash premium of $6.7 million of which $430,000 was identified as core deposit intangibles. The remaining $6.3 million of the premium was recorded as goodwill. The core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

 

The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branches were recorded at their fair values at the acquisition date.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

On November 1, 2002, the Company completed the acquisition of First National Bank of Bay City, Bay City, Texas (the “FNB Acquisition”(“FNB”), through the merger of FNB with and into Prosperity Bank®.the Bank. Under the terms of the Agreement and Plan of Reorganization dated as of August 15, 2002, as amended,agreement, the Company paid approximately $5.1 million in cash for all of the issued and outstanding common stock of FNB. FNB operated one (1) location in Bay City, Texas, which was closed and consolidated with Prosperitythe Bank’s®Bay City Banking Center. As of November 1, 2002, FNB had total assets of $27.1 million, total loans of $8.2 million and total deposits of $23.8 million.

PROSPERITY BANCSHARES, INC.sm AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

In connection with the purchase, the Company paid a cash premium of $2.2 million of which $168,000 was identified as core deposit intangibles. The remaining $2.0 million of the premium was recorded as goodwill. The core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

 

The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branches were recorded at their fair values at the acquisition date.

 

On October 1, 2002, the Company completed the acquisition of Southwest Bank Holding Company, Dallas, Texas (the “Southwest Acquisition”(“Southwest”). Southwest’s wholly owned subsidiary, Bank of the Southwest, Dallas, Texas, became a subsidiary of the Company. Under the terms of the Agreement and Plan of Merger dated as of July 14, 2002,agreement, the Company paid approximately $19.6 million in cash. Southwest was privately held and operated two (2) banking offices in Dallas, Texas. As of October 1, 2002, Southwest had total assets of $121.9 million, total loans of $58.7 million and total deposits of $108.9 million.

 

In connection with the purchase, the Company paid a cash premium of $5.7 million of which $640,000 was identified as core deposit intangibles. The remaining $5.0 million of the premium was recorded as goodwill. The core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

 

The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branches were recorded at their fair values at the acquisition date.

 

On September 1, 2002, the Company completed the acquisition of Paradigm Bancorporation, Inc. (the “Paradigm Acquisition”(“Paradigm”) in a stock transaction. Under the terms of the Agreement and Plan of Reorganization dated as of May 2, 2002, Prosperityagreement, the Company issued approximately 2.58 million shares of its common stock for all outstanding shares of Paradigm (giving effect to the two for one stock split). Paradigm operated a total of eleven (11) banking offices - offices—six (6) in the greater metropolitan Houston area and five (5) in the nearby Southeast Texas cities of Dayton, Galveston, Mont Belvieu, and Winnie, three (3) of which were closed following completion of the transaction. As of September 1, 2002, Paradigm Bancorporation had total assets of $248.7 million, total loans of $175.7 million and total deposits of $218.3 million.

 

In connection with the purchase, the Company paid a cash premium of $36.6 million of which $2.8 million was identified as core deposit intangibles. The remaining $33.8 million of the premium was recorded as goodwill. The core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

 

The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branches were recorded at their fair values at the acquisition date.

 

On July 12, 2002, the Company completed the acquisition of The First State Bank, Needville, Texas (the “First State Acquisition”(“First State”) for approximately $3.7 million in cash. ProsperityThe Bank’s® existing Needville Banking Center has relocated into the former First State Bank location effective July 15, 2002. As of July 12, 2002, The First State Bank had total assets of $16.3 million, loans of $5.5 million and deposits of $14.1 million.

 

In connection with the purchase, the Company paid a cash premium of $1.7 million of which $293,000 was identified as core deposit intangibles. The remaining $1.4 million of the premium was recorded as goodwill. The core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branches were recorded at their fair values at the acquisition date.

On May 8, 2002, the Company completed the acquisition of Texas Guaranty Bank, N.A. (“Texas Guaranty”) for approximately $11.8 million in cash. Texas Guaranty operated three (3) offices in Houston, Texas, all of which became full service banking centers of the Bank. As of May 8, 2002, Texas Guaranty had total assets of $74.0 million, loans of $45.7 million and deposits of $61.8 million.

In connection with the purchase, the Company paid a cash premium of $3.7 million of which $431,000 was identified as core deposit intangibles. The remaining $3.3 million of the premium was recorded as goodwill. The core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

 

The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branches were recorded at their fair values at the acquisition date.

Index to Financial Statements

On May 8, 2002, the Company completed the acquisition of Texas Guaranty Bank, N.A. (the “Texas Guaranty Acquisition”) for approximately $11.8 million in cash. Texas Guaranty Bank operated three (3) offices in Houston, Texas, all of which became full service banking centers of Prosperity BankPROSPERITY BANCSHARES, INC.® . As of May 8, 2002, Texas Guaranty Bank had total assets of $74.0 million, loans of $45.7 million and deposits of $61.8 million.AND SUBSIDIARIES

In connection with the purchase, the Company paid a cash premium of $3.7 million of which $431,000 was identified as core deposit intangibles. The remaining $3.3 million of the premium was recorded as goodwill. The core deposit intangibles are being amortized using an accelerated amortization method over an 8 year life.

PROSPERITY BANCSHARES, INC.sm AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — STATEMENTS—(Continued)

The acquisition was accounted for using the purchase method of accounting. Accordingly, the assets and liabilities of the acquired branches were recorded at their fair values at the acquisition date.

On February 23, 2001, the Company completed a merger with Commercial Bancshares, Inc., a Texas corporation (“Commercial”), whereby Commercial was merged with and into the Company (the “Commercial Merger”). The Company issued 2,768,610 shares of its Common Stock for all of the outstanding shares of Commercial. In connection with the Commercial Merger, Heritage Bank, Commercial’s wholly owned subsidiary, was merged with and into the Bank. Heritage Bank had 12 full-service banking locations in the Houston metropolitan area and in three adjacent counties, including Houston-Bellaire, Cleveland, Cypress, Fairfield, Houston-Downtown, Houston-Medical Center, Houston-River Oaks, Houston-Tanglewood, Houston-Waugh Drive, Liberty, Magnolia and Wharton.

In connection with this Commercial Merger, the Company incurred approximately $2.4 million in pretax merger-related expenses and other charges. The transaction was accounted for as a pooling of interests and therefore the historical financial data of the Company has been restated to include the accounts and operations of Commercial for all periods prior to the Effective Time of the Commercial Merger.

 

3. GOODWILL AND OTHER INTANGIBLE ASSETS

In June 2001, the FASB issued SFAS no. 142, which no longer permits the amortization of goodwill and indefinite-lived intangible assets. Instead, these assets must be reviewed annually (or more frequently under certain conditions) for impairment. Intangible assets that do not have indefinite lives will continue to be amortized over their useful lives and reviewed for impairment. The Company adopted the provisions of SFAS No. 142 and therefore discontinued the amortization of goodwill effective January 1, 2002. During fiscal 2003, the Company completed the goodwill impairment test, which did not indicate any goodwill impairment and therefore did not have an effect on the Company’s consolidated financial condition, results of operations or cash flows.

The following table presents a reconciliation of reported net income and earnings per share to the amounts adjusted for the exclusion of goodwill amortization, net of the related income tax effect:

     Fiscal 2003

    Fiscal 2002

    Fiscal 2001

     (Dollars in thousands, except per share data)

Net income

    $26,548    $21,321    $12,958

Add: Goodwill amortization, net of tax

     —       —       1,158
     

    

    

Adjusted

    $26,548    $21,321    $14,116
     

    

    

Basic earnings per common share

    $1.38    $1.25    $0.80

Add: Goodwill amortization, net of tax

     —       —       0.07
     

    

    

Adjusted

    $1.38    $1.25    $0.87
     

    

    

Diluted earnings per common share

    $1.36    $1.22    $0.79

Add: Goodwill amortization, net of tax

     —       —       0.07
     

    

    

Adjusted

    $1.36    $1.22    $0.86
     

    

    

PROSPERITY BANCSHARES, INC.sm AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Changes in the carrying amount of the Company’s goodwill and core deposit intangibles for fiscal 20022004 and 2003 were as follows:

 

  Goodwill

 Core Deposit Intangibles

   Goodwill

 Core
Deposit
Intangibles


 
  (Dollars in thousands) 

Balance as of December 31, 2001

  $22,641  $—   

Less:

   

Amortization

   —     (192)

Add:

   

Acquisition of Texas Guaranty Bank

   3,254   431 

Acquisition of First State Bank of Needville

   1,448   293 

Acquisition of Paradigm Bancorporation

   33,846   2,781 

Acquisition of First National Bank of Bay City

   2,048   168 

Acquisition of Southwest Bank Holding Company

   5,053   640 
  


 


  (Dollars in thousands) 

Balance as of December 31, 2002

   68,290   4,121   $68,290  $4,121 

Less:

      

Amortization

   —     (818)   —     (818)

Add:

      

Acquisition of Abrams Centre Bancshares

   6,707   430    6,707   430 

Acquisition of Dallas Bancshares

   2,953   45    2,953   45 

Acquisition of Mainbancorp

   27,180   2,657 

Acquisition of MainBancorp

   27,180   2,657 

Acquisition of FSBNT

   13,884   —      13,884   —   

Purchase accounting adjustments to prior year acquisitions:

      

Acquisition of Texas Guaranty Bank

   12   —      12   —   

Acquisition of First State Bank of Needville

   96   —      96   —   

Acquisition of Paradigm Bancorporation

   (826)  —      (826)  —   

Acquisition of First National Bank of Bay City

   (311)  308    (311)  308 

Acquisition of Southwest Bank Holding Company

   27   —      27   —   
  


 


  


 


Balance as of December 31, 2003

  $118,012  $6,743   $118,012  $6,743 

Less:

   

Amortization

   —     (1,781)

Add:

   

Acquisition of Liberty Bancshares

   23,803   3,797 

Acquisition of Village Bank and Trust, ssb

   11,851   331 

Acquisition of MainBancorp

   (203)  300 

Acquisition of FSBNT

   (2,266)  2,102 

Purchase accounting adjustments to prior year acquisitions (deferred tax adjustments):

   

Acquisition of FSBNT

   404   —   

Acquisition of MainBancorp

   748   —   

Acquisition of Texas Guaranty Bank

   (9)  —   

Acquisition of First State Bank of Needville

   (6)  —   

Acquisition of Paradigm Bancorporation

   (127)  —   

Acquisition of Abrams Centre

   153   —   

Acquisition of Dallas Bancshares

   24   —   

Acquisition of Southwest Bank Holding Company

   796   —   
  


 


  


 


Balance as of December 31, 2004

  $153,180  $11,492 
  


 


Purchase accounting adjustments to prior year acquisitions were made to adjust deferred tax asset balances. Gross core deposit intangibles outstanding were $7.8$14.3 million at December 31, 2003.2004.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Core deposit intangibles are amortized on an accelerated basis over their estimated lives which is 8 years. Amortization expense related to intangible assets totaled $1.8 million in 2004, $818,000 in 2003 and $192,000 in 2002 and $1.4 million in 2001.2002. The estimated aggregate future amortization expense for intangible assets remaining as of December 31, 20032004 is as follows:follows (dollars in thousands):

 

2004

  $1,529

2005

   1,429

2006

   1,330

2007

   1,230

2008

   1,131

Thereafter

   2,295
   

Total

  $8,943
   

PROSPERITY BANCSHARES, INC.sm AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

2005

  $2,106

2006

   1,963

2007

   1,820

2008

   1,678

2009

   1,535

Thereafter

   2,390
   

Total

  $11,492
   

 

4. CASH AND DUE FROM BANKS

 

The Bank is required by the Federal Reserve Bank to maintain average reserve balances. “Cash and due from banks” in the consolidated balance sheets includes amounts so restricted of $29.6$20.9 million and $15.0$29.6 million at December 31, 20032004 and 2002,2003, respectively.

 

5. SECURITIES

 

The amortized cost and fair value of debtinvestment securities are as follows:

 

  December 31, 2003

  December 31, 2004

  Amortized
Cost


  Gross
Unrealized
Gains


  Gross
Unrealized
Losses


  

Fair

Value


  Carrying
Value


  Amortized
Cost


  Gross
Unrealized
Gains


  Gross
Unrealized
Losses


  Fair Value

  Carrying
Value


  (Dollars in thousands)  (Dollars in thousands)

Available for Sale

                              

U.S. Treasury securities and obligations of U.S. government agencies

  $15,824  $247  $—    $16,071  $16,071  $10,579  $2  $69  $10,512  $10,512

70% non-taxable preferred stock

   44,015   —     327   43,688   43,688   24,000   —     6,150   17,850   17,850

States and political subdivisions

   23,141   1,798   —     24,939   24,939   14,382   1,366   —     15,748   15,748

Collateralized mortgage obligations

   17,745   510   68   18,187   18,187   13,143   76   35   13,184   13,184

Mortgage-backed securities

   159,525   1,179   224   160,480   160,480   112,050   545   502   112,093   112,093

Qualified Zone Academy Bond

   8,000   —     —     8,000   8,000

Equity securities

   283   —     —     283   283   296   —     —     296   296
  

  

  

  

  

  

  

  

  

  

Total

  $260,533  $3,734  $619  $263,648  $263,648  $182,450  $1,989  $6,756  $177,683  $177,683
  

  

  

  

  

  

  

  

  

  

Held to Maturity

                              

U.S. Treasury securities and obligations of U.S. government agencies

  $32,938  $1,591  $14  $34,515  $32,938  $20,147  $661  $6  $20,802  $20,147

States and political subdivisions

   23,317   510   15   23,812   23,317

Corporate debt securities

   15,619   743   —     16,362   15,619   10,491   301   —     10,792   10,491

States and political subdivisions

   30,597   1,121   —     31,718   30,597

Collateralized mortgage obligations

   160,742   1,338   191   161,889   160,742   225,851   97   802   225,146   225,851

Mortgage-backed securities

   873,336   7,806   3,175   877,967   873,336   845,303   3,559   4,914   843,948   845,303
  

  

  

  

  

  

  

  

  

  

Total

  $1,113,232  $12,599  $3,380  $1,122,451  $1,113,232  $1,125,109  $5,128  $5,737  $1,124,500  $1,125,109
  

  

  

  

  

  

  

  

  

  

Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — STATEMENTS—(Continued)

 

  December 31, 2002

  December 31, 2003

  Amortized
Cost


  Gross
Unrealized
Gains


  Gross
Unrealized
Losses


  Fair Value

  Carrying
Value


  Amortized
Cost


  Gross
Unrealized
Gains


  Gross
Unrealized
Losses


  Fair Value

  Carrying
Value


  (Dollars in thousands)  (Dollars in thousands)

Available for Sale

                              

U.S. Treasury securities and obligations of U.S. government agencies

  $18,511  $65  $—    $18,576  $18,576  $15,824  $247  $—    $16,071  $16,071

70% non-taxable preferred stock

   44,029   —     884   43,145   43,145   44,015   —     327   43,688   43,688

States and political subdivisions

   27,115   1,808   —     28,923   28,923   15,141   1,798   —     16,939   16,939

Collateralized mortgage obligations

   18,616   596   14   19,198   19,198   17,745   510   68   18,187   18,187

Mortgage-backed securities

   196,887   2,600   110   199,377   199,377   159,525   1,179   224   160,480   160,480

Qualified Zone Academy Bond

   8,000   —     —     8,000   8,000

Equity securities

   283   —     —     283   283
  

  

  

  

  

  

  

  

  

  

Total

  $305,158  $5,069  $1,008  $309,219  $309,219  $260,533  $3,734  $619  $263,648  $263,648
  

  

  

  

  

  

  

  

  

  

Held to Maturity

                              

U.S. Treasury securities and obligations of U.S. government agencies

  $78,587  $3,131  $—    $81,718  $78,587  $32,938  $1,591  $14  $34,515  $32,938

States and political subdivisions

   30,597   1,121   —     31,718   30,597

Corporate debt securities

   25,338   942   87   26,193   25,338   15,619   743   —     16,362   15,619

States and political subdivisions

   31,879   1,241   6   33,114   31,879

Collateralized mortgage obligations

   149,666   1,662   12   151,316   149,666   160,742   1,338   191   161,889   160,742

Mortgage-backed securities

   355,628   12,297   5   367,920   355,628   873,336   7,806   3,175   877,967   873,336
  

  

  

  

  

  

  

  

  

  

Total

  $641,098  $19,273  $110  $660,261  $641,098  $1,113,232  $12,599  $3,380  $1,122,451  $1,113,232
  

  

  

  

  

  

  

  

  

  

In estimating other-than-temporary impairment losses, management considers, among other things, (i) the length of time and the extent to which the fair value has been less than cost, (ii) the financial condition and near-term prospects of the issuer, and (iii) 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.

 

Management believes that based uponhas the credit qualityability and intent to hold its securities until they mature, at which time the Company will receive full value for the securities. The unrealized losses are largely due to increases in market interest rates over the yields available at the time the underlying securities were purchased. The fair value is expected to recover as the bonds approach their maturity date or repricing date or if market yields for such investments decline. Management does not believe any of the debt securities noneare impaired due to reasons of the unrealized loss on securities is considered other-than-temporary atcredit quality. Accordingly, as of December 31, 2003. No2004, management believes the impairments detailed in the table above are temporary and no impairment loss has been realized in the Company’s consolidated statements of income.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Securities with unrealized losses segregated by length of time such securities have been in a continuous unrealized loss position for twelve months or more.at December 31, 2004, were as follows:

   Less than 12 Months

  More than 12 Months

  Total

   Estimated
Fair Value


  Unrealized
Losses


  Estimated
Fair Value


  Unrealized
Losses


  Estimated
Fair Value


  Unrealized
Losses


   (Dollars in thousands)

Available for Sale

                        

U.S. Treasury securities and obligations of U.S. government agencies

  $9,979  $69  $—     —    $9,979  $69

70% non-taxable preferred stock

   12,250   4,750   5,600   1,400   17,850   6,150

Collateralized mortgage obligations

   2,921   13   2,132   22   5,053   35

Mortgage backed securities

   44,229   277   17,086   225   61,315   502
   

  

  

  

  

  

Total

  $69,379  $5,109  $24,818  $1,647  $94,197  $6,756
   

  

  

  

  

  

Held to Maturity

                        

U.S. Treasury securities and obligations of U.S. government agencies

  $998  $6  $—     —    $998  $6

70% non-taxable preferred stock

   3,359   15   —     —     3,359   15

Collateralized mortgage obligations

   190,352   802   —     —     190,352   802

Mortgage backed securities

   498,584   3,422   74,922   1,492   573,506   4,914
   

  

  

  

  

  

Total

  $693,293  $4,245  $74,922  $1,492  $768,215  $5,737
   

  

  

  

  

  

 

The amortized cost and fair value of debtinvestment securities at December 31, 2003,2004, by contractual maturity, are shown below. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations at any time with or without call or prepayment penalties.

 

  December 31, 2003

  December 31, 2004

  Held to Maturity

  Available for Sale

  Held to Maturity

  Available for Sale

  

Amortized

Cost


  

Fair

Value


  

Amortized

Cost


  

Fair

Value


  Amortized
Cost


  Fair Value

  Amortized
Cost


  Fair Value

  (Dollars in thousands)  (Dollars in thousands)

Due in one year or less

  $18,014  $18,296  $4,124  $4,130  $18,315  $18,560  $5,407  $5,383

Due after one year through five years

   47,832   50,504   13,267   13,336   30,129   31,138   5,918   5,883
  

Due after five years through ten years

   13,308   13,795   28,186   27,984   5,511   5,708   11,727   12,027

Due after ten years

   —     —     37,686   39,531   —     —     34,204   29,113
  

  

  

  

  

  

  

  

Subtotal

   79,154   82,595   83,263   84,981   53,955   55,406   57,256   52,406

Mortgage-backed securities and collateralized mortgage obligations

   1,034,078   1,039,856   177,270   178,667   1,071,154   1,069,094   125,194   125,277
  
  
  

  

  

  

  

  

  

  

Total

  $1,113,232  $1,122,451  $260,533  $263,648  $1,125,109  $1,124,500  $182,450  $177,683
  

  

  

  

  

  

  

  

 

Gross proceeds from the sale of securities classified as available for sale was approximately $20.1 million for the year ended December 31, 2004 and resulted in a gain of $78,000 for the same period. There were no sales of securities in 2003. Gross proceeds from the sale of held to maturity securities was approximately $17,400 and gross proceeds from the sale of available for sale securities was approximately $48,800 for the year ended December 31, 2002.

 

The Company does not own securities of any one issuer (other than the U.S. government and its agencies) for which aggregate adjusted cost exceeds 10% of the consolidated shareholders’ equity at December 31, 20032004 and December 31, 2002.2003.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — STATEMENTS—(Continued)

 

Securities with an amortized costscost of $600.4$790.2 million and $403.5$600.4 million and a fair value of $605.6$789.6 million and $416.8$605.6 million at December 31, 20032004 and 2002,2003, respectively, were pledged to securecollateralize public deposits and for other purposes required or permitted by law.

 

6. LOANS

 

The loan portfolio consists of various types of loans made principally to borrowers located in Southeast Texas, Dallas and DallasAustin and is classified by major type as follows:

 

  December 31,

  December 31,

  2003

  2002

  2004

  2003

  (Dollars in thousands)  (Dollars in thousands)

Commercial and industrial

  $93,989  $93,797  $144,432  $93,989

Real estate:

            

Construction and land development

   36,470   52,377   109,591   36,470

1-4 family residential

   237,055   206,586   260,453   237,055

Home equity

   27,943   23,249   34,453   27,943

Commercial mortgages

   260,882   183,970   369,151   260,882

Farmland

   15,247   11,887   22,240   15,247

Multi-family residential

   20,679   15,502   18,187   20,679

Agriculture

   20,693   24,683   21,906   20,693

Other

   2,274   3,020   2,246   2,274

Consumer

   54,980   64,919   52,887   54,980
  

  

  

  

Total

   770,212   679,990   1,035,546   770,212

Less unearned discount

   159   431   33   159
  

  

  

  

Total

  $770,053  $679,559  $1,035,513  $770,053
  

  

  

  

 

The contractual maturity ranges of the commercial and industrial and construction and land development portfolios and the amount of such loans with predetermined interest rates and floating rates in each maturity range are summarized in the following table:

 

  December 31, 2003

  December 31, 2004

  One Year
or Less


  After One
Through
Five Years


  After Five
Years


  Total

  One Year
or Less


  After One
Through
Five Years


  After
Five
Years


  Total

  (Dollars in thousands)  (Dollars in thousands)

Commercial and industrial

  $41,248  $35,464  $8,781  $85,493  $72,934  $55,947  $15,551  $144,432

Construction and land development

   22,255   12,872   1,342   36,469   84,235   19,766   5,590   109,591
  

  

  

  

  

  

  

  

Total

  $63,503  $48,336  $10,123  $121,962  $157,169  $75,713  $21,141  $254,023
  

  

  

  

  

  

  

  

Loans with a predetermined interest rate

  $18,728  $21,309  $598  $40,635  $39,873  $23,736  $4,351  $67,960

Loans with a floating interest rate

   44,775   27,027   9,525   81,327   117,296   51,977   16,790   186,063
  

  

  

  

  

  

  

  

Total

  $63,503  $48,336  $10,123  $121,962  $157,169  $75,713  $21,141  $254,023
  

  

  

  

  

  

  

  

Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — STATEMENTS—(Continued)

 

As of December 31, 20032004 and 2002,2003, loans outstanding to directors, officers and their affiliates totaled $5.6$8.1 million and $9.8$5.6 million, respectively. In the opinion of management, all transactions entered into between the Company and such related parties have been, and are, in the ordinary course of business, made on the same terms and conditions as similar transactions with unaffiliated persons.

 

An analysis of activity with respect to these related-party loans is as follows:

 

  Year Ended December 31,

 
  2003

 2002

   Year Ended December
31,


 
  (Dollars in thousands)   2004

 2003

 
  (Dollars in thousands) 

Beginning balance

  $9,804  $7,144   $5,589  $9,804 

New loans and reclassified related loans

   3,333   8,336        4,217       3,333 

Repayments

   (7,548)  (5,676)   (2,460)  (7,548)
  


 


  


 


Ending balance

  $5,589  $9,804   $7,346  $5,589 
  


 


  


 


 

7. ALLOWANCE FOR CREDIT LOSSES

 

An analysis of activity in the allowance for credit losses is as follows:

 

  Year Ended December 31,

   Year Ended December 31,

 
  2003

 2002

 2001

   2004

 2003

 2002

 
  (Dollars in thousands)   (Dollars in thousands) 

Balance at beginning of year

  $9,580  $5,985  $5,523 

Balance at beginning of year.

  $10,345  $9,580  $5,985 

Balance acquired in the Texas Guaranty, First State, Paradigm, FNB and Southwest acquisitions

   —     2,981   —      —     —     2,981 

Balance acquired in the Abrams, Dallas Bancshares, MainBancorp and FSBNT acquisitions

   1,900   —     —      —     1,900   —   

Addition — provision charged to operations

   483   1,010   700 

Balance acquired in the Liberty and Village acquisitions

   2,365   —     —   

Addition— provision charged to operations

   880   483   1,010 

(Charge-offs) and recoveries:

      

Loans charged off

   (2,241)  (767)  (429)   (950)  (2,241)  (767)

Loan recoveries

   623   371   191    465   623   371 
  


 


 


  


 


 


Total net (charge-offs) recoveries

   (1,618)  (396)  (238)

Net (charge-offs) recoveries

   (485)  (1,618)  (396)
  


 


 


  


 


 


Balance at end of year

  $10,345  $9,580  $5,985   $13,105  $10,345  $9,580 
  


 


 


  


 


 


 

8. PREMISES AND EQUIPMENT

 

Premises and equipment are summarized as follows:

 

  

Year Ended

December 31,


   Year Ended
December 31,


 
  2003

 2002

   2004

 2003

 
  (Dollars in thousands)   (Dollars in thousands) 

Land

  $7,907  $6,953   $8,636  $7,907 

Buildings

   27,823   19,966    30,236   27,823 

Furniture, fixtures and equipment

   9,980   9,595    10,739   9,980 

Construction in progress

   106   763    74   106 
  


 


  


 


Total

   45,816   37,277    49,685   45,816 

Less accumulated depreciation

   (11,517)  (10,267)   (13,892)  (11,517)
  


 


  


 


Premises and equipment, net

  $34,299  $27,010   $35,793  $34,299 
  


 


  


 


Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — STATEMENTS—(Continued)

 

9. DEPOSITS

 

Included in interest-bearing deposits are certificates of deposit in amounts of $100,000 or more. These certificates and their remaining maturities at December 31, 20032004 were as follows:

 

  December 31, 2003

  December 31,
2004


  (Dollars in thousands)  (Dollars in
thousands)

Three months or less.

  $138,460

Three months or less

  $174,012

Greater than three through six months

   67,726   68,672

Greater than six through twelve months

   63,514   73,199

Thereafter

   64,341   95,407
  

  

Total

  $334,041  $411,290
  

  

 

Interest expense for certificates of deposit in excess of $100,000 was $8.5 million, $7.4 million $6.9 million and $8.7$6.9 million, for the years ended December 31, 2004, 2003 2002 and 2001,2002, respectively.

 

The Company has no brokered deposits and there are no major concentrations of deposits.deposits with any one depositor.

 

10. OTHER BORROWINGS

 

Note PayableOther Borrowings—— During December 1997, Bancshares entered into an agreement with a bankThe Company utilizes borrowings to borrow upsupplement deposits to $8.0 million under a reducing, revolving line of credit (the “Line”). The purpose of the Line is to provide funding for potential acquisitions in the future. The maximum amount available under the Line is reduced by $1.1 million each year beginning December 1998 with all amounts due and payable on December 31, 2004. The Line bears interest, payable quarterly, at the Federal Funds Rate plus 2.75%. The Line is collateralized by 100% of the issued and outstanding common shares of Holdings and the Bank. At December 31, 2003 and 2002, Bancshares had no outstanding borrowings under the Line.

Other Borrowings– Deposits are the primary source of funds for the Company’sfund its lending and investment activities. As needed, the Company obtains additional funds from the Federal Home Loan Bank (“FHLB”) and correspondent banks. At December 31, 2003,2004, the Company had $13.1 million in FHLB borrowings compared with $11.9 million in FHLB borrowings at December 31, 2003, all of which consisted of long-term FHLB notes payable compared with $37.9payable. The $1.2 million in FHLB borrowings at December 31, 2002increase is attributable to the acquisition of which $12.6 million consisted of long-term FHLB notes payableone note from Village Bank and $25.3 million consisted of FHLB advances. The highest outstanding balance of FHLB advances during 2003 was $59.3 million compared with $31.4 million during 2002.Trust, ssb partially offset by normal pay downs on the remaining notes. The maturity dates on the FHLB notes payable range from 2004 to 20182028 and the interest rates range from 5.95%4.64% to 6.48%. FHLB advances are considered short-term, overnight borrowings. At December 31, 2002, theThe Company had $12.6 million inno FHLB notes payable compared with $13.3 millionadvances outstanding at December 31, 2001.

At December 31, 2003, the Company had $19.02004 and 2003. The highest outstanding balance of FHLB advances during 2004 was $50.0 million in securities sold under repurchase agreements.

compared with $59.3 million during 2003. The Company had no federal funds purchased at December 31, 2004 or 2003.

At December 31, 2004, the Company had $25.1 million in securities sold under repurchase agreements compared with $19.0 million at December 31, 2003, an increase of $6.1 million or 2002.31.8%. The increase is primarily attributable to the Liberty acquisition.

 

11. INTEREST RATE RISK

 

The Company is principally engaged in providing real estate, consumer and commercial loans, with interest rates that are both fixed and variable. These loans are primarily funded through short-term demand deposits and longer-term certificates of deposit with variable and fixed rates. The fixed real estate loans are more sensitive to interest rate risk because of their fixed rates and longer maturities.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — STATEMENTS—(Continued)

 

12. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK

 

In the normal course of business, the Company is a party to various financial instruments with off-balance-sheet risk to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates.customers. These financial instruments include commitments to extend credit and standby letters of credit. These instrumentscredit, which involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. The contract or notional amounts of these instruments reflect the extent of the Company’s involvement in particular classes of financial instruments.

 

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making these commitments and conditional obligations as it does for on-balance-sheet instruments.

 

The following is a summary of the various financial instruments entered into by the Company:

 

  December 31,

  2003

  2002

  December 31,

  (Dollars in thousands)  2004

  2003

  (Dollars in thousands)

Commitments to extend credit

  $83,609  $78,359  $190,845  $83,609

Standby letters of credit

   4,069   1,681   5,863   4,069

 

At December 31, 2003, $15.9 million of commitments to extend credit have fixed rates ranging from 2.75% to 18.00%. 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 payment of a fee. Since many of the commitments are expected to expire without being fully drawn upon, the total commitment amounts disclosed above do not necessarily represent future cash funding requirements. At December 31, 2004, $24.6 million of commitments to extend credit have fixed rates ranging from 2.25% to 18.00%.

 

Standby letters of credit are written conditional commitments issued by the Company to guarantee the performance of a customer to a third party. 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 credit risk involved in issuing lettersmaximum potential amount of future payments the Company could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, the Company would be entitled to seek recovery from the customer. The Company’s policies generally require that standby letter of credit is essentially the same as that involvedarrangements contain security and debt covenants similar to those contained in extending loan facilities to customers.agreements.

 

The Company evaluates customer creditworthiness on a case-by-case basis. The amount of collateral obtained, if considered necessary by the Company upon extension of credit, is based on management’s credit evaluation of the customer.

 

13. INCOME TAXES

 

The components of the provision for federal income taxes are as follows:

 

  Year Ended December 31,

 
  2003

  2002

  2001

   Year Ended December 31,

  (Dollars in thousands)   2004

  2003

  2002

  (Dollars in thousands)

Current

  $12,203  $8,963  $5,894   $16,211  $12,203  $8,963

Deferred

   210   592   (522)   1,533   210   592
  

  

  


  

  

  

Total

  $12,413  $9,555  $5,372   $17,744  $12,413  $9,555
  

  

  


  

  

  

Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — STATEMENTS—(Continued)

 

The provision for federal income taxes differs from the amount computed by applying the federal income tax statutory rate on income as follows:

 

  Year Ended December 31,

   Year Ended December 31,

 
  2003

 2002

 2001

   2004

 2003

 2002

 
  (Dollars in thousands)   (Dollars in thousands) 

Taxes calculated at statutory rate

  $13,636  $10,807  $6,415   $18,358  $13,636  $10,807 

Increase (decrease) resulting from:

      

Tax-exempt interest

   (702)  (690)  (702)   (612)  (702)  (690)

Qualified Zone Academy Bond credit

   (373)  (373)  (373)   (373)  (373)  (373)

Dividends received deduction

   (436)  (298)  (329)   (286)  (436)  (298)

Amortization of goodwill

   —     61   262 

Amortization of CDI and goodwill

   623   —     61 

Other, net

   288   48   99    35   288   48 
  


 


 


  


 


 


Total

  $12,413  $9,555  $5,372   $17,744  $12,413  $9,555 
  


 


 


  


 


 


 

Deferred tax assets and liabilities are as follows:

 

  December 31,

   December 31,

 
  2003

 2002

   2004

 2003

 
  (Dollars in thousands)   (Dollars in thousands) 

Deferred tax assets:

      

Allowance for credit losses

  $2,056  $1,088   $4,193  $2,056 

Nonaccrual loan interest

   104   104    104   104 

Accrued liabilities

   —     318    349   —   

Transfers from acquired banks

   2,753   579    —         2,753 

Bank premises and equipment

   616   —          1,080   616 

Basis difference in loans

   199   —   

Unrealized loss on available for sale securities

   1,669   —   

Loss carry forwards

   1,280   —   

Credit carry forwards

   2,077   —   

Other

   31   56    282   1 
  


 


  


 


Total deferred tax assets

   5,560   2,145    11,233   5,560 
  


 


  


 


Deferred tax liabilities:

      

Accretion on investments

  $(702) $(437)  $(1,196) $(702)

Bank premises and equipment

   —     (926)   —     —   

Core deposit intangibles

   (1,265)  —   

Goodwill and core deposit intangibles

   (4,879)  (1,265)

Securities premium amortization

   (368)  —      (205)  (368)

Investments in partnerships

   (1,259)  —   

Prepaid expenses

   (260)  —   

Unrealized gain on available for sale securities

   (1,091)  (1,417)   —     (1,091)

FHLB dividends

   (25)  (125)   (98)  (25)

Other

   —     —   
  


 


  


 


Total deferred tax liabilities

   (3,451)  (2,905)   (7,897)  (3,451)
  


 


  


 


Net deferred tax liabilities

  $2,109  $(760)

Net deferred tax assets

  $3,336  $2,109 
  


 


  


 


 

The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections forestimates of future taxable income over the periods for which the deferred tax assets are deductible, management

Index to Financial Statements

PROSPERITY BANCSHARES, INC.® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

believes it is more likely than not the Company will realize the benefits of these deductible differences at December 31, 2003. The net deferred tax liability is included in other liabilities in the accompanying balance sheets.

PROSPERITY BANCSHARES, INC.sm AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)2004.

 

14. STOCK INCENTIVE PROGRAMPROGRAMS

 

The Company hashad two stock-based employee compensation plans.plans at December 31, 2004. Prior to 2003, the Company accounted for those plans under the recognition and measurement provisions of APB Opinion No. 25,Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost was reflected in previously reported results, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. In December 2002, the FASB issued Statement No. 148 (SFAS 148).Accounting for Stock-Based Compensation – Transition and Disclosure, an amendment to FASB Statement 123. SFAS 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS 148 is effective for financial statements for fiscal years ending after December 15, 2002. Effective January 1, 2003, the Company adopted the fair value recognition provisions of FASB Statement No. 123,Accounting for Stock-Based Compensation, as provided by SFAS No. 148 for stock-based employee compensation.

 

During 1995, the Company’s Board of Directors approved a stock option plan (the “1995 Plan”) for executive officers and key associates to purchase common stock of Bancshares. A total of 660,000 options have been granted under the 1995 plan as of December 31, 2003.2004. Compensation expense was not recognized for the stock options granted under the 1995 Plan because the options had an exercise price approximating the fair value of Bancshares’ common stock at the date of grant. The maximum number of shares reserved for issuance pursuant to options granted under the 1995 Plan is 680,000 (after two-for-one and four-for-one stock splits). AOptions to acquire a total of 165,000 options88,000 shares of common stock of Bancshares were outstanding at December 31, 2003.2004, of which 3,000 shares were exercisable.

 

During 1998, the Company’s Board of Directors and shareholders approved a second stock option plan (the “1998 Plan”) which authorizes the issuance of up to 920,000 (after two-for-one stock split) shares of the common stock of Bancshares under both “non-qualified” and “incentive” stock options to employees and “non-qualified” stock options to directors who are not employees. The 1998 Plan also provides for the granting of restricted stock awards, stock appreciation rights, phantom stock awards and performance awards on substantially similar terms. Compensation expense was not recognized for the stock options granted under the 1998 Plan because the options had an exercise price approximating the fair value of Bancshares common stock at the date of grant. Options to purchase 386,500 (after two-for-one stock split)a total of 784,500 shares of Bancshares common stock have been granted under the 1998 Plan. A total of 386,500 optionsBancshares were outstanding at December 31, 2003.2004 of which 36,300 shares were exercisable.

 

On

In December 2004, the Company’s Board of Directors established the Prosperity Bancshares, Inc. 2004 Stock Incentive Plan (the “2004 Plan”), which was approved by the Company’s shareholders on February 23, 2001,2005. The 2004 Plan authorizes the Company consummated its merger with Commercial.issuance of up to 1,250,000 shares of Common Stock upon the exercise of options granted under the 2004 Plan or upon the grant or exercise, as the case may be, of other awards granted under the 2004 Plan. The 2004 Plan provides for the granting of incentive and nonqualified stock options to purchaseemployees and nonqualified stock options to directors who are not employees. The 2004 Plan also provides for the granting of shares of Commercial commonrestricted stock, which were outstanding at the effective timestock appreciation rights, phantom stock awards and performance awards on substantially similar terms. As of the merger were converted intoMarch 1, 2005, no options to purchase a total of 26,660 (after two-for-one stock split) shares of Bancshares common stock at exercise prices ranging from $0.725 to $5.16 per share. The converted options are governed by the original plans under which they were issued. During 2000, Commercialor other awards had been granted 8,680 options at an exercise price of $5.16 per share. All options under the Commercial plan have been exercised.2004 Plan.

 

On September 1, 2002, the Company acquired Paradigm Bancorporation. The options to purchase shares of Paradigm common stock outstanding at the effective time of the transaction were converted (at a rate of 1 to 1.08658) into options to purchase a total of 33,80434,673 shares of Bancshares Common Stock at exercise prices ranging from $8.28 to $11.50 per share. The converted options are governed by the original plan under which they were issued. A total of 17,06514,782 options were outstanding at December 31, 2003.2004.

 

On November 1, 2003, the Company acquired MainBancorp, Inc. A portion of the options to purchase shares of MainBancorp common stock outstanding at the effective time of the transaction were converted at the option of the holder were converted into options to purchase a total of 100,851 shares of Bancshares Common Stock at exercise prices ranging from $8.03 to $16.26 per share. The converted options are governed by the original plan under which they were issued. A total of 31,127 options were outstanding at December 31, 2003.2004.

On August 1, 2004, the Company acquired Liberty Bancshares, Inc. A portion of the options to purchase shares of Liberty Bank common stock outstanding at the effective time of the transaction, at the option of the holder, were converted into options to purchase a total of 107,948 shares of Bancshares Common Stock at exercise prices ranging from $3.66 to $7.79 per share. The converted options are governed by the original plan under which they were issued. No options were outstanding at December 31, 2004.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — STATEMENTS—(Continued)

 

   Year Ended December 31,

   2003

  2002

  2001

   Number
of Options


  

Weighted-

Average
Exercise
Price


  Number
of Options


  

Weighted-

Average
Exercise
Price


  Number
of Options


  

Weighted-

Average
Exercise
Price


Options outstanding, beginning of period

  684,153  $8.65  530,180  $4.47  486,780  $2.53

Options granted

  164,851(1)  14.58  287,804(2)  16.92  184,000(3)  10.01

Options forfeited

  (78,674)  15.91  (29,327)  15.55  (10,000)  10.01

Options exercised

  (170,638)  5.83  (104,504)  2.48  (130,600)  2.34
   

     

     

   

Options outstanding, end of period

  599,692  $11.69  684,153  $8.65  530,180  $4.47
   

 

  

 

  

 

   Year Ended December 31,

   2004

  2003

  2002

   

Number
of

Options


  Weighted-
Average
Exercise
Price


  

Number
of

Options


  Weighted-
Average
Exercise
Price


  

Number
of

Options


  Weighted-
Average
Exercise
Price


Options outstanding, beginning of period

  599,692  $11.69  684,153  $8.65  530,180  $4.47

Options granted

  576,948(1)  22.69  164,851(2)  14.58  287,804(3)  16.92

Options forfeited

  (52,000)  19.65  (78,674)  15.91  (29,237)  15.55

Options exercised

  (206,231)  4.60  (170,638)  5.83  (104,504)  2.48
   

     

     

 

Options outstanding, end of period

  918,409  $19.64  599,692  $11.69  684,153  $8.65
   

 

  

 

  

 


(1)Includes options to acquire 107,948 shares of Bancshares Common Stock assumed in connection with the Liberty acquisition.

(2)Includes options to acquire 100,851 shares of Bancshares Common Stock assumed in connection with the MainBancorp acquisition.

(2)(3)Includes options to acquire 33,80434,673 shares of Bancshares Common Stock assumed in connection with the Paradigm acquisition.
(3)Includes options to acquire 26,660 shares of Bancshares Common Stock assumed in connection with the Commercial Merger.

 

At December 31, 2004, there were 85,209 options exercisable under all plans at a weighted average exercise price of $14.00. During 2004, 260,231 options were exercised. At December 31, 2003, there were 79,192 options exercisable under all plans at a weighted average exercise price of $9.68. During 2003,$9.68 and 170,638 options were exercised. At December 31, 2002, there were 54,153 options exercisable under all plans and 104,504 options were exercised. At December 31, 2001, there were 94,380

During 2004, the Company granted 469,000 options exercisable under all plans and 130,600the 1998 Plan. The options were exercised.granted at exercise prices ranging from $23.60 per share to $27.02 per share. Compensation expense in the amount of $141,000 was recorded.

 

During 2003, the Company granted 64,000 options under the 1998 Plan. The options were granted at exercise prices ranging from $19.30 per share to $23.10 per share. CompensationsCompensation expense in the amount of $24,000 was recorded.

 

During 2002, the Company granted 254,000 options under the 1998 Plan. The options were granted at exercise prices ranging from $16.55 per share to $19.01 per share. Compensation expense was not recorded for the stock options because the exercise price approximated the fair value of common stock at the date of grant.grant and the Company had not adopted SFAS No. 123.

 

On April 18, 2001, the Company granted 184,000 options under the 1998 Plan. The options were granted at an exercise priceweighted-average fair value of $10.01 per share. Compensation expense was not recorded for the stock options becausegranted on the exercise price approximatedrespective grant dates ranged from $5.09 to $6.94 in 2004 and ranged from $3.89 to $5.13 in 2003 respectively. The weighted-average remaining contractual life of options outstanding as of December 31, 2004 ranged from 9.05 years to 9.80 years for the fair value of common stock atoptions granted in 2004 and ranged from 8.35 years to 8.84 years for the date of grant.

options granted in 2003, respectively. The weighted-average fair value of the stock options on the grant dates ranged from $3.89 to $5.13 in 2003 and ranged from $3.86 to $4.10 in 2002 respectively. The weighted-average remaining contractual life of options outstanding as of December 31, 20032004 ranged from 9.358.35 years to 9.848.84 years for the options granted in 2003 and ranged from 8.337.33 years to 8.917.91 years for the options granted in 2002, respectively.

 

The fair value of options was estimated using an option-pricing model with the following weighted average assumptions:

 

  Year Ended December 31,

   Year Ended December 31,

 
  2003

 2002

 2001

   2004

 2003

 2002

 

Expected life

  4.50  4.50  4.50   5.82  4.50  4.50 

Risk free interest rate

  2.58% 5.57% 5.38%  3.56% 2.58% 5.57%

Volatility

  23.00% 23.00% 23.60%  22.00% 23.00% 23.00%

Dividend yield

  1.25% 1.31% 1.95%  1.13% 1.25% 1.31%

Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — STATEMENTS—(Continued)

 

The following table presents information relating to the Company’s stock options outstanding at December 31, 2003 (share data in thousands):2004:

 

   Options Outstanding 2003

Range of Exercise Prices


  

Number

Outstanding


  

Weighted Average

Exercise Price


  

Weighted Average

Remaining Life (years)


$ 0.00 - $ 5.00

  153,000  $2.56  2.50

$ 5.01 - $10.00

  17,433   7.26  6.22

$10.01 - $15.00

  163,632   10.11  7.32

$15.00 - $20.00

  245,627   17.85  8.85

$20.01 - $25.00

  20,000   22.73  9.82
   
  

  
   599,692  $11.69  6.77
   
  

  
   Options Outstanding 2004

Range of Exercise Prices


  Number
Outstanding


  Weighted
Average
Exercise
Price


  Weighted
Average
Remaining
Life
(years)


$ 0.00-$ 5.00

  80,000  $2.76  2.07

$ 5.01-$10.00

  13,433   7.52  5.46

$10.01-$15.00

  143,349   10.10  8.36

$15.00-$20.00

  202,627   17.68  7.76

$20.01-$25.00

  75,000   23.56  9.34

$25.01-$30.00

  404,000   22.02  9.80
   
       
   918,409  $19.64  8.35
   
  

  

 

15. PROFIT SHARING PLAN

 

The Company has adopted a profit sharing plan pursuant to Section 401(k) of the Internal Revenue Code whereby the participants may contribute a percentage of their compensation as permitted under the Code. Matching contributions are made at the discretion of the Company. Presently, The Company matches 50 % of an employee’s contributions, up to 15 %15% of compensation, not to exceed the maximum allowable pursuant to the Internal Revenue Code and excluding catch-up contributions. Such matching contributions were approximately $681,000, $593,000 $439,000 and $351,000,$439,000, for the years ended December 31, 2004, 2003 2002 and 2001,2002, respectively.

 

16. COMMITMENTS AND CONTINGENCIES

 

Leases — A– The following table presents a summary of non-cancelable future operating lease commitments as of December 31, 2003 follows2004 (dollars in thousands):

 

2004

  $1,511

2005

   1,065  $2,028

2006

   944   1,890

2007

   815   1,753

2008

   1,434   1,419

2009

   1,102

Thereafter

   2,548
  

  

Total

  $5,769  $10,740
  

  

It is expected that in the normal course of business, expiring leases will be renewed or replaced by leases on other property or equipment.

 

Rent expense under all noncancelable operating lease obligations aggregated approximately $1.8 million for the year ended December 31, 2004, $1.3 million for the year ended December 31, 2003 and $1.6 million for the year ended December 31, 2002 and $957,000 for the year ended December 31, 2001.2002.

 

Litigation — The Company has been named as a defendant in various legal actions arising in the normal course of business. In the opinion of management, after reviewing such claims with outside counsel, resolution of such matters will not have a materially adverse impact on the consolidated financial statements.

 

17. REGULATORY MATTERS

 

The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Any institution that fails to meet its minimum capital requirements is subject to actions by regulators that could have a direct material effect on the Company’s and the Bank’s financial statements. Under the capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines based on the Bank’s assets, liabilities and certain off- balance-sheet items as calculated under regulatory accounting practices. The Company’s and the Bank’s capital amounts and the Bank’s classification under the regulatory framework for prompt corrective action are also subject to qualitative judgements by the regulators about the components, risk weightings and other factors.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

To meet the capital adequacy requirements, the Company and the Bank must maintain minimum capital amounts and ratios as defined in the regulations. Management believes, as of December 31, 20032004 that the Company and the Bank met all capital

PROSPERITY BANCSHARES, INC.sm AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

adequacy requirements to which they are subject.

 

At December 31, 2003,2004, the most recent notification from the FDIC categorized the Bank as “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier I risk-based and Tier I leverage ratios as set forth in the table. There have been no conditions or events since that notification which management believes have changed the Bank’s category.

 

The following is a summary of the Company’s and the Bank’s capital ratios at December 31, 20032004 and 20022003 (dollars in thousands):

 

   Actual

  For Capital
Adequacy Purposes


  To Be Well
Capitalized Under
Prompt Corrective
Action Provisions


   Amount

  Ratio

  Amount

  Ratio

  Amount

  Ratio

CONSOLIDATED:

                    

As of December 31, 2003:

                    

Total Capital (to Risk Weighted Assets)

  $161,154  16.90% $76,282  8.0% N/A  N/A

Tier I Capital (to Risk Weighted Assets)

   150,809  15.82   38,141  4.0  N/A  N/A

Tier I Capital (to Average Tangible Assets)

   150,809  7.10   63,753  3.0  N/A  N/A

As of December 31, 2002:

                    

Total Capital (to Risk Weighted Assets)

  $122,265  15.30% $63,914  8.0% N/A  N/A

Tier I Capital (to Risk Weighted Assets)

   112,685  14.10   31,957  4.0  N/A  N/A

Tier I Capital (to Average Tangible Assets)

   112,685  6.56   51,553  3.0  N/A  N/A

   Actual

  

For Capital

Adequacy Purposes


  

To Be Well

Capitalized Under

Prompt Corrective

Action Provisions


 
   Amount

  Ratio

  Amount

  Ratio

  Amount

  Ratio

 

PROSPERITY BANK® ONLY:

                      

As of December 31, 2003:

                      

Total Capital (to Risk Weighted Assets)

  $146,823  15.40% $76,262  8.0% $95,328  10.0%

Tier I Capital (to Risk Weighted Assets)

   136,478  14.32   38,131  4.0%  57,197  6.0 

Tier I Capital (to Average Tangible Assets)

   136,478  6.43   63,724  3.0%  106,207  5.0 

As of December 31, 2002:

         ��            

Total Capital (to Risk Weighted Assets)

  $110,587  14.91% $59,337  8.0% $74,171  10.0%

Tier I Capital (to Risk Weighted Assets)

   101,677  13.71   29,668  4.0   44,503  6.0 

Tier I Capital (to Average Tangible Assets)

   101,677  6.26   48,730  3.0   81,217  5.0 
   Actual

  For Capital
Adequacy Purposes


  To Be Categorized
as Well Capitalized
Under Prompt
Corrective Action
Provisions


 
   Amount

  Ratio

  Amount

  Ratio

  Amount

  Ratio

 

CONSOLIDATED:

                      

As of December 31, 2004:

                      

Total Capital
(to Risk Weighted Assets)

  $173,179  14.67% $94,411  8.0%  N/A  N/A 

Tier I Capital
(to Risk Weighted Assets)

   160,074  13.56   47,205  4.0   N/A  N/A 

Tier I Capital
(to Average Tangible Assets)

   160,074  6.30   76,218  3.0   N/A  N/A 

As of December 31, 2003:

                      

Total Capital
(to Risk Weighted Assets)

  $161,154  16.90% $76,282  8.0%  N/A  N/A 

Tier I Capital
(to Risk Weighted Assets)

   150,809  15.82   38,141  4.0   N/A  N/A 

Tier I Capital
(to Average Tangible Assets)

   150,809  7.10   63,753  3.0   N/A  N/A 
   Actual

  For Capital
Adequacy Purposes


  To Be Categorized
as Well Capitalized
Under Prompt
Corrective Action
Provisions


 
   Amount

  Ratio

  Amount

  Ratio

  Amount

  Ratio

 

PROSPERITY BANK® ONLY:

                      

As of December 31, 2004:

                      

Total Capital
(to Risk Weighted Assets)

  $167,157  14.20% $94,156  8.0% $117,695  10.0%

Tier I Capital
(to Risk Weighted Assets)

   154,052  13.09   47,078  4.0%  70,617  6.0 

Tier I Capital
(to Average Tangible Assets)

   154,052  6.07   76,120  3.0%  126,867  5.0 

As of December 31, 2003:

                      

Total Capital
(to Risk Weighted Assets)

  $146,823  15.40% $76,262  8.0% $95,328  10.0%

Tier I Capital
(to Risk Weighted Assets)

   136,478  14.32   38,131  4.0   57,197  6.0 

Tier I Capital
(to Average Tangible Assets)

   136,478  6.43   63,724  3.0   106,207  5.0 

 

Dividends paid by Bancshares and the Bank are subject to restrictions by certain regulatory agencies. There was an aggregate of $48.9 million and $7.1 million available for payment of dividends by Bancshares and by the Bank to Bancshares, respectively, at December 31, 2003 under these restrictions. Dividends paid by Bancshares during the years ended December 31, 2004 and 2003 and 2002 were $4.9$6.7 million and $3.9$4.9 million, respectively. There were $37.9$40.0 million of dividends paid by the Bank to Bancshares during the year ended 20032004 and $18.4$37.9 million paid by the Bank to Bancshares during the year ended 2002.2003.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — STATEMENTS—(Continued)

 

18. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS

 

Disclosures of the estimated fair value amounts of financial instruments have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies could have a material effect on the estimated fair value amounts.

 

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

 

Cash and Cash Equivalents—For these short-term instruments, the carrying amount is a reasonable estimate of fair value.

 

Interest-Bearing Deposits in Financial Institutions—The carrying amount is a reasonable estimate of fair value.

Securities—For securities held as investments, fair value equals quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.

 

Loan Receivables—For certain homogeneous categories of loans (such as some residential mortgages and other consumer loans), fair value is estimated by discounting the future cash flows using the risk-free Treasury rate for the applicable maturity, adjusted for servicing and credit risk. The carrying value of variable rate loans approximates fair value because the loans reprice frequently to current market rates.

 

Company-Obligated Mandatorily Redeemable Trust Preferred Securities of Subsidiary Trusts –Junior Subordinated Debentures—The fair value of the Company-Obligated Mandatorily Redeemable Trust Preferred Securities of Subsidiary Trustsjunior subordinated debentures was calculated using the quoted market price.

 

Deposit LiabilitiesDeposits—The fair value of demand deposits, savings accounts and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities.

 

Long-Term Debt and Other Borrowings—Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate the fair value of existing debt using a discounted cash flows methodology.

 

Off-Balance Sheet Financial Instruments—The fair value of commitments to extend credit and standby letters of credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreement and the present creditworthiness of the counterparties.

Securities Sold Under Repurchase Agreements—The fair value of securities sold under repurchase agreements is the amount payable on demand at the reporting date.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — STATEMENTS—(Continued)

 

The estimated fair values of the Company’s interest-earning financial instruments are as follows (dollars in thousands):

 

  December 31,

   December 31,

 
  2003

 2002

   2004

 2003

 
  

Carrying

Amount


 

Fair

Value


 

Carrying

Amount


 

Fair

Value


   Carrying
Amount


 

Fair

Value


 Carrying
Amount


 

Fair

Value


 

Financial assets:

      

Cash and due from banks

  $71,983  $71,983  $66,806  $66,806   $58,760  $58,760  $71,983  $71,983 

Interest bearing deposits in financial institutions

   200   200   200   200 

Federal funds sold

   11,730   11,730   13,993   13,993    79,150   79,150   11,730   11,730 

Held to maturity securities

   1,113,232   1,122,451   641,098   660,261    1,125,109   1,124,500   1,113,232   1,122,451 

Available for sale securities

   260,533   263,648   309,219   309,219    177,683   177,683   263,648   263,648 

Loans

   770,053   782,961   679,559   698,496    1,035,513   1,046,218   770,053   782,961 

Less allowance for credit losses

   (10,345)  (10,345)  (9,580)  (9,580)   (13,105)  (13,105)  (10,345)  (10,345)
  


 


 


 


  


 


 


 


Total

  $2,217,186  $2,242,428  $1,701,095  $1,739,195   $2,463,310  $2,473,406  $2,220,501  $2,242,628 
  


 


 


 


  


 


 


 


Financial liabilities:

      

Deposits

  $2,083,748  $2,089,859  $1,586,611  $1,594,728   $2,317,076  $2,322,213  $2,083,748  $2,089,859 

Company-obligated mandatorily redeemable trust preferred securities of subsidiary trusts

   58,000   58,900   33,000   33,900 

Federal Home Loan Bank Advances

   —     —     25,300   25,300 

Junior subordinated debentures

   47,424   42,795   59,804   60,704 

Other borrowings

   —     —     —     —   

Securities sold under repurchase agreements

   19,006   19,006     25,058   25,058   19,006   19,006 

Federal Home Loan Bank notes payable

   11,929   13,015   12,639   13,914    13,116   14,021   11,929   13,015 
  


 


 


 


  


 


 


 


Total

  $2,172,683  $2,180,780  $1,657,550  $1,667,842   $2,402,674  $2,404,087  $2,174,487  $2,182,584 
  


 


 


 


  


 


 


 


 

The differences in fair value and carrying value of commitments to extend credit and standby letters of credit were not material at December 31, 20032004 and 2002.2003.

 

The fair value estimates presented herein are based on pertinent information available to management as of the dates indicated. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since those dates and, therefore, current estimates of fair value may differ significantly from the amounts presented herein.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

19.TRUST PREFERRED SECURITIESJUNIOR SUBORDINATED DEBENTURES

At December 31, 2004, the Company had four issues of junior subordinated debentures outstanding totaling $47.4 million as shown in the following table:

Description


  

Issuance Date


  

Trust Preferred
Securities Outstanding


  

Interest Rate


  

Junior Subordinated
Debt Owed

to Trusts


  

Maturity Date


Prosperity Statutory Trust II

  July 31, 2001  $15,000,000  

3-month LIBOR

+ 3.58%, not to exceed 12.50%

  $15,464,000  July 31, 2031

Paradigm Capital Trust II(1)

  Aug. 31, 2002  6,000,000  

3-month LIBOR

+ 4.50%

  6,186,000  Feb. 20, 2031

Prosperity Statutory Trust III

  Aug. 15, 2003  12,500,000  6.50%(2)  12,887,000  Sept. 17, 2033

Prosperity Statutory Trust IV

  Dec. 30, 2003  12,500,000  6.50%(3)  12,887,000  Dec. 30, 2033

(1)Assumed in connection with the Paradigm acquisition on September 1, 2002.

(2)The debentures bear a fixed interest rate until September 17, 2008, when the rate begins to float on a quarterly basis based on the three-month LIBOR plus 3.00%.

(3)The debentures bear a fixed interest rate until December 30, 2008, when the rate begins to float on a quarterly basis based on the three-month LIBOR plus 2.85%.

 

On December 30, 2003,31, 2004, the Company formed Prosperity Statutory Trust IV (“Trust IV”) and on December 30, 2003, Trust IV issued 12,500 Floating Rate Capital Securities (the “Capital Securities”) with an aggregate liquidation value of $12,500,000 to a third party. Concurrent withredeemed in full the issuance of the Capital Securities, Trust IV issued trust common securities to the Company in the aggregate liquidation value of $387,000. The proceeds of the issuance of the Capital Securities and trust common securities were invested in the Company’s Floating Rate Junior Subordinated Deferrable Interest Debentures (the “Floating Rate Debentures”). The Floating Rate Debentures will mature on December 30, 2033, which date may be shortened to a date not earlier than December 30, 2008, if certain conditions are met (including the Company having received prior approval of the Federal Reserve and any other required regulatory approvals). These Floating Rate Debentures, which are the only assets of Trust IV, are subordinate and junior in right of payment to all present and future senior indebtedness (as defined in the Indenture dated December 30, 2003) of the Company. The Floating Rate Debentures accrue interest at a fixed rate of 6.50 % until December 30, 2008 at which time the Capital Securities will accrue interest at a floating rate equal to the 3-month LIBOR plus 2.85%. The quarterly distributions on the Capital Securities will be paid at the same rate that interest is paid on the Floating Rate Debentures.

The Company has fully and unconditionally guaranteed the Trust IV’s obligations under the Capital Securities. Trust IV must redeem the Capital Securities when the Floating Rate Debentures are paid at maturity or upon any earlier prepayment of the Floating Rate Debentures. The Floating Rate Debentures may be prepaid if certain events occur, including a change in the tax status or regulatory capital treatment of the Capital Securities or a change in existing laws that requires Trust IV to register as an investment company. The Company received net proceeds of $12.4 million which will be used for the general corporate purposes of the Company and the Bank, including supporting continued expansion activities in the Houston and Dallas metropolitan areas and surrounding counties through the establishment and/or acquisition of additional Banking Centers and possible acquisitions.

PROSPERITY BANCSHARES, INC.sm AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

On August 15, 2003, the Company formedjunior subordinated debentures issued to Prosperity StatutoryCapital Trust III (“Trust III”) and on August 15, 2003, Trust III issued 12,500 Fixed/Floating Rate Capital Securities (the “Capital Securities”) with an aggregate liquidation value of $12,500,000 to a third party. Concurrent with the issuance of the Capital Securities, Trust III issued trust common securities to the Company in the aggregate liquidation value of $387,000. The proceeds of the issuance of the Capital Securities and trust common securities were invested in the Company’s Floating Rate Junior Subordinated Deferrable Interest Debentures (the “Floating Rate Debentures”). The Floating Rate Debentures will mature on September 17, 2033, which date may be shortened to a date not earlier than September 17, 2008, if certain conditions are met (including the Company having received prior approval of the Federal Reserve and any other required regulatory approvals). These Floating Rate Debentures, which are the only assets of Trust III, are subordinate and junior in right of payment to all present and future senior indebtedness (as defined in the Indenture dated August 15, 2003) of the Company. The Floating Rate Debentures accrue interest at a fixed rate of 6.50 % until September 17, 2008 at which time the Capital Securities will accrue interest at a floating rate equal to the 3-month LIBOR plus 3.00%. The quarterly distributions on the Capital Securities will be paid at the same rate that interest is paid on the Floating Rate Debentures.

The Company has fully and unconditionally guaranteed the Trust III’s obligations under the Capital Securities. Trust III must redeem the Capital Securities when the Floating Rate Debentures are paid at maturity or upon any earlier prepayment of the Floating Rate Debentures. The Floating Rate Debentures may be prepaid if certain events occur, including a change in the tax status or regulatory capital treatment of the Capital Securities or a change in existing laws that requires Trust III to register as an investment company. The Company received net proceeds of $12.4 million, which will be used for the general corporate purposes of the Company and the Bank, including supporting continued expansion activities in the Houston and Dallas metropolitan areas and surrounding counties through the establishment and/or acquisition of additional Banking Centers and possible acquisitions.

In July 2001, the Company formed Prosperity Statutory Trust II (“Trust II”) and on July 31, 2001, Trust II issued 15,000 Floating Rate Capital Securities (the “Capital Securities”) with an aggregate liquidation value of $15,000,000 to a third party. Concurrent with the issuance of the Capital Securities, Trust II issued trust common securities to the Company in the aggregate liquidation value of $464,000. The proceeds of the issuance of the Capital Securities and trust common securities were invested in the Company’s Floating Rate Junior Subordinated Deferrable Interest Debentures (the “Floating Rate Debentures”). The Floating Rate Debentures will mature on July 31, 2031, which date may be shortened to a date not earlier than July 31, 2006, if certain conditions are met (including the Company having received prior approval of the Federal Reserve and any other required regulatory approvals). These Floating Rate Debentures, which are the only assets of Trust II, are subordinate and junior in right of payment to all present and future senior indebtedness (as defined in the Indenture dated July 31, 2001) of the Company. The Floating Rate Debentures accrue interest at a floating rate equal to 3-month LIBOR plus 3.58%, not to exceed 12.50%, payable quarterly. The quarterly interest rate on the Debentures for the period from October 31, 2002 through December 31, 2002 was equal to 5.34%. The quarterly distributions on the Capital Securities will be paid at the same rate that interest is paid on the Floating Rate Debentures.

The Company has fully and unconditionally guaranteed the Trust II’s obligations under the Capital Securities. Trust II must redeem the Capital Securities when the Floating Rate Debentures are paid at maturity or upon any earlier prepayment of the Floating Rate Debentures. The Floating Rate Debentures may be prepaid if certain events occur, including a change in the tax status or regulatory capital treatment of the Capital Securities or a change in existing laws that requires Trust II to register as an investment company. The Company received net proceeds of $14.5 million, which will be used for the general corporate purposes of the Company and the Bank, including supporting continued expansion activities in the Houston metropolitan area and surrounding counties through the establishment and/or acquisition of additional Banking Centers and possible acquisitions.

In November 1999, the Company formedI. Prosperity Capital Trust I in turn redeemed in full the trust preferred securities and common securities it issued.

Each of the trusts is a capital or statutory business trust formed underorganized for the lawssole purpose of issuing trust securities and investing the proceeds in the Company’s junior subordinated debentures. The preferred trust securities of each trust represent preferred beneficial interests in the assets of the State of Delaware (“Trust I”). Trust I issued $12.0 million of 9.60% Trust Preferred Securitiesrespective trusts and invested the proceeds thereof in the 9.60% Junior Subordinated Deferrable Interest Debentures (the “Fixed Rate Debentures”) issued by the Company. The Fixed Rate Debentures will mature on November 17, 2029, which date may be shortened to a date not earlier than November 17, 2004, if certain conditions are met (including the Company having received prior approval of the Federal Reserve and any other required regulatory approvals). The Trust Preferred Securities will be subject to mandatory redemption ifupon payment of the Fixed Rate Debenturesjunior subordinated debentures held by the trust. The common securities of each trust are repaidwholly-owned by the Company. The Fixed Rate Debentures may be prepaid if certain events occur, including a change inEach trust’s ability to pay amounts due on the tax status or regulatory capital treatment of the Trust Preferred Securities. In each case, redemption will be made at par, plus the accrued and unpaid distributions thereon through the redemption date.

PROSPERITY BANCSHARES, INC.sm AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

In connection with the Paradigm acquisition, on September 1, 2002trust preferred securities is solely dependent upon the Company acquired Paradigm Capital Trust II (“Paradigm Trust”), which issued $6.0 million of floating rate preferred securitiesmaking payment on February 20, 2001.the related junior subordinated debentures. The Company also assumed the obligations under the floating rate debentures held by Paradigm Trust. The floating rate debentures will mature on February 20, 2031, which date may be shortened to a date not earlier than February 20, 2006 if certain conditions are met. These debentures, which are the only assets of theeach trust, are subordinate and junior in right of payment to all of the Company’s present and future senior indebtedness (as defined in the Indenture) of Paradigm.indebtedness. The Company has fully and unconditionally guaranteed Paradigm Trust’seach trust’s obligations under the preferred securities.trust securities issued by each respective trust to the extent not paid or made by each trust, provided such trust has funds available for such obligations.

 

The Floating Rate Debentures held by Paradigm Trust accrueUnder the provisions of each issue of the debentures, the Company has the right to defer payment of interest on the debentures at a floating rate equalany time, or from time to 3-month LIBOR plus 4.5%, payable quarterly. The quarterlytime, for periods not exceeding five years. If interest payments on either issue of the debentures are deferred, the distributions on the applicable trust preferred securities are paid at the same rate that interest is paid on the debentures. For the quarter ended December 31, 2002, the rate on the debentures was 6.33%.and common securities will also be deferred.

 

For financial reporting purposes, Trust I, Trust II, Trust III, Trust IV and Paradigm Trust are treated as subsidiariesIn late 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46R (FIN 46R), “Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51 (Revised December 2003).” FIN 46R requires that trust preferred securities be deconsolidated from the Company andCompany’s consolidated in the corporate financial statements. The trust preferred securities are presentedCompany adopted FIN 46R on January 1, 2004 and as a separate category on the balance sheet. Althoughresult, no longer reflects the trust preferred securities in its consolidated financial statements. Instead, the junior subordinated debentures are not includedshown as a componentliabilities in the Company’s consolidated balance sheets and interest expense associated with the junior subordinated debentures is shown as interest expense in the Company’s consolidated statements of shareholders’ equity on the balance sheet, for regulatory purposes, the trust preferred securities are treated as Tier 1 capital by the Federal Reserve. The treatment of the trust preferred securities as Tier 1 capital, in addition to the ability to deduct the expense of the debentures for federal income tax purposes, provided the Company with a cost-effective method of raising capital.income.

Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — STATEMENTS—(Continued)

 

20. PARENT COMPANY ONLY FINANCIAL STATEMENTS

 

PROSPERITY BANCSHARES, INC.

(Parent Company Only)

BALANCE SHEETS

 

  December 31,

   December 31,

 
  2003

 2002

   2004

 2003

 
  (Dollars in thousands)   (Dollars in thousands) 

ASSETS

      

Cash.

  $14,398  $2,027 

Investment in subsidiaries

   259,284   181,615 

Cash

  $4,614  $14,398 

Investment in subsidiary

   311,656   259,284 

Investment in Prosperity Capital Trust I

   380   380    —     380 

Investment in Prosperity Statutory Trust II

   464   464    464   464 

Investment in Prosperity Statutory Trust III

   387   —      387   387 

Investment in Prosperity Statutory Trust IV

   387   —      387   387 

Investment in Paradigm Capital Trust II

   186   186    186   186 

Goodwill, net

   3,983   3,983    3,983   3,983 

Other assets

   245   587    1,753   245 
  


 


  


 


TOTAL

  $279,714  $189,242   $323,430  $279,714 
  


 


  


 


LIABILITIES AND SHAREHOLDERS’ EQUITY

      

LIABILITIES:

      

Accrued interest payable and other liabilities.

  $322  $473 

Accrued interest payable and other liabilities

  $359  $322 

Junior subordinated debentures

   59,804   34,030    47,424   59,804 
  


 


  


 


Total liabilities

   60,126   34,503    47,783   60,126 
  


 


  


 


SHAREHOLDERS’ EQUITY:

      

Common stock

   20,967   18,903    22,418   20,967 

Capital surplus

   102,594   60,312 

Capital surplus.

   134,288   102,594 

Retained earnings

   94,610   72,917    122,647   94,610 

Unrealized losses on available for sale securities, net of tax

   2,024   2,644 

Less treasury stock, at cost (37,088 and 7,152 shares at December 31, 2003 and 2002, respectively)

   (607)  (37)

Unrealized (loss) gain on available for sale securities, net of tax benefit and tax

   (3,099)  2,024 

Less treasury stock, at cost, 37,088 shares

   (607)  (607)
  


 


  


 


Total shareholders’ equity

   219,588   154,739    275,647   219,588 
  


 


  


 


TOTAL

  $279,714  $189,242   $323,430  $279,714 
  


 


  


 


Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — STATEMENTS—(Continued)

 

PROSPERITY BANCSHARES, INC.

(Parent Company Only)

STATEMENTS OF INCOME

 

  For the Years Ended December 31,

  For the Years Ended
December 31,


  2003

 2002

  2001

  2004

 2003

 2002

  (Dollars in thousands)  (Dollars in thousands)

OPERATING INCOME:

         

Dividends from subsidiaries

  $37,900  $18,350  $2,272  $40,000  $37,900  $18,350

Other income

   —     —     —     112   79   66
  


 

  

  


 


 

Total income

   37,900   18,350   2,272   40,112   37,979   18,416
  


 

  

OPERATING EXPENSE:

         

Amortization of goodwill

   —     —     466

Minority expense trust preferred securities

   2,551   2,104   1,580

Junior subordinated debentures interest expense

   4,046   2,630   2,170

Other expenses

   278   174   158   369   278   174
  


 

  

  


 


 

Total operating expense

   2,829   2,278   2,204   4,415   2,908   2,344
  


 

  

  


 


 

INCOME BEFORE INCOME TAX BENEFIT AND EQUITY IN UNDISTRIBUTED EARNINGS OF SUBSIDIARIES

   35,071   16,072   68   35,697   35,071   16,072

FEDERAL INCOME TAX BENEFIT

   990   797   716   1,498   990   797
  


 

  

  


 


 

INCOME BEFORE EQUITY IN UNDISTRIBUTED EARNINGS OF SUBSIDIARIES

   36,061   16,869   784   37,195   36,061   16,869

EQUITY IN UNDISTRIBUTED EARNINGS OF SUBSIDIARIES

   (9,513)  4,452   12,174

(DISTRIBUTIONS IN EXCESS OF EARNINGS) EQUITY IN UNDISTRIBUTED EARNINGS OF SUBSIDIARIES

   (2,488)  (9,513)  4,452
  


 

  

  


 


 

NET INCOME

  $26,548  $21,321  $12,958  $34,707  $26,548  $21,321
  


 

  

  


 


 

Index to Financial Statements

PROSPERITY BANCSHARES, INC.sm® AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — STATEMENTS—(Continued)

 

PROSPERITY BANCSHARES, INC.

(Parent Company Only)

STATEMENTS OF CASH FLOWS

 

   For the Years Ended December 31,

 
   2003

  2002

  2001

 
   (Dollars in thousands) 

CASH FLOWS FROM OPERATING ACTIVITIES:

             

Net income

  $26,548  $21,321  $12,958 

Adjustments to reconcile net income to net cash provided by operating activities:

             

Equity in undistributed earnings of subsidiaries

   9,513   (4,452)  (12,174)

Amortization of goodwill

   —     —     466 

Decrease (increase) in other assets

   369   268   708 

(Decrease) increase in accrued interest payable and other liabilities

   (164)  (43)  (62)

Cash paid in lieu of fractional shares

   —     —     —   

Increase in other liabilities

   —     —     —   
   


 


 


Total adjustments

   9,718   (4,227)  (11,062)
   


 


 


Net cash flows provided by (used in) operating activities

   36,266   17,094   1,896 
   


 


 


CASH FLOWS FROM INVESTING ACTIVITIES:

             

Capital contribution to subsidiary

   —     —     —   
   


 


 


Net cash flows used in investing activities

   —     —     —   
   


 


 


CASH FLOWS FROM FINANCING ACTIVITIES:

             

Issuance of common stock

   995   260   306 

Trust preferred securities issuance cost

   —     —     (476)

Payments of cash dividends

   (4,855)  (3,866)  (3,161)

Cash paid to dissenting shareholders

   —     (3)  667 

Cash paid for acquisitions

   (44,805)  (24,789)  —   

Proceeds from issuance of junior subordinated debentures

   24,770   —     15,000 
   


 


 


Net cash flows (used in) provided by financing activities

   (23,895)  (28,398)  11,002 
   


 


 


NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS

   12,371   (11,304)  12,898 

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD

   2,027   13,331   433 
   


 


 


CASH AND CASH EQUIVALENTS, END OF PERIOD

  $14,398  $2,027  $13,331 
   


 


 


   For the Years Ended December 31,

 
   2004

  2003

  2002

 
   (Dollars in thousands) 

CASH FLOWS FROM OPERATING ACTIVITIES:

             

Net income

  $34,707  $26,548  $21,321 

Adjustments to reconcile net income to net cash provided by operating activities:

             

Equity in undistributed earnings of subsidiaries

   2,488   9,513   (4,452)

Amortization of goodwill

   —     —     —   

(Increase) decrease in other assets

   (1,508)  369   268 

Increase (decrease) in accrued interest payable and other liabilities

   37   (164)  (43)
   


 


 


Total adjustments

   (1,017)  9,718   (4,227)
   


 


 


Net cash provided by operating activities

   35,724   36,266   17,094 
   


 


 


CASH FLOWS FROM INVESTING ACTIVITIES:

             

Capital contribution to subsidiary

   (10)  —     —   
   


 


 


Net cash used in investing activities

   (10)  —     —   
   


 


 


CASH FLOWS FROM FINANCING ACTIVITIES:

             

Issuance of common stock

   1,047   995   260 

Redemption of junior subordinated debentures (net)

   (12,000)  —     —   

Payments of cash dividends

   (6,670)  (4,855)  (3,866)

Cash paid to dissenting shareholders

   —     —     (3)

Stock option compensation expense

   141   —     —   

Cash paid for acquisitions

   (28,016)  (44,805)  (24,789)

Proceeds from issuance of junior subordinated debentures (net)

   —     24,770   —   
   


 


 


Net cash used in financing activities

   (45,498)  (23,895)  (28,398)
   


 


 


NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS

   (9,784)  12,371   (11,304)

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD

   14,398   2,027   433 
   


 


 


CASH AND CASH EQUIVALENTS, END OF PERIOD

  $4,614  $14,398  $2,027 
   


 


 


Index to Financial Statements

Exhibit Index

 

Exhibit
Number(1)

Number



  

Description


2.1  

-   Agreement and Plan of Reorganization, dated as of October 25, 2004, by and between the Company and First Capital Bankers, Inc. (incorporated herein by reference to Exhibit 2.1 to the Company’s Registration Statement on Form S-4 (Registration No. 333-121767)).

2.2  

-   Agreement and Plan of Reorganization dated as of May 1, 2002 by and between Prosperity Bancshares, Inc. and Paradigm Bancorporation, Inc. (incorporated herein by reference to Exhibit 2.1 to the Company’s Registration Statement on Form S-4 (Registration No. 333-91248))

2.22.3  

-

Stock Purchase Agreement dated as of February 22, 2002 by and between Prosperity Bancshares, Inc. and American Bancorp of Oklahoma, Inc. (incorporated herein by reference to Exhibit 2.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2002)

2.32.4  

-

Agreement and Plan of Reorganization dated as of April 26, 2002 by and among Prosperity Bancshares, Inc., Prosperity Bank® and The First State Bank (incorporated herein by reference to Exhibit 2.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2002)

2.42.5  

-

Agreement and Plan of Reorganization by and between the Prosperity Bancshares, Inc and Commercial Bancshares, Inc. dated November 8, 2000 (incorporated herein by reference to Exhibit 2.1 to the Company’s Registration Statement on Form S-4 (Registration No. 333-52342))

2.52.6  

-

Agreement and Plan of Reorganization by and between Prosperity Bancshares, Inc. and South Texas Bancshares, Inc. dated June 17, 1999 (incorporated herein by reference to Exhibit 2.1 to the Company’s Form 10-Q for the quarter ended June 30, 1999)

2.62.7  

-

Agreement and Plan of Reorganization dated June 5, 1998 by and among Prosperity, Prosperity Bank® and Union State Bank (incorporated herein by reference to Exhibit 10.4 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267))

3.1  

-

Amended and Restated Articles of Incorporation of Prosperity (incorporated herein by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267))

3.2

-   Amended and Restated Bylaws of Prosperity (incorporated herein by reference to Exhibit 3.1 to the Company’s Form 10-Q for the quarter ended March 31, 2001)

3.2-Amended and Restated Bylaws of Prosperity (incorporated herein by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267))
4.1  

-

Form of certificate representing shares of Prosperity common stock (incorporated herein by reference to Exhibit 4 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267))

4.2  

-

Form of Indenture by and between Prosperity Bancshares, Inc. and First Union Trust Company, N.A. with respect to the Junior Subordinated Debentures of Prosperity Bancshares, Inc. (incorporated herein by reference to Exhibit 4.1 to the Company’s Registration Statement on Form S-1 (Registration No. 333-89481))
4.3-Form of Amended and Restated Trust Agreement of Prosperity Capital Trust I (incorporated herein by reference to Exhibit 4.5 to the Company’s Registration Statement on Form S-1 (Registration No. 333-89481))
4.4-Form of Trust Preferred Securities Guarantee Agreement by and between Prosperity and First Union Trust Company, N.A. (incorporated herein by reference to Exhibit 4.7 to the Company’s Registration Statement on Form S-1 (Registration No. 333-89481))
4.5-Indenture dated as of July 31, 2001 by and between Prosperity Bancshares, Inc., as Issuer, and State Street Bank and Trust Company of Connecticut, National Association, with respect to the Floating Rate Junior Subordinated Deferrable Interest Debentures of Prosperity Bancshares, Inc. (incorporated herein by reference to Exhibit 4.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2001)

4.64.3  

-

Amended and Restated Declaration of Trust of Prosperity Statutory Trust II dated as of July 31, 2001 (incorporated herein by reference to Exhibit 4.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2001)


Index to Financial Statements
4.7
4.4   

-

Guarantee Agreement dated as of July 31, 2001 by and between Prosperity Bancshares, Inc. and State Street Bank and Trust Company of Connecticut, National Association (incorporated herein by reference to Exhibit 4.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2001)

10.1+10.1†   

-

Prosperity Bancshares, Inc. 1995 Stock Option Plan (incorporated herein by reference to Exhibit 10.1 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267))

10.2+10.2†   

-

Prosperity Bancshares, Inc. 1998 Stock Incentive Plan (incorporated herein by reference to Exhibit 10.2 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267))

10.3+10.3†   

-

Form of Employment Agreements   Prosperity Bancshares, Inc. 2004 Stock Incentive Plan (incorporated herein by reference to Exhibit 10.3 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267))
10.4-Loan Agreement dated December 27, 1997 between Prosperity and Norwest Bank Minnesota, National Association (incorporated herein by reference to Exhibit 10.5 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267))
10.5+-Form of Employment Agreement by and between Prosperity Bank® and H.E. Timanus, Jr. (incorporated herein by reference to Exhibit 10.510.2 to the Company’s Registration Statement on Form S-4 (Registration No. 333-52342)333- 121767))

10.6+10.4†   

-   Amended and Restated Employment Agreement by and between Prosperity Bank and David Zalman (incorporated herein by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated January 18, 2005)

10.5† 

-   Amended and Restated Employment Agreement by and between Prosperity Bank and H. E. Timanus, Jr. (incorporated herein by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K dated January 18, 2005)

10.6†

-   Employment Agreement between the Company, Prosperity Bank and D. Michael Hunter (incorporated herein by reference to Exhibit 10.4 to the Company’s Registration Statement on Form S-4 (Registration No. 333-121767))

10.7†

-   Commercial Bancshares, Inc. Incentive Stock Option Plan for Key Employees (incorporated herein by reference to Exhibit 4.5 to the Company’s Registration Statement on Form S-8 (Registration No. 333-57238))

10.7+10.8†   

-

Form of Stock Option Agreement under the Commercial Bancshares, Inc. Incentive Stock Option Plan for Key Employees (incorporated herein by reference to Exhibit 4.6 to the Company’s Registration Statement on Form S-8 (Registration No. 333-57238))

10.8+10.9†   

-

Paradigm Bancorporation, Inc. 1999 Stock Incentive Plan (incorporated herein by reference to Exhibit 4.2 to the Company’s Registration Statement on Form S-8 (Registration No. 333-100815))

10.9+10.10†   

-

MainBancorp, Inc. 1996 Employee Stock Option Plan (incorporated herein by reference to Exhibit 4.2 to the Company’s Registration Statement on Form S-8 (Registration No. 333-110755))

10.10+10.11†   

-

Form of MainBancorp, Inc. Non-Qualified Stock Option Agreement (incorporated herein by reference to Exhibit 4.3 to the Company’s Registration Statement on Form S-8 (Registration No. 333-110755))

10.12†*

-   First Capital Bankers, Inc. 1996 Executive Stock Option Plan

10.13†*

-   First Capital Bankers, Inc. Amended and Restated 1998 Stock Option Plan

21.1*  

-

Subsidiaries of Prosperity Bancshares, Inc.

23.1*  

-

Consent of Deloitte & Touche LLP


Index to Financial Statements
31.1*  

-

Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.

31.2*  

-

Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.

32.1*  

-

Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2*  

-

Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


+Management contract or compensatory plan or arrangement.
*Filed with this Annual Report on Form 10-K.
(1)The Company has other long-term debt agreements that meet the exclusion set forth in Section 601(b)(4)(iii)(A) of Regulation S-K. The Company hereby agrees to furnish a copy of such agreements to the Commission upon request.

 

2