UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

   
x Quarterly Report pursuant to Section 13 or 15(d) of the Securities and Exchange Act of 1934.
For the quarterly period ended September 30, 2003

For the quarterly period ended March 31, 2004

   
o Transition Report pursuant to Section 13 or 15(d) of the Securities and Exchange Act of 1934.
For the transition period from to

For the transition period from ________________ to ________________

Commission file number0-30533

TEXAS CAPITAL BANCSHARES, INC.

(Exact Name of Registrant as Specified in Its Charter)
   
Delaware
75-2679109
(State or other jurisdiction of incorporation or organization) 75-2679109
(I.R.S. Employer Identification Number)
   
2100 McKinney Avenue, Suite 900, Dallas, Texas, U.S.A.
75201
(Address of principal executive officers) 75201
(Zip Code)

214/932-6600
(Registrant’s telephone number,
including area code)

N/A
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last
Report)

     Indicate by checkmark whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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. Yesx Noo

     Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yesx Noo

APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY
PROCEEDINGS DURING THE PRECEDING FIVE YEARS:

     Indicate by check whether the issuer has filed all reports required to be filed by Section 12, 13 or 15(d) of the Securities and Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yeso Noo

APPLICABLE ONLY TO CORPORATE ISSUERS:

     On October 31, 2003,April 30, 2004, the number of shares set forth below was outstanding with respect to each of the issuer’s classes of common stock:

 
Common Stock24,634,04424,906,908
Series A-1 Non-voting Common Stock304,000286,934


TABLE OF CONTENTS

ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED STATEMENTS OF OPERATIONS — UNAUDITED
CONSOLIDATED BALANCE SHEETS — UNAUDITED
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY — UNAUDITED
CONSOLIDATED STATEMENTS OF CASH FLOWS — UNAUDITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — UNAUDITED
QUARTERLY FINANCIAL SUMMARY — UNAUDITED
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ITEM 4. CONTROLS AND PROCEDURES
PART II — OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
SIGNATURES
EXHIBIT INDEX
EX-31.1 Certification of CEO Pursuant to Sec. 302
EX-31.2 Certification of CFO Pursuant to Sec. 302
EX-32.1 Certification of CEO Pursuant to Sec. 906
EX-32.2 Certification of CFO Pursuant to Sec. 906


Texas Capital Bancshares, Inc.
Form 10-Q
Quarter Ended September 30, 2003March 31, 2004

Index

2


ITEM 1. FINANCIAL STATEMENTS

TEXAS CAPITAL BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS - UNAUDITED
(Dollars in thousands except per share data)
            
 Three Months Ended Nine Months Ended
 September 30 September 30        
 2003 2002 2003 2002 Three months ended March 31
 
 
 
 
 2004
 2003
Interest income
  
Interest and fees on loans $16,114 $14,219 $46,791 $39,545  $16,706 $14,696 
Securities 4,832 3,815 15,517 10,320  7,551 5,360 
Federal funds sold 20 25 150 204  15 87 
Deposits in other banks 4 3 11 6  2 3 
 
 
 
 
  
 
 
 
 
Total interest income 20,970 18,062 62,469 50,075  24,274 20,146 
Interest expense
  
Deposits 5,041 5,617 16,020 15,650  4,743 5,382 
Federal funds purchased 348 402 1,257 1,145  320 440 
Repurchase agreements 2,085 2,359 
Other borrowings 1,980 1,169 6,805 2,798  226 86 
Long-term debt 250  630   256 137 
 
 
 
 
  
 
 
 
 
Total interest expense 7,619 7,188 24,712 19,593  7,630 8,404 
 
 
 
 
  
 
 
 
 
Net interest income
 13,351 10,874 37,757 30,482  16,644 11,742 
Provision for loan losses
 475 2,380 3,325 4,359  750 1,250 
 
 
 
 
  
 
 
 
 
Net interest income after provision for loan losses
 12,876 8,494 34,432 26,123  15,894 10,492 
Non-interest income
  
Service charges on deposit accounts 856 710 2,596 2,055  857 843 
Trust fee income 350 235 937 727  437 281 
Gain on sale of securities  1,375 686 1,375   341 
Cash processing fees   973 993  587 900 
Bank owned life insurance (BOLI)
income
 451 144 1,293 144  321 414 
Mortgage warehouse fees 545 188 1,248 545  238 279 
Gain on sale of mortgage loans 463  
Other 310 211 924 680  409 269 
 
 
 
 
  
 
 
 
 
Total non-interest income 2,512 2,863 8,657 6,519  3,312 3,327 
Non-interest expense
  
Salaries and employee benefits 5,754 4,163 16,990 12,492  8,123 5,379 
Net occupancy expense 1,265 1,214 3,651 3,767  1,332 1,187 
Advertising and affinity payments 213 448 605 1,010  285 193 
Legal and professional 744 724 2,253 2,175  789 579 
Communications and data processing 767 717 2,223 2,117  859 720 
Franchise taxes 37 34 111 81  97 37 
Repurchase agreement penalties   6,262  
Other 1,703 1,263 4,667 3,701  1,844 1,283 
 
 
 
 
  
 
 
 
 
Total non-interest expense 10,483 8,563 36,762 25,343  13,329 9,378 
 
 
 
 
  
 
 
 
 
Income before income taxes
 4,905 2,794 6,327 7,299  5,877 4,441 
Income tax expense (benefit) 1,573 700  (3,893) 1,828 
Income tax expense 1,940 1,410 
 
 
 
 
  
 
 
 
 
Net income
 3,332 2,094 10,220 5,471  3,937 3,031 
Preferred stock dividends  (149)  (280)  (699)  (817)   (274)
 
 
 
 
  
 
 
 
 
Income available to common
stockholders
 $3,183 $1,814 $9,521 $4,654  $3,937 $2,757 
 
 
 
 
  
 
 
 
 
Earnings per share:
  
Basic $.15 $.09 $.47 $.24  $.16 $.14 
Diluted $.14 $.09 $.45 $.24  $.15 $.14 

See accompanying notes to consolidated financial statements.

3


TEXAS CAPITAL BANCSHARES, INC.

CONSOLIDATED BALANCE SHEETS — UNAUDITED
(Dollars in thousands except per share data)
               
 September 30, December 31, March 31, December 31,
 2003 2002 2004
 2003
 
 
 (Unaudited) 
Assets
Assets
  
Cash and due from banksCash and due from banks $78,900 $88,744  $55,203 $69,551 
Federal funds sold 4,620  
Securities, available-for-saleSecurities, available-for-sale 811,968 553,169  752,861 775,338 
Loans, netLoans, net 1,108,552 988,019  1,293,500 1,212,046 
Loans held for saleLoans held for sale 91,686 116,106  72,789 80,780 
Premises and equipment, netPremises and equipment, net 3,695 3,829  4,635 4,672 
Accrued interest receivable and other assetsAccrued interest receivable and other assets 54,211 41,919  48,031 48,992 
Goodwill, netGoodwill, net 1,496 1,496  1,496 1,496 
 
 
  
 
 
 
 
Total assetsTotal assets $2,150,508 $1,793,282  $2,233,135 $2,192,875 
 
 
  
 
 
 
 
Liabilities and Stockholders’ Equity
Liabilities and Stockholders’ Equity
  
Liabilities:Liabilities:  
Deposits: 
Non-interest bearing $309,927 $301,886 
Interest bearing 1,131,598 1,094,534 
Interest bearing in foreign branches 54,366 48,610 
Deposits:  
 
 
 
 
 Non-interest bearing $295,902 $238,873 
 Interest bearing 1,131,205 957,662 
 
 
 
Total deposits 1,427,107 1,196,535 
Accrued interest payable 2,530 3,826 
Other liabilities 8,178 8,485 
Federal funds purchased 103,726 83,629 
Repurchase agreements 418,605 302,083 
Other borrowings 5,282 63,748 
Long-term debt 20,000 10,000 
Total deposits 1,495,891 1,445,030 
Accrued interest payable 2,226 3,468 
Other liabilities 7,309 6,247 
Federal funds purchased 90,203 78,961 
Repurchase agreements 432,291 432,255 
Other borrowings 2,008 34,538 
Long-term debt 20,620 20,620 
 
 
  
 
 
 
 
Total liabilitiesTotal liabilities 1,985,428 1,668,306  2,050,548 2,021,119 
Stockholders’ equity:Stockholders’ equity:  
Series A convertible preferred stock, $.01 par value, 6%: 
 Authorized shares - 10,000,000 
 Issued shares - 1,057,142 at December 31, 2002  11 
Common stock, $.01 par value: 
 Authorized shares - 100,000,000 
 Issued shares - 24,523,254 and 18,500,812 at September 30, 2003 and December 31, 2002, respectively 245 185 
Series A-1 non-voting common stock, $.01 par value: 
 Issued shares - 304,000 and 695,516 at September 30, 2003 and December 31, 2002, respectively 3 7 
Additional paid-in capital 165,972 131,881 
Accumulated deficit  (3,127)  (13,347)
Treasury stock (shares at cost: 97,246 at September 30, 2003 and December 31, 2002)  (668)  (668)
Deferred compensation 573 573 
Accumulated other comprehensive income 2,082 6,334 
Common stock, $.01 par value: 
Authorized shares – 100,000,000 
Issued shares – 24,858,683 and 24,715,607 at March 31, 2004 and December 31, 2003, respectively 248 247 
Series A-1 non-voting common stock, $.01 par value: 
Issued shares – 286,934 and 293,918 at March 31, 2004 and December 31, 2003, respectively 3 3 
Additional paid-in capital 169,074 167,751 
Retained earnings 4,424 487 
Treasury stock (shares at cost: 84,274 at March 31, 2004 and December 31, 2003)  (573)  (573)
Deferred compensation 573 573 
Accumulated other comprehensive income 8,838 3,268 
 
 
  
 
 
 
 
Total stockholders’ equityTotal stockholders’ equity 165,080 124,976  182,587 171,756 
 
 
  
 
 
 
 
Total liabilities and stockholders’ equityTotal liabilities and stockholders’ equity $2,150,508 $1,793,282  $2,233,135 $2,192,875 
 
 
  
 
 
 
 

See accompanying notes to consolidated financial statements.

4


TEXAS CAPITAL BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY — UNAUDITED
(Dollars in thousands except per share data)
                         
  Series A         Series A-1
  Convertible         Non-voting
  Preferred Stock
 Common Stock
 Common Stock
  Shares
 Amount
 Shares
 Amount
 Shares
 Amount
Balance at December 31, 2002  1,057,142  $11   18,500,812  $185   695,516  $7 
Comprehensive income:                        
Net income                  
Change in unrealized gain (loss) on available-for-sale securities, net of taxes of $1,760, net of reclassification amount of $666                  
Total comprehensive income                        
Tax benefit related to exercise of stock options                  
Issuance of common stock        3,698,913   37       
Conversion of preferred stock  (1,057,142)  (11)  2,114,284   21       
Preferred dividends                  
Transfers        401,598   4   (401,598)  (4)
Sale of treasury stock                  
   
 
   
 
   
 
   
 
   
 
   
 
 
Balance at December 31, 2003        24,715,607   247   293,918   3 
Comprehensive income:                        
Net income (unaudited)                  
Change in unrealized gain (loss) on available-for-sale securities, net of taxes of $2,999 (unaudited)                  
Total comprehensive income                        
Tax benefit related to exercise of stock options (unaudited)                  
Issuance of common stock (unaudited)        136,092   1       
Transfers (unaudited)        6,984      (6,984)   
   
 
   
 
   
 
   
 
   
 
   
 
 
Balance at March 31, 2004 (unaudited)    $   24,858,683  $248   286,934  $3 
   
 
   
 
   
 
   
 
   
 
   
 
 

                          
Series ASeries A-1
ConvertibleNon-voting
Preferred StockCommon StockCommon Stock



SharesAmountSharesAmountSharesAmount






Balance at December 31, 2001  753,301  $8   18,400,310  $184   741,392  $7 
Comprehensive income:                        
 Net income                  
 Change in unrealized gain (loss) on available-for-sale securities, net of tax of $3,683, net of reclassification amount of $1,375                  
Total comprehensive income                        
Sale of Series A convertible preferred stock  303,841   3             
Sale of common stock        54,626   1       
Preferred dividends                  
Transfers        45,876     (45,876)   
Purchase of treasury stock                  
Sale of treasury stock                  
  
   
   
   
   
   
 
Balance at December 31, 2002  1,057,142   11   18,500,812   185   695,516   7 
Comprehensive income:                        
 Net income                  
 Change in unrealized gain (loss) on available-for-sale securities, net of taxes of $1,361, net of reclassification amount of $686                  
Total comprehensive income                        
Sale of common stock        3,516,642   35       
Conversion of preferred stock (1,057,142) (11)  2,114,284   21       
Transfers        391,516   4  (391,516) (4)
Preferred dividends                  
  
   
   
   
   
   
 
Balance at September 30, 2003    $   24,523,254  $245   304,000  $3 
  
   
   
   
   
   
 

[Additional columns below]

[Continued from above table, first column(s) repeated]
                              

Accumulated
Other
Compre-
AdditionalTreasury Stockhensive
Paid-inAccumulated
DeferredIncome
CapitalDeficitSharesAmountCompensation(Loss)Total







Balance at December 31, 2001 $127,378  $(20,690) (87,516) $(594) $573  $(507) $106,359 
Comprehensive income:                            
 Net income     7,343               7,343 
 Change in unrealized gain (loss) on available-for-sale securities, net of tax of $3,683, net of reclassification amount of $1,375                 6,841   6,841 
Total comprehensive income                          14,184 
Sale of Series A convertible preferred stock  5,247                  5,250 
Sale of common stock  350                  351 
Preferred dividends (1,097)                (1,097)
Transfers                     
Purchase of treasury stock       (14,144) (103)       (103)
Sale of treasury stock  3      4,414   29         32 
  
   
   
   
   
   
   
 
Balance at December 31, 2002  131,881  (13,347) (97,246) (668)  573   6,334   124,976 
Comprehensive income:                            
 Net income     10,220               10,220 
 Change in unrealized gain (loss) on available-for-sale securities, net of taxes of $1,361, net of reclassification amount of $686                (4,252) (4,252)
Total comprehensive income                          5,968 
Sale of common stock  34,800                  34,835 
Conversion of preferred stock (10)                  
Transfers                     
Preferred dividends (699)                (699)
  
   
   
   
   
   
   
 
Balance at September 30, 2003 $165,972  $(3,127) (97,246) $(668) $573  $2,082  $165,080 
  
   
   
   
   
   
   
 

                             
                      Accumulated  
                      Other  
      Retained             Compre-  
  Additional Earnings Treasury Stock     hensive  
  Paid-in (Accumulated 
 Deferred Income  
  Capital
 Deficit)
 Shares
 Amount
 Compensation
 (Loss)
 Total
Balance at December 31, 2002 $131,881  $(13,347)  (97,246) $(668) $573  $6,334  $124,976 
Comprehensive income:                            
Net income     13,834               13,834 
Change in unrealized gain (loss) on available-for-sale securities, net of taxes of $1,760, net of reclassification amount of $666                 (3,066)  (3,066)
                           
 
 
Total comprehensive income                          10,768 
Tax benefit related to exercise of stock options  412                  412 
Issuance of common stock  36,167                  36,204 
Conversion of preferred stock  (10)                  
Preferred dividends  (699)                 (699)
Transfers                     
Sale of treasury stock        12,972   95         95 
   
 
   
 
   
 
   
 
   
 
   
 
   
 
 
Balance at December 31, 2003  167,751   487   (84,274)  (573)  573   3,268   171,756 
Comprehensive income:                            
Net income (unaudited)     3,937               3,937 
Change in unrealized gain (loss) on available-for-sale securities, net of taxes of $2,999 (unaudited)                 5,570   5,570 
                           
 
 
Total comprehensive income                          9,507 
Tax benefit related to exercise of stock options (unaudited)  428                  428 
Issuance of common stock (unaudited)  895                  896 
Transfers (unaudited)                     
   
 
   
 
   
 
   
 
   
 
   
 
   
 
 
Balance at March 31, 2004 (unaudited) $169,074  $4,424   (84,274) $(573) $573  $8,838  $182,587 
   
 
   
 
   
 
   
 
   
 
   
 
   
 
 

See accompanying notes to consolidated financial statements.

5


TEXAS CAPITAL BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS UNAUDITED
(Dollars in thousands)
            
 Nine Months Ended
 September 30        
 2003 2002  Three months ended March 31
 
 
  2004
 2003
Operating activities
Operating activities
  
Net incomeNet income $10,220 $5,471  $3,937 $3,031 
Adjustments to reconcile net income to net cash provided by (used in) operating activities:Adjustments to reconcile net income to net cash provided by (used in) operating activities:  
Provision for loan losses 3,325 4,359 
Depreciation and amortization 1,060 1,299 
Amortization and accretion on securities 7,803 1,258 
Bank owned life insurance (BOLI) income  (1,293)  (144)
Gain on sale of securities  (686)  (1,375)
Originations of loans held for sale  (1,899,622)  (744,241)
Proceeds from sales of loans held for sale 1,924,496 711,952 
Impact of reversing valuation allowance  (5,929)  
Changes in operating assets and liabilities: 
 Accrued interest receivable and other assets  (4,840)  (3,947)
 Accrued interest payable and other liabilities 961  (2,429)
Provision for loan losses 750 1,250 
Depreciation and amortization 394 366 
Amortization and accretion on securities 1,376 1,975 
Bank owned life insurance (BOLI) income  (321)  (414)
Gain on sale of securities   (341)
Originations of loans held for sale  (359,016)  (452,891)
Proceeds from sales of loans held for sale 367,166 446,047 
Changes in operating assets and liabilities: 
Accrued interest receivable and other assets 1,282  (1,735)
Accrued interest payable and other liabilities  (2,751)  (1,867)
 
 
  
 
 
 
 
Net cash provided by (used in) operating activitiesNet cash provided by (used in) operating activities 35,495  (27,797) 12,817  (4,579)
Investing activities
Investing activities
  
Purchases of available-for-sale securitiesPurchases of available-for-sale securities  (609,127)  (329,361)  (11,552)  (145,660)
Proceeds from sales of available-for-sale securitiesProceeds from sales of available-for-sale securities 42,914 41,471   10,694 
Maturities and calls of available-for-sale securitiesMaturities and calls of available-for-sale securities 9,700 4,700  1,800 1,800 
Principal payments received on securitiesPrincipal payments received on securities 283,782 49,723  39,422 63,550 
Net increase in loansNet increase in loans  (124,701)  (122,832)  (82,420)  (50,408)
Purchase of premises and equipment, netPurchase of premises and equipment, net  (768)  (129)  (300) 5 
Purchase of BOLI   (25,000)
 
 
  
 
 
 
 
Net cash used in investing activitiesNet cash used in investing activities  (398,200)  (381,428)  (53,050)  (120,019)
Financing activities
Financing activities
  
Net increase in checking, money market and savings accountsNet increase in checking, money market and savings accounts 200,619 83,473  118,065 65,503 
Net increase in certificates of deposit 29,953 150,042 
Sale of common stock 34,835 193 
Net increase (decrease) in certificates of deposit  (67,204) 34,108 
Issuance of common stock 896 100 
Net other borrowingsNet other borrowings 58,056 201,489   (32,494)  (10,418)
Net federal funds purchasedNet federal funds purchased 20,097 3,000  11,242 65,100 
Sale of preferred stock  5,250 
Purchase of treasury stock, net   (70)
Trust preferred 10,000  
Dividends paidDividends paid  (699)  (563)   (280)
 
 
  
 
 
 
 
Net cash provided by financing activitiesNet cash provided by financing activities 352,861 442,814  30,505 154,113 
 
 
  
 
 
 
 
Net increase (decrease) in cash and cash equivalentsNet increase (decrease) in cash and cash equivalents  (9,844) 33,589   (9,728) 29,515 
Cash and cash equivalents at beginning of periodCash and cash equivalents at beginning of period 88,744 56,620  69,551 88,744 
 
 
  
 
 
 
 
Cash and cash equivalents at end of periodCash and cash equivalents at end of period $78,900 $90,209  $59,823 $118,259 
 
 
  
 
 
 
 
Supplemental disclosures of cash flow information:Supplemental disclosures of cash flow information:  
Cash paid during the period for interest $25,919 $20,162 
Cash paid during the period for income taxes 5,720  
Cash paid during the period for interest $8,872 $9,380 
Cash paid during the period for income taxes 200  
Non-cash transactions:Non-cash transactions:  
Transfers from loans/leases to other repossessed assets 230 342 
Transfers from loans/leases to premises and equipment 158 279 
Transfers from loans/leases to other repossessed assets  16 
Transfers from loans/leases to premises and equipment 57 40 

See accompanying notes to consolidated financial statements.

6


TEXAS CAPITAL BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — UNAUDITED

(1) ACCOUNTING POLICIES

Basis of Presentation

The accounting and reporting policies of Texas Capital Bancshares, Inc. (the “Company”) conform to accounting principles generally accepted in the United States and to generally accepted practices within the banking industry. The Consolidated Financial Statements of the Company include the accounts of the Company and its subsidiary, Texas Capital Bank, National Association (the “Bank”). The Company owns all of the outstanding common securities of Texas Capital Bancshares Statutory Trust I, a Connecticut business trust, and Texas Capital Statutory Trust II, a Delaware statutory trust. Certain prior period balances have been reclassified to conform with the current period presentation.

The consolidated interim financial statements have been prepared without audit. Certain information and footnote disclosures presented in accordance with accounting principles generally accepted in the United States have been condensed or omitted. In the opinion of management, the interim financial statements include all normal and recurring adjustments and the disclosures made are adequate to make interim financial information not misleading.

New Accounting Standards

In December 2002, the Financial Accounting Standards Board issued FASB Statement No. 148,Accounting for Stock-Based Compensation — Transition and Disclosure. Statement 148 amends FASB Statement No. 123,Accounting for Stock-Based Compensation, to provide alternative methods of transition to Statement 123’s fair value method of accounting for stock-based employee compensation. Statement 148 also amends the disclosure provisions of Statement 123 and APB Opinion No. 28,Interim Financial Reporting, to require disclosure in the summary of significant accounting policies of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. While the Statement does not amend Statement 123 to require companies to account for employee stock options using the fair value method, the disclosure provisions of Statement 148 are applicable to all companies with stock-based employee compensation, regardless of whether they account for that compensation using the fair value method of Statement 123 or the intrinsic value method of Opinion 25. The Company adopted the disclosure provisions of Statement 148 effective December

At March 31, 2002.

At September 30, 2003,2004, the Company had a stock-based employee compensation plan. The Company accounts for the plan under the recognition and measurement principles of APB Opinion No. 25,Accounting for Stock Issued to EmployeeEmployees,s, and related interpretations. No stock-based employee compensation cost for options is reflected in net income, as all options granted under those plansthe plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123,Accounting for Stock-Based Compensation, to stock-based employee compensation.

                  
   Three months ended September 30 Nine months ended September 30
(Dollars in thousands) 2003 2002 2003 2002
  
 
 
 
Net income:                
 Net income as reported $3,332  $2,094  $10,220  $5,471 
 Add: Total stock based employee compensation recorded  45   20   286   20 
 Deduct: Total stock based employee compensation expense determined under fair value based method for all awards  (204)  (184)  (759)  (483)
    
   
   
   
 
Pro forma net income $3,173  $1,930  $9,747  $5,008 
    
   
   
   
 

7


(1) ACCOUNTING POLICIES (continued)

                         
 Three months ended September 30 Nine months ended September 30 Three months ended March 31
 2003 2002 2003 2002 2004
 2003
Net income as reported $3,937 $3,031 
Add: Total stock-based employee compensation recorded, net of related tax effects 175 61 
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects  (370)  (238)
 
 
 
 
 
Pro forma net income $3,742 $2,854 
 
 
 
 
 
 
 
 
 
Basic income per share:Basic income per share:  
As reported $.15 $.09 $.47 $.24 
Pro forma $.14 $.09 $.45 $.22 
As reported $.16 $.14 
Pro forma $.15 $.13 
Diluted income per share:Diluted income per share:  
As reported $.14 $.09 $.45 $.24 
Pro forma $.13 $.08 $.43 $.22 
As reported $.15 $.14 
Pro forma $.14 $.13 

The fair value of these options was estimated at the date of grant using a Black-Scholes value option pricing model with the following weighted average assumptions used for 20032004 and 2002,2003, respectively: a risk free interest rate of 3.33%3.56% and 4.07%2.85%, a dividend yield of 0%, a volatility factor of .387.286 and .001, and an estimated life of five years.

7


(1) ACCOUNTING POLICIES (continued)

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

Financial Accounting Standards Board Interpretation (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. 34.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 our financial statements for the year ended December 31, 2002. Implementation of the remaining provisions of FIN 45 did not have a significant impact on our 2003 financial statements.

FIN No. 46,Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin 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 entity 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 or annual period ending after December 15, 2003. Texas Capital Statutory Trust II was formed subsequent to January 31, 2003 for the purpose of issuing $10 million of trust preferred securities and accordingly is currently subject to the requirements of FIN 46. Texas Capital Bancshares Statutory Trust I was formed prior to January 31, 2003 to issue $10 million of trust preferred securities and will be subject to FIN 46 in the fourth quarter of 2003. We currently believe the continued consolidation of Texas Capital Statutory Trust II is appropriate under FIN 46. However, the application of FIN 46 to this type of trust is an emerging issue and a possible unintended consequence of FIN 46 is the deconsolidation of these trusts. The deconsolidation of Texas Capital Bancshares Statutory Trust I and Texas Capital Statutory Trust II would not have a material effect on our consolidated balance sheet or our consolidated statement of operations. In July 2003, the Board of Governors of the Federal Reserve System issued a supervisory letter instructing bank holding companies to continue to include the trust preferred

8


(1) ACCOUNTING POLICIES (continued)

securities in their Tier I capital for regulatory capital purposes until notice is given to the contrary. The Federal Reserve intends to review the regulatory implications of any accounting treatment changes and, if necessary or warranted, provide further appropriate guidance. There can be no assurance that the Federal Reserve will continue to allow institutions to include trust preferred securities in Tier I capital for regulatory capital purposes. As of September 30, 2003, assuming we were not allowed to include the $20 million in trust preferred securities issued by Texas Capital Bancshares Statutory Trust I and Texas Capital Statutory Trust II in Tier 1 capital, the Corporation would still exceed the regulatory required minimums for capital adequacy purposes.

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; (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 also modified various other existing pronouncements to conform with the changes made to SFAS 133. 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 our financial statements.

SFAS No. 150,“Accounting for Certain Financial Instruments with Characteristics of Both 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 a liability, 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 predominately 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. SFAS 150 is effective for contracts entered into or modified after May 31, 2003, and is otherwise effective at the beginning of the first interim period beginning after June 15, 2003. Adoption of SFAS 150 on July 1, 2003 did not have a significant impact on our financial statements.

9


(2) EARNINGS PER SHARE

The following table presents the computation of basic and diluted earnings per share (dollars in thousands except per share data):

                  
 Three months ended September 30 Nine months ended September 30        
 2003 2002 2003 2002 Three months ended March 31
 
 
 
 
 2004
 2003
Numerator:Numerator:  
Net income $3,332 $2,094 $10,220 $5,471 
Preferred stock dividends  (149)  (280)  (699)  (817)
Net income $3,937 $3,031 
Preferred stock dividends   (274)
  
 
 
 
  
 
 
 
 
Numerator for basic earnings per share-income available to common stockholdersNumerator for basic earnings per share-income available to common stockholders 3,183 1,814 9,521 4,654  3,937 2,757 
Effective of dilutive securities:Effective of dilutive securities:  
Preferred stock dividends2
 149  699  
Preferred stock dividends  274 
  
 
 
 
  
 
 
 
 
Numerator for dilutive earnings per share-income available to common stockholders and assumed conversionNumerator for dilutive earnings per share-income available to common stockholders and assumed conversion $3,332 $1,814 $10,220 $4,654  $3,937 $3,031 
  
 
 
 
  
 
 
 
 
Denominator:Denominator:  
Denominator for basic earnings per share-weighted average shares 21,924,855 19,148,908 20,120,056 19,140,206 
Effective of dilutive securities: 
 
Employee stock options1
 1,137,947 573,922 580,593 332,666 
 
Convertible preferred stock2
 1,103,104  1,773,521  
Denominator for basic earnings per share-weighted average shares 25,108,746 19,194,023 
Effective of dilutive securities: 
Employee benefit plans(1)
 967,009 125,053 
Convertible preferred stock  2,114,284 
  
 
 
 
  
 
 
 
 
Dilutive potential common sharesDilutive potential common shares 2,241,051 573,922 2,354,114 332,666  967,009 2,239,337 
  
 
 
 
  
 
 
 
 
Denominator for dilutive earnings per share-adjusted weighted average shares and assumed conversionsDenominator for dilutive earnings per share-adjusted weighted average shares and assumed conversions 24,165,906 19,722,830 22,474,170 19,472,872  26,075,755 21,433,360 
  
 
 
 
  
 
 
 
 
Basic earnings per shareBasic earnings per share $.15 $.09 $.47 $.24  $.16 $.14 
Diluted earnings per shareDiluted earnings per share $.14 $.09 $.45 $.24  $.15 $.14 

(1) Excludes employee stock options with exercise price equal to or greater than currentaverage market price.

(2)Effectsprice of convertible preferred stock are anti-dilutive$15.75 for 2004 and are not included in September 2002. Effects of convertible preferred stock are dilutive and are included in September$7.25 for 2003.

108


(3) SEGMENT DATA

During prior reporting periods, the Company has operated two principal lines of business under the Bank: the traditional bank and BankDirect, an internet only bank. During the third quarter of 2003, a new chief financial officer joined the Company. In connection with the addition to executive management and the assignment of responsibility for BankDirect to the new executive, the Company has re-evaluated its reportable segments and determined that BankDirect should not be reported as a separate line of business. Historically, while BankDirect has always been a division of the Bank, not a separate legal entity, the business strategy and operating results of BankDirect were previously reviewed by the Company as a business segment in assessing the performance and making decisions about financial, marketing and staffing resource allocations to BankDirect. Over the past two years, BankDirect has evolved primarily into an internet-based funding and services channel for the Bank and become less significant to the overall business and funding strategies of the Company. The deposit products and other services offered by BankDirect are substantially identical to those offered to other Bank customers. Accordingly, BankDirect is now evaluated by management in a manner similar to other funding sources and services of the Bank, rather than a clearly distinct business segment. Based on the foregoing, we have concluded that the Company currently has only one principal line of business that would be reportable as a segment: the Bank. We have restated our 2002 segment information consistent with the 2003 presentation.

BANK
(Dollars in thousands)

                 
  Three months ended September 30 Nine months ended September 30
  2003 2002 2003 2002
  
 
 
 
Net interest income $13,601  $10,874  $38,387  $30,482 
Provision for loan losses  475   2,380   3,325   4,359 
Non-interest income  2,512   2,863   8,657   6,519 
Non-interest expense  10,164   8,410   35,629   24,767 
   
   
   
   
 
Pre-tax income $5,474  $2,947  $8,090  $7,875 
   
   
   
   
 

Reportable segment reconciliation to the Consolidated Financial Statements for the three month and nine month periods ended September 30, 2003 are as follows (dollars in thousands):

                  
   Three months ended September 30, 2003
   
   Net Interest Provision for Non-interest Non-interest
   Income Loan Losses Income Expense
   
 
 
 
Total Bank $13,601  $475  $2,512  $10,164 
Unallocated items:                
 Holding company  (250)        319 
   
   
   
   
 
The Company consolidated $13,351  $475  $2,512  $10,483 
   
   
   
   
 
                  
   Nine months ended September 30, 2003
   
   Net Interest Provision for Non-interest Non-interest
   Income Loan Losses Income Expense
   
 
 
 
Total Bank $38,387  $3,325  $8,657  $35,629 
Unallocated items:                
 Holding company  (630)        1,133 
   
   
   
   
 
The Company consolidated $37,757  $3,325  $8,657  $36,762 
��  
   
   
   
 

11


(3) SEGMENT DATA (continued)

Reportable segment reconciliation to the Consolidated Financial Statements for the three month and nine month periods ended September 30, 2002 are as follows (dollars in thousands):

                  
   Three months ended September 30, 2002
   
   Net Interest Provision for Non-interest Non-interest
   Income Loan Losses Income Expense
   
 
 
 
Total Bank $10,874  $2,380  $2,863  $8,410 
Unallocated items:                
 Holding company           153 
   
   
   
   
 
The Company consolidated $10,874  $2,380  $2,863  $8,563 
   
   
   
   
 
                  
   Nine months ended September 30, 2002
   
   Net Interest Provision for Non-interest Non-interest
   Income Loan Losses Income Expense
   
 
 
 
Total Bank $30,482  $4,359  $6,519  $24,767 
Unallocated items:                
 Holding company           576 
   
   
   
   
 
The Company consolidated $30,482  $4,359  $6,519  $25,343 
   
   
   
   
 

(4) FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK

The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit which involve varying degrees of credit risk in excess of the amount recognized in the consolidated balance sheets. The Bank’s exposure to credit loss in the event of non-performance 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 Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The amount of collateral obtained, if deemed necessary, is based on management’s credit evaluation of the borrower.

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 may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s credit-worthiness on a case-by-case basis.

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

     
 September 30,    
(Dollars in thousands)(Dollars in thousands) 2003 March 31, 2004
 
Financial instruments whose contract amounts represent credit risk:Financial instruments whose contract amounts represent credit risk:  
Commitments to extend credit $373,970 
Standby letters of credit 18,369 
Commitments to extend credit $464,973 
Standby letters of credit 24,997 

129



QUARTERLY FINANCIAL SUMMARY UNAUDITED
Consolidated Daily Average Balances, Average Yields and Rates
(Dollars in thousands except per share data)
                         
 For the three months ended For the three months ended
 September 30, 2003 September 30, 2002                    
 
 
 For the three months ended For the three months ended
 Average Revenue/ Yield/ Average Revenue/ Yield/ March 31, 2004
 March 31, 2003
 Balance Expense (1) Rate Balance Expense (1) Rate Average Revenue/ Yield/ Average Revenue/ Yield/
 
 
 
 
 
 
 Balance
 Expense (1)
 Rate
 Balance
 Expense (1)
 Rate
Assets
Assets
  
Taxable securities $652,082 $4,832  2.94% $304,724 $3,815  4.97%
Securities $758,966 $7,551  4.00% $546,120 $5,360  3.98%
Federal funds soldFederal funds sold 8,090 20  0.98% 5,903 25  1.68% 6,058 15  1.00% 29,394 87  1.20%
Deposits in other banksDeposits in other banks 1,118 4  1.42% 621 3  1.92% 829 2  0.97% 979 3  1.24%
Loans held for sale 61,177 1,157  7.61% 100,177 1,460  5.91%
LoansLoans 1,275,311 16,114  5.01% 1,000,356 14,219  5.64% 1,265,840 15,549  4.94% 1,019,507 13,236  5.27%
Less reserve for loan losses 17,573   12,871   
Less reserve for loan losses 17,720   14,944   
 
 
 
 
 
 
  
 
 
 
 
 
 
 
 
 
 
 
 
Loans, net of reserveLoans, net of reserve 1,257,738 16,114  5.08% 987,485 14,219  5.71% 1,309,297 16,706  5.13% 1,104,740 14,696  5.39%
 
 
 
 
 
 
  
 
 
 
 
 
 
 
 
 
 
 
 
Total earning assetsTotal earning assets 1,919,028 20,970  4.34% 1,298,733 18,062  5.52% 2,075,150 24,274  4.70% 1,681,233 20,146  4.86%
Cash and other assetsCash and other assets 143,765 69,876  146,414 144,205 
 
 
  
 
 
 
 
Total assetsTotal assets $2,062,793 $1,368,609  $2,221,564 $1,825,438 
 
 
  
 
 
 
 
Liabilities and Stockholders’
Equity
Liabilities and Stockholders’
Equity
  
Transaction depositsTransaction deposits $64,137 $102  0.63% $52,478 $123  0.93% $88,635 $132  .60% $59,584 $112  0.76%
Savings depositsSavings deposits 477,158 1,466  1.22% 352,364 1,880  2.12% 504,530 1,499  1.19% 381,587 1,640  1.74%
Time depositsTime deposits 548,288 3,473  2.51% 451,391 3,614  3.18% 534,981 3,112  2.34% 524,622 3,630  2.81%
 
 
 
 
 
 
  
 
 
 
 
 
 
 
 
 
 
 
 
Total interest bearing depositsTotal interest bearing deposits 1,089,583 5,041  1.84% 856,233 5,617  2.60% 1,128,146 4,743  1.69% 965,793 5,382  2.26%
Other borrowingsOther borrowings 527,658 2,328  1.75% 227,420 1,571  2.74% 620,982 2,631  1.70% 496,617 2,885  2.36%
Long-term debtLong-term debt 20,000 250  4.96%     20,620 256  4.99% 10,310 137  5.39%
 
 
 
 
 
 
  
 
 
 
 
 
 
 
 
 
 
 
 
Total interest bearing liabilitiesTotal interest bearing liabilities 1,637,241 7,619  1.85% 1,083,653 7,188  2.63% 1,769,748 7,630  1.73% 1,472,720 8,404  2.31%
Demand depositsDemand deposits 269,891 156,950  265,039 213,991 
Other liabilitiesOther liabilities 9,592 8,417  10,013 11,784 
Stockholders’ equityStockholders’ equity 146,069 119,589  176,764 126,943 
 
 
  
 
 
 
 
Total liabilities and stockholders’ equityTotal liabilities and stockholders’ equity $2,062,793 $1,368,609  $2,221,564 $1,825,438 
 
 
  
 
 
 
 
Net interest incomeNet interest income $13,351 $10,874  $16,644 $11,742 
Net interest income to earning
assets
Net interest income to earning
assets
  2.76%  3.32%  3.23%  2.83%
 
 
  
 
 
 
 
Provision for loan lossesProvision for loan losses 475 2,380  750 1,250 
Non-interest incomeNon-interest income 2,512 2,863  3,312 3,327 
Non-interest expenseNon-interest expense 10,483 8,563  13,329 9,378 
 
 
  
 
 
 
 
Income before taxes
Income before taxes
 4,905 2,794  5,877 4,441 
Income tax expenseIncome tax expense 1,573 700  1,940 1,410 
 
 
  
 
 
 
 
Net income
Net income
 $3,332 $2,094  $3,937 $3,031 
 
 
  
 
 
 
 
Earnings per share:
Earnings per share:
  
Net income
 
Basic $.15 $.09 
Diluted $.14 $.09 
Net income
 
Basic $.16 $.14 
Diluted $.15 $.14 
Return on average equityReturn on average equity  9.05%  6.95%   8.96%  9.68% 
Return on average assetsReturn on average assets  .64%  .61%   .71%  .67% 
Equity to assetsEquity to assets  7.08%  8.74%   7.96%  6.95% 

(1) The loan averages include loans on which the accrual of interest has been discontinued and are stated net of unearned income.

1310



QUARTERLY FINANCIAL SUMMARY — UNAUDITED
Consolidated Daily Average Balances, Average Yields and Rates
(Dollars in thousands except per share data)
                          
   For the nine months ended For the nine months ended
   September 30, 2003 September 30, 2002
   
 
   Average Revenue/ Yield/ Average Revenue/ Yield/
   Balance Expense (1) Rate Balance Expense (1) Rate
   
 
 
 
 
 
Assets
                        
Taxable securities $606,535  $15,517   3.42% $262,584  $10,320   5.25%
Federal funds sold  16,823   150   1.19%  15,813   204   1.72%
Deposits in other banks  1,007   11   1.46%  316   6   2.54%
Loans  1,201,507   46,791   5.21%  927,936   39,545   5.70%
 Less reserve for loan losses  16,215         12,903       
   
   
   
   
   
   
 
Loans, net of reserve  1,185,292   46,791   5.28%  915,033   39,545   5.78%
   
   
   
   
   
   
 
Total earning assets  1,809,657   62,469   4.62%  1,193,746   50,075   5.61%
Cash and other assets  136,016           70,165         
   
           
         
Total assets $1,945,673          $1,263,911         
   
           
         
Liabilities and Stockholders’
Equity
                        
Transaction deposits $62,082  $335   0.72% $50,177  $366   0.98%
Savings deposits  422,293   4,735   1.50%  340,706   4,981   1.95%
Time deposits  549,498   10,950   2.66%  414,413   10,303   3.32%
   
   
   
   
   
   
 
Total interest bearing deposits  1,033,873   16,020   2.07%  805,296   15,650   2.60%
Other borrowings  506,709   8,062   2.13%  193,711   3,943   2.72%
Long-term debt  16,374   630   5.14%         
   
   
   
   
   
   
 
Total interest bearing liabilities  1,556,956   24,712   2.12%  999,007   19,593   2.62%
Demand deposits  243,773           142,130         
Other liabilities  10,990           7,485         
Stockholders’ equity  133,954           115,289         
   
           
         
Total liabilities and stockholders’ equity $1,945,673          $1,263,911         
   
           
         
Net interest income     $37,757          $30,482     
Net interest income to earning assets          2.79%          3.41%
           
           
 
Provision for loan losses      3,325           4,359     
Non-interest income      8,657           6,519     
Non-interest expense      36,762           25,343     
       
           
     
Income before taxes
      6,327           7,299     
Income tax expense (benefit)      (3,893)          1,828     
       
           
     
Net income
     $10,220          $5,471     
       
           
     
Earnings per share:
                        
 
Net income
                        
 Basic     $.47          $.24     
 Diluted     $.45          $.24     
Return on average equity      10.20%          6.34%    
Return on average assets      .70%          .58%    
Equity to assets      6.88%          9.12%    

(1)The loan averages include loans on which the accrual of interest has been discontinued and are stated net of unearned income.

14


ITEM 2.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward Looking Statements

Statements and financial analysis contained in this document 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 describe our future plans, strategies and expectations and are based on certain assumptions. As a result, these forward looking statements involve substantial risks and uncertainties, many of which are beyond our control. The important factors that could cause actual results to differ materially from the forward looking statements include the following:

 (1) Changes in interest rates

 (2) Changes in the levels of loan prepayments, which could affect the value of our loans or investment securities

 (3) Changes in general economic and business conditions in areas or markets where we compete

 (4) Competition from banks and other financial institutions for loans and customer deposits

 (5) The failure of assumptions underlying the establishment of and provisions made to the allowance for credit losses

 (6) The loss of senior management or operating personnel and the potential inability to hire qualified personnel at reasonable compensation levels

 (7) Changes in government regulations

We have no obligation to update or revise any forward looking statements as a result of new information or future events. In light of these assumptions, risks and uncertainties, the events discussed in any forward looking statements in this quarterly report might not occur.

Results of Operations

Summary of Performance

The Company recorded net income of $3.3$3.9 million or $.15 per diluted common share for the first quarter of 2004 compared to $3.0 million or $.14 per diluted common share for the thirdfirst quarter of 2003 compared to $2.1 million or $.09 per diluted common share for the third quarter of 2002.2003. Return on average equity was 9.05%8.96% and return on average assets was .64%.71% for the thirdfirst quarter of 20032004 compared to 6.95%9.68% and .61%.67%, respectively, for the thirdfirst quarter of 2002.2003.

The increase in net income and continued improvement in returnsreturn on equity and assets in 20032004 are attributed to growth in net interest income, and improved efficiency.which came from continued earning asset growth, as well as an improvement in net interest margin. The reduction in return on equity resulted from the effect of the $34 million increase in stockholders’ equity from the initial public offering of our common stock completed during the third quarter of 2003. Net interest income for the thirdfirst quarter of 20032004 increased by $2.5$4.9 million or 22.8%41.7% from $10.9$11.7 million to $13.4$16.6 million over the thirdfirst quarter of 2002.2003. The increase in net interest income was due to an increase in average earning assets of $620.3$393.9 million or 47.8%23.4%, which offsetwith a 5640 basis point decreaseincrease in net interest margin.

Non-interest income, excluding gain on sale of securities, increased $1.0 million$326,000 or 68.8%10.9% compared to the thirdfirst quarter of 2002.2003. The Company benefited from growth in fees related to deposits and wealth management, BOLI, and gain on sale of mortgage warehousing.

15


Non-interest expense increased $1.9 million or 22.4% comparedloans, which is related to our residential mortgage lending division that was started in the third quarter of 2002.2003.

11


Non-interest expense increased $4.0 million or 42.1% compared to the first quarter of 2003. Salaries and employee benefits increased by $1.6$2.7 million or 38.2%51.0%. Total full time employees increased from 214224 at September 30, 2002March 31, 2003 to 271355 at September 30, 2003;March 31, 2004; the increase related primarily to continued growth, staffing for the new Houston office and the start-up of the residential mortgage origination group.lending division.

Basic and diluted earnings per share for the nine months ended September 30, 2003 were $0.47 and $0.45, respectively. Excluding the impact of reversing the valuation allowance, unwinding penalties and separation expense in the second quarter, basic and diluted income per share for the nine months ended September 30, 2003 would have been $0.40 and $0.39, respectively. Income per share excluding the impact of reversing the valuation allowance, unwinding penalties and separation expense is a non-GAAP financial measure. Please see the following discussion of why we believe this non-GAAP financial measure is useful to management and investors and the following table for a reconciliation of income per share excluding impact of reversing the valuation allowance, unwinding penalties and separation expense to income per share, which is the most directly comparable financial measure presented in accordance with GAAP.

Non-GAAP Financial Measures

Management believes that income per share excluding the impact of reversing the deferred tax asset valuation allowance, unwinding penalties relating to the unwinding of repurchase agreements prior to maturity and separation expense associated with the resignation of a senior officer, which is a non-GAAP financial measure, is useful to investors and to management because it provides additional information that more closely reflects our intrinsic operating performance and growth. Reversal of the entire valuation allowance was based on our assessment of our ability to generate earnings to allow the deferred tax assets to be realized which is supported by our current earnings trends. We unwound certain repurchase agreements, incurring the unwinding penalties, in order to take advantage of historical lows in interest rates, which had decreased on similar repurchase agreements by approximately 1.4% since the time we entered into the original repurchase agreements. Although we have experienced employee separations in the past, this was the first separation with an executive who had entered into an employment agreement with us. We currently have only four other employees with employment agreements. Since we have not had any reversals of valuation allowances, unwinding penalties or separation expenses related to employees who have employment agreements in our operating history, we believe that this non-GAAP financial measure is useful to investors and to management to understand the development of our income per share results since our founding and to help in comparing our intrinsic operating performance in different periods. Management also uses these measures internally to evaluate our performance and manage our results. This measurement should not be regarded as a replacement for the corresponding GAAP measure.

The following table reconciles income per share excluding the impact of reversing the valuation allowance, unwinding penalties and separation expense to income per share, which is the most directly comparable financial measure presented in accordance with GAAP.

16


Reconciliation of GAAP to income per share, excluding the impact of reversing the valuation allowance, unwinding penalties and separation expense.

         
(Dollars in thousands except per share data) Three months Nine months
  ended ended
  September 30, September 30,
  2003 2003
  
 
  (Unaudited)
Net income as reported $3,332  $10,220 
Repurchase agreement unwinding penalties     6,262 
Executive separation     250 
Tax effect of repurchase agreement unwinding penalties and separation costs     (2,120)
Impact of reversing deferred tax asset valuation allowance     (5,929)
   
   
 
Net income excluding the impact of reversing the valuation allowance, unwinding penalties, and separation expense  3,332   8,683 
Preferred stock dividends  (149)  (699)
   
   
 
Numerator used to calculate basic income per share excluding the impact of reversing the valuation allowance, unwinding penalties, and separation expense  3,183   7,984 
Effect of dilutive securities  149   699 
   
   
 
Numerator used to calculate diluted income per share excluding the impact of reversing the valuation allowance, unwinding penalties, and separation expense $3,332  $8,683 
   
   
 
Denominator used for GAAP and basic income per share excluding the impact of reversing the valuation allowance, unwinding penalties, and separation expense  21,924,855   20,120,056 
Denominator used for GAAP and diluted income per share excluding the impact of reversing the valuation allowance, unwinding penalties, and separation expense  24,165,906   22,474,170 
Basic income per share excluding the impact of reversing the valuation allowance, unwinding penalties, and separation expense $.15  $.40 
Diluted income per share excluding the impact of reversing the valuation allowance, unwinding penalties, and separation expense $.14  $.39 

Net Interest Income

Net interest income was $13.4$16.6 million for the thirdfirst quarter of 2003,2004, compared to $10.9$11.7 million for the thirdfirst quarter of 2002.2003. The increase was due to an increase in average earning assets of $620.3$393.9 million as compared to the thirdfirst quarter of 2002, which offset2003 and a 5640 basis point decreaseincrease in net interest margin. The increase in average earning assets included a $270.3$204.6 million increase in average net loans and a $347.4$212.8 million increase in average securities. For the quarter ended September 30, 2003,March 31, 2004, average net loans and securities represented 66%63% and 34%37%, respectively, of average earning assets compared to 76%66% and 23%32% in the same quarter of 2002.2003. The decrease in loan percentage reflects management’s decision to tighten lending standards beginning in 2001 and continuing during 20022003 pending clearer signs of improvement in the U.S. economy. While we continue to apply prudent lending standards, loan growth in the thirdfirst quarter of 20032004 in our core loan portfolio (excluding loans held for sale) totaled $35 million. Our securities percentage has increased as we have continued to use additional securities to increase our earnings and improve our return on equity by taking advantage of market spreads.

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Average interest bearing liabilities increased $553.6 million from the third quarter of 2002, which included a $233.4 million increase in interest bearing deposits and a $300.2 million increase in other borrowings. The increase in interest bearing deposits includes the purchase of deposit accounts from Bluebonnet Savings Bank, FSB in August 2003. The increase in average borrowings was primarily related to an increase in federal funds purchased and securities sold under repurchase agreements, and was used to supplement deposits in funding loan growth and securities purchases. The average cost of interest bearing liabilities decreased from 2.63% for the quarter ended September 30, 2002 to 1.85% for the same period of 2003, reflecting the reduction in market interest rates and a $112.9 million increase in average non-interest bearing deposits.

Net interest income was $37.8 million for the nine months ended September 30, 2003, compared to $30.5 million for the same period of 2002. The increase was due to an increase in average earning assets of $615.9 million as compared to 2002, which offset a 62 basis point decrease in net interest margin. The increase in average earning assets included a $270.3 million increase in average net loans and a $344.0 million increase in average securities. For the nine months ended September 30, 2003, average net loans and securities represented 65% and 34%, respectively, of average earning assets compared to 77% and 22% in the same period in 2002. The decrease in loan percentage reflected management’s decision to tighten lending standards beginning in 2001 and continuing during 2002 pending clearer signs of improvement in the U.S. economy. While we continue to apply prudent lending standards, loan growth in the third quarter of 2003 in our core loan portfolio (excluding loans held for sale) totaled $35$82.0 million. Our securities percentage has increased as we have continued to use additional securities to increase our earnings and improve our return on equity by taking advantage of market spreads.

Average interest bearing liabilities increased $557.9$297.0 million from the nine months ended September 30, 2002,first quarter of 2003, which included a $228.6$162.4 million increase in interest bearing deposits and a $313.0$124.4 million increase in other borrowings. Average other borrowings were 26.0% of average total assets for the nine months ended September 30, 2003 compared to 15.3% for the same period in 2002. The increase in average other borrowings was primarily related to an increase in federal funds purchased and securities sold under repurchase agreements and was used to supplement deposits in funding loan growth and securities purchases. The average cost of interest bearing liabilities decreased from 2.62%2.31% for the nine monthsquarter ended September 30, 2002March 31, 2003 to 2.12%1.73% for the same period in 2003,of 2004, reflecting the reduction in market interest rates and a $101.6 million increase in average non-interest bearing deposits.rates.


TABLE 1 — VOLUME/RATE ANALYSIS
(Dollars in thousands)
                  
 Three months ended Nine months ended
 September 30, 2003/2002 September 30, 2003/2002
 
 
 Change Due To(1) Change Due To(1)          
 
 
 Three months ended March 31, 2004/2003
 Change Volume Yield/Rate Change Volume Yield/Rate Change Due To(1)
 
 
 
 
 
 
 Change
 Volume
 Yield/Rate
Interest income:Interest income:  
Securities $1,017 $4,349 $(3,332) $5,197 $13,518 $(8,321)
Loans 1,895 3,908  (2,013) 7,246 11,658  (4,412)
Federal funds sold  (5) 9  (14)  (54) 13  (67)
Deposits in other banks 1 2  (1) 5 13  (8)
Securities $2,191 $2,151 $40 
Loans held for sale  (303)  (561) 258 
Loans 2,313 3,336  (1,023)
Federal funds sold  (72)  (69)  (3)
Deposits in other banks  (1)   (1)
  
 
 
 
 
 
  
 
 
 
 
 
 
TotalTotal 2,908 8,268  (5,360) 12,394 25,202  (12,808) 4,128 4,857  (729)
Interest expense:Interest expense:  
Transaction deposits  (21) 27  (48)  (31) 87  (118)
Savings deposits  (414) 666  (1,080)  (246) 1,193  (1,439)
Time deposits  (141) 776  (917) 647 3,359  (2,712)
Borrowed funds 1,007 2,212  (1,205) 4,749 6,704  (1,955)
Transaction deposits 20 56  (36)
Savings deposits  (141) 522  (663)
Time deposits  (518) 103  (621)
Borrowed funds  (135) 736  (871)
  
 
 
 
 
 
  
 
 
 
 
 
 
TotalTotal 431 3,681  (3,250) 5,119 11,343  (6,224)  (774) 1,417  (2,191)
  
 
 
 
 
 
  
 
 
 
 
 
 
Net interest incomeNet interest income $2,477 $4,587 $(2,110) $7,275 $13,859 $(6,584) $4,902 $3,440 $1,462 
  
 
 
 
 
 
  
 
 
 
 
 
 

(1) Changes attributable to both volume and yield/rate are allocated to both volume and yield/rate on an equal basis.

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Net interest margin, the ratio of net interest income to average earning assets, was 2.76%3.23% for the thirdfirst quarter of 2004 compared to 2.83% for the first quarter of 2003. The increase was due to a slight decrease in the earning asset yield from the first quarter of 2003, compared to 3.32% forand a much larger decrease in the third quartercost of 2002. The decrease was due primarily to the falling rate environment in which our balance sheet was asset sensitive, largely due to the concentration of assets in variable rate loans. In addition, a larger portion of our assets was invested in securities, which generally have a lower yield than loans.liabilities.

12


Non-interest Income

Non-interest income, excluding gain on sale of securities, increased $1.0 million$326,000 compared to the same quarter of 2002. Service charges on deposit accounts increased $146,000.2003. This increase was due to the increase in deposits, which resulted in a higher volume of transactions. Trust fee income increased $115,000,$156,000, due to continued growth of trust assets in 2003. BOLI income for the quarter ended September 30, 2003 was $451,000 compared to $144,000 for the same period in 2002. Our BOLI investment originated in August 2002. The current policy provides life insurance for 25 executives, naming us as beneficiary. Mortgage warehouse fees increased by $357,000 due to the continued growth in the mortgage warehouse business as a result of favorable mortgage rates and growth in our customer base.

Non-interest income increased $2.1 million, or 32.8%, in the nine months ended September 30, 2003 compared to the same period in 2002. Service charges on deposit accounts increased $541,000 for the nine months ended September 30, 2003 as compared to the same period in 2002. This increase was due to the significant increase in non-interest deposits, which resulted in a higher volume of transactions. Trust fee income increased $210,000 due to continued growth of trust assets during the nine month period ended September 30, 2003. During the nine month period ended September 30, 2003, we had gain2004. Gain on sale of securities of $686,000 compared to $1,375,000 during the same period in 2002 duemortgage loans totaled $463,000 and relates to our ability to realize substantial profits from sales of fixed-rate debt securities as a result of rapid declines in overall interest rates.newly created residential mortgage lending division. Cash processing fees totaled $973,000$587,000 for the nine months ended September 30, 2003, which is comparablefirst quarter of 2004 compared to $900,000 for the same period in 2002.quarter of 2003. These fees wereare related to a special project that has occurred duringin the first quarter of 2002, 2003 and 20022004. 2004 fees are lower than 2003 fees due to smaller participation and will not be recurring in future quarters of 2003. We had BOLI income of $1.3 million during the first nine months of 2003 compared to $144,000 during the same period in 2002. Our BOLI investment originated in August 2002. The current policy provides life insurance for 25 executives, naming us as beneficiary. Mortgage warehouse fees increased by $703,000 for the nine months ended September 30, 2003 as a result of favorable mortgage rates and growth in our customer base.more competitive pricing.

While management expects continued growth in non-interest income, the future rate of growth could be affected by increased competition from nationwide and regional financial institutions. In order to achieve continued growth in non-interest income, we may need to introduce new products or enter into new markets. Any new product introduction or new market entry would likely place additional demands on capital and managerial resources.


TABLE 2 NON-INTEREST INCOME
(Dollars in thousands)
            
 Three Months Ended Nine months Ended
 September 30 September 30        
 2003 2002 2003 2002  Three months ended March 31
 
 
 
 
  2004
 2003
Service charges on deposit accounts $856 $710 $2,596 $2,055  $857 $843 
Trust fee income 350 235 937 727  437 281 
Gain on sale of securities  1,375 686 1,375   341 
Cash processing fees   973 993  587 900 
Bank owned life insurance (BOLI) income 451 144 1,293 144  321 414 
Mortgage warehouse fees 545 188 1,248 545  238 279 
Gain on sale of mortgage loans 463  
Other 310 211 924 680  409 269 
 
 
 
 
  
 
 
 
 
Total non-interest income $2,512 $2,863 $8,657 $6,519  $3,312 $3,327 
 
 
 
 
  
 
 
 
 

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Non-interest Expense

Non-interest expense for the thirdfirst quarter of 20032004 increased $1.9$4.0 million or 22.4%42.1% compared to the thirdfirst quarter of 2002.2003. Salaries and employee benefits increased by $1.6$2.7 million or 38.2%51.0%. Total full time employees increased from 214224 at September 30, 2002March 31, 2003 to 271355 at September 30, 2003.March 31, 2004. Additional employees include employees hired in the recently openednew Houston office, employees in our recently created residential mortgage origination grouplending division as well as some additional employees in our lending and support functions.

Advertising expense decreased $235,000increased $92,000 or 52.5%47.7%. Advertising expense for the three months ended September 30, 2003March 31, 2004 included $37,000$27,000 of direct marketing and branding for the traditional bank and $176,000$258,000 for the purchase of miles related to the American Airlines AAdvantage® program, compared to $264,000$31,000 of direct marketing and branding for the traditional bank and $184,000$162,000 for the purchase of miles during the same period for 2002.2003.

Net occupancy expense for the three months ended September 30, 2003March 31, 2004 increased by $51,000$145,000 or 4.2%12.2% compared to the same quarter in 2002.2003 and is related to our continued growth, the new Houston office and the start-up of the residential mortgage lending division. Legal and professional expense for the three months ended March 31, 2004 increased $210,000 or 36.3% compared to the same quarter in 2003. Communications and data processing expense for the three months ended September 30, 2003March 31, 2004 increased $50,000$139,000 or 7.0%19.3% compared to the same quarter in 2002.2003. Both increases are due to continued growth.

Non-interest expense for the nine months ended September 30, 2003 increased $11.4 million, or 45.1%, compared to the same period of 2002. This increase included $6.3 million in penalties related to our restructuring of the maturities and pricing of our repurchase agreements in June 2003 in order to take advantage of historical lows in interest rates, which had decreased on similar repurchase agreements by approximately 1.4% since the time we entered into the original repurchase agreements. We unwound approximately $139 million in repurchase agreements prior to their maturities and entered into new repurchase agreements with respect to a significant portion of that amount, with the remainder replaced with overnight funds. A significant portion of these overnight funds were replaced with deposits when we completed our planned acquisition of the outstanding deposit accounts of Bluebonnet Savings Bank FSB, which occurred in August 2003. Salaries and employee benefits increased by $4.5 million or 36.0%. Total full time employees increased from 214 at September 30, 2002 to 271 at September 30, 2003. Also included in salaries and benefits for the nine months ended September 30, 2003, is $250,000 in separation costs related to the resignation of a senior officer in the second quarter. In addition, we experienced losses related to forged checks of approximately $300,000 in the first nine months of 2003. We have taken steps to attempt to reduce these types of losses in the future.13

Net occupancy expense for the nine months ended September 30, 2003 decreased by $116,000, or 3.1%, due to a decrease in depreciation as many of our fixed assets are becoming fully depreciated.

Advertising expense for the nine months ended September 30, 2003 decreased $405,000, or 40.1%, compared to 2002. Advertising expense for the nine months ended September 30, 2003 included $99,000 of direct marketing and branding for the traditional bank and $506,000 for the purchase of miles related to the American Airlines AAdvantage® program compared to direct marketing and branding of $553,000 and $457,000 for the purchases of American Airlines miles during the same period in 2002. Our direct marketing may increase as we seek to further develop our brand, reach more of our target customers and expand in our target markets. Legal and professional expenses increased $78,000 or 3.6%, mainly related to continued legal expenses incurred with our non-performing loans and leases. Communications and data processing expense for the nine months ended September 30, 2003 increased $106,000, or 5.0%, due to growth in our loan and deposit base and increased staff.

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TABLE 3 -NON-INTEREST– NON-INTEREST EXPENSE
(Dollars in thousands)
                
 Three Months Ended Nine months Ended
 September 30 September 30      
 2003 2002 2003 2002 Three months ended March 31
 
 
 
 
 2004
 2003
Salaries and employee benefits $5,754 $4,163 $16,990 $12,492  $8,123 $5,379 
Net occupancy expense 1,265 1,214 3,651 3,767  1,332 1,187 
Advertising and affinity payments 213 448 605 1,010  285 193 
Legal and professional 744 724 2,253 2,175  789 579 
Communications and data processing 767 717 2,223 2,117  859 720 
Franchise taxes 37 34 111 81  97 37 
Repurchase agreement penalties   6,262  
Other 1,703 1,263 4,667 3,701  1,844 1,283 
 
 
 
 
  
 
 
 
 
Total non-interest expense $10,483 $8,563 $36,762 $25,343  $13,329 $9,378 
 
 
 
 
  
 
 
 
 

INCOME TAXES

The Company had a gross deferred tax asset of $7.8 million at September 30, 2003. In 2003, as a result of our reassessment of our ability to generate sufficient earnings to allow the utilization of our deferred tax assets, we believe it is more likely than not that the deferred tax assets will be realized. Accordingly, in compliance with Statement of Financial Accounting Standards No. 109, we reversed the valuation allowance and certain related tax reserves during the quarter ended June 30, 2003.

Analysis of Financial Condition

The aggregate loan portfolio at September 30, 2003March 31, 2004 increased $98.6$73.8 million from December 31, 20022003 to $1.2$1.39 billion. Commercial loans increased $46.0$44.9 million and real estate loans increased $28.3$17.4 million. Construction loans increased $59.9 million and leases and consumer loans decreased $4.8increased $18.5 million and $6.4$2.8 million, respectively.respectively, and leases decreased $1.8 million.


TABLE 4 LOANS
(Dollars in thousands)
        
 September 30, December 31,        
 2003 2002 March 31, December 31,
 
 
 2004
 2003
Commercial $555,523 $509,505  $653,458 $608,542 
Construction 232,314 172,451  274,597 256,134 
Real estate 311,010 282,703  356,511 339,069 
Consumer 17,812 24,195  19,349 16,564 
Leases 12,727 17,546  11,363 13,152 
Loans held for sale 91,686 116,106  72,789 80,780 
 
 
  
 
 
 
 
Total $1,221,072 $1,122,506  $1,388,067 $1,314,241 
 
 
  
 
 
 
 

We continue to lend primarily in Texas. As of September 30, 2003,March 31, 2004, a substantial majority of the principal amount of the loans in our portfolio was to businesses and individuals in Texas. This geographic concentration subjects the loan portfolio to the general economic conditions within this area. We originate substantially all of the loans in our portfolio, except in certain instances we have purchased individual leases and loan and lease pools (primarily commercial and industrial equipment and vehicles), as well as selected loan participations and USDA government guaranteed loans.

2114


SUMMARY OF LOAN LOSS EXPERIENCESummary of Loan Loss Experience

The reserve for loan losses, which is available to absorb losses inherent in the loan portfolio, totaled $17.3$18.0 million at September 30, 2003, $14.5March 31, 2004, $17.7 million at December 31, 20022003 and $13.8$15.9 million at September 30, 2002.March 31, 2003. This represents 1.41%1.30%, 1.30%1.35% and 1.31%1.35% of total loans at September 30, 2003,March 31, 2004, December 31, 20022003 and September 30, 2002,March 31, 2003, respectively.

The provision for loan losses is a charge to earnings to maintain the reserve for loan losses at a level consistent with management’s assessment of the loan portfolio in light of current economic conditions and market trends. The Company recorded a provision of $475,000$750,000 for the quarter ended September 2003March 2004 and $2.4$1.3 million for the same quarter in 2002.2003. These provisions were made to reflect management’s assessment of the risk of loan losses specifically including risk associated with the continued rapidsignificant growth in the loan portfolio and the unseasoned natureoutstanding loans during each of the current portfolio.these periods.

The reserve for loan losses is comprised of specific reserves assigned to classifiedfor impaired loans and general reserves.an estimate of losses inherent in the portfolio at the balance sheet date, but not yet identified with specified loans. We continuouslyregularly evaluate our reserve for loan losses to maintain an adequate level to absorb estimated loan losses inherent in the loan portfolio. Factors contributing to the determination of specific reserves include the credit worthiness of the borrower, changes in the value of pledged collateral, and general economic conditions. All loan commitments rated substandard or worse and greater than $1,000,000 are specifically reviewed and a specific allocation is assigned based on the losses expected to be realized from those loans. For purposes of determining the general reserve, the portfolio is segregated by product types to recognize differing risk profiles among categories, and then further segregated by credit grades. Credit grades are assigned to all loans greater than $50,000. Each credit grade is assigned a risk factor, or reserve allocation percentage. These risk factors are multiplied by the outstanding principal balance and risk-weighted by product type to calculate the required reserve. A similar process is employed to calculate that portion of the required reserve assigned to unfunded loan commitments.

The reserve allocation percentages assigned to each credit grade have been developed based on an analysis of the Company’s historical loss rates and historical loss rates at selected peer banks, adjusted for certain qualitative factors. Qualitative adjustments for such things as general economic conditions, changes in credit policies and lending standards, and changes in the trend and severity of problem loans, can cause the estimation of future losses to differ from past experience. The unallocated portion of the general reserve serves to compensate for additional areas of uncertainty and considers industry trends. In addition, the reserve considers the results of reviews performed by independent third party reviewers as reflected in their confirmations of assigned credit grades within the portfolio.

The methodology used in the periodic review of reserve adequacy, which is performed at least quarterly, is designed to be dynamic and responsive to changes in actualportfolio credit quality and anticipated future credit losses. The changes are reflected in the general reserve and in specific reserves as the collectibility of larger classified loans is continuously recalculated with new information. As our portfolio matures, historical loss ratios are being closely monitored, and our reserve adequacy will rely primarily on our loss history. Currently, the review of reserve adequacy is performed by executive management and presented to the Boardour board of Directorsdirectors for their review, consideration and ratification on a quarterly basis.

22

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TABLE 5 SUMMARY OF LOAN LOSS EXPERIENCE
(Dollars in thousands)
             
 Nine months ended Nine months ended Year ended            
 September 30, September 30, December 31, Three months ended Three months ended Year ended
 2003 2002 2002 March 31, March 31, December 31,
 
 
 
 2004
 2003
 2003
Beginning balanceBeginning balance $14,538 $12,598 $12,598  $17,727 $14,538 $14,538 
Loans charged-off:Loans charged-off:  
Commercial 50 2,085 2,096 
Real estate 200   
Consumer 2 6 11 
Leases 511 1,042 1,740 
Commercial   50 
Real estate   402 
Consumer   5 
Leases 493 13 618 
 
 
 
  
 
 
 
 
 
 
TotalTotal 763 3,133 3,847  493 13 1,075 
Recoveries:Recoveries:  
Commercial 78  42 
Consumer  11  
Leases 98 9 116 
Commercial  78 78 
Leases 27 40 161 
 
 
 
  
 
 
 
 
 
 
Total recoveriesTotal recoveries 176 20 158  27 118 239 
 
 
 
  
 
 
 
 
 
 
Net charge-offs 587 3,113 3,689 
Net charge-offs (recoveries) 466  (105) 836 
Provision for loan lossesProvision for loan losses 3,325 4,359 5,629  750 1,250 4,025 
 
 
 
  
 
 
 
 
 
 
Ending balanceEnding balance $17,276 $13,844 $14,538  $18,011 $15,893 $17,727 
 
 
 
  
 
 
 
 
 
 
Reserve for loan losses to loans outstanding at end of periodReserve for loan losses to loans outstanding at end of period  1.41%  1.31%  1.30%  1.30%  1.35%  1.35%
Net charge-offs to average loans1
  .07%  .45%  .38%
Provision for loan losses to average loans1
  .37%  .63%  .58%
Net charge-offs (recoveries) to average loans(1)
  .14%  (.04)%  .07%
Provision for loan losses to average loans(1)
  .23%  .45%  .33%
Recoveries to gross charge-offsRecoveries to gross charge-offs  23.07%  .64%  4.11%  5.48%  907.69%  22.23%
Reserve as a multiple of net charge-offsReserve as a multiple of net charge-offs 29.4x 4.5x 3.9x  38.7x  21.2x
Non-performing and renegotiated loans:Non-performing and renegotiated loans:  
Loans past due (90 days) $1,095 $1,686 $135 
Non-accrual 11,026 6,474 2,776 
Loans past due (90 days)(2)
 $6,250 $38 $7 
Non-accrual 6,953 3,769 10,217 
 
 
 
  
 
 
 
 
 
 
TotalTotal $12,121 $8,160 $2,911  $13,203 $3,807 $10,224 
 
 
 
  
 
 
 
 
 
 
Reserve as a percent of non-performing
and renegotiated loans
  142.53%  169.66%  499.42%
Reserve as a percent of non-performing and renegotiated loans(2)
  136.42%  417.47%  173.39%

(1) Interim period ratios are annualized.

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(2)Subsequent to March 31, 2004, a $6.0 million past due loan was refinanced resulting in a reduction of total non-performing loans to $7.2 million and increasing the allowance to non-performing loans ratio from 136.42% to 250.05%.

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NON-PERFORMING ASSETSNon-performing Assets

Non-performing assets include non-accrual loans and leases, accruing loans 90 or more days past due, restructured loans, and other repossessed assets. We had non-accrual loans and leases of $11,026,000, $2,776,000 and $6,474,000 at September 30, 2003, December 31, 2002 and September 30, 2002, respectively. At September 30, 2003,The table below summarizes our non-accrual loans and leases consisted of $4,350,000 in commercial loans, $4,762,000 in construction loans, $375,000 in real estate loans, $115,000 in consumer loans and $1,424,000 in leases. by type:

             
  March 31, December 31, March 31,
  2004
 2003
 2003
  (In thousands)
Non-accrual loans:            
Commercial $157  $4,124  $815 
Construction  5,191   4,562   95 
Real estate  375   375   1,261 
Consumer  142   105   12 
Leases  1,088   1,051   1,586 
   
 
   
 
   
 
 
Total non-accrual loans $6,953  $10,217  $3,769 
   
 
   
 
   
 
 

At DecemberMarch 31, 2002, our non-accrual loans and leases consisted of $641,000 in commercial loans, $1,367,000 in real estate, $26,000 in consumer loans and $742,000 in leases. At September 30, 2003,2004, we had $1,095,000$6,250,000 in loans past due 90 days and still accruing interest which are fully guaranteed by the U.S. Government.interest. Subsequent to March 31, 2004, a $6.0 million past due loan was refinanced resulting in a reduction of total non-performing loans. At September 30, 2003,March 31, 2004, we had $189,000$64,000 in other repossessed assets.

Generally, we place loans on non-accrual when there is a clear indication that the borrower’s cash flow may not be sufficient to meet payments as they become due, which is generally when a loan is 90 days past due. When a loan is placed on non-accrual status, all previously accrued and unpaid interest is reversed. Interest income is subsequently recognized on a cash basis as long as the remaining unpaid principal amount of the loan is deemed to be fully collectible. If collectibility is questionable, then cash payments are applied to principal. As of September 30, 2003,March 31, 2004, approximately $8$4.0 million of our non-accrual loans were earning on a cash basis.

A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due (both principal and interest) according to the terms of the loan agreement. Reserves on impaired loans are measured based on the present value of the expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral.

LIQUIDITY AND CAPITAL RESOURCESLiquidity and Capital Resources

In general terms, liquidity is a measurement of our ability to meet our cash needs. Our objective in managing our liquidity is to maintain our ability to meet loan commitments, purchase securities or repay deposits and other liabilities in accordance with their terms, without an adverse impact on our current or future earnings. Our liquidity strategy is guided by policies, which are formulated and monitored by our senior management and our bank’s Balance Sheet Management Committee (BSMC), and which take into account the marketability of assets, the sources and stability of funding and the level of unfunded commitments. We regularly evaluate all of our various funding sources with an emphasis on accessibility, stability, reliability and cost-effectiveness. For the year ended December 31, 20022003 and for the ninethree months ended September 30, 2003,March 31, 2004, our principal source of funding has been our customer deposits, supplemented by our short-term and long-term borrowings, primarily from securities sold under repurchase agreements and federal funds purchased from our downstream correspondent bank relationships (which consist of banks that are considered to be smaller than our bank).

Since early 2001, our liquidity needs have primarily been fulfilled through growth in our core customer deposits. Our goal is to obtain as much of our funding as possible from deposits of these core customers, which as of September 30, 2003,March 31, 2004, comprised $1,285.7$1,405.8 million, or 90.0%94.0%, of total deposits. These deposits are generated principally through development of long-term relationships with customers and stockholders and our retail network which is mainly through BankDirect, our internet banking facility.

In addition to deposits from our core customers, we also have access to incremental deposits through brokered retail certificates of deposit, or CDs. As of September 30, 2003,March 31, 2004, brokered retail CDs comprised $141.4$90.1 million, or 10.0%6.0%, of total deposits. Our dependence on retail brokered CDs is limited by our internal funding guidelines, which as of September 30, 2003,March 31, 2004, limited borrowing from this source to 10-20% of total deposits.

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Additionally, we have borrowing sources available to supplement deposits and meet our funding needs. These borrowing sources include federal funds purchased from our downstream correspondent bank relationships (which consist of banks that are smaller than our bank) and from our upstream correspondent bank relationships (which consist of banks that are larger than our bank), securities sold under repurchase agreements, treasury, tax and loan notes, and advances from the Federal Home Loan Bank, or FHLB. As of September 30, 2003,March 31, 2004, our borrowings consisted of a total of $401.2$416.4 million of securities sold under repurchase agreements, $103.7$90.2 million of downstream federal funds purchased, $17.5$15.9 million from customer repurchase agreements, and $5.3$2.0 million of treasury, tax and loan notes. Credit availability from the FHLB is based on our bank’s financial and operating condition and borrowing collateral we hold with the FHLB. At September 30, 2003,March 31, 2004, we had no borrowings from the FHLB. Our unused FHLB borrowing capacity at September 30, 2003March 31, 2004 was approximately $450.0$200.0 million. As of September 30, 2003,March 31, 2004, we had unused upstream federal fund lines available from commercial banks of approximately $72.6 million. During the ninethree months ended September 30, 2003,March 31, 2004, our average other borrowings from these sources were $506.7$621.0 million or 26.0%28.0% of average assets, which is well within our internal funding guidelines, which limit our dependence on borrowing sources to 25-30% of total assets. In September 2003, we unwound approximately $139 million of these term repurchase agreements and replaced a significant portion of that amount with new securities repurchase agreements subject to lower interest rates, with the remainder replaced with overnight funds. A significant portion of these overnight funds were replaced with deposits when we completed our acquisition of the outstanding deposits accounts of Bluebonnet Savings Bank, FSB in August 2003. The maximum amount of borrowed funds outstanding at any month-end during the first ninethree months of 20032004 was $546.3$622.5 million, or 26.8%27.8%, of total assets.

As of September 30, 2003,March 31, 2004, our significant fixed and determinable contractual obligations and commercial commitments, other than deposit liabilities,to third parties were as follows:

                  
(Dollars in thousands) After One After Three    
 Within but Within but Within After Five                      
 One Year Three Years Five Years Years Total After One After Three    
 
 
 
 
 
 Within but Within but Within After Five  
(Dollars in thousands)
 One Year
 Three Years
 Five Years
 Years
 Total
Deposits without a stated maturity(1)
 $955,760 $ $ $ $955,760 
Time deposits(1)
 405,395 114,948 19,788  540,131 
Federal funds purchased $103,726 $ $ $ $103,726  90,203    90,203 
Securities sold under repurchase agreements 163,652 226,300 11,200  401,152  267,016 138,150 11,200  416,366 
Customer repurchase agreements 17,453    17,453  15,925    15,925 
Treasury, tax and loan notes 5,282    5,282  2,008    2,008 
Operating lease obligations 3,150 9,604 7,457 1,289 21,500  3,178 6,429 6,120 4,203 19,930 
Long-term debt    20,000 20,000     20,620 20,620 
 
 
 
 
 
  
 
 
 
 
 
 
 
 
 
 
Total contractual obligations $293,263 $235,904 $18,657 $21,289 $569,113  $1,739,485 $259,527 $37,108 $24,823 $2,060,943 
 
 
 
 
 
  
 
 
 
 
 
 
 
 
 
 

(1) Excludes interest

The contractual amount of our financial instruments with off-balance sheet risk expiring by period at September 30, 2003March 31, 2004 is presented below:

                 
(Dollars in thousands) After One After Three    
 Within but Within but Within After Five                      
 One Year Three Years Five Years Years Total After One After Three    
 
 
 
 
 
 Within but Within but Within After Five  
(Dollars in thousands)
 One Year
 Three Years
 Five Years
 Years
 Total
Commitments to extend credit $247,980 $101,065 $19,125 $5,800 $373,970  $263,108 $171,270 $19,493 $11,102 $464,973 
Standby letters of credit 17,783 586   18,369  22,038 2,959   24,997 
 
 
 
 
 
  
 
 
 
 
 
 
 
 
 
 
Total financial instruments with off-balance sheet risk $265,763 $101,651 $19,125 $5,800 $392,339  $285,146 $174,229 $19,493 $11,102 $489,970 
 
 
 
 
 
  
 
 
 
 
 
 
 
 
 
 

Due to the nature of our unfunded loan commitments, including unfunded lines of credit, the amounts presented in the table above do not necessarily represent amounts that we anticipate funding in the periods presented above.

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Our equity capital averaged $134.0$176.8 million for the ninethree months ended September 30, 2003March 31, 2004 as compared to $115.3$126.9 million for the same period in 2002.2003. This increase reflects our retention of net earnings during this period and the IPO proceeds. We have not paid any cash dividends on our common stock since we commenced operations and have no plans to do so in the near future.

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TABLE 6 CAPITAL RATIOS

         
 September 30, September 30,        
 2003 2002 March 31, March 31,
 
 
 2004
 2003
Risk-based capital:Risk-based capital:  
Tier 1 capital  12.35%  9.59%
Total capital  13.53%  10.75%
Tier 1 capital  11.73%  9.69%
Total capital  12.84%  10.88%
LeverageLeverage  8.81%  8.45%  8.67%  7.15%

CRITICAL ACCOUNTING POLICIESCritical Accounting Policies

The Securities and Exchange Commission (SEC) recently issued guidance for the disclosure of “critical accounting policies.” The SEC defines “critical accounting policies” as those that are most important to the presentation of a company’s financial condition and results, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

We follow financial accounting and reporting policies that are in accordance with generally accepted accounting principles generally accepted in the United States. The more significant of these policies are summarized in Note 1 to the consolidated financial statements in our 20022003 Form 10K filed with the SEC. Not all these significant accounting policies require management to make difficult, subjective, or complex judgments. However, the policies noted below could be deemed to meet the SEC’s definition of critical accounting policies.

Management considers the policies related to the allowance for loan losses as the most critical to the financial statement presentation. The total allowance for loan losses includes activity related to allowances calculated in accordance with Statement of Financial Accounting Standards (SFAS) No. 114,Accounting by Creditors for Impairment of a Loan, and SFAS No. 5,Accounting for Contingencies. The allowance for loan losses is established through a provision for loan losses charged to current earnings. The amount maintained in the allowance reflects management’s continuing evaluation of the loan losses inherent in the loan portfolio. The allowance for loan losses is comprised of specific reserves assigned to certain classified loans and general reserves. Factors contributing to the determination of specific reserves include the credit-worthiness of the borrower, and more specifically, changes in the expected future receipt of principal and interest payments and/or in the value of pledged collateral. A reserve is recorded when the carrying amount of the loan exceeds the discounted estimated cash flows using the loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. For purposes of determining the general reserve, the portfolio is segregated by product types in order to recognize differing risk profiles among categories, and then further segregated by credit grades. See “Summary of Loan Loss Experience” for further discussion of the risk factors considered by management in establishing the allowance for loan losses.

Management considers the policies related to income taxes to be critical to the financial statement presentation. The Company utilizes the liability method in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based upon the difference between the values of the assets and liabilities as reflected in the financial statements and their related tax basis using enacted tax rates in effect for the year in which the differences are expected to be recovered or settled. As changes in tax law or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. A valuation reserve is provided against deferred tax assets unless it is more likely than not that such deferred tax assets will be realized.

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We had a gross deferred tax asset of $7.8 million at September 30, 2003. In 2003, as a result of a reassessment of our ability to generate sufficient earnings to allow the utilization of our deferred tax assets, we believebelieved it iswas more likely than not that the deferred tax assets will be realized. Accordingly, in compliance with SFAS No. 109, we reversed the valuation allowance and certain related tax reserves during the period.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk is a broad term for the risk of economic loss due to adverse changes in the fair value of a financial instrument. These changes may be the result of various factors, including interest rates, foreign exchange rates, commodity prices, or equity prices. Additionally, the financial instruments subject to market risk can be classified either as held for trading purposes or held for other than trading.

The Company is subject to market risk primarily through the effect of changes in interest rates on its portfolio of assets held for purposes other than trading. The effect of other changes, such as foreign exchange rates, commodity prices, and/or equity prices do not pose significant market risk to the Company.

The responsibility for managing market risk rests with the BSMC, which operates under policy guidelines established by the Boardour board of Directors.directors. The negative acceptable variation in net interest revenue due to a 200 basis point increase or decrease in interest rates is generally limited by these guidelines to +/- 10%. These guidelines also establish maximum levels for short-term borrowings, short-term assets, and public and brokered deposits. They also establish minimum levels for unpledged assets, among other things. Compliance with these guidelines is the ongoing responsibility of the BSMC, with exceptions reported to the full Boardboard of Directorsdirectors on a quarterly basis.

Interest Rate Risk Management

We perform a sensitivity analysis to identify interest rate risk exposure on net interest income. We quantify and measure interest rate risk exposure using a model to dynamically simulate the effect of changes in net interest income relative to changes in interest rates over the next twelve months based on three interest rate scenarios. These are a “most likely” rate scenario and two “shock test” scenarios.

The “most likely” rate scenario is based on the consensus forecast of future interest rates published by independent sources. These forecasts incorporate future spot rates and relevant spreads of instruments that are actively traded in the open market. The Federal Reserve’s Federal Funds target affects short-term borrowing; the prime lending rate and the London Interbank Offering Rate are the basis for most of our variable-rate loan pricing.

The 10-year mortgage rate is also monitored because of its effect on prepayment speeds for mortgage-backed securities. These are our primary interest rate exposures. We are currently not using derivatives to manage our interest rate exposure.

The two “shock test” scenarios assume a sustained parallel 200 basis point increase or decrease, respectively, in interest rates. As short-term rates have continued to fall since 2001 we could not assume interest rate changes of 200 basis points as the results of the decreasing rates scenario would be negative rates. Therefore, our “shock test” scenarios with respect to decreases in rates now assume a decrease of 100 basis points in the current interest rate environment. We will continue to evaluate these scenarios as interest rates change, until short term rates rise above 2.0%.

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Our interest rate risk exposure model incorporates assumptions regarding the level of interest rate or balance changes on indeterminable maturity deposits (demand deposits, interest bearing transaction accounts and savings accounts) for a given level of market rate changes. These assumptions have been developed through a combination of historical analysis and future expected pricing behavior. Changes in prepayment behavior of mortgage-backed securities, residential, and commercial mortgage loans in each rate environment are captured using industry estimates of prepayment speeds for various coupon segments of the portfolio. The impact of planned growth and new business activities is factored into the simulation model.

20


This modeling indicated interest rate sensitivity is as follows:


TABLE 7 INTEREST RATE SENSITIVITY
(Dollars in thousands)
         
  Anticipated Impact Over the Next Twelve Months
  as Compared to Most Likely Scenario
  
  200 bp Increase 100 bp Decrease
  September 30, 2003 September 30, 2003
  
 
Change in net interest income $11,736  $(7,934)
         
  Anticipated Impact Over the Next Twelve Months
  as Compared to Most Likely Scenario
  200 bp Increase 100 bp Decrease
  March 31, 2004
 March 31, 2004
Change in net interest income $10,343  $(5,825)

The estimated changes in interest rates on net interest income are within guidelines established by our Boardboard of Directorsdirectors for all interest rate scenarios.

The simulations used to manage market risk are based on numerous assumptions regarding the effect of changes in interest rates on the timing and extent of repricing characteristics, future cash flows, and customer behavior. These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and management strategies, among other factors.

We expect our balance sheet will continue to be asset sensitive over the next twelve months, largely due to the concentration of assets in variable rate loans. If, as we expect will occur, interest rates rise in 2004, this asset-sensitivity will tend to result in an increase in our interest margin, all other factors being equal. In the event of a rising rate environment, management may choose to fund investment securities purchased with term liabilities/deposits to lock in a return. Investment securities are generally held in the “available-for-sale” category so that gains and losses can be realized as appropriate. At certain times, we use the “held-to-maturity” category if we are not planning to sell these securities before maturity.

ITEM 4. CONTROLS AND PROCEDURES

Our management, including our chief executive officer and chief financial officer have evaluated the Company’sour disclosure controls and procedures as of September 30, 2003March 31, 2004 and concluded that those disclosure controls and procedures are effective. There have been no changes in the Company’sour internal controls or in other factors known to the Companyus that could significantly affect these controls subsequent to their evaluation, nor any corrective actions with regard to significant deficiencies and material weaknesses. While the Company believeswe believe that itsour existing disclosure controls and procedures have been effective to accomplish these objectives, the Company intendswe intend to continue to examine, refine and formalize itsour disclosure controls and procedures and to monitor ongoing developments in this area.

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PART II — OTHER INFORMATION

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

 (a) Exhibits

       
 
31.1

 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.2003.
       
 
31.2

 Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.2003.
       
 
32.1

 Certification of Chief Executive Officer pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,2003, filed herewith.
       
 
32.2

 Certification of Chief Financial Officer pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,2003, filed herewith.

 (b) Report on Form 8-K

  Current report filed on Form 8-K regarding Item 5 (Other Events and Regulation FD Disclosure) and Item 7 (Financial Statements, Pro Forma Financial Information and Exhibits) and Item 12 (Results of Operations and Financial Condition) dated August 4, 2003.January 27, 2004.

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SIGNATURES

SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

   
 TEXAS CAPITAL BANCSHARES, INC.
   
Date: November 14, 2003May 10, 2004 /s/Peter B. Bartholow

Peter B. Bartholow
Chief Financial Officer
(Duly authorized officer and principal
financial officer)

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EXHIBIT INDEX

Exhibit Number

Exhibit Number
   
31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.2003.
   
31.2 Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.2003.
   
32.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,2003, filed herewith.
   
32.2 Certification of Chief Financial Officer pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,2003, filed herewith.

3124