424B4 1 d424b4.htm DEFINITIVE PROSPECTUS Definitive Prospectus
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Index to Financial Statements

Filed pursuant to Rule 424(b)(4)
Registration No. 333-142735

PROSPECTUS

1,979,761 Shares

LOGO

Common Stock

 


Encore Bancshares, Inc. is a bank holding company headquartered in Houston, Texas. We are offering 1,904,761 shares of our common stock and two of our shareholders are offering 75,000 shares of our common stock. We will not receive any of the proceeds from shares sold by any selling shareholder. This is an initial public offering. The initial public offering price of our common stock is $21.00 per share.

Prior to this offering, there has been no public market for our common stock. See the section of this prospectus captioned “Underwriting” for a discussion of the factors that were considered in determining the initial public offering price. The market price of our shares after the offering may be higher or lower than the initial public offering price. Our common stock has been approved for listing on the NASDAQ Global Market under the symbol “EBTX.”

Investing in our common stock involves risks. For additional information, see the section of this prospectus captioned “ Risk Factors” beginning on page 9 for a discussion of the factors you should consider before you make your decision to invest in our common stock.

 

    

Per

Share

   Total

Initial public offering price of common stock

   $ 21.00    $ 40,000,000

Underwriting discounts and commissions

   $ 1.47    $ 2,800,000

Proceeds to us (before expenses) (1)

   $ 19.53    $ 37,200,00

Proceeds to the selling shareholders

   $ 19.53    $ 1,465,000

(1) This amount is the total before deducting legal, accounting, printing and other offering expenses payable by us, which are estimated to be $1,020,000.

The underwriters may also purchase up to 285,714 additional shares of our common stock from us at the public offering price, less the underwriting discount and commissions, within 30 days following the date of this prospectus to cover over-allotments.

The underwriters expect to deliver the shares of our common stock against payment in New York, New York on or about July 23, 2007, subject to customary closing conditions.

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense.

These securities are not deposits or savings accounts of a bank or savings association, and they are not insured or guaranteed by the Federal Deposit Insurance Corporation or any other governmental agency.

 


Keefe, Bruyette & Woods

                        Sandler O’Neill + Partners, L.P.

SMH Capital     

The date of this prospectus is July 17, 2007


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LOGO


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TABLE OF CONTENTS

 

     Page

Prospectus Summary

   1

Selected Historical Consolidated Financial Data

   7

Risk Factors

   9

Special Cautionary Notice Regarding Forward-Looking Statements

   20

Use of Proceeds

   21

Our Dividend Policy

   22

Dilution

   23

Price Range of Our Common Stock

   24

Capitalization

   25

Business

   26

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

   39

Management

  

90

Executive Compensation and Other Matters

  

98

Certain Relationships and Related Transactions

  

110

Beneficial Ownership of Common Stock by Management of the Company and Principal Shareholders

  

111

Supervision and Regulation

  

113

Description of Our Capital Stock

  

121

Shares Eligible for Future Sale

  

126

Underwriting

  

129

Legal Matters

  

131

Experts

  

132

Where You Can Find More Information

  

132

Index to Consolidated Financial Statements

   F-1

You should rely only on the information contained in this prospectus. Neither we, the selling shareholders nor any underwriter has authorized anyone to provide prospective investors with information different from that contained in this prospectus. If anyone provides you with different or inconsistent information, you should not rely on it. You should not assume that the information appearing in this prospectus is accurate as of any date other than the date on the front cover of this prospectus, regardless of the time of delivery of this prospectus or any sale of common stock. Our business, financial condition, results of operations cash flows and/or prospects may have changed since that date. Information contained on, or accessible through, our website is not part of this prospectus.

In this prospectus we rely on and refer to information and statistics regarding the banking industry, demographics and populations and the Texas and Florida markets. We obtained this information from independent publications or other publicly available information.

 

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PROSPECTUS SUMMARY

This summary highlights key aspects of the offering and does not contain all of the material information you should consider before investing in our common stock. You should read this prospectus carefully, including “Risk Factors” and our consolidated financial statements and the accompanying notes, before making an investment decision.

Unless we indicate otherwise, the information in this prospectus assumes that the underwriters will not exercise their option to purchase additional shares to cover over-allotments.

Overview

Encore Bancshares, Inc. is a bank holding company and wealth management organization that provides banking, investment management, financial planning and insurance services to professional firms, privately-owned businesses, investors and affluent individuals. We are headquartered in Houston, Texas and currently manage, through our primary subsidiary Encore Bank, N.A., 11 private client offices in the greater Houston market and six private client offices and two loan production offices in southwest Florida. We also operate five wealth management offices and three insurance offices in Texas. As of March 31, 2007, we reported, on a consolidated basis, total assets of $1.3 billion, total loans of $932.8 million, total deposits of $997.3 million, shareholders’ equity of $108.9 million and $2.6 billion of assets under management.

History and Franchise Transformation

In September 2000, our current Chief Executive Officer, James S. D’Agostino, Jr., led a group of primarily local Houston investors in our purchase of Guardian Savings and Loan Association. At the time of the acquisition, Guardian’s balance sheet was comprised of investment securities and purchased loans funded principally by certificates of deposit originated through 24 branch offices in Atlanta, Boston, Kansas City and St. Louis and one Houston location.

Starting in late 2000, our current management team took the following strategic actions to transform our franchise:

 

   

We recapitalized our company with $25.0 million at the time of the acquisition and raised an additional $23.7 million in common equity in three separate private placements through January 2005.

 

   

We changed the name of the bank to Encore Bank and initiated our strategy of providing superior customer service in a “private banking” environment to professional firms, privately-owned businesses, investors and affluent individuals. Consistent with this strategy, we refer to the locations of Encore Bank we opened in and after November 2000 as private client offices.

 

   

We sold all 24 branches located outside of our target markets in four separate transactions in the period from December 2001 to September 2003, disposing of approximately $674.9 million in deposits and approximately $50.8 million in real estate. For the years ended December 31, 2006, 2005, 2004, 2003 and 2002, we had non-recurring gains on the sale of branches and certain real estate of $370,000, $303,000, $3.9 million, $6.1 million and $8.4 million, respectively. We had $0 and $144,000 in non-recurring gains for the three months ended March 31, 2007 and 2006, respectively.

 

   

We completed the opening of nine de novo private client offices in Houston and southwest Florida by December 2003. We now have 17 private client offices in our target markets.

 

   

We rolled out a full line of deposit and cash management products, which enabled us to replace higher cost brokered deposits with lower cost core deposits.

 

 

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We built a loan platform and recruited 20 experienced loan officers, which enabled us to replace lower yielding purchased loans and securities with traditional bank loans.

 

   

We completed and successfully integrated four acquisitions between April 2004 and August 2005 that included an investment management and financial planning firm, a trust company and two insurance agencies.

Business Strengths and Growth Strategies

We have now built a platform designed to continue to grow loans and deposits and improve profitability, which we intend to accomplish utilizing the following strengths and strategies:

Optimize our deposit mix. Increasing personal and business checking (noninterest and interest checking, or transaction deposits) is key to our strategy of decreasing our funding costs and continuing to increase our net interest margin from 2.55% for the three months ended March 31, 2007. We have had considerable success in building business demand deposits, which has resulted largely from our continued growth in lending to privately-owned businesses and professional firms, and our offering of cash management services. We have increased our transaction deposits to $287.2 million, or 28.8% of total deposits, as of March 31, 2007 from $189.8 million, or 25.1% of total deposits, as of December 31, 2002, a compounded annual growth rate of 10.2%. Also contributing to the reduction in our funding costs is the increase in our core deposits, which consist of transaction deposits, money market and savings accounts and time deposits less than $100,000. As of March 31, 2007, core deposits represented 79.6% of total deposits. Our ability to generate deposits is reflected in the growth of total deposits in Houston and southwest Florida, as our total deposits have grown at a 26.3% compounded annual growth rate since 2002.

Continue to increase loan originations. We believe our seasoned team of commercial lenders can continue to grow commercial loans organically to replace lower yielding securities as they mature and purchased mortgages as they are paid down. From 2002 through March 31, 2007, we have increased our total originated loans by $688.1 million, a compounded annual growth rate of 62.4%, and our total commercial loans by $418.9 million, a compounded annual growth rate of 75.1%.

Expand wealth management and insurance businesses. We believe that our ability to offer sophisticated wealth management products and services within a high-touch community bank framework gives us a competitive advantage and an avenue for growth. In addition, the expected demographic shift should generate more wealth management requirements as baby boomers reach retirement age and inherit additional investment assets. As such, we believe that our wealth management franchise is well positioned to increase its assets under management, which have increased from $2.2 billion as of December 31, 2005 to $2.6 billion as of March 31, 2007. Revenues from our wealth management group comprised 50.2% of our first quarter 2007 noninterest income, while our insurance group contributed 20.3% of our noninterest income. Our ratio of noninterest income to total revenue for the three months ended March 31, 2007 was 52.40%. Net earnings from our wealth management group for the first quarter 2007 comprised $823,000, or 46.4%, of our consolidated net earnings and net earnings from our insurance group for the same period comprised $489,000, or 27.5%, of our consolidated net earnings. The remainder of our consolidated net earnings were derived from our banking operations.

Leverage our infrastructure. Over the past several years, we have made significant investments in our private client offices, people and technology. Since most of our offices are relatively new, we have not maximized their potential and we believe the platform is in place for significant growth with minimal additional expense. In fact, seven of our 17 private client offices were opened in the last three years. Increasing deposits per office and loans per officer should enable us to improve our efficiency ratio from 75.25% for the three months ended March 31, 2007, as well as enhance other profitability ratios.

Acquire compatible banks and financial services companies. Having successfully integrated our recent wealth management and insurance acquisitions, we plan to pursue select acquisitions related to expanding our

 

 

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banking, wealth management and insurance capabilities. We will focus on targets within our existing footprint or other attractive markets with significant core deposits and/or a potential client base compatible with our operating philosophy.

Continue to leverage our experienced management team and board. Our executive management team has a wealth and depth of experience in the financial services industry, which we believe better positions us to take advantage of future growth opportunities. Our Chief Executive Officer, James S. D’Agostino, Jr., was Chairman, President and Chief Executive Officer of American General Life and Accident Insurance Company (Nashville, TN) from 1993 to 1997 and was Vice Chairman of its parent company, American General Corporation (Houston, TX), until 1999. Prior to these roles, Mr. D’Agostino spent 18 years in commercial banking. Our Chief Financial Officer, L. Anderson Creel, has 30 years of banking and accounting experience, including eight years as Chief Financial Officer of Prime Bancshares, Inc., a publicly traded bank holding company. Before joining us in 2002, Robert Mrlik spent over 13 years at American General, prior to which he worked at several commercial banks. J. Harold Williams brings to us from Linscomb & Williams over 30 years of wealth management experience. Thomas Ray, who runs our Florida operation, has over 26 years of banking experience, mostly in that state. The management team’s operating strategy is guided by our board of directors, which is composed of well-regarded professionals and entrepreneurs with collective depth and experience in wealth management, financial planning, real estate development, private equity investments and commercial banking. We currently expect that one of our directors will purchase approximately 36,538 shares of our common stock in this offering.

Markets

We operate in what we believe are two of the most attractive banking and wealth management markets in the United States—the greater Houston area and southwest Florida. The Houston economy is strong, diverse and growing, and benefits from large energy and healthcare industries. Houston is also the home to more than 76,000 small businesses. Southwest Florida continues its rapid economic growth supported by a strong increase in population and expanded service-related and healthcare industries. Both markets have a large population of the professional and affluent clients that we target.

Houston Market. We have 11 private client offices in the greater Houston area, which includes high growth areas in Fort Bend, Montgomery and Harris counties. The Houston-Sugar Land-Baytown Metropolitan Statistical Area (MSA) had a population of approximately 5.6 million people in 2006 and ranked 6th in the nation in terms of size. The Houston-Sugar Land-Baytown MSA had a median household income of approximately $56,000 in 2006, which was 8% higher than the national median. The MSA also has access to approximately $98 billion in deposits. Often called the world’s energy capital, Houston is also home to one of the world’s largest healthcare complexes, the nation’s largest port in volume of foreign tonnage and 24 companies on the 2006 Fortune 500 list. In addition, Houston boasts a significant and growing number of legal and accounting professionals.

Southwest Florida Market. We have expanded our presence to include six private client offices in southwest Florida. The Naples-Marco Island MSA had a population of approximately 325,000 in 2006 and continues to grow rapidly. The Naples-Marco Island MSA is one of the wealthiest in the nation, having a median household income of approximately $59,000 in 2006, which was 15% higher than the national median. The Naples-Marco Island MSA has approximately $11 billion in deposits. We also have private client offices in the Tampa-St. Petersburg-Clearwater and Cape Coral-Ft. Myers MSAs with populations of 2.7 million and 588,000, respectively, in 2006. The Tampa-St. Petersburg-Clearwater MSA and the Cape Coral-Ft. Myers MSA have approximately $55 billion and $11 billion in deposits, respectively. Commercial real estate, residential property and leisure activities have provided stimulus to southwest Florida to service the growing retired population.

Within our target markets, our strategy is to selectively place our private client offices in convenient, high-traffic locations in high net worth areas. For example, in the greater Houston area, we have identified several

 

 

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affluent sub-markets where we operate at major intersections or other highly visible areas. The median household income within our Houston branch zip codes is approximately $91,000, 64% higher than the MSA as a whole, and the comparable figure for our Naples branch zip codes is approximately $75,000, 27% higher than the MSA as a whole. However, by being selective in where we place our offices within each zip code, we believe the household income levels within our sub-markets are higher.

Operating Philosophy

Since our transformation is largely completed, we believe that we are now positioned to become the premier provider in our target markets of banking, wealth management and insurance products and services to professional firms, privately-owned businesses, investors and affluent individuals. Our individual clients generally have a net worth of between $500,000 and $20 million. We believe that these clients constitute an underserved market as most wealth management specialists at large commercial banks and other financial services firms typically focus on clients at the upper end of our target range. We offer a broad array of products and services tailored to the objectives of our target clients, ranging from checking accounts to state-of-the-art cash management to real estate loans to sophisticated financial and estate planning, all within a high-touch community bank framework. We believe we are the only community bank within our target markets that focuses on privately-owned businesses and wealth management with such a high level of professional expertise and abundant product offering.

Our clients are served by a private banker or relationship manager who understands each client’s financial needs and offers products and services designed to meet those needs. We believe that our clients and prospects prefer this type of highly personalized service, often referred to as “private banking,” and that our way of building client relationships, while potentially more costly in the short term, yields high returns over the course of the entire relationship. Our private bankers and relationship managers are able to offer traditional banking services and to collaborate with investment management, financial planning, trust and insurance specialists in our subsidiaries to meet our clients’ financial needs. By providing services in this collaborative manner, we believe we are able to diminish the possibility of disintermediation by other financial services providers.

We believe that the quality of our people is the backbone of our organization-wide commitment to superior client service. Our ability to recruit and retain experienced and motivated financial professionals results from our size, minimal bureaucracy, high growth, abundant product offering and performance-based incentive programs. The continuing high level of merger and acquisition activity in the Texas and southwest Florida financial markets has also enhanced our recruitment efforts. We actively seek to identify and employ quality employees who become available as a result of this activity. Our low level of employee turnover has provided a continuity of service that fosters long-term client relationships.

Corporate Information

Our principal executive office is located at Nine Greenway Plaza, Suite 1000, Houston, Texas 77046, and our telephone number is (713) 787-3100. Our corporate website address is www.encorebank.com. Information contained on our website is not incorporated by reference into this prospectus and you should not consider information contained on, or accessible through, our website as part of this prospectus.

 

 

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The Offering

 

Common stock offered by us

   1,904,761 shares (1)

Common stock offered by the selling shareholders

   75,000 shares

Total common stock offered

   1,979,761 shares

Common stock to be outstanding immediately after this offering

  

9,801,626 shares (1)(2)

Use of proceeds

  

We estimate that the net proceeds to us from this offering will be approximately $36.2 million based on the initial offering price of $21.00, after deducting underwriting discounts and commissions and expenses payable by us. We intend to use these net proceeds to support anticipated balance sheet growth, which may include, among other things, contributions to the capital of Encore Bank, for possible future acquisitions and for general corporate purposes. See the section of this prospectus captioned “Use of Proceeds” for further details.

 

We will not receive any of the proceeds from the sale of shares of our common stock offered by any selling shareholder.

Dividend policy

   We have not historically declared or paid dividends on our common stock and we do not expect to do so in the foreseeable future. Any future determination relating to dividend policy will be made at the discretion of our board of directors and will depend on a number of factors, including our earnings and financial condition, liquidity and capital requirements, the general economic and regulatory climate, our ability to service any equity or debt obligations senior to the common stock and other factors deemed relevant by our board of directors. See the section of this prospectus captioned “Our Dividend Policy” for further details.

Risk factors

   See the section of this prospectus captioned “Risk Factors,” beginning on page 9 and other information included in this prospectus for a discussion of certain factors that you should carefully consider before making a decision to invest in our common stock.

NASDAQ Global Market symbol

   Our common stock has been approved for listing on the NASDAQ Global Market under the symbol “EBTX.”

(1)

Assumes that the underwriters will not exercise their option to purchase up to an additional 285,714 shares of our common stock to cover over-allotments, if any. If the underwriters exercise this option in full,

 

 

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10,087,340 shares of our common stock will be outstanding immediately after this offering. See the section of this prospectus captioned “Underwriting.”

 

(2) The number of shares of common stock outstanding immediately after this offering is based on the number of shares outstanding as of March 31, 2007 and does not include:

 

   

1,089,750 shares of common stock that we may issue upon the exercise of stock options outstanding as of March 31, 2007 at a weighted average exercise price of $9.84 per share;

 

   

53,817 shares of common stock reserved for issuance pursuant to future grants under our 2000 Stock Incentive Plan; and

 

   

A number of shares of our common stock that may be issued to the former shareholders of Linscomb & Williams no later than March 31, 2010 depending on the after-tax net earnings of Linscomb & Williams from the date of acquisition through December 31, 2009, subject to certain limitations, which, based on the after-tax net earnings of Linscomb & Williams for the period from the date of acquisition through March 31, 2007 and the initial public offering price of $21.00, would be 123,270 shares.

 


 

 

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SELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA

The following table summarizes our historical consolidated financial data for the periods and at the dates indicated. You should read this information in conjunction with our audited consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The selected historical consolidated financial data as of December 31, 2006 and 2005 and for the three years ended December 31, 2006 is derived from our audited consolidated financial statements and related notes included in this prospectus. The historical consolidated financial data as of December 31, 2004, 2003 and 2002 and for the two years ended December 31, 2003 has been derived from our audited consolidated financial statements not included in this prospectus. The selected historical consolidated financial data as of March 31, 2007 and 2006 and for the three-month periods then ended are derived from our unaudited interim consolidated financial statements. Management believes that such amounts reflect all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of our results of operations and financial condition as of the dates and for the periods indicated. You should not assume the results of operations for past periods indicate results for any future period.

 

    As of and for the Three
Months Ended
March 31,
  As of and for the Years Ended December 31,
    2007   2006   2006   2005   2004   2003   2002
    (unaudited)                    
    (dollars in thousands, except per share data)

Income Statement Data:

             

Interest income

  $ 19,480   $ 17,820   $ 75,810   $ 64,653   $ 58,470   $ 62,689   $ 71,633

Interest expense

    11,800     10,309     45,637     38,400     34,456     43,836     51,169
                                         

Net interest income

    7,680     7,511     30,173     26,253     24,014     18,853     20,464

Provision for loan losses

    900     705     3,491     3,198     3,159     3,900     2,940
                                         

Net interest income after provision for loan losses

    6,780  

 

6,806

    26,682     23,055     20,855     14,953     17,524

Noninterest income (1)

    8,455     9,713     35,083     29,334     21,822     28,872     18,595

Noninterest expense

    12,462     13,057     50,338     45,502     32,547     30,662     20,508
                                         

Net earnings before income taxes

    2,773     3,462     11,427     6,887     10,130     13,163     15,611

Income tax expense

    998     1,196     3,949     2,098     3,267     4,553     4,417
                                         

Net earnings

  $ 1,775   $ 2,266   $ 7,478   $ 4,789   $ 6,863   $ 8,610   $ 11,194
                                         

Common Share Data:

             

Basic earnings per share

  $ 0.23   $ 0.30   $ 1.00   $ 0.70   $ 1.15   $ 1.46   $ 2.13

Diluted earnings per share

    0.22     0.29     0.94     0.66     1.11     1.41     2.11

Book value per share

    13.80     12.96     13.57     12.68     11.83     10.63     10.48

Tangible book value per share

    9.33     8.37     9.01     8.07     11.01     10.63     10.48

Weighted average shares outstanding (basic)

    7,554,893     7,495,859     7,501,131     6,824,712     5,986,274     5,910,383     5,254,531

Weighted average shares outstanding (diluted)

    8,131,379     7,860,835     7,925,685     7,288,499     6,175,819     6,094,618     5,298,580

Shares outstanding at end of period

    7,896,865     7,703,559     7,786,315     7,691,559     6,173,832     6,023,349     5,648,603

Period-End Balance Sheet Data:

             

Total assets

  $ 1,294,987   $ 1,330,593   $ 1,336,843   $ 1,316,565   $ 1,273,071   $ 1,326,467   $ 1,374,553

Investment securities

    207,911     305,273     256,256     323,074     480,143     582,596     702,267

Loans receivable

    932,793  

 

819,406

    908,368     808,204     660,694     617,781     546,342

Allowance for loan losses

    9,790     8,991     9,056     8,719     7,658     5,604     4,668

Goodwill and other intangible assets

    35,302     35,341     35,487     35,442     5,080     —       —  

Deposits

    997,298     832,519     1,030,811     815,074     729,328     743,134     754,760

Shareholders’ equity (2)

 

 

108,944

 

 

99,808

    105,677     97,513     73,051     64,045     59,191

Junior subordinated debentures

    20,619     20,619     20,619     20,619     20,619     20,619     15,464

Average Balance Sheet Data:

             

Total assets

  $ 1,313,328   $ 1,305,732   $ 1,316,572   $ 1,293,781   $ 1,261,970   $ 1,356,361   $ 1,308,883

Investment securities

    232,154     315,311     288,082     385,502     506,800     690,790     616,235

Loans receivable

    916,523     809,487     840,330     747,079     626,225     541,647     579,679

Deposits

    998,645     800,985     882,581     767,358     739,126     843,051     748,543

Shareholders’ equity (3)

    107,719     97,954     100,827     87,358     67,160     61,089     39,792

 

 

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    As of and for the
Three Months Ended
March 31,
    As of and for the Years Ended December 31,  
        2007             2006             2006             2005             2004             2003             2002      
    (unaudited)                                
    (dollars in thousands, except per share data)  

Selected Performance Ratios:

             

Return on average assets

 

0.55

%

 

0.70

%

      0.57 %       0.37 %       0.54 %       0.63 %       0.86 %

Return on average equity (4)

  6.68    

9.38

 

  7.42     5.48     10.22     14.09     28.13  

Return on average tangible equity (4)

 

9.96

 

  14.73     11.40     7.37     10.70     14.09     28.13  

Net interest margin (5)

  2.55     2.50     2.46     2.14     1.96     1.42     1.63  

Efficiency ratio (1)(6)

      75.25         74.40     75.68     80.42     69.87     63.09     60.43  

Noninterest income to total revenue

  52.40     56.39     53.76     52.77     47.61     60.50     47.61  

Asset Quality Ratios (7):

             

Nonperforming assets to total loans and investment in real estate

  1.11 %   0.27 %   1.07 %   0.56 %   0.92 %   1.40 %   1.24 %

Net charge-offs to average loans

  0.07     0.22     0.38     0.29     0.18     0.55     0.22  

Allowance for loan losses to period-end loans

  1.05     1.10     1.00     1.08     1.16     0.91     0.85  

Allowance for loan losses to nonperforming loans (8)

  114.56     522.41     95.26     250.26     179.77     200.57     141.37  

Capital Ratios:

             

Leverage ratio (9)

  7.23 %   6.38 %   6.90 %   6.23 %   6.63 %   6.16 %   5.95 %

Tier 1 risk-based capital ratio (9)

  10.07    

10.06

 

  10.17     9.89     12.63     12.78     13.32  

Total risk-based capital ratio (9)

  11.14    

11.15

 

  11.19    

10.97

 

  13.78     13.66     14.08  

Tangible common equity to tangible assets (10)

  5.85     4.18     5.39     4.85     5.36     4.83     4.31  

(1) For the years ended December 31, 2006, 2005, 2004, 2003 and 2002, noninterest income included nonrecurring gains on the sale of branches and certain real estate of $370,000, $303,000, $3.9 million, $6.1 million and $8.4 million, respectively. For the three months ended March 31, 2007 and 2006, noninterest income included nonrecurring gains of $0 and $144,000, respectively.
(2) Shareholders’ equity as of March 31, 2006 and December 31, 2006 and 2005 includes $10.3 million in puttable common stock. The put agreement to which the stock was subject was terminated on March 30, 2007. For a discussion of the puttable common stock, see the section of this prospectus captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations—For the Three Months Ended March 31, 2007 and 2006—Financial Condition—Shareholders’ Equity and Puttable Common Stock.”

 

(3) Average shareholders’ equity for the three months ended March 31, 2007 and 2006 and the years ended December 31, 2006 and 2005 includes $10.0 million, $10.3 million, $10.3 million and $3.4 million, respectively, in puttable common stock.

 

(4) The ratios for the three months ended March 31, 2007 and 2006 and the years ended December 31, 2006 and 2005 include puttable common stock as a part of shareholders’ equity.

 

(5) Net interest margin is calculated by dividing net interest income by average earning assets.

 

(6) Calculated by dividing total noninterest expense, less amortization of intangibles, by the sum of net interest income plus noninterest income, excluding gains and losses on sales of securities.

 

(7) At period end, except net charge-offs to average loans, which is for periods ended at such dates.

 

(8) Nonperforming loans consist of nonaccrual loans, loans contractually past due 90 days or more, restructured loans and any other loan management deems to be nonperforming.

 

(9) The regulatory capital ratios included in the table are the capital ratios of Encore Bank. On March 30, 2007, we became a bank holding company and Encore Bank became a national bank. For all periods prior to March 30, 2007, the capital ratios are calculated in accordance with Office of Thrift Supervision regulations and as of March 31, 2007, the capital ratios are calculated in accordance with Office of the Comptroller of the Currency regulations. We were not required to monitor consolidated capital ratios as a thrift holding company, but we are required to do so as a bank holding company. As of March 31, 2007, our consolidated leverage ratio, Tier 1 risk-based capital ratio and total risk-based capital ratio were 7.40%, 10.28% and 11.35%, respectively. See the section of this prospectus captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations—For the Three Months Ended March 31, 2007 and 2006—Financial Condition—Regulatory Capital” for details relating to our regulatory capital ratios.

 

(10) At period end. Tangible common equity includes $10.3 million of puttable common stock as of March 31, 2006 and December 31, 2006 and 2005.

 

 

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R ISK FACTORS

An investment in our common stock involves risks. You should carefully read and consider the following risks and all other information contained in this prospectus, including the financial statements and the notes to those financial statements before making an investment decision. The realization of any of the risks described below could have a material adverse effect on our business, financial condition, results of operations, cash flows and/or future prospects. The trading price of our common stock could decline due to any of these risks, and you could lose part or all of your investment. The order of these risk factors does not reflect the likelihood of their occurrence.

Risks Associated With Our Business

If we are unable to continue to transform our balance sheet by originating loans and growing core deposits and if our strategic decision to open a number of new private client offices and offer wealth management services and insurance products does not continue to generate new business, our business and earnings may be negatively affected.

We have transformed our balance sheet by replacing lower yielding investment securities and purchased mortgage loans with our own higher yielding originated loans. We have also rolled out a full line of deposit and cash management products, which has enabled us to replace brokered deposits with core deposits. In connection with this transformation, we have disposed of our out-of-market locations and expanded the number of private client offices we operate in attractive markets in Texas and southwest Florida. Additionally, we have made strategic acquisitions enabling us to offer wealth management services and insurance products to our clients. Our ability to continue the growth of originated loans and core deposits depends, in part, upon our ability to leverage our current offices and infrastructure, successfully attract core deposits, identify attractive commercial lending opportunities and retain experienced lending officers. Our ability to continue to successfully execute our business plan requires effective planning and management implementation, which may be affected by factors outside of our control. If we are not able to attract significant business from our target markets, our business and earnings may be negatively affected.

Our dependence on loans secured by real estate subjects us to risks relating to fluctuations in the real estate market and related interest rates and legislation that could result in significant additional costs and capital requirements that could adversely affect our financial condition and results of operations.

Approximately 81.3% of our loan portfolio as of March 31, 2007 was comprised of loans collateralized by real estate. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. A weakening of the real estate market in our primary market areas could have an adverse effect on the demand for new loans, the ability of borrowers to repay outstanding loans, the value of real estate and other collateral securing the loans and the value of real estate owned by us. If real estate values decline, it is also more likely that we would be required to increase our allowance for loan losses, which could adversely affect our financial condition and results of operations.

As of March 31, 2007, we had $134.8 million, or 14.5%, of our total loans in real estate construction loans. Of this amount, $35.3 million were made to finance residential construction with an identified purchaser and $34.3 million were made to finance residential construction with no identified purchaser. Substantially all of these loans are located in the Houston area. Further, $65.2 million of real estate construction loans were made to finance commercial construction, with the majority of these loans made to finance construction projects located in southwest Florida. Construction loans are subject to risks during the construction phase that are not present in standard residential real estate and commercial real estate loans. These risks include:

 

   

the viability of the contractor;

 

   

the contractor’s ability to complete the project, to meet deadlines and time schedules and to stay within cost estimates; and

 

   

concentrations of such loans with a single contractor and its affiliates.

 

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Real estate construction loans also present risks of default in the event of declines in property values or volatility in the real estate market during the construction phase. If any of these risks were to occur, it could adversely affect our financial condition and results of operations.

In December 2006, banking regulators issued guidance regarding high concentrations of commercial and real estate construction loans within bank loan portfolios. The guidance requires institutions that exceed certain levels of real estate lending to maintain higher capital ratios than institutions with lower concentrations if they do not have appropriate risk management policies and practices in place. If there is any deterioration in our commercial real estate portfolio or if our regulators conclude that we have not implemented appropriate risk management policies and practices, it could adversely affect our business and result in a requirement of increased capital levels, and such capital may not be available at that time.

If we are unable to continue to originate residential real estate loans and sell them into the secondary market for a profit, our earnings could decrease.

We derive a portion of our noninterest income from the origination of residential real estate loans and the subsequent sale of such loans into the secondary market. For the three months ended March 31, 2007, we originated $92.5 million in residential real estate loans, sold $69.4 million in such loans and recognized $2.0 million in gains on such sales. For the year ended December 31, 2006, we originated $458.3 million in residential real estate loans, sold $381.4 million in such loans and recognized $9.6 million in gains on such sales. The amount of gains recognized for the three months ended March 31, 2007 and the year ended December 31, 2006 were less than the gains recognized in the same period of the prior year. If this trend continues and we are unable to continue to originate and sell residential real estate loans at historical or greater levels, our residential real estate loan volume would decrease, which could decrease our earnings. A rising interest rate environment, general economic conditions or other factors beyond our control could adversely affect our ability to originate residential real estate loans. Additionally, we sell a large portion of our residential real estate loans to third party investors, and rising interest rates could negatively affect our ability to generate suitable profits on the sale of such loans. If interest rates increase after we originate the loans, our ability to market those loans is impaired as the profitability on the loans decreases. These fluctuations can have an adverse effect on the revenue we generate from residential real estate loans and in certain instances, could result in a loss on the sale of the loans.

As a consequence of our efforts to transform our balance sheet over the last five years by originating new loans, in certain circumstances there is limited repayment history against which we can fully assess the adequacy of our allowance for loan losses. If our allowance for loan losses is not adequate to cover actual loan losses, our earnings will decrease.

As a consequence of our efforts to transform our balance sheet over the last five years, many of our loans have been made recently, and in those circumstances, there is limited repayment history against which we can fully assess the adequacy of our allowance for loan losses. Over $784.0 million, or 84.1%, of our loan portfolio as of March 31, 2007 represents loans originated since 2002 and $144.3 million, or 15.5%, of our loan portfolio represents purchased loans. As a lender, we are exposed to the risk that our loan clients may not repay their loans according to the terms of these loans, and the collateral securing the payment of these loans may be insufficient to assure repayment. We make various assumptions and judgments about the collectibility of our loan portfolio, including the creditworthiness of the borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. We maintain an allowance for loan losses to cover any loan losses inherent in the loan portfolio. In determining the size of the allowance, we rely on a periodic analysis of our loan portfolio, our historical loss experience and our evaluation of general economic conditions. If our assumptions prove to be incorrect or if we experience significant loan losses, our current allowance may not be sufficient to cover actual loan losses and adjustments may be necessary to allow for different economic conditions or adverse developments in our loan portfolio. A material addition to the allowance for loan losses could cause our earnings to decrease. Due to the relatively unseasoned nature of our loan portfolio, we cannot assure you that we will not experience an increase in delinquencies and losses as these loans continue to mature.

 

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In addition, federal regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further charge-offs, based on judgments different than those of our management. Any significant increase in our allowance for loan losses or charge-offs required by these regulatory agencies could have a material adverse effect on our results of operations and financial condition.

Our profitability depends significantly on local economic conditions in the areas where our operations and loans are concentrated.

Our profitability depends on the general economic conditions in our primary markets in Texas and southwest Florida. Unlike larger banks that are more geographically diversified, we provide banking and financial services to clients primarily in the greater Houston area, including Harris, Ft. Bend and Montgomery counties, and southwest Florida, including Lee, Collier, Pinellas and Hillsborough counties. As of March 31, 2007, $383.0 million, or 56.3%, of our commercial real estate, real estate construction and residential real estate loans were made to borrowers in Texas and $159.7 million, or 23.5%, of such loans (which includes $41.0 million in purchased loans) were made to borrowers in Florida. The local economic conditions in these areas have a significant impact on our commercial, real estate and construction and consumer loans, the ability of the borrowers to repay these loans and the value of the collateral securing these loans. In addition, if the population or income growth in either of these regions is slower than projected, income levels, deposits and housing starts could be adversely affected and could result in the curtailment of our expansion, growth and profitability. If either of these regions experiences a downturn or a recession for a prolonged period of time, we would likely experience significant increases in nonperforming loans, which could lead to operating losses, impaired liquidity and eroding capital.

Moreover, a significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, an outbreak of hostilities or other international or domestic calamities, unemployment or other factors beyond our control could impact these local economic conditions and could negatively affect the financial results of our banking operations.

The properties that we own and our foreclosed real estate assets could subject us to environmental risks and associated costs.

There is a risk that hazardous substances or wastes, contaminants, pollutants or other environmentally restricted substances could be discovered on our properties or our foreclosed assets (particularly in the case of real estate loans). In this event, we might be required to remove the substances from the affected properties or to engage in abatement procedures at our sole cost and expense. Besides being liable under applicable federal and state statutes for our own conduct, we may also be held liable under certain circumstances for actions of borrowers or other third parties with respect to property that collateralizes one or more of our loans or property that we own. Potential environmental liability could include the cost of remediation and also damages for any injuries caused to third-parties. We cannot assure you that the cost of removal or abatement will not substantially exceed the value of the affected properties or the loans secured by those properties, that we would have adequate remedies against prior owners or other responsible parties or that we would be able to resell the affected properties either prior to or following completion of any such removal or abatement procedures. If material environmental problems are discovered prior to foreclosure, we generally will not foreclose on the related collateral or will transfer ownership of the loan to a subsidiary. It should be noted, however, that the transfer of the property or loans to a subsidiary may not protect us from environmental liability. Furthermore, despite these actions on our part, the value of the property as collateral will generally be substantially reduced and, as a result, we may suffer a loss upon collection of the loan.

The small to medium-sized businesses we lend to may have fewer resources to weather a downturn in the economy, which may impair a borrower’s ability to repay a loan to us, and such impairment could materially harm our operating results.

We make loans to professional firms and privately-owned businesses that are considered to be small to medium-sized businesses. Small to medium-sized businesses frequently have smaller market shares than their

 

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competition, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience substantial volatility in operating results, any of which may impair a borrower’s ability to repay a loan. In addition, the success of a small to medium-sized business often depends on the management talents and efforts of one or two persons or a small group of persons, and the death, disability or resignation of one or more of these persons could have a material adverse impact on the business and its ability to repay our loan. Economic downturns and other events that negatively impact our target market could cause us to incur substantial credit losses that could materially harm our operating results.

Our banking business is subject to interest rate risk and fluctuations in interest rates may adversely affect our results of operations and financial condition.

The majority of our banking assets are monetary in nature and subject to risk from changes in interest rates. Like most financial institutions, our earnings are significantly dependent on our net interest income, which is the difference between interest earned from interest-earning assets, such as loans and investment securities, and interest paid on interest-bearing liabilities, such as deposits and borrowings. We expect that we will periodically experience “gaps” in the interest rate sensitivities of our assets and liabilities, meaning that either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest-earning assets, or vice versa. In either event, if market interest rates should move contrary to our position, this “gap” will negatively impact our earnings. Many factors impact interest rates, including governmental monetary policies, inflation, recession, changes in unemployment, the money supply, and international disorder and instability in domestic and foreign financial markets.

As of March 31, 2007, we were liability sensitive, meaning that our interest-bearing liabilities reprice more quickly than our interest-earning assets, so in the event of a sharp increase in interest rates, our net interest income will be affected negatively. Although our asset liability management strategy is designed to control our risk from changes in market interest rates, it may not be able to prevent changes in interest rates from having a material adverse effect on our results of operations and financial condition.

The wealth management fees we receive may decrease as a result of poor investment performance, in either relative or absolute terms, which could decrease our revenues and net earnings.

For the three months ended March 31, 2007 and the year ended December 31, 2006, we received $4.2 million and $17.3 million, respectively, in fees from our wealth management business, which represented 50.2% and 49.4%, respectively, of our total noninterest income. We derive our revenues from this business primarily from investment management fees based on assets under management and, to a lesser extent, fee-based financial planning services. Our ability to maintain or increase assets under management is subject to a number of factors, including investors’ perception of our past performance, in either relative or absolute terms, market and economic conditions, and competition from investment management companies. Financial markets are affected by many factors, all of which are beyond our control, including general economic conditions; securities market conditions; the level and volatility of interest rates and equity prices; competitive conditions; liquidity of global markets; international and regional political conditions; regulatory and legislative developments; monetary and fiscal policy; investor sentiment; availability and cost of capital; technological changes and events; outcome of legal proceedings; changes in currency values; inflation; credit ratings; and the size, volume and timing of transactions. A decline in the fair value of the assets under management caused by a decline in general economic conditions would decrease our wealth management fee income.

Investment performance is one of the most important factors in retaining existing clients and competing for new wealth management clients. Poor investment performance could reduce our revenues and impair our growth in the following ways:

 

   

existing clients may withdraw funds from our wealth management business in favor of better performing products;

 

   

asset-based management fees could decline from a decrease in assets under management;

 

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our ability to attract funds from existing and new clients might diminish; and

 

   

our wealth managers and investment advisors may depart, to join a competitor or otherwise.

Even when market conditions are generally favorable, our investment performance may be adversely affected by the investment style of our wealth management and investment advisors and the particular investments that they make. To the extent our future investment performance is perceived to be poor in either relative or absolute terms, the revenues and profitability of our wealth management business will likely be reduced and our ability to attract new clients will likely be impaired. As such, fluctuations in the equity and debt markets can have a direct impact upon our net earnings.

Linscomb & Williams’ investment advisory contracts are subject to termination on short notice, and termination of a significant number of investment advisory contracts could have a material adverse impact on our revenues.

Linscomb & Williams derived 91.7% of its revenue for the three months ended March 31, 2007 from investment advisory contracts with its clients. These contracts are typically terminable by clients without penalty upon relatively short notice (generally not more than 60 days). Our wealth management clients can terminate their relationships with us, reduce their aggregate assets under management, or shift their funds to other types of accounts with different rate structures for any number of reasons, including investment performance, changes in prevailing interest rates, inflation, changes in investment preferences of clients, changes in our reputation in the marketplace, changes in management or control of clients, loss of key investment management personnel and financial market performance. We cannot be certain that Linscomb & Williams’ management will be able to retain all of their clients. If its clients terminate their investment advisory contracts, Linscomb & Williams, and consequently we, could lose a substantial portion of our revenues.

Our insurance agency’s commission revenues are based on premiums set by insurers and any decreases in these premium rates could adversely affect our operations and revenues.

Our insurance agency subsidiary, Town & Country, is engaged in insurance agency and brokerage activities. For the three months ended March 31, 2007 and the year ended December 31, 2006, we received $1.7 million and $5.5 million, respectively, in fees from Town & Country, which represented 20.3% and 15.7%, respectively, of our total noninterest income. Town & Country derives revenues primarily from commissions paid by the insurance underwriters on the sale of insurance products to clients. These commissions are highly dependent on the premiums charged by insurance underwriters, which historically have been cyclical in nature, vary by region and display a high degree of volatility based on the prevailing economic and competitive factors that affect insurance underwriters. These factors, which are not within Town & Country’s control, include the capacity of insurance underwriters to place new business, non-underwriting profits of insurance underwriters, consumer demand for insurance products, the availability of comparable products from other insurance underwriters at a lower cost and the availability to consumers of alternative insurance products, such as government benefits and self-insurance plans.

Town & Country also receives contingent commissions, which are commissions paid by insurance underwriters based on profitability of the business, premium growth, total premium volume, or some combination of these factors. Town & Country generally receives these contingent commissions in the first and second quarters of each year. Due to the nature of these commissions, it is difficult for us to predict their payment. Increases in loss ratios experienced by insurance underwriters will result in a decreased profit to them and may result in decreases in the payment of contingent commissions to us.

Town & Country cannot predict the timing or extent of future changes in premiums and thus commissions. As a result, we cannot predict the effect that future premium rates will have on our operations. While increases in premium rates may result in revenue increases, decreases in premium rates may result in revenue decreases. These decreases may adversely affect our operations and revenues for the periods in which they occur.

 

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Our business would be harmed if we lost the services of any of our senior management team and senior relationship bankers and are unable to recruit or retain suitable replacements.

We believe that our success to date and our prospects for future success in our banking, wealth management and insurance businesses depend significantly on the continued services and performance of our chief executive officer, James S. D’Agostino, Jr., and the other members of our senior management team. While we have granted restricted stock to, and have change in control agreements with, each of these persons, our ability to retain such officers may be hindered by the fact that we have not entered into employment or non-competition agreements with most of them. Therefore, they may terminate their employment with us at any time, and we could have difficulty replacing such officers with persons who are experienced in the specialized aspects of our business or who have ties to the communities within our primary market areas. The unexpected loss of services of any of these key officers could materially harm our business.

Our growth could be hindered unless we are able to recruit and retain qualified employees.

The markets in which we operate are experiencing a period of rapid growth, placing a premium on highly qualified employees in a number of industries, including the financial services industry. Our business plan includes, and is dependent upon, our hiring and retaining highly qualified and motivated executives and employees at every level and, in particular, experienced loan officers and relationship managers. We expect to experience substantial competition in our endeavor to identify, hire and retain the top-quality employees that we believe are key to our future success. If we are unable to hire and retain qualified employees, we may not be able to grow our franchise and successfully execute our business.

We operate in a highly regulated environment and, as a result, are subject to extensive regulation and supervision and changes in federal and local laws and regulations that could adversely affect our financial performance.

We and Encore Bank are subject to extensive regulation, supervision and examination by federal banking authorities. Any change in applicable regulations or federal or state legislation could have a substantial impact on us and Encore Bank and our respective operations. Additional legislation and regulations may be enacted or adopted in the future that could significantly affect our powers, authority and operations or the powers, authority and operations of Encore Bank, which could have a material adverse effect on our financial condition and results of operations. Further, regulators have significant discretion and power to prevent or remedy unsafe or unsound practices or violations of laws by banks and bank holding companies in the performance of their supervisory and enforcement duties. The exercise of this regulatory discretion and power may have a negative impact on us.

Our wealth management subsidiary, Linscomb & Williams, is registered with the Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940. The Investment Advisers Act imposes numerous obligations and fiduciary duties on registered investment advisers including record-keeping, operating and marketing requirements, disclosure obligations and prohibitions on fraudulent activities. The failure of Linscomb & Williams to comply with the Investment Advisers Act and regulations promulgated thereunder could cause the SEC to institute proceedings and impose sanctions for violations of this act, including censure, termination of an investment adviser’s registration, or prohibition to serve as adviser to funds registered with the SEC and could lead to litigation by investors in those funds or harm to our reputation, any of which could adversely affect our financial performance.

In addition, our insurance subsidiary, Town & Country, is subject to regulation by the Texas Department of Insurance. State insurance regulators and the National Association of Insurance Commissioners continually re-examine existing laws and regulations, and such re-examination may result in the enactment of insurance-related laws and regulations, or the issuance of interpretations thereof, that adversely affect the financial performance of Town & Country, and hence, us.

 

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We face strong competition with other financial institutions and financial service companies, which could adversely affect our results of operations and financial condition.

The banking, wealth management and insurance businesses are highly competitive, and our profitability depends heavily on our ability to compete in our markets with other financial institutions and financial service companies offering products and services at prices similar to those offered by us. In our banking business, we face vigorous competition from banks and other financial institutions, including savings and loan associations, savings banks, finance companies and credit unions. A number of these banks and other financial institutions have substantially greater resources and lending limits, larger branch systems and a wider array of banking services. We also compete with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies, insurance companies and governmental organizations which may offer more favorable financing than we can offer. Some of our nonbank competitors are not subject to the same extensive regulations that govern us. To the extent that we are forced to compete on the basis of price, we may not be able to maintain our current fee structure.

In our wealth management and insurance businesses, we compete with national and regional investment management and financial planning firms, broker-dealers, accounting firms, trust companies and law firms. Many of these companies are more geographically diversified and have greater resources than we do. This competition in all of our businesses may reduce or limit our margins on banking services, reduce our market share, reduce our noninterest income and adversely affect our results of operations and financial condition.

An interruption in or breach in security of our information systems may result in a loss of client business and have an adverse effect on our results of operations and financial condition.

We rely heavily on communications and information systems to conduct our business. Any failure or interruption or breach in security of these systems could result in failures or disruptions in our client relationship management, general ledger, deposits, servicing or loan origination systems. We cannot assure you that such failures or interruptions will not occur or, if they do occur, that they will be adequately addressed by us. The occurrence of any failures or interruptions could result in a loss of client business and have an adverse effect on our results of operations and financial condition.

If we are unable to accurately and favorably assess the effectiveness of our internal controls over financial reporting, or if our independent auditors are unable to provide an unqualified attestation report in our assessment, our stock price could be adversely affected.

Pursuant to Section 404 of the Sarbanes-Oxley Act and beginning with our Annual Report on Form 10-K for the fiscal year ending December 31, 2008, our management will be required to report on, and our independent auditors to attest to, the effectiveness of our internal controls over financial reporting as of December 31, 2008. The rules governing the standards that must be met for management to assess our internal controls over financial reporting are complex, and require significant documentation, testing and possible remediation. In connection with this effort and the related requirements to file periodic reports with the SEC and maintain effective disclosure controls and procedures, we will likely incur increased expenses and diversion of management’s time and other internal resources. We may encounter problems or delays in completing the implementation of any changes necessary to make a favorable assessment of our internal controls over financial reporting. In addition, in connection with the attestation process by our independent auditors, we may encounter problems or delays in completing the implementation of any requested improvements and receiving a favorable attestation. If we cannot favorably assess the effectiveness of our internal controls over financial reporting, or if our independent auditors are unable to provide an unqualified attestation report on our assessment, we could lose investor confidence and our stock price could be adversely affected.

 

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Risks Associated With an Investment in Our Common Stock

After completion of the offering, our directors and executive officers will continue to own a significant number of shares of our common stock, allowing management further control over our corporate affairs.

After the completion of this offering, our directors and executive officers will beneficially own 28.21% of the outstanding shares of our common stock, and approximately 27.44% of such shares of our common stock if the underwriters’ over-allotment option is fully exercised. Accordingly, these directors and executive officers will be able to control, to a significant extent, the outcome of all matters required to be submitted to our shareholders for approval, including decisions relating to the election of directors, the determination of our day-to-day corporate and management policies and other significant corporate transactions. See the sections of this prospectus captioned “Management” and “Description of Our Capital Stock.”

Our corporate organizational documents and the provisions of Texas law to which we are subject may delay or prevent a change in control of our company that you may favor.

Our amended and restated articles of incorporation and amended and restated bylaws contain certain provisions which may delay, discourage or prevent an attempted acquisition or change of control of our company. These provisions include:

 

   

a provision that any special meeting of our shareholders may be called only by a majority of the board of directors, the Chairman of the Board, the President or the holders of at least 50% of our total number of shares of common stock entitled to vote at the meeting;

 

   

a provision establishing certain advance notice procedures for nomination of candidates for election as directors and for shareholder proposals to be considered at an annual or special meeting of shareholders; and

 

   

a provision that denies shareholders the right to amend our bylaws.

Our amended and restated articles of incorporation provide for noncumulative voting for directors and authorize our board of directors to issue shares of preferred stock, $1.00 par value per share, without shareholder approval and upon such terms as our board of directors may determine. The issuance of preferred stock, while providing desirable flexibility in connection with possible acquisitions, financings and other corporate purposes, could have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from acquiring, a controlling interest in us. In addition, certain provisions of Texas law, including a provision which restricts certain business combinations between a Texas corporation and certain affiliated shareholders, may delay, discourage or prevent an attempted acquisition or change in control of our company. See the sections of this prospectus captioned “Description of Our Capital Stock—Preferred Stock,” and “— Certain Provisions of Texas Law and our Amended and Restated Articles of Incorporation and Amended and Restated Bylaws Could Have an Anti-Takeover Effect.”

We cannot be sure that an active trading market will develop to provide liquidity for our investors.

Prior to the offering, there has been no public market for our common stock. As of March 31, 2007, there were approximately 265 holders of record of our common stock. Our common stock has been approved for listing on the NASDAQ Global Market under the symbol “EBTX.” However, there can be no assurance that an established and liquid market for our common stock will develop on NASDAQ, or that a market will continue if one does develop. One of the requirements for trading on the NASDAQ Global Market is that there be at least three registered market makers in our common stock before trading can commence. The underwriters have each advised us that they intend to make a market in our common stock as long as the volume of trading activity in our common stock and certain other market making conditions justify doing so. Nonetheless, none of the underwriters nor any other market maker is obligated to make a market in our common stock, and any such market making may be discontinued at any time in the sole discretion of each market maker. Making a market

 

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involves maintaining bid and asked quotations for our common stock and being available as principal to effect transactions in reasonable quantities at those quoted prices, subject to various securities laws and other regulatory requirements. A public trading market having the desired characteristics of depth, liquidity and orderliness depends upon the presence in the marketplace of willing buyers and sellers of our common stock at any given time, which presence is dependent upon the individual decisions of investors over which neither we nor any market maker has any control.

Purchasers of our common stock will experience immediate dilution.

If you purchase shares of our common stock in this offering, you will experience immediate dilution of approximately 46.7% in your investment, in that our tangible book value after the offering will be approximately $11.20 per share compared with the initial public offering price of $21.00 per share. See the section of this prospectus captioned “Dilution.”

Your share ownership may be diluted by the issuance of additional shares of our common stock in the future.

Your share ownership may be diluted by the issuance of additional shares of our common stock or securities convertible into common stock in the future. As of March 31, 2007, a total of 1,089,750 shares of our common stock were issuable under options granted under our current 2000 Stock Incentive Plan and 53,817 shares of our common stock are reserved for future issuance to directors, employees and other individuals under our 2000 Stock Incentive Plan.

It is probable that options to purchase our common stock will be exercised during their respective terms if the market value of our common stock exceeds the exercise price of the particular option. Our 2000 Stock Incentive Plan also provides that all issued options automatically and fully vest upon a change in control of our company. If the stock options are exercised, your share ownership will be diluted.

Further, pursuant to our acquisition agreement with Linscomb & Williams, we are required to issue an additional number of shares of our common stock to the former shareholders of Linscomb & Williams no later than March 31, 2010 depending on the after-tax net earnings of Linscomb & Williams from the date of acquisition through December 31, 2009, subject to certain limitations. Based on the after-tax net earnings of Linscomb & Williams for the period from the date of acquisition through March 31, 2007 and the initial public offering price of $21.00, we would be required to issue approximately 123,270 shares.

In addition, our amended and restated articles of incorporation authorize the issuance of up to 50,000,000 shares of common stock, but do not provide for preemptive rights to the holders of our common stock. Any authorized but unissued shares following the offering will be available for issuance by our board of directors. Therefore, persons who subscribe for shares in the offering will not automatically have the right to subscribe for additional shares of common stock issued at any time in the future. As a result, if we issue additional shares of common stock to raise additional capital or for other corporate purposes, you may be unable to maintain your pro rata ownership in us.

Future sales of our common stock could depress the market price of our common stock.

Sales of a substantial number of shares of our common stock in the public market following this offering, or the perception that large sales could occur, could cause the market price of our common stock to decline or limit our future ability to raise capital through an offering of equity securities.

After completion of this offering, there will be 9,801,626 shares of our common stock outstanding. All of the shares of common stock sold in this offering will be freely tradable without restriction or further registration under the federal securities laws unless purchased by our “affiliates” within the meaning of Rule 144 under the

 

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Securities Act, which shares will be subject to the resale limitations of Rule 144, or shares purchased under the directed share program, which shares will be subject to a 180-day lock-up period. Our directors, executive officers, selling shareholders and certain other shareholders have agreed to enter into lock-up agreements (and purchasers of shares of our common stock under the directed share program will agree to restrictions) generally providing, subject to limited exceptions, that they will not, without the prior written consent of Keefe, Bruyette & Woods, Inc., directly or indirectly, during the period ending 180 days after the date of this prospectus, offer to sell, or otherwise dispose of any shares of our common stock.

Following the completion of this offering, we also intend to file a registration statement on Form S-8 under the Securities Act covering the 1,489,000 shares of our common stock reserved for issuance under our 2000 Stock Incentive Plan. Accordingly, subject to the exercise of options, which may be subject to certain vesting requirements, shares registered under that registration statement will be available for sale in the open market immediately by persons other than our executive officers and directors and immediately after the lock-up agreements expire by our executive officers and directors.

Our determination of the offering price of our common stock may not be indicative of its market price after this offering and our market price may decline.

There has been no active market for our common stock before this offering. The initial public offering price for our common stock in this offering was determined by negotiations between us and the underwriters and may not necessarily bear any relationship to our book value, past operating results, financial condition or other established criteria of value and may not be indicative of the price at which our common stock will trade after this offering. Among the factors considered in determining the offering price of our common stock, in addition to prevailing market conditions, were our results of operations in recent periods; expectations regarding our future results of operations; possible third-party claims against us; possible changes in law and regulations; future sales of our common stock and the consideration of the above factors in relation to the market value of companies in our industry. You may not be able to resell your shares at or above the initial public offering price.

We will retain broad discretion in using the net proceeds from this offering, and may not use the net proceeds effectively, which could have an adverse effect on our business, financial condition and results of operations.

Although we expect to use the net proceeds from this offering as capital for operations and expansion of our business, we have not designated the amount we will use for any particular purpose. Accordingly, our management will retain broad discretion to allocate the net proceeds of this offering. The net proceeds may be applied in ways with which you and other investors in the offering may not agree. Moreover, our management may use the net proceeds for corporate purposes that may not increase our market value or make us profitable. In addition, it may take us some time to deploy the proceeds from this offering effectively in accordance with our intended uses. Until the proceeds are effectively deployed, our return on equity and earnings per share may be negatively affected. Management’s failure to utilize the proceeds effectively could have an adverse effect on our business, financial condition and results of operations.

We currently do not intend to pay dividends on our common stock. In addition, our future ability to pay dividends is subject to restrictions.

We have not paid any dividends to our holders of common stock in the past and we currently do not intend to pay any dividends on our common stock in the foreseeable future. In the event that we decide to pay dividends, there are a number of restrictions on our ability to pay dividends. It is the policy of the Federal Reserve that bank holding companies should pay cash dividends on common stock only out of income available over the past year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. The policy provides that bank holding companies should not maintain a level of cash dividends that undermines the bank holding company’s ability to serve as a source of strength to its banking subsidiaries.

 

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Our principal source of funds to pay dividends on our common stock will be cash dividends that we receive from Encore Bank. The payment of dividends by Encore Bank to us is subject to certain restrictions imposed by federal banking laws, regulations and authorities. The federal banking statutes prohibit federally insured banks from making any capital distributions (including a dividend payment) if, after making the distribution, the institution would be “under-capitalized” as defined by statute. In addition, the relevant federal regulatory agencies have authority to prohibit an insured bank from engaging in an unsafe or unsound practice, as determined by the agency, in conducting an activity. The payment of dividends could be deemed to constitute such an unsafe or unsound practice, depending on the financial condition of Encore Bank. Regulatory authorities could impose administratively stricter limitations on the ability of Encore Bank to pay dividends to us if such limits were deemed appropriate to preserve certain capital adequacy requirements.

The holders of our junior subordinated debentures have rights that are senior to those of our shareholders.

We have two issues of junior subordinated debentures outstanding, with an aggregate liquidation amount totaling $20.6 million related to the issuance of trust preferred securities by our non-consolidated subsidiary trusts, which are treated as capital for regulatory ratio compliance purposes. Although these securities are viewed as capital for regulatory purposes, they are debt securities and have provisions which, in the event of noncompliance, could have an adverse effect on our operations. For example, these securities permit us to defer the periodic payment of interest for various periods, but if such payments are deferred, we would be prohibited from paying cash dividends on our common stock during deferral periods and until deferred interest is paid. Future payment of interest depends upon the earnings of Encore Bank and its subsidiaries and dividends from Encore Bank to us, which may be inadequate to service the obligations.

Your shares of common stock will not be an insured deposit.

Your investment in our common stock will not be a bank deposit and will not be insured or guaranteed by the FDIC or any other government agency. Your investment will be subject to investment risk, and you must be capable of affording the loss of your entire investment.

 

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SPECIAL CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS

This prospectus contains statements about future expectations, activities and events that constitute forward-looking statements. Forward-looking statements are based on our beliefs, assumptions and expectations of our future financial and operating performance and growth plans, taking into account the information currently available to us. These statements are not statements of historical fact. The words “believe,” “may,” “should,” “anticipate,” “estimate,” “expect,” “intend,” “continue,” “would,” “could,” “hope,” “might,” “assume,” “objective,” “seek,” “plan,” “strive” or similar words, or the negatives of these words, identify forward-looking statements.

Forward-looking statements involve risks and uncertainties that may cause our actual results to differ materially from the expectations of future results we express or imply in any forward-looking statements. In addition to the other factors discussed in the “Risk Factors” section of this prospectus, factors that could contribute to those differences include, but are not limited to:

 

   

general business or economic conditions, either nationally, regionally or in the local markets we serve, may be less favorable than expected, resulting in, among other things, a deterioration of credit quality or a reduced demand for credit or a decline in wealth management fees;

 

   

changes in the interest rate environment, which may reduce our margins or impact the value of changes in market rates and prices may impact the value of securities, loans, deposits and other financial instruments;

 

   

legislative or regulatory developments including changes in laws concerning taxes, banking, securities, investment advisory, trust, insurance and other aspects of the financial securities industry;

 

   

the continued service of key management personnel;

 

   

our ability to attract, motivate and retain key employees;

 

   

factors that increase competitive pressure among financial services organizations, including product and pricing pressures;

 

   

our ability to expand and grow our business and operations, including the establishment of additional private client offices and acquisition of additional banks, and our ability to realize the cost savings and revenue enhancements we expect from such activities; and

 

   

fiscal and governmental policies of the United States federal government.

For other factors, risks and uncertainties that could cause actual results to differ materially from estimates and projections contained in forward-looking statements, see the section of this prospectus captioned “Risk Factors.”

Forward-looking statements are not guarantees of performance or results. A forward-looking statement may include a statement of the assumptions or bases underlying the forward-looking statement. We believe we have chosen these assumptions or bases in good faith and that they are reasonable. We caution you, however, that assumptions or bases almost always vary from actual results, and the differences between assumptions or bases and actual results can be material. When considering forward-looking statements, you should keep in mind the risk factors and other cautionary statements in this prospectus. These statements speak only as of the date of this prospectus (or an earlier date to the extent applicable). Except as required by applicable law, we undertake no obligation to update publicly these statements in light of new information or future events.

Neither we, the selling shareholders nor any underwriter is making an offer of these securities in any jurisdiction where the offer is not permitted. Furthermore, you should not consider this prospectus to be an offer or solicitation relating to our common stock if the person making the offer or solicitation is not qualified to do so, or it is unlawful for you to receive such an offer or solicitation.

No action is being taken in any jurisdiction outside the United States to permit a public offering of the common stock or possession or distribution of this prospectus in that jurisdiction. Persons who come into possession or distribution of this prospectus in jurisdictions outside the United States are required to inform themselves about and to observe any restrictions as to this offering and the distribution of this prospectus applicable to that jurisdiction.

 

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USE OF PROCEEDS

In this offering of our common stock, we are offering 1,904,761 shares and the selling shareholders are offering 75,000 shares. We estimate that our net proceeds from our sale of 1,904,761 shares of our common stock in this offering (at the initial public offering price of $21.00 per share) will be approximately $36.2 million, after deducting offering expenses estimated to be $1,020,000 and underwriting discounts and commissions. We will not receive any proceeds from the sale of shares of common stock offered by any selling shareholder. If the underwriters exercise the over-allotment option in full, we anticipate that the net proceeds from the sale of our common stock will be approximately $41.8 million after deducting offering expenses and underwriting discounts and commissions.

We plan to use the net proceeds from this offering as follows:

 

   

to support anticipated balance sheet growth, including contributions to the capital of Encore Bank;

 

   

for possible future acquisitions; and

 

   

for general corporate purposes.

We have not specifically allocated the amount of net proceeds that will be used for these purposes. We are conducting this offering at this time because we believe that it will allow us to better execute our growth strategies. We believe that as a public company we will have greater visibility with prospective clients and industry peers, increased access to capital and additional currency with which to explore strategic opportunities as they arise.

From time to time in the ordinary course of our business, we evaluate potential acquisition opportunities, some of which may be material. At the present time, we do not have any plans, arrangements or understandings relating to any material acquisition.

The precise amounts and timing of the application of the net proceeds from this offering depend upon many factors, including, but not limited to, the amount of any such proceeds and actual funding requirements. Until the proceeds are used, we may invest the proceeds, depending on our cash flow requirements, in short- and long-term investments, including, but not limited to treasury bills, commercial paper, certificates of deposit, securities issued by U.S. government agencies, money market funds, repurchase agreements and other similar investments.

 

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OUR DIVIDEND POLICY

Holders of our common stock are entitled to receive dividends when, as and if declared by our board of directors out of funds legally available for that purpose. We have not paid any dividends to our holders of common stock in the past and we currently do not intend to pay dividends on our common stock in the foreseeable future. In the event that we decide to pay dividends, there are a number of restrictions on our ability to do so.

For a foreseeable period of time, our principal source of cash revenues will be dividends paid by Encore Bank with respect to its capital stock. There are certain restrictions on the payment of these dividends imposed by federal banking laws, regulations and authorities. See the sections of this prospectus captioned “Supervision and Regulation—Encore Bancshares, Inc. —Regulatory Restrictions on Dividends; Source of Strength” and “Supervision and Regulation—Encore Bank— Restrictions on Distribution of Subsidiary Bank Dividends and Assets.”

The declaration and payment of dividends on our common stock will depend upon our earnings and financial condition, liquidity and capital requirements, the general economic and regulatory climate, our ability to service any equity or debt obligations senior to the common stock and other factors deemed relevant by our board of directors. Regulatory authorities could impose administratively stricter limitations on the ability of Encore Bank to pay dividends to us if such limits were deemed appropriate to preserve certain capital adequacy requirements. In addition, the terms of our junior subordinated debentures may limit our ability to pay dividends on our common stock.

 

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DILUTION

If you invest in our common stock, you will suffer dilution to the extent that the initial public offering price per share of our common stock exceeds the tangible book value per share of our common stock immediately after the offering. The tangible book value of our common stock as of March 31, 2007 was approximately $73.6 million, or $9.33 per share. Tangible book value represents shareholders’ equity less intangible assets and goodwill, divided by the number of shares of common stock outstanding.

Dilution in tangible book value per share represents the difference between the amount per share paid by purchasers of our common stock in this offering and the pro forma tangible book value per share of our common stock immediately after the offering. After giving effect to our issuance and sale of 1,904,761 shares of common stock in this offering at the initial public offering price of $21.00 per share, not including the possible issuance of an additional 285,714 shares pursuant to the underwriters’ over-allotment, and after deduction of the underwriting discounts and commissions and estimated offering expenses payable by us, our pro forma tangible book value as of March 31, 2007 would have been $109.8 million, or $11.20 per share. This represents an immediate increase in tangible book value per share of $1.87 to existing shareholders and an immediate dilution of $9.80 per share to purchasers of our common stock in this offering.

The following table illustrates the per share dilution to new investors as of March 31, 2007:

 

Initial public offering price per share

   $ 21.00

Tangible book value per share as of March 31, 2007

     9.33

Increase per share attributable to new investors

     1.87

Pro forma tangible book value per share after the offering

     11.20

Dilution per share to new investors

   $ 9.80

The following table summarizes, as of March 31, 2007, the total number of shares of common stock purchased or issued from us, and the total consideration paid to us by existing shareholders and new investors for our common stock, before deducting underwriting discounts and commissions and estimated offering expenses, and the average price per share paid by existing shareholders and by new investors who purchase shares of common stock in this offering at the initial public offering price of $21.00 per share. The shares of common stock outstanding exclude shares of common stock (1) reserved for issuance under our 2000 Stock Incentive Plan, of which 1,089,750 shares were subject to outstanding options as of March 31, 2007 and (2) that may be issued to the former shareholders of Linscomb & Williams no later than March 31, 2010 depending on the after-tax net earnings of Linscomb & Williams from the date of acquisition through December 31, 2009, subject to certain limitations, which, based on the after-tax net earnings of Linscomb & Williams for the period from the date of acquisition through March 31, 2007 and the initial public offering price of $21.00, would equal 123,270 shares. To the extent that options are exercised or other share awards are made under our 2000 Stock Incentive Plan or the number of shares issuable to the former shareholders of Linscomb & Williams increases, there will be further dilution to new investors.

 

    

Shares

Purchased/Issued

    Total Consideration     Average
Price
Per
Share
     Number    Percent     Amount    Percent    

Shareholders existing as of March 31, 2007

   7,896,865    80.6 %   $ 72,562,973    64.5 %   $ 9.19

New investors for this offering

   1,904,761    19.4       39,999,981    35.5       21.00
                              

Total

   9,801,626    100.0 %  

$

112,562,954

   100.0 %   $ 11.48
                              

 

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PRICE RANGE OF OUR COMMON STOCK

Prior to this offering, our common stock has not been traded on an established public trading market and quotations for our common stock were not reported on any market. As a result, there has been no regular market for our common stock. Although our shares have been infrequently traded in private transactions, the prices at which such transactions occurred may not necessarily reflect the price that would be paid for our common stock in an active market. As of March 31, 2007, there were approximately 265 holders of record of our common stock.

We anticipate that this offering and the listing of our common stock on the NASDAQ Global Market will result in a more active trading market for our common stock. However, we cannot assure you that a liquid trading market for our common stock will develop or be sustained after this offering. You may not be able to sell your shares quickly or at the market price if trading in our common stock is not active. See the section of this prospectus captioned “Underwriting” for more information regarding our arrangements with the underwriters and the factors considered in setting the initial public offering price.

 

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CAPITALIZATION

The following table sets forth our unaudited consolidated capitalization as of March 31, 2007:

 

   

on an actual basis; and

 

   

on an “as adjusted” basis to give effect to the issuance and sale of 1,904,761 shares of common stock in this offering, assuming that the underwriter’s over-allotment is not exercised, at the initial public offering price per share of $21.00, net of underwriting discounts and commissions and other estimated offering expenses.

The following data should be read in conjunction with the financial information included in this prospectus, including our historical consolidated financial statements and related notes.

 

    

As of

March 31, 2007

 
     Actual     As adjusted for
the offering
 
     (dollars in thousands)  
     (unaudited)  

Long-term debt:

    

Junior subordinated debentures

   $ 20,619     $ 20,619  

Shareholders’ equity:

    

Preferred stock, $1 par value, 20,000,000 shares authorized, no shares issued and outstanding and no shares outstanding, as adjusted

     —         —    

Common stock, $1 par value, 50,000,000 shares authorized, 7,900,865 shares issued and 7,896,865 shares outstanding; 9,805,626 shares issued and 9,801,626 shares outstanding, as adjusted

  

 

7,901

 

    9,806  

Additional paid-in capital

     67,670       101,945  

Retained earnings

     34,154    

 

34,154

 

Treasury stock, at cost (4,000 shares as of March 31, 2007)

     (69 )     (69 )

Accumulated other comprehensive loss

     (712 )     (712 )
                

Total shareholders’ equity

  

 

108,944

 

    145,124  
                

Total capitalization

  

$

129,563

 

  $ 165,743  
                

Consolidated capital ratios (1):

    

Leverage ratio (2)

     7.40 %     10.24 %

Tier 1 risk-based capital ratio

  

 

10.28

 

    14.22  

Total risk-based capital ratio

  

 

11.35

 

    15.29  

Tangible common equity to tangible assets (3)

  

 

5.85

 

    8.47  

(1) These ratios are explained in the section of the prospectus captioned “Supervision and Regulation—Encore Bancshares, Inc.” As of March 31, 2007, $20.0 million of our junior subordinated debentures associated with trust preferred securities counted as Tier 1 capital under current Federal Reserve guidelines.

 

(2) The leverage ratio is Tier 1 capital divided by average quarterly assets, after deducting goodwill, intangible assets and net deferred assets in excess of regulatory maximum limits.

 

(3) At period end.

 

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BUSINESS

General

We were organized as a Texas corporation in March of 2000 to serve as a vehicle to acquire Encore Bank, formerly named Guardian Savings and Loan Association. We completed this acquisition on September 30, 2000 and became a registered thrift holding company. On March 30, 2007, we completed the conversion of Encore Bank into a national banking association and became a registered bank holding company. We are headquartered in Houston, Texas, and offer a broad range of banking, wealth management and insurance services primarily through our main subsidiary, Encore Bank, included in which is a trust division referred to as Encore Trust, and two subsidiaries of Encore Bank: Linscomb & Williams, Inc. and Town & Country Insurance Agency, Inc. As of March 31, 2007, we had, on a consolidated basis, total assets of $1.3 billion, total loans of $932.8 million, total deposits of $997.3 million and shareholders’ equity of $108.9 million. We also had $2.6 billion in assets under management in our wealth management operation.

History and Franchise Transformation

Encore Bank was founded as Guardian Savings and Loan of Dallas in 1928. In September 2000, our current Chief Executive Officer, James S. D’Agostino, Jr., led a group of primarily local Houston investors in our acquisition of Guardian for $8.0 million. At the closing of the acquisition, we recapitalized our company with $25.0 million. At the time of the acquisition, Guardian’s balance sheet was comprised primarily of investment securities and purchased loans funded principally by borrowings and certificates of deposit originated through 24 branch offices in Atlanta, Boston, Kansas City and St. Louis, and one Houston location.

Starting in September 2000, our new management team took action to transform the bank by aligning its assets and liabilities with our business strategies. We changed the name of the bank to Encore Bank in September 2001. We targeted professional firms, privately-owned businesses, investors and affluent individuals as clients, and initiated our strategy of providing them with superior service in a “private banking” environment. In four separate transactions in the period from December 2001 to September 2003, we sold all 24 branches located outside our target markets, disposing of $674.9 million in deposits and $50.8 million in real estate. While divesting these branches, we established new private client offices in our target markets. By December 2003, we had opened nine new private client offices in Texas and southwest Florida. We also recruited new lending officers and began changing our asset mix, replacing lower yielding investment securities and purchased mortgage loans with our own higher yielding originated loans. On the liability side, we actively solicited deposits, replacing brokered deposits with core deposits. We now have 17 private client offices in our target markets. As of March 31, 2007, originated loans constituted 84.5% of our loan portfolio and core deposits constituted 79.6% of our total deposits.

In addition to building out our core banking platform, we have also completed and integrated the following series of acquisitions to add wealth management and insurance services to our product offering:

Insurance. On April 30, 2004, we acquired the Town & Country Insurance Agency. The agency, with offices in Houston and Galveston and over 9,000 clients, sells property and casualty insurance and is one of the largest independent agencies in the Houston area and has a clientele that matches our target demographic. On January 1, 2005, Town & Country purchased certain assets and assumed certain liabilities of the Bumstead Insurance Agency, further enhancing the agency’s penetration of affluent households.

Trust. On March 31, 2005, we acquired National Fiduciary Services, N.A. and renamed the entity Encore Trust Company, N.A. Encore Trust Company became a division of Encore Bank on June 30, 2007. Encore Trust provides personal trust services in the greater Houston metropolitan area, Dallas and Austin, Texas. As of March 31, 2007, Encore Trust had $831.0 million in assets under management.

Investment Management and Financial Planning. On August 31, 2005, we acquired Linscomb & Williams, Inc., an investment management and financial planning firm based in Houston. With over 30 years of experience,

 

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Linscomb & Williams is, in the opinion of management, one of Houston’s largest and most respected financial planning firms. As of March 31, 2007, Linscomb & Williams had $1.8 billion in assets under management.

Business Strengths and Growth Strategies

We have now built a platform designed to continue to grow loans and deposits and improve profitability, which we intend to accomplish utilizing the following strengths and strategies:

Optimize our deposit mix. Increasing personal and business checking (noninterest and interest checking, or transaction deposits) is key to our strategy of decreasing our funding costs and continuing to increase our net interest margin from 2.55% for the three months ended March 31, 2007. We have had considerable success in building business demand deposits, which has resulted largely from our continued growth in lending to privately-owned businesses and professional firms and our offering of cash management services. We have increased our transaction deposits to $287.2 million, or 28.8% of total deposits, as of March 31, 2007 from $189.8 million, or 25.1% of total deposits, as of December 31, 2002, a compounded annual growth rate of 10.2%. Also contributing to the reduction in our funding costs is the increase in our core deposits, which consist of transaction deposits, money market and savings accounts and time deposits less than $100,000. As of March 31, 2007, core deposits represented 79.6% of total deposits. Our ability to generate deposits is reflected in the growth of total deposits in Houston and southwest Florida, as our total deposits have grown at a 26.3% compounded annual growth rate since 2002.

Continue to increase loan originations. We believe our seasoned team of commercial lenders can continue to grow commercial loans organically to replace lower yielding securities as they mature and purchased mortgages as they are paid down. From 2002 through March 31, 2007, we have increased our total originated loans by $688.1 million, a compounded annual growth rate of 62.4%, and our total commercial loans by $418.9 million, a compounded annual growth rate of 75.1%.

Expand wealth management and insurance businesses. We believe that our ability to offer sophisticated wealth management products and services within a high-touch community bank framework gives us a competitive advantage and an avenue for growth. In addition, the expected demographic shift should generate more wealth management requirements as baby boomers reach retirement age and inherit additional investment assets. As such, we believe that our wealth management franchise is well positioned to increase its assets under management which have increased from $2.2 billion as of December 31, 2005 to $2.6 billion as of March 31, 2007. Revenues from our wealth management group comprised 50.2% of our first quarter 2007 noninterest income while our insurance group contributed 20.3% of our noninterest income. Our ratio of noninterest income to total revenue for the three months ended March 31, 2007 was 52.40%.

Leverage our infrastructure. Over the past several years, we have made significant investments in our private client offices, people and technology. Since most of our offices are relatively new, we have not maximized their potential and we believe the platform is in place for significant growth with minimal additional expense. In fact, seven of our 17 private client offices were opened in the last three years. Increasing deposits per office and loans per officer should enable us to improve our efficiency ratio from 75.25% for the three months ended March 31, 2007, as well as enhance other profitability ratios.

Acquire compatible banks and financial services companies. Having successfully integrated our recent wealth management and insurance acquisitions, we plan to pursue select acquisitions related to expanding our banking, wealth management and insurance capabilities. We will focus on targets within our existing footprint or other attractive markets with significant core deposits and/or a potential client base compatible with our operating philosophy.

Continue to leverage our experienced management team and board. Our executive management team has a wealth and depth of experience in the financial services industry, which we believe better positions us to take

 

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advantage of future growth opportunities. Our Chief Executive Officer, James S. D’Agostino, Jr., was Chairman, President and Chief Executive Officer of American General Life and Accident Insurance Company (Nashville, TN) from 1993 to 1997 and was Vice Chairman of its parent company, American General Corporation (Houston, TX), until 1999. Prior to these roles, Mr. D’Agostino spent 18 years in commercial banking. Our Chief Financial Officer, L. Anderson Creel, has 30 years of banking and accounting experience, including eight years as Chief Financial Officer of Prime Bancshares, Inc., a publicly traded bank holding company. Before joining us in 2002, Robert Mrlik spent over 13 years at American General, prior to which he worked at several commercial banks. J. Harold Williams brings to us from Linscomb & Williams over 30 years of wealth management experience. Thomas Ray, who runs our Florida operation, has over 26 years of banking experience, mostly in that state. The management team’s operating strategy is guided by our board of directors, which is composed of well-regarded professionals and entrepreneurs with collective depth and experience in wealth management, financial planning, real estate development, private equity investments and commercial banking.

Markets

We operate in what we believe are two of the most attractive banking and wealth management markets in the United States—the greater Houston area and southwest Florida. The Houston economy is strong, diverse and growing, and benefits from large energy and healthcare industries. Houston is also the home to more than 76,000 small businesses. Southwest Florida continues its rapid economic growth supported by a strong increase in population and expanded service-related and healthcare industries. Both markets have a large population of the professional and affluent clients that we target.

Houston Market. We have 11 private client offices in the greater Houston area, which includes high growth areas in Fort Bend, Montgomery and Harris counties. The Houston-Sugar Land-Baytown MSA had a population of approximately 5.6 million people in 2006 and ranked 6th in the nation in terms of size. The Houston-Sugar Land-Baytown MSA had a median household income of approximately $56,000 in 2006, which was 8% higher than the national median. The MSA also has access to approximately $98 billion in deposits. Often called the world’s energy capital, Houston is also home to one of the world’s largest healthcare complexes, the nation’s largest port in volume of foreign tonnage and 24 companies on the 2006 Fortune 500 list. In addition, Houston boasts a significant and growing number of legal and accounting professionals.

Southwest Florida Market. We have expanded our presence to include six private client offices in southwest Florida. The Naples-Marco Island MSA had a population of approximately 325,000 in 2006 and continues to grow rapidly. The Naples-Marco Island MSA is one of the wealthiest in the nation, having a median household income of approximately $59,000 in 2006, which was 15% higher than the national median. The Naples-Marco Island MSA has approximately $11 billion in deposits. We also have private client offices in the Tampa-St. Petersburg-Clearwater and Cape Coral-Ft. Myers MSAs with populations of 2.7 million and 588,000, respectively, in 2006. The Tampa-St. Petersburg-Clearwater MSA and the Cape Coral-Ft. Myers MSA have approximately $55 billion and $11 billion in deposits, respectively. Commercial real estate, residential property and leisure activities have provided stimulus to southwest Florida to service the growing retired population.

Within our target markets, our strategy is to selectively place our attractive private client offices in convenient, high-traffic locations in high net worth areas. For example, in the greater Houston area, we have identified several affluent sub-markets where we operate at major intersections or other highly visible areas. The median household income within our Houston branch zip codes is approximately $91,000, 64% higher than the MSA as a whole, and the comparable figure for our Naples branch zip codes is approximately $75,000, 27% higher than the MSA as a whole. However, by being selective in where we place our offices within each zip code, we believe the household income levels within our sub-markets are higher.

 

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Operating Philosophy

Since our transformation is largely completed, we believe that we are now positioned to become the premier provider in our target markets of banking, wealth management and insurance products and services to professional firms, privately-owned businesses, investors and affluent individuals. These clients include attorneys, doctors and other professionals, real estate developers, executives, entrepreneurs, high net worth families, and their business interests. Our individual clients generally have a net worth of between $500,000 and $20 million. We believe that these clients constitute an underserved market as most wealth management specialists at large commercial banks and other financial services firms typically focus on clients at the upper end of our target range. We offer a broad array of products and services tailored to the objectives of our target clients, ranging from checking accounts to state-of-the-art cash management to real estate loans to sophisticated financial and estate planning, all within a high-touch community bank framework. We believe we are the only community bank within our target markets that focuses on privately-owned businesses and wealth management with such a high level of professional expertise and abundant product offering.

Our clients are served by a private banker or relationship manager who understands each client’s financial needs and offers products and services designed to meet those needs. We believe that our clients and prospects prefer this type of highly personalized service, often referred to as “private banking,” and that our way of building client relationships, while potentially more costly in the short term, yields high returns over the course of the entire relationship. Our private bankers and relationship managers are able to offer traditional banking services and to collaborate with investment management, financial planning, trust and insurance specialists in our subsidiaries to meet our clients’ financial needs. By providing services in this collaborative manner, we believe we are able to diminish the possibility of disintermediation by other financial services providers.

Our private client offices are designed to have the look and feel of a comfortable living room or study and are furnished with a personal computer with internet access, a large screen television tuned to financial news, leather chairs, a library of financial information and a refreshment center.

We believe that the quality of our people is the backbone of our organization-wide commitment to superior client service. Our ability to recruit and retain experienced and motivated financial professionals results from our size, minimal bureaucracy, high growth, abundant product offering and performance-based incentive programs. The continuing high level of merger and acquisition activity in the Texas and southwest Florida financial markets has also enhanced our recruitment efforts. We actively seek to identify and employ quality employees who become available as a result of this activity. We believe that top performers are attracted to us because they can make a significant contribution to our growth and performance while better serving their clients. Our low level of employee turnover has provided a continuity of service that fosters long-term client relationships.

Arnold Palmer has served as our spokesperson since 2001. We are the only financial services organization represented by Mr. Palmer in the United States of America. We believe that using Arnold Palmer as our spokesperson has enhanced the public’s perception of our organization as a significant and trustworthy institution.

Banking Services

Lending Activities

We specialize in lending to professional firms, privately-owned businesses, investors and affluent individuals. The types of loans we make to businesses include commercial loans, commercial real estate loans, real estate construction loans, revolving lines of credit, working capital loans, equipment financing and letters of credit. We focus our lending efforts on commercial-related loans because they are generally higher yielding and often generate a deposit relationship. These loans are primarily originated in our target markets. The types of loans we make to individuals include residential mortgage loans and mortgage loans on investment and vacation properties, unsecured and secured personal lines of credit, home equity lines of credit and overdraft protection.

 

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In connection with our transformation, we purchased residential real estate loans and consumer loans in order to build our loan portfolio and leverage our capital. During the last several years, we have been replacing these purchased loans with our own originated loans. The following table sets forth, as of the dates indicated, the balance of loans we originated and purchased:

 

     As of
March 31,
2007
    As of December 31,  
       2006     2005     2004     2003     2002  
    

(dollars in thousands)

 

Originated loans

   $ 788,489     $ 751,802     $ 606,907     $ 388,798     $ 231,446     $ 100,377  

Purchased loans

     144,304       156,566       201,297       271,896       386,335       445,965  
                                                

Total loans

   $ 932,793     $ 908,368     $ 808,204     $ 660,694     $ 617,781     $ 546,342  
                                                

Originated loans to total loans

     84.5 %     82.8 %     75.1 %     58.8 %     37.5 %     18.4 %

The following is a discussion of our major types of lending:

Commercial Loans

Our commercial loans are primarily made within our market areas and are underwritten on the basis of the borrower’s ability to service the debt from income. As a general practice, we take as collateral a lien on any available real estate, equipment, or other assets owned by the borrower and obtain the personal guaranty of the business owner. In general, commercial loans involve more credit risk than residential mortgage loans and commercial mortgage loans and, therefore, usually yield a higher return. The increased risk derives from the expectation that commercial loans generally will be serviced principally from the operation of the business, which may not be successful, and from the type of collateral securing these loans. Generally, historical trends have shown these types of loans to have higher delinquencies than loans collateralized by real estate. As a result of these additional complexities, variables and risks, commercial loans require more thorough underwriting and servicing than other types of loans.

Underwriting commercial loans focuses on an analysis of cash flow, including primary and secondary sources of repayment, and the stability of the underlying business which provides the cash flow stream for debt service. Coupled with this analysis is an assessment of the financial strength of the guarantor, the borrower’s liquidity and leverage, management experience of the owners or principals, economic conditions, industry trends and the collateral securing the loan. We require a first lien position in all collateral and the loan to value ratio of commercial loans varies based on the collateral securing the loan. Generally, loans collateralized by accounts receivable are financed at 50% to 80% of accounts receivable less than 90 days past due. Loans collateralized by inventory will be made at 50% to 80% of the inventory value. Commercial loans generally have amortization periods from 10 to 25 years, with five year balloon payments, and have fixed or floating interest rates. As of March 31, 2007, we had $115.9 million in commercial loans, which represented 12.4% of our total loans.

Included in commercial loans as of March 31, 2007 are $45.8 million in loans to law firms which are generally made to fund case expenses and which are collateralized by the anticipated fees to be received in pending cases. We require that the amount of anticipated fees be several times greater than the amount of the loan. We also require personal guarantees of the principals of the law firm. These loans represent 39.5% of total commercial loans and 4.9% of total loans, and are our largest concentration within our commercial loans.

Commercial Real Estate Loans

In addition to commercial loans, we originate commercial real estate mortgage loans to finance the purchase of real property, which generally consists of real estate with completed structures. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is dependent, in large part, on sufficient income from the properties securing the loans to cover operating expenses and debt service. As a general practice, we require our commercial real estate loans to be secured by well-managed income producing

 

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property with adequate margins and to be guaranteed by responsible parties. We look for opportunities where cash flow from the collateral provides adequate debt service coverage and the guarantor’s net worth is centered on assets other than the project we are financing.

Our commercial real estate loans are generally secured by first liens on real estate and, if rental property, an assignment of the lease, have fixed or floating interest rates and amortize over a 10 to 20-year period with balloon payments due at the end of one to ten years. Payments on loans secured by such properties are often dependent on the successful operation or management of the properties. Accordingly, repayment of these loans may be subject to adverse conditions in the real estate market or the economy to a greater extent than other types of loans.

In underwriting commercial real estate loans, we seek to minimize the risks in a variety of ways, including giving careful consideration to the property’s operating history, future operating projections, current and projected occupancy, location and physical condition. Our underwriting analysis also includes credit checks, reviews of appraisals and environmental hazards or EPA reports, the borrower’s liquidity and leverage, management experience of the owners or principals, economic conditions and industry trends. Our policies require us to visit properties on an annual basis, but our practice is to conduct more frequent visits of properties if possible. Generally, we will originate commercial real estate loans in an amount up to 85% of the value of improved property, up to 65% of the value of raw land and up to 75% of the value of land to be acquired and developed. As of March 31, 2007, we had $211.0 million in commercial real estate loans, which represented 22.6% of our total loans.

Residential Real Estate Loans

Our lending activities also include the origination of first and second lien residential real estate loans that we consider to be predominately prime, collateralized by residential real estate that is located primarily in our market areas. We offer a variety of mortgage loan products which generally are amortized over 15 to 30 years. We originate second mortgage loans through a network of brokers, primarily in the Houston, Dallas and Austin, Texas markets and, to a lesser extent, the Denver, Colorado market. These loans, which are included on our balance sheet as mortgages held for sale, have fixed rates and are generally sold within 60 days of production.

Our first lien residential real estate loans are collateralized by 1-4 family residential real estate and generally have been originated in amounts of no more than 90% of appraised value, with most being jumbo adjustable rate mortgages. We sell most of our first lien residential real estate loans, although we generally elect to keep for our own account loans that are nonconforming with an adjustable rate that adjusts within a period of not more than five years and made to a client who has a relationship with us or the potential for a relationship. We retain a valid lien on real estate and obtain a title insurance policy that insures that the property is free of encumbrances. We also require hazard insurance in the amount of the loan and, if the property is in a flood plain as designated by the Department of Housing and Urban Development, we require flood insurance. We offer the option to borrowers to advance funds on a monthly basis from which we make disbursements for items such as real estate taxes, private mortgage insurance and hazard insurance.

For the three months ended March 31, 2007, we originated $96.3 million in residential real estate loans, sold $69.4 million in such loans and recognized $2.0 million in gains on such sales and for the year ended December 31, 2006, we originated $458.3 million in residential real estate loans, sold $381.4 million in such loans and recognized $9.6 million in gains on such sales.

From 2000 to 2006, we purchased residential mortgage loans serviced by others in order to build our loan portfolio and leverage our capital. We have not purchased any loans with evidence of deterioration of credit quality for which it was probable, at acquisition date, that we would be unable to collect all contractually required payments. Other than in certain circumstances, including to meet certain regulatory requirements, we do not intend to purchase such loans in the future, as it is inconsistent with our goal of developing client relationships. As of March 31, 2007, we had $141.7 million in purchased residential real estate loans, which represented 42.4% of our residential real estate loans.

 

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As of March 31, 2007, our residential real estate loan portfolio was $334.2 million, which represented 35.8% of our total loans. Of this amount, $45.6 million is repriceable in one year or less and an additional $170.2 million is repriceable in greater than one year to five years.

Real Estate Construction Loans

We make loans to finance the construction of residential properties to clients with a relationship with us or the potential of a relationship. We also make construction loans to custom high-end home builders who operate in the markets where our clients are located, and to a limited extent, to finance commercial properties. Substantially all of our residential construction loans are originated in our Houston market. Real estate construction loans generally are secured by first liens on real estate and have floating interest rates. We employ a third party construction inspector to make regular inspections prior to approval of periodic draws on these loans. Underwriting guidelines similar to those described above under Commercial Real Estate Loans are also used in our construction lending activities. Real estate construction loans involve additional risks attributable to the fact that loan funds are advanced upon the security of a project under construction, and the value of the project is typically dependent on its successful completion. As a result of these uncertainties, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project rather than the ability of a borrower or guarantor to repay the loan. If we are forced to foreclose on a project prior to completion, there is no assurance that we will be able to recover the entire unpaid portion of the loan. In addition, we may be required to fund additional amounts to complete a project and may have to hold the property for an indeterminate period of time.

As of March 31, 2007, real estate construction loans totaled $134.8 million, which represented 14.5% of our total loans. Of this total, $35.3 million in real estate construction loans were to finance residential construction with an identified purchaser, $34.3 million were to finance residential construction with no identified purchaser and $65.2 million were to finance commercial construction.

Consumer Loans

Substantially all of our consumer loan origination function exists to support client relationships. We provide a variety of consumer loans, including automobile loans, personal loans and lines of credit (secured and unsecured) and deposit account collateralized loans. The terms of these loans typically range from 12 to 120 months and vary based upon the nature of the collateral and size of the loan.

Generally, consumer loans entail greater risk than do real estate secured loans, particularly in the case of consumer loans that are unsecured or secured by rapidly depreciating assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan balance. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws may limit the amount which can be recovered on such loans. As of March 31, 2007, we had $19.3 million in other consumer loans, which represented 2.1% of our total loans.

From 2002 through 2005, we originated indirect automobile and boat loans. We eliminated this lending function in the third quarter of 2005, as this type of lending was not consistent with our goal of developing client relationships. As of March 31, 2007, we had $39.2 million in consumer installment-indirect loans, which represented 4.2% of our total loans.

Underwriting Strategy

While Encore Bank’s legal lending limit for loans to one borrower as of March 31, 2007 was $13.8 million, we generally operate within an internal lending guideline equal to less than half of our legal lending limit.

 

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Lending officers are assigned various levels of loan approval authority based upon their respective levels of experience and expertise. Loans with relationships over the lending authority of the account officer up to $2.5 million that conform to policy must be approved by a regional loan committee in Houston or Florida chaired by the respective head of the regional banking group. Loans that either have a total relationship exceeding $2.5 million or do not conform to policy must be approved by the senior loan committee, which includes our Chief Executive Officer, Chief Financial Officer and Chief Credit Officer, and loans with a total relationship exceeding $7.5 million must be approved by the board of directors of Encore Bank.

Loan decisions are documented as to the borrower’s business, purpose of the loan, evaluation of the repayment source and the associated risks, evaluation of collateral, covenants and monitoring requirements, and the risk rating rationale. When making consumer loans, we use standard credit scoring systems to assess the credit risk of consumers. Our loan committees generally meet three times weekly to evaluate applications for new and renewed loans, or modifications to loans, in which the loan relationship is above an individual loan officer’s approval authority. Our strategy for approving or disapproving loans is to follow conservative loan policies and consistent underwriting practices which include:

 

   

knowing our clients;

 

   

granting loans on sound and collectible basis;

 

   

ensuring that primary and secondary sources of repayment are adequate in relation to the amount of the loan;

 

   

developing and maintaining our targeted levels of diversification for our loan portfolio as a whole and for loans within each category; and

 

   

ensuring that each loan is properly documented and that any insurance coverage requirements are satisfied.

Managing credit risk is a company-wide process. Our strategy for credit risk management includes well-defined, centralized credit policies, uniform underwriting criteria, and ongoing risk monitoring and review processes for all commercial and consumer credit exposures. The strategy also emphasizes regular credit examinations and management reviews of loans exhibiting deterioration in credit quality. While each business unit has the primary responsibility for managing its own credit risk, our Chief Credit Officer provides bank-wide credit oversight and periodically reviews all credit risk portfolios to ensure that the risk identification processes are functioning properly and that our credit standards are followed. In addition, a third party loan review is performed approximately three times annually to identify problem assets. We strive to identify potential problem loans early in an effort to aggressively seek resolution of these situations before the loans become a loss, record any necessary charge-offs promptly and maintain adequate allowance levels for probable loan losses inherent in the loan portfolio. Our Chief Credit Officer provides a quarterly review to Encore Bank’s asset classification committee, which reviews credit concerns and reports to the board of directors.

Deposit Products and Other Sources of Funds

Our primary sources of funds for use in our lending and investing activities consist of deposits, maturities and principal and interest payments on loans and securities and other borrowings. We closely monitor rates and terms of competing sources of funds and utilize those sources we believe to be most cost effective and consistent with our asset and liability management policies.

Deposits

Deposits are our principal source of funds for use in lending and for other general business purposes. We provide checking, savings, money market accounts, time deposits ranging from 90 days to five years and individual retirement accounts. For businesses, we provide a range of cash management products and services. As of March 31, 2007, core deposits (which consist of noninterest-bearing deposits, interest checking, money

 

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markets, savings and time deposits less than $100,000) were $793.4 million, or 79.6% of total deposits, while time deposits $100,000 and greater and brokered deposits made up 20.4% of total deposits.

An important balance sheet component impacting our net interest margin is the composition of our deposit base. We believe that we can improve our net interest margin by growing our core deposits, as we believe they are less sensitive to our competitors’ interest rates. We attempt to price our deposit products in order to promote core deposit growth and maintain our liquidity requirements in order to satisfy client needs.

In connection with our transformation, we disposed of deposits and branches outside our target markets and actively solicited deposits within our target markets, replacing brokered deposits with core deposits. The following table sets forth, as of the dates indicated, the amount of our deposits held by clients located inside and outside our market areas:

 

     As of
March 31,
2007
    As of December 31,  
       2006     2005     2004     2003     2002  
    

(dollars in thousands)

 

Houston and Florida deposits

   $ 986,776     $ 1,021,844     $ 806,412     $ 678,502     $ 566,797     $ 365,624  

Other deposits (1)

     10,522       8,967       8,662       50,826       176,337       389,136  
                                                

Total deposits

   $ 997,298     $ 1,030,811     $ 815,074     $ 729,328     $ 743,134     $ 754,760  
                                                

Houston and Florida deposits to total deposits

     98.9 %     99.1 %     98.9 %     93.0 %     76.3 %     48.4 %

(1) Includes brokered certificates of deposit and deposits in branches previously disposed.

We intend to continue our efforts to attract deposits from our business lending relationships in order to reduce our cost of funds and improve our net interest margin. We believe that we have the ability to attract sufficient additional deposits by repricing the yields on our certificates of deposit in order to meet loan demand during times that growth in core deposits lags growth in loan demand.

We have a relatively new branch network, as seven of our private client offices were added within the last three years. We believe that our offices still have significant growth potential and, thus, we have ample deposit growth potential without significantly increasing our number of offices. Further, our insurance and wealth management businesses, which we acquired in 2004 and 2005 have large client bases that we expect will provide additional deposit growth and cross-selling opportunities.

Borrowings, Repurchase Agreements and Junior Subordinated Debentures

We borrow from the Federal Home Loan Bank (FHLB) pursuant to a blanket lien based on the value of our loans and securities. These borrowings provide a cost effective alternative in a competitive deposit market. As of March 31, 2007, we had $35.0 million in long-term borrowings with remaining maturity of greater than one year and $67.0 million in short-term borrowings with remaining maturity of one year or less from the FHLB.

We also obtain other overnight borrowed funds under arrangements with certain clients and investment banks whereby investment securities are sold under an agreement to repurchase the next business day. These borrowing arrangements are collateralized by pledging applicable investment securities. The borrowing costs of these arrangements are priced lower than the daily Federal funds rate. As of March 31, 2007, we had $55.1 million in repurchase agreements.

In addition, we have raised additional regulatory capital through the issuance of junior subordinated debentures in connection with trust preferred securities issuances by separate non-consolidated statutory trust subsidiaries in April 2002 (which were redeemed and replaced with a new issue of junior subordinated debentures in April 2007) and September 2003.

 

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Wealth Management Services

We provide a wide variety of wealth management services to our clients through our subsidiary, Linscomb & Williams, Inc., and the trust division of Encore Bank, Encore Trust, which we manage as one segment. As of March 31, 2007, we had $2.6 billion in assets under management in our wealth management group.

Linscomb & Williams, Inc.

Linscomb & Williams is an investment management and financial planning firm that operates primarily in the Houston market. Linscomb & Williams provides fee-based financial planning services for clients and investment management services for a quarterly management fee based on the value of assets in the account. The majority of Linscomb & Williams’ fees originate from investment management services. Linscomb & Williams has been in Houston for over 30 years and all of the senior staff from the firm have remained with our company after we acquired it in August 2005. As of March 31, 2007, Linscomb & Williams had $1.8 billion in assets under management.

Through Linscomb & Williams, we offer personal financial planning based on a comprehensive review and coordination of a client’s financial situation and objectives that may include asset preservation/protection, employee benefits, estate planning, investments and asset allocation, retirement planning, risk management and insurance and tax planning. We also assist our clients in preparing for special situations by offering financial planning tailored to specific situations such as charitable giving, death of a spouse, divorce, education funding, executive benefits/stock options, inheritance, legal settlements, long-term care, retirement plan distributions and wealth transfer. Additionally, we provide financial services for businesses through financial counseling for employees, financial planning for executives and financial workshops for employees.

Our investment management services include comprehensive investment planning and implementation for individual and business clients including understanding client objectives and risk tolerance, developing appropriate asset allocation, selecting and implementing specific investments, regular reviewing and monitoring of client portfolios and providing regular market comments, comprehensive quarterly reports and attentive servicing of each client’s needs. For discretionary investment management services, we charge a quarterly management fee in arrears, which is generally determined on a sliding scale based on the portfolio value.

We also provide investment consulting services to individuals, companies and qualified retirement plans, which may include assistance in developing a written statement of investment policy to provide guidance on asset allocation, asset allocation studies, assistance with money manager searches and/or mutual fund selection, manager and/or mutual fund performance measurement and/or portfolio monitoring, review of portfolio allocation and construction and assistance with programs of employee investment education for firms sponsoring participant-directed retirement plans.

Encore Bank’s Trust Division

Encore Trust became a division of Encore Bank as of June 30, 2007 in connection with the merger of Encore Bank with Encore Trust Company. Prior to this merger, Encore Trust Company was a subsidiary of Encore Bank. Encore Trust provides trust services primarily to individuals in Houston, Austin and Dallas. The personal trust business focuses primarily on the Houston market to service the needs of individuals. We also administer court-appointed trusts on behalf of individuals in Houston, Austin and Dallas who receive monetary awards. As of March 31, 2007, Encore Trust had $831.0 million in assets under management.

We deliver trust services to individuals under the supervision of trust professionals. Our level of involvement—from full management to specific assistance—is based on our client’s needs, the type of trust established and the responsibilities assigned in the trust agreement. Our trust officers possess an average of 25 years of trust experience, which enables them to provide prudent and efficient management of trust assets in administering complex financial holdings. We administer personal trusts, assist with estate trust administration, handle charitable trust and foundation needs and manage employee retirement assets in retirement programs, such as profit sharing plans, defined benefit plans, money purchase plans, individual retirement plans and non-qualified retirement trusts for employee benefit trusts.

 

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We also provide management of judgment or settlement awards for minors or incapacitated persons. We handle Section 142 Trusts, Section 867 Trusts, Special Needs Trusts, 468b Qualified Settlement Fund Trusts and U.S. Government Periodic Payment Trusts, which offer alternatives to registries of the court, annuities and guardianships. While the company we acquired and made a division of Encore Bank known as Encore Trust has been in business for over 50 years, approximately ten years ago the company created a special team to focus specifically on court trust business. Court-created trusts benefit clients by providing the flexibility to adapt the administration of the trust to the needs of our clients, as those needs change, protecting assets to balance near and long-term needs, allowing distributions without court expense, providing professional money management, creating a competitive return on investment, safeguarding against inflation, providing accurate trust accounting, allowing the ability to adjust to market conditions, avoiding liability and malpractice issues and having the balance of principal returned at the trust end, unlike the payout system of annuities.

Insurance

We offer a wide variety of personal and commercial property and casualty insurance products through our insurance agency, Town & Country Insurance Agency, Inc. With offices in Houston, Galveston and, most recently, Fort Worth, Town & Country has been providing personal and commercial insurance for almost 40 years. As of March 31, 2007, we had over 9,000 insurance clients and were one of the largest independent insurance brokerage companies in the Houston metropolitan area. Town & Country provides commercial, personal, and life and health insurance for businesses and individuals through a staff of 32 licensed and experienced insurance professionals. Our independent insurance professionals can help clients select the coverage and price best suited to their particular needs. In addition to home, auto, business and life insurance, we also offer condominium and renters insurance, fine art coverage, personal umbrella policies and boat insurance. Our business coverages include medical and legal professional liability, director and officer, fleet, worker compensation, property, liability and energy policies. Our insurance partners include AIG, Chubb Group of Insurance Companies, Fidelity National Financial, Hanover Insurance, Progressive, Texas Mutual Insurance Company, Travelers, The Hartford and Zurich Insurance and have access to London and Bermuda markets through third party partners.

Competition

The banking, wealth management and insurance businesses are highly competitive, and our profitability depends principally on our ability to compete in the market areas in which we are located. In our banking business, we experience substantial competition in attracting and retaining deposits and in making loans. The primary factors we encounter in competing for deposits are convenient office locations and rates offered. Direct competition for deposits comes from other commercial banks and thrift institutions, money market mutual funds and corporate and government securities which may offer more attractive rates than insured depository institutions are willing to pay. The primary factors we encounter in competing for loans include, among other things, the interest rate, loan origination fees and the range of services offered. Competition for commercial real estate loans normally comes from other commercial banks, thrift institutions, mortgage bankers and mortgage brokers, and insurance companies. We believe that we have been able to compete effectively with other financial institutions by emphasizing client service, by establishing long-term relationships and building client loyalty, and by providing products and services designed to address the specific needs of our clients.

Our senior management reviews rate surveys weekly to ensure that we are consistently offering competitive rates. The financial institutions included in the surveys are located in our market areas and were selected based on their asset size, branch network and their consistent advertisement of similar products. We also survey the top ten mortgage lenders in each market to ensure that our rates are competitive. In addition, newspapers we advertise in are monitored weekly to review the competition’s advertising for both deposit and loan products.

Our loan and deposit rates are set by region, which enables us to respond timely to the local market conditions. We closely monitor competitor responses regarding our rates and product types to ensure that we are emphasizing the most effective products and utilizing the most efficient rates in each market. Ultimately, we seek to balance the rate levels in each region to achieve the appropriate overall target cost of funds.

 

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In providing wealth management services, we compete with a wide variety of firms including national and regional investment management and financial planning firms, broker-dealers, accounting firms, trust companies and law firms. Many of these companies have greater resources and may already have relationships with our clients in related product areas. We believe that our ability to compete effectively with other firms is dependent upon the quality and level of service, personal relationships, price and investment performance. These factors are also the basis for competition in the insurance industry. With respect to our insurance business, some of Town & Country’s competitors are larger and have greater resources than we do and operate on an international scale. We are also in competition with insurance companies that write insurance directly for their customers as well as companies that provide self-insurance and other employer-sponsored programs.

Properties

We operate 17 private client offices through Encore Bank. We also operate four offices of Encore Trust, three offices of Town & Country Insurance and one office of Linscomb & Williams. We lease all of our locations, except with respect to our private client offices located at 6330 San Felipe, 5815 Kirby, 3754 Westheimer, 5548 FM 1960 and 4647 Sweetwater Blvd., where in each location we own the building and lease the underlying land. Our principal office is located at Nine Greenway Plaza, Suite 1000, Houston, Texas, 77046. The following table sets forth our banking, wealth management and insurance office locations, the date we opened or acquired them, the square footage and, with respect to our private client offices, the amount of deposits:

 

Type of Office

   Date Opened/
Acquired
   Square Footage    Deposits as of
March 31, 2007 (1)
 
               (dollars in thousands)  

Private Client Offices—Houston Market

        

Houston, Texas

        

12520 Memorial Drive

   11/01/2000    2,886    $ 116,253  

2049 West Gray

   8/01/2002    2,000   

 

111,461

 

6330 San Felipe

   3/17/2003    4,750   

 

77,895

 

909 Fannin, Suite 1350

   8/04/2003    5,563      71,189  

6411 Fannin, Suite 222 (2)

   2/15/2007    4,102      10,406  

5815 Kirby

   1/20/2004    2,720      43,410  

3754 Westheimer

   1/05/2004    3,200      38,001  

5548 FM 1960 West

   7/14/2003    3,895      51,959  

Nine Greenway Plaza, Suite 1000 (2)

   3/21/2005    70,071      196,166 (3)

Sugar Land, Texas

        

4647 Sweetwater Blvd., Suite A.

   5/30/2006    3,500      14,603  

The Woodlands, Texas

        

9595 Six Pines Drive, Suite 1500

   9/07/2004    3,800      16,207  
Private Client Offices—Florida Market         

Sun City Center

        

1653 Sun City Plaza, Suite 1001 (2)

   9/04/2001    2,092      69,303  

Ft. Myers

        

7091 College Parkway, Suite 16

   10/16/2001    2,511      37,936  

Clearwater

        

2566 McCullen Booth Road, Suite G

   3/25/2002    2,000      42,359  

Belleair Bluffs

        

2973/2975 West Bay Drive

   4/08/2002    2,100      55,055  

Naples

        

10600 Tamiami Trail N., Suite 604

   4/19/2004    4,240      43,055  

3003 Tamiami Trail, Suite 100

   1/03/2007    5,651      2,040  
Loan Production Offices—Florida Market         

Ft. Myers

        

2627 McCormick, #102

   6/01/2005    2,200      N/A  

Clearwater

        

8200 College Parkway, Suite 202

   6/01/2005    1,452      N/A  

 

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Type of Office

   Date Opened/
Acquired
   Square Footage    Deposits as of
March 31, 2007
               (dollars in thousands)
Encore Trust Offices         

Houston, Texas

        

10411 Westheimer, 2nd Fl.

   3/31/2005    17,199    N/A

Nine Greenway Plaza, Suite 1000

   3/31/2005    4,800    N/A

Dallas, Texas

        

5956 Sherry Lane Place, Suite 630

   3/31/2005    2,079    N/A

Austin, Texas

        

100 Congress Ave.

   3/31/2005    400    N/A
Town & Country Offices         

Houston, Texas

        

10575 Katy Freeway, Suite 150

   4/30/2004    6,653    N/A

Galveston, Texas

        

1605 Tremont

   4/30/2004    2,400    N/A

Ft. Worth, Texas

        

307 W. 7th Street, Suite 1800

   4/01/2006    260    N/A
Linscomb & Williams Office         

Houston, Texas

        

1400 Post Oak Blvd., Suite 1000

   8/31/2005    8,891    N/A

(1) The deposits as of March 31, 2007 are shown on a pro forma basis to give effect to the merger of Encore Bank and Encore Trust Company which was consummated as of June 30, 2007. In connection with the merger, the main office of Encore Bank was relocated from our private client office at 10600 Tamiami Trail N., Naples, Florida, to our private client office at Nine Greenway Plaza, Houston, Texas. The merger did not impact the amount of deposits at any private client office, except as indicated in footnote 3.

 

(2) These private client offices also offer wealth management services.

 

(3) Includes $149.5 million in corporate deposits which are related to commercial accounts and generally associated with Encore Bank’s main office. These deposits were relocated to the Nine Greenway Plaza private client office upon consummation of the merger of Encore Bank and Encore Trust Company as of June 30, 2007.

Employees

As of March 31, 2007, we had 318 full-time employees. Management considers our relations with employees to be good. Neither we nor Encore Bank or any of its subsidiaries are a party to any collective bargaining agreement.

Legal Proceedings

We and Encore Bank and its subsidiaries from time to time will be party to or otherwise involved in legal proceedings arising in the normal course of business. Management does not believe that there is any pending or threatened legal proceeding against us or Encore Bank or its subsidiaries which, if determined adversely, would have a material adverse effect on our or Encore Bank’s financial condition, results of operations or cash flows.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the major elements of our consolidated balance sheets and consolidated statements of earnings. This section should be read in conjunction with our audited consolidated financial statements and related notes as of December 31, 2006 and 2005 and for each of the three years ended December 31, 2006 and our unaudited interim consolidated financial statements and related notes as of March 31, 2007 and for the three months ended March 31, 2007 and 2006, which are included in this prospectus. In addition to the historical information provided below, we have made certain estimates and forward-looking statements that involve risks and uncertainties. Our actual results could differ significantly from those anticipated in these estimates and in the forward-looking statements as a result of certain factors, including those discussed in the section of this prospectus captioned “Risk Factors,” and elsewhere in this prospectus.

General

We generate our revenue from net interest income and noninterest income. Net interest income is the difference between interest income on interest-earning assets such as loans and securities and interest expense on interest-bearing liabilities such as client deposits and other borrowings that are used to fund those assets. Net interest income is a significant contributor to net earnings. Interest rate fluctuations, as well as changes in the amount and type of earning assets and liabilities, combine to affect net interest income.

During the past two years we have generated the largest portion of our noninterest income through trust and investment management fees and mortgage banking income. We also have an insurance agency that generates commissions on sales of insurance. Trust and investment management fees, mortgage banking income, insurance commissions and gain or loss on the sale of securities are reported in our consolidated statement of earnings under “noninterest income.” Offsetting these earnings are operating expenses referred to as “noninterest expense.” Because banking is a labor intensive business, our largest operating expense is employee compensation.

While Encore Bank has been in existence since 1928, October 1, 2000 marked the beginning of our existing business strategy as our current ownership and management team formed our company and assumed control of Encore Bank. Since that date, we have transformed from a mortgage loan, security and wholesale deposit strategy into a more relationship driven loan and deposit strategy. In the process of this transformation, we sold a significant amount of assets, including investment securities and real estate, sold interest rate caps and made significant investments in building a loan platform which would allow us to originate higher yielding commercial loans. We also made significant changes to our branch network by selling our branches in St. Louis, Kansas City, Atlanta and Boston and opening new private client offices in Houston and southwest Florida. As a result of the sale of those branches and certain real estate, we recognized non-recurring gains of $370,000, $303,000, $3.9 million, $6.1 million and $8.4 million for the years ended December 31, 2006, 2005, 2004, 2003 and 2002, respectively. We recognized non-recurring gains of $0 and $144,000 for the three months ended March 31, 2007 and 2006, respectively. In addition, we added the insurance and wealth management lines of business which have significantly diversified our noninterest income.

Effective March 30, 2007, Encore Bank converted from a federal savings association to a national banking association subject to supervision and regulation by the Office of the Comptroller of the Currency. In connection with the conversion, we became a bank holding company subject to supervision and regulation by the Board of Governors of the Federal Reserve System. When we acquired Encore Bank, it was primarily a mortgage lender, and the rules and regulations governing thrifts and regulation by the Office of Thrift Supervision were more suitable for an entity engaging in that activity. As we have transformed our business by increasing commercial loans, we believe that operation as a national bank regulated by the OCC is consistent with our business plan to better serve the financial needs of our target market. Although we are continuing our transformation process, we believe that we have put in place the primary infrastructure to enable us to realize our vision of becoming the premier provider of banking, wealth management and insurance products and services to professional firms, privately-owned businesses, investors and affluent individuals in the markets we serve.

 

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Throughout this building process, lower yielding purchased mortgage loans and securities have paid down or matured and been replaced with our own originated loans. Consequently, while our total assets have not increased significantly, our net interest margin and other profitability measures have improved primarily due to the higher yielding mix of earning assets.

Our core products have grown significantly from 2004 to 2006:

 

   

Average loans grew by 34.2% (up 93.4% excluding residential mortgage loans)

 

   

Average core deposits grew by 26.3%

 

   

Assets managed and administered totaled $2.5 billion

Recent Developments

Trust Preferred Securities Issuance. On April 19, 2007, we issued $15.5 million of junior subordinated debentures to Encore Capital Trust III. The junior subordinated debentures, which mature on April 19, 2037, bear a fixed rate of 6.85% until April 19, 2012, at which date we may call the junior subordinated debentures, and a floating rate equal to 3 month LIBOR + 1.75% thereafter. With the proceeds of these junior subordinated debentures, on April 23, 2007 we redeemed an aggregate of $15.5 million of junior subordinated debentures we had issued on April 10, 2002 at a floating rate equal to 6 month LIBOR + 3.70%.

Merger of Encore Bank and Encore Trust Company. As part of a corporate reorganization following the conversion of Encore Bank to a national banking association, on June 1, 2007, Encore Bank and Encore Trust Company entered into an Agreement and Plan of Merger pursuant to which Encore Bank was merged with and into Encore Trust Company as of June 30, 2007. The resulting bank, which was renamed Encore Bank, N.A., operates as a national banking association with its main office in Houston, Texas. Following the merger, the business of Encore Trust Company is being conducted as a division of Encore Bank.

Critical Accounting Policies

The accounting principles we follow and the methods of applying these principles conform with generally accepted accounting principles in the United States of America (GAAP) and with general practices within the banking industry. Our critical accounting policies relate to (1) the allowance for loan losses, (2) income taxes, (3) goodwill and intangible assets and (4) stock-based compensation. These critical accounting policies require the use of estimates, assumptions and judgments which are based on information available as of the date of the relevant financial statement. Accordingly, as this information changes, future financial statements could reflect the use of different estimates, assumptions and judgments. Certain determinations inherently have a greater reliance on the use of estimates, assumptions and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported.

Allowance for Loan Losses. We maintain an allowance for loan losses sufficient to absorb probable losses inherent in the loan portfolio, and Encore Bank’s asset classification committee and board of directors evaluates the adequacy of the allowance for loan losses on a quarterly basis. We estimate the adequacy of the allowance using, among other things, historical loan loss experience, the growth, composition and diversification of our loan portfolio, current delinquency levels, adverse situations that may affect the borrower’s ability to repay, estimated value of the underlying collateral, the results of recent regulatory examinations and general economic conditions. While we estimate the allowance for loan losses, in part, based on historical losses within each loan category, estimates for losses within the commercial portfolio are more dependent upon credit analysis and recent payment performance. Allocation of the allowance may be made for specific loans or loan categories, but the entire allowance is available for any loan that, in our judgment, should be charged off.

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are individually classified as impaired. The general component covers non-classified and classified loans without a specific allowance and is based on the factors discussed in the preceding paragraph. We increase the amount of the allowance allocated to commercial and consumer loans in response to the growth of the

 

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commercial and consumer loan portfolios and recognition of the higher risks and loan losses in these lending areas. Allowance estimates are considered a prudent measurement of the risk in the loan portfolio and are applied to individual loans based on loan type. If the mix and amount of future charge-off percentages differ significantly from those assumptions used by us in making our determination, the adequacy of our allowance for loan losses could be materially affected.

Income Taxes. The calculation of our income tax provision is complex and requires the use of estimates and judgment in its determination. We are subject to the income tax laws of the various jurisdictions where we conduct business, and we estimate income tax expense based on amounts expected to be owed to these various tax jurisdictions. On a quarterly basis, we evaluate the reasonableness of our effective tax rate based upon our current net earnings and the applicable statutory tax rates expected for the full year. The estimated income tax expense is reported in our consolidated statement of earnings. We assess the appropriate tax treatment of transactions and filing positions after considering statutes, regulations, judicial precedent and other pertinent information, and we maintain tax accruals consistent with our evaluation. Changes in the estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, the status of examinations by the taxing authorities, and newly enacted statutory, judicial, and regulatory guidance that could impact the relative merits of the tax positions. These changes, when they occur, impact accrued taxes and can materially affect our operating results. For additional information, see Note J, “Income Taxes,” to our consolidated financial statements included in this prospectus.

Goodwill and Intangible Assets. Goodwill and intangible assets that have indefinite useful lives are subject to an impairment test at least annually and more frequently if circumstances indicate their value may not be recoverable. Goodwill is tested for impairment using a two-step process that begins with an estimation of the fair value of each of our reporting units compared to its carrying value. If a reporting unit’s carrying value exceeds its fair value, a second test is completed comparing the implied fair value of the reporting unit’s goodwill to its carrying value to measure the amount of impairment. Other identifiable intangible assets that are subject to amortization are amortized on an accelerated basis over their estimated useful lives, ranging from two to 20 years. These amortizable intangible assets are reviewed for impairment if circumstances indicate their value may not be recoverable. Based on our most recent annual goodwill impairment test, management does not believe any of our goodwill is impaired as of December 31, 2006.

Stock-Based Compensation. Effective January 1, 2006, we adopted Statement No. 123R which requires companies to measure and recognize compensation expense for all stock-based payments at fair value. SFAS No. 123R is being applied on the modified prospective basis. Prior to the adoption of SFAS No. 123R, we applied the intrinsic value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations including FASB Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25, to account for our fixed-plan stock options and followed the disclosure requirements of SFAS No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure. Under the intrinsic value-based method, compensation expense was recognized only to the extent that the current market price of the underlying stock on the date of grant exceeded the exercise price. Because, historically, we have granted stock options with an exercise price equal to the current market price of the underlying stock, we had not recognized any compensation expense related to stock options granted to employees. Historically we have, however, recognized compensation expense related to stock options granted to non-employees and restricted stock awards.

Among other things, SFAS No. 123R eliminates the ability to account for stock-based compensation using the intrinsic value-based method of accounting and requires that such transactions be recognized as compensation expense in the consolidated statement of earnings based on their fair values on the date of the grant. SFAS No. 123R requires that management make assumptions including stock price volatility and employee turnover that are utilized to measure compensation expense. The fair value of stock options granted is estimated at the date of grant using the Black-Scholes option-pricing model. This model requires the input of highly subjective assumptions, which are set forth in Note L to our consolidated financial statements included in this prospectus.

 

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Accounting Policies Recently Adopted and Pending Accounting Pronouncements

On January 1, 2007, we adopted the following new accounting pronouncements:

FIN 48—Financial Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement 109; and

FAS 155—Statement of Financial Accounting Standards 155, Accounting for Certain Hybrid Financial Instruments, and amendment of FASB Statements 133 and 140.

The adoption of FAS 155 did not have any effect on our consolidated financial statements at the date of adoption. The adoption of FIN 48 resulted in a cumulative adjustment of $150,000 that decreased retained earnings as discussed in Note D, “Income Taxes,” to our interim consolidated financial statements included in this prospectus.

Recently issued and pending accounting pronouncements are disclosed in Note A, “Summary of Significant Accounting Policies,” to our consolidated financial statements included in this prospectus.

Acquisitions

During the three months ended March 31, 2007 and 2006 and the years ended December 31, 2006, 2005 and 2004, our earnings performance was impacted by the following acquisitions:

On April 30, 2004, we acquired Town & Country Insurance Agency, Inc., a Houston-based insurance agency with offices on the west side of Houston and in Galveston, Texas. The consideration for the acquisition was $3.8 million in cash and $926,000 in notes payable. As a result of the transaction, we recorded $3.0 million in goodwill. On January 1, 2005, Town & Country purchased certain assets and assumed certain liabilities of the Bumstead Insurance Agency, a Houston-based insurance agency, for $750,000 in cash.

On March 31, 2005, we acquired National Fiduciary Services, N.A., a Houston-based trust company. National Fiduciary Services, renamed Encore Trust Company, N.A., and subsequently made a division of Encore Bank as of June 30, 2007, had $735.6 million in assets under management as of the acquisition date, excluding trust related assets subsequently sold. The consideration for the acquisition was $15.5 million, which consisted of $13.5 million in cash and $2.0 million (170,164 shares) in our common stock. As a result of the transaction, we recorded $11.1 million in goodwill.

On August 31, 2005, we acquired Linscomb & Williams, Inc., a Houston-based investment management and financial planning business. Linscomb & Williams had $1.3 billion in assets under management as of the acquisition date. The consideration for the acquisition was $16.3 million, which consisted of $6.0 million in cash and $10.3 million (773,616 shares) in our common stock, plus a contingent payment that may be made on March 31, 2010 depending on the amount of after-tax net earnings of Linscomb & Williams from the acquisition date through December 31, 2009, subject to certain limitations. As a result of the transaction, we recorded $13.8 million in goodwill. Linscomb & Williams and Encore Trust, now a division of Encore Bank, comprise our wealth management group.

For the Three Months Ended March 31, 2007 and 2006

Key Financial Measures

Our net earnings decreased $491,000, or 21.7%, to $1.8 million for the three months ended March 31, 2007 compared with $2.3 million for the three months ended March 31, 2006. Our diluted earnings per common share were $0.22 for the three months ended March 31, 2007 compared with $0.29 for the same period in 2006, a decrease of 24.1%. Our net earnings and diluted earnings per common share decreased primarily due to a reduction in mortgage banking income in the first quarter of 2007, which resulted from a slowdown in the housing market and lower premiums on sales of residential real estate loans due primarily to changes in the market for mortgage loans.

Our return on average assets was 0.55% for the three months ended March 31, 2007 compared with 0.70% for the three months ended March 31, 2006. Our return on average equity was 6.68% for the quarter ended March 31, 2007

 

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compared with 9.38% for the same period in 2006. The decrease in both ratios was due primarily to the aforementioned reduction in mortgage banking income. Our return on average equity for the three months ended March 31, 2007 and 2006 includes $10.0 million and $10.3 million, respectively, in puttable common stock associated with the Linscomb & Williams acquisition. See the section of this prospectus captioned “—Financial Condition—Shareholders’ Equity and Puttable Common Stock” for a detailed discussion of the puttable common stock.

Our net interest margin was 2.55% for the three months ended March 31, 2007 compared with 2.50% for the three months ended March 31, 2006. Our net interest margin continued to improve due to our more favorable mix of earning assets, as originated loans continued to replace lower yielding purchased mortgage loans and securities.

Our efficiency ratio (calculated by dividing total noninterest expense, less amortization of intangibles, by the sum of net interest income plus noninterest income, excluding gain and losses on sales of securities) was 75.25% for the three months ended March 31, 2007 compared with 74.40% for the same period in 2006. The efficiency ratio is a supplemental financial measure utilized in management’s internal evaluation of our performance and is not defined under GAAP. An increase in the efficiency ratio indicates that more resources are being utilized to generate the same dollar amount of income, while a decrease indicates a more efficient allocation of resources. The increase in our efficiency ratio in the first quarter of 2007 compared with the first quarter of 2006 was due primarily to revenue decreasing more than expenses. Revenue, defined as net interest income plus noninterest income, decreased 6.3% in the three months ended March 31, 2007 compared with the same period in 2006, due primarily to a decline in mortgage banking income.

Our total assets decreased $41.9 million, or 3.1%, to $1.3 billion as of March 31, 2007 compared with total assets of $1.3 billion as of December 31, 2006 primarily as the result of our sale in the first quarter 2007 of $41.0 million in lower yielding securities to improve the overall mix of our balance sheet. Our loan portfolio grew $24.4 million, or 2.7%, to $932.8 million as of March 31, 2007 compared with loans as of December 31, 2006. Shareholders’ equity increased $3.3 million, or 3.1%, to $108.9 million as of March 31, 2007 compared with shareholders’ equity and puttable common stock of $105.7 million as of December 31, 2006. The puttable common stock was reclassified to shareholders’ equity on March 30, 2007 as a result of the termination of the put agreement to which the shares were subject.

Results of Operations

Net Interest Income

Our operating results are significantly impacted by net interest income, which represents the amount by which interest income on interest-earning assets, including securities and loans, exceeds interest expense incurred on interest-bearing liabilities, including deposits and other borrowed funds. Net interest income is a key source of our earnings. Interest rate fluctuations, as well as changes in the amount and type of earning assets and liabilities, combine to affect net interest income. Net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as “volume changes.” It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as “rate changes.”

Net interest income increased $169,000, or 2.3%, to $7.7 million for the three months ended March 31, 2007 compared with $7.5 million for the comparable period in 2006. Because average interest-earning assets remained relatively unchanged in the first quarter of 2007 compared with the first quarter of 2006, the increase in net interest income was primarily due to a 5 basis point increase in our net interest margin to 2.55%. This increase resulted primarily from an improvement in our asset composition, as average loans in the first quarter of 2007 increased $107.0 million, or 13.2%, compared with the first quarter of 2006. The increase in average loans was primarily in commercial loan categories, which consisted generally of higher yielding, floating rate loans, which benefited from an increase in short-term rates in the first half of 2006. Consistent with our strategy, this increase in loans was complemented by a $83.2 million, or 26.4%, reduction in lower yielding securities. As a result of this shift, average loans increased to 75.1% of average earning assets for the first quarter of 2007 compared with 66.5% for the first quarter of 2006. The yield on average earning assets increased 53 basis points and our average

 

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loan yield rose 44 basis points in the first quarter of 2007 compared with the same quarter of 2006. Our net interest margin further benefited from a $28.8 million, or 37.3%, increase in demand deposit balances. Average deposits rose $197.7 million, or 24.7%, which allowed us to decrease average borrowings by $201.6 million, or 53.9%. The shift from borrowings to deposits improved our net interest margin because wholesale borrowings are generally more expensive than deposits.

The following table sets forth for the periods indicated an analysis of net interest income by each major category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest earned or paid on such amounts and the average rate earned or paid. The table also sets forth the average rate earned on total interest-earning assets, the average rate paid on total interest-bearing liabilities and the net interest margin for the same periods. All balances are daily average balances and nonaccrual loans were included in average loans with a zero yield for the purpose of calculating the rate earned on total loans. We have no tax-exempt securities and an insignificant amount of tax-exempt loans, and no tax equivalent adjustments have been made with respect to these loans.

 

     For the Three Months Ended March 31,  
     2007     2006  
     Average
Outstanding
Balance
    Interest
Earned/
Paid
   Average
Yield/
Rate
    Average
Outstanding
Balance
    Interest
Earned/
Paid
   Average
Yield/
Rate
 
     (dollars in thousands)  

Assets:

              

Interest-earning assets:

              

Loans

   $ 916,523     $ 15,808    6.99 %   $ 809,487     $ 13,079    6.55 %

Mortgages held for sale

     52,273       1,121    8.70       67,485       1,403    8.43  

Securities

     232,154       2,273    3.97       315,311       3,073    3.95  

Federal funds sold and other

     19,412       278    5.81       24,639       265    4.36  
                                  

Total interest-earning assets

     1,220,362       19,480    6.47       1,216,922       17,820    5.94  

Less: Allowance for loan losses

     (9,268 )          (8,775 )     

Noninterest-earning assets

     102,234            97,585       
                          

Total assets

   $ 1,313,328          $ 1,305,732       
                          

Liabilities, shareholders’ equity and puttable common stock:

              

Interest-bearing liabilities:

              

Interest checking

   $ 183,335     $ 1,301    2.88 %   $ 163,172     $ 842    2.09 %

Money market and savings

     334,971       3,619    4.38       214,753       1,620    3.06  

Time deposits

     374,389       4,536    4.91       345,875       3,407    3.99  
                                  

Total interest-bearing deposits

     892,695       9,456    4.30       723,800       5,869    3.29  

Borrowings and repurchase agreements

     172,660       1,889    4.44       374,260       4,031    4.37  

Junior subordinated debentures

     20,619       455    8.95       20,619       409    8.04  
                                  

Total interest-bearing liabilities

     1,085,974       11,800    4.41       1,118,679       10,309    3.74  
                                  

Noninterest-bearing liabilities:

              

Noninterest-bearing deposits

     105,950            77,185       

Other liabilities

     13,685            11,914       
                          

Total liabilities

     1,205,609            1,207,778       

Shareholders’ equity and puttable common stock

     107,719            97,954       
                          

Total liabilities, shareholders’ equity and puttable common stock

   $ 1,313,328          $ 1,305,732       
                          

Net interest income

     $ 7,680        $ 7,511   
                      

Net interest spread (1)

        2.06 %        2.20 %

Net interest margin (2)

        2.55 %        2.50 %

(1) Represents the average rate earned on interest-earning assets less the average rate paid on interest-bearing liabilities.
(2) Represents net interest income as a percentage of average interest-earning assets.

 

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The following table presents information regarding changes in interest income and interest expense for the periods indicated for each major category of interest-earning assets and interest-bearing liabilities, which distinguishes between the changes attributable to (1) changes in volume (changes in volume multiplied by old rate), (2) changes in rates (changes in rates multiplied by old volume) and (3) changes in rate-volume (changes in rate multiplied by change in volume). Changes in rate-volume are proportionately allocated between rate and volume variances.

 

     For the Three Months Ended
March 31,
 
     2007 vs. 2006  
     Increase (Decrease)
Due To Change In
       
     Volume     Rate     Total  
     (dollars in thousands)  

Interest-earning assets:

      

Loans (net of unearned income)

   $ 1,807     $ 922     $ 2,729  

Mortgages held for sale

     (325 )     43       (282 )

Securities

     (814 )     14       (800 )

Federal funds sold and other

     (63 )     76       13  
                        

Total increase in interest income

   $ 605     $ 1,055     $ 1,660  
                        

Interest-bearing liabilities:

      

Interest checking

   $ 114     $ 345     $ 459  

Money market and savings

     1,128       871       1,999  

Time deposits

     298       831       1,129  

Borrowings and repurchase agreements

     (2,205 )     63       (2,142 )

Junior subordinated debentures

     —           46       46  
                        

Total (decrease) increase in interest expense

     (665 )     2,156       1,491  
                        

Total increase (decrease) in net interest income

   $ 1,270     $ (1,101 )   $ 169  
                        

Provision for Loan Losses

We assess the adequacy of our allowance for loan losses by applying the provisions of Statement of Financial Accounting Standards No. 5 and No. 114. We determine specific allocations for loans considered to be impaired and assign loss factors to the remainder of the loan portfolio to determine an appropriate level of allowance for loan losses. The allowance is increased, as necessary, by making a provision for loan losses. The specific allocations for impaired loans are assigned based on an estimated net realizable value after a thorough review of the credit relationship. The potential loss factors associated with the remainder of the loan portfolio are based on our internal net loss experience, as well as our review of historical loss experience in peer financial institutions.

Generally, commercial, commercial real estate and real estate construction loans are assigned a risk grade at origination. These loans are then reviewed on a regular basis. The periodic reviews generally include loan payment and collateral status, the borrower’s financial data, and key ratios such as cash flows, operating income, liquidity and leverage. A material change in the borrower’s credit risk profile can result in an increase or decrease in the loan’s assigned risk grade. Aggregate dollar volume by risk grade is monitored on an ongoing basis. Consumer loans, including residential real estate, are evaluated periodically based on their repayment status.

The provision for loan losses represents our determination of the amount necessary to be charged against the current period’s earnings to maintain the allowance for loan losses at a level that is considered adequate in relation to the estimated losses inherent in the loan portfolio. The provision was $900,000 and $705,000 for the

 

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three months ended March 31, 2007 and 2006, respectively. The increase in the provision for the first quarter of 2007 compared with the same period in 2006 primarily reflects the provision we consider necessary as a result of the growth in the commercial, commercial real estate and real estate construction loan portfolios.

Noninterest Income

Noninterest income represented 52.40% and 56.39% of total revenue for the three months ended March 31, 2007 and 2006, respectively. Noninterest income decreased $1.3 million, or 13.0%, to $8.5 million for the three months ended March 31, 2007 compared with $9.7 million for the three months ended March 31, 2006. The decrease was due primarily to a $348,000, or 7.6%, decrease in trust and investment management fees and a $716,000, or 24.6%, decrease in mortgage banking fees. The decrease in trust and investment management fees was due to the sale of certain trust related assets in 2006, which reduced the amount of fee generating assets. On June 30, 2006, Encore Trust Company sold the certain trust related assets to a third party financial institution.

Excluding the sale of those trust related assets, trust and investment management fee income grew $464,000, or 12.3%, due to a combination of pricing increases for trust customers and an increase in assets under management. Assets under management grew 13.7% to $2.6 billion as of March 31, 2007 compared with $2.3 billion as of March 31, 2006.

The decease in mortgage banking fees was due to a combination of a lower dollar volume of loans sold and lower pricing, which resulted from a slowdown in the housing market and changes in the market for mortgage loans. The majority of the reduction in mortgage banking fees was related to second mortgages.

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

 

     For the Three Months
Ended March 31,
     2007      2006
     (dollars in thousands)

Trust and investment management fees

   $ 4,244      $ 4,592

Mortgage banking

     2,192        2,908

Insurance commissions and fees

     1,713        1,728

Real estate operations, including net gain on sales

     18        159

Net (loss) gain on sale of available-for-sale securities

     (149 )      —  

Other

     437        326
               

Total noninterest income

   $ 8,455      $ 9,713
               

Noninterest Expense

Noninterest expense decreased $595,000, or 4.6%, to $12.5 million for the three months ended March 31, 2007 compared with $13.1 million for the same three months in 2006, due primarily to a reduction in administrative costs related to certain trust related assets sold in June 2006. Excluding the sale of these trust related assets, noninterest expense increased $217,000, or 1.8%.

More specifically, compensation expense decreased $538,000, or 6.4%, for the three months ended March 31, 2007 compared with the same three months in 2006, due primarily to the termination of the employees associated with the trust related assets. Excluding the reduction in compensation expense resulting from the sale of these trust related assets, compensation expense rose $67,000, or 0.9%. This increase in compensation expense was primarily due to the opening of two new private client offices, one in Houston, Texas, and one in Naples, Florida. This increase was partially offset by a decrease in commissions paid with respect to the mortgage origination business. Occupancy expense rose $129,000, or 10.2%, due primarily to the addition of the two new private client offices. Data processing expense increased $73,000, or 9.9%, due primarily to growth in new accounts and the expense related to a more comprehensive disaster recovery program. Professional fees decreased $74,000, or 15.9%, primarily due to the higher fees in 2006 related to the sale of certain trust related assets.

 

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

 

     Three Months Ended
March 31,
     2007    2006
     (dollars in thousands)

Compensation

   $ 7,863    $ 8,401

Non-staff expenses:

     

Occupancy

     1,399      1,270

Equipment

     520      530

Advertising and promotion

     196      234

Outside data processing

     808      735

Professional fees

     390      464

Intangible amortization

     209      243

Other

     1,077      1,180
             

Total noninterest expense

   $ 12,462    $ 13,057
             

We expect our noninterest expense to increase as a result of our becoming a publicly-traded company. Specifically, we expect increases in audit fees, legal fees associated with public reporting, printing costs, proxy solicitation costs, additional directors and officers insurance cost and other expenses generally associated with publicly-traded companies.

Income Tax Expense

The provision for income taxes decreased $198,000, or 16.6%, to $998,000 for the three months ended March 31, 2007, compared with $1.2 million for the same three months in 2006. The change in income tax expense primarily reflects the decrease in earnings before income tax expense. The effective tax rate for the three months ended March 31, 2007 and 2006 was 36.0% and 34.5%, respectively.

 

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Results of Segment Operations

We manage our company along three operating segments: banking, wealth management and insurance. The column identified as “Other” includes the parent company and the elimination of transactions between segments. The accounting policies of the individual operating segments are the same as our accounting policies described in Note A to our consolidated financial statements included in this prospectus. The following table presents the net earnings and total assets for each of our operating segments as of and for the periods indicated:

 

     Banking    Wealth
Management
   Insurance    Other     Consolidated
     (dollars in thousands)

As of and for the three months ended March 31,

             

2007

             

Net interest income (expense)

   $ 8,035    $ 73    $ 27    $ (455 )   $ 7,680

Provision for loan losses

     900      —        —        —         900

Noninterest income

     2,481      4,244      1,716      14       8,455

Noninterest expense

     8,453      3,027      982      —         12,462
                                   

Earnings (loss) before income taxes

     1,163      1,290      761      (441 )     2,773

Income tax expense (benefit)

     396      467      272      (137 )     998
                                   

Net earnings (loss)

   $ 767    $ 823    $ 489    $ (304 )   $ 1,775
                                   

Total assets as of March 31,

  

$

1,301,562

   $ 43,935    $ 9,278    $ (59,788 )  

$

1,294,987

                                   

2006

             

Net interest income (expense)

   $ 7,878    $ 35    $ 7    $ (409 )   $ 7,511

Provision for loan losses

     705      —        —        —         705

Noninterest income

     3,381      4,592      1,730      10       9,713

Noninterest expense

     8,400      3,680      977      —         13,057
                                   

Earnings (loss) before income taxes

     2,154      947      760      (399 )     3,462

Income tax expense (benefit)

     639      381      259      (83 )     1,196
                                   

Net earnings (loss)

   $ 1,515    $ 566    $ 501    $ (316 )   $ 2,266
                                   

Total assets as of March 31,

   $ 1,331,811    $ 40,852    $ 8,318    $ (50,388 )   $ 1,330,593
                                   

Banking. Net earnings for the three months ended March 31, 2007 decreased $748,000, or 49.4%, compared with the same period in 2006. Net interest income increased $157,000, or 2.0%, but was offset by an increase in the provision for loan losses of $195,000, or 27.7%, and a decrease in noninterest income of $900,000, or 26.6%.

Net interest income for the three months ended March 31, 2007 increased $157,000, or 2.0%, compared with the same period of 2006. The increase resulted primarily from an improvement in the net interest margin, as the volume of average interest-earning assets remained approximately the same year over year. The net interest margin improved as a result of a more optimal mix of earning assets. See the analysis of net interest income included in the section of this prospectus captioned “—Net Interest Income.”

The provision for loan losses for the three months ended March 31, 2007 totaled $900,000 compared with $705,000 for the same period of 2006. See analysis of the provision for loan losses included in the section of this prospectus captioned “—Provision for Loan Losses.”

Noninterest income for the three months ended March 31, 2007 decreased $900,000, or 26.6%, compared with the same period in 2006. The decrease was due primarily to lower mortgage banking income as a result of a combination of lower dollar volume and price of loans sold. In addition, during the first quarter of 2007, we sold securities resulting in a loss of $149,000.

 

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Noninterest expense for the three months ended March 31, 2007 was essentially unchanged from the same period of 2006. Although we incurred additional expenses in connection with the addition of two new private client offices, these expenses were mostly offset by decreased commissions and other expenses from our mortgage banking activities.

Wealth Management. Net earnings for the three months ended March 31, 2007 increased $257,000, or 45.4%, compared with the same period in 2006. The increase in earnings was due primarily to an increase in assets under management and an increase in fees. Assets under management were $2.6 billion as of March 31, 2007 compared with $2.3 billion as of March 31, 2006, a 13.7% increase.

Noninterest income for the three months ended March 31, 2007 decreased $348,000, or 7.6%, compared with the same period of 2006, due primarily to the sale of certain trust related assets in June 2006. Excluding this sale, noninterest income rose $464,000, or 12.3%, due to the aforementioned increase in assets under management and the fee increase.

Noninterest expense for the three months ended March 31, 2007 decreased $653,000, or 17.7%, due primarily to the sale of certain trust related assets. Excluding this sale, noninterest expense rose $162,000, or 5.7%, due primarily to higher compensation expense due to hiring of additional staff and merit increases.

Insurance. Net earnings for the three months ended March 31, 2007 decreased slightly from the same period of 2006, due primarily to lower contingency commissions.

Noninterest income for the three months ended March 31, 2007 decreased $14,000, or 0.8%, from the same period in 2006 due primarily to lower contingent commissions and a declining premium environment. Noninterest expense for the three months ended March 31, 2007 was essentially unchanged from the prior year period.

Other. “Other” consists of interest expense on our junior subordinated debentures, which is not allocated to the business segments. Interest expense on these floating rate borrowings increased as interest rates rose from the first quarter of 2006 to the first quarter of 2007, contributing to the decline in net earnings.

Financial Condition

Our total assets decreased $41.9 million, or 3.1%, to $1.3 billion as of March 31, 2007 compared with total assets of $1.3 billion as of December 31, 2006. Our loan portfolio grew $24.4 million, or 2.7%, to $932.8 million as of March 31, 2007. Our securities portfolio decreased $48.3 million, or 18.9%, to $207.9 million compared with $256.3 million as of December 31, 2006. During the first quarter of 2007, we sold $41.0 million of lower yielding securities to improve the asset mix of our balance sheet. Shareholders’ equity increased $3.3 million, or 3.1%, to $108.9 million compared with shareholders’ equity and puttable common stock of $105.7 million as of December 31, 2006. The puttable common stock was reclassified to shareholders’ equity on March 30, 2007 as a result of the termination of the put agreement to which the shares were subject.

Loan Portfolio

Our primary lending focus is to professional firms, privately-owned businesses, investors and affluent individuals. To these customers we make commercial, commercial real estate, real estate construction, residential real estate and consumer loans. Total commercial loans, which consist of commercial, commercial real estate and real estate construction loans, accounted for 49.5% of our portfolio as of March 31, 2007. Total consumer loans, which consist of residential real estate, home equity lines of credit, consumer installment-indirect and other consumer loans, made up 50.5% of our loan portfolio as of March 31, 2007.

Total loans were $932.8 million as of March 31, 2007, an increase of $24.4 million, or 2.7%, compared with loans of $908.4 million as of December 31, 2006. The majority of loan growth occurred in commercial real estate, which increased $20.4 million, or 10.7%, to $211.0 million, and construction, which increased $12.9 million, or 10.6%. This growth was due primarily to increased commercial activity in the Houston market.

 

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The following table summarizes our loan portfolio by type of loan as of the dates indicated:

 

    

As of

March 31, 2007

   

As of

December 31, 2006

 
     Amount    Percent     Amount    Percent  
     (dollars in thousands)  

Commercial:

          

Commercial

   $ 115,896    12.4 %   $ 113,526    12.5 %

Commercial real estate

     210,992    22.6       190,550    21.0  

Real estate construction

     134,781    14.5       121,848    13.4  
                          

Total commercial

     461,669    49.5       425,924    46.9  

Consumer:

          

Residential real estate (1)

     334,156    35.8       336,077    37.0  

Home equity lines

     78,430    8.4       78,158    8.6  

Consumer installment—indirect

     39,204    4.2       44,360    4.9  

Consumer other

     19,334    2.1       23,849    2.6  
                          

Total consumer

     471,124    50.5       482,444    53.1  
                          

Total loans receivable

   $ 932,793    100.0 %   $ 908,368    100.0 %
                          

(1) Includes $141.7 million and $152.6 million of purchased loans as of March 31, 2007 and December 31, 2006, respectively.

The contractual maturity ranges of our commercial and consumer loan portfolios and the amount of such loans with predetermined and adjustable interest rates in each maturity range as of the date indicated are summarized in the following table:

 

     As of March 31, 2007
     One Year
or Less
   After One
Through
Five Years
   After Five
Years
   Total
     (dollars in thousands)

Commercial:

           

Commercial

   $ 89,080    $ 23,854    $ 2,962    $ 115,896

Commercial real estate

     40,297      148,955      21,740      210,992

Real estate construction

     83,798      36,303      14,680      134,781
                           

Total commercial

     213,175      209,112      39,382      461,669
                           

Consumer:

           

Residential real estate

     2,446      8,170      323,540      334,156

Home equity lines

     1,286      166      76,978      78,430

Consumer installment—indirect

     1,523      24,776      12,905      39,204

Consumer other

     15,492      3,687      155      19,334
                           

Total consumer

     20,747      36,799      413,578      471,124
                           

Total loans receivable

   $ 233,922    $ 245,911    $ 452,960    $ 932,793
                           

Loans with a predetermined interest rate

   $ 43,550    $ 185,681    $ 129,965    $ 359,196

Loans with an adjustable interest rate

     190,372      60,230      322,995      573,597
                           

Total loans receivable

   $ 233,922    $ 245,911    $ 452,960    $ 932,793
                           

 

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As of March 31, 2007, 38.5% of our total loan portfolio carried fixed interest rates and 61.5% of our loan portfolio had adjustable interest rates. Scheduled contractual principal repayments do not reflect the actual maturities of loans. The average maturity of our loans is substantially less than their average contractual term because of prepayments. The average life of mortgage loans tends to increase when the current mortgage loan rates are substantially higher than rates on existing mortgage loans and, conversely, decrease when current mortgage loan rates are substantially lower than rates on existing mortgages due primarily to refinancings of adjustable rate and fixed rate loans at lower rates.

Real Estate Loan Portfolio Concentrations

Loan concentrations may exist when borrowers are engaged in similar activities or types of loans extended to a diverse group of borrowers that could cause those borrowers or loans to be similarly impacted by economic or other conditions. We have a geographic concentration in our residential real estate and home equity lines portfolios in Texas, Florida, Colorado and California.

As of March 31, 2007, the geographic concentrations of residential mortgage and home equity lines of credit by state were as follows:

 

     As of March 31, 2007  
     Residential
Mortgage-
Originated
   Residential
Mortgage-
Purchased
   Home
Equity
Lines
   Total    Percent
of
Total
Loans
 
     (dollars in thousands)  

Texas

   $ 167,561    $ 5,587    $ 19,520    $ 192,668    20.7 %

Florida

  

 

6,007

  

 

41,034

     10,378      57,419    6.1  

Colorado

  

 

4,194

  

 

7,501

     40,463      52,158    5.6  

California

  

 

1,683

  

 

30,964

     3,586      36,233    3.9  

Other (1)

  

 

13,031

  

 

56,594

     4,483      74,108    7.9  
                                  

Total

   $ 192,476    $ 141,680    $ 78,430    $ 412,586    44.2 %
                                  

(1) Loans in any other individual state do not exceed 1.1% of total loans.

Changes in real estate values and underlying economic or market conditions in these areas are monitored regularly. As of March 31, 2007, approximately 8.1% of our total loans consisted of residential real estate loans that include an interest only feature as one of the loan terms. We consider the credit quality of substantially all of these loans to be prime.

We originate commercial real estate and real estate construction loans primarily to clients in our market areas in Texas and southwest Florida, and a significant portion of the property collateralizing our commercial real estate and real estate construction loans is located in these areas. Approximately 30% of commercial real estate loans and real estate construction loans are loans to owner occupants. In certain circumstances, these loans may be collateralized by property outside of Texas or Florida.

 

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The following tables set forth, as of March 31, 2007, our commercial real estate loans and real estate construction loans based on the state where the property is located and based on the type of property collateralizing such loans:

 

     As of March 31, 2007  
     Commercial
Real Estate
   Real Estate
Construction
   Total    Percent of
Total Loans
 
     (dollars in thousands)  

Texas

   $ 123,313    $ 86,542    $ 209,855    22.5 %

Florida

     71,310      41,315      112,625    12.1  

Other (1)

     16,369      6,924      23,293    2.5  
                           

Total

   $ 210,992    $ 134,781    $ 345,773    37.1 %
                           

(1) Loans in any other individual state do not exceed 1.2% of total loans.

 

     As of March 31, 2007  
     Commercial
Real Estate
   Real Estate
Construction
   Total    Percent of
Total Loans
 
     (dollars in thousands)  

1-4 family structures

   $ 36    $ 80,755    $ 80,791    8.7 %

Retail

     51,253      20,761      72,014    7.7  

Office building

     43,176      13,360      56,536    6.1  

Land

     43,465      1,084      44,549    4.8  

Industrial and warehouse

     26,768      7,011      33,779    3.6  

1-4 family land

     19,519      57      19,576    2.1  

Condominium

     —        11,753      11,753    1.3  

Multi-family

     7,735      —        7,735    0.8  

Other

     19,040      —        19,040    2.0  
                           

Total

   $ 210,992    $ 134,781    $ 345,773    37.1 %
                           

Delinquent and Nonperforming Assets

We have several procedures in place to assist in maintaining the overall quality of our loan portfolio. We have established underwriting guidelines to be followed by our management and delinquency levels are monitored by Encore Bank’s asset classification committee and reviewed by Encore Bank’s board of directors for any negative or adverse trends. There can be no assurance, however, that our loan portfolio will not become subject to increasing pressures from deteriorating borrower credit due to general economic conditions.

Trends in delinquency ratios represent an indicator, among other considerations, of credit risk within the loan portfolio. The entire balance of an account is considered delinquent if the minimum payment contractually required to be made is not received by the specified date. Loans 90 days past due totaled $8.4 million as of March 31, 2007, compared with $2.8 million as of December 31, 2006. The ratio of 90 days delinquent loans to total loans was 0.90% as of March 31, 2007 compared with 0.31% as of December 31, 2006. The increase in loans 90 days delinquent was primarily due to one loan to a law firm in the amount of $6.3 million. Although this loan was not delinquent as of December 31, 2006, it was, however, on nonaccrual status as of such date.

We generally place a loan on nonaccrual status and cease to accrue interest when the loan becomes 90 days past due or when loan payment performance is deemed uncertain, unless the loan is both well secured and in the process of collection. Cash payments received while a loan is classified as nonaccrual are recorded as a reduction of principal as long as doubt exists as to collection. We are sometimes required to revise the interest rate or repayment terms in a troubled debt restructuring. If interest on nonaccrual loans as of March 31, 2007 had been accrued under the original loan terms, approximately $159,000 would have been recorded as income during the first three months of 2007, compared with interest payments of $3,000 actually recorded during the first three months of 2007.

 

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We obtain appraisals on loans secured by real estate with principal amounts in excess of $250,000 and may update such appraisals for loans categorized as nonperforming loans and potential problem loans. In instances where updated appraisals reflect reduced collateral values, an evaluation of the borrower’s overall financial condition is made to determine the need, if any, for possible writedowns or appropriate additions to the allowance for loan losses. We record real estate acquired through foreclosure at fair value at the time of acquisition, less estimated costs to sell the property.

The following table presents information regarding nonperforming assets as of the dates indicated:

 

     As of
March 31,
2007
    As of
December 31,
2006
 
     (dollars in thousands)  

Nonaccrual loans

   $ 8,446     $ 9,411  

Accruing loans past due 90 days or more

     100       96  

Restructured loans

     —         —    
                

Total nonperforming loans

     8,546       9,507  
                

Investment in real estate

  

 

1,785

 

    235  
                

Total nonperforming assets

  

$

10,331

 

  $ 9,742  
                

Nonperforming assets to total loans and investment in real estate

  

 

1.11

%

    1.07 %

Nonperforming assets were $10.3 million and $9.7 million as of March 31, 2007 and December 31, 2006, respectively. Our ratio of nonperforming assets to total loans and investment in real estate was 1.11% and 1.07% as of March 31, 2007 and December 31, 2006, respectively. The increase in nonperforming assets was attributable primarily to the reclassification to investment in real estate of a property in the amount of $1.1 million, which we originally purchased for a new private client office location and carried in premises and equipment. Because we no longer intend to open a private client office at that location, such property is currently held for sale and included in investment in real estate. Excluding this reclassification, which was unrelated to credit issues, our ratio of nonperforming assets to total loans and investment in real estate as of March 31, 2007 would have been 0.99%.

We follow a loan review program designed to evaluate the credit risk in our loan portfolio. Through this loan review process, we maintain an internally classified watch list which helps management assess the overall quality of the loan portfolio and the adequacy of the allowance for loan losses. Loans included on the watch list that are not otherwise classified show warning elements where the present status portrays one or more deficiencies that require attention in the short term or where pertinent ratios of the loan account have weakened to a point where more frequent monitoring is warranted. These loans do not have all of the characteristics of a classified loan (substandard or doubtful) but do show weakened elements compared with those of a satisfactory credit.

In establishing the appropriate classification for specific assets, we consider, among other factors, the estimated value of the underlying collateral, the borrower’s ability to repay, the borrower’s repayment history and the current delinquent status. As a result of this process, loans are classified as substandard, doubtful or loss.

Loans classified as “substandard” are those loans with clear and defined weaknesses such as a highly leveraged position, unfavorable financial ratios, uncertain repayment sources or poor financial condition which may jeopardize the repayment of the debt as contractually agreed. They are characterized by the distinct possibility that we will sustain some losses if the deficiencies are not corrected. Loans classified as “doubtful” are those loans which have characteristics similar to substandard loans but with an increased risk that collection or liquidation in full is highly questionable and improbable. Loans classified as “loss” are those loans that are in the process of being charged off. Once a loan is deemed uncollectible as contractually agreed, the loan is charged off either partially or in-full against the allowance for loan losses.

As of March 31, 2007, we had $504,000 of loans classified as substandard, $6.9 million classified as doubtful and none classified as loss. As of March 31, 2007, we had specific allocations of $5.0 million in the

 

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allowance for loan losses related to these classified loans. We recently renegotiated an $8.8 million line of credit to an energy-related construction company and a $2.0 million portion of the new facility was classified as substandard as of June 30, 2007. We believe these facilities are well-secured by equipment and receivables and have been guaranteed by the owner of the borrower.

Allowance for Loan Losses

Our allowance for loan losses is a reserve established through charges to earnings in the form of a provision for loan losses. The allowance for loan losses is maintained at a level which we believe is adequate to absorb all probable losses on loans inherent in the loan portfolio. The amount of the allowance is affected by loan charge-offs, which decrease the allowance; recoveries on loans previously charged off, which increase the allowance; and the provision for loan losses charged to earnings, which increases the allowance. In determining the provision for loan losses, we monitor fluctuations in the allowance resulting from actual charge-offs and recoveries and periodically review the size and composition of the loan portfolio in light of current and anticipated economic conditions. If actual losses exceed the amount of the allowance for loan losses, our earnings could be adversely affected.

The allowance for loan losses represents management’s estimate of the amount necessary to provide for losses inherent in the loan portfolio in the normal course of business. Due to the uncertainty of risks in the loan portfolio, management’s judgment of the amount of the allowance necessary to absorb loan losses is approximate. The allowance for loan losses is also subject to regulatory examinations and determination by the regulatory agencies as to its adequacy in comparison with peer institutions.

The allowance for loan losses is comprised of three components: specific reserves, general reserves and unallocated reserves. Generally, all loans that have been identified as impaired are reviewed on a quarterly basis in order to determine whether a specific reserve is required. A loan is considered impaired when, based on current information, it is probable that we will not receive all amounts due in accordance with the contractual terms of the loan agreement. Once a loan has been identified as impaired, management measures impairment in accordance with Statement of Financial Accounting Standards (SFAS) No. 114, Accounting By Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan—Income Recognition and Disclosures. The measurement of impaired loans is based on the present value of expected future cash flows discounted at the loan’s effective interest rate or the loan’s observable market price, or based on the fair value of the collateral if the loan is collateral-dependent. When management’s measured value of the impaired loan is less than the recorded investment in the loan, the amount of the impairment is recorded as a specific reserve. These specific reserves are determined on an individual loan basis based on our current evaluation of our loss exposure for each credit, given the payment status, financial condition of the borrower and value of any underlying collateral. Loans for which specific reserves are provided are excluded from the general reserve and unallocated reserve calculations described below. Changes in specific reserves from period to period are the result in changes in the circumstances of individual loans such as charge-offs, pay-offs, changes in collateral values or other factors.

We also maintain a general reserve for each loan type in the loan portfolio. In determining the amount of the general reserve portion of our allowance for loan losses, we consider factors such as our historical loan loss experience, the growth, composition and diversification of our loan portfolio, current delinquency levels, adverse situations that may affect the borrower’s ability to repay, estimated value of the underlying collateral, the results of recent regulatory examinations and general economic conditions. Our emphasis on continued growth of our loan portfolio through the origination of commercial, commercial real estate and real estate construction loans has been one of the more significant factors we have taken into account in evaluating the general reserve. Based on these factors, we apply estimated percentages to the various categories of loans, not including any loan that has a specific reserve allocated to it, based on our historical experience, portfolio trends and economic and industry trends. We use this information to set the general reserve portion of the allowance for loan losses at a level we deem prudent.

 

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Because there are additional risks of losses that cannot be quantified precisely or attributed to particular loans or types of loans, including general economic and business conditions and credit quality trends, we have established an unallocated portion of the allowance for loan losses based on our evaluation of these risks. The unallocated portion of our allowance is determined based on various factors including, but not limited to, general economic conditions of our market area, the growth, composition and diversification of our loan portfolio, types of collateral securing our loans, the experience level of our lending officers and staff, the quality of our credit risk management and the results of independent third party reviews of our classification of credits. As of March 31, 2007, the unallocated portion of the allowance for loan losses was $97,000, or 1.0% of the total allowance, compared with an unallocated portion of $209,000, or 2.3% of the total allowance, as of December 31, 2006. The decline reflected our reclassification of certain risk factors formerly considered in the unallocated allowance to the allocated allowance associated with commercial real estate loans.

Based on an evaluation of the loan portfolio, management presents a quarterly review of the allowance for loan losses to Encore Bank’s asset classification committee and our board of directors, indicating any change in the allowance for loan losses since the last review and any recommendations as to adjustments in the allowance for loan losses. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available or as events change. We used the same methodology and generally similar assumptions in assessing the allowance for both comparison periods. The allowance for loan losses was $9.8 million as of March 31, 2007 compared with $9.1 million as of December 31, 2006. This increase primarily reflects the growth in the loan portfolio.

 

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The following table summarizes the activity in our allowance for loan losses as of and for the periods indicated:

 

     As of and for
the Three
Months
Ended
March 31,
2007
    As of and for
the Year
Ended
December 31,
2006
 
     (dollars in thousands)  

Average loans outstanding

   $ 916,523     $ 840,330  
                

Total loans outstanding at end of period

   $ 932,793     $ 908,368  
                

Allowance for loan losses at beginning of period

   $ 9,056     $ 8,719  

Charge-offs:

    

Commercial:

     —         —    

Commercial

     —         (1,488 )

Commercial real estate

     —         —    

Real estate construction

     —         —    
                

Total commercial

     —         (1,488 )
                

Consumer:

    

Residential real estate

     (84 )     (210 )

Home equity lines

     (10 )     (236 )

Consumer installment—indirect

     (80 )     (1,362 )

Consumer other

     (144 )     (558 )
                

Total consumer

     (318 )     (2,366 )
                

Total charge-offs

     (318 )     (3,854 )
                

Recoveries:

    

Commercial:

    

Commercial

     —         —    

Commercial real estate

     —         —    

Real estate construction

     —         —    
                

Total commercial

     —         —    
                

Consumer:

    

Residential real estate

     26       187  

Home equity lines

     43       1  

Consumer installment—indirect

     64       405  

Consumer other

     19       107  
                

Total consumer

     152       700  
                

Total recoveries

     152       700  
                

Net charge-offs

     (166 )     (3,154 )
                

Provision for loan losses

     900       3,491  
                

Allowance for loan losses at end of period

   $ 9,790     $ 9,056  
                

Ratio of net charge-offs to average loans

     0.07 %     0.38 %

Ratio of allowance for loan losses to period end loans

     1.05 %     1.00 %

Ratio of allowance for loan losses to nonperforming loans

     114.56 %     95.26 %

 

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Allocated Allowance for Loan Losses. We use a risk rating and specific reserve methodology in the calculation and allocation of our allowance for loan losses. The following table describes the allocation of the allowance for loan losses among various categories of loans and certain other information for the dates indicated. The allocation is made for analytical purposes and is not necessarily indicative of the categories in which future losses may occur. The total allowance is available to absorb losses from any segment of loans.

 

    

As of

March 31, 2007

   

As of

December 31, 2006

 
     Amount    Percent of
Loans to
Total
Loans
    Amount    Percent of
Loans to
Total
Loans
 
     (dollars in thousands)  

Commercial:

          

Commercial

   $ 6,471    12.4 %   $ 6,486    12.5 %

Commercial real estate

     1,126    22.6       368    21.0  

Real estate construction

     661    14.5       312    13.4  
                          

Total commercial

     8,258    49.5       7,166    46.9  

Consumer:

          

Residential real estate

     235    35.8       250    37.0  

Home equity lines

     103    8.4       104    8.6  

Consumer installment—indirect

     749    4.2       864    4.9  

Consumer other

     348    2.1       463    2.6  
                          

Total consumer

     1,435    50.5       1,681    53.1  

Unallocated

     97    —         209    —    
                          

Total loans receivable

   $ 9,790    100.0 %   $ 9,056    100.0 %
                          

Management believes that the allowance for loan losses as of March 31, 2007 is adequate to cover losses inherent in the portfolio as of such date. The estimate of losses represented by the allowance is subject to change as more information becomes known. Future losses, which could vary greatly in amount, will be recognized through future loan loss provisions in the period in which such losses are determined.

Investment Securities

The securities portfolio serves as a source of liquidity and earnings and is used to manage interest rate risk and to ensure collateral is available for pledging requirements. Securities within the portfolio are classified as held-to-maturity, available-for-sale or trading based on the intent and objective of the investment and the ability to hold to maturity. As of March 31, 2007, we had no securities classified as trading. Fair values of securities are based on quoted market prices where available. If quoted market prices are not available, estimated fair values are based on quoted market prices of comparable securities.

Securities available-for-sale are carried at fair value with unrealized holding gains and losses reported as a separate component of shareholders’ equity called other comprehensive income. Securities that are held as available-for-sale are used as a part of our asset/liability management strategy. Securities may be sold in response to interest rate changes, changes in prepayment risk or changes to underlying bank funding. Available-for-sale securities were $51.4 million as of March 31, 2007 compared with $83.7 million as of December 31, 2006. The decrease was primarily due to normal pay downs and sales of securities. Available-for-sale securities with a carrying value of $33.5 million were sold in the three months ended March 31, 2007. As of March 31, 2007, $39.8 million, or 77.5%, of the available-for-sale securities were invested in mortgage-backed securities, compared with $75.2 million, or 89.8%, as of December 31, 2006. The remainder of the available-for-sale portfolio was invested primarily in securities to support our community reinvestment obligations.

Securities held-to-maturity are carried at amortized historical cost. Securities that we have the intent and ability to hold until maturity or on a long-term basis are classified as held-to maturity. Held-to-maturity securities

 

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decreased to $156.5 million as of March 31, 2007 compared with $172.6 million as of December 31, 2006 due primarily to sales and pay downs of such securities. Held-to-maturity securities that were sold had a carrying value of $7.4 million and less than 15% of the original principal amount at acquisition remaining. All of the securities in the held-to-maturity category were mortgage-backed securities.

The following table summarizes the amortized cost of securities classified as available-for-sale and held-to-maturity and their approximate fair values as of the dates shown:

 

    As of March 31, 2007   As of December 31, 2006
    Amortized
Cost
  Gross
Unrealized
Gains
  Gross
Unrealized
Losses
    Fair Value   Amortized
Cost
  Gross
Unrealized
Gains
  Gross
Unrealized
Losses
    Fair Value
    (dollars in thousands)

Available-for-sale:

               

Mortgage-backed securities

  $ 40,039   $   $ (194 )   $ 39,845   $ 76,904   $ 95   $ (1,814 )   $ 75,185

Other securities

    11,599     46     (51 )     11,594     8,547     36     (67 )     8,516
                                                   

Total

  $ 51,638   $ 46   $ (245 )   $ 51,439   $ 85,451   $ 131   $ (1,881 )   $ 83,701
                                                   

Held-to-maturity:

               

Mortgage-backed securities

  $ 156,472   $   $ (4,052 )   $ 152,420   $ 172,555   $ 36   $ (5,202 )   $ 167,389
                                                   

Certain investment securities are valued at less than their historical cost. We believe these declines resulted primarily from increases in market interest rates. Because the declines in market value are due to changes in interest rates and not credit quality, and because we have the ability and intent to hold these securities until a recovery in fair value, management believes the declines in fair value for these securities are temporary. Should the impairment of any of these securities become other than temporary, the cost basis of the investment will be reduced and the resulting loss recognized in net earnings in the period the other than temporary impairment is identified.

As of March 31, 2007, we had net unrealized losses of $4.3 million in the securities portfolio compared with net unrealized losses of $6.9 million as of December 31, 2006. The $2.7 million decrease in net unrealized losses is primarily attributable to the decreased size and reduced time to maturity of the portfolio and the fluctuation in market interest rates from December 31, 2006 to March 31, 2007.

Mortgage-backed securities (MBSs) are securities that have been developed by pooling a number of real estate mortgages and are principally issued by “quasi-federal” agencies such as Fannie Mae and Freddie Mac. These securities are deemed to have high credit ratings, and the minimum monthly cash flows of principal and interest are guaranteed by the issuing agencies. Investors generally assume that the Federal government will support these agencies, although it is under no obligation to do so. Other MBSs are issued by Ginnie Mae, which is a Federal agency, and are guaranteed by the U.S. government.

Unlike U.S. government securities, which have a lump sum payment at maturity, MBSs provide cash flows from regular principal and interest payments and principal prepayments throughout the lives of the securities. MBSs which are purchased at a premium will generally suffer decreasing net yields as interest rates drop because homeowners tend to refinance their mortgages. Thus, the premium paid must be amortized over a shorter period. Conversely, MBSs purchased at a discount will obtain higher net yields in a decreasing interest rate environment. As interest rates rise, the opposite will generally be true. During a period of increasing interest rates, fixed rate MBSs do not tend to experience heavy prepayments of principal, and consequently the average life of this security will be lengthened. If interest rates begin to fall, prepayments will increase, thereby shortening the estimated lives of these securities.

 

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The following table summarizes the contractual maturities of investment securities on an amortized cost basis and their weighted average yields as of March 31, 2007. This table shows the contractual maturities of the related investment securities and not the estimated average lives of the securities. The contractual maturity of an MBS is the date at which the last underlying mortgage matures. In the case of a 15-year pool of loans or a 30-year pool of loans, the maturity date of the security will be the date the last payment is due on the underlying mortgages.

 

     As of March 31, 2007  
    

Due Within

One Year

   

After One

Year but Within

Five Years

   

After Five
Years but Within

Ten Years

    After Ten Years     Amount    Yield  
     Amount    Yield     Amount    Yield     Amount    Yield     Amount    Yield       
     (dollars in thousands)  

Available-for-sale:

                         

Mortgage-backed securities

   $  —      %   $ —        $  —      %   $ 40,039    4.05 %   $ 40,039    4.05 %

Other securities

     —            3,721    2.17       —            813    7.81       4,534    3.18  

Held-to-maturity:

                         

Mortgage-backed securities

     —            114,104    3.58       —            42,368    4.36       156,472    3.79  
                                             

Total

   $ —      %   $ 117,825    3.54 %   $ —      %   $ 83,220    4.24 %     201,045    3.83  
                                         

Equity securities

                         7,065    —    
                             

Total securities

                       $ 208,110    3.70 %
                             

Contractual maturity of an MBS is not a reliable indicator of its expected life because borrowers have the right to prepay their obligations at any time. A third party analysis of our mortgage-backed securities as of March 31, 2007 shows the estimated average lives for fixed MBSs to be 2.47 years and for adjustable MBSs to be 4.05 years. The estimated average life will change if interest rates change. The average life of the total securities portfolio was 3.08 years as of March 31, 2007.

Goodwill and Other Intangibles

SFAS No. 141, Business Combinations and SFAS No. 142, Goodwill and Other Intangible Assets requires that all business combinations initiated after June 30, 2001 be accounted for under the purchase method and addressed the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. SFAS No. 142 also addresses the accounting for goodwill and other intangible assets subsequent to their acquisition and provides that intangible assets with finite useful lives should continue to be amortized and that goodwill and intangible assets with indefinite lives should no longer be amortized, but rather, they should be tested annually for impairment.

The change in our carrying amount of goodwill for the three months ended March 31, 2007 and the year ended December 31, 2006 is as follows:

 

     For the Three
Months Ended
March 31,
2007
   For the Year
Ended
December 31,
2006
     (dollars in thousands)

Balance, beginning

   $ 27,869    $ 26,873

Goodwill from acquisitions

     25      996
             

Balance, ending

   $ 27,894    $ 27,869
             

 

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Deposits

Deposits are our primary source of funds and we rely on our private client offices to attract and retain those deposits. We offer a variety of products, which consist of noninterest-bearing and interest-bearing checking accounts, money market and savings accounts and certificates of deposit. Deposits are gathered from individuals, partnerships and corporations in our market areas. From time to time, we also purchase brokered deposits. Our deposits averaged $998.6 million for the three months ended March 31, 2007 and $882.6 million for the year ended December 31, 2006.

The interest rates we pay are based on the competitive environments in each of our markets. We manage our interest expense through weekly deposit pricing reviews that compare our deposit rates with the competition and wholesale alternatives. The rising cost of our deposits over the past few years reflects the impact of the increase in the Federal Funds rate from 2004 through 2006. In addition, we have at times offered special products or attractive rates so that our deposits will keep up with our loan growth. The average cost of deposits, including noninterest-bearing deposits, for the three months ended March 31, 2007 was 3.84% compared with 3.46% for the year ended December 31, 2006. The increase in average cost of deposits was primarily due to the rise in short-term interest rates.

As of March 31, 2007, core deposits (which consist of noninterest-bearing deposits, interest checking, money markets and savings and time deposits less than $100,000) were $793.4 million, or 79.6%, of total deposits, while time deposits $100,000 and greater and brokered deposits made up 20.4% of total deposits. As of March 31, 2007, total deposits decreased to $997.3 million from $1.0 billion as of December 31, 2006, a decrease of $33.5 million, or 3.3%. During this time period, noninterest-bearing deposits decreased $18.9 million to $112.6 million, or 14.4%, primarily due to seasonal fluctuations. Additionally, interest checking, money market and savings and time deposits decreased $14.6 million, or 1.6%, to $884.7 million.

The following table presents the daily average balances and weighted average rates paid on deposits for the periods indicated:

 

     Three Months Ended
March 31, 2007
    Year Ended
December 31, 2006
 
     Average
Balance
   Average
Rate
    Average
Balance
   Average
Rate
 
     (dollars in thousands)  

Noninterest-bearing deposits

   $ 105,950    —   %   $ 87,788    —   %

Interest checking

     183,335    2.88       168,881    2.50  

Money market and savings

     334,971    4.38       264,219    3.96  

Time deposits less than $100,000

     175,380    4.82       171,390    4.23  
                  

Core deposits

     799,636    3.55       692,278    3.17  
                  

Time deposits $100,000 and greater

     189,220    5.02       176,461    4.49  

Brokered deposits

     9,789    4.56       13,842    4.80  
                  

Total deposits

   $ 998,645    3.84 %   $ 882,581    3.46 %
                  

 

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The following table sets forth the amount of our time deposits as of March 31, 2007 that are $100,000 and greater by time remaining until maturity:

 

     As of March 31, 2007
     (dollars in thousands)

Three months or less

   $ 62,721

Over three months through six months

     46,047

Over six months through one year

     61,823

Over one year

     25,302
      

Total

   $ 195,893
      

While a majority of the time deposits in amounts of $100,000 and greater will mature within one year, we expect that a significant portion of these deposits will be renewed as the rates we offer on time deposits are competitive in the market. If a significant portion of the time deposits are not renewed, it would have an adverse effect on our liquidity. We monitor maturities and have other available funding sources such as FHLB advances to mitigate this effect.

Borrowings, Repurchase Agreements and Junior Subordinated Debentures

We utilize borrowings to supplement deposits in funding our lending and investing activities. These borrowings are typically advances from the FHLB, which have terms ranging from overnight to several years. All borrowings from the FHLB are collateralized by investment securities or first mortgage loans. Additionally, we borrow from other financial institutions using investment securities as collateral and have issued junior subordinated debentures to subsidiary trusts.

Our borrowings and repurchase agreements were $157.5 million as of March 31, 2007. The outstanding balance as of March 31, 2007 includes $67.0 million in short-term FHLB advances, $35.0 million in long-term FHLB advances, $25.8 million in repurchase agreements with brokerage firms and $29.3 million in repurchase agreements with clients. Additionally, as of March 31, 2007 we had $386,000 in notes payable related to the acquisition of Town & Country.

We decreased our borrowing and repurchase agreements $14.2 million, or 8.3%, to $157.5 million as of March 31, 2007 from $171.7 million as of December 31, 2006. The decrease was primarily due to reduced funding requirements resulting from our securities sales.

The following table summarizes our outstanding borrowings and repurchase agreements as of the dates indicated:

 

     As of and for
the Three Months
Ended March 31, 2007
    As of and for
the Year Ended
December 31, 2006
 
     (dollars in thousands)  

Ending balance

   $ 157,505     $ 171,732  

Average balance for the period

     172,660       298,907  

Maximum month-end balance during the period

     167,414       378,323  

Average interest rate for the period

     4.44 %     4.48 %

Weighted average interest rate at the end of the period

     4.59 %     4.27 %

 

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In addition to the borrowings and repurchase agreements discussed above, as of March 31, 2007, we had two issues of junior subordinated debentures outstanding totaling $20.6 million as follows:

 

Description

  Issuance
and Call
Dates (1)
  Trust
Preferred
Securities
Outstanding
  Interest
Rate as of
March 31,
2007
   

Fixed/

Adjustable

  Interest Rate
Basis
  Junior
Subordinated
Debt Owed
to Trusts
  Final
Maturity
Date
    (dollars in thousands)

Encore Capital Trust I (2)

  4/10/2002   $ 15,000   9.09 %   Adjustable
semi-annually
  6 month
LIBOR + 3.70%
  $ 15,464   4/22/2032

Encore Statutory Trust II

  9/17/2003     5,000   8.30     Adjustable quarterly   3 month
LIBOR + 2.95%
    5,155   9/24/2033

(1) Each issue of junior subordinated debentures is callable by us after five years from the issuance date.

 

(2) On April 19, 2007, we issued $15.5 million of junior subordinated debentures to Encore Capital Trust III. The junior subordinated debentures mature on April 19, 2037, bear a fixed rate of 6.85% until April 19, 2012, at which date we may call the junior subordinated debentures, and a floating rate of 3 month LIBOR + 1.75% thereafter. With the proceeds of these junior subordinated debentures, on April 23, 2007, we redeemed an aggregate of $15.5 million of junior subordinated debentures issued by us on April 10, 2002 at a floating rate of 6 month LIBOR + 3.70%.

Each of the trusts is a capital or statutory business trust organized for the sole purpose of issuing trust securities and investing the proceeds in our junior subordinated debentures. The trust preferred securities of each trust represent preferred beneficial interests in the assets of the respective trusts and are subject to mandatory redemption upon payments of the junior subordinated debentures held by the trust. The common securities of each trust are wholly-owned by us. Each trust’s ability to pay amounts due on the trust preferred securities is solely dependent upon our making payment on the related junior subordinated debentures. The debentures, which are the only assets of each trust, are subordinate and junior in right of payment to all of our present and future senior indebtedness. We have fully and unconditionally guaranteed each trust’s obligations under the trust securities issued by such trust to the extent not paid or made by each trust, provided that such trust has funds available for such obligations.

Under the provisions of each issue of the junior subordinated debentures, we have the right to defer payment of interest on the debentures at any time, or from time to time, for periods not exceeding five years. If interest payments on either issue of the junior subordinated debentures are deferred, the distributions on the applicable trust preferred securities will also be deferred. However, the interest due would continue to accrue during any such interest payment deferral period.

The trust preferred securities issued by the trusts are currently included in our Tier 1 capital for regulatory purposes. On March 1, 2005, the Federal Reserve adopted final rules that would continue to allow trust preferred securities to be included in Tier 1 capital, subject to stricter quantitative and qualitative limits. Currently, trust preferred securities and qualifying perpetual preferred stock are limited in the aggregate to no more than 25% of a bank holding company’s core capital elements. The new rule amends the existing limit by providing that restricted core capital elements (including trust preferred securities and qualifying perpetual preferred stock) can be no more than 25% of core capital, net of goodwill and associated deferred tax liability. Because the 25% limit currently is calculated without deducting goodwill, the final rule reduces the amount of trust preferred securities that we can include in Tier 1 capital. The amount of such excess trust preferred securities are includable in Tier 2 capital. The new quantitative limits will be fully effective on March 31, 2009. As of March 31, 2007, the new rules would not have effected the amount of trust preferred securities that we may include in our Tier 1 capital.

Each of the trusts issuing the trust preferred securities holds junior subordinated debentures we issued with a 30-year maturity. The final rules provide that in the last five years before the junior subordinated debentures mature, the associated trust preferred securities will be excluded from Tier 1 capital and included in Tier 2

 

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capital, subject (together with subordinated debt and certain other investments) to an aggregate limit of 50% of Tier 1 capital. In addition, under the regulations, the trust preferred securities during this five-year period would be amortized out of Tier 2 capital by one-fifth each year and excluded from Tier 2 capital completely during the year prior to maturity of the debentures.

Liquidity and Funding

Our liquidity represents our ability to meet cash demands as they arise. Such needs can develop from loan demand, deposit withdrawals or acquisition opportunities. Potential obligations resulting from the issuance of standby letters of credit and commitments to fund future borrowings to our loan customers also affect our liquidity needs. Many of these obligations and commitments are expected to expire without being drawn upon; therefore the total commitment amounts do not necessarily represent future cash requirements affecting our liquidity position.

Liquidity needs of a financial institution can be met from either assets or liabilities. On the asset side, our primary sources of liquidity are cash and due from banks, federal funds sold, maturities of securities and scheduled repayments and maturities of loans. On the liability side, our principal sources of liquidity are deposits, borrowed funds and the accessibility to money and capital markets. Client deposits are our largest source of funds. As of March 31, 2007 and December 31, 2006, our average deposits were $998.6 million, or 76.0% of average total assets, and $882.6 million, or 67.0% of average total assets, respectively.

In addition, we have raised capital through the issuance of junior subordinated debentures in connection with trust preferred securities issuances by various non-consolidated statutory trust subsidiaries in April 2002 (which were redeemed and replaced with the same amount of junior subordinated debentures in April 2007) and September 2003. Further, in March 2002, we issued 1,111,112 shares of our common stock, in December 2002, we issued 500,000 shares of our common stock and in January 2005, we issued 450,000 shares of our common stock in private placement transactions. The net proceeds of these private placements, an aggregate of $15.9 million in 2002 and $7.8 million in 2005, were used for general corporate purposes and to fund a portion of our acquisition of National Fiduciary Services.

Funds are also available from borrowings from the FHLB pursuant to an existing commitment based on the value of the collateral pledged (either loans or securities) and repurchase agreements. As of March 31, 2007, we had $180.0 million in available credit from the FHLB.

The primary source of our parent company funding has been dividends from our subsidiary bank, the payment of which is subject to bank regulatory limitations. Accordingly, consolidated cash flows as presented in the consolidated statements of cash flows may not represent cash immediately available to us.

Shareholders’ Equity and Puttable Common Stock

Shareholders’ equity increased $3.3 million, or 3.1%, to $108.9 million as of March 31, 2007 compared with shareholders’ equity and puttable common stock $105.7 million as of December 31, 2006, primarily due to net earnings and lower unrealized loss on the available-for-sale securities portfolio. Our ratio of average shareholders’ equity and puttable common stock to average assets increased to 8.20% as of March 31, 2007 compared with a ratio of 7.66% as of December 31, 2006.

The acquisition agreement and related put agreement pursuant to which we issued cash and shares of our common stock in exchange for all of the shares of Linscomb & Williams gave the shareholders of Linscomb & Williams a non-transferable right to put such stock back to us on August 31, 2009 in exchange for all of the shares of Linscomb & Williams if such put right was not otherwise extinguished pursuant to the terms of the agreement. The put option was extinguishable at any time if our common stock became listed for trading on the New York Stock Exchange, the NASDAQ National Market (now known as the NASDAQ Global Market) or the

 

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American Stock Exchange, or we were acquired by another company in a transaction in which our shareholders received securities, cash or a combination thereof, issued by a publicly traded company on or before August 31, 2009. The put agreement was terminated on March 30, 2007.

As of December 31, 2006 and 2005, we classified the puttable common stock outside of shareholders’ equity on the consolidated balance sheet as the ability to extinguish the put was not considered to be completely within our control. As the puttable common stock was not redeemable as of these dates and it was probable that the put would not be exercised, we did not adjust the puttable common stock to its redemption amount.

Regulatory Capital

We actively manage our capital. Our potential sources of capital are earnings and common or preferred equity. From time to time, we have issued trust preferred securities through a subsidiary trust either to fund organic growth or to support an acquisition. Trust preferred securities can be eligible for treatment as Tier 1 regulatory capital provided such securities comprise less than 25% of Tier 1 regulatory capital. Any amount above this limit can be eligible for treatment as Tier 2 capital. We currently have the capacity to issue additional trust preferred securities that would be treated as Tier 1 capital.

Each of the federal bank regulatory agencies has established minimum capital adequacy and leverage capital requirements for banking organizations. Since the conversion of Encore Bank to a national bank on March 30, 2007, Encore Bank is subject to the capital adequacy requirements of the Office of the Comptroller of the Currency (OCC) and we, as a bank holding company, are subject to the capital adequacy requirements of the Federal Reserve. As of March 31, 2007, Encore Bank was categorized as “well capitalized” under the regulatory framework for prompt corrective action. To be categorized “well capitalized,” Encore Bank must maintain minimum Tier 1 core, Tier 1 risked based capital, and total risked based capital ratios as set forth in the table below. There are no conditions or events since that notification that we believe have changed Encore Bank’s capital position. We intend that Encore Bank will maintain a capital position that meets or exceeds the “well capitalized” requirements as defined by the OCC.

The following table presents capital amounts and ratios for us and Encore Bank as of March 31, 2007:

 

     Actual     For Capital
Adequacy
Purposes
    To Be Categorized
as Well
Capitalized Under
Prompt Corrective
Action Provisions
 
     Amount    Ratio     Amount    Ratio     Amount    Ratio  
     (dollars in thousands)  

Encore Bancshares, Inc.

               

Leverage

  

$

94,354

   7.40 %   $ 51,014    4.00 %   $ N/A    N/A  

Tier 1 risk-based

  

 

94,354

   10.28       36,675    4.00       N/A    N/A  

Total risk-based

     104,144    11.35       73,350    8.00       N/A    N/A  

Encore Bank, N.A.

               

Leverage (1)

   $ 92,211    7.23 %   $ 51,008    4.00 %   $ 63,760    5.00 %

Tier 1 risk-based

     92,211    10.07       36,592    4.00       54,888    6.00  

Total risk-based

     102,001    11.14       73,185    8.00       91,481    10.00  

 


(1) As part of Encore Bank’s conversion to a national bank, the OCC required that Encore Bank have a leverage ratio of at least 7.28% as of December 31, 2007 and at least 7.75% as of December 31, 2008. Assuming the offering was completed prior to March 31, 2007, Encore Bank’s leverage ratio would have been 7.95% as of March 31, 2007.

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

 

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The risk-based capital standards issued by the Federal Reserve require all bank holding companies to have Tier 1 capital of at least 4.0% to be “adequately capitalized” and at least 6.0% to be “well capitalized” and total risk-based capital (Tier 1 and Tier 2) of at least 8.0% of total risk-weighted assets to be “adequately capitalized” and at least 10.0% to be “well capitalized.” Tier 1 capital generally includes common shareholders’ equity and qualifying perpetual preferred stock together with related surpluses and retained earnings, less deductions for goodwill and various other intangibles. Tier 2 capital may consist of a limited amount of intermediate-term preferred stock, a limited amount of term subordinated debt, certain hybrid capital instruments and other debt securities, perpetual preferred stock not qualifying as Tier 1 capital, and a limited amount of the general valuation allowance for loan losses. The sum of Tier 1 capital and Tier 2 capital is total risk-based capital.

The Federal Reserve has also adopted guidelines which supplement the risk-based capital standards with a minimum ratio of Tier 1 capital to average total consolidated assets (leverage ratio) of 3.0% for institutions with well diversified risk, including no undue interest rate exposure; excellent asset quality; high liquidity; good earnings; and that are generally considered to be strong banking organizations, rated composite 1 under applicable federal guidelines, and that are not experiencing or anticipating significant growth. Other banking organizations are required to maintain a leverage ratio of at least 4.0% in order to be categorized as “adequately capitalized” and at least 5.0% to be categorized as “well capitalized.” These rules further provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain capital positions substantially above the minimum supervisory levels and comparable to peer group averages, without significant reliance on intangible assets.

Encore Bank is subject to capital adequacy guidelines of the OCC that are substantially similar to the Federal Reserve’s guidelines. As part of Encore Bank’s conversion to a national bank, the OCC required that Encore Bank meet certain additional capital requirements. Specifically, as of December 31, 2007, Encore Bank is required to have a leverage ratio of at least 7.28% and as of December 31, 2008, Encore Bank is required to have a leverage ratio of at least 7.75%. As of March 31, 2007, Encore Bank’s leverage ratio was 7.23%. Assuming the offering was completed prior to March 31, 2007, Encore Bank’s leverage ratio would have been 7.95% as of March 31, 2007.

Asset/Liability Management

Our asset liability and funds management policy provides us with the necessary guidelines for effective funds management, and we have established a measurement system for monitoring our net interest rate sensitivity position. We seek to maintain a sensitivity position within established guidelines.

As a financial institution, the primary component of market risk is interest rate volatility. Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on most of the assets and liabilities, other than those which have a short term to maturity. Because of the nature of our operations, we are not subject to foreign exchange or commodity price risk. We do not own any trading assets.

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

We actively manage our exposure to adverse changes in interest rates through asset and liability management activities within guidelines established by our asset/liability management committee (ALCO). The ALCO, which is composed primarily of senior officers of Encore Bank, has the responsibility for ensuring compliance with asset/liability management policies. Interest rate risk is the exposure to adverse changes in net interest income as a result of market fluctuations in interest rates. On a regular basis, the ALCO monitors interest rate and liquidity risk in order to implement appropriate funding and balance sheet strategies.

We utilize a net interest income simulation model to analyze net interest income sensitivity. Potential changes in market interest rates and their subsequent effects on net interest income are then evaluated. The model

 

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projects the effect of instantaneous movements in interest rates of both 100 and 200 basis points. Assumptions based on the historical behavior of our deposit rates and balances in relation to changes in interest rates are also incorporated into the model. These assumptions are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various management strategies.

Our interest sensitivity profile was liability sensitive as of March 31, 2007. Given an instantaneous 100 basis point increase in rates that was sustained for 12 months, our base net interest income would decrease by an estimated 3.0% for the three months ended March 31, 2007. Given a 100 basis point decrease in interest rates for the same period, our base net interest income would increase by an estimated 2.4% for the three months ended March 31, 2007.

The following table sets forth the net interest income simulation analysis as of March 31, 2007:

 

Interest Rate Scenario

   % Change in
Net Interest Income
 

+200 basis points

   (6.1 )%

+100 basis points

   (3.0 )%

Base

    

–100 basis points

   2.4 %

–200 basis points

   3.7 %

We also manage our exposure to interest rates by structuring our balance sheet in the ordinary course of business. An important measure of interest rate risk is the relationship of the repricing period of earning assets and interest-bearing liabilities. The more closely the repricing periods are correlated, the less interest rate risk we have. From time to time, we may use instruments such as leveraged derivatives, structured notes, interest rate swaps, caps, floors, financial options, financial futures contracts, or forward delivery contracts to reduce interest rate risk. As of March 31, 2007, we had hedging instruments in the notional amount of $40.0 million and with a fair value of a $9,000 net liability.

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

 

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The following table sets forth our interest rate sensitivity analysis as of March 31, 2007:

 

    Volumes Subject to Repricing Within
   

0-30

Days

    31-90
Days
    91-180
Days
    181-365
Days
   

1-2

Years

   

2-5

Years

    Over 5
Years
    Non-Rate
Sensitive
    Total
Balance
    (dollars in thousands)

Earning assets:

                 

Mortgages held-for-sale

  $ —       $ 45,954     $ —       $ —       $ —       $ —       $ —       $ —       $ 45,954

Loans

    374,586       17,179       22,903       80,497       164,104       209,828       53,753       9,943       932,793

Securities

    23,602       2,151       17,048       18,147       49,208       95,414       3,443       (1,102 )     207,911

Other interest-earning assets

    14,621       —         —         —         —         —         —         —         14,621
                                                                     

Total earning assets

    412,809       65,284       39,951       98,644       213,312       305,242       57,196       8,841       1,201,279

Interest-bearing liabilities:

                 

Interest checking, money markets and savings

    504,014       —         —         —         —         —         —         —         504,014

Time deposits

    53,737       54,713       88,964       117,724       27,973       37,588       —         —         380,699

FHLB advances

    67,000       —         —         25,000       —         10,000       —         —         102,000

Borrowings and repurchase agreements

    29,276       25,843       —         —         —         386       —         —         55,505

Junior subordinated debentures

    15,464       5,155       —         —         —         —         —         —         20,619
                                                                     

Total interest-bearing liabilities

    669,491       85,711       88,964       142,724       27,973       47,974       —         —         1,062,837
                                                                     

Interest rate sensitivity gap

  $ (256,682 )   $ (20,427 )   $ (49,013 )   $ (44,080 )   $ 185,339     $ 257,268     $ 57,196     $ 8,841     $ 138,442
                                                                     

Cumulative interest rate sensitivity gap

  $ (256,682 )     (277,109 )     (326,122 )     (370,202 )     (184,863 )   $ 72,405     $ 129,601      
                                                           

Cumulative interest rate sensitive assets to rate sensitive liabilities

    61.7 %     63.3 %     61.4 %     62.5 %     81.8 %     106.8 %     112.2 %    

Cumulative gap as a percent of total earning assets

    (21.4 %)     (23.1 %)     (27.1 %)     (30.8 %)     (15.4 %)     6.0 %     10.8 %    

Certain shortcomings are inherent in the method of analysis presented in the gap table. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market interest rates. Additionally, certain assets, such as adjustable-rate loans, have features that restrict changes in interest rates, both on a short-term basis and over the life of the asset. More importantly, changes in interest rates, prepayments and early withdrawal levels may deviate significantly from those assumed in the calculations in the table. As a result of these shortcomings, we focus more on a net interest income simulation model than on gap analysis. Although the gap analysis reflects a ratio of cumulative gap to total earning assets within acceptable limits, the net interest income simulation model is considered by management to be more informative in forecasting future income at risk.

We face the risk that borrowers might repay their loans sooner than the contractual maturity. If interest rates fall, the borrower might repay their loan, forcing us to reinvest in a potentially lower yielding asset. This prepayment would have the effect of lowering the overall portfolio yield which may result in lower net interest income. We have assumed that these loans will prepay, if the borrower has sufficient incentive to do so, using

 

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prepayment tables provided by third party consultants. In addition, some of our assets, such as mortgage-backed securities or purchased loans, are held at a premium, and if these assets prepaid, we would have to write down the premium, which would temporarily reduce the yield. Conversely, as interest rates rise, our borrowers might prepay their loans more slowly, which would leave us with higher yielding assets as interest rates rise.

Impact of Inflation and Changing Prices

Our financial statements and related notes included in this prospectus have been prepared in accordance with GAAP. These require the measurement of financial position and operating results in historical dollars without considering changes in the relative purchasing power of money over time due to inflation.

We have an asset and liability structure that is essentially monetary in nature. As a result, interest rates have a more significant impact on our performance than the effects of general levels of inflation. Periods of high inflation are often accompanied by relatively higher interest rates, and periods of low inflation are accompanied by relatively lower interest rates. As market interest rates rise or fall in relation to the rates earned on our loans and investments, the value of these assets decreases or increases respectively.

 

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For the Years Ended December 31, 2006, 2005 and 2004

Key Financial Measures

Our net earnings increased $2.7 million, or 56.2%, to $7.5 million for the year ended December 31, 2006, compared with $4.8 million for 2005. Our diluted earnings per common share were $0.94 for 2006 compared with $0.66 for 2005, an increase of 42.4%. Our net earnings decreased $2.1 million, or 30.2%, to $4.8 million for the year ended December 31, 2005, compared with $6.9 million for 2004 due primarily to a one time gain on the sale of real estate in 2004 and no such gain in 2005. For the same reason, our diluted earnings per common share decreased to $0.66 for 2005 compared with $1.11 for 2004, a 40.5% decline.

Our return on average assets was 0.57% for the year ended December 31, 2006, compared with 0.37% for 2005. Our return on average equity was 7.42% for the year ended December 31, 2006, compared with 5.48% for 2005. The increase in both ratios was due primarily to greater net interest income and additional earnings resulting from our first full year of net revenue from our wealth management business. Our return on average assets was 0.37% for the year ended December 31, 2005, compared with 0.54% for 2004. Our return on average equity was 5.48% for the year ended December 31, 2005, compared with 10.22% for 2004. The decrease in both ratios was due primarily to the aforementioned one time gain on the sale of real estate in 2004. The return on average equity for 2006 and 2005 includes $10.3 million in puttable common stock associated with the Linscomb & Williams acquisition. See the section of this prospectus captioned “—Financial Condition—Shareholders’ Equity and Puttable Common Stock” for a detailed discussion of the puttable common stock.

Our net interest margin was 2.46% for the year ended December 31, 2006, compared with 2.14% for 2005, and 1.96% in 2004. Our net interest margin continued to improve due to our more favorable mix of earning assets, as originated loans replaced lower yielding purchased mortgage loans and securities.

Our efficiency ratio was 75.68% for the year ended December 31, 2006, compared with 80.42% for 2005 and 69.87% in 2004. The improvement in our efficiency ratio in 2006 was due primarily to revenue increasing more than expenses. Revenue, defined as net interest income plus noninterest income, increased 17.4% in 2006 and 21.3% in 2005. The unfavorable change in our efficiency ratio in 2005 was primarily due to the one time gain on the sale of real estate in 2004.

Our total assets increased $20.3 million, or 1.5%, to $1.3 billion as of December 31, 2006, compared with total assets as of December 31, 2005. Total assets increased $43.5 million, or 3.4%, to $1.3 billion as of December 31, 2005. Our loan portfolio grew $100.2 million, or 12.4%, to $908.4 million as of December 31, 2006. Our loan portfolio grew $147.5 million, or 22.3%, to $808.2 million as of December 31, 2005. Shareholders’ equity and puttable common stock increased $8.2 million, or 8.4%, to $105.7 million as of December 31, 2006. Shareholders’ equity and puttable common stock increased $24.5 million, or 33.5%, to $97.5 million as of December 31, 2005.

Results of Operations

Net Interest Income

2006 vs. 2005. Net interest income increased $3.9 million, or 14.9%, to $30.2 million for the year ended December 31, 2006 compared with $26.3 million for 2005. Because average interest-earning assets remained approximately the same, year over year, the increase in net interest income was primarily due to a 32 basis point increase in our net interest margin to 2.46% in 2006. This increase resulted primarily from an improvement in our asset composition, as average loans in 2006 increased $93.3 million, or 12.5%, compared with 2005. The increase in average loans was primarily in commercial loan categories, which consisted generally of higher yielding, floating rate loans and which benefited from an increase in short-term interest rates in 2005 and 2006. Consistent with our strategy, this increase in average loans was offset by a $97.4 million reduction in lower

 

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yielding securities. As a result of this shift, average loans increased to 68.6% of average earning assets for 2006 compared with 60.9% for 2005. The yield on average earning assets increased 92 basis points in 2006 to 6.19%, as the average loan yield was approximately 285 basis points higher than the average securities yield. Our net interest margin further benefited from an increase in average deposits of $115.2 million, or 15.0%, in 2006. The increase in average deposits was impacted by an increase of $30.7 million, or 53.9%, in average noninterest-bearing deposits. The increase in deposits allowed us to decrease average borrowings, which are generally more expensive than deposits, by $111.5 million, or 27.2%.

2005 vs. 2004. Net interest income increased $2.2 million, or 9.3%, to $26.3 million for the year ended December 31, 2005 compared with $24.0 million for 2004. Average interest-earning assets remained approximately the same, year over year, and the increase in net interest income was primarily due to an 18 basis point increase in the net interest margin to 2.14% in 2005. This increase resulted primarily from an improvement in our asset composition, as average loans in 2005 rose $120.9 million, or 19.3%, versus 2004. The increase in average loans resulted primarily from growth in commercial loan categories. The increase in average loans was offset by a reduction in average securities of $121.3 million. Average loans represented 60.9% of average earning assets for 2005 compared with 51.0% in 2004. The yield on average earning assets grew 51 basis points in 2005 to 5.27%, as the average loan yield was 224 basis points higher than the average securities yield. During 2005, average deposit balances increased $28.2 million, which was due primarily to an increase of $29.7 million, or 108.6% in average noninterest-bearing deposits. Average borrowings decreased in 2005 by $15.0 million or 3.5%.

 

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The following table sets forth for the periods indicated an analysis of net interest income by each major category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest earned or paid on such amounts and the average rate earned or paid. The table also sets forth the average rate earned on total interest-earning assets, the average rate paid on total interest-bearing liabilities and the net interest margin for the same periods. All balances are daily average balances and nonaccrual loans were included in average loans with a zero yield for the purpose of calculating the rate earned on total loans. We have no tax-exempt securities and an insignificant amount of tax-exempt loans, and no tax equivalent adjustments have been made with respect to these loans.

 

    For the Years Ended December 31,  
    2006     2005     2004  
    Average
Outstanding
Balance
    Interest
Income/
Expense
  Average
Yield/
Rate
    Average
Outstanding
Balance
    Interest
Income/
Expense
  Average
Yield/
Rate
    Average
Outstanding
Balance
    Interest
Income/
Expense
  Average
Yield/
Rate
 
    (dollars in thousands)  

Assets:

                 

Interest-earning assets:

                 

Loans

  $ 840,330     $ 56,753   6.75 %   $ 747,079     $ 44,362   5.94 %   $ 626,225     $ 34,876   5.57 %

Mortgages held for sale

    72,977       6,546   8.97       64,066       4,958   7.74       66,629       4,798   7.20  

Securities

    288,082       11,239   3.90       385,502       14,273   3.70       506,800       18,326   3.62  

Federal funds sold and other

    24,127       1,272   5.27       30,069       1,060   3.53       27,420       470   1.71  
                                               

Total interest-earning assets

    1,225,516       75,810   6.19       1,226,716       64,653   5.27       1,227,074       58,470   4.76  

Less: Allowance for loan losses

    (9,442 )         (7,900 )         (6,605 )    

Noninterest-earning assets

    100,498           74,965           41,501      
                                   

Total assets

  $ 1,316,572         $ 1,293,781         $ 1,261,970      
                                   

Liabilities, shareholders’ equity and puttable common stock:

                 

Interest-bearing liabilities:

                 

Interest checking

  $ 168,881     $ 4,220   2.50 %   $ 146,457     $ 2,513   1.72 %   $ 107,672     $ 1,400   1.30 %

Money market and savings

    264,219       10,457   3.96       230,632       5,863   2.54       263,931       5,120   1.94  

Time deposits

    361,693       15,843   4.38       333,224       11,880   3.57       340,174       10,720   3.15  
                                               

Total interest-bearing deposits

    794,793       30,520   3.84       710,313       20,256   2.85       711,777       17,240   2.42  

Borrowings and repurchase agreements

    298,907       13,378   4.48       410,378       16,765   4.09       425,344       16,200   3.81  

Junior subordinated debentures

    20,619       1,739   8.43       20,619       1,379   6.69       20,619       1,016   4.93  
                                               

Total interest-bearing liabilities

    1,114,319       45,637   4.10       1,141,310       38,400   3.36       1,157,740       34,456   2.98  
                                               

Noninterest-bearing liabilities:

                 

Noninterest-bearing deposits

    87,788           57,045           27,349      

Other liabilities

    13,638           8,068           9,721      
                                   

Total liabilities

    1,215,745           1,206,423           1,194,810      

Shareholders’ equity and puttable common stock

    100,827           87,358           67,160      
                                   

Total liabilities, shareholders’ equity and puttable common stock

  $ 1,316,572         $ 1,293,781         $ 1,261,970      
                                   

Net interest income

    $ 30,173       $ 26,253       $ 24,014  
                             

Net interest spread (1)

      2.09 %       1.91 %       1.78 %

Net interest margin (2)

      2.46 %       2.14 %       1.96 %

(1) Represents the average rate earned on interest-earning assets less the average rate paid on interest-bearing liabilities.
(2) Represents net interest income as a percentage of average interest-earning assets.

 

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Table of Contents
Index to Financial Statements

The following table presents information regarding changes in interest income and interest expense for the periods indicated for each major category of interest-earning assets and interest-bearing liabilities, which distinguishes between the changes attributable to (1) changes in volume (changes in volume multiplied by old rate), (2) changes in rates (changes in rates multiplied by old volume) and (3) changes in rate-volume (changes in rate multiplied by change in volume). Changes in rate-volume are proportionately allocated between rate and volume variances.

 

     For the Years Ended December 31,  
     2006 vs. 2005     2005 vs. 2004  
     Increase (Decrease)
Due to Change In
    Total     Increase (Decrease)
Due to Change In
    Total  
     Volume     Rate       Volume     Rate    
     (dollars in thousands)  

Interest-earning assets:

            

Loans (net of unearned income)

   $ 5,900     $ 6,491     $ 12,391     $ 7,062     $