10-Q 1 d10q.htm FORM 10-Q FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2011. Form 10-Q for the quarterly period ended March 31, 2011.
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

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

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2011

OR

 

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

FOR THE TRANSITION PERIOD FROM                      TO                     

COMMISSION FILE NUMBER: 000-25051

PROSPERITY BANCSHARES, INC.®

(Exact name of registrant as specified in its charter)

 

TEXAS   74-2331986

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

Prosperity Bank Plaza

4295 San Felipe

Houston, Texas 77027

(Address of principal executive offices, including zip code)

(713) 693-9300

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “accelerated filer”, “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

 

Large Accelerated Filer   x      Accelerated Filer   ¨
Non-accelerated Filer   ¨   (Do not check if a smaller reporting company)    Smaller Reporting Company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of May 4, 2011, there were 46,885,976 outstanding shares of the registrant’s Common Stock, par value $1.00 per share.

 

 

 


Table of Contents

PROSPERITY BANCSHARES, INC.® AND SUBSIDIARIES

INDEX TO FORM 10-Q

 

          Page  

PART I - FINANCIAL INFORMATION

  

Item 1.

  

Interim Consolidated Financial Statements

     1   
  

Consolidated Balance Sheets as of March 31, 2011 and December 31, 2010 (unaudited)

     1   
  

Consolidated Statements of Income for the Three Months Ended March 31, 2011 and 2010 (unaudited)

     2   
  

Consolidated Statements of Changes in Shareholders’ Equity for the Year Ended December 31, 2010 and for the Three Months Ended March 31, 2011 (unaudited)

     3   
  

Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2011 and 2010 (unaudited)

     4   
  

Notes to Interim Consolidated Financial Statements (unaudited)

     6   

Item 2.

  

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

     23   

Item 3.

  

Quantitative and Qualitative Disclosures about Market Risk

     37   

Item 4.

  

Controls and Procedures

     37   

PART II - OTHER INFORMATION

  

Item 1.

  

Legal Proceedings

     37   

Item 1A.

  

Risk Factors

     38   

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

     38   

Item 3.

  

Defaults upon Senior Securities

     38   

Item 4.

  

Removed and Reserved

     38   

Item 5.

  

Other Information

     38   

Item 6.

  

Exhibits

     38   

Signatures

     39   


Table of Contents

PART I – FINANCIAL INFORMATION

 

ITEM 1. INTERIM CONSOLIDATED FINANCIAL STATEMENTS

PROSPERITY BANCSHARES, INC®. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

 

     March 31,
2011
    December 31,
2010
 
     (In thousands, except share data)  
ASSETS     

Cash and due from banks

   $ 145,521      $ 158,975   

Federal funds sold

     517        393   
                

Total cash and cash equivalents

     146,038        159,368   

Securities available for sale, at fair value (amortized cost of $376,289 and $406,546, respectively)

     397,377        428,553   

Securities held to maturity, at cost (fair value of $4,518,166 and $4,310,807, respectively)

     4,401,265        4,188,563   

Loans held for investment

     3,572,920        3,485,023   

Allowance for credit losses

     (51,760     (51,584
                

Loans, net

     3,521,160        3,433,439   

Accrued interest receivable

     29,803        29,935   

Goodwill

     924,537        924,258   

Core deposit intangibles, net of accumulated amortization of $52,412 and $50,378, respectively

     26,742        28,776   

Bank premises and equipment, net

     159,050        159,053   

Other real estate owned

     10,465        11,053   

Bank Owned Life Insurance (BOLI)

     49,020        48,697   

Federal Home Loan Bank stock

     20,343        24,982   

Other assets

     37,147        39,895   
                

TOTAL ASSETS

   $ 9,722,947      $ 9,476,572   
                
LIABILITIES AND SHAREHOLDERS’ EQUITY     

LIABILITIES:

    

Deposits:

    

Noninterest-bearing

   $ 1,730,427      $ 1,673,190   

Interest-bearing

     6,085,957        5,781,730   
                

Total deposits

     7,816,384        7,454,920   

Other borrowings

     228,092        374,433   

Securities sold under repurchase agreements

     51,847        60,659   

Accrued interest payable

     3,518        4,014   

Other liabilities

     57,553        37,942   

Junior subordinated debentures

     85,055        92,265   
                

Total liabilities

     8,242,449        8,024,233   
                

COMMITMENTS AND CONTINGENCIES

    

SHAREHOLDERS’ EQUITY:

    

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

     —          —     

Common stock, $1 par value; 200,000,000 shares authorized; 46,818,714 and 46,721,114 shares issued at March 31, 2011 and December 31, 2010, respectively; 46,781,626 and 46,684,026 shares outstanding at March 31, 2011 and December 31, 2010, respectively

     46,819        46,721   

Capital surplus

     879,016        876,050   

Retained earnings

     541,563        515,871   

Accumulated other comprehensive income — net unrealized gain on available for sale securities, net of tax of $7,381 and $7,702, respectively

     13,707        14,304   

Less treasury stock, at cost, 37,088 shares

     (607     (607
                

Total shareholders’ equity

     1,480,498        1,452,339   
                

TOTAL LIABILITIES AND SHAREHOLDERS’

    

EQUITY

   $ 9,722,947      $ 9,476,572   
                

See notes to interim condensed consolidated financial statements.

 

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Table of Contents

PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)

 

     Three Months Ended March 31,  
             2011                      2010          
     (Dollars in thousands, except per share data)  

INTEREST INCOME:

     

Loans, including fees

   $ 52,200       $ 51,453   

Securities

     41,204         45,014   

Federal funds sold

     5         29   
                 

Total interest income

     93,409         96,496   
                 

INTEREST EXPENSE:

     

Deposits

     11,512         17,485   

Junior subordinated debentures

     1,147         791   

Notes payable and other borrowings

     337         448   
                 

Total interest expense

     12,996         18,724   
                 

NET INTEREST INCOME

     80,413         77,772   

PROVISION FOR CREDIT LOSSES

     1,700         4,410   
                 

NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES

     78,713         73,362   
                 

NONINTEREST INCOME:

     

Customer service fees

     12,042         11,589   

Other

     1,825         1,389   
                 

Total noninterest income

     13,867         12,978   
                 

NONINTEREST EXPENSE:

     

Salaries and employee benefits

     23,204         21,112   

Net occupancy expense

     3,648         3,434   

Depreciation expense

     2,021         2,006   

Data processing

     1,672         1,415   

Communications expense

     1,692         2,019   

Core deposit intangibles amortization

     2,034         2,290   

Other

     7,424         7,449   
                 

Total noninterest expense

     41,695         39,725   
                 

INCOME BEFORE INCOME TAXES

     50,885         46,615   

PROVISION FOR INCOME TAXES

     17,007         15,617   
                 

NET INCOME

   $ 33,878       $ 30,998   
                 

EARNINGS PER SHARE

     

Basic

   $ 0.72       $ 0.67   
                 

Diluted

   $ 0.72       $ 0.66   
                 

See notes to interim consolidated financial statements.

 

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Table of Contents

PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(UNAUDITED)

 

     Common Stock      Capital
Surplus
     Retained
Earnings
    Accumulated
Other
Comprehensive
Income
    Treasury
Stock
    Total
Shareholders’
Equity
 
     Shares      Amount              
     (Amounts in thousands, except share and per share data)  

BALANCE AT JANUARY 1, 2010

     46,577,968       $ 46,578       $ 870,460       $ 418,008      $ 16,806      $ (607   $ 1,351,245   

Comprehensive Income:

                 

Net income

              127,708            127,708   

Net change in unrealized gain on available for sale securities (net of tax of $1,347)

                (2,502       (2,502
                       

Total comprehensive income

                    125,206   

Common stock issued in connection with the exercise of stock options and restricted stock awards

     143,146         143         2,553               2,696   

Stock based compensation expense

           3,037               3,037   

Cash dividends declared, $0.64 per share

              (29,845         (29,845
                                                           

BALANCE AT DECEMBER 31, 2010

     46,721,114         46,721         876,050         515,871        14,304        (607     1,452,339   

Comprehensive income:

                 

Net income

              33,878            33,878   

Net change in unrealized gain on available for sale securities (net of tax of $321)

                (597       (597
                       

Total comprehensive income

                    33,281   

Common stock issued in connection with the exercise of stock options and restricted stock awards

     97,600         98         2,259               2,357   

Stock based compensation expense

           707               707   

Cash dividends declared, $0.175 per share

              (8,186         (8,186
                                                           

BALANCE AT MARCH 31, 2011

     46,818,714       $ 46,819       $ 879,016       $ 541,563      $ 13,707      $ (607   $ 1,480,498   
                                                           

 

See notes to interim consolidated financial statements.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

 

     Three Months Ended
March 31,
 
     2011     2010  
     (Dollars in thousands)  

CASH FLOWS FROM OPERATING ACTIVITIES:

    

Net income

   $ 33,878      $ 30,998   

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

    

Depreciation and amortization

     4,055        4,296   

Provision for credit losses

     1,700        4,410   

Net premium amortization on investments

     6,980        2,324   

Stock based compensation expense

     707        791   

Net accretion of discount on loans and deposits

     (50     (237

(Gain) loss on sale of assets and other real estate

     (4     294   

Decrease in other assets and accrued interest receivable

     7,195        5,474   

Increase in accrued interest payable and other liabilities

     19,295        13,998   
                

Net cash provided by operating activities

     73,756        62,348   
                

CASH FLOWS FROM INVESTING ACTIVITIES:

    

Proceeds from maturities and principal paydowns of held to maturity securities

     334,446        245,201   

Purchase of held to maturity securities

     (554,369     (689,171

Proceeds from maturities and principal paydowns of available for sale securities

     30,497        536,284   

Purchase of available for sale securities

     —          (499,999

Net (increase) decrease in loans

     (94,435     41,278   

Cash and cash equivalents acquired in the purchase of U.S. Bank branches

     —          344,722   

Premium paid for U.S. Bank branches

     —          (13,136

Purchase of bank premises and equipment

     (2,288     (6,297

Net proceeds from sale of bank premises, equipment and other real estate

     5,628        9,806   
                

Net cash used in investing activities

     (280,521     (31,312
                

 

(Table continued on following page)

 

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Table of Contents
     Three Months Ended
March 31,
 
     2011     2010  
     (Dollars in thousands)  

CASH FLOWS FROM FINANCING ACTIVITIES:

    

Net increase (decrease) in noninterest-bearing deposits

   $ 57,237      $ (14,412

Net increase (decrease) in interest-bearing deposits

     304,390        (21,082

Net repayments of short-term borrowings

     (146,000     —     

Net repayments of long-term borrowings

     (341     (10,261

Net repayments from securities sold under repurchase agreements

     (8,812     (4,155

Redemption of junior subordinated debentures

     (7,210     —     

Proceeds from exercise of stock options

     2,357        886   

Payments of cash dividends

     (8,186     (7,218
                

Net cash provided by (used in) financing activities

     193,435        (56,242
                

NET DECREASE IN CASH AND CASH EQUIVALENTS

   $ (13,331   $ (25,206

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD

     159,368        195,317   

CASH AND CASH EQUIVALENTS, END OF PERIOD

   $ 146,038      $ 170,111   
                

SUPPLEMENTAL DISCLOSURES:

    

Cash paid for interest

   $ 13,492      $ 18,894   

Cash paid for income taxes

     2,000        3,250   

Noncash investing and financing activities-acquisition of real estate through foreclosure of collateral

     5,935        17,967   

 

 

See notes to interim consolidated financial statements.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2011

(UNAUDITED)

1. BASIS OF PRESENTATION

The interim consolidated financial statements include the accounts of Prosperity Bancshares, Inc.® (the “Company”) and its wholly-owned subsidiaries, Prosperity Bank® (the “Bank”) and Prosperity Holdings of Delaware, LLC. All significant inter-company transactions and balances have been eliminated.

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the rules and regulations of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the statements reflect all adjustments necessary for a fair presentation of the financial position, results of operations and cash flows of the Company on a consolidated basis, and all such adjustments are of a normal recurring nature. These financial statements and the notes thereto should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2010. Operating results for the three-month period ended March 31, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011 or any other period.

2. INCOME PER COMMON SHARE

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

 

     Three Months Ended March 31,  
         2011              2010      
     (In thousands, except per share data)  

Net income available to shareholders

   $ 33,878       $ 30,998   
                 

Weighted average shares outstanding

     46,733         46,553   

Potential dilutive shares

     209         305   
                 

Weighted average shares and equivalents outstanding

     46,942         46,858   
                 

Basic earnings per share

   $ 0.72       $ 0.67   
                 

Diluted earnings per share

   $ 0.72       $ 0.66   
                 

The incremental shares for the assumed exercise of the outstanding options were determined by application of the treasury stock method. There were no stock options exercisable during the quarter ended March 31, 2011 or 2010 that would have had an anti-dilutive effect on the above computation.

3. NEW ACCOUNTING STANDARDS

Accounting Standards Updates

ASU No. 2010-06, “Fair Value Measurements and Disclosures (Topic 820)—Improving Disclosures About Fair Value Measurements.” ASU 2010-06 requires expanded disclosures related to fair value measurements including (i) the amounts of significant transfers of assets or liabilities between Levels 1 and 2 of the fair value hierarchy and the reasons for the transfers, (ii) the reasons for transfers of assets or liabilities in or out of Level 3 of the fair value hierarchy, with significant transfers disclosed separately, (iii) the policy for determining when transfers between levels of the fair value hierarchy are recognized and (iv) for recurring fair value measurements of assets and liabilities in Level 3 of the fair value hierarchy, a gross presentation of information about purchases, sales, issuances and settlements. ASU 2010-06 further clarifies that (i) fair value measurement disclosures should be provided for each class of assets and liabilities (rather than major category), which would generally be a subset of assets or liabilities within a line item in the statement of financial position and (ii) company’s should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements for each class of assets and liabilities included in Levels 2 and 3 of the fair

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2011

(UNAUDITED)

 

value hierarchy. The disclosures related to the gross presentation of purchases, sales, issuances and settlements of assets and liabilities included in Level 3 of the fair value hierarchy was required for the Company beginning January 1, 2011. The remaining disclosure requirements and clarifications made by ASU 2010-06 became effective for the Company on January 1, 2010.

ASU No. 2010-20, “Receivables (Topic 310)—Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.” ASU 2010-20 requires entities to provide disclosures designed to facilitate financial statement users’ evaluation of (i) the nature of credit risk inherent in the entity’s portfolio of financing receivables, (ii) how that risk is analyzed and assessed in arriving at the allowance for credit losses and (iii) the changes and reasons for those changes in the allowance for credit losses. Disclosures must be disaggregated by portfolio segment, the level at which an entity develops and documents a systematic method for determining its allowance for credit losses, and class of financing receivable, which is generally a disaggregation of portfolio segment. The required disclosures include, among other things, a rollforward of the allowance for credit losses as well as information about modified, impaired, non-accrual and past due loans and credit quality indicators. ASU 2010-20 became effective for the Company’s financial statements as of December 31, 2010, as it relates to disclosures required as of the end of a reporting period. Disclosures that relate to activity during a reporting period will be required for the Company’s financial statements that include periods beginning on or after January 1, 2011. ASU 2011-01, “Receivables (Topic 310)—Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20,” temporarily deferred the effective date for disclosures related to troubled debt restructurings to coincide with the effective date of a proposed accounting standards update related to troubled debt restructurings, which is currently expected to be effective for periods ending after June 15, 2011.

ASU No. 2010-28, “Intangibles—Goodwill and Other (Topic 350)—When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts.” ASU 2010-28 modifies Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that an impairment may exist such as if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. ASU 2010-28 became effective for the Company on January 1, 2011 and did not have a significant impact on the Company’s financial statements.

ASU No. 2010-29, “Business Combinations (Topic 805)—Disclosure of Supplementary Pro Forma Information for Business Combinations.” ASU 2010-29 provides clarification regarding the acquisition date that should be used for reporting the pro forma financial information disclosures required by Topic 805 when comparative financial statements are presented. ASU 2010-29 also requires entities to provide a description of the nature and amount of material, nonrecurring pro forma adjustments that are directly attributable to the business combination. ASU 2010-29 is effective for the Company prospectively for business combinations occurring after December 31, 2010.

ASU No. 2011-01, “Deferral of the Effective Date of Disclosures About Troubled Debt Restructurings in Update No. 2010-20”. ASU 2011-01 temporarily defers the effective date in ASU 2010-20 for public-entity creditors’ disclosures about troubled debt restructurings (TDRs) until the Board finalizes its project on determining what constitutes a TDR for a creditor. ASU 2011-01 is effective for the Company upon issuance and is not expected have a significant impact on the Company’s financial statements.

ASU No. 2011-02, “A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring”. ASU 2011-02 provides additional guidance or clarification to help determine whether a creditor has granted a concession and whether a debtor is experiencing financial difficulties for purposes of determining whether a restructuring constitutes a troubled debt restructuring. The amendments in this update are effective for the first interim or annual period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. The adoption of ASU 2011-02 is not expected to have a significant impact on the Company’s financial statements.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2011

(UNAUDITED)

 

4. LOANS AND ALLOWANCE FOR CREDIT LOSSES

The loan portfolio consists of various types of loans made principally to borrowers located in South and Southeast Texas, Houston, Central Texas, Bryan/College Station, East Texas, Corpus Christi and Dallas/Fort Worth and is classified by major type as follows:

 

     March 31,
2011
     December 31,
2010
 
     (Dollars in thousands)  

Commercial and industrial

   $ 429,208       $ 409,426   

Real estate:

     

Construction and land development

     494,159         502,327   

1-4 family residential

     882,807         824,057   

Home equity

     123,696         118,781   

Commercial mortgage

     1,299,680         1,288,023   

Agriculture real estate

     103,159         98,871   

Multi-family residential

     85,351         82,626   

Agriculture

     41,376         41,881   

Consumer (net of unearned discount)

     82,626         87,977   

Other

     30,858         31,054   
                 

Total

   $ 3,572,920       $ 3,485,023   
                 

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

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2011

(UNAUDITED)

 

(ii) Commercial Mortgages. The Company makes commercial mortgage loans collateralized by owner-occupied and non-owner-occupied real estate to finance the purchase of real estate. The Company’s commercial mortgage loans are collateralized by first liens on real estate, typically have variable interest rates (or five year or less fixed rates) and amortize over a 15 to 20 year period. 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. The Company seeks to minimize these risks in a variety of ways, including giving careful consideration to the property’s operating history, future operating projections, current and projected occupancy, location and physical condition in connection with underwriting these loans. The underwriting analysis also includes credit verification, analysis of global cash flow, appraisals and a review of the financial condition of the borrower. At March 31, 2011, approximately 35.3% of the outstanding principal balance of the Company’s commercial real estate loans was secured by owner-occupied properties. At March 31, 2011, the Company had commercial real estate loans totaling $1.88 billion which include the categories of construction and land development loans, commercial mortgage loans and multi-family residential loans.

(iii) 1-4 Family Residential Loans. The Company originates 1-4 family residential mortgage loans collateralized by owner-occupied residential properties located in the Company’s market areas. The Company offers a variety of mortgage loan products which generally are amortized over five to 25 years. Loans collateralized by 1-4 family residential real estate generally have been originated in amounts of no more than 89% of appraised value or have mortgage insurance. The Company requires mortgage title insurance and hazard insurance. The Company has elected to keep all 1-4 family residential loans for its own account rather than selling such loans into the secondary market. By doing so, the Company is able to realize a higher yield on these loans; however, the Company also incurs interest rate risk as well as the risks associated with nonpayments on such loans.

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

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

(vi) Consumer Loans. Consumer loans made by the Company include direct credit automobile loans, recreational vehicle loans, boat loans, home improvement loans, home equity loans, personal loans (collateralized and uncollateralized) and deposit account collateralized loans. The terms of these loans typically range from 12 to 120 months and vary based upon the nature of collateral and size of loan. Generally, consumer loans entail greater risk than do real estate secured loans, particularly in the case of consumer loans that are unsecured or collateralized 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

 

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NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2011

(UNAUDITED)

 

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.

The Company maintains an independent loan review department that reviews and validates the credit risk program on a periodic basis. Results of these reviews are presented to management. The loan review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel, as well as the Company’s policies and procedures.

Concentrations of Credit. Most of the Company’s lending activity occurs within the State of Texas, including the four largest metropolitan areas of Austin, Dallas/Ft. Worth, Houston and San Antonio, as well as other markets. The majority of the Company’s loan portfolio consists of commercial and industrial and commercial real estate loans. As of March 31, 2011 and December 31, 2010, there were no concentrations of loans related to any single industry in excess of 10% of total loans.

Foreign Loans. The Company has U.S. dollar denominated loans and commitments to borrowers in Mexico. The outstanding balance of these loans and the unfunded amounts available under these commitments were not significant at March 31, 2011 or December 31, 2010.

Related Party Loans. As of March 31, 2011 and December 31, 2010, loans outstanding to directors, officers and their affiliates totaled $6.6 million and $12.8 million, respectively. All transactions entered into between the Company and such related parties are done in the ordinary course of business, made on the same terms and conditions as similar transactions with unaffiliated persons.

An analysis of activity with respect to these related-party loans is as follows:

 

     March 31,
2011
    December 31,
2010
 
     (Dollars in thousands)  

Beginning balance

   $ 12,783      $ 15,540   

New loans and reclassified related loans

     76        910   

Repayments

     (6,272     (3,667
                

Ending balance

   $ 6,587      $ 12,783   
                

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

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

 

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NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2011

(UNAUDITED)

 

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

As of the dates indicated, nonaccrual loans, segregated by class of loans, were as follows:

 

     March 31,
2011
     December 31,
2010
 
     (Dollars in thousands)  

Construction and land development

   $ 178       $ 1,417  

Agriculture and agriculture real estate

     17         11   

1-4 family (includes home equity)

     711         1,559   

Commercial real estate (includes multi-family residential)

     539         235   

Commercial and industrial

     812         1,179   

Consumer and other

     22         38   
                 

Total

   $ 2,279       $ 4,439   
                 

An age analysis of past due loans, segregated by class of loans, as of March 31, 2011 was as follows:

 

     As of March 31, 2011  
     Loans
30-89 Days
Past Due
     Loans
90 or  More
Days

Past Due
     Total Past
Due Loans
     Current
Loans
     Accruing
Loans 90 or
More Days
Past Due
 
     (Dollars in thousands)  

Construction and land development

   $ 3,550       $ 253       $ 3,803       $ 490,356       $ 76   

Agriculture and agriculture real estate

     286         11         297         144,238         —     

1-4 family (includes home equity)

     4,990         481         5,471         1,001,032         —     

Commercial real estate (includes multi- family residential)

     8,175         526         8,701         1,376,330         —     

Commercial and industrial

     2,257         738         2,995         426,213         —     

Consumer and other

     310         14         324         113,160         —     
                                            

Total

   $ 19,568       $ 2,023       $ 21,591       $ 3,551,329       $ 76   
                                            

 

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NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2011

(UNAUDITED)

 

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

 

     March 31,
2011
    December 31,
2010
 
     (Dollars in thousands)  

Nonaccrual loans

   $ 2,279      $ 4,439   

Accruing loans 90 or more days past due

     76        189   
                

Total nonperforming loans

     2,355        4,628   

Repossessed assets

     68        161   

Other real estate

     10,465        11,053   
                

Total nonperforming assets

   $ 12,888      $ 15,842   
                

Nonperforming assets to total loans and other real estate

     0.36     0.45

The Company’s conservative lending approach has resulted in strong asset quality. The Company had $12.9 million in nonperforming assets at March 31, 2011 compared with $15.8 million at December 31, 2010. If interest on nonaccrual loans had been accrued under the original loan terms, approximately $86,000 would have been recorded as income for the three months ended March 31, 2011.

Impaired Loans. Loans are considered impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loan basis for other loans. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

 

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NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2011

(UNAUDITED)

 

Impaired loans as of March 31, 2011 are set forth in the following table. No interest income was recognized on impaired loans subsequent to their classification as impaired. The average recorded investment is reported on a year-to-date basis.

 

     March 31, 2011  
     Recorded Investment      Unpaid Principal
Balance
     Related Allowance      Average Recorded
Investment
 
     (Dollars in thousands)  

With no related allowance recorded:

           

Construction and land development

   $ —         $ —         $ —         $ 63   

Agriculture and agriculture real estate

     6         7         —           3   

1-4 family (includes home equity)

     262         279         —           246   

Commercial real estate (includes multi-family residential)

     526         526         —           374   

Commercial and industrial

     326         1,326         —           340   

Consumer and other

     7         7         —           4   

With an allowance recorded:

           

Construction and land development

     128         128         23         728   

Agriculture and agriculture real estate

     11         11         5         11   

1-4 family (includes home equity)

     125         133         74         695   

Commercial real estate (includes multi-family residential)

     360         360         260         180   

Commercial and industrial

     493         685         440         609   

Consumer and other

     15         26         10         22   

Total:

           

Construction and land development

     128         128         23         791   

Agriculture and agriculture real estate

     17         18         5         14   

1-4 family (includes home equity)

     387         412         74         941   

Commercial real estate (includes multi-family residential)

     886         886         260         554   

Commercial and industrial

     819         2,011         440         949   

Consumer and other

     22         33         10         26   

Credit Quality Indicators. As part of the ongoing monitoring of the credit quality of the corporations loan portfolio and methodology for calculating the allowance for credit losses, management assigns and tracks loan grades to be used as credit quality indicators. The following is a general description of the loan grades used (1-7):

Grade 1 – Credits in this category are of the highest standards of credit quality with virtually no risk of loss. These borrowers would represent top rated companies and individuals with unquestionable financial standing with excellent global cash flow coverage, net worth, liquidity and collateral coverage and/or secured by CD/savings accounts.

Grade 2 – Credits in this category are not immune for risk but are well-protected by the collateral and paying capacity of the borrower. These loans may exhibit a minor unfavorable credit factor, but the overall credit is sufficiently strong to minimize the possibility of loss.

 

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MARCH 31, 2011

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Grade 3 – Credits graded 3 constitute an undue and unwarranted credit risk, however the factors do not rise to a level of substandard. These credits have potential weaknesses and/or declining trends that, if not corrected, could expose the bank to risk at a future date. Credits graded 3 are monitored on the banks internally generated watch list and evaluated on a quarterly basis.

Grade 4 – Credits in this category are deemed “substandard” loans in accordance with regulatory guidelines. Loans in this category have well-defined weakness that, if not corrected, could make default of principal and interest possible, but it is not yet certain. Loans in this category are still accruing interest and may be dependent upon secondary sources of repayment and/or collateral liquidation.

Grade 5 – Credits in this category are deemed “substandard” and “impaired” pursuant to regulatory guidelines. As such, the Bank has determined that it is probable that less than 100% of the principal and interest will be collected. Loans graded 5 are individually evaluated for a specific reserve valuation and will typically have the accrual of interest stopped.

Grade 6 – Credits in this category include “doubtful” loans in accordance with regulatory guidance. Such loans are on nonaccrual and factors have indicated a loss is imminent. These loans are also deemed “impaired.” While a specific reserve may be in place while the loan and collateral is being evaluated these loans are typically charged down to an amount the bank deems can be collected.

Grade 7 – Credits in this category are deemed a “loss” in accordance with regulatory guidelines and charged off or charged down. The bank may continue collection efforts and may have partial recovery in the future.

The following table presents risk grades and classified loans by class of loan at March 31, 2011. Classified loans include loans in Risk Grades 5, 6 and 7.

 

     Construction
and Land
Development
     Agriculture
and
Agriculture
Real Estate
     1-4 Family
(Includes Home
Equity)
     Commercial
Real Estate
(Includes
Multi-Family)
     Commercial
and Industrial
     Consumer and
Other
     Total  
     (Dollars in thousands)  

Grade 1

   $ —         $ 3,782       $ —         $ —         $ 44,418       $ 31,084       $ 79,284   

Grade 2

     475,745         140,565         995,008         1,350,826         381,518         82,372         3,426,034   

Grade 3

     2,373         119         6,514         9,412         842         —           19,260   

Grade 4

     15,913         52         4,595         23,907         1,611         6         46,084   

Grade 5

     128         17         372         886         300         22         1,725   

Grade 6

     —           —           14         —           519         —           533   

Grade 7

     —           —           —           —           —           —           —     
                                                              

Total

   $ 494,159       $ 144,535       $ 1,006,503       $ 1,385,031       $ 429,208       $ 113,484       $ 3,572,920   
                                                              

 

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NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2011

(UNAUDITED)

 

Allowance for Credit Losses. The allowance for credit losses is a valuation established through charges to earnings in the form of a provision for credit losses. Management has established an allowance for credit losses which it believes is adequate for estimated losses in the Company’s loan portfolio. The amount of the allowance for credit losses is affected by the following: (i) charge-offs of loans that occur when loans are deemed uncollectible and decrease the allowance, (ii) recoveries on loans previously charged off that increase the allowance and (iii) provisions for credit losses charged to earnings that increase the allowance. Based on an evaluation of the loan portfolio and consideration of the factors listed below, management presents a quarterly review of the allowance for credit losses to the Bank’s Board of Directors, indicating any change in the allowance since the last review and any recommendations as to adjustments in the allowance.

The Company’s allowance for credit losses consists of two components: a specific valuation allowance based on probable losses on specifically identified loans and a general valuation allowance based on historical loan loss experience, general economic conditions and other qualitative risk factors both internal and external to the Company.

In setting the specific valuation allowance, the Company follows a loan review program to evaluate the credit risk in the loan portfolio. Through this loan review process, the Company maintains an internal list of impaired loans which, along with the delinquency list of loans, helps management assess the overall quality of the loan portfolio and the adequacy of the allowance for credit losses. All loans that have been identified as impaired are reviewed on a quarterly basis in order to determine whether a specific reserve is required. For each impaired loan, the Company allocates a specific loan loss reserve primarily based on the value of the collateral securing the impaired loan in accordance with ASC Topic 310, Receivables. The specific reserves are determined on an individual loan basis. Loans for which specific reserves are provided are excluded from the general valuation allowance described below.

In determining the amount of the general valuation allowance, management considers factors such as historical loan loss experience, industry diversification of the Company’s commercial loan portfolio, concentration risk of specific loan types, the volume, growth and composition of the Company’s loan portfolio, current economic conditions that may affect the borrower’s ability to pay and the value of collateral, the evaluation of the Company’s loan portfolio through its internal loan review process, general economic conditions and other qualitative risk factors both internal and external to the Company and other relevant factors in accordance with ASC Topic 450. Based on a review of these factors for each loan type, the Company applies an estimated percentage to the outstanding balance of each loan type, excluding any loan that has a specific reserve allocated to it. The Company uses this information to establish the amount of the general valuation allowance.

In connection with its review of the loan portfolio, the Company considers risk elements attributable to particular loan types or categories in assessing the quality of individual loans. Some of the risk elements include:

 

   

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

 

   

for commercial mortgage loans and multifamily residential loans, the debt service coverage ratio (income from the property in excess of operating expenses compared to loan payment requirements), operating results of the owner in the case of owner-occupied properties, the loan to value ratio, the age and condition of the collateral and the volatility of income, property value and future operating results typical of properties of that type;

 

   

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

 

   

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

 

   

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

 

   

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

 

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NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2011

(UNAUDITED)

 

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

At March 31, 2011, the allowance for credit losses totaled $51.8 million or 1.45% of total loans. At December 31, 2010, the allowance aggregated $51.6 million or 1.48% of total loans.

The following table details the recorded investment in loans and activity in the allowance for credit losses by portfolio segment for the three months ended March 31, 2011. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.

 

     Construction
and Land
Development
    Agriculture
and
Agriculture
Real Estate
     1-4 Family
(Including
Home
Equity)
    Commercial
Real Estate
(Includes
Multi-
Family)
    Commercial
and
Industrial
    Consumer
and Other
    Total  
     (Dollars in thousands)  

Allowance for credit losses:

               

Beginning balance

   $ 15,304      $ 271       $ 9,724     $ 21,239      $ 3,891      $ 1,155      $ 51,584  

Provision for credit losses

     (676     10         418        518        556        874        1,700   

Charge-offs

     (750     —           (227     (321     (284     (275     (1,857

Recoveries

     53        —           1        2        68        209        333   
                                                         

Net charge-offs

     (697     —           (226     (319     (216     (66     (1,524
                                                         

Ending balance

     13,931        281         9,916        21,438        4,231        1,963        51,760   
                                                         

Ending balance:
individually evaluated for impairment

     23        5         74        260        440        10        812   

Ending balance:
collectively evaluated for impairment

     13,908        276         9,842        21,178        3,791        1,953        50,948   

Loans:

               

Ending balance:
individually evaluated for impairment

     18,413        187         11,495        34,207        3,272        28        67,602   

Ending balance:
collectively evaluated for impairment

     475,746        144,348         995,008        1,350,824        425,936        113,456        3,505,318   
                                                         

Ending balance

     494,159        144,535         1,006,503        1,385,031        429,208        113,484        3,572,920   
                                                         

5. FAIR VALUE

Effective January 1, 2008, the Company adopted FASB ASC Topic 820, Fair Value Measurement and Disclosures. ASC Topic 820, which defines fair value, addresses aspects of the expanding application of fair value accounting and establishes a consistent framework for measuring fair value. Fair value represents the estimated price that would be received from selling an asset or paid to transfer a liability, otherwise knows as an “exit price”.

 

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NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2011

(UNAUDITED)

 

Fair Value Hierarchy

ASC Topic 820 specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. In accordance with ASC Topic 820, these inputs are summarized in the three broad levels listed below:

 

   

Level 1 – Quoted prices in active markets for identical assets or liabilities. Level 1 assets include U.S. Treasury securities that are highly liquid and are actively traded in over-the-counter markets.

 

   

Level 2 – Other significant observable inputs (including quoted prices in active markets for similar assets or liabilities) or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. The Company’s Level 2 assets include U.S. government and agency mortgage-backed debt securities, corporate securities, municipal bonds and CRA funds.

 

   

Level 3 – Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair values requires significant management judgment or estimation.

In determining the appropriate levels, the Company performs a detailed analysis of the assets and liabilities that are subject to ASC Topic 820.

The following table summarizes financial assets and financial liabilities measured at fair value on a recurring basis as of March 31, 2011, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

 

     Level 1      Level 2      Level 3      Total  
     (Dollars in thousands)  

Available for sale securities (at fair value):

           

States and political subdivisions (including Qualified Zone Academy Bond (“QZAB”))

   $ —         $ 49,676       $ —         $ 49,676   

Corporate debt securities and other

     —           9,104         —           9,104   

Collateralized mortgage obligations

     —           897         —           897   

Mortgage-backed securities

     —           337,700         —           337,700   
                                   

TOTAL

   $ —         $ 397,377       $ —         $ 397,377   
                                   

Certain assets and liabilities are measured at fair value on a non-recurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). These instruments include other real estate owned, repossessed assets and impaired loans per ASC Topic 310, Receivables. For the three months ended March 31, 2011, the Company had additions to impaired loans of $645,000 and additions to other real estate owned of $5.9 million, of which $645,000 and $1.8 million were outstanding at March 31, 2011, respectively. The remaining financial assets and financial liabilities measured at fair value on a non-recurring basis that were recorded in 2011 and remained outstanding at March 31, 2011 were not significant.

The fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for such asset or liability. In estimating fair value, the Company utilizes valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. Such valuation techniques are consistently applied. Inputs to valuation techniques include the assumptions that market participants would use in pricing an asset or liability. FASB ASC Topic 820 establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2011

(UNAUDITED)

 

These fair value disclosures represent the Company’s estimates based on relevant market information and information about the financial instruments. Fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of the various instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in the above methodologies and assumptions could significantly affect the estimates.

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and Cash Equivalents—For these short-term instruments, the carrying amount is a reasonable estimate of fair value.

Federal Funds Sold—The carrying amount is a reasonable estimate of fair value.

Securities—For securities held as investments, fair value equals quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.

Loans Held for Investment—For fixed rate loans and certain homogeneous categories of loans (such as some residential mortgages and other consumer loans), fair value is estimated by discounting the future cash flows using the risk-free Treasury rate for the applicable maturity, adjusted for servicing and credit risk. The carrying value of variable rate loans approximates fair value because the loans reprice frequently to current market rates.

Deposits—The fair value of demand deposits, savings accounts and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities.

Junior Subordinated Debentures—The fair value of the junior subordinated debentures was calculated using the quoted market prices, if available. If quoted market prices are not available, fair value is estimated using quoted market prices for similar subordinated debentures.

Other Borrowings—Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate the fair value of existing debt using a discounted cash flows methodology.

Securities Sold Under Repurchase Agreements—The fair value of securities sold under repurchase agreements is the amount payable on demand at the reporting date.

Off-Balance Sheet Financial Instruments—The fair value of commitments to extend credit and standby letters of credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreement and the present creditworthiness of the counterparties.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2011

(UNAUDITED)

FASB ASC Topic 825, Financial Instruments, requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis. The carrying amount and estimated fair values of the Company’s financial instruments are as follows:

 

     March 31, 2011  
     Carrying Amount      Estimated Fair Value  
     (Dollars in thousands)  

Financial assets:

     

Cash and due from banks

   $ 145,521       $ 145,521   

Federal funds sold

     517         517   

Available for sale securities

     397,377         397,377   

Held to maturity securities

     4,401,265         4,518,166   

Loans held for investment and for sale (net of allowance for credit losses)

     3,521,160         3,488,398   
                 

Total

   $ 8,465,840       $ 8,549,979   
                 

Financial liabilities:

     

Deposits

   $ 7,816,384       $ 7,827,231   

Other borrowings

     228,092         229,479   

Securities sold under repurchase agreements

     51,847         51,847   

Junior subordinated debentures

     85,055         79,764   
                 

Total

   $ 8,181,378       $ 8,188,321   
                 

The Company’s off-balance sheet commitments, which totaled $459.3 million at March 31, 2011, are funded at current market rates at the date they are drawn upon. It is management’s opinion that the fair value of these commitments would approximate their carrying value, if drawn upon.

The fair value estimates presented herein are based on pertinent information available to management at March 31, 2011. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since those dates and, therefore, current estimates of fair value may differ significantly from the amounts presented herein.

6. GOODWILL AND CORE DEPOSIT INTANGIBLES

Changes in the carrying amount of the Company’s goodwill and core deposit intangibles (“CDI”) for three months ended March 31, 2011 were as follows:

 

     Goodwill      Core Deposit
Intangibles
 
     (Dollars in thousands)  

Balance as of December 31, 2010

   $ 924,258       $ 28,776   

Amortization

     —           (2,034

Acquisition of First Bank branches

     279         —     
                 

Balance as of March 31, 2011

   $ 924,537       $ 26,742   
                 

Purchase accounting adjustments to prior year acquisitions were made to adjust deferred tax asset and liability balances. Goodwill is recorded on the acquisition date of each entity. The Company may record subsequent adjustments to goodwill for amounts undeterminable at acquisition date, such as deferred taxes and real estate valuations, and therefore the goodwill amounts reflected in the table above may change accordingly. The Company initially records the total premium paid on acquisitions as goodwill. After finalizing the valuation, core deposit intangibles are identified and reclassified from goodwill to core deposit intangibles on the balance sheet. This reclassification has no effect on total assets, liabilities, shareholders’ equity, net income or cash flows. Management performs an evaluation annually, and more frequently if a triggering event occurs, of whether any impairment of the goodwill and other intangibles has occurred. If any such impairment is determined, a write-down is recorded. As of March 31, 2011, there were no impairments recorded on goodwill.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2011

(UNAUDITED)

 

CDI is amortized on an accelerated basis over their estimated lives, which the Company believes is between 8 and 10 years. Gross core deposit intangibles outstanding were $79.2 million at March 31, 2011 and December 31, 2010. Net core deposit intangibles outstanding were $26.7 million and $28.8 million at the same dates, respectively. Amortization expense related to intangible assets totaled $2.0 million and $2.3 million for the three months ended March 31, 2011 and 2010, respectively. The estimated aggregate future amortization expense for intangible assets remaining as of March 31, 2011 is as follows (dollars in thousands):

 

Remaining 2011

   $ 5,746   

2012

     6,347   

2013

     4,465   

2014

     3,314   

2015

     2,804   

Thereafter

     4,066   
        

Total

   $ 26,742   
        

7. STOCK BASED COMPENSATION

At March 31, 2011, the Company had three stock-based employee compensation plans and two stock option plans assumed in connection with acquisitions under which no additional options will be granted. Two of the three plans adopted by the Company have expired and therefore no additional awards may be issued under those plans. The Company accounts for stock-based employee compensation plans using the fair value-based method of accounting in accordance with ASC Topic 718. ASC Topic 718 was effective for companies in 2006; however, the Company has been recognizing compensation expense since January 1, 2003. The Company recognized $707,000 and $791,000 in stock-based compensation expense for the three months ended March 31, 2011 and 2010, respectively. There was approximately $234,000 and $252,000 of income tax benefit recorded for the stock-based compensation expense for the same periods.

During 2004, the Company’s Board of Directors and shareholders approved the Prosperity Bancshares, Inc. 2004 Stock Incentive Plan (the “2004 Plan”). The Company has granted shares (“restricted stock”) to certain directors, officers and associates under the 2004 Plan. The awardee is not entitled to the shares until they vest, which is generally over a 1 to 5 year period, but the awardee is entitled to receive dividends on and vote the shares prior to vesting. The shares granted do not have a cost to the awardee and the only requirement of vesting is continued service to the Company. Compensation cost related to restricted stock is calculated based on the fair value of the shares at the date of grant. If the awardee leaves the Company before the shares vest, the unvested shares are forfeited. As of March 31, 2011, there were 351,200 shares of restricted stock outstanding with a weighted average grant date fair value of $36.53 per share.

Stock options are issued at the current market price on the date of the grant, subject to a pre-determined vesting period with a contractual term of 10 years. Options assumed in connection with acquisitions also have a contractual term of 10 years from date of original issuance under the original plan. The fair value of stock options granted is estimated at the date of grant using the Black-Scholes option-pricing model. Stock-based compensation expense is recognized ratably over the requisite service period for all awards.

The fair value of options was estimated using an option-pricing model with the following weighted average assumptions as of the dates indicated:

 

     March 31,  
     2011     2010  

Expected life (in years)

     5.20        5.11   

Risk free interest rate

     3.72     3.95

Volatility

     20.96     21.28

Dividend yield

     1.25     1.26

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2011

(UNAUDITED)

 

A summary of changes in outstanding options during the three months ended March 31, 2011 is set forth below:

 

     Number of
Options
    Weighted Average
Exercise Price
     Weighted Average
Remaining Contractual
Term
     Aggregate Intrinsic
Value
 
     (In thousands)            (In years)      (In thousands)  

Options outstanding, beginning of period

     696      $ 27.24         

Options granted

     —          —           

Options forfeited

     —          —           

Options exercised

     (100     23.66         
                

Options outstanding, end of period

     596      $ 27.85         4.53       $ 8,891   
                                  

Options vested or expected to vest

     578      $ 27.61         4.49       $ 8,764   
                                  

Options exercisable, end of period

     295      $ 26.10         3.70       $ 4,918   
                                  

No options were granted during the three months ended March 31, 2011 or 2010. The total intrinsic value of the options exercised during the three-month periods ended March 31, 2011 and 2010 was $1.9 million and $539,000, respectively. The total fair value of shares vested during the three-month period ended March 31, 2011 and 2010 was approximately $66,000 and $80,000, respectively.

A summary of changes in non-vested options is set forth below:

 

     Three Months Ended March 31,  
     2011      2010  
     Number of
Options
    Weighted Average
Grant Date Fair Value
     Number of
Options
    Weighted Average
Grant Date Fair Value
 
     (In thousands)            (In thousands)        

Non-vested options outstanding, beginning of period

     313      $ 6.89         376      $ 6.78   

Options granted

     —          —           —          —     

Non-vested options forfeited

     —          —           —          —     

Options vested

     (12     5.62         (14     5.62   
                     

Non-vested options outstanding, end of period

     301      $ 6.94         362      $ 6.83   
                                 

The Company received $2.4 million and $886,000 in cash from the exercise of stock options during the three-month periods ended March 31, 2011 and 2010, respectively. There was no tax benefit realized from option exercises of the share-based payment arrangements during the three-month periods ended March 31, 2011 and 2010.

As of March 31, 2011, there was $11.2 million of total unrecognized compensation expense related to stock-based compensation arrangements. That cost is expected to be recognized over a weighted average period of 2.6 years.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2011

(UNAUDITED)

 

8. CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ITEMS

Contractual Obligations

The following table summarizes the Company’s contractual obligations and other commitments to make future payments as of March 31, 2011 (other than deposit obligations). The payments do not include pre-payment options that may be available to the Company. The Company’s future cash payments associated with its contractual obligations pursuant to its junior subordinated debentures, Federal Home Loan Bank (“FHLB”) notes payable and operating leases as of March 31, 2011 are summarized below. Payments for junior subordinated debentures include interest of $52.6 million that will be paid over future periods. Future interest payments were calculated using the current rate in effect at March 31, 2011. With respect to floating interest rates, the payments were determined based on the 3-month LIBOR in effect at March 31, 2011. The current principal balance of the junior subordinated debentures at March 31, 2011 was $85.1 million. Payments for FHLB notes payable include interest of $4.0 million that will be paid over the future periods. Payments related to leases are based on actual payments specified in underlying contracts.

 

     Payments due in:  
     Remaining
Fiscal 2011
     Fiscal
2012-2013
     Fiscal
2014-2015
     Thereafter      Total  
     (Dollars in thousands)  

Junior subordinated debentures

   $ 1,755       $ 4,680       $ 4,680       $ 126,584       $ 137,699   

Federal Home Loan Bank borrowings

     215,698         3,356         3,837         9,211         232,102   

Operating leases

     4,112         9,293         5,103         1,376         19,884   
                                            

Total

   $ 221,565       $ 17,329       $ 13,620       $ 137,171       $ 389,685   
                                            

Off-Balance Sheet Items

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

The Company’s commitments associated with outstanding standby letters of credit and commitments to extend credit as of March 31, 2011 are summarized below. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements:

 

     Remaining
Fiscal 2011
     Fiscal
2012-2013
     Fiscal
2014-2015
     Thereafter      Total  
     (Dollars in thousands)  

Standby letters of credit

   $ 12,589       $ 2,589       $ 80       $ 54       $ 15,312   

Commitments to extend credit

     208,459         96,012         5,449         149,335         459,255   
                                            

Total

   $ 221,048       $ 98,601       $ 5,529       $ 149,389       $ 474,567   
                                            

 

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

Special Cautionary Notice Regarding Forward-Looking Statements

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

 

   

changes in the strength of the United States economy in general and the strength of the local economies in which the Company conducts operations resulting in, among other things, a deterioration in credit quality or reduced demand for credit, including the result and effect on the Company’s loan portfolio and allowance for credit losses;

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

the possible impairment of goodwill associated with an acquisition and possible adverse short-term effects on the results of operations;

 

   

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

 

   

the concentration of the Company’s loan portfolio in loans collateralized by real estate;

 

   

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

 

   

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

 

   

a deterioration or downgrade in the credit quality and credit agency ratings of the securities in the Company’s securities portfolio;

 

   

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

 

   

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

 

   

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

 

   

government intervention in the U.S. financial system;

 

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

 

   

increases in FDIC deposit insurance assessments;

 

   

potential risk of environmental liability associated with lending activities;

 

   

potential payment of interest on demand deposit accounts to effectively compete for clients;

 

   

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

 

   

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

A forward-looking statement may include a statement of the assumptions or bases underlying the forward-looking statement. The Company believes it has chosen these assumptions or bases in good faith and that they are reasonable. However, the Company cautions you that assumptions or bases almost always vary from actual results, and the differences between assumptions or bases and actual results can be material. The Company undertakes no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the major elements of the Company’s interim consolidated financial statements and accompanying notes. This section should be read in conjunction with the Company’s interim consolidated financial statements and accompanying notes included elsewhere in this report and with the consolidated financial statements and accompanying notes and other detailed information appearing in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

OVERVIEW

The Company, a Texas corporation, was formed in 1983 as a vehicle to acquire the former Allied First Bank in Edna, Texas which was chartered in 1949 as The First National Bank of Edna and is now known as Prosperity Bank. The Company is a registered financial holding company that derives substantially all of its revenues and income from the operation of its bank subsidiary, Prosperity Bank® (“Prosperity Bank®” or the “Bank”). The Bank provides a wide array of financial products and services to small and medium-sized businesses and consumers. As of March 31, 2011, the Bank operated one hundred seventy-five (175) full-service banking locations; with sixty (60) in the Houston area, twenty (20) in the South Texas area including Corpus Christi and Victoria, thirty-three (33) in the Central Texas, ten (10) in the Bryan/College Station area, twenty-one (21) in East Texas and thirty-one (31) in the Dallas/Fort Worth, Texas area. The Company’s headquarters are located at Prosperity Bank Plaza, 4295 San Felipe in Houston, Texas and its telephone number is (281) 269-7199. The Company’s website address is www.prosperitybanktx.com. Information contained on the Company’s website is not incorporated by reference into this quarterly report on Form 10-Q and is not part of this or any other report.

The Company generates the majority of its revenues from interest income on loans, service charges on customer accounts and income from investment in securities. The revenues are partially offset by interest expense paid on deposits and other borrowings and noninterest expenses such as administrative, occupancy and general operating expenses. Net interest income is the difference between interest income on earning assets such as loans and securities and interest expense on liabilities such as deposits and borrowings which are used to fund those earning assets. The level of interest rates and the volume and mix of earning assets and interest-bearing liabilities impact net interest income and margin.

Three principal components of the Company’s growth strategy are internal growth, stringent cost control practices and acquisitions, including strategic merger transactions and FDIC assisted transactions. The Company focuses on continuous internal growth. Each banking center is operated as a separate profit center, maintaining separate data with respect to its net interest income, efficiency ratio, deposit growth, loan growth and overall profitability. Banking center presidents and managers are accountable for performance in these areas and compensated accordingly. The Company also focuses on maintaining stringent cost control practices and policies. The Company has centralized many of its critical operations, such as data processing and loan processing. Management believes that this centralized infrastructure can accommodate substantial additional growth while enabling the Company to minimize operational costs through certain economies of scale. The Company also intends to continue to seek expansion opportunities. On March 29, 2010, the Company purchased three (3) retail branches of U.S. Bank. The three banking centers acquired by the Company were the Texas locations U.S. Bank acquired from the FDIC on October 30, 2009 when U.S. Bank acquired the nine (9) subsidiary banks of FBOP Corporation. On April 30, 2010, the

 

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Company purchased nineteen (19) Texas retail branches of First Bank, and subsequently consolidated four (4) of these branches into nearby existing Company banking centers.

Total assets were $9.72 billion at March 31, 2011 compared with $9.48 billion at December 31, 2010, an increase of $246.4 million or 2.6%. Total loans were $3.57 billion at March 31, 2011 compared with $3.49 billion at December 31, 2010, an increase of $87.9 million or 2.5%. Total deposits were $7.82 billion at March 31, 2011 compared with $7.45 billion at December 31, 2010, an increase of $361.5 million or 4.8%. Shareholders’ equity increased $28.2 million or 1.9%, to $1.48 billion at March 31, 2011 compared with $1.45 billion at December 31, 2010.

CRITICAL ACCOUNTING POLICIES

The Company’s accounting policies are integral to understanding the financial results reported. Accounting policies are described in detail in Note 1 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010. The Company believes that of its significant accounting policies, the following may involve a higher degree of judgment and complexity:

Allowance for Credit Losses—The allowance for credit losses is established through charges to earnings in the form of a provision for credit losses. Management has established an allowance for credit losses which it believes is adequate for estimated losses in the Company’s loan portfolio. Based on an evaluation of the loan portfolio, management presents a monthly review of the allowance for credit losses to the Bank’s Board of Directors, indicating any change in the allowance since the last review and any recommendations as to adjustments in the allowance. In making its evaluation, management considers factors such as historical loan loss experience, industry diversification of the Company’s commercial loan portfolio, the amount of nonperforming assets and related collateral, the volume, growth and composition of the Company’s loan portfolio, current economic conditions that may affect the borrower’s ability to pay and the value of collateral, the evaluation of the Company’s loan portfolio through its internal loan review process and other relevant factors. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. Charge-offs occur when loans are deemed to be uncollectible. The allowance for credit losses includes allowance allocations calculated in accordance with FASB ASC Topic 310, Receivables, and allowance allocations determined in accordance with FASB ASC Topic 450, Contingencies.

Goodwill and Intangible Assets—Goodwill and intangible assets that have indefinite useful lives are subject to an impairment test at least annually, or more often, if events or circumstances indicate that it is more likely than not that the fair value of Prosperity Bank, the Company’s only reporting unit with assigned goodwill, is below the carrying value of its equity. Goodwill is tested for impairment using a two-step process that begins with an estimation of the fair value of the Company’s reporting unit compared with its carrying value. If the carrying amount exceeds the fair value of the reporting unit, 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. The Company estimated the fair value of its reporting unit through several valuation techniques that consider, among other things, the historical and current financial position and results of operations of the Company, general economic and market conditions and exit prices for recent market transactions. The Company had no intangible assets with indefinite useful lives at March 31, 2011. Other identifiable intangible assets that are subject to amortization are amortized on an accelerated basis over the years expected to be benefited, which the Company believes is between eight and ten years. These amortizable intangible assets are reviewed for impairment if circumstances indicate their value may not be recoverable based on a comparison of fair value to carrying value. Based on the Company’s annual goodwill impairment test as of September 30, 2010, management does not believe any of its goodwill is impaired as of March 31, 2011 because the fair value of the Company’s equity exceeded its carrying value. While the Company believes no impairment existed at March 31, 2011 under accounting standards applicable at that date, different conditions or assumptions, or changes in cash flows or profitability, if significantly negative or unfavorable, could have a material adverse effect on the outcome of the Company’s impairment evaluation and financial condition or future results of operations.

Stock-Based Compensation—The Company accounts for stock-based employee compensation plans using the fair value-based method of accounting in accordance with FASB ASC Topic 718, Stock Compensation. ASC 718 was effective for companies in 2006; however, the Company had been recognizing compensation expense since January 1, 2003. The Company’s results of operations reflect compensation expense for all employee stock-based compensation, including the unvested portion of stock options granted prior to 2003. ASC 718 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 subjective assumptions.

Other Than Temporarily Impaired Securities—The Company’s available for sale securities portfolio is reported at fair value. When the fair value of a security is below its amortized cost, and depending on the length of time the condition exists and the extent the fair market value is below amortized cost, additional analysis is performed to determine whether an impairment exists. Available for sale and held to maturity securities are analyzed quarterly for possible other-than-temporary impairment. The analysis considers (i) the length of time and the extent to which the fair value has been less than cost, (ii) the financial condition and near-term prospects of the issuer, (iii) whether the market decline was affected by macroeconomic conditions, and (iv) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security

 

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before its anticipated recovery. Often, the information available to conduct these assessments is limited and rapidly changing, making estimates of fair value subject to judgment. If actual information or conditions are different than estimated, the extent of the impairment of the security may be different than previously estimated, which could have a material effect on the Company’s results of operations and financial condition.

RESULTS OF OPERATIONS

Net income available to shareholders was $33.9 million ($0.72 per common share on a diluted basis) for the quarter ended March 31, 2011 compared with $31.0 million ($0.66 per common share on a diluted basis) for the quarter ended March 31, 2010, an increase of $2.9 million or 9.3%. The Company posted returns on average common equity of 9.22% and 9.07%, returns on average assets of 1.42% and 1.40% and efficiency ratios of 44.30% and 43.77% for the quarters ended March 31, 2011 and 2010, respectively. The efficiency ratio is calculated by dividing total noninterest expense (excluding credit loss provisions) by net interest income plus noninterest income (excluding net gains and losses on the sale of securities and assets). Additionally, taxes are not part of this calculation.

Net Interest Income

The Company’s net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as a “volume change.” It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as a “rate change.”

Net interest income before the provision for credit losses was $80.4 million for the quarter ended March 31, 2011 compared with $77.8 million for the quarter ended March 31, 2010, an increase of $2.6 million or 3.4%. The average rate paid on interest-bearing liabilities decreased 43 basis points from 1.26% for the quarter ended March 31, 2010 to 0.83% for the quarter ended March 31, 2011, while the average yield on interest-earning assets decreased 54 basis points from 5.16% for the quarter ended March 31, 2010 compared with 4.62% for the quarter ended March 31, 2011. The average volume of interest-bearing liabilities increased $357.5 million and the average volume of interest-earning assets increased $626.7 million for the same period. The net interest margin on a tax equivalent basis decreased 18 basis points from 4.20% for the quarter ended March 31, 2010 to 4.02% for the quarter ended March 31, 2011.

 

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The following table sets forth, for 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 for the quarters ended March 31, 2011 and 2010. The table also sets forth the average rate paid on total interest-bearing liabilities, and the net interest margin on average total interest-earning assets for the same periods. Except as indicated in the footnotes, no tax-equivalent adjustments were made and all average balances are daily average balances. Any nonaccruing loans have been included in the table as loans carrying a zero yield.

 

     Three Months Ended March 31,  
     2011     2010  
     Average
Outstanding
Balance
    Interest
Earned/
Paid
     Average
Yield/
Rate (4)
    Average
Outstanding
Balance
    Interest
Earned/
Paid
     Average
Yield/
Rate (4)
 
     (Dollars in thousands)  

Assets

              

Interest-earning assets:

              

Loans

   $ 3,516,524      $ 52,200         6.02   $ 3,342,842      $ 51,453         6.24

Securities (1)

     4,677,900        41,204         3.52        4,177,540        45,014         4.31   

Federal funds sold and other temporary investments

     13,179        5         0.15        60,536        29         0.19   
                                      

Total interest-earning assets

     8,207,603        93,409         4.62     7,580,918        96,496         5.16
                          

Less allowance for credit losses

     (51,697          (51,750     
                          

Total interest-earning assets, net of allowance

     8,155,906             7,529,168        

Noninterest-earning assets

     1,405,708             1,351,056        
                          

Total assets

   $ 9,561,614           $ 8,880,224        
                          

Liabilities and shareholders’ equity

              

Interest-bearing liabilities:

              

Interest-bearing demand deposits

   $ 1,489,160      $ 2,238         0.61   $ 1,384,304      $ 2,738         0.80

Savings and money market accounts

     2,359,077        3,336         0.57        2,037,235        4,020         0.80   

Certificates of deposit

     2,177,566        5,938         1.11        2,385,804        10,727         1.82   

Junior subordinated debentures

     91,063        1,147         5.11        92,265        791         3.48   

Federal funds purchased and other borrowings

     191,945        268         0.57        32,080        300         3.79   

Securities sold under repurchase agreements

     51,609        69         0.54        71,250        148         0.84   
                                      

Total interest-bearing liabilities

     6,360,420        12,996         0.83     6,002,938        18,724         1.26
                                      

Noninterest-bearing liabilities:

              

Noninterest-bearing demand deposits

     1,672,590             1,445,859        

Other liabilities

     59,556             63,916        
                          

Total liabilities

     8,092,566             7,512,713        
                          

Shareholders’ equity

     1,469,048             1,367,511        
                          

Total liabilities and shareholders’ equity

   $ 9,561,614           $ 8,880,224        
                          

Net interest rate spread

          3.79          3.90

Net interest income and margin (2)

     $ 80,413         3.97     $ 77,772         4.16
                          

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

     $ 81,302         4.02     $ 78,465         4.20
                          

 

(1) Yield is based on amortized cost and does not include any component of unrealized gains or losses.
(2) The net interest margin is equal to net interest income divided by average interest-earning assets.
(3) In order to make pretax income and resultant yields on tax-exempt investments and loans comparable to those on taxable investments and loans, a tax-equivalent adjustment has been computed using a federal income tax rate of 35%.
(4) Annualized and based on an actual/365 basis.

 

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

 

     Three Months Ended March 31,  
     2011 vs. 2010  
     Increase
(Decrease)
Due to
       
     Volume     Rate     Total  
     (Dollars in thousands)  

Interest-earning assets:

      

Loans

   $ 2,673      $ (1,926   $ 747   

Securities

     5,391        (9,201     (3,810

Federal funds sold and other temporary investments

     (23     (1     (24
                        

Total increase (decrease) in interest income

     8,041        (11,128     (3,087
                        

Interest-bearing liabilities:

      

Interest-bearing demand deposits

     207        (707     (500

Savings and money market accounts

     635        (1,319     (684

Certificates of deposit

     (936     (3,853     (4,789

Junior subordinated debentures

     (10     366        356   

Federal funds purchased and other borrowings

     1,495        (1,527     (32

Securities sold under repurchase agreements

     (41     (38     (79
                        

Total increase (decrease) in interest expense

     1,350        (7,078     (5,728
                        

Increase (decrease) in net interest income

   $ 6,691      $ (4,050   $ 2,641   
                        

Provision for Credit Losses

Management actively monitors the Company’s asset quality and provides specific loss provisions when necessary. Provisions for credit losses are charged to income to bring the total allowance for credit losses to a level deemed appropriate by management of the Company based on such factors as historical credit loss experience, industry diversification of the commercial loan portfolio, the amount of nonperforming loans and related collateral, the volume growth and composition of the loan portfolio, current economic conditions that may affect the borrower’s ability to pay and the value of collateral, the evaluation of the loan portfolio through the internal loan review function and other relevant factors.

Loans are charged-off against the allowance for credit losses when appropriate. Although management believes it uses the best information available to make determinations with respect to the provision for credit losses, future adjustments may be necessary if economic conditions differ from the assumptions used in making the initial determinations.

The Company recorded a $1.7 million and $4.4 million provision for credit losses for the quarters ended March 31, 2011 and 2010, respectively. For the quarter ended March 31, 2011, net charge-offs were $1.5 million compared with net charge-offs of $4.4 million for the quarter ended March 31, 2010.

Noninterest Income

The Company’s primary sources of recurring noninterest income are NSF fees, debit and ATM card income and service charges on deposit accounts. Noninterest income does not include loan origination fees which are recognized over the life of the related loan as an adjustment to yield using the interest method. Noninterest income totaled $13.9 million for the three months ended March 31, 2011 compared with $13.0 million for the same period in 2010, an increase of $889,000 or 6.9%. The increase was primarily due to the increase in deposit accounts resulting mainly from the U.S. Bank and First Bank branch acquisitions and an increase in debit card and ATM card income, partially offset by a decrease in NSF fees.

 

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

 

     Three months ended March 31,  
     2011     2010  
     (Dollars in thousands)  

Non-sufficient Funds (NSF) fee

   $ 6,107      $ 6,485   

Debit card and ATM card income

     3,452        2,726   

Service charges on deposit accounts

     2,483        2,378   

Banking related service fees

     500        469   

Brokered mortgage income

     45        13   

Trust and investment income

     153        214   

Income from leased assets

     51        74   

Bank owned life insurance income (BOLI)

     335        327   

Gain on sale of assets, net

     165        —     

(Loss) gain on sale of other real estate, net

     (160     (294

Other noninterest income

     736        586   
                

Total noninterest income

   $ 13,867      $ 12,978   
                

Noninterest Expense

Noninterest expense totaled $41.7 million for the quarter ended March 31, 2011 compared with $39.7 million for the quarter ended March 31, 2010, an increase of $2.0 million or 5.0%. This increase was principally due to additional salaries and benefits expense which was impacted by personnel added from the U.S. Bank and First Bank branch acquisitions.

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

 

     Three Months Ended March 31,  
     2011      2010  
     (Dollars in thousands)  

Salaries and employee benefits (1)

   $ 23,204       $ 21,112   

Non-staff expenses:

     

Net occupancy

     3,648         3,434   

Depreciation

     2,021         2,006   

Data processing

     1,672         1,415   

Communications

     1,692         2,019   

Printing and supplies

     446         478   

Regulatory assessments and FDIC insurance

     3,001         2,609   

Ad valorem and franchise taxes

     1,005         936   

Core deposit intangibles amortization

     2,034         2,290   

Other real estate

     292         566   

Other

     2,680         2,860   
                 

Total non-staff expenses

     18,491         18,612   
                 

Total noninterest expense

   $ 41,695       $ 39,725   
                 

 

(1) Includes stock-based compensation expense of $708,000 and $791,000 for the three months ended March 31, 2011 and 2010, respectively.

Salaries and employee benefit expenses were $23.2 million for the quarter ended March 31, 2011 compared with $21.1 million for the quarter ended March 31, 2010, an increase of $2.1 million or 9.9%. The increase was principally due to additional staff from the 2010 acquisitions. The number of full-time equivalent (“FTE”) associates employed by the Company increased from 1,651 at March 31, 2010 to 1,672 at March 31, 2011.

Income Taxes

Income tax expense increased $1.4 million to $17.0 million for the quarter ended March 31, 2011 compared with $15.6 million for the same period in 2010. The increase was primarily attributable to higher pretax net earnings for the quarter ended March 31, 2011 compared with the same period in 2010. The Company’s effective tax rate for the three months ended March 31, 2011 was 33.4% compared with 33.5% for the same period in 2010.

 

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FINANCIAL CONDITION

Loan Portfolio

Total loans were $3.57 billion at March 31, 2011, an increase of $87.9 million or 2.5% compared with $3.49 billion at December 31, 2010. Outstanding loans at March 31, 2011 comprised 43.5% of average earning assets for the quarter ended March 31, 2011.

The following table summarizes the loan portfolio of the Company by type of loan as of March 31, 2011 and December 31, 2010:

 

     March 31,
2011
    December 31,
2010
 
     Amount      Percent     Amount      Percent  
     (Dollars in thousands)  

Commercial and industrial

   $ 429,208         12.0   $ 409,426         11.7

Real estate:

          

Construction and land development

     494,159         13.8        502,327         14.4   

1-4 family residential

     882,807         24.7        824,057         23.7   

Home equity

     123,696         3.4        118,781         3.4   

Commercial mortgages

     1,299,680         36.4        1,288,023         37.0   

Farmland

     103,159         2.9        98,871         2.8   

Multifamily residential

     85,351         2.4        82,626         2.4   

Agriculture

     41,376         1.2        41,881         1.2   

Consumer (net of unearned discount)

     82,626         2.3        87,977         2.5   

Other

     30,858         0.9        31,054         0.9   
                                  

Total loans

   $ 3,572,920         100.0   $ 3,485,023         100.0
                                  

Nonperforming Assets

The Company had $12.9 million in nonperforming assets at March 31, 2011 and $15.8 million in nonperforming assets at December 31, 2010, a decrease of $3.0 million or 18.6%. The ratio of nonperforming assets to loans and other real estate was 0.36% at March 31, 2011 compared with 0.45% at December 31, 2010.

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

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

 

     March 31,
2011
    December 31,
2010
 
     (Dollars in thousands)  

Nonaccrual loans

   $ 2,279      $ 4,439   

Restructured loans

     —          —     

Accruing loans 90 or more days past due

     76        189   
                

Total nonperforming loans

     2,355        4,628   

Repossessed assets

     68        161   

Other real estate

     10,465        11,053   
                

Total nonperforming assets

   $ 12,888      $ 15,842   
                

Nonperforming assets to total loans and other real estate

     0.36     0.45

Nonperforming assets to average earning assets

     0.16     0.20

 

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Allowance for Credit Losses

Management actively monitors the Company’s asset quality and provides specific loss allowances when necessary. The allowance for credit losses is a reserve established through charges to earnings in the form of a provision for credit losses. Loans are charged off against the allowance for credit losses when appropriate. Although management believes it uses the best information available to make determinations with respect to the allowance for credit losses, future adjustments may be necessary if economic conditions differ from the assumptions used in making the initial determinations. As of March 31, 2011, the allowance for credit losses amounted to $51.8 million or 1.47% of total loans compared with $51.6 million or 1.48% of total loans at December 31, 2010.

Set forth below is an analysis of the allowance for credit losses as of and for the three months ended March 31, 2011 and as of and for the year ended December 31, 2010:

 

     As of and for the Three
Months Ended
March 31, 2011
    As of and for the
Year Ended
December 31, 2010
 
     (Dollars in thousands)  

Average loans outstanding

   $ 3,516,524      $ 3,394,502   
                

Gross loans outstanding at end of period

   $ 3,572,920      $ 3,485,023   
                

Allowance for credit losses at beginning of period

   $ 51,584      $ 51,863   

Provision for credit losses

     1,700        13,585   

Charge-offs:

    

Commercial and industrial

     (284     (2,863

Real estate and agriculture

     (1,298     (10,549

Consumer

     (275     (2,071

Recoveries:

    

Commercial and industrial

     68        346   

Real estate and agriculture

     54        444   

Consumer

     211        829   
                

Net charge-offs

     (1,524     (13,864
                

Allowance for credit losses at end of period

   $ 51,760      $ 51,584   
                

Ratio of allowance to end of period loans

     1.47     1.48

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

     0.17     0.41

Ratio of allowance to end of period nonperforming loans

     2,197.9     1,114.6

Securities

The following table summarizes the amortized cost of securities as of the dates shown (available for sale securities are not adjusted for unrealized gains or losses):

 

     March 31,
2011
     December 31,
2010
 
     (In thousands)  

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

   $ 9,908       $ 10,996   

States and political subdivisions

     74,734         76,031   

Corporate debt securities

     2,985         2,984   

Collateralized mortgage obligations

     399,462         444,827   

Mortgage-backed securities

     4,262,277         4,032,084   

Qualified Zone Academy Bond (QZAB) and Qualified School Constructions Bonds (QSCB)

     20,900         20,900   

Equity securities

     7,288         7,288   
                 

Total amortized cost

   $ 4,777,554       $ 4,595,110   
                 

Total fair value

   $ 4,915,543       $ 4,739,360   
                 

 

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Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. The investment securities portfolio is evaluated for OTTI by segregating the portfolio into two general segments and applying the appropriate OTTI model. Investment securities classified as available for sale or held to maturity are generally evaluated for OTTI under FASB ASC Topic 320, Investments- Debt and Equity Securities. Certain purchased beneficial interests, including non-agency mortgage-backed securities, asset-backed securities, and collateralized debt obligations, that had credit ratings at the time of purchase of below AA are evaluated using the model outlined in ASC Topic 325, Investments-Other. The Company currently does not own any securities that are accounted for under ASC Topic 325.

In determining OTTI under ASC Topic 320, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time. If applicable, the second segment of the portfolio uses the OTTI guidance provided by ASC Topic 325 that is specific to purchased beneficial interests that, on the purchase date, were rated below AA. Under the ASC Topic 325 model, the Company compares the present value of the remaining cash flows as estimated at the preceding evaluation date to the current expected remaining cash flows. An OTTI is deemed to have occurred if there has been an adverse change in the remaining expected future cash flows.

When OTTI occurs under either model, the amount of the other-than-temporary-impairment recognized in earnings depends on whether an entity intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss. If an entity intends to sell or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current-period loss, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the total OTTI related to other factors shall be recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings shall become the new amortized cost basis of the investment.

Management believes the Company does not intend to sell any debt securities or more likely than not will not be required to sell any debt securities before their anticipated recovery, at which time the Company will receive full value for the securities. Furthermore, management has the ability and intent to hold the securities classified as available for sale that were in a loss position as of March 31, 2011 for a period of time sufficient for an entire recovery of the cost basis of the securities. The unrealized losses are largely due to increases in market interest rates over the yields available at the time the underlying securities were purchased. The fair value is expected to recover as the securities approach their maturity date or repricing date or if market yields for such investments decline. Management does not believe any of the securities are impaired due to reasons of credit quality. Accordingly, as of March 31, 2011, management believes any impairment in the Company’s securities are temporary and no impairment loss has been realized in the Company’s consolidated income statement.

 

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The following table presents the amortized cost and fair value of securities classified as available for sale at March 31, 2011:

 

     March 31, 2011  
     Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair
Value
 
     (Dollars in thousands)  

States and political subdivisions (including QZAB)

   $ 47,184       $ 2,542       $ (50   $ 49,676   

Corporate debt securities and other

     8,773         331         —          9,104   

Collateralized mortgage obligations

     922         —           (25     897   

Mortgage-backed securities

     319,410         18,362         (72     337,700   
                                  

Total

   $ 376,289       $ 21,235       $ (147   $ 397,377   
                                  

The following table presents the amortized cost and fair value of securities classified as held to maturity at March 31, 2011:

 

     March 31, 2011  
     Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair
Value
 
     (Dollars in thousands)  

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

   $ 9,907       $ 712       $ —        $ 10,619   

States and political subdivisions (including QSCB)

     48,450         1,404         (960     48,894   

Corporate debt securities

     1,500         172         —          1,672   

Collateralized mortgage obligations

     398,541         7,341         (435     405,447   

Mortgage-backed securities

     3,942,867         120,621         (11,954     4,051,534   
                                  

Total

   $ 4,401,265       $ 130,250       $ (13,349   $ 4,518,166   
                                  

Premises and Equipment

Premises and equipment, net of accumulated depreciation, totaled $159.1 million at March 31, 2011 and December 31, 2010.

Deposits

Total deposits were $7.82 billion at March 31, 2011 compared with $7.45 billion at December 31, 2010, an increase of $361.5 million or 4.8%. At March 31, 2011, noninterest-bearing deposits accounted for approximately 22.1% of total deposits compared with 22.4% of total deposits at December 31, 2010. Interest-bearing demand deposits totaled $6.09 billion or 77.9% of total deposits at March 31, 2011 compared with $5.78 billion or 77.6% of total deposits at December 31, 2010.

 

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

 

     Three Months Ended
March 31,

2011
    Year Ended
December 31,

2010
 
     Average
Balance
     Average
Rate
    Average
Balance
     Average
Rate
 
     (Dollars in thousands)  

Interest-bearing demand

   $ 1,489,160         0.61   $ 1,336,400         0.67

Regular savings

     433,227         0.40        377,456         0.46   

Money market savings

     1,925,850         0.61        1,812,239         0.74   

Time deposits

     2,177,566         1.11        2,438,968         1.53   
                      

Total interest-bearing deposits

     6,025,803         0.77        5,965,063         1.03   

Noninterest-bearing deposits

     1,672,590         —          1,567,676         —     
                      

Total deposits

   $ 7,698,393         0.61   $ 7,532,739         0.82
                                  

Other Borrowings

The Company utilizes borrowings to supplement deposits to fund its lending and investment activities. Borrowings consist of funds from the FHLB and correspondent banks. FHLB advances are considered short-term, overnight borrowings. At March 31, 2011, the Company had $214.0 million in FHLB advances and $14.1 million in FHLB long-term notes payable compared with $360.0 million in FHLB advances and $14.4 million in FHLB long-term notes payable at December 31, 2010. FHLB advances are available to the Company under a security and pledge agreement. At March 31, 2011, the Company had total funds of $3.23 billion available under this agreement of which $228.1 million was outstanding. The weighted average interest rate paid on the FHLB notes payable at period end was 5.2%. The maturity dates on the FHLB notes payable range from the years 2011 to 2028 and have interest rates ranging from 3.55% to 6.10%. The highest outstanding balance of FHLB advances during the first quarter of 2011 was $365.0 million compared with $465.0 million for the year ended December 31, 2010. The average rate paid on FHLB advances for the quarter ended March 31, 2011 was 0.05%.

At March 31, 2011, the Company had $51.8 million in overnight securities sold under repurchase agreements compared with $60.7 million at December 31, 2010, a decrease of $8.8 million or 14.5% with average rates paid of 0.54% and 0.73%, respectively.

The following table presents the Company’s borrowings at March 31, 2011 and December 31, 2010:

 

     March 31,
2011
     December 31,
2010
 
     (Dollars in thousands)  

FHLB advances

   $ 214,000       $ 360,000   

FHLB long-term notes payable

     14,092         14,433   
                 

Total other borrowings

     228,092         374,433   

Securities sold under repurchase agreements

     51,847         60,659   
                 

Total

   $ 279,939       $ 435,092   
                 

Junior Subordinated Debentures

At March 31, 2011 and December 31, 2010, the Company had outstanding $85.1 million and $92.3 million in junior subordinated debentures issued to the Company’s unconsolidated subsidiary trusts, respectively. On March 7, 2011, the Company redeemed $7.2 million in junior subordinated debentures held by TXUI Statutory Trust I that bore a fixed interest rate of 10.60%. A penalty of $383,000 was incurred in connection with the payoff and recorded as interest expense.

 

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A summary of pertinent information related to the Company’s seven issues of junior subordinated debentures outstanding at March 31, 2011 is set forth in the table below:

 

Description

   Issuance Date      Trust
Preferred
Securities
Outstanding
    

Interest Rate(1)

   Junior
Subordinated
Debt Owed
to Trusts
     Maturity
Date(2)
 

Prosperity Statutory Trust II

     July 31, 2001       $ 15,000,000      

3 month LIBOR

+ 3.58%, not to exceed 12.50%

   $ 15,464,000         July 31, 2031   

Prosperity Statutory Trust III

     Aug. 15, 2003         12,500,000       3 month LIBOR + 3.00%(3)      12,887,000         Sept. 17, 2033   

Prosperity Statutory Trust IV

     Dec. 30, 2003         12,500,000       3 month LIBOR + 2.85%(4)      12,887,000         Dec. 30, 2033   

SNB Capital Trust IV(5)

     Sept. 25, 2003         10,000,000      

3 month LIBOR

+ 3.00%

     10,310,000         Sept. 25, 2033   

TXUI Statutory Trust II(6)

     Dec. 19, 2003         5,000,000       3 month LIBOR + 2.85%(7)      5,155,000         Dec. 19, 2033   

TXUI Statutory Trust III(6)

     Nov. 30, 2005         15,500,000      

3 month LIBOR

+ 1.39%

     15,980,000         Dec. 15, 2035   

TXUI Statutory Trust IV(6)

     Mar. 31, 2006         12,000,000      

3 month LIBOR

+ 1.39%

     12,372,000         June 30, 2036   

 

(1) The 3-month LIBOR in effect as of March 31, 2011 was 0.30%.
(2) All debentures are callable five years from issuance date.
(3) The debentures bore a fixed interest rate of 6.50% until September 17, 2008, when the rate began to float on a quarterly basis based on the 3-month LIBOR plus 3.00%.
(4) The debentures bore a fixed interest rate of 6.50% until December 30, 2008, when the rate began to float on a quarterly basis based on the 3-month LIBOR plus 2.85%.
(5) Assumed in connection with the SNB acquisition on April 1, 2006.
(6) Assumed in connection with the TXUI acquisition on January 31, 2007.
(7) The debentures bore a fixed interest rate of 6.45% until January 23, 2009, when the rate began to float on a quarterly basis based on the 3-month LIBOR plus 2.85%.

Liquidity

Liquidity involves the Company’s ability to raise funds to support asset growth or reduce assets to meet deposit withdrawals and other payment obligations, to maintain reserve requirements and otherwise to operate the Company on an ongoing basis. The Company’s largest source of funds is deposits and its largest use of funds is loans. The Company does not expect a change in the source or use of its funds in the future. Although access to purchased funds from correspondent banks is available and has been utilized on occasion to take advantage of investment opportunities, the Company does not generally rely on these external funding sources. The cash and federal funds sold position, supplemented by amortizing investment and loan portfolios, has generally created an adequate liquidity position.

As of March 31, 2011, the Company had outstanding $459.3 million in commitments to extend credit and $15.3 million in commitments associated with outstanding standby letters of credit. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the total outstanding may not necessarily reflect the actual future cash funding requirements.

The Company has no exposure to future cash restrictions associated with known uncertainties or capital expenditures of a material nature.

Asset liquidity is provided by cash and assets which are readily marketable or which will mature in the near future. As of March 31, 2011, the Company had cash and cash equivalents of $146.0 million compared with $159.4 million at December 31, 2010, a decrease of $13.3 million. The decrease was primarily due to net repayments of long-term borrowings of $146.0 million, purchases of securities of $554.4 million and an increase in loans of $94.4 million offset by an increase in deposits of $361.6 million, proceeds from the maturities and repayments of securities of $364.9 million, an increase in accrued interest payable and other liabilities of $19.3 million and net earnings of $33.9 million.

 

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Contractual Obligations

The following table summarizes the Company’s contractual obligations and other commitments to make future payments as of March 31, 2011 (other than deposit obligations). The payments do not include pre-payment options that may be available to the Company. The Company’s future cash payments associated with its contractual obligations pursuant to its junior subordinated debentures, FHLB notes payable and operating leases as of March 31, 2011 are summarized below. Payments for junior subordinated debentures include interest of $52.6 million that will be paid over future periods. Future interest payments were calculated using the current rate in effect at March 31, 2011. With respect to floating interest rates, the payments were determined based on the 3-month LIBOR in effect at March 31, 2011. The current principal balance of the junior subordinated debentures at March 31, 2011 was $85.1 million. Payments for FHLB notes payable include interest of $4.0 million that will be paid over the future periods. Payments related to leases are based on actual payments specified in underlying contracts.

 

     Payments due in:  
     Remaining
Fiscal 2011
     Fiscal
2012-2013
     Fiscal
2014-2015
     Thereafter      Total  
              
     (Dollars in thousands)  

Junior subordinated debentures

   $ 1,755       $ 4,680       $ 4,680       $ 126,584       $ 137,699   

Federal Home Loan Bank borrowings

     215,698         3,356         3,837         9,211         232,102   

Operating leases

     4,112         9,293         5,103         1,376         19,884   
                                            

Total

   $ 221,565       $ 17,329       $ 13,620       $ 137,171       $ 389,685   
                                            

Off-Balance Sheet Items

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

The Company’s commitments associated with outstanding standby letters of credit and commitments to extend credit as of March 31, 2011 are summarized below. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements:

 

     Remaining
Fiscal  2011
     Fiscal
2012-2013
     Fiscal
2014-2015
     Thereafter      Total  
              
     (Dollars in thousands)  

Standby letters of credit

   $ 12,589       $ 2,589       $ 80       $ 54       $ 15,312   

Commitments to extend credit

     208,459         96,012         5,449         149,335         459,255   
                                            

Total

   $ 221,048       $ 98,601       $ 5,529       $ 149,389       $ 474,567   
                                            

Capital Resources

Total shareholders’ equity was $1.48 billion at March 31, 2011 compared with $1.45 billion at December 31, 2010, an increase of $28.2 million or 1.9%. The increase was due primarily to net earnings of $33.9 million and the issuance of common stock in connection with the exercise of stock options and restricted stock awards of $2.4 million, which was partially offset by dividends paid of $8.2 million for the three months ended March 31, 2011.

 

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Both the Board of Governors of the Federal Reserve System with respect to the Company, and the Federal Deposit Insurance Corporation (“FDIC”) with respect to the Bank, have established certain minimum risk-based capital standards that apply to bank holding companies and federally insured banks. The following table sets forth the Company’s total risk-based capital, Tier 1 risk-based capital, and Tier 1 to average assets (leverage) ratios as of March 31, 2011:

 

Consolidated Capital Ratios:

  

Total capital (to risk weighted assets)

     15.21

Tier 1 capital (to risk weighted assets)

     14.00

Tier 1 capital (to average assets)

     6.97

As of March 31, 2011, the Bank’s risk-based capital ratios were above the levels required for the Bank to be designated as “well capitalized” by the FDIC. To be designated as “well capitalized”, the minimum ratio requirements for the Bank’s total risk-based capital, Tier 1 risk-based capital, and Tier 1 to average assets (leverage) capital ratios must be 10.0%, 6.0% and 5.0%, respectively. The following table sets forth the Bank’s total risk-based capital, Tier 1 risk-based capital, and Tier 1 to average assets (leverage) capital ratios as of March 31, 2011:

 

Capital Ratios (Bank Only):

  

Total capital (to risk weighted assets)

     14.83

Tier 1 capital (to risk weighted assets)

     13.62

Tier 1 capital (to average assets)

     6.79

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company manages market risk, which for the Company is primarily interest rate volatility, through its Asset Liability Committee which is composed of senior officers of the Company, in accordance with policies approved by the Company’s Board of Directors.

The Company uses simulation analysis to examine the potential effects of market changes on net interest income and market value. The Company considers macroeconomic variables, Company strategy, liquidity and other factors as it quantifies market risk. See the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Interest Rate Sensitivity and Liquidity” which was filed with the Securities and Exchange Commission on March 1, 2011 for further discussion.

 

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures. As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of its management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management was required to apply judgment in evaluating its controls and procedures. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) were effective as of the end of the period covered by this report.

Changes in internal control over financial reporting. There were no changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended March 31, 2011 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II – OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

The Company and the Bank are defendants, from time to time, in legal actions arising from transactions conducted in the ordinary course of business. The Company and Bank believe, after consultations with legal counsel, that the ultimate liability, if any, arising from such actions will not have a material adverse effect on their financial statements.

 

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ITEM 1A. RISK FACTORS

There have been no material changes in the Company’s risk factors from those disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

 

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

  a. Not applicable
  b. Not applicable
  c. Not applicable

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable

 

ITEM 4. REMOVED AND RESERVED

 

ITEM 5. OTHER INFORMATION

Not applicable

 

ITEM 6. EXHIBITS

 

Exhibit
Number

 

Description of Exhibit

3.1   Amended and Restated Articles of Incorporation of Prosperity Bancshares, Inc. (incorporated herein by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-1 (Registration No. 333-63267) (the “Registration Statement”))
3.2   Articles of Amendment to Amended and Restated Articles of Incorporation of Prosperity Bancshares, Inc. (incorporated herein by reference to Exhibit 3.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2006)
3.3   Amended and Restated Bylaws of Prosperity Bancshares, Inc. (incorporated herein by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on October 19, 2007)
4.1   Form of certificate representing shares of the Company’s common stock (incorporated by reference to Exhibit 4 to the Registration Statement)
31.1*   Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended
31.2*   Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended
32.1**   Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2**   Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101*   Interactive Financial Data

 

* Filed with this Quarterly Report on Form 10-Q.
** Furnished with this Quarterly Report on Form 10-Q.

 

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SIGNATURES

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

 

    PROSPERITY BANCSHARES, INC. ®
    (Registrant)
Date:    05/09/11      

/s/ David Zalman

    David Zalman
    Chief Executive Officer
Date:    05/09/11    

/s/ David Hollaway

    David Hollaway
    Chief Financial Officer

 

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