10-K 1 d267108d10k.htm FORM 10-K Form 10-K
Table of Contents
Index to Financial Statements

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

(Mark One)

 

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

 

   For The Fiscal Year Ended December 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 001-35388

 

 

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)   (Zip Code)

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

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

 

Common Stock, par value  
$1.00 per share   New York Stock Exchange, Inc.
(Title of each class)   (Name of each exchange on which registered)

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

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  x    No  ¨

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15 (d) of the Act.    Yes  ¨    No  x

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

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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check One):

 

Large Accelerated Filer  x   Accelerated Filer  ¨   Non-accelerated Filer  ¨   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

The aggregate market value of the shares of common stock held by non-affiliates as of June 30, 2011, based on the closing price of the common stock on the NASDAQ Global Select Market on June 30, 2011 was approximately $1.89 billion.

As of February 15, 2012, the number of outstanding shares of common stock was 47,233,431.

Documents Incorporated by Reference:

Portions of the Company’s Proxy Statement relating to the 2012 Annual Meeting of Shareholders, which will be filed within 120 days after December 31, 2011, are incorporated by reference into Part III, Items 10-14 of this Annual Report on Form 10-K.

 

 

 


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Index to Financial Statements

PROSPERITY BANCSHARES, INC.®

2011 ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

 

PART I

      
  Item 1.  

Business

     1   
   

General

     1   
   

Pending and Recent Acquisitions

     1   
   

Available Information

     3   
   

Officers and Associates

     4   
   

Banking Activities

     4   
   

Business Strategies

     5   
   

Competition

     6   
   

Supervision and Regulation

     6   
  Item 1A.  

Risk Factors

     19   
  Item 1B.  

Unresolved Staff Comments

     28   
  Item 2.  

Properties

     28   
  Item 3.  

Legal Proceedings

     28   
  Item 4.  

Mine Safety Disclosures

     28   

PART II

      
  Item 5.  

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

     29   
  Item 6.  

Selected Consolidated Financial Data

     32   
  Item 7.  

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

     35   
   

Overview

     36   
   

Recent Developments

     37   
   

Critical Accounting Policies

     38   
   

Results of Operations

     39   
   

Financial Condition

     45   
  Item 7A.  

Quantitative and Qualitative Disclosures about Market Risk

     66   
  Item 8.  

Financial Statements and Supplementary Data

     67   
  Item 9.  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

     68   
  Item 9A.  

Controls and Procedures

     68   
  Item 9B.  

Other Information

     71   

PART III

      
  Item 10.  

Directors, Executive Officers and Corporate Governance

     71   
  Item 11.  

Executive Compensation

     71   
  Item 12.  

Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters

     71   
  Item 13.  

Certain Relationships and Related Transactions and Director Independence

     71   
  Item 14.  

Principal Accountant Fees and Services

     71   

PART IV

      
  Item 15.  

Exhibits and Financial Statement Schedules

     72   
 

Signatures

     75   


Table of Contents
Index to Financial Statements

PART I

ITEM 1. BUSINESS

General

Prosperity Bancshares, Inc.®, a Texas corporation (the “Company”), was formed in 1983 as a vehicle to acquire the former Allied Bank in Edna, Texas which was chartered in 1949 as The First National Bank of Edna 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 broad line of financial products and services to small and medium-sized businesses and consumers. As of December 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 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.

The Company’s market consists of the communities served by its banking centers. The diverse nature of the economies in each local market served by the Company provides the Company with a varied customer base and allows the Company to spread its lending risk throughout a number of different industries including professional service firms and their principals, manufacturing, tourism, recreation, petrochemicals, farming and ranching. The Company’s market areas outside of Houston, Dallas, Corpus Christi, San Antonio and Austin are dominated by either small community banks or branches of large regional banks. Management believes that the Company, as one of the few mid-sized financial institutions that combines responsive community banking with the sophistication of a regional bank holding company, has a competitive advantage in its market areas and excellent growth opportunities through acquisitions, including acquisitions of failed financial institutions, new banking center locations and additional business development.

Operating under a community banking philosophy, the Company seeks to develop broad customer relationships based on service and convenience while maintaining its conservative approach to lending and sound asset quality. The Company has grown through a combination of internal growth, the acquisition of community banks and branches of banks and the opening of new banking centers. Utilizing a low cost of funds and employing stringent cost controls, the Company has been profitable in every full year of its existence, including the period of adverse economic conditions in Texas in the late 1980s and more recently in 2009 and 2010. From 1988 to 1992 as a sound and profitable institution, the Company took advantage of this economic downturn and acquired the deposits and certain assets of failed banks in West Columbia, El Campo and Cuero, Texas and two failed banks in Houston, which diversified the Company’s franchise and increased its core deposits. The Company opened a full-service banking center in Victoria, Texas in 1993 and the following year established a banking center in Bay City, Texas. The Company expanded its Bay City presence in 1996 with the acquisition of an additional branch location from Norwest Bank Texas (now Wells Fargo), and in 1997, the Company acquired the Angleton, Texas branch of Wells Fargo Bank. In 1998, the Company enhanced its West Columbia Banking Center with the purchase of a commercial bank branch located in West Columbia and acquired Union State Bank in East Bernard, Texas.

 

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From December 31, 1998 through December 31, 2011, the Company grew through internal growth and the completion of the following acquisitions:

 

Acquired Entity

   Acquired Bank   Completion
Date
     Number of
Banking Centers
As of
December 31,
2011(1)
 

South Texas Bancshares, Inc.

   Commercial National Bank     1999         3   

Compass Bank (5 branches)

   N/A     2000         4   

Commercial Bancshares, Inc.

   Heritage Bank     2001         12   

Texas Guaranty Bank, N.A.

   Same     2002         2   

The First State Bank of Needville

   Same     2002         (2) 

Paradigm Bancorporation, Inc.

   Paradigm Bank Texas     2002         8   

Southwest Bank Holding Company

   Bank of the Southwest     2002         2   

First National Bank of Bay City

   Same     2002         (2) 

Abrams Centre Bancshares, Inc.

   Abrams Centre National Bank     2003         1   

Dallas Bancshares, Inc.

   BankDallas     2003         1   

MainBancorp, Inc.

   main bank, n.a.     2003         3   

First State Bank of North Texas

   Same     2003         3   

Liberty Bancshares, Inc.

   Liberty Bank, S.S.B.     2004         4   

Village Bank and Trust, s.s.b

   Same     2004         1   

First Capital Bankers, Inc.

   FirstCapital Bank, s.s.b.     2005         20   

Grapeland Bancshares, Inc.

   First State Bank of Grapeland     2005         2   

SNB Bancshares, Inc

   Southern National Bank of Texas     2006         6 (3) 

Texas United Bancshares, Inc

   State Bank, GNB Financial, n.a.,
Gateway National Bank and
Northwest Bank
    2007         34   

The Bank of Navasota

   Same     2007         1   

Banco Popular, NA (6 branches)

   N/A     2008         5   

1st Choice Bancorp

   1st Choice Bank     2008         1   

Franklin Bank (from FDIC, as receiver)(4)

   N/A     2008         33   

U.S. Bank (3 branches)

   N/A     2010         3   

First Bank (19 branches)

   N/A     2010         15   

 

(1) The number of banking centers added does not include any locations of the acquired entity that were closed and consolidated with existing banking centers of the Company upon consummation of the transaction or closed after consummation of the transaction.
(2) The only banking center of the acquired entity was closed and consolidated into an existing banking center of the Company.
(3) Included one banking center under construction at the time of consummation.
(4) Assumed approximately $3.6 billion of deposits and acquired certain assets, including thirty-three (33) banking centers, from the FDIC, acting in its capacity as receiver for Franklin Bank.

Pending and Recent Acquisitions

Pending Acquisition of American State Financial CorporationOn February 27, 2012, the Company announced the signing of a definitive agreement to acquire American State Financial Corporation and its wholly owned subsidiary, American State Bank (“ASB”), through the merger of American State Financial with and into the Company. ASB operates thirty-seven (37) banking offices in eighteen (18) counties across West Texas. As of December 31, 2011, American State Financial, on a consolidated basis, reported total assets of $3.08 billion, total loans of $1.21 billion and total deposits of $2.46 billion. Under the terms of the definitive agreement, the Company will issue up to 8,525,000 shares of its common stock plus $178.5 million in cash for all outstanding shares of American State Financial capital stock, subject to certain conditions and potential adjustment.

 

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The merger has been approved by the Boards of Directors of both companies and is expected to close during the third quarter of 2012, although delays may occur. The transaction is subject to certain conditions, including the approval by American State Financial’s shareholders and customary regulatory approvals. Operational integration is anticipated to begin during the third quarter of 2012.

Pending Acquisition of The Bank Arlington—On January 19, 2012, the Company entered into a definitive agreement to acquire The Bank Arlington. The Bank Arlington operates one (1) banking office in Arlington, Texas, in the Dallas/Fort Worth CMSA. As of December 31, 2011, The Bank Arlington reported total assets of $37.3 million, total loans of $21.2 million and total deposits of $32.8 million.

Under the terms of the definitive agreement, the Company will issue up to 138,600 shares of Company common stock for all outstanding shares of The Bank Arlington capital stock, subject to certain conditions and potential adjustments. The transaction is subject to customary closing conditions, including the receipt of regulatory approvals and approval of the shareholders of The Bank Arlington. The transaction is expected to close during the second quarter of 2012, although delays could occur.

Pending Acquisition of East Texas Financial Services, Inc.—On December 8, 2011, the Company entered into a definitive agreement to acquire East Texas Financial Services, Inc. (OTC BB: FFBT) and its wholly-owned subsidiary, First Federal Bank Texas (“Firstbank”). First Bank operates four (4) banking offices in the Tyler MSA, including three (3) locations in Tyler, Texas and one (1) location in Gilmer, Texas. As of December 31, 2011, East Texas Financial Services reported total assets of $210.5 million, total loans of $163.1 million and total deposits of $126.7 million.

Under the terms of the definitive agreement, the Company will issue up to 531,000 shares of Company common stock for all outstanding shares of East Texas Financial Services capital stock, subject to certain conditions and potential adjustments. The transaction is subject to customary closing conditions, including the receipt of regulatory approvals and approval of the stockholders of East Texas Financial Services. The transaction is expected to close during the second quarter of 2012, although delays could occur.

Acquisition of Texas Bankers, Inc.—On January 1, 2012, the Company completed the previously announced acquisition of Texas Bankers, Inc. and its wholly-owned subsidiary, Bank of Texas, Austin, Texas. The transaction continues the Company’s strategic growth and expansion of the franchise in Central Texas.

The three (3) Bank of Texas banking offices in the Austin, Texas CMSA consist of a location in Rollingwood, which upon operational integration will be consolidated with the Company’s Westlake location and remain in Bank of Texas’ Rollingwood banking office; one banking center in downtown Austin, which upon operational integration will be consolidated into the Company’s downtown Austin location; and another banking center in Thorndale. Following the acquisition, the Company operates thirty-four (34) banking centers in the Central Texas area including Austin and San Antonio.

Texas Bankers, Inc. reported total assets of $77.0 million, total loans of $27.6 million and total deposits of $70.4 million as of December 31, 2011. Under the terms of the agreement, the Company issued 314,953 shares of Company common stock for all outstanding shares of Texas Bankers capital stock which resulted in a premium of $5.2 million.

Available Information

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

 

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Officers and Associates

The Company’s directors and officers are important to the Company’s success and play a key role in the Company’s business development efforts by actively participating in civic and public service activities in the communities served by the Company.

The Company has invested heavily in its officers and associates by recruiting talented officers in its market areas and providing them with economic incentive in the form of stock-based compensation and bonuses based on cross-selling performance. The senior management team has substantial experience in the Houston, Dallas, Austin, Bryan/College Station, East Texas, Corpus Christi and San Antonio markets and the surrounding communities in which the Company has a presence. Each banking center location is administered by a local president or manager with knowledge of the community and lending expertise in the specific industries found in the community. The Company entrusts its banking center presidents and managers with authority and flexibility within general parameters with respect to product pricing and decision making in order to avoid the bureaucratic structure of larger banks. The Company operates each banking center as a separate profit center, maintaining separate data with respect to each banking center’s 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’s local banking centers have no 1-800 telephone numbers. Each banking center has its own listed local business telephone number. Customers are served by a local banker with decision making authority.

As of December 31, 2011, the Company and the Bank had 1,664 full-time equivalent associates, 671 of whom were officers of the Bank. The Company provides medical and hospitalization insurance to its full-time associates. The Company considers its relations with associates to be excellent. Neither the Company nor the Bank is a party to any collective bargaining agreement.

Banking Activities

The Company, through the Bank, offers a variety of traditional loan and deposit products to its customers, which consist primarily of consumers and small and medium-sized businesses. The Bank tailors its products to the specific needs of customers in a given market. At December 31, 2011, the Bank maintained approximately 366,000 separate deposit accounts including certificates of deposit, 33,000 separate loan accounts and 24.5% of the Bank’s total deposits were noninterest-bearing demand deposits. For the year ended December 31, 2011, the Company’s average cost of funds was 0.56% and the Company’s average cost of deposits (excluding all borrowings) was 0.53%.

The Company has been an active real estate lender, with commercial mortgage and 1-4 family residential loans comprising 35.9% and 26.7% of the Company’s total loans as of December 31, 2011, respectively. The Company also offers commercial loans, loans for automobiles and other consumer durables, home equity loans, debit cards, internet banking and other cash management services and automated telephone banking. By offering certificates of deposit, interest checking accounts, savings accounts and overdraft protection at competitive rates, the Company gives its depositors a full range of traditional deposit products.

The businesses targeted by the Company in its lending efforts are primarily those that require loans in the $100,000 to $8.0 million range. The Company offers these businesses a broad array of loan products including term loans, lines of credit and loans for working capital, business expansion and the purchase of equipment and machinery, interim construction loans for builders and owner-occupied commercial real estate loans.

 

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Business Strategies

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

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

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

Increase Loan Volume and Diversify Loan Portfolio. While maintaining its conservative approach to lending, the Company has emphasized both new and existing loan products, focusing on managing its commercial mortgage and commercial loan portfolios. During the one year period from December 31, 2010 to December 31, 2011, the Company’s commercial and industrial loans decreased from $409.4 million to $406.4 million, or 0.7%, and represented 11.7% and 10.8% of the total portfolio, respectively. Commercial mortgages increased from $1.29 billion to $1.35 billion, or 5.0%, and represented 37.0% and 35.9% of the total portfolio, respectively, for the same period. In addition, the Company targets professional service firms, including legal and medical practices, for both loans secured by owner-occupied premises and personal loans to their principals.

Maintain Sound Asset Quality. The Company continues to maintain the sound asset quality that has been representative of its historical loan portfolio. As the Company continues to diversify and increase its lending activities and acquire loans in acquisitions, it may face higher risks of nonpayment and increased risks in the event of continued economic downturns. The Company intends to continue to employ the strict underwriting guidelines and comprehensive loan review process that have contributed to its low incidence of nonperforming assets and its minimal charge-offs in relation to its size.

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

Enhance Cross-Selling. The Company recognizes that its customer base provides significant opportunities to cross-sell various products and it seeks to develop broader customer relationships by identifying cross-selling opportunities. The Company uses incentives and friendly competition to encourage cross-selling efforts and increase cross-selling results among its associates. Officers and associates have access to each customer’s

 

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existing and related account relationships and are better able to inform customers of additional products when customers visit or call the various banking centers or use their drive-in facilities. In addition, the Company includes product information in monthly statements and other mailings.

Competition

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

Supervision and Regulation

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

The following description summarizes some of the laws to which the Company and the Bank are subject. References in this Annual Report on Form 10-K to applicable statutes and regulations are brief summaries thereof, do not purport to be complete, and are qualified in their entirety by reference to such statutes and regulations.

The Company

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

Regulatory Restrictions on Dividends; Source of Strength. The Company is regarded as a legal entity separate and distinct from the Bank. The principal source of the Company’s revenues is dividends received from the Bank. As described in more detail below, federal law places limitations on the amount that state banks may pay in dividends, which the Bank must adhere to when paying dividends to the Company. It is the policy of the Federal Reserve Board that bank holding companies should pay cash dividends on common stock only out of income available over the past year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. The policy provides that bank holding companies should not maintain a level of cash dividends that undermines the bank holding company’s ability to serve as a source of strength to its banking subsidiaries.

Under Federal Reserve Board policy, a bank holding company has historically been required to act as a source of financial strength to each of its banking subsidiaries. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) codified this policy as a statutory requirement. Under this requirement, the Company is expected to commit resources to support the Bank, including at times when the Company may not be in a financial position to provide such resources. Any capital loans by a bank holding

 

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company to any of its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary banks. As discussed below, a bank holding company, in certain circumstances, could be required to guarantee the capital plan of an undercapitalized banking subsidiary.

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

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

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

A bank holding company may become a financial holding company by filing a declaration with the Federal Reserve Board if each of its subsidiary banks is well capitalized under the Federal Deposit Insurance Corporation Improvement Act of 1991 (the “FDICIA”) prompt-corrective-action provisions, is well managed, and has at least a satisfactory rating under the Community Reinvestment Act of 1977 (“CRA”). The Company became a financial holding company on April 18, 2000.

Since July 2011, the Company’s financial holding company status depends upon it maintaining its status as “well capitalized” and “well managed” under applicable Federal Reserve Board regulations. If a financial holding company ceases to meet these requirements, the Federal Reserve Board may impose corrective capital and/or managerial requirements on the financial holding company and place limitations on its ability to conduct the broader financial activities permissible for financial holding companies. In addition, the Federal Reserve Board may require divestiture of the holding company’s depository institutions and/or its non-bank subsidiaries if the deficiencies persist.

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

 

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

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

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

Capital Adequacy Requirements. The Federal Reserve Board has adopted a system using risk-based capital guidelines under a two-tier capital framework to evaluate the capital adequacy of bank holding companies. Tier 1 capital generally consists of common stockholders’ equity, retained earnings, a limited amount of qualifying perpetual preferred stock, qualifying trust preferred securities and noncontrolling interests in the equity accounts of consolidated subsidiaries, less goodwill and certain intangibles. Tier 2 capital generally consists of certain hybrid capital instruments and perpetual debt, mandatory convertible debt securities and a limited amount of subordinated debt, qualifying preferred stock, loan loss allowance, and unrealized holding gains on certain equity securities.

Under the guidelines, specific categories of assets are assigned different risk weights, based generally on the perceived credit risk of the asset. These risk weights are multiplied by corresponding asset balances to determine a “risk-weighted” asset base. The guidelines require a minimum ratio of total capital to total risk-weighted assets of 8.0% (of which at least 4.0% is required to consist of Tier 1 capital elements). Total capital is the sum of Tier 1 and Tier 2 capital. As of December 31, 2011, the Company’s ratio of Tier 1 capital to total risk-weighted assets was 15.90% and its ratio of total capital to total risk-weighted assets was 17.09%. Risk-weighted assets exclude intangible assets such as goodwill and core deposit intangibles.

In addition to the risk-based capital guidelines, the Federal Reserve Board uses a leverage ratio as an additional tool to evaluate the capital adequacy of bank holding companies. The leverage ratio is a company’s Tier 1 capital divided by its average total consolidated assets. Certain highly rated bank holding companies may maintain a minimum leverage ratio of 3.0%, but other bank holding companies are required to maintain a leverage ratio of 4.0%. As of December 31, 2011, the Company’s leverage ratio was 7.89%.

The federal banking agencies’ risk-based and leverage capital ratios are minimum supervisory ratios generally applicable to banking organizations that meet certain specified criteria. Banking organizations not meeting these criteria are expected to operate with capital positions well above the minimum ratios. The federal bank regulatory agencies may set capital requirements for a particular banking organization that are higher than the minimum ratios when circumstances warrant. Federal Reserve Board guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.

Proposed Revisions to Capital Adequacy Requirements. The Dodd-Frank Act requires the Federal Reserve Board, the Office of the Comptroller of the Currency (“OCC”) and the FDIC to adopt regulations imposing a continuing “floor” of the 1988 capital accord (“Basel I”) of the Basel Committee on Banking Supervision (the “Basel Committee”) capital requirements in cases where the 2004 Basel Committee capital accord (“Basel II”)

 

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capital requirements and any changes in capital regulations resulting from Basel III (defined below) otherwise would permit lower requirements. In December 2010, the Federal Reserve Board, the OCC and the FDIC issued a joint notice of proposed rulemaking that would implement this requirement.

On December 16, 2010, the Basel Committee released its final framework for strengthening international capital and liquidity regulation (“Basel III”). Basel III, when implemented by the U.S. banking agencies and fully phased-in, will require bank holding companies and their bank subsidiaries to maintain substantially more capital, with a greater emphasis on common equity. The timing for the U.S. banking agencies’ publication of proposed rules to implement the Basel III capital framework and the implementation schedule is uncertain, but the U.S. banking agencies have indicated informally that regulations implementing the Basel III capital framework will be published for comment during the first half of 2012. Notwithstanding its release of the Basel III framework, the Basel Committee is considering further amendments to Basel III, including the imposition of additional capital surcharges on globally and systemically important financial institutions. In addition to Basel III, the Dodd-Frank Act requires or permits the U.S. banking agencies to adopt regulations affecting banking institutions’ capital requirements in a number of respects. Accordingly, the regulations ultimately adopted and made applicable to the Company may be substantially different from the Basel III final framework as published in December 2010.

The Basel III final capital framework, among other things, (i) introduces as a new capital measure “Common Equity Tier 1” (“CET1”), (ii) specifies that Tier 1 capital consists of CET1 and “Additional Tier 1 capital” instruments meeting specified requirements, (iii) defines CET1 narrowly by requiring that most adjustments to regulatory capital measures be made to CET1 and not to the other components of capital and (iv) expands the scope of the adjustments as compared to existing regulations.

When fully phased in on January 1, 2019, Basel III will require banks to maintain (i) as a newly adopted international standard, a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7%), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of total (that is, Tier 1 plus Tier 2) capital to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation) and (iv) as a newly adopted international standard, a minimum leverage ratio of 3%, calculated as the ratio of Tier 1 capital to balance sheet exposures plus certain off-balance sheet exposures (computed as the average for each quarter of the month-end ratios for the quarter). Basel III also provides for a “countercyclical capital buffer,” that would be added to the capital conservation buffer generally to be imposed when national regulators determine that excess aggregate credit growth becomes associated with a buildup of systemic risk.

Proposed Liquidity Requirements. Historically, regulation and monitoring of bank and bank holding company liquidity has been addressed as a supervisory matter, without required formulaic measures. The Basel III final framework will require banks and bank holding companies to measure their liquidity against specific liquidity tests that, although similar in some respects to liquidity measures historically applied by banks and regulators for management and supervisory purposes, going forward will be required by regulation. One test, referred to as the liquidity coverage ratio (“LCR”), is designed to ensure that the banking entity maintains an adequate level of unencumbered high-quality liquid assets equal to the entity’s expected net cash outflow for a 30-day time horizon (or, if greater, 25% of its expected total cash outflow) under an acute liquidity stress scenario. The other, referred to as the net stable funding ratio (“NSFR”), is designed to promote more medium- and long-term funding of the assets and activities of banking entities over a one-year time horizon. These requirements will incent banking entities to increase their holdings of U.S. Treasury securities and other sovereign debt as a component of assets and increase the use of long-term debt as a funding source. The Basel III liquidity framework contemplates that the LCR and NSFR will be subject to observation periods continuing through mid-2013 and mid-2016, respectively, and subject to any revisions resulting from the analyses conducted and data collected during the observation period, the LCR and NSFR will be implemented as minimum standards

 

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on January 1, 2015 and by January 1, 2018, respectively. The proposed liquidity requirements will likely apply to bank holding companies with total assets of $50 billion or greater. These new standards are subject to further rulemaking and their terms could change before implementation.

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

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

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

Control Acquisitions. The Change in Bank Control Act (“CBCA”) prohibits a person or group of persons from acquiring “control” of a bank holding company unless the Federal Reserve Board has been notified and has not objected to the transaction. Under a rebuttable presumption established by the Federal Reserve Board, the acquisition of 10% or more of a class of voting stock of a bank holding company with a class of securities registered under Section 12 of the Exchange Act, such as the Company, would, under the circumstances set forth in the presumption, constitute acquisition of control of the Company.

In addition, the CBCA prohibits any entity from acquiring 25% (5% in the case of an acquiror that is a bank holding company) or more of a bank holding company’s or bank’s voting securities, or otherwise obtaining control or a controlling influence over a bank holding company or bank without the approval of the Federal Reserve Board. In most circumstances, an entity that owns 25% or more of the voting securities of a banking organization owns enough of the capital resources to have a controlling influence over such banking organization for purposes of the CBCA. On September 22, 2008, the Federal Reserve Board issued a policy statement on equity investments in bank holding companies and banks, which allows the Federal Reserve Board to generally be able to conclude that an entity’s investment is not “controlling” if the entity does not own in excess of 15% of the voting power and 33% of the total equity of the bank holding company or bank. Depending on the nature of the overall investment and the capital structure of the banking organization, the Federal Reserve Board will permit, based on the policy statement, noncontrolling investments in the form of voting and nonvoting shares that represent in the aggregate (i) less than one-third of the total equity of the banking organization (and less than one-third of any class of voting securities, assuming conversion of all convertible nonvoting securities held by the entity) and (ii) less than 15% of any class of voting securities of the banking organization.

 

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The Bank

The Bank is a Texas-chartered banking association, the deposits of which are insured by the DIF of the FDIC. The Bank is not a member of the Federal Reserve System; therefore, the Bank is subject to supervision and regulation by the FDIC and the Texas Department of Banking. Such supervision and regulation subject the Bank to special restrictions, requirements, potential enforcement actions and periodic examination by the FDIC and the Texas Department of Banking. Because the Federal Reserve Board regulates the Company, the Federal Reserve Board also has supervisory authority which directly affects the Bank.

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

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

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

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

Restrictions on Transactions with Affiliates and Insiders. Transactions between the Bank and its nonbanking affiliates, including the Company, are subject to Section 23A of the Federal Reserve Act. In general, Section 23A imposes limits on the amount of such transactions to 10% of the Bank’s capital stock and surplus and requires that such transactions be secured by designated amounts of specified collateral. It also limits the amount of advances to third parties which are collateralized by the securities or obligations of the Company or its subsidiaries. The Dodd-Frank Act significantly expanded the coverage and scope of the limitations on affiliate transactions within a banking organization. For example, it requires that the 10% of capital limit on covered transactions begin to apply to financial subsidiaries. “Covered transactions” are defined by statute to include a loan or extension of credit, as well as a purchase of securities issued by an affiliate, a purchase of assets (unless otherwise exempted by the Federal Reserve Board) from the affiliate, certain derivative transactions that create a credit exposure to an affiliate, the acceptance of securities issued by the affiliate as collateral for a loan, and the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate.

Affiliate transactions are also subject to Section 23B of the Federal Reserve Act which generally requires that certain transactions between the Bank and its affiliates be on terms substantially the same, or at least as favorable to

 

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the Bank, as those prevailing at the time for comparable transactions with or involving other nonaffiliated persons. The Federal Reserve Board has also issued Regulation W which codifies prior regulations under Sections 23A and 23B of the Federal Reserve Act and interpretive guidance with respect to affiliate transactions.

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

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

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

Audit Reports. Insured institutions with total assets of $500 million or more must submit annual audit reports prepared by independent auditors to federal and state regulators. In some instances, the audit report of the institution’s holding company can be used to satisfy this requirement. Auditors must receive examination reports, supervisory agreements and reports of enforcement actions. For institutions with total assets of $1 billion or more, financial statements prepared in accordance with generally accepted accounting principles, management’s certifications concerning responsibility for the financial statements, internal controls and compliance with legal requirements designated by the FDIC, and an attestation by the auditor regarding the statements of management relating to the internal controls must be submitted. For institutions with total assets of more than $3 billion, independent auditors may be required to review quarterly financial statements. FDICIA requires that independent audit committees be formed, consisting of outside directors only. The committees of such institutions must include members with experience in banking or financial management, must have access to outside counsel, and must not include representatives of large customers.

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

The FDIC’s risk-based capital guidelines generally require state banks to have a minimum ratio of Tier 1 capital to total risk-weighted assets of 4.0% and a ratio of total capital to total risk-weighted assets of 8.0%. The

 

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capital categories have the same definitions for the Bank as for the Company. As of December 31, 2011, the Bank’s ratio of Tier 1 capital to total risk-weighted assets was 15.62% and its ratio of total capital to total risk-weighted assets was 16.81%.

The FDIC’s leverage guidelines require state banks to maintain Tier 1 capital of no less than 4.0% of average total assets, except in the case of certain highly rated banks for which the requirement is 3.0% of average total assets. The Texas Department of Banking has issued a policy which generally requires state chartered banks to maintain a leverage ratio (defined in accordance with federal capital guidelines) of 5.0%. As of December 31, 2011, the Bank’s ratio of Tier 1 capital to average total assets (leverage ratio) was 7.75%.

Corrective Measures for Capital Deficiencies. The federal banking regulators are required to take “prompt corrective action” with respect to capital-deficient institutions. Agency regulations define, for each capital category, the levels at which institutions are “well-capitalized,” “adequately capitalized,” “under capitalized,” “significantly under capitalized” and “critically under capitalized.” A “well-capitalized” bank has a total risk-based capital ratio of 10.0% or higher; a Tier 1 risk-based capital ratio of 6.0% or higher; a leverage ratio of 5.0% or higher; and is not subject to any written agreement, order or directive requiring it to maintain a specific capital level for any capital measure. An “adequately capitalized” bank has a total risk-based capital ratio of 8.0% or higher; a Tier 1 risk-based capital ratio of 4.0% or higher; a leverage ratio of 4.0% or higher (3.0% or higher if the bank was rated a composite 1 in its most recent examination report and is not experiencing significant growth); and does not meet the criteria for a well capitalized bank. A bank is “under capitalized” if it fails to meet any one of the ratios required to be adequately capitalized. At December 31, 2011, the Bank was classified as “well-capitalized” for purposes of the FDIC’s prompt corrective action regulations.

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

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

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

Deposit Insurance Assessments. Substantially all of the deposits of the Bank are insured up to applicable limits by the DIF of the FDIC and the Bank must pay deposit insurance assessments to the FDIC for such deposit insurance protection. The FDIC maintains the DIF by designating a required reserve ratio. If the reserve ratio falls below the designated level, the FDIC must adopt a restoration plan that provides that the DIF will return to an acceptable level generally within 5 years. The designated reserve ratio is currently set at 2.00%. The FDIC has the discretion to price deposit insurance according to the risk for all insured institutions regardless of the level of the reserve ratio.

The DIF reserve ratio is maintained by assessing depository institutions an insurance premium based upon statutory factors. Under its current regulations, the FDIC imposes assessments for deposit insurance according to a depository institution’s ranking in one of four risk categories based upon supervisory and capital evaluations. The assessment rate for an individual institution is determined according to a formula based on a combination of weighted average CAMELS component ratings, financial ratios and, for institutions that have long-term debt ratings, the average ratings of its long-term debt. Well-capitalized institutions (generally those with CAMELS

 

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composite ratings of 1 or 2) are grouped in Risk Category I and the initial base assessment rate for deposit insurance is set at an annual rate of between 12 and 16 basis points. The initial base assessment rate for institutions in Risk Categories II, III and IV is set at annual rates of 22, 32 and 50 basis points, respectively. These initial base assessment rates are adjusted to determine an institution’s final assessment rate based on its brokered deposits, secured liabilities and unsecured debt. Total base assessment rates after adjustments range from 7 to 24 basis points for Risk Category I, 17 to 43 basis points for Risk Category II, 27 to 58 basis points for Risk Category III, and 40 to 77.5 basis points for Risk Category IV.

In November, 2009, the FDIC adopted a rule that required all insured institutions with limited exceptions, to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The assessment, which for the Company totaled $35.6 million, was calculated by taking the institution’s actual September 30, 2009 assessment base and adjusting it quarterly by an estimated 5% annual growth rate through the end of 2012. Each institution records the entire amount of its prepaid assessment as a prepaid expense, an asset on its balance sheet, as of December 30, 2009. As of December 31, 2009, and each quarter thereafter, each institution records an expense, or a charge to earnings, for its quarterly assessment invoiced on its quarterly statement and an offsetting credit to the prepaid assessment until the asset is exhausted.

On February 7, 2011, the FDIC approved a final rule that amends its existing DIF restoration plan and implements certain provisions of the Dodd-Frank Act. As of April 1, 2011 the assessment base is determined using average consolidated total assets minus average tangible equity rather than the current assessment base of adjusted domestic deposits. Since the change resulted in a much larger assessment base, the final rule also lowers the assessment rates in order to keep the total amount collected from financial institutions relatively unchanged from the amounts currently being collected. The new assessment rates, calculated on the revised assessment base, generally range from 2.5 to 9 basis points for Risk Category I institutions, 9 to 24 basis points for Risk Category II institutions, 18 to 33 basis points for Risk Category III institutions, and 30 to 45 basis points for Risk Category IV institutions. For large institutions (generally those with total assets of $10 billion or more), which as of December 31, 2011 did not include the Bank, the initial base assessment rate ranges from 5 to 35 basis points on an annualized basis. After the effect of potential base-rate adjustments, the total base assessment rate could range from 2.5 to 45 basis points on an annualized basis. Assessment rates for large institutions are calculated using a scorecard that combines CAMELS ratings and certain forward-looking financial measures to assess the risk a large institution poses to the DIF. The new assessment rates were calculated for the quarter beginning April 1, 2011 and reflected in invoices for assessments due September 30, 2011.

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

Concentrated Commercial Real Estate Lending Regulations. The federal banking agencies, including the FDIC, have promulgated guidance governing financial institutions with concentrations in commercial real estate lending. The guidance provides that a bank has a concentration in commercial real estate lending if (i) total reported loans for construction, land development, and other land represent 100% or more of total capital or (ii) total reported loans secured by multifamily and non-farm residential properties and loans for construction, land development, and other land represent 300% or more of total capital and the bank’s commercial real estate loan portfolio has increased 50% or more during the prior 36 months. Owner occupied loans are excluded from this second category. If a concentration is present, management must employ heightened risk management practices that address the following key elements: including board and management oversight and strategic planning, portfolio management, development of underwriting standards, risk assessment and monitoring through market analysis and stress testing, and maintenance of increased capital levels as needed to support the level of commercial real estate lending.

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

 

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Community Reinvestment Act. The CRA and the regulations issued thereunder are intended to encourage banks to help meet the credit needs of their service area, including low and moderate income neighborhoods, consistent with the safe and sound operations of the banks. These regulations also provide for regulatory assessment of a bank’s record in meeting the needs of its service area when considering applications to establish branches, merger applications and applications to acquire the assets and assume the liabilities of another bank. FIRREA requires federal banking agencies to make public a rating of a bank’s performance under the CRA. In the case of a bank holding company, the CRA performance record of the banks involved in the transaction are reviewed in connection with the filing of an application to acquire ownership or control of shares or assets of a bank or to merge with any other bank holding company. An unsatisfactory record can substantially delay or block the transaction.

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

Anti-Money Laundering and Anti-Terrorism Legislation. A major focus of governmental policy on financial institutions in recent years has been aimed at combating money laundering and terrorist financing. The USA PATRIOT Act of 2001 (the “USA Patriot Act”) substantially broadened the scope of United States anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States. The United States Treasury Department has issued and, in some cases, proposed a number of regulations that apply various requirements of the USA Patriot Act to financial institutions. These regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing and to verify the identity of their customers. Certain of those regulations impose specific due diligence requirements on financial institutions that maintain correspondent or private banking relationships with non-U.S. financial institutions or persons. Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution.

Office of Foreign Assets Control Regulation. The United States has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others. These are typically known as the “OFAC” rules based on their administration by the U.S. Treasury Department Office of Foreign Assets Control (“OFAC”). The OFAC-administered sanctions targeting countries take many different forms. Generally, however, they contain one or more of the following elements: (i) restrictions on trade with or investment in a sanctioned country, including prohibitions against direct or indirect imports from and exports to a sanctioned country and prohibitions on “U.S. persons” engaging in financial transactions relating to making investments in, or providing investment-related advice or assistance to, a sanctioned country; and (ii) a blocking of assets in which the government or specially designated nationals of the sanctioned country have an interest, by prohibiting transfers of property subject to U.S. jurisdiction (including property in the possession or control of U.S. persons). Blocked assets (e.g., property and bank deposits) cannot be paid out, withdrawn, set off or transferred in any manner without a license from OFAC. Failure to comply with these sanctions could have serious legal and reputational consequences.

Privacy. In addition to expanding the activities in which banks and bank holding companies may engage, the Gramm-Leach-Bliley Act also imposed new requirements on financial institutions with respect to customer privacy. The Gramm-Leach-Bliley Act generally prohibits disclosure of customer information to non-affiliated third parties unless the customer has been given the opportunity to object and has not objected to such disclosure.

 

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Financial institutions are further required to disclose their privacy policies to customers annually. Financial institutions, however, will be required to comply with state law if it is more protective of customer privacy than the Gramm-Leach-Bliley Act.

Legislative Initiatives

In light of current conditions and the market outlook for continuing weak economic conditions, regulators have increased their focus on the regulation of financial institutions. A number of government initiatives designed to respond to the current conditions have been introduced recently and proposals for legislation that could substantially intensify the regulation of financial institutions have been adopted by Congress and state legislatures. Such initiatives may change banking statutes and the operating environment of the Company and the Bank in substantial and unpredictable ways. The Company cannot determine the ultimate effect that any potential legislation, if enacted, or implementing regulations with respect thereto, would have, upon the financial condition or results of operations of the Company or the Bank. A change in statutes, regulations or regulatory policies applicable to the Company or the Bank could have a material effect on the financial condition, results of operations or business of the Company and the Bank.

Dodd-Frank Act. In July 2010, Congress enacted the Dodd-Frank Act regulatory reform legislation, which the President signed into law on July 21, 2010. Many aspects of the Dodd–Frank Act are subject to further rulemaking and will take effect over several years, making it difficult for the Company to anticipate the overall financial impact to it or across the industry. This new law broadly affects the financial services industry by implementing changes to the financial regulatory landscape aimed at strengthening the sound operation of the financial services sector, including provisions that, among other things:

 

   

Create a new agency, the Consumer Financial Protection Bureau (“CFPB”), responsible for implementing, examining and enforcing compliance with federal consumer protection laws;

 

   

Apply the same leverage and risk–based capital requirements that apply to insured depository institutions to most bank holding companies, which, among other things, will require the Company to deduct all trust preferred securities issued on or after May 19, 2010 from the Company’s Tier 1 capital (existing trust preferred securities issued prior to May 19, 2010 for all bank holding companies with less than $15.0 billion in total consolidated assets as of December 31, 2009 are exempt from this requirement);

 

   

Broaden the base for FDIC insurance assessments from the amount of insured deposits to average total consolidated assets less average tangible equity during the assessment period;

 

   

Permanently increase FDIC deposit insurance to $250,000 and provide unlimited FDIC deposit insurance beginning December 31, 2010 until January 1, 2013 for noninterest bearing demand transaction accounts at all insured depository institutions;

 

   

Permit banks to engage in de novo interstate branching if the laws of the state where the new branch is to be established would permit the establishment of the branch if it were chartered by such state;

 

   

Repeal the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts;

 

   

Require financial holding companies, such as the Company, to be well capitalized and well managed as of July 21, 2011. Bank holding companies and banks must also be both well capitalized and well managed in order to acquire banks located outside their home state;

 

   

Eliminate the ceiling on the size of the DIF and increase the floor of the size of the DIF;

 

   

Implement corporate governance revisions, including with regard to executive compensation and proxy access by shareholders, that apply to all public companies, not just financial institutions;

 

   

Amend the Electronic Fund Transfer Act (“EFTA”) to, among other things, give the Federal Reserve Board the authority to establish rules regarding interchange fees charged for electronic debit transactions

 

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by payment card issuers, such as the Bank, having assets over $10 billion and to enforce a new statutory requirement that such fees be reasonable and proportional to the actual cost of a transaction to the issuer through regulations adopted by the Federal Reserve Board in June 2011, which set a maximum permissible interchange fee; and

 

   

Increase the authority of the Federal Reserve Board to examine the Company and its non-bank subsidiaries.

The Dodd-Frank Act also authorized the Federal Reserve Board to adopt enhanced supervision and prudential standards for, among others, bank holding companies with total consolidated assets of $50 billion or more (often referred to as “systemically important financial institutions” or “SIFI”), and authorized the Federal Reserve Board to establish such standards either on its own or upon the recommendations of the Financial Stability Oversight Council (“FSOC”), a new systemic risk oversight body created by the Dodd-Frank Act. In December 2011, the Federal Reserve Board issued for public comment a notice of proposed rulemaking establishing enhanced prudential standards responsive to these provisions for (i) risk-based capital requirements and leverage limits, (ii) stress testing of capital, (iii) liquidity requirements (iv) overall risk management requirements (v) resolution plan and credit exposure reporting and (vi) concentration/credit exposure limits. Comments on these proposed rules (the “Proposed SIFI Rules”), are due by March 31, 2012. The Proposed SIFI Rules address a wide, diverse array of regulatory areas, each of which is highly complex. Most of the Proposed SIFI Rules will not apply to the Company as its total consolidated assets remain below $50 billion. However, two aspects of the Proposed SIFI Rules apply to bank holding companies with total consolidated assets of $10 billion or more (a) requirements for annual stress testing of capital under one base and two stress scenarios and (b) certain corporate governance provisions requiring, among other things, that each bank holding company establish a risk committee of its board of directors and that that committee include a “risk expert.” While the Company and the Bank did not have total assets in excess of $10 billion as of December 31, 2011, the Company may reach that threshold in the future due to its organic growth.

The Dodd-Frank Act established the CFPB, which has supervisory authority over depository institutions with total assets of $10 billion or greater. The CFPB will focus their supervision and regulatory efforts on (i) risks to consumers and compliance with the federal consumer financial laws, when it evaluates the policies and practices of a financial institution; (ii) the markets in which firms operate and risks to consumers posed by activities in those markets; (iii) depository institutions that offer a wide variety of consumer financial products and services; depository institutions with a more specialized focus; and (iv) non-depository companies that offer one or more consumer financial products or services. While the Company and the Bank did not have total assets in excess of $10 billion as of December 31, 2011, over the course of the next year, the Company and the Bank may become subject to the CFPB’s supervision through organic growth.

The Company’s management continues to review actively the provisions of the Dodd–Frank Act and assess its probable impact on its business, financial condition, and results of operations. Provisions in the legislation that affect deposit insurance assessments and payment of interest on demand deposits could increase the costs associated with deposits as well as place limitations on certain revenues those deposits may generate. Provisions in the legislation that revoke the Tier 1 capital treatment of newly issued trust preferred securities could require the Company to seek other sources of capital in the future. Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on the Company, its customers or the financial industry more generally.

Incentive Compensation. In June 2010, the Federal Reserve Board, OCC and FDIC issued comprehensive final guidance on incentive compensation policies intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should (i) provide incentives that do not encourage

 

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risk-taking beyond the organization’s ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors. Also, on April 14, 2011 the FDIC published a proposed interagency rule to implement certain incentive compensation requirements of the Dodd-Frank Act. Under the proposed rule, financial institutions must prohibit incentive-based compensation arrangements that encourage inappropriate risk taking that are deemed excessive or that may lead to material losses.

The Federal Reserve Board will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Company, that are not “large, complex banking organizations.” These reviews will be tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization’s supervisory ratings, which can affect the organization’s ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.

Enforcement Powers of Federal and State Banking Agencies

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

Effect on Economic Environment

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

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

 

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ITEM 1A. RISK FACTORS

An investment in the Company’s common stock involves risks. The following is a description of the material risks and uncertainties that the Company believes affect its business and an investment in the common stock. Additional risks and uncertainties that the Company is unaware of, or that it currently deems immaterial, also may become important factors that affect the Company and its business. If any of the risks described in this Annual Report on Form 10-K were to occur, the Company’s financial condition, results of operations and cash flows could be materially and adversely affected. If this were to happen, the value of the common stock could decline significantly and you could lose all or part of your investment.

Risks Associated with the Company’s Business

If the Company is not able to continue its historical levels of growth, it may not be able to maintain its historical earnings trends.

To achieve its past levels of growth, the Company has focused on both internal growth and acquisitions. The Company may not be able to sustain its historical rate of growth or may not be able to grow at all. In addition, the Company may not be able to obtain the financing necessary to fund additional growth and may not be able to find suitable candidates for acquisition. Various factors, such as economic conditions and competition, may impede or prohibit the opening of new banking centers. Further, the Company may be unable to attract and retain experienced bankers, which could adversely affect its internal growth. If the Company is not able to continue its historical levels of growth, it may not be able to maintain its historical earnings trends.

If the Company is unable to manage its growth effectively, its operations could be negatively affected.

Companies that experience rapid growth face various risks and difficulties, including:

 

   

finding suitable markets for expansion;

 

   

finding suitable candidates for acquisition;

 

   

attracting funding to support additional growth;

 

   

maintaining asset quality;

 

   

attracting and retaining qualified management; and

 

   

maintaining adequate regulatory capital.

In addition, in order to manage its growth and maintain adequate information and reporting systems within its organization, the Company must identify, hire and retain additional qualified associates, particularly in the accounting and operational areas of its business.

If the Company does not manage its growth effectively, its business, financial condition, results of operations and future prospects could be negatively affected, and the Company may not be able to continue to implement its business strategy and successfully conduct its operations.

Difficult market conditions and economic trends have adversely affected the banking industry and could adversely affect the Company’s business, financial condition, results of operations and cash flows.

The Company is operating in a challenging and uncertain economic environment, including generally uncertain conditions nationally and locally in its markets. Financial institutions continue to be affected by declines in the real estate market that have negatively impacted the credit performance of 1-4 family residential, construction and land development and commercial real estate loans and resulted in significant write-downs of assets by many financial institutions. The Company retains direct exposure to the residential and commercial real estate markets, and it is affected by these events.

 

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The Company’s ability to assess the creditworthiness of customers and to estimate the losses inherent in its loan portfolio is made more complex by these difficult market and economic conditions. A prolonged national economic recession or further deterioration of these conditions in the Company’s markets could drive losses beyond that which is provided for in its allowance for credit losses and result in the following consequences:

 

   

increases in loan delinquencies;

 

   

increases in nonperforming assets and foreclosures;

 

   

decreases in demand for the Company’s products and services, which could adversely affect its liquidity position; and

 

   

decreases in the value of the collateral securing the Company’s loans, especially real estate, which could reduce customers’ borrowing power.

While economic conditions in the State of Texas and the U.S. are showing signs of recovery, there can be no assurance that these difficult conditions will continue to improve. Continued declines in real estate values, home sales volumes and financial stress on borrowers as a result of the uncertain economic environment, including job losses, could have an adverse effect on the Company’s borrowers or their customers, which could adversely affect the Company’s business, financial condition, results of operations and cash flows.

Liquidity risk could impair the Company’s ability to fund operations and jeopardize its financial condition.

Liquidity is essential to the Company’s business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a substantial negative effect on its liquidity. The Company’s access to funding sources in amounts adequate to finance its activities or on terms which are acceptable to it could be impaired by factors that affect the Company specifically or the financial services industry or economy in general. Factors that could detrimentally impact the Company’s access to liquidity sources include a decrease in the level of its business activity as a result of a downturn in the markets in which its loans are concentrated or adverse regulatory action against it. The Company’s ability to borrow could also be impaired by factors that are not specific to it, such as a disruption in the financial markets or negative views and expectations about the prospects for the financial services industry in light of the recent turmoil faced by banking organizations and the continued deterioration in credit markets.

If the Company is unable to identify and acquire other financial institutions and successfully integrate its acquired businesses, its business and earnings may be negatively affected.

The market for acquisitions remains highly competitive, and the Company may be unable to find acquisition candidates in the future that fit its acquisition and growth strategy. To the extent that the Company is unable to find suitable acquisition candidates, an important component of its growth strategy may be lost.

Acquisitions of financial institutions involve operational risks and uncertainties and acquired companies may have unforeseen liabilities, exposure to asset quality problems, key employee and customer retention problems and other problems that could negatively affect the Company’s organization. The Company may not be able to complete future acquisitions and, if completed, the Company may not be able to successfully integrate the operations, management, products and services of the entities that it acquires and eliminate redundancies. The integration process could result in the loss of key employees or disruption of the combined entity’s ongoing business or inconsistencies in standards, controls, procedures and policies that adversely affect the Company’s ability to maintain relationships with customers and employees or achieve the anticipated benefits of the transaction. The integration process may also require significant time and attention from the Company’s management that they would otherwise direct at servicing existing business and developing new business. The Company’s failure to successfully integrate the entities it acquires into its existing operations may increase its operating costs significantly and adversely affect its business and earnings.

 

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The Company’s dependence on loans secured by real estate subjects it to risks relating to fluctuations in the real estate market and related interest rates and regulatory guidance that could require additional capital and could adversely affect its financial condition, results of operations and cash flows.

Approximately 85.3% of the Company’s total loans as of December 31, 2011 consisted of loans included in the real estate loan portfolio with 12.8% in construction and land development, 30.6% in residential real estate and 41.9% in commercial real estate. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. A weakening of the real estate market in the Company’s primary market areas could have an adverse effect on the demand for new loans, the ability of borrowers to repay outstanding loans, the value of real estate and other collateral securing the loans and the value of real estate owned by the Company. If real estate values decline, it is also more likely that the Company would be required to increase its allowance for credit losses, which could adversely affect its financial condition, results of operations and cash flows.

As of December 31, 2011, the Company had $482.1 million or 12.8% of total loans in construction and land development loans. Construction loans are subject to risks during the construction phase that are not present in standard residential real estate and commercial real estate loans. These risks include:

 

   

the viability of the contractor;

 

   

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

 

   

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

Real estate construction loans also present risks of default in the event of declines in property values or volatility in the real estate market during the construction phase. If the Company is forced to foreclose on a project prior to completion, it may not be able to recover the entire unpaid portion of the loan, may be required to fund additional amounts to complete a project and may have to hold the property for an indeterminate amount of time. If any of these risks were to occur, it could adversely affect the Company’s financial condition, results of operations and cash flows.

The federal banking agencies have issued guidance regarding high concentrations of commercial real estate loans within bank loan portfolios. The guidance requires financial institutions that exceed certain levels of commercial real estate lending compared with their total capital to maintain heightened risk management practices that address the following key elements: including board and management oversight and strategic planning, portfolio management, development of underwriting standards, risk assessment and monitoring through market analysis and stress testing, and maintenance of increased capital levels as needed to support the level of commercial real estate lending. If there is any deterioration in the Company’s commercial mortgage or construction and land development portfolios or if its regulators conclude that the Company has not implemented appropriate risk management practices, it could adversely affect the Company’s business and result in a requirement of increased capital levels, and such capital may not be available at that time.

The Company’s commercial mortgage and commercial loans expose it to increased credit risks, and these risks will increase if the Company succeeds in increasing these types of loans.

The Company, while maintaining its conservative approach to lending, has emphasized both new and existing loan products, focusing on managing its commercial mortgage and commercial loan portfolios, and intends to continue to increase its lending activities and acquire loans in possible future acquisitions. As a result, commercial real estate and commercial loans as a proportion of its portfolio could increase. As of December 31, 2011, commercial real estate and commercial loans totaled $1.76 billion. In general, commercial real estate loans and commercial loans yield higher returns and often generate a deposit relationship, but also pose greater credit risks than do owner-occupied residential real estate loans. As the Company’s various commercial loan portfolios increase, the corresponding risks and potential for losses from these loans will also increase.

 

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The Company makes both secured and some unsecured commercial loans. Unsecured loans generally involve a higher degree of risk of loss than do secured loans because, without collateral, repayment is wholly dependent upon the success of the borrowers’ businesses. Secured commercial loans are generally collateralized by accounts receivable, inventory, equipment or other assets owned by the borrower and include a personal guaranty of the business owner. Compared to real estate, that type of collateral is more difficult to monitor, its value is harder to ascertain, it may depreciate more rapidly and it may not be as readily saleable if repossessed. Further, commercial loans generally will be serviced primarily from the operation of the business, which may not be successful, and commercial mortgage loans generally will be serviced from income on the properties securing the loans.

The Company’s business is subject to interest rate risk and fluctuations in interest rates may adversely affect its earnings and capital levels.

The majority of the Company’s assets are monetary in nature and, as a result, the Company is subject to significant risk from changes in interest rates. Changes in interest rates can impact the Company’s net interest income as well as the valuation of its assets and liabilities. The Company’s earnings are significantly dependent on its net interest income. Net interest income is the difference between the interest income earned on loans, investments and other interest-earning assets and the interest expense paid on deposits, borrowings and other interest-bearing liabilities. Therefore, any change in general market interest rates, such as a change in the monetary policy of the Federal Reserve Board or otherwise, can have a significant effect on the Company’s net interest income. The Company’s assets and liabilities may react differently to changes in overall market rates or conditions because there may be mismatches between the repricing or maturity characteristics of the assets and liabilities.

The Company’s profitability depends significantly on local economic conditions.

The Company’s success depends primarily on the general economic conditions of the primary markets in Texas in which it operates and where its loans are concentrated. Unlike nationwide banks that are more geographically diversified, the Company provides banking and financial services to customers primarily in the greater Houston and Dallas/Fort Worth metropolitan areas and in the east, central, north central, south central and southeast areas of Texas. The local economic conditions in these areas have a significant impact on the Company’s commercial, real estate and construction and land development loans, the ability of its borrowers to repay their loans and the value of the collateral securing these loans. In addition, if the population or income growth in the Company’s market areas is slower than projected, income levels, deposits and housing starts could be adversely affected and could result in a reduction of the Company’s expansion, growth and profitability. Although economic conditions in Texas have not deteriorated to the same extent as in other areas of the country, such conditions could decline further. If the Company’s market areas experience a downturn or a recession for a prolonged period of time, the Company could experience significant increases in nonperforming loans, which could lead to operating losses, impaired liquidity and eroding capital. A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreaks of hostilities or other international or domestic calamities, unemployment or other factors could impact these local economic conditions and could negatively affect the Company’s financial condition, results of operations and cash flows.

The Company’s allowance for credit losses may not be sufficient to cover actual credit losses, which could adversely affect its earnings.

As a lender, the Company is exposed to the risk that its loan customers may not repay their loans according to the terms of these loans and the collateral securing the payment of these loans may be insufficient to fully compensate the Company for the outstanding balance of the loan plus the costs to dispose of the collateral. Management makes various assumptions and judgments about the collectability of the Company’s loan portfolio, including the diversification by industry of its commercial loan portfolio, the amount of nonperforming assets and related collateral, the volume, growth and composition of its loan portfolio, the effects on the loan portfolio of current economic indicators and their probable impact on borrowers and the evaluation of its loan portfolio through its internal loan review process and other relevant factors.

 

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The Company maintains an allowance for credit losses in an attempt to cover estimated losses inherent in its loan portfolio. Additional credit losses will likely occur in the future and may occur at a rate greater than the Company has experienced to date. In determining the size of the allowance, the Company relies on an analysis of its loan portfolio, its historical loss experience and its evaluation of general economic conditions. Continuing deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of the Company’s control, may require an increase in the allowance for credit losses. If the Company’s assumptions prove to be incorrect or if it experiences significant loan losses in future periods, its current allowance may not be sufficient to cover actual loan losses and adjustments may be necessary to allow for different economic conditions or adverse developments in its loan portfolio. A material addition to the allowance could cause net income, and possibly capital, to decrease.

In addition, federal and state regulators periodically review the Company’s allowance for credit losses and may require the Company to increase its provision for credit losses or recognize further charge-offs, based on judgments different than those of the Company’s management. An increase in the Company’s allowance for credit losses or charge-offs as required by these regulatory agencies could have a material adverse effect on the Company’s operating results and financial condition.

The small to medium-sized businesses that the Company lends to may have fewer resources to weather a downturn in the economy, which may impair a borrower’s ability to repay a loan to the Company that could materially harm the Company’s operating results.

The Company targets its business development and marketing strategy primarily to serve the banking and financial services needs of small to medium-sized businesses. These small to medium-sized businesses frequently have smaller market share than their competition, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience significant volatility in operating results. Any one or more of these factors may impair the borrower’s ability to repay a loan. In addition, the success of a small to medium-sized business often depends on the management talents and efforts of one or two persons or a small group of persons, and the death, disability or resignation of one or more of these persons could have a material adverse impact on the business and its ability to repay a loan. Economic downturns and other events that negatively impact the Company’s market areas could cause the Company to incur substantial credit losses that could negatively affect the Company’s results of operations and financial condition.

If the goodwill that the Company recorded in connection with a business acquisition becomes impaired, it could require charges to earnings, which would have a negative impact on the Company’s financial condition and results of operations.

Goodwill represents the amount by which the acquisition cost exceeds the fair value of net assets the Company acquired in the purchase of another financial institution. The Company reviews goodwill for impairment at least annually, or more frequently if events or changes in circumstances indicate the carrying value of the asset might be impaired.

The Company determines impairment by comparing the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. Any such adjustments are reflected in the Company’s results of operations in the periods in which they become known. At December 31, 2011, the Company’s goodwill totaled $924.5 million. While the Company has not recorded any such impairment charges since it initially recorded the goodwill, there can be no assurance that the Company’s future evaluations of goodwill will not result in findings of impairment and related write-downs, which may have a material adverse effect on its financial condition and results of operations.

 

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The Company may be required to pay higher FDIC deposit insurance assessments in the future.

Recent insured depository institution failures, as well as deterioration in banking and economic conditions generally, have significantly increased the loss provisions of the FDIC, resulting in a decline in the designated reserve ratio of the FDIC to historical lows. The FDIC expects a higher rate of insured depository institution failures in the next few years compared to recent years; thus, the reserve ratio may continue to decline. In addition, the deposit insurance limit on FDIC deposit insurance coverage generally has increased to $250,000. These developments have resulted in increased FDIC assessments in 2009 and 2010 and may result in increased assessments in the future.

On February 7, 2011, the FDIC approved a final rule that amends its existing DIF restoration plan and implements certain provisions of the Dodd-Frank Act. Effective April 1, 2011 the assessment base is determined using average consolidated total assets minus average tangible equity rather than the previous assessment base of adjusted domestic deposits. The new assessment rates, calculated on the revised assessment base generally range from 2.5 to 9 basis points for Risk Category I institutions, 9 to 24 basis points for Risk Category II institutions, 18 to 33 basis points for Risk Category III institutions, and 30 to 45 basis points for Risk Category IV institutions. The new assessment rates were calculated for the quarter beginning April 1, 2011 and reflected in invoices for assessments due September 30, 2011.

The final rule provides the FDIC’s board with the flexibility to adopt actual rates that are higher or lower than the total base assessment rates adopted on February 7, 2011 without notice and comment, if certain conditions are met. An increase in the assessment rates could have an adverse impact on the Company’s results of operations. For the year ended December 31, 2011, the Company’s FDIC insurance related costs were $8.3 million compared with $10.4 million for the year ended December 31, 2010.

The Company may be adversely affected by the soundness of other financial institutions.

Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. The Company has exposure to many different industries and counterparties, and routinely executes transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. Many of these transactions expose the Company to credit risk in the event of a default by a counterparty or client. In addition, the Company’s credit risk may be exacerbated when the collateral held by the Company cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due to the Company. Any such losses could have a material adverse effect on the Company’s financial condition, results of operations and cash flows.

The Company may need to raise additional capital in the future and such capital may not be available when needed or at all.

The Company may need to raise additional capital in the future to provide it with sufficient capital resources and liquidity to meet its commitments and business needs. In addition, the Company may elect to raise additional capital to support its business or to finance acquisitions, if any. The Company’s ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of its control, and its financial performance. Accordingly, the Company cannot assure you that such capital will be available to it on acceptable terms or at all. Any occurrence that may limit its access to the capital markets, such as a decline in the confidence of investors, depositors of Prosperity Bank or counterparties participating in the capital markets, may adversely affect the Company’s capital costs and its ability to raise capital and, in turn, its liquidity. An inability to raise additional capital on acceptable terms when needed could subject the Company to increased regulatory supervision and the imposition of restrictions on its growth or business, which could have a material adverse effect on the Company’s business, financial condition and results of operations.

 

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An interruption in or breach in security of the Company’s information systems may result in a loss of customer business and have an adverse effect on the Company’s results of operations, financial condition and cash flows.

The Company relies heavily on communications and information systems to conduct its business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in the Company’s customer relationship management, general ledger, deposits, servicing or loan origination systems. Although the Company has policies and procedures designed to prevent or minimize the effect of a failure, interruption or breach in security of its communications or information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur, or if they do occur, that they will be adequately addressed by the Company. The occurrence of any such failures, interruptions or security breaches could result in a loss of customer business and have a negative effect on the Company’s results of operations, financial condition and cash flows.

The business of the Company is dependent on technology and the Company’s inability to invest in technological improvements may adversely affect its results of operations, financial condition and cash flows.

The financial services industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services. In addition to better serving customers, the effective use of technology increases efficiency and enables financial institutions to reduce costs. The Company’s future success depends in part upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands for convenience as well as create additional efficiencies in its operations. Many of the Company’s competitors have substantially greater resources to invest in technological improvements. The Company may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers, which may negatively affect the Company’s results of operations, financial condition and cash flows.

The Company operates in a highly regulated environment and, as a result, is subject to extensive regulation and supervision; and changes in federal, state and local laws and regulations could adversely affect its financial performance.

The Company and the Bank are subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds and the banking system as a whole, not the Company’s shareholders. These regulations affect the Company’s lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. Any change in applicable regulations or federal or state legislation could have a substantial impact on the Company, the Bank and their respective operations.

The Dodd-Frank Act, enacted in July 2010, instituted major changes to the banking and financial institutions regulatory regimes in light of the recent performance of and government intervention in the financial services sector. Additional legislation and regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could significantly affect the Company’s powers, authority and operations, or the powers, authority and operations of the Bank in substantial and unpredictable ways. Further, regulators have significant discretion and power to prevent or remedy unsafe or unsound practices or violations of laws by banks and bank holding companies in the performance of their supervisory and enforcement duties. The exercise of this regulatory discretion and power could have a negative impact on the Company. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on the Company’s business, financial condition and results of operations.

 

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The Company is subject to losses resulting from fraudulent and negligent acts on the part of loan applicants, correspondents or other third parties.

The Company relies heavily upon information supplied by third parties, including the information contained in credit applications, property appraisals, title information, equipment pricing and valuation and employment and income documentation, in deciding which loans the Company will originate, as well as the terms of those loans. If any of the information upon which the Company relies is misrepresented, either fraudulently or inadvertently, and the misrepresentation is not detected prior to asset funding, the value of the asset may be significantly lower than expected, or the Company may fund a loan that it would not have funded or on terms it would not have extended. Whether a misrepresentation is made by the applicant or another third party, the Company generally bears the risk of loss associated with the misrepresentation. A loan subject to a material misrepresentation is typically unsellable or subject to repurchase if it is sold prior to detection of the misrepresentation. The sources of the misrepresentations are often difficult to locate, and it is often difficult to recover any of the monetary losses the Company may suffer.

The recent repeal of federal prohibitions on payment of interest on demand deposits could increase the Company’s interest expense.

All federal prohibitions on the ability of financial institutions to pay interest on demand deposit accounts were repealed as part of the Dodd-Frank Act. As a result, beginning on July 21, 2011, financial institutions can now offer interest on demand deposits to compete for clients. The Company’s interest expense will increase and its net interest margin will decrease if it begins offering interest on demand deposits to attract additional customers or maintain current customers, which could have an adverse effect on the Company’s business, financial condition and results of operations.

The Company is subject to environmental liability risk associated with lending activities.

A significant portion of the Company’s loan portfolio is secured by real property. During the ordinary course of business, the Company may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, the Company may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require the Company to incur substantial expenses and may materially reduce the affected property’s value or limit the Company’s ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase the Company’s exposure to environmental liability. Although the Company has policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on the Company’s financial condition and results of operations.

Risks Associated with the Company’s Common Stock

The Company’s corporate organizational documents and the provisions of Texas law to which it is subject may delay or prevent a change in control of the Company that a shareholder may favor.

The Company’s amended and restated articles of incorporation and amended and restated bylaws contain various provisions which may delay, discourage or prevent an attempted acquisition or change of control of the Company. These provisions include:

 

   

a board of directors classified into three classes of directors with the directors of each class having staggered three-year terms;

 

   

a provision that any special meeting of the Company’s shareholders may be called only by the chairman of the board and chief executive officer, the president, a majority of the board of directors or the holders of at least 50% of the Company’s shares entitled to vote at the meeting;

 

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Index to Financial Statements
   

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

 

   

a provision that denies shareholders the right to amend the Company’s bylaws.

The Company’s articles of incorporation provide for noncumulative voting for directors and authorize the board of directors to issue shares of its preferred stock without shareholder approval and upon such terms as the board of directors may determine. The issuance of the Company’s preferred stock could have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from acquiring, a controlling interest in the Company. In addition, certain provisions of Texas law, including a provision which restricts certain business combinations between a Texas corporation and certain affiliated shareholders, may delay, discourage or prevent an attempted acquisition or change in control of the Company.

There are restrictions on the Company’s ability to pay dividends.

Holders of the Company’s common stock are only entitled to receive such dividends as the Company’s Board of Directors may declare out of funds legally available for such payments. Although the Company has historically declared cash dividends on its common stock, it is not required to do so and there can be no assurance that the Company will pay dividends in the future. Any declaration and payment of dividends on common stock will depend upon the Company’s earnings and financial condition, liquidity and capital requirements, the general economic and regulatory climate, the Company’s ability to service any equity or debt obligations senior to the common stock and other factors deemed relevant by the Board of Directors.

The Company’s principal source of funds to pay dividends on the shares of common stock is cash dividends that the Company receives from the Bank. Various banking laws applicable to the Bank limit the payment of dividends and other distributions by the Bank to the Company, and may therefore limit the Company’s ability to pay dividends on its common stock. Regulatory authorities could impose administratively stricter limitations on the ability of the Bank to pay dividends to the Company if such limits were deemed appropriate to preserve certain capital adequacy requirements. In addition, the Federal Reserve Board has indicated that bank holding companies should carefully review their dividend policy in relation to the organization’s overall asset quality, level of current and prospective earnings and level, composition and quality of capital. The guidance provides that the Company inform and consult with the Federal Reserve Board prior to declaring and paying a dividend that exceeds earnings for the period for which the dividend is being paid or that could result in an adverse change to the Company’s capital structure, including interest on the subordinated debentures underlying the Company’s trust preferred securities. If required payments on the Company’s outstanding junior subordinated debentures held by its unconsolidated subsidiary trusts are not made or are suspended, the Company will be prohibited from paying dividends on its common stock.

The holders of the Company’s junior subordinated debentures have rights that are senior to those of the Company’s shareholders.

As of December 31, 2011, the Company had $85.1 million in junior subordinated debentures outstanding that were issued to the Company’s unconsolidated subsidiary trusts. The subsidiary trusts purchased the junior subordinated debentures from the Company using the proceeds from the sale of trust preferred securities to third party investors. Payments of the principal and interest on the trust preferred securities are conditionally guaranteed by the Company to the extent not paid or made by each trust, provided the trust has funds available for such obligations.

The junior subordinated debentures are senior to the Company’s shares of common stock. As a result, the Company must make interest payments on the junior subordinated debentures (and the related trust preferred securities) before any dividends can be paid on its common stock; and, in the event of the Company’s bankruptcy, dissolution or liquidation, the holders of the debentures must be satisfied before any distributions can

 

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be made to the holders of the common stock. Additionally, the Company has the right to defer periodic distributions on the junior subordinated debentures (and the related trust preferred securities) for up to five years, during which time the Company would be prohibited from paying dividends on its common stock. The Company’s ability to pay the future distributions depends upon the earnings of the Bank and dividends from the Bank to the Company, which may be inadequate to service the obligations.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

ITEM 2. PROPERTIES

As of December 31, 2011, the Company conducted business at one hundred seventy-five (175) full-service banking centers. The Company’s headquarters are located at Prosperity Bank Plaza, 4295 San Felipe, in the Galleria area in Houston, Texas. The Company also owns or leases other facilities in which its banking centers are located as listed below by geographical market area. The expiration dates of the leases range from 2012 to 2025 and do not include renewal periods which may be available at the Company’s option.

The following table sets forth specific information regarding the banking centers located in each of the Company’s geographical market areas at December 31, 2011:

 

Geographical Area

   Number of
Banking Centers
     Number of
Leased Banking Centers
     Deposits at
December 31, 2011
 
                   (Dollars in
thousands)
 

Bryan/College Station

     10         —         $ 577,391   

Houston area

     60         18         3,785,556   

Central Texas area

     33         7         1,070,620   

Dallas/Fort Worth Texas area

     31         9         1,144,226   

East Texas area

     21         —           664,919   

South Texas area including Corpus Christi

     20         5         817,542   
  

 

 

    

 

 

    

 

 

 

Total

     175         39       $ 8,060,254   
  

 

 

    

 

 

    

 

 

 

ITEM 3. 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.

ITEM 4. MINE SAFETY DISCLOSURES

None.

 

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PART II.

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

Common Stock Market Prices

The Company’s common stock is listed on the New York Stock Exchange under the symbol “PB.” Prior to December 28, 2011, the Company’s common shares were listed for trading under the symbol “PRSP” on the NASDAQ Global Select Market (“NASDAQ”). As of February 15, 2012, there were 47,233,431 shares outstanding and 1,925 shareholders of record. The number of beneficial owners is unknown to the Company at this time.

The following table presents the high and low intra-day sales prices for the common stock as reported by NASDAQ (through December 27, 2011) or the New York Stock Exchange (beginning December 28, 2011) during the two years ended December 31, 2011:

 

2011

   High      Low  

Fourth Quarter

   $ 41.74       $ 31.31   

Third Quarter

     46.87         30.91   

Second Quarter

     46.75         40.83   

First Quarter

     42.92         38.23   

2010

   High      Low  

Fourth Quarter

   $ 39.96       $ 30.37   

Third Quarter

     36.05         28.27   

Second Quarter

     43.66         34.31   

First Quarter

     42.55         37.93   

Dividends

Holders of common stock are entitled to receive dividends when, as and if declared by the Company’s Board of Directors out of funds legally available therefore. While the Company has declared dividends on its common stock since 1994, and paid quarterly dividends aggregating $0.72 per share in 2011 and $0.64 per share in 2010, there is no assurance that the Company will continue to pay dividends in the future. Future dividends on the common stock will depend upon the Company’s earnings and financial condition, liquidity and capital requirements, the general economic and regulatory climate, the Company’s ability to service any equity or debt obligations senior to the common stock and other factors deemed relevant by the Board of Directors of the Company.

As a holding company, the Company is ultimately dependent upon its subsidiaries to provide funding for its operating expenses, debt service and dividends. Various banking laws applicable to the Bank limit the payment of dividends and other distributions by the Bank to the Company, and may therefore limit the Company’s ability to pay dividends on its common stock. Regulatory authorities could impose administratively stricter limitations on the ability of the Bank to pay dividends to the Company if such limits were deemed appropriate to preserve certain capital adequacy requirements.

In addition, the Federal Reserve Board has indicated that bank holding companies should carefully review their dividend policy in relation to the organization’s overall asset quality, level of current and prospective earnings and level, composition and quality of capital. The guidance provides that the Company inform and consult with the Federal Reserve Board prior to declaring and paying a dividend that exceeds earnings for the period for which the dividend is being paid or that could result in an adverse change to the Company’s capital structure, including interest on the subordinated debentures underlying the Company’s trust preferred securities.

 

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If required payments on the Company’s outstanding junior subordinated debentures held by its unconsolidated subsidiary trusts are not made or suspended, the Company will be prohibited from paying dividends on its common stock.

The cash dividends declared per share by quarter (and paid on the first business day of the subsequent quarter except for the fourth quarter of 2010 which was paid on December 31, 2010) for the Company’s last two fiscal years were as follows:

 

     2011      2010  

Fourth quarter

   $ 0.1950       $ 0.1750   

Third quarter

     0.1750         0.1550   

Second quarter

     0.1750         0.1550   

First quarter

     0.1750         0.1550   

Recent Sales of Unregistered Securities

None.

Securities Authorized for Issuance under Equity Compensation Plans

As of December 31, 2011, the Company had outstanding stock options granted under three stock option plans, all of which were approved by the Company’s shareholders. As of such date, the Company also had outstanding stock options granted under stock option plans that it assumed in connection with various acquisition transactions. The following table provides information as of December 31, 2011 regarding the Company’s equity compensation plans under which the Company’s equity securities are authorized for issuance:

 

Plan category

   Number of securities to
be issued upon exercise
of outstanding  options,
warrants and rights
(a)
    Weighted-average
exercise price of
outstanding options,
warrants and rights
(b)
     Number of securities
remaining available for
future issuance  under
equity compensation
plans (excluding
securities reflected in
column (a))
(c)
 

Equity compensation plans approved by security holders

     525,012 (1)    $ 28.18         544,791   

Equity compensation plans not approved by security holders

     —          —           —     
  

 

 

   

 

 

    

 

 

 

Total

     525,012      $ 28.18         544,791   
  

 

 

   

 

 

    

 

 

 

 

(1) Includes (a) 11,698 shares which may be issued upon exercise of options outstanding assumed by the Company in connection with the acquisition of SNB Bancshares, Inc. at a weighted average exercise price of $16.39.

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

None.

 

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Performance Graph

The following Performance Graph compares the cumulative total shareholder return on the Company’s common stock for the period beginning at the close of trading on December 31, 2006 to December 31, 2011, with the cumulative total return of the S&P 500 Total Return Index and the Nasdaq Bank Index for the same period. Dividend reinvestment has been assumed. The Performance Graph assumes $100 invested on December 31, 2006 in the Company’s common stock, the S&P 500 Total Return Index and the Nasdaq Bank Index. The historical stock price performance for the Company’s common stock shown on the graph below is not necessarily indicative of future stock performance.

 

LOGO

 

 

   12/06      12/07      12/08      12/09      12/10      12/11  

Prosperity Bancshares, Inc.

     100.00         86.37         88.49         123.29         121.80         127.45   

S&P 500

     100.00         105.49         66.46         84.05         96.71         98.75   

NASDAQ Bank

     100.00         76.94         64.14         53.93         61.47         54.83   

Copyright© 2012 Standard & Poor’s, a division of The McGraw-Hill Companies Inc. All rights reserved. (www.researchdatagroup.com/S&P.htm)

 

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ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

The following selected consolidated financial data of the Company for, and as of the end of, each of the years in the five-year period ended December 31, 2011 is derived from and should be read in conjunction with the Company’s consolidated financial statements and the notes thereto appearing elsewhere in this Annual Report on Form 10-K.

 

     As of and for the Years Ended December 31,  
     2011(1)     2010(1)     2009     2008     2007  
     (Dollars in thousands, except per share data)  

Income Statement Data:

          

Interest income

   $ 371,908      $ 384,537      $ 409,614      $ 347,878      $ 340,608   

Interest expense

     45,240        66,389        102,513        120,149        140,173   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

     326,668        318,148        307,101        227,729        200,435   

Provision for credit losses

     5,200        13,585        28,775        9,867        760   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income after provision for credit losses

     321,468        304,563        278,326        217,862        199,675   

Noninterest income

     56,043        53,833        60,097        52,370        52,923   

Noninterest expense

     163,745        166,594        169,700        143,796        126,843   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income before taxes

     213,766        191,802        168,723        126,436        125,755   

Provision for income taxes

     72,017        64,094        56,844        41,929        41,604   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 141,749      $ 127,708      $ 111,879      $ 84,507 (2)    $ 84,151 (2) 
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Per Share Data:

          

Basic earnings per share

   $ 3.03      $ 2.74      $ 2.42      $ 1.87 (2)    $ 1.96 (2) 

Diluted earnings per share

     3.01        2.73        2.41        1.86 (2)      1.94 (2) 

Book value per share

     33.41        31.11        29.03        27.24        25.51   

Cash dividends declared

     0.72        0.64        0.57        0.51        0.46   

Dividend payout ratio

     23.80     23.37     23.45     27.66     24.15

Weighted average shares outstanding (basic) (in thousands)

     46,846        46,621        46,177        45,300        42,928   

Weighted average shares outstanding (diluted) (in thousands)

     47,017        46,832        46,354        45,479        43,310   

Shares outstanding at end of period (in thousands)

     46,910        46,684        46,541        46,080        44,188   

Balance Sheet Data (at period end):

          

Total assets

   $ 9,822,671      $ 9,476,572      $ 8,850,400      $ 9,072,364      $ 6,372,343   

Securities

     4,658,936        4,617,116        4,118,290        4,160,401        1,857,606   

Loans

     3,765,906        3,485,023        3,376,703        3,567,057        3,142,971   

Allowance for credit losses

     51,594        51,584        51,863        36,970        32,543   

Total goodwill and intangibles

     945,533        953,034        912,372        912,850        799,978   

Other real estate owned

     8,328        11,053        7,829        4,450        10,207   

Total deposits

     8,060,254        7,454,920        7,258,550        7,303,297        4,966,407   

Borrowings and notes payable

     12,790        374,433        98,736        325,412        116,047   

Junior subordinated debentures

     85,055 (3)      92,265        92,265        92,265        112,885   

Total shareholders’ equity

     1,567,265        1,452,339        1,351,245        1,255,106        1,127,431   

 

(Table continued on next page)

 

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     As of and for the Years Ended December 31,  
     2011(1)     2010(1)     2009     2008     2007  
     (Dollars in thousands, except per share data)  

Average Balance Sheet Data:

          

Total assets

   $ 9,628,884      $ 9,278,380      $ 8,851,694      $ 7,025,418      $ 6,094,064   

Securities

     4,625,833        4,508,918        4,052,989        2,409,758        1,849,613   

Loans

     3,648,701        3,394,502        3,455,761        3,250,447        3,092,797   

Allowance for credit losses

     51,871        52,151        42,279        33,004        34,705   

Total goodwill and intangibles

     949,273        940,080        914,384        842,580        759,733   

Total deposits

     7,751,196        7,532,739        7,212,015        5,471,441        4,727,519   

Junior subordinated debentures

     86,557        92,265        92,265        99,998        124,613   

Total shareholders’ equity

     1,513,749        1,406,159        1,304,749        1,192,293        1,039,955   

Performance Ratios:

          

Return on average assets

     1.47     1.38     1.26     1.20 %(4)      1.38 %(5) 

Return on average equity

     9.36        9.08        8.57        7.09 (4)      8.09 (5) 

Net interest margin (tax equivalent)

     3.98        4.04        4.08        3.96        4.06   

Efficiency ratio(6)

     42.76        44.83        46.27        46.51        46.19   

Asset Quality Ratios(7):

          

Nonperforming assets to total loans and other real estate

     0.32     0.45     0.48     0.40     0.49

Net charge-offs to average loans

     0.14        0.41        0.40        0.23        0.18   

Allowance for credit losses to total loans

     1.37        1.48        1.54        1.04        1.04   

Allowance for credit losses to nonperforming loans(8)

     1,442.0        1,114.6        616.6        379.7        634.7   

Capital Ratios(7):

          

Leverage ratio

     7.89     6.87     6.47     5.68     8.09

Average shareholders’ equity to average total assets

     15.72        15.16        14.74        16.97        17.07   

Tier 1 risk-based capital ratio

     15.90        13.64        12.61        10.27        13.13   

Total risk-based capital ratio

     17.09        14.87        13.86        11.17        14.11   

 

(1) The Company completed no acquisitions during the twelve months ended December 31, 2011 and completed the acquisition of three branches of U.S Bank on March 29, 2010 and the acquisition of nineteen branches of First Bank on April 30, 2010.
(2) Net income for the year ended December 31, 2008 includes a $14.0 million pre-tax, or $9.1 million after-tax, impairment charge on write-down of securities which resulted in a decrease of basic and diluted earnings per share of $0.20 for the year ended December 31, 2008. Net income for the year ended December 31, 2007 includes a $10.0 million pre-tax, or $6.5 million after-tax, impairment charge on write-down of securities, which resulted in a decrease of basic and diluted earnings per share of $0.15 for the year ended December 31, 2007.
(3) Consists of $15.5 million of junior subordinated debentures of Prosperity Statutory Trust II due July 31, 2031, $12.9 million of junior subordinated debentures of Prosperity Statutory Trust III due September 17, 2033, $12.9 million of junior subordinated debentures of Prosperity Statutory Trust IV due December 30, 2033, $10.3 million of junior subordinated debentures of SNB Capital Trust IV due September 25, 2033 (assumed by the Company on April 1, 2006), $5.2 million of junior subordinated debentures of TXUI Statutory Trust II due December 19, 2033 (assumed by the Company on January 3l, 2007), $16.0 million of junior subordinated debentures of TXUI Statutory Trust III due December 15, 2035 (assumed by the Company on January 3l, 2007) and $12.4 million of junior subordinated debentures of TXUI Statutory Trust IV due June 30, 2036 (assumed by the Company on January 3l, 2007).
(4) Includes a $14.0 million pre-tax, or $9.1 million after-tax, impairment charge on write-down of securities, which resulted in a decrease of return on average assets of 13 basis points and a decrease of return on average equity of 76 basis points for the year ended December 31, 2008.

 

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(5) Includes a $10.0 million pre-tax, or $6.5 million after-tax, impairment charge on write-down of securities, which resulted in a decrease of return on average assets of 11 basis points and a decrease of return on average equity of 63 basis points for the year ended December 31, 2007.
(6) Calculated by dividing total noninterest expense, excluding credit loss provisions and impairment write-down on securities, 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.
(7) At period end, except for net charge-offs to average loans and average shareholders’ equity to average total assets, which is for periods ended at such dates.
(8) Nonperforming loans consist of nonaccrual loans, loans contractually past due 90 days or more, restructured loans and any other loan management deems to be nonperforming.

 

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

Special Cautionary Notice Regarding Forward-Looking Statements

Statements and financial discussion and analysis contained in this Annual Report on Form 10-K that are not statements of historical fact constitute forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These 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, but are not limited to:

 

   

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;

 

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government intervention in the U.S. financial system;

 

   

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;

 

   

the potential payment of interest on demand deposit accounts in order 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. Therefore, the Company cautions you not to place undue reliance on its forward-looking statements. The forward-looking statements speak only as of the date the statements are made. 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 balance sheets and statements of income. This section should be read in conjunction with the Company’s consolidated financial statements and accompanying notes and other detailed information appearing elsewhere in this Annual Report on Form 10-K.

For the Years Ended December 31, 2011, 2010 and 2009

Overview

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

Three principal components of the Company’s growth strategy are internal growth, stringent cost control practices and acquisitions, including strategic merger transactions and FDIC assisted transactions. The Company focuses on continual internal growth. Each banking center is operated as a separate profit center, maintaining separate data with respect to its net interest income, efficiency ratio, deposit growth, loan growth and overall profitability. Banking center presidents and managers are accountable for performance in these areas and compensated accordingly. The Company also focuses on maintaining stringent cost control practices and policies. The Company has 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

 

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

Net income was $141.7 million, $127.7 million and $111.9 million for the years ended December 31, 2011, 2010 and 2009, respectively, and diluted earnings per share were $3.01, $2.73 and $2.41, respectively, for these same periods. The change in net income during both 2011 and 2010 was principally due to an increase in net interest income resulting from balance sheet growth from acquisitions, including the acquisition of three (3) branches of U.S. Bank and the acquisition of nineteen (19) branches of First Bank in 2010. Net income growth during 2009 resulted principally from an increase in net interest income. The Company posted returns on average assets of 1.47%, 1.38% and 1.26% and returns on average equity of 9.36%, 9.08% and 8.57% for the years ended December 31, 2011, 2010 and 2009, respectively. The Company’s efficiency ratio was 42.76% in 2011, 44.83% in 2010 and 46.27% in 2009. The efficiency ratio is calculated by dividing total noninterest expense (excluding credit loss provisions and impairment write-down on securities) 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.

Total assets at December 31, 2011 and 2010 were $9.823 billion and $9.477 billion, respectively. Total deposits at December 31, 2011 and 2010 were $8.060 billion and $7.455 billion, respectively. Total loans were $3.766 billion at December 31, 2011, an increase of $280.9 million or 8.1% compared with $3.485 billion at December 31, 2010. At December 31, 2011, the Company had $3.6 million in nonperforming loans and its allowance for credit losses was $51.6 million compared with $4.6 million in nonperforming loans and an allowance for credit losses of $51.6 million at December 31, 2010. Shareholders’ equity was $1.567 billion and $1.452 billion at December 31, 2011 and 2010, respectively.

Recent Developments

Pending Acquisition of American State Financial CorporationOn February 27, 2012, the Company announced the signing of a definitive agreement to acquire American State Financial Corporation and its wholly owned subsidiary, American State Bank (“ASB”), through the merger of American State Financial with and into the Company. ASB operates thirty-seven (37) banking offices in eighteen (18) counties across West Texas. As of December 31, 2011, American State Financial, on a consolidated basis, reported total assets of $3.08 billion, total loans of $1.21 billion and total deposits of $2.46 billion. Under the terms of the definitive agreement, the Company will issue up to 8,525,000 shares of its common stock plus $178.5 million in cash for all outstanding shares of American State Financial capital stock, subject to certain conditions and potential adjustment.

The merger has been approved by the Boards of Directors of both companies and is expected to close during the third quarter of 2012, although delays may occur. The transaction is subject to certain conditions, including the approval by American State Financial’s shareholders and customary regulatory approvals. Operational integration is anticipated to begin during the third quarter of 2012.

Pending Acquisition of The Bank Arlington—On January 19, 2012, the Company entered into a definitive agreement to acquire The Bank Arlington. The Bank Arlington operates one (1) banking office in Arlington, Texas, in the Dallas/Fort Worth CMSA.

Under the terms of the definitive agreement, the Company will issue up to 138,600 shares of Company common stock for all outstanding shares of The Bank Arlington capital stock, subject to certain conditions and potential adjustments. The transaction is expected to close during the second quarter of 2012, although delays could occur.

 

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Pending Acquisition of East Texas Financial Services, Inc.—On December 8, 2011, the Company entered into a definitive agreement to acquire East Texas Financial Services, Inc. (OTC BB: FFBT) and its wholly-owned subsidiary, First Federal Bank Texas (“Firstbank”). Firstbank operates four (4) banking offices in the Tyler MSA, including three (3) locations in Tyler, Texas and one (1) location in Gilmer, Texas.

Under the terms of the definitive agreement, the Company will issue up to 531,000 shares of Company common stock for all outstanding shares of East Texas Financial Services capital stock, subject to certain conditions and potential adjustments. The transaction is expected to close during the second quarter of 2012, although delays could occur.

Acquisition of Texas Bankers, Inc.—On January 1, 2012, the Company completed the previously announced acquisition of Texas Bankers, Inc. and its wholly-owned subsidiary, Bank of Texas, Austin, Texas. The three (3) Bank of Texas banking offices in the Austin, Texas CMSA consist of a location in Rollingwood, which upon operational integration will be consolidated with the Company’s Westlake location and remain in Bank of Texas’ Rollingwood banking office; one banking center in downtown Austin, which upon operational integration will be consolidated into the Company’s downtown Austin location; and another banking center in Thorndale.

Under the terms of the agreement, the Company issued 314,953 shares of Company common stock for all outstanding shares of Texas Bankers capital stock, which resulted in a premium of $5.2 million.

Critical Accounting Policies

The Company’s significant accounting policies are integral to understanding the results reported. The Company’s accounting policies are described in detail in Note 1 to the consolidated financial statements, appearing elsewhere is this Annual Report on Form 10-K. 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

 

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economic and market conditions and exit prices for recent market transactions. The Company had no intangible assets with indefinite useful lives at December 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, 2011, management does not believe any of its goodwill is impaired as of December 31, 2011 because the fair value of the Company’s equity exceeded its carrying value. While the Company believes no impairment existed at December 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—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 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 Interest Income

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

2011 versus 2010. Net interest income before the provision for credit losses for the year ended December 31, 2011 was $326.7 million compared with $318.1 million for the year ended December 31, 2010, an increase of $8.5 million or 2.7%. The improvement in net interest income for 2011 was principally due to a $349.0 million or 4.4% increase in average interest-earning assets to $8.301 billion at December 31, 2011 compared with $7.952 billion at December 31, 2010. The average rate paid on interest-bearing liabilities

 

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decreased 34 basis points from 1.06% for the year ended December 31, 2010 to 0.72% for the year ended December 31, 2011 and the average yield on interest-earning assets decreased 36 basis points from 4.84% at December 31, 2010 to 4.48% at December 31, 2011. At December 31, 2011, period end demand deposits represented an important component of funding and were 24.5% of total period end deposits compared with 22.4% at December 31, 2010.

Net interest margin on a tax equivalent basis, defined as net interest income divided by average interest-earning assets, for 2011 was 3.98%, a decrease of 6 basis points compared with 4.04% for 2010.

2010 versus 2009. Net interest income before the provision for credit losses for the year ended December 31, 2010 was $318.1 million compared with $307.1 million for the year ended December 31, 2009, an increase of $11.0 million or 3.6%. The improvement in net interest income for 2010 was principally due to a $366.3 million or 4.8% increase in average interest-earning assets to $7.952 billion at December 31, 2010 compared with $7.586 billion at December 31, 2009. The improvement in net interest income for 2010 was also partially due to the decrease in the yield on interest-earning assets being less than the decrease in rates paid on interest-bearing liabilities. The average rate paid on interest-bearing liabilities decreased 65 basis points from 1.71% for the year ended December 31, 2009 to 1.06% for the year ended December 31, 2010 and the average yield on interest-earning assets decreased 56 basis points from 5.40% at December 31, 2009 to 4.84% at December 31, 2010. At December 31, 2010, period end demand deposits represented an important component of funding and were 22.4% of total period end deposits compared with 20.6% at December 31, 2009.

Net interest margin on a tax equivalent basis, defined as net interest income divided by average interest-earning assets, for 2010 was 4.04%, a decrease of 4 basis points compared with 4.08% for 2009.

 

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

 

    Years Ended December 31,  
    2011     2010     2009  
    Average
Outstanding
Balance
    Interest
Earned/
Paid
    Average
Yield/
Rate
    Average
Outstanding
Balance
    Interest
Earned/
Paid
    Average
Yield/
Rate
    Average
Outstanding
Balance
    Interest
Earned/
Paid
    Average
Yield/
Rate
 
    (Dollars in thousands)  

Assets

                 

Interest-earning assets:

                 

Loans

  $ 3,648,701      $ 214,273        5.87   $ 3,394,502      $ 209,711        6.18   $ 3,455,761      $ 219,320        6.35

Securities(1)

    4,625,833        157,580        3.41        4,508,918        174,707        3.87        4,052,989        190,106        4.69   

Federal funds sold and other temporary investments

    26,879        55        0.20        48,944        119        0.24        77,328        188        0.24   
 

 

 

   

 

 

     

 

 

   

 

 

     

 

 

   

 

 

   

Total interest-earning assets

    8,301,413        371,908        4.48     7,952,364        384,537        4.84     7,586,078        409,614        5.40
 

 

 

   

 

 

     

 

 

   

 

 

     

 

 

   

 

 

   

Less allowance for credit losses

    (51,871         (52,151         (42,279    
 

 

 

       

 

 

       

 

 

     

Total interest-earning assets, net of allowance

    8,249,542            7,900,213            7,543,799       

Noninterest-earning assets

    1,379,342            1,378,167            1,307,895       
 

 

 

       

 

 

       

 

 

     

Total assets

  $ 9,628,884          $ 9,278,380          $ 8,851,694       
 

 

 

       

 

 

       

 

 

     

Liabilities and shareholders’ equity

                 

Interest-bearing liabilities:

                 

Interest-bearing demand deposits

  $ 1,393,501      $ 7,416        0.53   $ 1,336,400      $ 8,994        0.67   $ 1,082,332      $ 8,587        0.79

Savings and money market accounts

    2,421,735        11,836        0.49        2,189,695        15,159        0.69        1,910,721        19,405        1.02   

Certificates of deposit

    2,135,858        21,723        1.02        2,438,968        37,356        1.53        2,730,263        67,842        2.48   

Junior subordinated debentures

    86,557        2,984        3.45        92,265        3,250        3.52        92,265        3,760        4.08   

Securities sold under repurchase agreements

    68,049        369        0.54        81,623        595        0.73        93,625        1,166        1.25   

Other borrowings

    152,716        912        0.60        109,260        1,035        0.95        75,747        1,753        2.31   
 

 

 

   

 

 

     

 

 

   

 

 

     

 

 

   

 

 

   

Total interest-bearing liabilities

    6,258,416        45,240        0.72     6,248,211        66,389        1.06     5,984,953        102,513        1.71
 

 

 

   

 

 

     

 

 

   

 

 

     

 

 

   

 

 

   

Noninterest-bearing liabilities:

                 

Noninterest-bearing demand deposits

    1,800,102            1,567,676            1,488,699       

Other liabilities

    56,617            56,334            73,293       
 

 

 

       

 

 

       

 

 

     

Total liabilities

    8,115,135            7,872,221            7,546,945       
 

 

 

       

 

 

       

 

 

     

Shareholders’ equity

    1,513,749            1,406,159            1,304,749       
 

 

 

       

 

 

       

 

 

     

Total liabilities and shareholders’ equity

  $ 9,628,884          $ 9,278,380          $ 8,851,694       
 

 

 

       

 

 

       

 

 

     

Net interest rate spread

        3.76         3.78         3.69

Net interest income and margin(2)

    $ 326,668        3.94     $ 318,148        4.00     $ 307,101        4.05
   

 

 

       

 

 

       

 

 

   

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

    $ 330,282        3.98     $ 321,049        4.04     $ 309,866        4.08
   

 

 

       

 

 

       

 

 

   

 

(1) Yield is based on amortized cost and does not include any component of unrealized gains or losses.
(2) The net interest margin is equal to net interest income divided by average interest-earning assets.
(3) In order to make pretax income and resultant yields on tax-exempt investments and loans comparable to those on taxable investments and loans, a tax-equivalent adjustment has been computed using a federal income tax rate of 35% for the years ended December 31, 2011, 2010 and 2009 and other applicable effective tax rates.

 

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The following table presents information regarding the dollar amount of changes in interest income and interest expense for the periods indicated for each major component of interest-earning assets and interest-bearing liabilities and distinguishes between the changes attributable to changes in volume and changes in interest rates. For purposes of this table, changes attributable to both rate and volume which cannot be segregated have been allocated to rate.

 

     Years Ended December 31,  
     2011 vs. 2010     2010 vs. 2009  
     Increase
(Decrease)
Due to Change in
    Total     Increase
(Decrease)
Due to Change in
    Total  
     Volume     Rate       Volume     Rate    
     (Dollars in thousands)  

Interest-earning assets:

            

Loans

   $ 15,704      $ (11,142   $ 4,562      $ (3,888   $ (5,721   $ (9,609

Securities

     4,530        (21,657     (17,127     21,385        (36,784     (15,399

Federal funds sold and other temporary investments

     (54     (10     (64     (69     —          (69
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total increase (decrease) in interest income

     20,180        (32,809     (12,629     17,428        (42,505     (25,077
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Interest-bearing liabilities:

            

Interest-bearing demand deposits

     384        (1,962     (1,578     2,016        (1,609     407   

Savings and money market accounts

     1,606        (4,929     (3,323     2,833        (7,079     (4,246

Certificates of deposit

     (4,643     (10,990     (15,633     (7,238     (23,248     (30,486

Junior subordinated debentures

     (201     (65     (266     —          (510     (510

Securities sold under repurchase agreements

     (99     (127     (226     (149     (422     (571

Other borrowings

     412        (535     (123     776        (1,494     (718
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total decrease in interest expense

     (2,541     (18,608     (21,149     (1,762     (34,362     (36,124
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Increase (decrease) in net interest income

   $ 22,721      $ (14,201   $ 8,520      $ 19,190      $ (8,143   $ 11,047   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Provision for Credit Losses

The Company’s provision for credit losses is established through charges to income in the form of the provision in order to bring the Company’s allowance for credit losses to a level deemed appropriate by management based on the factors discussed under “Financial Condition—Allowance for Credit Losses.” The allowance for credit losses at December 31, 2011 was $51.6 million, representing 1.37% of outstanding loans as of such date. The provision for credit losses for the year ended December 31, 2011 was $5.2 million compared with $13.6 million for the year ended December 31, 2010. Net charge-offs for each of the years ended December 31, 2011 and 2010 were $5.2 million and $13.9 million, respectively. The provision for credit losses for the year ended December 31, 2010 was $13.6 million compared with $28.8 million for the year ended December 31, 2009. Net charge-offs for the year ended December 31, 2009 were $13.9 million.

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. For the year ended December 31, 2011, noninterest income totaled $56.0 million, an increase of $2.2 million or 4.1% compared with $53.8 million in 2010. The increase was primarily due to an increase in debit card and ATM card income and a reduction in net losses on sale of other real estate, partially offset by a decrease in NSF fees. Noninterest income for 2010 was $53.8 million, a decrease of $6.3 million or 10.4% compared with $60.1 million in 2009.

 

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

 

     Years Ended December 31,  
     2011     2010     2009  
     (Dollars in thousands)  

Non-sufficient Funds (NSF) fees

   $ 24,442      $ 27,580      $ 31,094   

Debit card and ATM card income

     15,391        12,581        10,795   

Service charges on deposit accounts

     9,981        10,089        9,853   

Banking related service fees

     2,184        2,166        2,009   

Bank Owned Life Insurance income (BOLI)

     1,382        1,658        1,344   

Net (losses) gains on sales of assets

     (527 )(1)      (3,860 )(2)      839 (3)  

Net losses on sale of securities

     (581     —          —     

Other

     3,771        3,619        4,163   
  

 

 

   

 

 

   

 

 

 

Total noninterest income

   $ 56,043      $ 53,833      $ 60,097   
  

 

 

   

 

 

   

 

 

 

 

(1) Includes net losses on the sale of various other real estate properties of $904,000 and gains on the sale of real estate.
(2) Includes net losses on the sale of various other real estate properties of $4.3 million and gains on the sale of real estate.
(3) Includes net gains on the sale of various other real estate properties of $417,000 and gains on the sale of real estate.

Noninterest Expense

For the year ended December 31, 2011, noninterest expense totaled $163.7 million, a decrease of $2.8 million or 1.7% compared with $166.6 million for the same period in 2010. This decrease was principally due to reductions in FDIC assessments, reductions in ORE expenses and a decrease in core deposit intangibles amortization. For the year ended December 31, 2010, noninterest expense totaled $166.6 million, a decrease of $3.1 million or 1.8% compared with $169.7 million for the same period in 2009. This decrease was principally due to reductions in FDIC assessments and a decrease in core deposit intangibles amortization, partially offset by increases in salaries and employee benefits. These items and other changes in the various components of noninterest expense are discussed in more detail below.

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

 

     Years Ended December 31,  
     2011      2010      2009  
     (Dollars in thousands)  

Salaries and employee benefits(1)

   $ 92,057       $ 86,980       $ 84,395   

Non-staff expenses:

        

Net occupancy

     14,634         15,153         14,910   

Depreciation

     8,150         8,313         8,226   

Debit card, data processing and software amortization

     6,823         6,222         6,449   

Regulatory assessments and FDIC insurance

     8,901         11,039         13,662   

Ad valorem and franchise taxes

     3,823         3,947         3,561   

Core deposit intangibles amortization

     7,780         9,016         10,076   

Communications(2)

     6,946         7,781         8,466   

Other real estate

     1,501         3,483         3,205   

Professional fees

     2,598         3,099         4,419   

Printing and supplies

     1,807         1,951         2,250   

Other

     8,725         9,610         10,081   
  

 

 

    

 

 

    

 

 

 

Total noninterest expense

   $ 163,745       $ 166,594       $ 169,700   
  

 

 

    

 

 

    

 

 

 

 

(1) Total salaries and employee benefits includes $3.6 million, $3.0 million and $1.5 million in 2011, 2010 and 2009, respectively, in stock-based compensation expense.
(2) Communications expense includes telephone, data circuits, postage and courier expenses.

 

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Salaries and Employee Benefits. Salaries and employee benefits increased $5.1 million to $92.1 million at December 31, 2011 compared with $87.0 million at December 31, 2010 primarily due to the full year effect of the U.S. Bank and First Bank acquisitions and increases in incentive pay. The number of associates employed by the Company decreased from 1,708 at December 31, 2010 to 1,664 at December 31, 2011. Salaries and employee benefits increased $2.6 million to $87.0 million at December 31, 2010 compared with $84.4 million at December 31, 2009 primarily due to the U.S. Bank and First Bank acquisitions. The number of associates employed by the Company increased from 1,594 at December 31, 2009 to 1,708 at December 31, 2010. Total noninterest expense for the year ended December 31, 2011 includes $3.6 million in stock-based compensation expense compared with $3.0 million and $1.5 million recorded for each of the years ended December 31, 2010 and 2009, respectively.

Regulatory Assessments and FDIC Insurance. Regulatory assessments and FDIC insurance assessments were $8.9 million for the year ended December 31, 2011 compared with $11.0 million and $13.7 million for the years ended December 31, 2010 and 2009. This was a decrease of $2.1 million or 19.4% in 2011. Regulatory assessments and FDIC insurance assessments decreased $2.6 million or 19.2% from $13.7 million for the year ended December 31, 2009 to $11.0 million for the year ended December 31, 2010. In 2009, the FDIC assessments of $13.7 million were due to higher FDIC assessment rates and an increase in the amount of the Company’s deposits in connection with its 2008 acquisitions and a one-time special assessment of $4.2 million in the second quarter of 2009. On February 7, 2011, the FDIC approved a final rule that amends its existing DIF restoration plan and implements certain provisions of the Dodd-Frank Act. Effective April 1, 2011 the assessment base is determined using average consolidated total assets minus average tangible equity rather than the assessment base of adjusted domestic deposits and the assessments rates were lowered to account for the larger assessment base. Additional information is discussed under the section captioned “Supervision and Regulation—The Bank—Deposit Insurance Assessments” in Part I, Item 1 of this Annual Report on Form 10-K.

Core Deposit Intangibles Amortization. Core deposit intangibles (“CDI”) amortization decreased $1.2 million or 13.7% from $9.0 million for the year ended December 31, 2010 to $7.8 million for the year ended December 31, 2011. The decrease was primarily attributed to certain CDI that fully amortized in 2011. CDI amortization decreased $1.1 million or 10.5% from $10.1 million for the year December 31, 2009 to $9.0 million for the year ended December 31, 2010. The decrease was primarily attributed to certain CDI that fully amortized in 2010. Core deposit intangibles are being amortized on an accelerated basis over an estimated life of eight to ten years.

Other real estate. Other real estate expense decreased $2.0 million or 56.9% from $3.5 million for the year ended December 31, 2010 to $1.5 million for the year ended December 31, 2011. The decrease was primarily due to reduced ORE property recorded by the Company. Other real estate expense increased $278,000 or 8.7% from $3.2 million for the year ended December 31, 2009 to $3.5 million for the year ended December 31, 2010.

Efficiency Ratio. The efficiency ratio is a supplemental financial measure utilized in management’s internal evaluation of the Company and is not defined under generally accepted accounting principles. The efficiency ratio is calculated by dividing total noninterest expense, excluding credit loss provisions and impairment write-down on available for sale securities, by net interest income plus noninterest income, excluding net gains and losses on the sale of securities and on the sale of assets. Taxes are not part of this calculation. An increase in the efficiency ratio indicates that more resources are being utilized to generate the same volume of income, while a decrease would indicate a more efficient allocation of resources. The Company’s efficiency ratio was 42.76% for the year ended December 31, 2011, compared with 44.83% for the year ended December 31, 2010. The Company’s efficiency ratio was 46.27% for the year ended December 31, 2009.

Income Taxes

The amount of federal income tax expense is influenced by the amount of pre-tax income, the amount of tax-exempt income, the amount of nondeductible interest expense and the amount of other nondeductible

 

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expenses. For the year ended December 31, 2011, income tax expense was $72.0 million compared with $64.1 million for the year ended December 31, 2010 and $56.8 million for the year ended December 31, 2009. The increases were primarily attributable to higher pretax net earnings which resulted primarily from an increase in net interest income for the year ended December 31, 2011 compared with the same period in 2010 and 2009. The effective tax rate for the years ended December 31, 2011, 2010 and 2009 was 33.7%, 33.4% and 33.7%, respectively. The effective income tax rates differed from the U.S. statutory rate of 35% during the comparable periods primarily due to the effect of tax-exempt income from loans and securities.

Impact of Inflation

The Company’s consolidated financial statements and related notes included in this Annual Report on Form 10-K have been prepared in accordance with generally accepted accounting principles. These require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative value of money over time due to inflation or recession.

Unlike many industrial companies, substantially all of the Company’s assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on the Company’s performance than the effects of general levels of inflation. Interest rates may not necessarily move in the same direction or in the same magnitude as the prices of goods and services. However, other operating expenses do reflect general levels of inflation.

Financial Condition

Loan Portfolio

At December 31, 2011, total loans were $3.766 billion, an increase of $280.9 million or 8.1% compared with $3.485 billion at December 31, 2010. The increase was due to internal growth. At December 31, 2011, total loans were 46.7% of deposits and 38.3% of total assets. At December 31, 2010, total loans were $3.485 billion, an increase of $108.3 million or 3.2% compared with $3.377 billion at December 31, 2009. The increase was primarily attributable to U.S. Bank and First Bank acquisitions which added $28.4 million and $54.0 million in loans at December 31, 2010, respectively. At December 31, 2010, total loans were 46.7% of deposits and 36.8% of total assets.

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

 

    December 31,  
    2011     2010     2009     2008     2007  
    Amount     Percent     Amount     Percent     Amount     Percent     Amount     Percent     Amount     Percent  
    (Dollars in thousands)  

Commercial and industrial

  $ 406,433        10.8   $ 409,426        11.7   $ 392,975        11.6   $ 482,476        13.5   $ 436,338        13.9

Real estate:

                   

Construction and land development

    482,140        12.8        502,327        14.4        557,245        16.5        666,081        18.7        683,171        21.7   

1-4 family residential

    1,007,266        26.7        824,057        23.7        709,101        21.0        668,097        18.7        526,338        16.7   

Home equity

    146,999        3.9        118,781        3.4        117,661        3.5        107,048        3.0        93,877        3.0   

Commercial mortgage(1)

    1,351,986        35.9        1,288,023        37.0        1,261,267        37.4        1,268,340        35.6        1,075,285        34.3   

Farmland

    136,008        3.6        98,871        2.8        93,288        2.8        96,970        2.7        63,873        2.0   

Multifamily residential

    89,240        2.4        82,626        2.4        77,952        2.3        75,063        2.1        73,424        2.3   

Agriculture

    34,226        0.9        41,881        1.2        42,241        1.3        48,679        1.3        50,146        1.6   

Consumer (net of unearned discount)

    78,187        2.1        87,977        2.5        102,436        3.0        137,639        3.9        123,213        3.9   

Other

    33,421        0.9        31,054        0.9        22,537        0.6        16,664        0.5        17,306        0.6   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans(2)

  $ 3,765,906        100.0   $ 3,485,023        100.0   $ 3,376,703        100.0   $ 3,567,057        100.0   $ 3,142,971        100.0
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Commercial mortgage loans include approximately $602.8 million and $641.8 million of owner-occupied loans for the years ended December 31, 2011 and 2010, respectively.
(2) Includes loans held for sale for in 2008 and 2007.

 

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The Company’s commercial mortgages increased from $1.288 billion at December 31, 2010 to $1.352 billion at December 31, 2011, an increase of $64.0 million or 5.0%. The Company’s commercial and industrial loans decreased from $409.4 million at December 31, 2010 to $406.4 million at December 31, 2011, a decrease of $3.0 million or 0.7%. The Company offers a variety of commercial lending products including term loans and lines of credit. The Company offers a broad range of short to medium-term commercial loans, primarily collateralized, to businesses for working capital (including inventory and receivables), business expansion (including acquisitions of real estate and improvements) and the purchase of equipment and machinery. Historically, the Company has originated loans for its own account and has not securitized its loans. The purpose of a particular loan generally determines its structure. All loans in the 1-4 family residential category were originated by the Company.

All loans over $500,000 and below $2.5 million are evaluated and acted upon on a daily basis by two of the six company-wide loan concurrence officers. All loans above $2.5 million are evaluated and acted upon by an officers’ loan committee which meets weekly. In addition to the officers’ loan committee evaluation, loans from $15.0 million to $25.0 million are evaluated and acted upon by the directors’ loan committee which consists of three directors of the Bank and meets as necessary. Loans over $25.0 million are evaluated and acted upon by the Bank’s Board of Directors either at a regularly scheduled monthly board meeting or by teleconference or written consent.

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.

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.

1-4 Family Residential Loans. The Company’s lending activities also includes the origination of 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. Other than with respect to mortgage banking activities acquired in the TXUI acquisition, 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.

 

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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.

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.

Consumer Loans. Consumer loans made by the Company include direct “A”-credit automobile loans, recreational vehicle loans, boat loans, home improvement loans, home equity loans, personal loans (collateralized and uncollateralized) and deposit account collateralized loans. The terms of these loans typically range from 12 to 120 months and vary based upon the nature of collateral and size of loan. 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 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.

 

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The contractual maturity ranges of the 1-4 family residential, home equity, commercial and industrial, commercial mortgage, construction and land development and agriculture portfolios and the amount of such loans with predetermined interest rates and floating rates in each maturity range as of December 31, 2011 are summarized in the following table:

 

     December 31, 2011  
     One Year
or Less
     After One
Through
Five Years
     After Five
Years
     Total  
     (Dollars in thousands)  

1-4 family residential and home equity

   $ 9,490       $ 43,819       $ 1,100,956       $ 1,154,265   

Commercial and industrial

     154,649         144,070         107,714         406,433   

Commercial mortgages

     30,714         97,811         1,223,461         1,351,986   

Construction and land development

     93,174         55,445         333,521         482,140   

Agriculture

     22,946         10,992         288         34,226   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 310,973       $ 352,137       $ 2,765,940       $ 3,429,050   
  

 

 

    

 

 

    

 

 

    

 

 

 

Loans with a predetermined interest rate

   $ 92,662       $ 199,524       $ 1,189,365       $ 1,481,551   

Loans with a floating interest rate

     218,311         152,613         1,576,575         1,947,499   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 310,973       $ 352,137       $ 2,765,940       $ 3,429,050   
  

 

 

    

 

 

    

 

 

    

 

 

 

Nonperforming Assets

The Company has several procedures in place to assist it in maintaining the overall quality of its loan portfolio. The Company has established underwriting guidelines to be followed by its officers 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.

As part of the on-going monitoring of the Company’s loan portfolio and the methodology for calculating the allowance for credit losses, management grades each loan from 1 to 7. Depending on the grade, loans in the same grade are aggregated and a loss factor is applied to the total loans in the group to determine the allowance for credit losses. For certain loans in risk grades 5 to 7, a specific reserve may be taken.

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 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.

The Company’s conservative lending approach has resulted in sound asset quality. The Company had $12.1 million in nonperforming assets at December 31, 2011 compared with $15.8 million at December 31, 2010 and $16.4 million at December 31, 2009. The nonperforming assets at December 31, 2011 consisted of ninety-nine (99) separate credits or ORE properties. If interest on nonaccrual loans had been accrued under the original loan terms, approximately $253,000, $701,000 and $434,000 would have been recorded as income for the years ended December 31, 2011, 2010 and 2009, respectively.

 

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

 

     December 31,  
     2011     2010     2009     2008     2007  
     (Dollars in thousands)  

Nonaccrual loans

   $ 3,578      $ 4,439      $ 6,079      $ 2,142      $ 1,035   

Accruing loans 90 or more days past due

     —          189        2,332        7,594        4,092   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total nonperforming loans

     3,578        4,628        8,411        9,736        5,127   

Repossessed assets

     146        161        116        182        56   

Other real estate

     8,328        11,053        7,829        4,450        10,207   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total nonperforming assets

   $ 12,052      $ 15,842      $ 16,356      $ 14,368      $ 15,390   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Nonperforming assets to total loans and other real estate

     0.32     0.45     0.48     0.40     0.49

Nonperforming assets to average earning assets

     0.15     0.20     0.22     0.25     0.31

Allowance for Credit Losses

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

 

    Years Ended December 31,  
    2011     2010     2009     2008     2007  
    (Dollars in thousands)  

Average loans outstanding

  $ 3,648,701      $ 3,394,502      $ 3,455,761      $ 3,250,447      $ 3,092,797   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross loans outstanding at end of period

  $ 3,765,906      $ 3,485,023      $ 3,376,703      $ 3,567,057      $ 3,142,971   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Allowance for credit losses at beginning of period

  $ 51,584      $ 51,863      $ 36,970      $ 32,543      $ 23,990   

Balance acquired with acquisitions

    —          —          —          2,182        13,386   

Provision for credit losses

    5,200        13,585        28,775        9,867        760   

Charge-offs:

         

Commercial and industrial

    (1,694     (2,863     (3,816     (2,799     (1,045

Real estate and agriculture

    (3,927     (10,549     (8,585     (3,650     (4,143

Consumer

    (1,229     (2,071     (2,998     (2,733     (2,974

Recoveries:

         

Commercial and industrial

    481        346        275        308        1,175   

Real estate and agriculture

    472        444        236        220        208   

Consumer

    707        829        1,006        1,032        1,186   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net charge-offs

    (5,190     (13,864     (13,882     (7,622     (5,593
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Allowance for credit losses at end of period

  $ 51,594      $ 51,584      $ 51,863      $ 36,970      $ 32,543   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Ratio of allowance to end of period loans

    1.37     1.48     1.54     1.04     1.04

Ratio of net charge-offs to average loans

    0.14        0.41        0.40        0.23        0.18   

Ratio of allowance to end of period nonperforming loans

    1,442.0        1,114.6        616.6        379.7        634.7   

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

 

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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 and assigns risk grades to each loan. 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 certain impaired loans, 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. 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;

 

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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.

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 December 31, 2011, the allowance for credit losses totaled $51.6 million, or 1.37% of total loans. At December 31, 2010, the allowance aggregated $51.6 million or 1.48% of total loans and at December 31, 2009, the allowance was $51.9 million or 1.54% of total loans.

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

 

     December 31,  
     2011     2010  
     Amount      Percent of
Loans to
Total Loans
    Amount      Percent of
Loans to
Total Loans
 
     (Dollars in thousands)  

Balance of allowance for credit losses applicable to:

          

Commercial and industrial

   $ 3,826         10.8   $ 3,891         11.7

Real estate

     46,587         85.3        46,446         83.7   

Agriculture

     123         0.9        92         1.2   

Consumer and other

     1,058         3.0        1,155         3.4   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total allowance for credit losses

   $ 51,594         100.0   $ 51,584         100.0
  

 

 

    

 

 

   

 

 

    

 

 

 

 

    December 31,  
    2009     2008     2007  
    Amount     Percent of
Loans to
Total Loans
    Amount     Percent of
Loans to
Total Loans
    Amount     Percent of
Loans to
Total Loans
 
    (Dollars in thousands)  

Balance of allowance for credit losses applicable to:

           

Commercial and industrial

  $ 5,107        11.6   $ 6,159        13.5   $ 4,790        13.9

Real estate

    44,799        83.4        27,953        80.8        22,505        80.0   

Agriculture

    221        1.3        313        1.3        506        1.6   

Consumer and other

    1,736        3.7        2,545        4.4        2,153        4.5   

Unallocated

    —          —          —          —          2,589        —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total allowance for credit losses

  $ 51,863        100.0   $ 36,970        100.0   $ 32,543        100.0
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The Company believes that the allowance for credit losses at December 31, 2011 is adequate to cover estimated losses in the loan portfolio as of such date. There can be no assurance, however, that the Company will not sustain losses in future periods, which could be substantial in relation to the size of the allowance at December 31, 2011.

 

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Securities

The Company uses its securities portfolio as a source of income, as a source of liquidity for cash requirements and to manage interest rate risk. At December 31, 2011, the carrying amount of investment securities totaled $4.659 billion, an increase of $41.8 million or 0.9% compared with $4.617 billion at December 31, 2010. At December 31, 2011, securities represented 47.4% of total assets compared with 48.7% of total assets at December 31, 2010.

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

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):

 

     December 31,  
     2011      2010      2009      2008      2007  
     (Dollars in thousands)  

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

   $ 8,696       $ 10,996       $ 41,715       $ 151,147       $ 229,119   

70% non-taxable preferred stock

     —           —           —           —           14,025   

States and political subdivisions

     74,974         76,031         82,174         84,569         87,517   

Corporate debt securities

     2,990         2,984         3,227         3,221         3,215   

Collateralized mortgage obligations

     282,565         444,827         296,923         179,389         223,952   

Mortgage-backed securities

     4,248,796         4,032,084         3,640,208         3,711,629         1,282,338   

Qualified Zone Academy Bond (QZAB)(1) and Qualified School Construction Bonds (QSCB)

     12,900         20,900         20,900         8,000         8,000   

Other

     7,288         7,288         7,288         7,288         7,260   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 4,638,209       $ 4,595,110       $ 4,092,435       $ 4,145,243       $ 1,855,426   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) The Qualified Zone Academy Bond with an amortized cost of $8.0 million, matured in December 2011.

 

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The following table summarizes the contractual maturity of securities and their weighted average yields as of December 31, 2011. The contractual maturity of a mortgage-backed security is the date at which the last underlying mortgage matures. Available-for-sale securities are shown at fair value and held-to-maturity securities are shown at amortized cost. Other securities are included in the corporate debt securities category. For purposes of the table below, tax-exempt states and political subdivisions are calculated on a tax equivalent basis. The QZAB and QSCB bonds are not calculated on a tax equivalent basis and the bonds generate tax credits as follows: QZAB at 7.18% and the two QSCB at 6.11% and 5.95%. The tax credits are shown as a reduction to federal income tax expense.

 

    December 31, 2011  
    Within One
Year
    After One Year
but
Within Five Years
    After Five Years
but
Within Ten Years
    After Ten
Years
    Total  
    Amount     Yield     Amount     Yield     Amount     Yield     Amount     Yield     Total     Yield  
    (Dollars in thousands)  

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

  $ 4,981        5.11   $ 3,715        5.15   $ —          —        $ —          —        $ 8,696        5.13

States and political subdivisions

    2,085        6.78        9,383        6.13        35,341        6.18     30,181        6.18     76,990        6.19   

Corporate debt securities and other

    7,656        3.41        3,113        7.64        —          —          —          —          10,769        5.39   

Collateralized mortgage obligations

    —          —          3,334        4.57        103,108        3.25        176,101        2.74        282,543        2.95   

Mortgage-backed securities

    77        4.91        74,492        4.33        2,510,671        3.29        1,681,798        3.36        4,267,038        3.33   

Qualified School Construction Bonds (QSCB)

    —          —          —          —          —          —          12,900        1.58        12,900        1.58   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 14,799        4.46   $ 94,037        4.66   $ 2,649,120        3.32   $ 1,900,980        3.33   $ 4,658,936        3.41
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The contractual maturity of mortgage-backed securities and collateralized mortgage obligations is not a reliable indicator of their expected life because borrowers have the right to prepay their obligations at any time. Mortgage-backed securities monthly pay downs cause the average lives of the securities to be much different than their stated lives. The weighted average life of the Company’s complete portfolio is 2.6 years with an effective duration of 2.5 years at December 31, 2011.

At December 31, 2011 and 2010, the Company did not own securities of any one issuer (other than the U.S. government and its agencies) for which aggregate adjusted cost exceeded 10% of the consolidated shareholders’ equity at such respective dates.

The average yield of the securities portfolio was 3.41% in 2011 compared with 3.87% in 2010 and 4.69% in 2009. Both decreases in yields were primarily due to the Company reinvesting funds at lower rates in 2011 and 2010 compared to 2010 and 2009, respectively. The overall growth in the average securities portfolio over the comparable periods was primarily funded by deposit growth.

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

 

     December 31,  
     2011      2010      2009      2008      2007  
     (Dollars in thousands)  

Available-for-sale

   $ 322,316       $ 428,553       $ 599,503       $ 817,244       $ 260,444   

Held-to-maturity

     4,336,620         4,188,563         3,518,787         3,343,157         1,597,162   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 4,658,936       $ 4,617,116       $ 4,118,290       $ 4,160,401       $ 1,857,606   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

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The following tables present the amortized cost and fair value of securities classified as available-for-sale at December 31, 2011, 2010 and 2009:

 

    December 31, 2011     December 31, 2010  
    Amortized
Cost
    Gross
Unrealized
Gains
    Gross
Unrealized
Losses
    Fair
Value
    Amortized
Cost
    Gross
Unrealized
Gains
    Gross
Unrealized
Losses
    Fair
Value
 
    (Dollars in thousands)     (Dollars in thousands)  

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

  $ —        $ —        $ —        $ —        $ —        $ —        $ —        $ —     

States and political subdivisions

    37,060        2,022        (6     39,076        39,637        1,155        (278     40,514   

Collateralized mortgage obligations

    786        —          (21     765        967        —          (24     943   

Mortgage-backed securities

    254,965        18,307        (66     273,206        349,170        20,466        (91     369,545   

Qualified Zone Academy Bond (QZAB)

    —          —          —          —          8,000        326        —          8,326   

Other

    8,778        491        —          9,269        8,772        453        —          9,225   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 301,589      $ 20,820      $ (93   $ 322,316      $ 406,546      $ 22,400      $ (393   $ 428,553   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

    December 31, 2009  
    Amortized
Cost
    Gross
Unrealized
Gains
    Gross
Unrealized
Losses
    Fair
Value
 
    (Dollars in thousands)  

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

  $ 1,014      $ 26      $ —        $ 1,040   

States and political subdivisions

    49,280        1,398        (356     50,322   

Collateralized mortgage obligations

    1,169        —          (31     1,138   

Mortgage-backed securities

    505,170        24,306        (106     529,370   

Qualified Zone Academy Bond (QZAB)

    8,000        582        —          8,582   

Other

    9,015        36        —          9,051   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 573,648      $ 26,348      $ (493   $ 599,503   
 

 

 

   

 

 

   

 

 

   

 

 

 

 

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The following tables present the amortized cost and fair value of securities classified as held-to-maturity at December 31, 2011, 2010 and 2009:

 

    December 31, 2011     December 31, 2010  
    Amortized
Cost
    Gross
Unrealized
Gains
    Gross
Unrealized
Losses
    Fair
Value
    Amortized
Cost
    Gross
Unrealized
Gains
    Gross
Unrealized
Losses
    Fair
Value
 
    (Dollars in thousands)     (Dollars in thousands)  

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

  $ 8,696      $ 455      $ —        $ 9,151      $ 10,996      $ 789      $ —        $ 11,785   

States and political subdivisions

    37,914        1,282        (283     38,912        36,394        639        (1,155     35,878   

Corporate debt securities

    1,500        114        —          1,614        1,500        176        —          1,676   

Collateralized mortgage obligations

    281,778        5,009        (149     286,637        443,859        7,272        (429     450,702   

Mortgage-backed securities

    3,993,832        147,991        (91     4,141,732        3,682,914        118,886        (4,259     3,797,541   

Qualified School Construction Bonds (QSCB)

    12,900        2,042        —          14,942        12,900        325        —          13,225   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 4,336,620      $ 156,893      $ (523   $ 4,492,988      $ 4,188,563      $ 128,087      $ (5,843   $ 4,310,807   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

    December 31, 2009  
    Amortized
Cost
    Gross
Unrealized
Gains
    Gross
Unrealized
Losses
    Fair
Value
 
    (Dollars in thousands)  

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

  $ 40,701      $ 1,621      $ —        $ 42,322   

States and political subdivisions

    32,895        809        (1,050     32,654   

Corporate debt securities

    1,500        10        —          1,510   

Collateralized mortgage obligations

    295,754        3,652        (1,156     298,250   

Mortgage-backed securities

    3,135,037        111,045        (22     3,246,060   

Qualified School Construction Bonds (QSCB)

    12,900        57        —          12,957   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 3,518,787      $ 117,194      $ (2,228   $ 3,633,753   
 

 

 

   

 

 

   

 

 

   

 

 

 

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 ASC Topic 320, “Investments—Debt and Equity Securities.” If the Company were to purchase 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, they would be 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: (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

 

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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 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, an impairment is considered other than temporary if, based on the Company’s best estimate of cash flows that a market participant would use in determining the current fair value of the beneficial interest, there has been an adverse change in those estimated 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 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, as of December 31, 2011, management does not have the intent to sell any of the securities classified as available for sale and believes that it is more likely than not that the Company will not have to sell any such securities before a recovery of cost. 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 December 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. The Company recorded no other-than-temporary impairment charges in 2009, 2010 or 2011.

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

Unlike U.S. Treasury and U.S. government agency securities, which have a lump sum payment at maturity, mortgage-backed securities provide cash flows from regular principal and interest payments and principal prepayments throughout the lives of the securities. Mortgage-backed securities which are purchased at a premium will generally suffer decreasing net yields as interest rates drop because home owners tend to refinance their mortgages. Thus, the premium paid must be amortized over a shorter period. Therefore, these securities purchased at a discount will obtain higher net yields in a decreasing interest rate environment. As interest rates rise, the opposite will generally be true. During a period of increasing interest rates, fixed rate mortgage-backed securities do not tend to experience heavy prepayments of principal and consequently, the average life of this security will be lengthened. If interest rates begin to fall, prepayments will increase, thereby shortening the estimated life of this security. At December 31, 2011, 39.2% of the mortgage-backed securities held by the Company had contractual final maturities of more than ten years with a weighted average life of 3.0 years.

 

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

Deposits

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

Total deposits at December 31, 2011 were $8.060 billion, an increase of $605.3 million or 8.1% compared with $7.455 billion at December 31, 2010. Total deposits at December 31, 2010 were $7.455 billion, an increase of $196.4 million or 2.7% compared with $7.259 billion at December 31, 2009. The increase is primarily attributed to the deposits assumed in the U.S. Bank and First Bank acquisitions. At December 31, 2010, deposits assumed from these two acquisitions totaled $638.5 million. Noninterest-bearing deposits at December 31, 2011 were $1.972 billion compared with $1.673 billion at December 31, 2010, an increase of $299.0 million or 17.9%. Noninterest-bearing deposits were $1.673 billion at December 31, 2010, an increase of $180.6 million or 12.1% compared with $1.493 billion at December 31, 2009. Interest-bearing deposits at December 31, 2011 were $6.088 billion, up $306.3 million or 5.3% compared with $5.782 billion at December 31, 2010. Interest-bearing deposits at December 31, 2010 of $5.782 billion represented a $15.8 million increase compared with $5.766 billion at December 31, 2009. There were no major concentrations of deposits at December 31, 2011, 2010 or 2009.

The daily average balances and weighted average rates paid on deposits for each of the years ended December 31, 2011, 2010 and 2009 are presented below:

 

     Years Ended December 31,  
     2011     2010     2009  
     Average
Balance
     Average
Rate
    Average
Balance
     Average
Rate
    Average
Balance
     Average
Rate
 
     (Dollars in thousands)  

Interest-bearing checking

   $ 1,393,501         0.53   $ 1,336,400         0.67   $ 1,082,332         0.79

Regular savings

     472,983         0.32        377,456         0.46        320,530         0.56   

Money market savings

     1,948,752         0.53        1,812,239         0.74        1,590,191         1.11   

Time deposits

     2,135,858         1.02        2,438,968         1.53        2,730,263