10-Q 1 d510129d10q.htm FORM 10-Q Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

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

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2013

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, including zip code)

(713) 693-9300

(Registrant’s telephone number, including area code)

 

 

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

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

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

 

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

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

As of May 1, 2013, there were 60,275,312 outstanding shares of the registrant’s Common Stock, par value $1.00 per share.

 

 

 


Table of Contents

PROSPERITY BANCSHARES, INC.® AND SUBSIDIARIES

INDEX TO FORM 10-Q

 

         Page  
PART I—FINANCIAL INFORMATION   
Item 1.   Interim Consolidated Financial Statements      3   
 

Consolidated Balance Sheets as of March 31, 2013 and December 31, 2012 (unaudited)

     3   
 

Consolidated Statements of Income for the Three Months Ended March 31, 2013 and 2012 (unaudited)

     4   
 

Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2013 and 2012 (unaudited)

     5   
 

Consolidated Statements of Changes in Shareholders’ Equity for the Three Months Ended March 31, 2013 and 2012 (unaudited)

     6   
 

Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2013 and 2012 (unaudited)

     7   
 

Notes to Interim Consolidated Financial Statements (unaudited)

     8   
Item 2.  

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

     36   
Item 3.  

Quantitative and Qualitative Disclosures about Market Risk

     52   
Item 4.  

Controls and Procedures

     52   
PART II—OTHER INFORMATION   
Item 1.  

Legal Proceedings

     52   
Item 1A.  

Risk Factors

     53   
Item 2.  

Unregistered Sales of Equity Securities and Use of Proceeds

     53   
Item 3.  

Defaults upon Senior Securities

     53   
Item 4.  

Mine Safety Disclosures

     53   
Item 5.  

Other Information

     53   
Item 6.  

Exhibits

     53   

Signatures

     54   

 

2


Table of Contents

PART I – FINANCIAL INFORMATION

ITEM 1. INTERIM CONSOLIDATED FINANCIAL STATEMENTS

PROSPERITY BANCSHARES, INC.® AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

 

     March 31,     December 31,  
     2013     2012  
     (Dollars in thousands)  
ASSETS     

Cash and due from banks

   $ 180,577      $ 325,952   

Federal funds sold

     835        352   
  

 

 

   

 

 

 

Total cash and cash equivalents

     181,412        326,304   

Available for sale securities, at fair value

     206,073        226,670   

Held to maturity securities, at cost (fair value of $7,929,833 and $7,418,695, respectively)

     7,779,738        7,215,395   
  

 

 

   

 

 

 

Total securities

     7,985,811        7,442,065   

Loans held for sale

     8,496        10,433   

Loans held for investment

     5,254,528        5,169,507   
  

 

 

   

 

 

 

Total loans

     5,263,024        5,179,940   

Less: allowance for credit losses

     (55,049     (52,564
  

 

 

   

 

 

 

Loans, net

     5,207,975        5,127,376   

Accrued interest receivable

     38,047        42,337   

Goodwill

     1,235,743        1,217,162   

Core deposit intangibles, net

     26,514        26,159   

Bank premises and equipment, net

     206,829        205,268   

Other real estate owned

     9,913        7,234   

Bank Owned Life Insurance (BOLI)

     115,434        109,108   

Federal Home Loan Bank of Dallas stock

     34,858        34,461   

Other assets

     38,778        46,099   
  

 

 

   

 

 

 

TOTAL ASSETS

   $ 15,081,314      $ 14,583,573   
  

 

 

   

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

    

LIABILITIES:

    

Deposits:

    

Noninterest-bearing

   $ 2,995,828      $ 3,016,205   

Interest-bearing

     8,717,639        8,625,639   
  

 

 

   

 

 

 

Total deposits

     11,713,467        11,641,844   

Other borrowings

     576,768        256,753   

Securities sold under repurchase agreements

     470,241        454,502   

Junior subordinated debentures

     85,055        85,055   

Accrued interest payable

     1,665        1,904   

Other liabilities

     84,663        54,126   
  

 

 

   

 

 

 

Total liabilities

     12,931,859        12,494,184   

COMMITMENTS AND CONTINGENCIES

     —          —     

SHAREHOLDERS’ EQUITY:

    

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

     —          —     

Common stock, $1 par value; 200,000,000 shares authorized; 57,050,932 and 56,484,234 shares issued at March 31, 2013 and December 31, 2012, respectively; 57,013,844 and 56,447,146 shares outstanding at March 31, 2013 and December 31, 2012, respectively

     57,051        56,484   

Capital surplus

     1,297,891        1,274,290   

Retained earnings

     787,285        750,236   

Accumulated other comprehensive income—net unrealized gain on available for sale securities, net of tax of $4,219 and $4,839, respectively

     7,835        8,986   

Less treasury stock, at cost, 37,088 shares

     (607     (607
  

 

 

   

 

 

 

Total shareholders’ equity

     2,149,455        2,089,389   
  

 

 

   

 

 

 

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

   $ 15,081,314      $ 14,583,573   
  

 

 

   

 

 

 

See notes to interim consolidated financial statements.

 

3


Table of Contents

PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)

 

     Three Months Ended
March 31,
 
     2013      2012  
     (Dollars in thousands, except per
share data)
 

INTEREST INCOME:

     

Loans, including fees

   $ 81,464       $ 53,217   

Securities

     36,548         38,321   

Federal funds sold

     19         78   
  

 

 

    

 

 

 

Total interest income

     118,031         91,616   
  

 

 

    

 

 

 

INTEREST EXPENSE:

     

Deposits

     8,690         8,791   

Other borrowings

     362         316   

Securities sold under repurchase agreements

     292         —     

Junior subordinated debentures

     605         663   
  

 

 

    

 

 

 

Total interest expense

     9,949         9,770   
  

 

 

    

 

 

 

NET INTEREST INCOME

     108,082         81,846   

PROVISION FOR CREDIT LOSSES

     2,800         150   
  

 

 

    

 

 

 

NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES

     105,282         81,696   
  

 

 

    

 

 

 

NONINTEREST INCOME:

     

Nonsufficient funds (NSF) fees

     8,509         5,389   

Debit card and ATM card income

     6,487         3,836   

Service charges on deposit accounts

     2,931         2,441   

Trust income

     1,017         —     

Mortgage income

     991         59   

Other

     3,506         2,220   
  

 

 

    

 

 

 

Total noninterest income

     23,441         13,945   
  

 

 

    

 

 

 

NONINTEREST EXPENSE:

     

Salaries and employee benefits

     33,209         23,252   

Net occupancy and equipment

     4,278         3,557   

Debit card, data processing and software amortization

     2,570         1,532   

Regulatory assessments and FDIC insurance

     2,395         1,548   

Core deposit intangibles amortization

     1,755         1,695   

Depreciation

     2,378         2,035   

Communications (including telephone, courier and postage)

     2,196         1,748   

Other real estate expense

     223         691   

Other

     6,763         4,401   
  

 

 

    

 

 

 

Total noninterest expense

     55,767         40,459   
  

 

 

    

 

 

 

INCOME BEFORE INCOME TAXES

     72,956         55,182   
  

 

 

    

 

 

 

PROVISION FOR INCOME TAXES

     23,651         18,695   
  

 

 

    

 

 

 

NET INCOME

   $ 49,305       $ 36,487   
  

 

 

    

 

 

 

EARNINGS PER SHARE:

     

Basic

   $ 0.87       $ 0.77   
  

 

 

    

 

 

 

Diluted

   $ 0.86       $ 0.77   
  

 

 

    

 

 

 

See notes to interim consolidated financial statements.

 

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Table of Contents

PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(UNAUDITED)

 

     Three Months Ended March 31,  
     2013     2012  
     (Dollars in thousands)  

Net income

   $ 49,305      $ 36,487   

Other comprehensive loss, before tax:

    

Securities available for sale:

    

Change in unrealized gain during period

     (1,771     (1,185
  

 

 

   

 

 

 

Total other comprehensive loss

     (1,771     (1,185

Deferred tax benefit related to other comprehensive income

     620        415   
  

 

 

   

 

 

 

Other comprehensive loss, net of tax

     (1,151     (770
  

 

 

   

 

 

 

Comprehensive income

   $ 48,154      $ 35,717   
  

 

 

   

 

 

 

See notes to interim consolidated financial statements.

 

5


Table of Contents

PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(UNAUDITED)

 

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

BALANCE AT DECEMBER 31, 2011

    46,947,415      $ 46,947      $ 883,575      $ 623,878      $ 13,472      $ (607   $ 1,567,265   

Net income

          36,487            36,487   

Other comprehensive loss

            (770       (770

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

    71,581        72        1,779              1,851   

Common stock issued in connection with the acquisition of Texas Bankers, Inc.

    314,953        315        12,393              12,708   

Stock based compensation expense

        1,215              1,215   

Cash dividends declared, $0.195 per share

          (9,223         (9,223
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

BALANCE AT MARCH 31, 2012

    47,333,949      $ 47,334      $ 898,962      $ 651,142      $ 12,702      $ (607   $ 1,609,533   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

BALANCE AT DECEMBER 31, 2012

    56,484,234      $ 56,484      $ 1,274,290      $ 750,236      $ 8,986      $ (607   $ 2,089,389   

Net income

          49,305            49,305   

Other comprehensive loss

            (1,151       (1,151

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

    35,758        36        634              670   

Common stock issued in connection with the acquisition of East Texas Financial Services, Inc.

    530,940        531        21,769              22,300   

Stock based compensation expense

        1,198              1,198   

Cash dividends declared, $0.215 per share

          (12,256         (12,256
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

BALANCE AT MARCH 31, 2013

    57,050,932      $ 57,051      $ 1,297,891      $ 787,285      $ 7,835      $ (607   $ 2,149,455   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

See notes to interim consolidated financial statements.

 

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Table of Contents

PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

 

     Three Months Ended March 31,  
     2013     2012  
     (Dollars in thousands)  

CASH FLOWS FROM OPERATING ACTIVITIES:

    

Net income

   $ 49,305      $ 36,487   

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

    

Depreciation and CDI amortization

     4,133        3,730   

Provision for credit losses

     2,800        150   

Net amortization of premium on investments

     22,710        9,720   

Loss (gain) on sale or write down of premises, equipment and other real estate

     104        (411

Net accretion of discount on loans

     (14,292     —     

Proceeds from sale of loans held for sale

     42,131        —     

Originations of loans held for sale

     (40,131     —     

Stock based compensation expense

     1,198        1,215   

Decrease (increase) in accrued interest receivable and other assets

     16,784        (24,626

Increase in accrued interest payable and other liabilities

     28,036        23,846   
  

 

 

   

 

 

 

Net cash provided by operating activities

     112,778        50,111   
  

 

 

   

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

    

Proceeds from maturities and principal paydowns of held to maturity securities

     589,924        354,183   

Purchase of held to maturity securities

     (1,159,815     (1,375,431

Proceeds from maturities, sales and principal paydowns of available for sale securities

     403,912        22,813   

Purchase of available for sale securities

     (384,999     —     

Net increase (decrease) in loans held for investment

     47,199        (85,120

Purchase of bank premises and equipment

     (1,588     (2,264

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

     1,425        4,817   

Net cash and cash equivalents acquired in the purchase of Texas Bankers, Inc.

     —          44,550   

Net cash and cash equivalents acquired in the purchase of East Texas Financial Services, Inc.

     3,471        —     
  

 

 

   

 

 

 

Net cash used in investing activities

     (500,471     (1,036,452
  

 

 

   

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES:

    

Net (decrease) increase in noninterest-bearing deposits

     (32,934     95,498   

Net (decrease) increase in interest-bearing deposits

     (7,851     318,341   

Net proceeds from other short-term borrowings

     280,000        515,000   

Repayments of other long-term borrowings

     (567     (254

Net increase in securities sold under repurchase agreements

     15,739        3,598   

Proceeds from stock option exercises

     670        1,851   

Payments of cash dividends

     (12,256     (9,223
  

 

 

   

 

 

 

Net cash provided by financing activities

     242,801        924,811   
  

 

 

   

 

 

 

NET DECREASE IN CASH AND CASH EQUIVALENTS

   $ (144,892   $ (61,530

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD

     326,304        213,442   
  

 

 

   

 

 

 

CASH AND CASH EQUIVALENTS, END OF PERIOD

   $ 181,412      $ 151,912   
  

 

 

   

 

 

 

NONCASH ACTIVITIES:

    

Stock issued in connection with the Texas Bankers, Inc. acquisition

   $ —        $ 12,708   

Stock issued in connection with the East Texas Financial Services, Inc. acquisition

     22,300        —     

Acquisition of real estate through foreclosure of collateral

     1,347        3,559   

SUPPLEMENTAL INFORMATION:

    

Income taxes paid

   $ —        $ 250   

Interest paid

     10,034        10,001   

See notes to interim consolidated financial statements.

 

7


Table of Contents

PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

1. BASIS OF PRESENTATION

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

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the rules and regulations of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the statements reflect all adjustments necessary for a fair presentation of the financial position, results of operations and cash flows of the Company on a consolidated basis, and all such adjustments are of a normal recurring nature. These financial statements and the notes thereto should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2012. Operating results for the three-month period ended March 31, 2013 are not necessarily indicative of the results that may be expected for the year ending December 31, 2013 or any other period.

2. INCOME PER COMMON SHARE

Outstanding stock options issued by the Company represent the only dilutive effect reflected in diluted weighted average shares. The following table illustrates the computation of basic and diluted earnings per share:

 

     Three Months Ended March 31,  
     2013      2012  
     Amount      Per Share
Amount
     Amount      Per Share
Amount
 
     (In thousands, except per share data)  

Net income

   $ 49,305          $ 36,487      
  

 

 

       

 

 

    

Basic:

           

Weighted average shares outstanding

     56,988       $ 0.87         47,238       $ 0.77   
     

 

 

       

 

 

 

Diluted:

           

Add incremental shares for:

           

Effect of dilutive securities - options

     146            173      
  

 

 

       

 

 

    

Total

     57,134       $ 0.86         47,411       $ 0.77   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

8


Table of Contents

PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

There were no stock options exercisable during the quarters ended March 31, 2013 or 2012 that would have had an anti-dilutive effect on the above computation.

3. NEW ACCOUNTING STANDARDS

Accounting Standards Updates

ASU 2012-02 “Intangibles—Goodwill and Other (Topic 350) — Testing Indefinite-Lived Intangible Assets for Impairment.” ASU 2012-02 gives entities the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that an indefinite-lived intangible asset is impaired. If, after assessing the totality of events or circumstances, an entity determines it is more likely than not that an indefinite-lived intangible asset is impaired, then the entity must perform the quantitative impairment test. If, under the quantitative impairment test, the carrying amount of the intangible asset exceeds its fair value, an entity should recognize an impairment loss in the amount of that excess permitting an entity to assess qualitative factors when testing indefinite-lived intangible assets for impairment results in guidance that is similar to the goodwill impairment testing guidance in ASU 2011-08. ASU 2012-02 became effective for the Company on January 1, 2013 and did not have a significant impact on the Company’s financial statements.

ASU 2013-02 “Comprehensive Income (Topic 220) — Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” ASU 2013-02 amends recent guidance related to the reporting of comprehensive income to enhance the reporting of reclassifications out of accumulated other comprehensive income. ASU 2013-02 became effective for the Company on January 1, 2013 and did not have a significant impact on the Company’s financial statements. See Note 10 —Other Comprehensive (Loss) Income for applicable disclosures.

 

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Table of Contents

PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

4. SECURITIES

The amortized cost and fair value of investment securities were as follows:

 

     March 31, 2013  
            Gross      Gross        
     Amortized      Unrealized      Unrealized     Fair  
     Cost      Gains      Losses     Value  
    

(Dollars in thousands)

 

Available for Sale

          

States and political subdivisions

   $ 33,964       $ 1,460       $ —        $ 35,424   

Collateralized mortgage obligations

     583         —           (13     570   

Mortgage-backed securities

     150,684         10,300         (25     160,959   

Other securities

     8,788         332         —          9,120   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 194,019       $ 12,092       $ (38   $ 206,073   
  

 

 

    

 

 

    

 

 

   

 

 

 

Held to Maturity

          

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

   $ 5,792       $ 112       $ —        $ 5,904   

States and political subdivisions

     363,352         6,692         (450     369,594   

Corporate debt securities

     2,027         10         —          2,037   

Collateralized mortgage obligations

     96,525         2,061         (98     98,488   

Mortgage-backed securities

     7,299,142         164,023         (24,571     7,438,594   

Qualified School Construction Bonds (QSCB)

     12,900         2,316         —          15,216   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 7,779,738       $ 175,214       $ (25,119   $ 7,929,833   
  

 

 

    

 

 

    

 

 

   

 

 

 

 

     December 31, 2012  
            Gross      Gross        
     Amortized      Unrealized      Unrealized     Fair  
     Cost      Gains      Losses     Value  
     (Dollars in thousands)  

Available for Sale

          

States and political subdivisions

   $ 34,743       $ 1,691       $ —        $ 36,434   

Collateralized mortgage obligations

     616         —           (12     604   

Mortgage-backed securities

     168,701         11,742         (27     180,416   

Other securities

     8,786         430         —          9,216   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 212,846       $ 13,863       $ (39   $ 226,670   
  

 

 

    

 

 

    

 

 

   

 

 

 

Held to Maturity

          

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

   $ 7,061       $ 160       $ —        $ 7,221   

States and political subdivisions

     391,510         7,074         (354     398,230   

Corporate debt securities

     1,500         28         —          1,528   

Collateralized mortgage obligations

     125,912         2,304         (50     128,166   

Mortgage-backed securities

     6,676,512         196,206         (4,517     6,868,201   

Qualified School Construction Bonds (QSCB)

     12,900         2,449         —          15,349   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 7,215,395       $ 208,221       $ (4,921   $ 7,418,695   
  

 

 

    

 

 

    

 

 

   

 

 

 

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

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.

In determining OTTI, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

When OTTI occurs, 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-related portion of the impairment loss (“credit loss”) and the noncredit portion of the impairment loss (“noncredit portion”). The amount of the total OTTI related to the credit loss is determined based on the difference between the present value of cash flows expected to be collected and the amortized cost basis and such difference is recognized in earnings. The amount of the total OTTI related to the noncredit portion is 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.

As of March 31, 2013, the Company does not intend to sell any debt securities and management believes that the Company 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 March 31, 2013, management does not have the intent to sell any of its securities 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 March 31, 2013, management believes any impairment in the Company’s securities are temporary and no impairment loss has been realized in the Company’s consolidated statements of income.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

Securities with unrealized losses segregated by length of time that have been in a continuous loss position at March 31, 2013 and December 31, 2012 were as follows:

 

     March 31, 2013  
   Less than 12 Months     More than 12 Months     Total  
     Estimated      Unrealized     Estimated      Unrealized     Estimated      Unrealized  
   Fair Value      Losses     Fair Value      Losses     Fair Value      Losses  
     (Dollars in thousands)  

Available for Sale

               

Collateralized mortgage obligations

   $ —         $ —        $ 570       $ (13   $ 570       $ (13

Mortgage-backed securities

     311         —          3,794         (25     4,105         (25
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 311       $ —        $ 4,364       $ (38   $ 4,675       $ (38
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Held to Maturity

               

States and political subdivisions

   $ 47,000       $ (430   $ 1,140       $ (20   $ 48,140       $ (450

Collateralized mortgage obligations

     2,025         (60     1,236         (38     3,261         (98

Mortgage-backed securities

     2,197,825         (24,570     220         (1     2,198,045         (24,571
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 2,246,850       $ (25,060   $ 2,596       $ (59   $ 2,249,446       $ (25,119
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

 

     December 31, 2012  
   Less than 12 Months     More than 12 Months     Total  
     Estimated      Unrealized     Estimated      Unrealized     Estimated      Unrealized  
   Fair Value      Losses     Fair Value      Losses     Fair Value      Losses  
     (Dollars in thousands)  

Available for Sale

               

Collateralized mortgage obligations

   $ —         $ —        $ 603       $ (12   $ 603       $ (12

Mortgage-backed securities

     224         —          3,964         (27     4,188         (27
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 224       $ —        $ 4,567       $ (39   $ 4,791       $ (39
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Held to Maturity

               

States and political subdivisions

   $ 37,322       $ (335   $ 1,140       $ (19   $ 38,462       $ (354

Collateralized mortgage obligations

     2,366         (50     —           —          2,366         (50

Mortgage-backed securities

     1,081,414         (4,516     234         (1     1,081,648         (4,517
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 1,121,102       $ (4,901   $ 1,374       $ (20   $ 1,122,476       $ (4,921
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

At March 31, 2013, there were approximately 337 securities in an unrealized loss position for more than 12 months.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

The amortized cost and fair value of investment securities at March 31, 2013, by contractual maturity, are shown below. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations at any time with or without call or prepayment penalties.

 

     Held to Maturity      Available for Sale  
     Amortized      Fair      Amortized      Fair  
   Cost      Value      Cost      Value  
     (Dollars in thousands)  

Due in one year or less

   $ 30,686       $ 30,848       $ 8,878       $ 9,212   

Due after one year through five years

     125,686         126,744         4,925         5,134   

Due after five years through ten years

     140,637         143,215         23,401         24,396   

Due after ten years

     87,062         91,944         5,548         5,802   
  

 

 

    

 

 

    

 

 

    

 

 

 

Subtotal

     384,071         392,751         42,752         44,544   

Mortgage-backed securities and collateralized mortgage obligations

     7,395,667         7,537,082         151,267         161,529   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 7,779,738       $ 7,929,833       $ 194,019       $ 206,073   
  

 

 

    

 

 

    

 

 

    

 

 

 

The Company had no gain or loss on sale of securities for the three months ended March 31, 2013 or 2012. As of March 31, 2013, the Company had eight non-agency CMO’s remaining with a total book value of $2.2 million and total market value of $2.2 million.

At March 31, 2013 and December 31, 2012, 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.

Securities with an amortized cost of $4.40 billion and $4.13 billion and a fair value of $4.50 billion and $4.27 billion at March 31, 2013 and December 31, 2012, respectively, were pledged to collateralize public deposits and for other purposes required or permitted by law.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

5. LOANS AND ALLOWANCE FOR CREDIT LOSSES

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

 

     March 31,      December 31,  
     2013      2012  
     (Dollars in thousands)  

Residential mortgage loans held for sale

   $ 8,496       $ 10,433   
  

 

 

    

 

 

 

Commercial and industrial

     732,308         771,114   

Real estate:

     

Construction and land development

     575,307         550,768   

1-4 family residential (including home equity)

     1,534,255         1,432,133   

Commercial real estate (including multi-family residential)

     1,993,518         1,990,642   

Farmland

     226,406         211,156   

Agriculture

     60,383         74,481   

Consumer and other (net of unearned discount)

     132,351         139,213   
  

 

 

    

 

 

 

Total loans held for investment

     5,254,528         5,169,507   
  

 

 

    

 

 

 

Total

   $ 5,263,024       $ 5,179,940   
  

 

 

    

 

 

 

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

(ii) Commercial Real Estate. The Company makes commercial real estate related loans collateralized by owner-occupied and non-owner-occupied real estate to finance the purchase of real estate. The Company’s commercial real estate related loans are collateralized by first liens on real estate, typically have variable interest rates (or five year or less fixed rates) and amortize over a 15 to 20 year period. Payments on loans secured by such properties are often dependent on the successful operation or management of the properties. Accordingly, repayment of these loans may be subject to adverse conditions in the real estate market or the economy to a greater extent than other types of loans. The Company seeks to minimize these risks in a variety of ways, including giving careful consideration to the property’s operating history, future operating projections, current and projected occupancy, location and physical condition in connection with underwriting these loans. The underwriting analysis also includes credit verification, analysis of global cash flow, appraisals and a review of the financial condition of the borrower. At March 31, 2013, the Company had commercial real estate related loans totaling $2.57 billion which includes the categories of construction and land development loans, commercial real estate loans and multi-family residential loans. At March 31, 2013, approximately 36.8% of the outstanding principal balance of the Company’s commercial real estate related loans was secured by owner-occupied properties.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

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

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

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

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

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

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

Concentrations of Credit. Most of the Company’s lending activity occurs within the State of Texas. The majority of the Company’s loan portfolio consists of commercial and industrial, commercial real estate and 1-4 family residential loans. As of March 31, 2013 and December 31, 2012, there were no concentrations of loans related to any single industry in excess of 10% of total loans.

Foreign Loans. The Company has U.S. dollar denominated loans and commitments to borrowers in Mexico. The outstanding balance of these loans and the unfunded amounts available under these commitments were not significant at March 31, 2013 or December 31, 2012.

Related Party Loans. As of March 31, 2013 and December 31, 2012, loans outstanding to directors, officers and their affiliates totaled $6.8 million and $6.7 million, respectively. All transactions entered into between the Company and such related parties are done in the ordinary course of business and made on the same terms and conditions as similar transactions with unaffiliated persons.

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

 

     March 31,     December 31,  
     2013     2012  
     (Dollars in thousands)  

Beginning balance

   $ 6,682      $ 9,809   

New loans and reclassified related loans

     221        967   

Repayments

     (80     (4,094
  

 

 

   

 

 

 

Ending balance

   $ 6,823      $ 6,682   
  

 

 

   

 

 

 

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

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

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.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

An aging analysis of past due loans, segregated by class of loans, is as follows:

 

     March 31, 2013  
     Loans Past Due and Still Accruing                       
            90 or More      Total Past      Nonaccrual      Current      Total  
     30-89 Days      Days      Due Loans      Loans      Loans      Loans  
     (Dollars in thousands)  

Construction and land development

   $ 9,113       $ —         $ 9,113       $ 1,792       $ 564,402       $ 575,307   

Agriculture and agriculture real estate (includes farmland)

     440         11         451         107         286,231         286,789   

1-4 family (includes home equity) (1)

     2,533         —           2,533         674         1,539,544         1,542,751   

Commercial real estate (includes multi-family residential)

     4,114         —           4,114         1,643         1,987,761         1,993,518   

Commercial and industrial

     3,568         631         4,199         3,220         724,889         732,308   

Consumer and other

     545         —           545         93         131,713         132,351   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 20,313       $ 642       $ 20,955       $ 7,529       $ 5,234,540       $ 5,263,024   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

     December 31, 2012  
     Loans Past Due and Still Accruing                       
            90 or More      Total Past      Nonaccrual      Current      Total  
     30-89 Days      Days      Due Loans      Loans      Loans      Loans  
     (Dollars in thousands)  

Construction and land development

   $ 3,863       $ —         $ 3,863       $ 1,170       $ 545,735       $ 550,768   

Agriculture and agriculture real estate (includes farmland)

     310         21         331         396         284,910         285,637   

1-4 family (includes home equity) (1)

     2,307         310         2,617         1,598         1,438,351         1,442,566   

Commercial real estate (includes multi-family residential)

     9,163         —           9,163         —           1,981,479         1,990,642   

Commercial and industrial

     4,843         —           4,843         1,469         764,802         771,114   

Consumer and other

     856         —           856         749         137,608         139,213   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 21,342       $ 331       $ 21,673       $ 5,382       $ 5,152,885       $ 5,179,940   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Includes $8,496 and $10,433 of residential mortgage loans held for sale at March 31, 2013 and December 31, 2012, respectively.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

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

 

     March 31,     December 31,  
     2013     2012  
     (Dollars in thousands)  

Nonaccrual loans

   $ 7,529      $ 5,382   

Accruing loans 90 or more days past due

     642        331   
  

 

 

   

 

 

 

Total nonperforming loans

     8,171        5,713   

Repossessed assets

     49        68   

Other real estate

     9,913        7,234   
  

 

 

   

 

 

 

Total nonperforming assets

   $ 18,133      $ 13,015   
  

 

 

   

 

 

 

Nonperforming assets to total loans and other real estate

     0.34     0.25

The Company believes its conservative lending approach has resulted in sound asset quality. The Company had $18.1 million in nonperforming assets at March 31, 2013 compared with $13.0 million at December 31, 2012. If interest on nonaccrual loans had been accrued under the original loan terms, approximately $111 thousand and $162 thousand would have been recorded as income for the three months ended March 31, 2013 and 2012, respectively.

Purchased Credit-Impaired (PCI) Loans. In connection with the acquisition of American State Financial Corporation (ASB) on July 1, 2012, Community National Bank on October 1, 2012 and East Texas Financial Services on January 1, 2013, the Company acquired loans both with and without evidence of credit quality deterioration since origination. The acquired loans were initially recorded at fair value with no carryover of any allowance for loan losses.

Loans acquired with evidence of credit quality deterioration at acquisition for which it was probable that the Company would not be able to collect all contractual amounts due were accounted for as PCI.

The carrying amount of acquired PCI loans included in the consolidated balance sheet and the related outstanding balance at March 31, 2013 and December 31, 2012 were as set forth in the following table. The outstanding balance represents the total amount owed as of March 31, 2013 and December 31, 2012, including accrued but unpaid interest and any amounts previously charged off. No allowance for loan losses was required on the acquired PCI loan pools at both March 31, 2013 and December 31, 2012.

 

     March 31,      December 31,  
     2013      2012  
     (Dollars in thousands)  

Acquired PCI loans:

     

Carrying amount

   $ 28,028       $ 22,880   

Outstanding balance

     56,481         46,914   

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

Changes in the accretable yield for acquired PCI loans for the three month periods ended March 31, 2013 and 2012 were as follows:

 

     Three Month Periods Ended  
     2013     2012  
     (Dollars in thousands)  

Balance at beginning of period

   $ 7,459      $ —     

Additions

     1,736        —     

Reclassifications from nonaccretable

     143        —     

Accretion

     (1,769     —     
  

 

 

   

 

 

 

Balance at March 31

   $ 7,569      $ —     
  

 

 

   

 

 

 

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

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

Impaired loans as of March 31, 2013 are set forth in the following table. No interest income was recognized on impaired loans subsequent to their classification as impaired for the three month periods ended March 31, 2013 and 2012. The average recorded investment presented in the table below is reported on a year-to-date basis.

 

     March 31, 2013  
            Unpaid             Average  
   Recorded      Principal      Related      Recorded  
   Investment      Balance      Allowance      Investment  
     (Dollars in thousands)  

With no related allowance recorded:

           

Construction and land development

   $ 18       $ 20       $ —         $ 70   

Agriculture and agriculture real estate (includes farmland)

     77         77         —           77   

1-4 family (includes home equity)

     303         344         —           383   

Commercial real estate (includes multi-family residential)

     1,461         1,490         —           930   

Commercial and industrial

     222         222         —           155   

Consumer and other

     4         4         —           2   

With an allowance recorded:

           

Construction and land development

   $ 617       $ 617       $ 134       $ 308   

Agriculture and agriculture real estate (includes farmland)

     30         37         27         32   

1-4 family (includes home equity)

     183         202         94         591   

Commercial real estate (includes multi-family residential)

     1,203         1,203         786         1,827   

Commercial and industrial

     2,987         3,037         1,467         2,014   

Consumer and other

     65         79         65         66   

Total:

           

Construction and land development

   $ 635       $ 637       $ 134       $ 378   

Agriculture and agriculture real estate (includes farmland)

     107         114         27         109   

1-4 family (includes home equity)

     486         546         94         974   

Commercial real estate (includes multi-family residential)

     2,664         2,693         786         2,757   

Commercial and industrial

     3,209         3,259         1,467         2,169   

Consumer and other

     69         83         65         68   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 7,170       $ 7,332       $ 2,573       $ 6,455   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

Impaired loans as of December 31, 2012 are set forth in the following table. No interest income was recognized on impaired loans subsequent to their classification as impaired. The average recorded investment is reported on a year-to-date basis.

 

     December 31, 2012  
            Unpaid             Average  
     Recorded      Principal      Related      Recorded  
     Investment      Balance      Allowance      Investment  
     (Dollars in thousands)  

With no related allowance recorded:

           

Construction and land development

   $ 1,144       $ 1,175       $ —         $ 368   

Agriculture and agriculture real estate (includes farmland)

     77         77         —           34   

1-4 family (includes home equity)

     491         522         —           381   

Commercial real estate (includes multi-family residential)

     450         476         —           676   

Commercial and industrial

     87         89         —           75   

Consumer and other

     10         10         —           3   

With an allowance recorded:

           

Construction and land development

   $ —         $ —         $ —         $ 451   

Agriculture and agriculture real estate (includes farmland)

     34         41         29         45   

1-4 family (includes home equity)

     999         1,017         273         720   

Commercial real estate (includes multi-family residential)

     2,450         2,451         610         2,725   

Commercial and industrial

     1,043         1,079         1,002         782   

Consumer and other

     66         81         67         21   

Total:

           

Construction and land development

   $ 1,144       $ 1,175       $ —         $ 819   

Agriculture and agriculture real estate (includes farmland)

     111         118         29         79   

1-4 family (includes home equity)

     1,490         1,539         273         1,101   

Commercial real estate (includes multi-family residential)

     2,900         2,927         610         3,401   

Commercial and industrial

     1,130         1,168         1,002         857   

Consumer and other

     76         91         67         24   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 6,851       $ 7,018       $ 1,981       $ 6,281   
  

 

 

    

 

 

    

 

 

    

 

 

 

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

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

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

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

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

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

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

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

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

The following table presents risk grades and classified loans by class of loan at March 31, 2013. Classified loans include loans in risk grades 5, 6 and 7.

 

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

Grade 1

   $ 277       $ 3,961       $ 289       $ —         $ 50,578       $ 35,862       $ 90,967   

Grade 2

     564,386         281,853         1,531,042         1,947,913         671,492         96,403         5,093,089   

Grade 3

     6,388         —           4,590         11,520         3,722         12         26,232   

Grade 4

     3,606         440         3,164         9,952         376         —           17,538   

Grade 5

     635         107         474         2,664         3,209         69         7,158   

Grade 6

     —           —           12         —           —           —           12   

Grade 7

     —           —           —           —           —           —           —     

PCI Loans

     15         428         3,180         21,469         2,931         5         28,028   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 575,307       $ 286,789       $ 1,542,751       $ 1,993,518       $ 732,308       $ 132,351       $ 5,263,024   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Includes $8,496 of residential mortgage loans held for sale at March 31, 2013.

The following table presents risk grades and classified loans by class of loan at December 31, 2012.

 

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

Grade 1

   $ 476       $ 4,195       $ 515       $ —         $ 53,965       $ 38,789       $ 97,940   

Grade 2

     537,340         277,333         1,431,095         1,945,319         702,587         100,163         4,993,837   

Grade 3

     7,250         2,024         4,947         11,760         8,926         —           34,907   

Grade 4

     4,256         1,694         4,303         11,711         1,385         176         23,525   

Grade 5

     1,144         111         1,477         2,900         1,130         76         6,838   

Grade 6

     —           —           13         —           —           —           13   

Grade 7

     —           —           —           —           —           —           —     

PCI Loans

     302         280         216         18,952         3,121         9         22,880   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 550,768       $ 285,637       $ 1,442,566       $ 1,990,642       $ 771,114       $ 139,213       $ 5,179,940   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Includes $10,433 of residential mortgage loans held for sale at December 31, 2012.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

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

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

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

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 impaired loan. The Company uses this information to establish the amount of the general valuation allowance.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

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

 

   

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

 

   

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

 

   

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

 

   

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

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

At March 31, 2013, the allowance for credit losses totaled $55.0 million or 1.05% of total loans. At December 31, 2012, the allowance aggregated $52.6 million or 1.01% of total loans.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

The following table details the recorded investment in loans and activity in the allowance for credit losses by portfolio segment for the three months ended March 31, 2013 and 2012. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.

 

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

Allowance for credit losses:

             

Balance January 1, 2012

  $ 12,094      $ 511      $ 12,645      $ 21,460      $ 3,826      $ 1,058      $ 51,594   

Provision for credit losses

    (732     109        (72     468        171        206        150   

Charge-offs

    (26     —          (52     (23     (78     (203     (382

Recoveries

    4        —          2        5        93        176        280   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net charge-offs

    (22     —          (50     (18     15        (27     (102
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance March 31, 2012

  $ 11,340      $ 620      $ 12,523      $ 21,910      $ 4,012      $ 1,237      $ 51,642   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance January 1, 2013

  $ 11,909      $ 764      $ 13,942      $ 19,607      $ 5,777      $ 565      $ 52,564   

Provision for credit losses

    270        116        272        2,205        (318     255        2,800   

Charge-offs

    —          —          (111     (68     (155     (606     (940

Recoveries

    56        7        9        125        96        332        625   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net charge-offs

    56        7        (102     57        (59     (274     (315
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance March 31, 2013

  $ 12,235      $ 887      $ 14,112      $ 21,869      $ 5,400      $ 546      $ 55,049   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Allowance for credit losses related to:

             

March 31, 2012

             

Individually evaluated for impairment

  $ 312      $ 42      $ 272      $ 815      $ 310      $ 6      $ 1,757   

Collectively evaluated for impairment

    11,028        578        12,251        21,095        3,702        1,231        49,885   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total allowance for credit losses

  $ 11,340      $ 620      $ 12,523      $ 21,910      $ 4,012      $ 1,237      $ 51,642   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

March 31, 2013

             

Individually evaluated for impairment

  $ 134      $ 27      $ 94      $ 786      $ 1,467      $ 65      $ 2,573   

Collectively evaluated for impairment

    12,101        860        14,018        21,083        3,933        481        52,476   

PCI loans

    —          —          —          —          —          —          —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total allowance for credit losses

  $ 12,235      $ 887      $ 14,112      $ 21,869      $ 5,400      $ 546      $ 55,049   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Recorded investment in loans:

             

March 31, 2012

             

Individually evaluated for impairment

  $ 1,340      $ 47      $ 941      $ 6,666      $ 614      $ 7      $ 9,615   

Collectively evaluated for impairment

    482,955        178,427        1,184,974        1,467,259        441,945        109,687        3,865,247   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans evaluated for impairment

  $ 484,295      $ 178,474      $ 1,185,915      $ 1,473,925      $ 442,559      $ 109,694      $ 3,874,862   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

March 31, 2013

             

Individually evaluated for impairment

  $ 635      $ 107      $ 486      $ 2,664      $ 3,209      $ 69      $ 7,170   

Collectively evaluated for impairment

    574,657        286,254        1,539,085        1,969,385        726,168        132,277        5,227,826   

PCI

    15        428        3,180        21,469        2,931        5        28,028   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans evaluated for impairment

  $ 575,307      $ 286,789      $ 1,542,751      $ 1,993,518      $ 732,308      $ 132,351      $ 5,263,024   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

25


Table of Contents

PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

Troubled Debt Restructurings. The restructuring of a loan is considered a “troubled debt restructuring” if both (i) the borrower is experiencing financial difficulties and (ii) the creditor has granted a concession. Concessions may include interest rate reductions or below market interest rates, principal forgiveness, restructuring amortization schedules and other actions intended to minimize potential losses.

There were no loans restructured during the three months ended March 31, 2013 or 2012. Default is determined at 90 or more days past due. The restructured loans from prior periods are performing and accruing loans.

6. FAIR VALUE

The Company uses fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures. Fair values represent the estimated price that would be received from selling an asset or paid to transfer a liability, otherwise known as an “exit price.” Securities available for sale are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis such as certain loans including loans held for sale, goodwill and other intangible assets and other real estate owned. These nonrecurring fair value adjustments typically involve application of lower-of-cost-or-market accounting or write downs of individual assets.

Fair Value Hierarchy

The Company groups financial assets and financial liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

 

   

Level 1—Quoted prices in active markets for identical assets or liabilities.

 

   

Level 2—Other significant observable inputs (including quoted prices in active markets for similar assets or liabilities) or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

 

   

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

The fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for such asset or liability. In estimating fair value, the Company utilizes valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. Such valuation techniques are consistently applied. Inputs to valuation techniques include the assumptions that market participants would use in pricing an asset or liability.

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

 

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Table of Contents

PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

The following tables present fair values for assets measured at fair value on a recurring basis:

 

     As of March 31, 2013  
     Level 1      Level 2      Level 3      Total  
     (Dollars in thousands)  

Available for sale securities:

           

States and political subdivisions

   $ —         $ 35,424       $ —         $ 35,424   

Corporate debt securities and other

     7,621         1,499         —           9,120   

Collateralized mortgage obligations

     —           570         —           570   

Mortgage-backed securities

     —           160,959         —           160,959   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 7,621       $ 198,452       $ —         $ 206,073   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

     As of December 31, 2012  
     Level 1      Level 2      Level 3      Total  
     (Dollars in thousands)  

Available for sale securities:

        

States and political subdivisions

   $ —         $ 36,434       $ —         $ 36,434   

Corporate debt securities and other

     7,688         1,528         —           9,216   

Collateralized mortgage obligations

     —           604         —           604   

Mortgage-backed securities

     —           180,416         —           180,416   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 7,688       $ 218,982       $ —         $ 226,670   
  

 

 

    

 

 

    

 

 

    

 

 

 

Certain financial assets and financial liabilities are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). Financial assets measured at fair value on a non-recurring basis during the reported periods include certain impaired loans reported at the fair value of the underlying collateral if repayment is expected solely from the collateral. Collateral values are estimated using Level 2 inputs based on observable market data, typically in the case of real estate collateral. For the three months ended March 31, 2013, the Company had additions to impaired loans of $4.1 million all of which were outstanding at March 31, 2013.

Financial assets measured at fair value on a non-recurring basis during the reported periods also include other real estate owned and repossessed assets. For the three months ended March 31, 2013, the Company had additions to other real estate owned of $2.1 million, of which $2.0 million were outstanding at March 31, 2013. The remaining financial assets and financial liabilities measured at fair value on a non-recurring basis that were recorded in 2013 and remained outstanding at March 31, 2013 were not significant. During the reported periods, all fair value measurements for other real estate owned and repossessed assets utilized Level 2 inputs based on observable market data. There were no transfers between Level 1 and Level 2 assets during the three months ended March 31, 2013.

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

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

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

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

Cash and due from banks — For these short-term instruments, the carrying amount is a reasonable estimate of fair value. The Company classifies the estimated fair value of these instruments as Level 1.

Federal funds sold — For these short-term instruments, the carrying amount is a reasonable estimate of fair value. The Company classifies the estimated fair value of these instruments as Level 1.

Securities — Fair value measurements based upon quoted prices are considered Level 1 inputs. Level 1 securities consist of U.S. Treasury securities and certain equity securities which are included in the available for sale portfolio. For all other available for sale and held to maturity securities, if quoted prices are not available, fair values are measured using Level 2 inputs. For these securities, the Company generally obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. The Company reviews the prices supplied by the independent pricing service, as well as their underlying pricing methodologies, for reasonableness.

Securities available for sale are recorded at fair value on a recurring basis.

Loans held for investment — The Company does not record loans at fair value on a recurring basis. As such, valuation techniques discussed herein for loans are primarily for estimating fair value disclosures. However, from time to time, the Company records nonrecurring fair value adjustments to impaired loans to reflect (1) partial write downs that are based on the observable market price or current appraised value of the collateral, or (2) the full charge-off of the loan carrying value. Where appraisals are not available, estimated cash flows are discounted using a rate commensurate with the credit risk associated with those cash flows. Assumptions regarding credit risk, cash flows and discount rates are judgmentally determined using available market information and specific borrower information.

The estimated fair value approximates carrying value for variable-rate loans that reprice frequently and with no significant change in credit risk. The fair value of fixed-rate loans and variable-rate loans which reprice on an infrequent basis is estimated by discounting future cash flows using the current interest rates at which similar loans with similar terms would be made to borrowers of similar credit quality. An overall valuation adjustment is made for specific credit risks as well as general portfolio credit risk. The Company classifies the estimated fair value of loans held for investment as Level 3.

Loans held for sale — Loans held for sale are carried at the lower of cost or estimated fair value. Fair value for consumer mortgages held for sale is based on commitments on hand from investors or prevailing market prices. As such, the Company classifies loans subjected to nonrecurring fair value adjustments as Level 1.

Federal Home Loan Bank of Dallas Stock — The fair value of FHLB stock is estimated to be equal to its carrying amount as reported in the accompanying Consolidated Balance Sheets, given it is not a publicly traded equity security, it has an adjustable dividend rate, and all transactions in the stock are executed at the stated par value. FHLB stock is considered a Level 1 fair value.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

Other real estate owned — Other real estate owned is primarily foreclosed properties securing residential loans and commercial real estate. Foreclosed assets are adjusted to fair value less estimated costs to sell upon transfer of the loans to other real estate owned. Subsequently, these assets are carried at the lower of carrying value or fair value less estimated costs to sell. Other real estate carried at fair value based on an observable market price or a current appraised value is classified by the Company as Level 2. When management determines that the fair value of other real estate requires additional adjustments, either as a result of a non-current appraisal or when there is no observable market price, the Company classifies the other real estate as Level 3.

Deposits — The fair value of demand deposits, savings accounts and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. Deposits fair value measurements utilize Level 2 inputs.

Junior subordinated debentures — The fair value of the junior subordinated debentures was calculated using the quoted market prices, if available. If quoted market prices are not available, fair value is estimated using quoted market prices for similar subordinated debentures. Junior subordinated debentures fair value measurements utilize Level 2 inputs.

Other borrowings — Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate the fair value of other borrowings using a discounted cash flows methodology and are measured utilizing Level 2 inputs.

Securities sold under repurchase agreements — The fair value of securities sold under repurchase agreements is the amount payable on demand at the reporting date and are measured utilizing Level 2 inputs.

Off-balance sheet financial instruments — The fair value of commitments to extend credit and standby letters of credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreement and the present creditworthiness of the counterparties. The Company has reviewed the unfunded portion of commitments to extend credit as well as standby and other letters of credit, and has determined that the fair value of such financial instruments is not material. The Company classifies the estimated fair value of credit-related financial instruments as Level 3.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

The following table summarizes the carrying values and estimated fair values of certain financial instruments not recorded at fair value on a regular basis:

 

     As of March 31, 2013  
     Carrying      Estimated Fair Value  
     Amount      Level 1      Level 2      Level 3      Total  
     (Dollars in thousands)  

Assets

  

Cash and due from banks

   $ 180,577       $ 180,577       $ —         $ —         $ 180,577   

Federal funds sold

     835         835         —           —           835   

Held to maturity securities

     7,779,738         —           7,929,833         —           7,929,833   

Loans held for sale

     8,496         8,496         —           —           8,496   

Loans held for investment, net of allowance

     5,199,479         —           —           5,258,055         5,258,055   

Federal Home Loan Bank of Dallas stock

     34,858         34,858         —           —           34,858   

Liabilities

              

Deposits:

              

Noninterest-bearing

   $ 2,995,828       $ —         $ 2,995,728       $ —         $ 2,995,728   

Interest-bearing

     8,717,639         —           8,730,834         —           8,730,834   

Other borrowings

     576,768         —           582,415         —           582,415   

Securities sold under repurchase agreements

     470,241         —           470,322         —           470,322   

Junior subordinated debentures

     85,055         —           72,905         —           72,905   

 

     As of December 31, 2012  
     Carrying      Estimated Fair Value  
     Amount      Level 1      Level 2      Level 3      Total  
     (Dollars in thousands)  

Assets

  

Cash and due from banks

   $ 325,952       $ 325,952       $ —         $ —         $ 325,952   

Federal funds sold

     352         352         —           —           352   

Held to maturity securities

     7,215,395         —           7,418,695         —           7,418,695   

Loans held for sale

     10,433         10,433         —           —           10,433   

Loans held for investment, net of allowance

     5,116,943         —           —           5,186,779         5,186,779   

Federal Home Loan Bank of Dallas stock

     34,461         34,461         —           —           34,461   

Liabilities

              

Deposits:

              

Noninterest-bearing

   $ 3,016,205       $ —         $ 3,016,205       $ —         $ 3,016,205   

Interest-bearing

     8,625,639         —           8,640,625         —           8,640,625   

Other borrowings

     256,753         —           258,819         —           258,819   

Securities sold under repurchase agreements

     454,502         —           454,596         —           454,596   

Junior subordinated debentures

     85,055         —           72,705         —           72,705   

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

The Company’s off-balance sheet commitments including letters of credit, which totaled $1.02 billion at March 31, 2013, are funded at current market rates at the date they are drawn upon. It is management’s opinion that the fair value of these commitments would approximate their carrying value, if drawn upon.

The fair value estimates presented herein are based on pertinent information available to management at March 31, 2013. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since those dates and, therefore, current estimates of fair value may differ significantly from the amounts presented herein.

7. GOODWILL AND CORE DEPOSIT INTANGIBLES

Changes in the carrying amount of the Company’s goodwill and core deposit intangibles (“CDI”) for three months ended March 31, 2013 and the year ended December 31, 2012 were as follows:

 

     Goodwill     Core Deposit
Intangibles
 
     (Dollars in thousands)  

Balance as of December 31, 2011

   $ 924,537      $ 20,996   

Less:

    

Amortization

     —          (7,229

Add:

    

Acquisition of Texas Bankers, Inc.

     6,077        —     

Acquisition of The Bank Arlington

     2,102        —     

Acquisition of ASB

     274,119        12,392   

Acquisition of Community National Bank

     10,327        —     
  

 

 

   

 

 

 

Balance as of December 31, 2012

     1,217,162        26,159   

Less:

    

Amortization

     —          (1,755

Add:

    

Measurement period adjustment of The Bank Arlington

     (130  

Measurement period adjustment of ASB

     (1,371     2,110   

Measurement period adjustment of Community National Bank

     2,069        —     

Acquisition of East Texas Financial Services, Inc.

     18,013        —     
  

 

 

   

 

 

 

Balance as of March 31, 2013

   $ 1,235,743      $ 26,514   
  

 

 

   

 

 

 

Goodwill is recorded on the acquisition date of each entity. The Company may record subsequent adjustments to goodwill for amounts undeterminable at acquisition date, such as deferred taxes and real estate valuations, and therefore the goodwill amounts reflected in the table above may change accordingly. The Company initially records the total premium paid on acquisitions as goodwill. After finalizing the valuation, core deposit intangibles are identified and reclassified from goodwill to core deposit intangibles on the balance sheet. This reclassification has no effect on total assets, liabilities, shareholders’ equity, net income or cash flows. Management performs an evaluation annually and more frequently if a triggering event occurs, of whether any impairment of the goodwill and other intangibles has occurred. If any such impairment is determined, a write-down is recorded. As of March 31, 2013, there were no impairments recorded on goodwill.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

The measurement period for the Company to determine the fair value of acquired identifiable assets and assumed liabilities will be at the end of the earlier of (i) twelve months from the date of acquisition or (ii) as soon as the Company receives the information it was seeking about facts and circumstances that existed as of the date of acquisition. As such, certain acquisitions completed during 2012 and 2013 may be subject to adjustment.

Core deposit intangibles are amortized on an accelerated basis over their estimated lives, which the Company believes is between 8 and 15 years. Amortization expense related to intangible assets totaled $1.8 million and $1.7 million for the three months ended March 31, 2013 and 2012, respectively. The estimated aggregate future amortization expense for intangible assets remaining as of March 31, 2013 is as follows (dollars in thousands):

 

Remaining 2013

   $ 4,387   

2014

     4,830   

2015

     4,189   

2016

     3,756   

2017

     2,083   

Thereafter

     7,269   
  

 

 

 

Total

   $ 26,514   
  

 

 

 

8. STOCK BASED COMPENSATION

At March 31, 2013, the Company had four stock-based employee compensation plans and one stock option plan assumed in connection with an acquisition under which no additional options will be granted. Two of the four plans adopted by the Company have expired and therefore no additional awards may be issued under those plans.

During 2004, the Company’s Board of Directors adopted the Prosperity Bancshares, Inc. 2004 Stock Incentive Plan (the “2004 Plan”) which authorizes the issuance of up to 1,250,000 shares of common stock pursuant to the exercise or grant, as the case may be, of awards under such plan and the shareholders approved the 2004 Plan in 2005. The Company has granted shares with forfeiture restrictions (“restricted stock”) to certain directors, officers and associates under the 2004 Plan. The awardee is not entitled to the shares until they vest, which is generally over a one to five year period, but the awardee is entitled to receive dividends on and vote the shares prior to vesting. The shares granted do not have a cost to the awardee and the only requirement of vesting is continued service to the Company. Compensation cost related to restricted stock is calculated based on the fair value of the shares at the date of grant. If the awardee leaves the Company before the shares vest, the unvested shares are forfeited.

On February 22, 2012, the Company’s Board of Directors adopted the Prosperity Bancshares, Inc. 2012 Stock Incentive Plan (the “2012 Plan”), subject to approval by the Company’s shareholders. The Company’s shareholders approved the 2012 Plan at the annual meeting of shareholders on April 17, 2012. The 2012 Plan authorizes the issuance of up to 1,250,000 shares of common stock upon the exercise of options granted under the 2012 Plan or pursuant to the grant or exercise, as the case may be, of other awards granted under the 2012 Plan, including restricted stock, stock appreciation rights, phantom stock awards and performance awards. As of March 31, 2013, no options or other awards have been granted under the 2012 Plan.

The Company received $669.7 thousand and $1.9 million in cash from the exercise of stock options during the three-month periods ended March 31, 2013 and 2012, respectively. There was no tax benefit realized from option exercises of the share-based payment arrangements during the three-month periods ended March 31, 2013 and 2012.

As of March 31, 2013, there was $7.5 million of total unrecognized compensation expense related to stock-based compensation arrangements. That cost is expected to be recognized over a weighted average period of 2.0 years.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

9. CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ITEMS

Contractual Obligations

The following table summarizes the Company’s contractual obligations and other commitments to make future payments as of March 31, 2013 (other than deposit obligations). The payments do not include pre-payment options that may be available to the Company. The Company’s future cash payments associated with its contractual obligations pursuant to its junior subordinated debentures, Federal Home Loan Bank (“FHLB”) advances and long-term notes payable and operating leases as of March 31, 2013 are summarized below. Payments for junior subordinated debentures include interest of $47.8 million that will be paid over future periods. Future interest payments were calculated using the current rate in effect at March 31, 2013. The current principal balance of the junior subordinated debentures at March 31, 2013 was $85.1 million. Payments for FHLB borrowings include contractual interest of $8.2 million that will be paid over the future periods and excludes a $5.3 million premium. Payments related to leases are based on actual payments specified in underlying contracts.

 

     1 year or less      More than 1
year but less
than 3 years
     3 years or
more but less
than 5 years
     5 years
or more
     Total  
     (Dollars in thousands)  

Junior subordinated debentures

   $ 1,750       $ 4,666       $ 4,665       $ 121,771       $ 132,852   

Federal Home Loan Bank notes payable and other borrowings

     527,150         6,972         38,631         6,899         579,652   

Operating leases

     3,945         7,369         3,103         —           14,417   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 532,845       $ 19,007       $ 46,399       $ 128,670       $ 726,921   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Off-Balance Sheet Items

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

The Company’s commitments associated with outstanding standby letters of credit and commitments to extend credit as of March 31, 2013 are summarized below. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements:

 

     1 year or less      More than 1
year but less
than 3 years
     3 years or
more but less
than 5 years
     5 years
or more
     Total  
     (Dollars in thousands)  

Standby letters of credit

   $ 25,421       $ 5,445       $ 66       $ —         $ 30,932   

Commitments to extend credit

     370,725         292,672         63,018         260,642         987,057   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 396,146       $ 298,117       $ 63,084       $ 260,642       $ 1,017,989   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

10. OTHER COMPREHENSIVE (LOSS) INCOME

The tax effects allocated to each component of other comprehensive (loss) income were as follows:

 

     Three Months Ended March 31,  
     2013     2012  
     Before Tax
Amount
    Tax Benefit     Net of Tax
Amount
    Before Tax
Amount
    Tax Benefit     Net of Tax
Amount
 
     (Dollars in thousands)  

Other comprehensive loss:

            

Securities available for sale:

            

Change in unrealized gain during period

   $ (1,771   $ (620   $ (1,151   $ (1,185   $ (415   $ (770
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total securities available for sale

     (1,771     (620     (1,151     (1,185     (415     (770
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total other comprehensive loss

   $ (1,771   $ (620   $ (1,151   $ (1,185   $ (415   $ (770
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Activity in accumulated other comprehensive income, net of tax, was as follows:

 

     Securities
Available for
Sale
    Accumulated
Other
Comprehensive
Income
 
     (Dollars in thousands)  

Balance at January 1, 2013

   $ 8,986      $ 8,986   

Other comprehensive loss

     (1,151     (1,151
  

 

 

   

 

 

 

Balance at March 31, 2013

   $ 7,835      $ 7,835   
  

 

 

   

 

 

 

Balance at January 1, 2012

   $ 13,472      $ 13,472   

Other comprehensive loss

     (770     (770
  

 

 

   

 

 

 

Balance at March 31, 2012

   $ 12,702      $ 12,702   
  

 

 

   

 

 

 

11. ACQUISITIONS

Acquisition of East Texas Financial Services, Inc.On January 1, 2013, the Company completed the acquisition of East Texas Financial Services, Inc. (OTC BB: FFBT) and its wholly-owned subsidiary, First Federal Bank Texas (“Firstbank”). The acquisition is not considered significant to the Company’s financial statements. As of December 31, 2012, East Texas Financial Services reported, on a consolidated basis, total assets of $165.0 million, total loans of $129.3 million and total deposits of $112.3 million. The Company issued 530,940 shares of Company common stock for all outstanding shares of East Texas Financial Services capital stock, which resulted in a premium of $7.0 million. For the three months ended March 31, 2013, the Company incurred $36 thousand of pre-tax merger related expenses related to the East Texas Financial Services acquisition.

Acquisition of Community National Bank On October 1, 2012, the Company completed the acquisition of Community National Bank, Bellaire, Texas. The acquisition is not considered significant to the Company’s financial statements. As of September 30, 2012, Community National Bank reported total assets of $183.0 million, total loans of $68.0 million and total deposits of $164.6 million. The Company issued 372,282 shares of Company common stock plus $11.4 million in cash for all outstanding shares of Community National Bank capital stock which resulted in a premium of $10.6 million.

 

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PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(UNAUDITED)

 

Acquisition of American State Financial Corporation On July 1, 2012, the Company completed the acquisition of American State Financial Corporation and its wholly owned subsidiary American State Bank (collectively referred to as “ASB”). As of June 30, 2012, ASB, on a consolidated basis, reported total assets of $3.16 billion, total loans of $1.24 billion and total deposits of $2.51 billion. The Company issued 8,524,835 shares of Company common stock plus $178.5 million in cash for all outstanding shares of American State Financial Corporation capital stock, for total merger consideration of $536.8 million and a premium of $240.4 million.

Acquisition of The Bank ArlingtonOn April 1, 2012, the Company completed the acquisition of The Bank Arlington. The acquisition is not considered significant to the Company’s financial statements. As of March 31, 2012, The Bank Arlington reported total assets of $37.3 million, total loans of $22.8 million and total deposits of $33.2 million. The Company issued 135,347 shares of Company common stock for all outstanding shares of The Bank Arlington capital stock, which resulted in a premium of $2.8 million.

The following pro forma information presents the results of operations for the three months ended March 31, 2013 and 2012, as if the East Texas Financial Services, Community National Bank, ASB and The Bank Arlington acquisitions had occurred on January 1, 2012.

 

     Three months ended March 31,  
     2013      2012  
     (Dollars in thousands,
except per share data)
 

Net interest income

   $ 108,082       $ 116,912   

Net income

     49,305         48,689   

Basic earnings per share

     0.87         0.86   

Diluted earnings per share

     0.86         0.85   

12. SUBSEQUENT EVENTS

Acquisition of Coppermark Bancshares, Inc. - On April 1, 2013, the Company completed the merger with Coppermark Bancshares, Inc. and its wholly-owned subsidiary, Coppermark Bank (collectively referred to as “Coppermark”) headquartered in Oklahoma City, Oklahoma. Coppermark operated nine (9) full-service banking offices: six (6) in Oklahoma City, Oklahoma and surrounding areas and three (3) in the Dallas, Texas area. As of March 31, 2013, Coppermark reported, on a consolidated basis, total assets of $1.25 billion, total loans of $847.6 million and total deposits of $1.11 billion. For the three months ended March 31, 2013, the Company incurred $93 thousand of pre-tax merger related expenses related to the Coppermark acquisition.

Pursuant to the terms of the acquisition agreement, the Company issued 3,258,718 shares of Company common stock plus approximately $60.0 million in cash for all outstanding shares of Coppermark Bancshares capital stock, which resulted in a premium of $91.7 million.

 

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

Special Cautionary Notice Regarding Forward-Looking Statements

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

government intervention in the U.S. financial system;

 

   

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;

 

   

poor performance by external vendors;

 

   

the failure of analytical and forecasting models used by the Company to estimate probable credit losses and to measure the fair value of financial instruments;

 

   

additional risks from new lines of businesses or new products and services;

 

   

claims or litigation related to intellectual property or fiduciary responsibilities;

 

   

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;

 

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

 

   

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

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

Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the major elements of the Company’s interim consolidated financial statements and accompanying notes. This section should be read in conjunction with the Company’s interim consolidated financial statements and accompanying notes included elsewhere in this report and with the consolidated financial statements and accompanying notes and other detailed information appearing in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

OVERVIEW

The Company, a Texas corporation, was formed in 1983 as a vehicle to acquire the former Allied First Bank in Edna, Texas, which was chartered in 1949 as The First National Bank of Edna and is now known as Prosperity Bank. The Company is a registered financial holding company that derives substantially all of its revenues and income from the operation of its bank subsidiary, Prosperity Bank® (“Prosperity Bank®” or the “Bank”). The Bank provides a wide array of financial products and services to small and medium-sized businesses and consumers. As of March 31, 2013, the Bank operated two hundred fifteen (215) full-service banking locations throughout Texas. The Company’s headquarters are located at Prosperity Bank Plaza, 4295 San Felipe in Houston, Texas and its telephone number is (713) 693-9300. The Company’s website address is www.prosperitybankusa.com. Information contained on the Company’s website is not incorporated by reference into this quarterly report on Form 10-Q and is not part of this or any other report.

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

Three principal components of the Company’s growth strategy are internal growth, stringent cost control practices and acquisitions, including strategic merger transactions and FDIC assisted transactions. The Company focuses on continuous internal growth. Each banking center is operated as a separate profit center, maintaining separate data with respect to its net interest income, efficiency ratio, deposit growth, loan growth and overall profitability. Banking center presidents and managers are accountable for performance in these areas and compensated accordingly. The Company also focuses on maintaining stringent cost control practices and policies. The Company has centralized many of its critical operations, such as data processing and loan processing. Management believes that this centralized infrastructure can accommodate substantial additional growth while enabling the Company to minimize operational costs through certain economies of scale. During 2012, the Company completed four acquisitions including Texas Bankers, Inc., The Bank Arlington, ASB and Community National Bank. Combined these acquisitions added forty-one (41) banking centers. On January 1, 2013, the Company completed its acquisition of East Texas Financial Services, Inc. and on April 1, 2013 completed the acquisition of Coppermark Bancshares, Inc., which expanded the Company’s geographic footprint into the Oklahoma City, Oklahoma area.

Total assets were $15.08 billion at March 31, 2013 compared with $14.58 billion at December 31, 2012, an increase of $497.7 million or 3.4%. Total loans were $5.26 billion at March 31, 2013 compared with $5.18 billion at December 31, 2012, an increase of $83.1 million or 1.6%. Total deposits were $11.71 billion at March 31, 2013 compared with $11.64 billion at December 31, 2012, an increase of $71.6 million or 0.6%. Shareholders’ equity increased $60.1 million or 2.9%, to $2.15 billion at March 31, 2013 compared with $2.09 billion at December 31, 2012.

 

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CRITICAL ACCOUNTING POLICIES

The Company’s accounting policies are integral to understanding the financial results reported. Accounting policies are described in detail in Note 1 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012. 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.

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. The Company has the option to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining the need to perform step one of the annual test for goodwill impairment. An entity has an unconditional option to bypass the qualitative assessment described in the preceding paragraph for any reporting unit in any period and proceed directly to performing the first step of the goodwill impairment test. An entity may resume performing the qualitative assessment in any subsequent period.

If the Company bypasses the qualitative assessment, a two-step goodwill impairment test is performed. The two-step process 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.

Estimating the fair value of the Company’s reporting unit is a subjective process involving the use of estimates and judgments, particularly related to future cash flows of the reporting unit, discount rates (including market risk premiums) and market multiples. Material assumptions used in the valuation models include the comparable public company price multiples used in the terminal value, future cash flows and the market risk premium component of the discount rate. The estimated fair values of the reporting unit is determined using a blend of two commonly used valuation techniques: the market approach and the income approach. The Company gives consideration to both valuation techniques, as either technique can be an indicator of value. For the market approach, valuations of the reporting unit were based on an analysis of relevant price multiples in market trades in companies with similar characteristics. For the income approach, estimated future cash flows (derived from internal forecasts and economic expectations) and terminal value (value at the end of the cash flow period, based on price multiples) were discounted. The discount rate was based on the imputed cost of equity capital.

The Company had no intangible assets with indefinite useful lives at March 31, 2013. 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, 2012, management does not believe any of its goodwill is impaired as of March 31, 2013, because the fair value of the Company’s equity substantially exceeded its carrying value. While the Company believes no impairment existed at March 31, 2013, 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. 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. 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 including stock price volatility and employee turnover that are utilized to measure compensation expense.

 

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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.

Fair Values of Financial Instruments. The Company determines the fair market values of financial instruments based on the fair value hierarchy established which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. There are three levels of inputs that may be used to measure fair value. Level 1 inputs include quoted market prices, where available. If such quoted market prices are not available, Level 2 inputs are used. These inputs are based upon internally developed models that primarily use observable market-based parameters. Level 3 inputs are unobservable inputs which are typically based on an entity’s own assumptions, as there is little, if any, related market activity. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.

RECENT ACQUISITIONS

Acquisition of East Texas Financial Services, Inc.- On January 1, 2013, the Company completed the acquisition of East Texas Financial Services, Inc. (OTC BB: FFBT) and its wholly-owned subsidiary, First Federal Bank Texas (“Firstbank”). As of December 31, 2012, East Texas Financial Services reported, on a consolidated basis, total assets of $165.0 million, total loans of $129.3 million and total deposits of $112.3 million. The Company issued 530,940 shares of Company common stock for all outstanding shares of East Texas Financial Services capital stock, which resulted in a premium of $7.0 million.

SUBSEQUENT EVENTS

Acquisition of Coppermark Bancshares, Inc. - On April 1, 2013, the Company completed the merger with Coppermark Bancshares, Inc. and its wholly-owned subsidiary, Coppermark Bank (collectively referred to as “Coppermark”) headquartered in Oklahoma City, Oklahoma. Coppermark operated nine (9) full-service banking offices: six (6) in Oklahoma City, Oklahoma and surrounding areas and three (3) in the Dallas, Texas area. As of March 31, 2013, Coppermark reported, on a consolidated basis, total assets of $1.25 billion, total loans of $847.6 million and total deposits of $1.11 billion.

Pursuant to the terms of the acquisition agreement, the Company issued 3,258,718 shares of Company common stock plus approximately $60.0 million in cash for all outstanding shares of Coppermark Bancshares capital stock, which resulted in a premium of $91.7 million.

RESULTS OF OPERATIONS

Net income available to common shareholders was $49.3 million ($0.86 per common share on a diluted basis) for the quarter ended March 31, 2013 compared with $36.5 million ($0.77 per common share on a diluted basis) for the quarter ended March 31, 2012, an increase of $12.8 million or 35.1%. The Company posted returns on average common equity of 9.23% and 9.15%, returns on average assets of 1.33% and 1.39% and efficiency ratios of 42.40% and 42.23% for the quarters

 

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ended March 31, 2013 and 2012, respectively. The efficiency ratio is calculated by dividing total noninterest expense (excluding credit loss provisions) by net interest income plus noninterest income (excluding net gains and losses on the sale of securities and assets). Additionally, taxes are not part of this calculation.

Net Interest Income

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

Net interest income before the provision for credit losses was $108.1 million for the quarter ended March 31, 2013 compared with $81.8 million for the quarter ended March 31, 2012, an increase of $26.2 million or 32.1%. This increase includes $14.3 million related to purchase accounting accretion during the three months ended March 31, 2013. There was no purchase accounting accretion recorded during the three months ended March 31, 2012. The average rate paid on interest-bearing liabilities decreased 15 basis points from 0.57% for the quarter ended March 31, 2012 to 0.42% for the quarter ended March 31, 2013, while the average yield on interest-earning assets decreased 36 basis points from 4.03% for the quarter ended March 31, 2012 compared with 3.67% for the quarter ended March 31, 2013. The average volume of interest-bearing liabilities increased $2.84 billion and the average volume of interest-earning assets increased $3.92 billion for the same period. The net interest margin on a tax equivalent basis decreased 22 basis points from 3.64% for the quarter ended March 31, 2012 to 3.42% for the quarter ended March 31, 2013.

The following table sets forth, for each major category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest earned or paid on such amounts, and the average rate earned or paid for the quarters ended March 31, 2013 and 2012. The table also sets forth the average rate paid on total interest-bearing liabilities, and the net interest margin on average total interest-earning assets for the same periods. Except as indicated in the footnotes, no tax-equivalent adjustments were made and all average balances are daily average balances. Any nonaccruing loans have been included in the table as loans carrying a zero yield.

 

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     Three Months Ended  
     Mar 31, 2013     Mar 31, 2012  
     Average
Balance
    Interest
Earned/
Interest
Paid
     Average
Yield/Rate (4)
    Average
Balance
    Interest
Earned/
Interest
Paid
     Average
Yield/Rate (4)
 
     (Dollars in thousands)  

Interest-Earning Assets:

              

Loans

   $ 5,263,784      $ 81,464         6.28   $ 3,818,991      $ 53,217         5.60

Investment securities

     7,755,567        36,548         1.91     5,192,257        38,321         2.95

Federal funds sold and other earning assets

     34,793        19         0.22     126,154        78         0.25
  

 

 

   

 

 

      

 

 

   

 

 

    

Total interest-earning assets

     13,054,144      $ 118,031         3.67     9,137,402      $ 91,616         4.03
  

 

 

   

 

 

      

 

 

   

 

 

    

Allowance for credit losses

     (53,242          (51,601     

Noninterest-earning assets

     1,849,461             1,414,340        
  

 

 

        

 

 

      

Total assets

   $ 14,850,363           $ 10,500,141        
  

 

 

        

 

 

      

Interest-Bearing Liabilities:

              

Interest-bearing demand deposits

   $ 2,659,489      $ 2,210         0.34   $ 1,694,240      $ 2,063         0.49

Savings and money market deposits

     3,790,416        2,829         0.30     2,792,348        2,589         0.37

Certificates and other time deposits

     2,370,499        3,651         0.62     1,971,071        4,139         0.84

Securities sold under repurchase agreements

     448,542        292         0.26     53,304        37         0.28

Federal funds purchased and other borrowings

     358,120        362         0.41     272,760        279         0.41

Junior subordinated debentures

     85,055        605         2.88     85,055        663         3.14